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"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." - Warren Buffett
Do you want to learn how the best investors today make a fortune when everybody else is falling for Wall Street’s latest scam? Investors like Warren Buffett and Charlie Munger?
Anybody interested in value stock investing is quickly swept up in the Wall Street lead mill. This machine is designed to sell you subscriptions to advisory services proven not to beat the market.
Clever newsletter editors and CNN Money talk show hosts move from side-to-side faster than a Mojave sidewinder.
People end up confused as to what works and what doesn’t. The only sure thing is a loss. Some give up altogether.
Others wonder every-time they hear a feature story about famous value investors such as Warren Buffett. “Is it true?” they think. Do you ever feel like you have been hit with a data fire-hose? Does the vocabulary of finance make reading even the Wall Street Journal difficult at best?
This unique Udemy course on Value Investing is just for you!
This value stock investing course teaches you the underpinning of corporate finance that Warren Buffett learned under professor Benjamin Graham at Columbia University. All that is known of his “top-secret” strategies is disclosed in detail from actual reports to Berkshire Hathaway shareholders Buffett himself penned.
Other courses are based on hearsay and conjecture, this explores the subject of value investing in the most intimate detail with an extensive ebook, quizzes, guideposts and intuition to train you into an intelligent investor.
The curriculum starts with the most basic concepts of corporate finance, so that you build your knowledge in progressive layers. Warren Buffett value investing is a low-risk strategy where Berkshire Hathaway investors have enjoyed a 20% return on average over 30 years.
This allowed Donald and Mildred Othmer to accumulate a fortune of $210,000,000 in 1996 from an initial investment of $25,000 in 1960.
Upon successful completion of this course you will be able to:
✔ Know when to look for value stocks.
✔ Find 5-10 good Buffett stocks like a fine art collector
✔ Invest in Wall Street “risky” stocks Buffett considers safe
✔ Set yourself up for the possibility of consistent high returns by following Buffett’s writings
✔ Safeguard your retirement investing in value
✔ Understand why Buffett says that an indexed fund may be best for your family
✔ This is just the tip of the iceberg!
Enroll in this Value Investing course that actually teaches what Buffett has written.
I am not just a successful stock investor with 4 decades of proven experience but I also happen to hold a doctorate in the subject. -Doc Brown
Dr. Scott Brown, Associate Professor of Finance of the AACSB Accredited Graduate School of Business of the University of Puerto Rico.
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|Section 1: Doc Brown Welcomes you to Value Investing with Corporate Finance!|
Dr. Scott Brown explains how to get the most out of this course.
Think of this document as a CliffsNotes to the value investing classic "The Essays of Warren Buffet: Lessons for Corporate America" by Lawrence Cunningham and "Principles of Corporate Finance" 11th Edition by Brealey, Myers, and Allen.
Make sure you print. Read each chapter brief before watching the video lecture.
Then take the quizzes. Go back and study everything again if you score poorly on the quizzes.
|Section 2: The Adviata Vedanta of Value — An Interview with Dhando Investor Mohnish Prabai!|
The Adviata Vedanta of Value: an Expert Interview with Dhando Investor Mohnish Prabai
By Dr. Scott Brown and Daniel Hall, J.D.
Logic says that on any given year half of stocks will beat the averages.
Science has shown that just two efficiency anomalies guide investors to the highest market beating returns: value and momentum. The January size effect has drifted out of the data.
It gives us great pleasure to interview engineer Mohnish Prabia author of the Amazon bestseller "The Dhando Investor."
Mohnish is an astute engineer who acquired a small fortune selling his business. He parlayed his stakes by switching to money management. He is noted for paying $650,100 for lunch with Warren Buffet. This act of bravado won Buffet over as a friend and mentor.
It helps that Mr. Pabrai is very pleasant in person.
Today he manages just over a half a billion extending Warren Buffett’s value investment approach. Mohnish follows directly in the footsteps of legendary value investors Warren Buffet and Benjamin Graham. He extends a similar fee structure for clients charging no management fees but taking 25% of returns above a 6% threshold.
When I first met Monish all I knew was that he was an important money manager who was taking advantage of act 20 and 22 tax benefits.
He was hard to miss. He was a keynote speaker at the Puerto Rico Investment Summit 2015.
Daniel's plane arrived late. He had no time to change into a suit and it was getting late in the day. "Who do we have for the cover of Issue IV [of Momentum Investor Magazine]?" he asked. "Nobody" I responded.
We were standing in the lobby of the show when Patricia de la Haro of the DDEC directed us into the press interview room. Mohnish sat talking to a local reporter. Mr. Pabrai's Puerto Rican assistants buzzed about.
Suddenly he looked at me as if he expected something intelligent to come out of my mouth...
Scott: How did you start in business? How did you get interested in business? Were you always interested in it? As a child? From childhood?
Mohnish: Well, you know my father was an entrepreneur in India, and he had a number of ups and downs. So, he’d been bankrupt a number of times. But, every time he went bankrupt, and you know, the family would lose everything.
Scott: Yeah, I’ve been through it.
Mohnish: But I saw him repeatedly go to zero and then come up with a new idea and build a new business. And, he repeatedly said to me growing up that you could put him naked on a rock on some remote place with nothing and that he could come back.
Mohnish: When I grew up I saw so much volatility that I actually didn’t want to do business at all. When I graduated from engineering, I said “Okay, good. Now I’ve got a good job. I can stay at this company, and save some of the money, and everything will be fine…” My dad encouraged me to go from engineering into marketing because he thought that would be a better place for me. Then, when I moved, after that he said, “Well, it’s time to quit and start your own thing.” I said, “You know, have you forgotten…”
Scott: The pain!
Mohnish: Yes, the pain. I was already getting to the point where the work was getting to be very, kind of routine, monotonous and such. There was a business opportunity that looked interesting, so I took the plunge. And I’ve never looked back.
Scott: Wow, that’s interesting. So, how did you end up coming into Puerto Rico, what was the initial drive? Did you find out about it through the Internet, or how did it come to your attention?
Mohnish: I About a year ago we set up a new company, and we raised over $150 million from our investors. That company is going to make a number of investments and such and can do a variety of things. One of my investors, who had invested, said, “You know, maybe you should look into Puerto Rico.” He sent me a link to one of his presentations about it. So, I started to poke around and look at it. The more research I did, the more no-brainer it looked. And so, here we are…
Scott: What’s the worst day you’ve had in business after your dad set you out on that path, of owning your own business? I want to know what the worst day was, and then I’m going to ask you for the best day.
Mohnish: Well, the worst day, I think, was in 2004. You know, I run an investment company, and that investment company started in 1999, and in 2004, Forbes had done a profile on me and my Pabrai Investment Funds. The Funds had generated something like 35% a year after fees. I’m talking about ridiculous fees for investors. And, you know, in that period the markets had crashed. The NASDAQ was at a low level...I got a FedEx package at home one day. It was a letter from the SEC, which said “We have opened an investigation…”
Scott: Oh my!
Mohnish: I was reading the legalese in it, and at the end of the letter there was this lady who signed the letter and had given a phone number. So I called the phone number because I had no idea what was going on. She was shocked that I called. I said, “Well, I got a letter that has your number, and I’m calling because you sent me this letter, and…Did you not send the letter?” She said, “Yes I did, but I can’t talk to you.” So, I said, “Why can’t you talk to me?” She said, “Have your attorney call me.” I said, “He’s going to charge me.”
Scott: [Laughter over the "he's going to charge me" part.]
Mohnish: I said “This is free.” She said “I cannot talk to you, okay? Have your attorney call.” So, I contacted my attorney, and I sent them the letter. When I talked to my attorney after he read the letter and brought in one of their SECexperts. They said to me “Are you sitting down?”, and I said “Yes, I’m sitting down.” They explained that the SEC has opened what they call an investigation. "Okay?" I responded.
The attorney continued.
"When the SEC opens up an 'investigation,' they have five commissioners at the SEC, and one of them is the supreme commissioner. At least three of those five, they have to approve an investigation before it can start, which means that the letter that you received is not from some, you know, third-level down SEC person. It was approved by the commissioner at the highest level.
A formal investigation is done because they believe it’s fraudulent, and probably within hours or days, they are looking to shut you down."
So, I said “Why? I’ve done nothing wrong.” So, they said “Because they probably think that you’re a fallacy.”
Scott: Because of the returns…the high returns…?
Innocence Stains on S.E.C. Cross of the Wall Street Church of Efficient Markets!
Scott: No. That’s fantastic. Thank you. So, my next question is what’s been your best day? That’s got to be interesting because here you get out of engineering school, you fly into this shark pool, and you know, you’re terrified because you’ve seen your family knocked down before. What was your best day?
Mohnish: The best day was when I started a business, and when my father told me “I’m proud of you.” What I was doing was straddling. I had my job. I hadn’t quit my job, and I had started a company but I didn’t have any cash; I was running on credit cards. And so, I was working for 80 or 90 hours a week, right? For a 40 hour job, and another 50 hours on my business, and after about eight months of this activity, I got the first client.
And, the first client was massive in the sense that it was something like three quarters of a million dollars. I would end up making, probably at least $150,000, $200,000 profit on that. My salary was $45,000, right. So I remember…I just went into this meeting with the company CEO. And, the meeting lasted about six minutes. He asked me a bunch of questions. He said, “Outside my office is a purchasing guy, and I’ve instructed him to have a PO [purchase order] ready. Can you start in 10 days?” Okay?
And, I didn’t understand what was going on, but I walked out and he gave me this purchase order and I had this very high feeling because I knew at that point that I could quit. I was already dying to quit and the business was going to make it.
Mohnish: That was the best feeling…the complete opposite of the SEC.
Scott: That’s awesome. That’s awesome.
Daniel: May I ask a question? What advice would you give a Main Street versus a Wall Street, a Main Street investor? Your best advice.
Mohnish: Well, the best advice is extremely simple. A young guy once asked Charlie Munger, “Mr. Munger, how can I get rich?” So, people started laughing, and Charlie Munger said “The way to get rich is very simple.” He says, “Number one, consistently spend less than you earn.” He said that if you spend even 10-15% less than you earn, then invest that money in the low-cost index fund. He said, “You know, you do that for a lifetime, even if you don’t make much money, you’re going to wake up when you’re 70 and you’re going to be incredibly rich.”
Mohnish: That’s what I’m telling you, a Main Street investor.
Daniel: Thank you.
|Section 3: #1 - Where White People Keep Their Money|
Curtis Carroll faces a group of inmates in San Quentin explaining that the only difference between the wealthy and poor comes from just four steps. Each is simple …
Academic research has shown that families stewarded by people who have made money raise children who are far more likely to thrive financially. Unfortunately, Mr. Carroll was born into an Oakland family more akin to a ‘Breaking Bad’ episode.
His single mother and grandmother suffered addictions to crack. Curtis received little guidance from his elders. He wiggled his way out of homework rendering himself illiterate.
The only thing he learned was that he hated school. Curtis was eventually forced onto the streets with his brother at an early age — homeless.
A gang took him in. Then a robbery ended in murder.
Curtis Carroll has lived in jail for two decades since age seventeen. He has thirty-four years left on his sentence. The light at the end of his tunnel is two hundred dollars and a hard shove out of the prison gates.
“Do You Play Stocks?”
… a fellow inmate asked one day. Curtis was baffled. He listened intently as the man explained “This is where white people keep their money.” The conversation ignited Mr. Carroll’s definite major purpose of succeeding in equity investments.
To do so required the ability to read.
He focused his burning desire on deciphering popular t-shirts and wrappers of candy he ate.
As his literacy grew he consumed the financial media. The world of Wall Street came to absorb the attention of every fiber of his being. Curtis studied the market every day until collapse from exhaustion.
He recorded and tracked his stock picks on paper in an envelope stuck to his cell wall.
The San Quentin nickname of Curtis Carroll quickly became “Wall Street.” His following has grown.
Every Thursday night, according to National Public Radio (NPR), about a hundred inmates meet to hear his purely positive message that even though people are in prison that they are on the same ground as Warren Buffet. Inmates working with parents, siblings and spouses on the outside can invest in the same stock Buffet buys and sells. They can't buy as many shares, but they can buy shares in the same firms.
Warren Buffet’s Top 10 Stock Investing Rules
The San Quentin Freeman Capital financial literacy inmate group of Curtis “Wall Street” Carroll teaches wisdom straight from the lips of the Oracle of Omaha …
Warren Buffett doesn’t measure success in terms of a lavish lifestyle. He measures success by the degree to which he squeezes every drop of potential profit out of the investment portfolio he stewards.
He follows his own internal score-card. An ever frugal Buffett shuns glossy external displays (score-cards) of wealth commonly projected by Wall Street Fortune 500 CEOs.
Buffett's frugality rings true throughout the history of financial greatness.
Think and Grow Rich
At the turn of the last century the richest man in the world commissioned a young man with the unlikely name of Napoleon to document a universal philosophy of wealth. After decades of unpaid toil ‘Think and Grow Rich’ became an enduring best-seller that has inspired millions.
Case in point is another destitute lad, not unlike Mr. Carroll, who decided to shun poverty after reading a discarded copy of Think and Grow Rich.
W. Clement Stone had tired of throwing rocks at stokers tending steam locomotive coal tenders out of horror of the possible injury of others. He had been doing what he had to do to survive. This action helped his family heat their home in otherwise lethally cold northern winters with lumps of coal boiler-men threw back.
CEO Stone rose to great wealth at the top of the insurance industry teaching others to “Have the courage to say no. Have the courage to face the truth. Do the right thing because it is right. These are the magic keys to living your life with integrity.”
Curtis Carroll follows the same path as W. Clement Stone and Warren Buffett helping inmates guide family members on the outside to wise investment decisions. Mr. Carroll teaches in atonement of past destruction with hope that his paroled friends fall into the loving arms of wealthy families rather than badass gang-bangers.
Let’s Start Our Exploration of Value Investing with Economic Goodwill
Assets can be physical. These tangible assets are acquired through capital expenditures. Examples include plant, property, and equipment.
Ideas or the productive capacity of a workforce are not fixed or movable objects. These intangible assets are also acquired or developed through capital expenditures. Economic goodwill can emanate from a well trained workforce, loyal customers and patents as common examples.
But a company can have each of the above and yet display negative economic goodwill.
Goodwill is measured as the total purchase price of a company less the fair value of identifiable assets. This is normally amortized over 40 years with equal charges.
Buffet explains goodwill as follows,
“you can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and so shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission… for example, a business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T before the breakup, was generally well thought of, but possessed not a dime of economic Goodwill.)”
When Buffett used Blue Chip Stamps to acquire the candy company See’s in 1972 it paid $25 million for around $8 million in net tangible assets. Those assets produced $2 million in after tax earnings.
This was used as a conservative estimate of future earning power in constant 1972 dollars. The net present value of $2 million of annual excess return represents the economic Goodwill in the purchase of See’s.
Hence the purchase price Buffett paid for See’s was …
$25 Million Total Purchase Price = $8 Million in Net Tangible Assets + $17 Million in DCF
DCF is the discounted cash flow amount of $2 million as a perpetuity. To decide the amount to pay for See’s Buffet converted firm excess return into certainty equivalent cash flow.
This allows him to perform his capital budgeting simply with U.S. Treasury returns for discount rates. The process of deciding the best choice of tangible and intangible assets is known as capital budgeting.
This is the most important and rarest skill among CEOs in Fortune 500 companies today according to Warren Buffet. He seeks out high potential managers in companies who are masters of implementation of the methods your about to learn.
This is the basis for value investing.
Capital budgeting involves assessing choices against a hurdle rate of some kind to decide the bare minimum return a manager is willing to accept on a project. Ahurdle rate is also called a cost of capital.
I want to caution you that Charlie Munger has never seen Warren Buffett whip out a calculator or a spreadsheet. Clearly Buffett has a mental notion of the minimum productive potential of any firm he invests in even if largely non-numerical.
Investing in a new project is risky business for firm managers. The act of investment itself restricts opportunity. Capital in one project cannot be invested in another.
This creates a conflict that is measured by the opportunity cost of capital.
Regardless of the severity of such conflicts bottom line income is dictated by a list of financial claims management generates from the capital budgeting process. Tangible real assets are purchased through the sale of financial assets such as stocks and bonds.
Investors who purchase these financial assets hold claims as shareholders. In Germany the term stakeholder is used to denote the fact that shareholders are but one of many agents who can hold financial claims against bottom-line corporate profits.
The United States Fortune 500 business model focuses on protecting the shareholders. The main reason investors feel comfortable buying stocks and bonds of Fortune 500 companies is because liability is limited to investment.
And English common law that is the origin of the United States constitution confers the greatest property protection of stock investments of any country in the world. This is why capital flows to the United States as a safe harbor in financial storms.
The stock investments of the United States are the most legally protected for investors of any in the world. And the stock market itself offers additional advantages.
Savers have an opportunity to garner an expected return in stocks that is higher than that of any other capital market; bonds, commodities, or currencies.
The liquidity of the stock market is much higher than that of real estate. Investors can sell shares of Fortune 500 stocks for instantaneous cash.
Investors who know this structure their stock and bond portfolios to maximize wealth with the lowest risk of consumption restriction.
Shareholders want return on investment. The animal spirit desires leading to undeserved perquisites and pet projects of CEOs that do not increase shareholder wealth.
These agency problems create conflict between firm managers and shareholders. Conflicts don’t just arise solely from differences in objectives but also from inside information
Tangible and intangible products make up coarse differences in capital budgeting choices. Building out a series of new Denny’s restaurants would be an example of a tangible capital budgeting project.
The development of a new biotech patent and completion of the FDA approval process is an intangible capital budgeting project particular to the pharmaceutical field.
|Quiz 1||10 questions|
This quiz tests your knowledge of the 1st chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 4: #2 - Present Value Calculations Protect Buffett from Wasting on Worthlessness|
Buffett would never own a yacht. He says, "Most toys are just a pain in the neck."
Warren Buffett is successful because he spends far less than he earns. He lives in a modest home. He avoids expensive luxuries that don’t increase value. He never pays a luxury tag when he buys a car.
The manufacturer's suggested retail price (MSRP) of the Cadillac XTS is $46,290. This is the car that Warren Buffet bought in 2014. He didn’t buy the typical Fortune 500 CEO bling …
Each of these cars offer the same basic private transportation as Warren Buffett’s Cadillac. But the automobile that Buffett selects costs between half to a sixth of that of status conscious Fortune 500 CEOs. Ever wondered if you paid too much for your wheels?
Calculate true value the way Warren Buffet does before you enter the dealership.
Consumer reports offers valuable information to identify best value. Knowing fair price will make you the one-eyed-person in the land of the blind. All of your bargaining will revolve around the fair price. If you don’t get at least fair price you walk.
And what about winning the lottery? It probably won’t happen to you. But what if it does?
Understanding net present value (NPV) will give you a framework to correctly decide whether to take the lump sum or payments.
I have seen many families overpay for homes and rentals. Fair value shows you the right price to offer.
Get ready for lots of rejected offers. Stick at it and the ones you do pick up will be diamonds in the rough.
Delve into the wisdom behind the time value of money. This is easily calculated on the back of an envelope, cocktail napkin, spreadsheet, or financial calculator.
All you need is an understanding of the formula to punch the key that spit out fair values!
|Quiz 2||10 questions|
This quiz tests your knowledge of the 2nd chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 5: #3 - Bond Valuations Even Warren Buffet Pays Attention Too|
Buffett gives us a signal that he does occasionally use ratios when he writes,
“Investing in junk bonds and investing in stocks are alike in certain ways: Both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios. Purchasing junk bonds, we are dealing with enterprises that are far more marginal. These business are usually overloaded with debt and often operate in industries characterized by low returns on capital. Additionally, the quality of management is sometimes questionable. Management may even have interests that are directly counter to those of debt-holders. Therefore, we expect that we will have occasional large losses in junk issues. So far, however, we have done reasonably well in this field.”
My students are astounded to discover that many investors became rich at the turn of the century because of a market condition that is mysterious to most people. Long-term interest rates dropped below the money market yield in the year 2000.
One man who took notice was at the helm of PIMCO.
Bill Gross made a huge amount of money for his bond investors as interest rates dropped. Meanwhile most stock investors were hammered in the crash from 2000 to 2003.
The best bonds to buy and sell are issued by Fortune 500 firms.
This lecture explores key pricing relationships that give you vital market intuition on the same level as that of Bill Gross. This allows you to generate a matrix of different maturities and ratings to create a safe but surprisingly highly yielding corporate bond portfolio.
Benefits of bonds is not United States restricted. You will discover how French investors can buy and sell Euro Currency (EUR) denominated sovereign bonds.
This leads to an investigation of yen denominated Japanese country bonds. This is all done in the historic backdrop of interest rates from nineteen hundred forward.
You will know the direction bond prices must move as interest rates rise and fall. This allows you to insulate your bond portfolio from principal rate hike crunch-downs and default risk.
Duration is the length of time it takes to get your investment back out of a bond portfolio. Duration is easy to calculate for zero coupon bonds — it is equal to the maturity.
Buffett has few kind words for Fortune 500 issuers of zero coupon bonds when he writes,
“Neither our [zero-coupon] bonds nor those of certain other companies that issued similar bonds last year (notably Loews and Motorola) resemble the great bulk of zero-coupon bonds that have been issued in recent years. Of these, Charlie and I have been, and will continue to be, outspoken critics. As I will later explain, such bonds have often been used in the most deceptive of ways and with deadly consequences to investors. To these issuers, zero (or pay-in-kind PIK) bonds offer one overwhelming advantage: It is impossible to default on a promise to pay nothing.”
The premium tool for controlling downside risk in your portfolio is duration. Rising rate markets are more amenable to short-duration.
Falling rate markets are best for longer duration portfolios. Short duration allows you to simply wait a few years for repayment of your investment when rates go against you.
But this does not account for volatility. For that you will learn about modified duration.
I mentioned before that Bill Gross noticed the downward sloping term structure of interest rates in 2000. This structure conforms with the law of one price grounded in classical interest rate theory.
The term structure of interest rates can also be humped. These shapes are better described by the theory of expectation.
Interest rates should be nominally adjusted for inflation or deflation to reflect real impact to consumers. The real interest rate is surprisingly stable in the short term.
Nonetheless inflation should be tracked a hundred years or so. From this we know that inflation ramps up after war. Deflation craters in economic depressions.
You can also investigate the propensity for inflation by country. Finally bond yields are heavily influenced by credit ratings that measure default risk.
I am extremely pleased and excited that you have joined this investment management learning community on value investing and corporate finance. I started right where you are today looking for better ways to manage our money. That was decades ago before I earned my Ph.D. in finance.
I finished the #1 ranked program in international financial management per the U.S. News and World report.
When I looked back on what MBA course was most responsible for my success in business only one stood out: corporate finance. The course you have just completed allows you to understand financial information that is beyond the comprehension of the typical investor.
But there is much more to discover.
There are four courses that may interest you to round-out your education. Here is a super special tuition deal of $10. That is whopping $190 off the regular rate.
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We started years ago managing our money properly and the results have been astounding. I am here to help you make the same journey as us. Enroll today. Coupons are limited and do expire. -Doc Brown
|Quiz 3||10 questions|
This quiz tests your knowledge of the 3rd chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 6: #4 - Common Stock Valuation Used by Wall Street Analyst Funny-mentalists|
I am going to show you the most common models for mathematically calculating the value of common stocks. I want to warn you before I show you this that Warren Buffett never runs these calculations.
These models will give you an understanding of how Wall Street analysts set price forecasts based on earnings and dividends. This is the most basic form of stock analysis.
This applies equally to the secondary and primary markets where shares confer ownership.
Recent innovations in electronic trading through massive ECN communication networks and exchange traded funds allow you to add commodities and currencies to your Roth 401(k). This gives you a conceptual framework for deeper exploration into …
These variables allow you to construct DCF, the discounted cash flow formula. This equates the actual share price to paid outflows and earned inflows stretching forward in time.
Wall Street loves to split the price of rising stocks. Warren Buffett does not agree when he writes,
“We often are asked why Berkshire Hathaway does not split its stock. The assumption behind this question usually appears to be that a split would be a pro-shareholder action. We disagree. Let me tell you why. One of our tools is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. High quality ownership can be attracted and maintained if we consistently communicate our business and ownership philosophy — along with no other conflicting messages.”
The required market capitalization rates of return of the DCF model allow you to calculate the cost of equity capital of any Fortune 500 firm. Dividend payments can be crammed into an adjusted DCF approach called the dividend discount stock valuation model.
In this light the capitalization rate equates to dividend yield. This is used to sort the five higher expected return small dogs from the thirty Multi-National Corporations (MNCs) on the Dow index.
The theory of the present value of growth opportunity will shed light as to why some seemingly overpriced stocks perhaps are not. The sustainable growth rate will reign an uptrend in as a firm matures and plowback and return on equity (ROE) ratios drop.
A closely related concept is that of preferred stocks used to interlock boards. Buffett writes, “The preferred-stock structures will provide a mediocre return for us if industry economics hinder performance of our investees, but will produce reasonably attractive results for us if they can earn a return comparable to that of American industry in general.”
|Quiz 4||10 questions|
This quiz tests your knowledge of the 4th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 7: #5 - More Funny-mentalist Valuation Models Warren Buffett Never Uses|
Academics love the net present value model as the Pope loves the Catholic church. The problem is that Charlie Munger admits that he has never seen Warren Buffett use neither spreadsheet nor calculator to estimate fundamental value.
This is likely due to the complexity of the models. The more complex the mathematical model the more possible answers.
It is clear that none of these models are useful to Warren when Buffett writes,
“Whenever Charlie and I buy common stocks for Berkshire’s insurance companies we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
When a large capital budgeting project has unrealistic inputs and market variables valuation models become shockingly imprecise. Nonetheless these models can be very effective when dealing with small projects with few inputs and market variables.
In this case the NPV is superior to Pay-Back. That is why even Warren Buffett consults bond prices calculated from net present value (NPV) where the initial investment in the bond is added to discounted future cash flows that are certain. Buffett also consults yield to maturity that is calculated via the internal rate of return.
Deal negotiations like Pay-Back can be calculated in the head. And although NPV is exactly precise Pay-Back is reasonably precise in a number of situations.
A good example of where Pay-Back is not only useful but also commonly used is when assessing a fair offer for a real estate rehab-flip.
|Quiz 5||10 questions|
This quiz tests your knowledge of the 5th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 8: #6 - Value Investing in Residential and Commercial Real Estate|
Warren Buffet equates real estate values to economic goodwill when he writes,
“In character economic goodwill does not, in many cases diminish. Indeed, in a great many instances — perhaps most — it actually grows in value over time. In character, economic goodwill is much like land: The value of both assets is sure to fluctuate, but the direction in which value is going to go is in no way ordained. At See’s for example, economic goodwill has grown, in an irregular but very substantial manner for 78 years.”
The trick to succeeding as a real estate investor is to see the clear and present application of both the net present value (NPV) and internal rate of return (IRR) Formula in both commercial and residential real estate.
The more deals you do, the better you will get. You will have more data and more knowledge of doing deals.
Do your best to get it right each time. Bring your ‘A’-game every day you work your real estate business.
But double-check your offers within a time value of money framework.
This will insure that you start to notice and track all of your associated expenses. Focus on key neighborhoods.
Commercial property is affected by more factors. A deal in commercial real estate requires more detailed NPV analysis.
Always remember that whomever does the most real estate deals and survives wins. The real estate investors with the most experience make the most money in any metropolitan statistical area (MSA).
|Quiz 6||10 questions|
This quiz tests your knowledge of the 6th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 9: #7 - The Highest Expected Returns of any Investment Are in Common Stocks!|
Warren Buffett berates academics when he writes that they,
“like to define investment ‘risk’ relative volatility as compared to that of a large universe of stocks and then build arcane investment and capital-allocation theories around this calculation.” He explains that it is better to get things more-or-less right rather than exactly wrong.
He explains that Washington Post had dropped very sharply as compared to the indexes when he bought it in 1973. The capital asset pricing model portrayed the stock as far riskier.
Buffett saw himself as “offered the entire company at a vastly reduced price.”
The main concern about the widespread use of modern portfolio theory a “beta purist” ignores any detailed analysis of the business model of the company with regard to products, services, competitors and debt. Warren Buffett on the other hand seeks to obtain an intimate knowledge of the business with regard to (1) the certainty of the long-term economic goodwill (discounted earnings) in terms of (3) the transparency and (3) integrity of management in light of the (3) purchase price of the firm and finally (4) taxes and inflation that erode investing capital over time.
The skinny low-down is that stocks offer higher passive returns than real estate, forex, futures, or bonds. Studies by Fama and French (2012), Asness et. al. (2013) and Barber et. al. (2013) updated the expected returns for different types of investing. Nobel Laureate Bob Shiller has shown the returns to real estate investors to be zero. Here are the tallies.
Investors in the United States have enjoyed above average nominal returns in the past. Other countries that have rewarded investors well at times include Australia, Finland, Japan, Germany, France, Italy, and South Africa.
Stock returns and dividend payments have been highly volatile back to the year nineteen hundred. Stacking up annual stock returns in a histogram shows that the stock market goes into a tail-spin 25% of the time.
Historical return volatility is measured with variance and the square root; standard deviation. This allows you to calculate portfolio risk where you will discover a rise in major index risk for the last hundred years…
The lowest risk equity markets by this measure are in the United States, United Kingdom, Canada, Australia and New Zealand. All are sovereign societies of English common law origin.
The introduction of covariance allows you to calculate beta. This is the lens for understanding diversification as well as firm unique and general market risk.
Unique risk drives the high returns of anomalies such as momentum. Diversification pulls unique risk out leaving lack luster returns for index investors.
Another problem with index diversification is that it exposes investors to what Warren Buffet calls the institutional imperative problem of corporate hubris and inefficiency that plague most companies. This can be a “cut-of-the-pie” managerial approach to capital rather than a focus on the returns to investors. Old management and staff has a tendency to resist change. Corporate CEOs have too much control over employment of capital in bad projects. Finally, the blind imitation of competitors dramatically hampers business. This is why Buffett and Munger focus their investments on companies that are actively monitoring for these problems.
|Quiz 7||10 questions|
This quiz tests your knowledge of the 7th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 10: #8 - The Church of Market Efficiency and the CAPM Modern Portfolio Theory|
The Pet Rock made a lot of money for somebody but only for a short period of time. Meanwhile Barbie Dolls have been selling since March of 1959. The Barbie Doll is a product with a durable advantage. Not so for the Pet Rock. Buffett writes,
“in many industries, of course, Charlie and I can’t determine whether we are dealing with a ‘pet rock’ or a ‘Barbie.’ We couldn’t solve this problem, moreover, even if we were to spend years intensely studying those industries. Sometimes our own intellectual shortcomings would stand in the way of understanding, and in other cases the nature of the industry would be a roadblock. For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. We’ll stick to easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight? If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you.”
Portfolio return changes with every additional stock added or deleted. This allows a range of return possibilities that when ordered fall under a bell curve.
The log-normal distribution of stock returns makes the true curve look flatter than a bell.
The two stock portfolio from the last lecture is readdressed to see the return relationship with risk. This example is extended to a 10 stock portfolio that closely approximates portfolios that balance risk with return.
The efficient portfolio is that which gives you the best profit for the lowest risk along an efficiency frontier.
A treasury bill or a certificate of deposit at an international bank is close to risk free. This allows you to borrow or lend to expand your opportunity set of possible portfolios.
You will see how risk progressively reduces as you start with one stock and add more. Each portfolio has a different pattern of risk to return.
The Sharpe ratio allows you to precisely measure this relationship as a ratio of return to risk. The most efficient portfolio is the one with the highest Sharpe Ratio.
The only quadrant the efficient portfolio does not span is that of high risk with low return in the upper left.
This gives rise to the SML. This security market line has most recently been characterized as …
The last three are CAPM anomalies. Such simple to construct portfolios should not cough up such high returns.
These offer acid-test benchmarks for fund managers, stock analysts, and investment newsletter editors who claim to beat the market.
Finally, see how the arbitrage pricing theory (APT) of Ross allows analysts to string any combination of factors they believe to offer positive abnormal expected returns in a regression model like lights on a Christmas tree.
Warren Buffett paints a bleak reality of how ineffectively most Fortune 500 CEOs use these models in mergers and acquisitions when he writes,
“Some extraordinary excesses have developed in the takeover field. We have no desire to arbitrage transactions that reflect the unbridled — and, in our view, often unwarranted — optimism of both buyers and sellers. In our activities, we will heed the wisdom of Herb Stein: 'If something can’t go on forever, it will end.'"
The buyers and sellers Buffett refers to are corporate Fortune 500 managers who get bonuses on each side of the table for putting the deal together at the expense of shareholders.
This allows him to discuss the efficient market theory (EMT) of which the apex is the capital asset pricing model (CAPM) when he writes,
“The preceding discussion about [risk] arbitrage makes a small discussion of ‘efficient market theory’ (EMT) also seem relevant. This doctrine became highly fashionable — indeed almost holy scripture — in academic circles in the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects as good as one selected by the brightest, most hard-working security analysis. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between the two propositions is night and day.”
He concludes with,
“In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp., Buffett Partnership, and Berkshire illustrates just how foolish EMT is. While at Graham-Newman, I made a study of its earnings from [risk] arbitrage during the entire 1926-1959 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffet Partnership and then Berkshire. I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben; he had 1929-1932 to contend with.)”
|Quiz 8||10 questions|
This quiz tests your knowledge of the 8th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 11: #9 - Warren Buffet Say’s CEOS Cheat at Cost of Capital and Get Away with It|
There are certain signs that management does not care about shareholders. Warren Buffet explains that,
“when available funds exceed needs [expenditures needed to maintain competitive position or optional outlays that management expects will produce more than a dollar of value for each dollar spent], a company with a growth oriented shareholder population can buy new businesses or repurchase shares. If a company’s stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been pursued. Indeed, during the 1970s (and, spasmodically, for some year thereafter) we searched for companies that were larger repurchases of their shares. This often was a tipoff that the company was both undervalued and run by a shareholder-oriented management.”
Buffett continues in explaining why this strategy does not work today,
A big part of the reason economists love Net Present Value (NPV) calculations is because of the mathematical property that the formula is additive. This is due to the fact that the value of any firm is simply the sum of assets both now and projected into the future.
One view of the cost of capital is the discount rate that equates firm in and out-flows to zero NPV. This is the company cost of capital.
The intuition is that any project must earn more than company cost of capital as a minimum hurdle rate. Otherwise the new idea would be unprofitable.
Some projects require higher hurdle rates than the company cost of capital. This happens when one or more divisions are in industries where the typical firm has higher earnings than the parent.
To correct this problem, analysts break up a large conglomerate or multi-national corporation (MNC) into stand-alone businesses. Then they will use the typical beta for that industry with any necessary firm specific adjustments. For this reason, Fortune 500 accountants and analysts define project specific hurdle rates that ignore the firm cost of capital other than as a lower threshold.
The reason Warren Buffett makes bold statements implying that CEOs cheat at the cost of capital and get away with it is because he himself never calculates it. In fact, his partner Charlie Munger freely admits “I’ve never heard an intelligent cost of capital discussion.” If Buffet discounts at all it is with the risk free rate of long maturity U.S. Treasuries.
Buffet shuns complicated calculations of firm and project cost of capital. I ask you this, “how is it possible that the confusing calculations the majority of Fortune 500 CEOs love to banter about are in any way reliable?”
A Fortune 500 accountant measures value by balance sheet book worth. His or her job description is to report the cost of assets to firm managers (insiders) or shareholders (outsiders).
Financial analysts use market values. Shareholders want to know how many cents per dollar they are likely to recover in bankruptcy.
Varied clientele perspectives require very differing accounting reports of the same public company. Each is correct depending on the lens used to interpret the data.
Each is part of a very big puzzle in determining the true value of the firm. Analysts use the market price of new debt issuance in weighted-average cost of capital (WACC) estimations.
The cost of issuing more stock is then estimated using the capital asset pricing (CAPM) model looking back over 60 months (5 years) of total returns. An alternative way to estimate the cost of equity issuance is with the Stephen A. Ross arbitrage pricing model. Dr. Ross is the MIT Sloan School of Management Franco Modigliani Professor of Financial Economics. Myron Gordon at the University of Toronto developed a third alternative method of estimating the cost of equity through his discounted cash flow model [DCF].
Fortune 500 Analysts will calculate all three models because each is derived from different data. Buffet doesn’t use any of them.
He focuses on businesses he knows like the back of his hand. This allows him to project future cash-flows with enough confidence to treat the most conservative estimate as a certainty equivalent.
This makes the valuation buffet uses as easy as straight bond valuation.
Accounting book values don’t reflect the market price of equity or debt that the firm would actually have to pay to raise more capital for a new project. Market values are the prices the firm will have to pay to issue new securities from a shelf registration of common stock or corporate bonds.
But the ratio of book to market values is an interesting barometer of the degree to which a stock might be under or over-valued. However, it is a rough filter at best that must be augmented with the ability to assess the business quality of any firm displaying unusually high book to market ratios.
The eventual mix of stocks and bonds issued to capitalize new projects and operations is the capital structure of the firm.
The security market line (SML) is often used to determine the required rate of return on projects. Market versus company returns are plotted across the x and y axis where the fitted slope is beta.
This can be done with a simple financial calculator.
The video lecture estimates beta for a large Fortune 500 bank from the United States. Then you walk through three other large stocks.
It is impossible to precisely determine the slope of a fitted line at any point. It moves around too much over time in natural phenomenon such as that of the stock market. But statistical analysis does offer a range of values within which the rise over the run must exist.
This is called the standard error of beta.
Firms shift between different risk classes as beta (the slope) moves around over five years in an example I show you. You can chop the company up into components that make up sub-industries and generate asset betas. That is because betas — like NPV — are mathematically additive.
This also means that economic goodwill is additive. Economic goodwill, as you remember, is the present value of excess earnings after taxes produced by tangible or intangible assets.
Another factoid regarding beta is that it is low for debt and high for equity in a healthy company.
Asset betas cluster between high for equity and low for debt. Beta is clearly dependent on capital structure.
Capital expenditures (CAPX) intended to improve operational efficiency have little risk and hence low betas.
Asset betas can also be calculated on revenues as well as assets. These can be used in lieu of equity betas when not available or obtainable.
Any variable cost will have a negative beta. But here is a trick question, “what is the beta of a fixed cost?”
High fixed costs are commonly associated with lots of corporate debt. An example are cruise lines who finance floating cities that run at a fixed cost by issuing corporate bonds.
Managers can find themselves in situations where the cash flow from existing operations is certain. The CEO of Apple is reasonably certain of the number of computers to be sold into the next quarter. This same CEO may also face additional opportunities that are not certain but offer a higher expected return.
In this case the certainty equivalent cash-flow would be that of existing computer revenues. Then the analysts use a risk-adjusted discount rate to more deeply discount the riskier cash flows for reporting to other managers and shareholders.
The idea is to use this Fortune 500 tool to show other insiders (or outsiders) that a bird in the hand is worth two in the bush. Some managers simply give a haircut to CAPM numbers to account for any oversight in risk and cash flows are more uncertain.
Another arena where certainty equivalence is useful is for planning swaps and forward rate agreements (FRA). Calculating present values is simple risk-free discounting when you know the certainty equivalent cash-flows for a project.
Certainty equivalent cash-flows are hard to estimate. But if you can derive them you don’t need to know the cost of capital.
A “moat” of competitive (comparative) advantage around a firm increases the certainty of cash flows. Would a child in your family accept anything but a Barbie from Hasbro?
Warren Buffet has such a deep command of Berkshire Hathaway businesses that does not need to quote a cost of capital. He and Charlie Munger have never had intelligent conversations with other Fortune 500 CEOs regarding the cost of capital because none of them know their certainty equivalent cash-flows like Warren Buffet does!
|Quiz 9||10 questions|
This quiz tests your knowledge of the 9th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 12: #10 - A Core Skill Warren Buffet Does Not Expect the Typical American CEO to Kno|
This entire course has focused your attention on the Midas touch that, according to Warren Buffett, but a tiny fraction of Fortune 500 CEOs possesses. Business skills at the top are capital budgeting based. This is what he means when he states that “many people who are smart, articulate and admired have no real understanding of business” with regard to directors.
Warren Buffett writes about pervasive Fortune 500 corporate hubris as follows, “(1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction, (2) corporate projects will materialize to soak up funds, (3) any business craving of the leader (CEO), however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops, and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”
Buffett is describing what the typical Fortune 500 CEO calls professional project management. This is taught to MBA students as capital budgeting. And the most lacking skill among Fortune 500 CEOs today is capital budgeting laments Warren Buffett.
But just what is capital budgeting? A list of projects under choice of the CEO is known as a capital budget.
And for that reason multiple cash-flow assessments are produced by the troops the CEO assigns to the project team. Warren Buffett ignores all of this. But you need to understand this corporate shell game so that you can avoid the ways investors are deceived.
A dazzling array of cash flow estimates are used based on the
These are all strung together to generate sensitivity analysis that is intended to be convincing to anybody who does not agree with the CEO. Reports are created in spreadsheets where readers can see the effect of changing a variable one-by-one. Then readers are shown a simulation where all of the variables change in the way that the team expects — and assuages the ego of the typical Fortune 500 CEO. Post-audit reviews are employed to monitor how well the actual returns of the project matches forecasts.
if the project goes sour the CEO is ejected with a lottery like payout from a golden parachute. The next CEO moves in and the cycle repeats in Fortune 500 firms with chronic organizational behavior problems.
I used to ride around the island of Crete in Greece on a moped. The moped was invented in Sweden when somebody slapped a motor on a bicycle.
In highly congested cities with high population density a moped is the fastest way to work. And they are the cheapest to own for agile young workers.
This is why mopeds are very popular in Japan’s congested population dense cities. The video lecture walks you through a capital budgeting example of a potential project to build mopeds for the Japanese market.
A decision tree allows managers to perform sensitivity analysis over time as different outcomes unfold. As possibilities unfold into reality some choices are no longer available even as new options appear.
Option pricing theory allows managers to value each outcome and choice. There are four forms of real options in an example of a major shipping company used as an example in the lecture.
Any of these features present in an existing project increase the real option value. Remember that not all projects come with the option to abandon, expand, repurpose, or time entry.
Each branch in a real option decision tree has a specific associated probability. Weighted net present value (NPV) is calculated for each branch from the distal point backward.
The main lesson of this lecture is that as dazzling as all this seems, Warren Buffett won’t read these types of studies performed by the typical Fortune 500 CEO and his or her cronies.
|Quiz 10||10 questions|
This quiz tests your knowledge of the 10th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 13: #11- How Comparative Advantages Keep Berkshire Hathaway CEOs Out of Trouble|
Warren Buffet goes to great lengths to focus on simple businesses like See’s candy that produce one simple product with slight variations. He gives the example,
“The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie. But it’s quite possible for ordinary investors to make such distinctions if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness. Obviously every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.”
My life in corporate finance started as a research assistant for finance professor Eric Powers at the University of South Carolina. One of the first things I learned to do when assessing Fortune 500 value is to filter away the financial firms.
Eric explained that a company is supposed to be designed around a tangible or intellectual product because these expand the real economy. They also offer the highest potential NPV. Financial firms do nothing for the economy.
Hence I never invest in financial firms from Goldman Sachs to Citibank. That has turned out to be wise in light of the opacity of the derivative contracts both organizations have been caught dealing in.
Buffett takes great pains to understand industries that are simple to his intellect and background. Then he identifies the very few firms in those industries that have a comparative (competitive) advantage.
This is in alignment with the behavior of excellent managers hundreds of year ago in Europe. David Ricardo was the first academic to point out that managers should choose capital budgeting projects with the highest comparative advantages.
He scaled that idea up to show that this forces politicians of entire countries to do the same with trading partner countries.
Warren Buffet writes about this process,
“if you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices — the business he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”
Don’t think that Buffett recommends holding five to ten stocks. He doesn’t.
In fact, he buys more the righter he is. In the 1960s he became so convinced of the potential of American Express that he used 40% of Berkshire Hathaway capital to buy it.
Statistics professor Ziemba of UBC has concluded that Buffett follows a Kelly criterion rather than diversified modern portfolio theory.
Warren Buffett is an excellent example of a good manager who assesses market values under the microscope of common sense for making strategic capital budgeting decisions in a way that compliments rather than detracts from shareholder wealth.
Forecasting errors are the biggest problem with rigid numerical calculations of NPV. Most managers are overly optimistic due to poor calibration from little or poor job experience.
They underestimate the detrimental impact of even small competitors.
This is another mistake that leads to mergers and acquisitions that destroy, rather than enhance shareholder value. Discounted cash flow analysis becomes wildly wrong with incorrect forecasts.
One way to verify NPV forecasts is to compare with the source and value of economic rents of each. Economic rents that are large enough give rise to competitive advantages.
Rents arise from higher quality, lower price, barriers to entry or some other mechanism that makes it hard for a competitor to enter. Economic rent is measured as excess profit above capital costs.
Rents decline over time which is why good managers seek out new or improved products and markets. Good managers hate competition.
In a fully competitive market no economic rent exists.
Prudent managers look first to market values when estimating economic rent. Business people with the most experience know the most about market values.
This is why Buffett seeks out proven management. He frequently buys into family companies and leaves proven management in place.
A new up and coming manager in this regard with the same strategy is Marcus Lemonis. His T.V. show 'The Profit' consists of weekly case studies in capital budgeting.
|Quiz 11||10 questions|
This quiz tests your knowledge of the 11th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
|Section 14: #12 - Why Warren Buffett Considers CEO Incentive Bypass Problem Pervasive|
Warren Buffet writes to his shareholders that
“Charlie and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations. We’ve read management treaties that specify exactly how many people should report to any one executive, but they make little sense to us. When you have able managers of high character running businesses about which they are passionate, you can have a dozen or more reporting to you and still have time for an afternoon nap. Conversely, if you have even one person reporting to you who is deceitful, inept or uninterested, you will find yourself with more than you can handle. Charlie and I could work with could double the number of managers we now have, so long as they had the rare qualities of the present ones.”
A form of deceit Warren Buffett sees are Fortune 500 CEO using projects as incentive bypass vehicles. This problem occurs when a CEO is disinterested in maximizing the wealth of shareholders.
They can use projects to tunnel Fortune 500 lifestyle perks ranging from half million dollar automobiles to multi-million dollar airlines with expensive supermodels for attendants. They do this by using their capital budgets as camouflage for sacking shareholder invested savings through personal extravagances paid by the firm.
These agency problems of management misfeasance and perquisite malfeasance lead to poor stock performance at the cost of shareholders. This is a public crime against millions of hard working households spread across the land working, saving, and investing with implicit trust in management.
A CEO who violates shareholder trust through excessive perks is nothing more than a common criminal. Managers are just plain bad who harm company value through sloth, temerity, turf battles, inefficient expansion of personnel, employment guaranteeing projects, and value destroying mergers.
Shareholders acting through an independent board-of-directors attempt to mitigate these Fortune 500 inefficiencies through incentivize plans and constant monitoring of progress.
High ranking managers are more likely to be risk takers since the meek don’t move up the corporate ladder. Stock option grants can help incentivize good managers to seek risks since a rising share price increases premium value.
Such strategies that are instigated as a gamble for redemption can magnify a pre-existing loss where the manager leaves his or her job for another as share prices plummet. Entire organizations have been caught engaging in value destroying activities with short-term payoff.
Watch the movie “The Big Short” for a description of the subprime crisis instigated by corrupt credit rating agencies and all of the major investment banks on Wall Street. Still no subpoenas.
There is a balance between monitoring and agency cost. That is because monitoring managers in itself is costly.
But each has been caught in scandals. Take for example KPMG involvement with insider trading in Herbalife in light of what you now understand about agency problems. It is easy to understand why Warren Buffett does not trust the capital budget reports of the majority of Fortune 500 CEOs.
The auditors have been caught reinforcing corporate lies rather than uncovering them for shareholders. When big 4 auditors are doing the job such activities are reported through a recommendation in a qualified opinion letter.
This is amended to financial statements by SEC law. Analysts flag the company as mismanaged if managers ignore the qualified opinion letter.
Lenders in the form of banks and bondholders are other agents who monitor firm performance.
Shareholders sell out when a company is clearly mismanaged. Finally, a poorly managed company can become victim to a predatory buyout by competitors.
In short the gist is that managers are extremely hard to monitor. The best signal for value investors is negative price impact.
This condition occurs when a graph of share price slopes downward in response to high volume.
Most companies try to align the interests of the CEO with shareholders. This is most commonly done with options awarded by the compensation committee. Warren Buffett has noticed that too many compensation committees are under direct or indirect control of the CEO.
This is another clear agency conflict despite Securities and Exchange Commission (SEC) and NYSE regulations that require compensation committee directors to be independent.
Accounting measures are widely known to be distorted by book values from depreciation that is not economically meaningful to investors since asset values do not change. Stern-Stewart developed an economic value added (EVA) benchmark of CEO performance that is designed to enhance accounting metrics of complicated valuation scenarios.
This has become popular because EVA tracks shareholder value and rewards performance. But EVA is no panacea. It also has disadvantages when compared to customary accounting metrics of performance.
EVA is based on economic income which is the cash flow less economic depreciation.
In closing, I wish to shed additional light on the portfolio management procedure used by Warren Buffett. He locked up 40% of Berkshire funds in the 1960s in one position in American Express.
Professor Ziemba of the University of British Columbia has identified this as Kelly criterion behavior. I only partially agree because of this passage of a letter to shareholder by Buffett,
“Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than The Inevitables. But I would rather be certain of a good result than hopeful of a great one. Of course, Charlie and I can identify only a few inevitables, even after a lifetime of looking for them. Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish Survival of the Fittest as almost a natural law, most do not. Thus, for every Inevitable, there are dozens of Imposters, companies now riding high but vulnerable to competitive attacks. Considering what it takes to be an Inevitable, Charlie and I recognize that we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty. To the Inevitables in our portfolio, therefore, we add a few “Highly Probables.” You can, of course pay too much for eventhe best of businesses. Overpayment risk surfaces for even periodically and, in our opinion may be quite high  for the purchasers of virtually all stocks, The Inevitables included. Investors making purchases in an overheated market need to recognize that it may take an extended period for the value of even an outstanding company to catch up with the price they paid.”
This indicates that Buffet (1) buys in low markets after a crash rather than at the top of a bull market and (2) that even though he was initially willing to go nearly all in on Amex that he operated more as an extremely picky art collector moving forward. And in that way was able to string together an amazing collection of outstanding companies bought dirt-cheap! -Doc Brown
|Quiz 12||10 questions|
This quiz tests your knowledge of the 12th chapter of the 'Principles of Corporate Finance' text by Brealey, Myers and Allen 11th edition (my hard-core value investing students can get it on Amazon).
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Investment Writing and Speaking:
I am an internationalspeaker oninvestments. In 2010 I gave a series of lectures onboard Brilliance of the Seas as a guest speaker on their Mediterranean cruise. Financial topics are normally forbidden for cruise speakers. But with me they make an exception because of my financial pedigree.
On day 6 the topic I discussed was “Free and Clear: Secrets of Safely Investing in Real Estate!“ The day 7 topic was “Investment Style and Category: How the Stock Market Really Works!” Then on day 8 I spoke about “The 20% Solution: How to Survive and Thrive Financially in any Market!” The final talk on day 11 was “Value Investing for Dummies: When Dumb Money is Smart!”
Gina Verteouris is the Cruise Programs Administrator of the Brilliance of the Seas of Royal Caribbean Cruise Lines. Regarding my on-board teachings she writes on June 19th, “You have really gone above and beyond expectations with your lectures and we have received many positive comments from our Guests.”
I sponsored and organized an investing conference at Caesars Palace in Las Vegas in 2011 under my Wallet Doctor brand. This intimate conference was attended by 14 paying attendees.
As such many strides were made in financial education that week. For instance I met a woman who is a retired engineer from the Reno, Nevada area.
She made a fortune on deep in the money calls during the bull markets of the 90s.
This humble and retired engineer inspired me to look more seriously at deep in the money calls with far expiration. She also gave me an important clue regarding trading volume.
Her call option and volume insights have been confirmed in the Journal of Finance.
In 2012 I gave a workshop at the FreedomFest Global Financial Summit on stock investing at the Atlantis Bahamas Resort. I was also a panelist on a discussion of capital markets.
My course “How to Build a Million Dollar Portfolio from Scratch" at the Oxford Club is an international bestseller. In 2014 I co-authored “Tax Advantaged Wealth” with leading IRS expert Jack Cohen, CPA. This was the crown jewel of the Oxford Club Wealth Survival Summit.
I have been a regular speaker at the Investment U Conferences.
In 2012 I gave a workshop entitled “How to Increase Oxford Club Newsletter Returns by 10 Fold!” The conference was held at the Grand Del Mar Resort in San Diego, California. This resort destination is rated #1 on TripAdvisor.
In 2013 I spoke at the Oxford Club’s Investment U Conference in San Diego California. The talk was entitled “The Best Buy Signal in 103 Years!” Later in the summer I spoke at the Oxford Club Private Wealth Conference at the Ojai Valley Inn.
This was at the same time that Jimmy Kimmel married Molly McNearney in the posh California celebrity resort. It was fun to watch some of the celebrities who lingered.
I also operate a live weekly investment mentorship subscription service under the Bullet-Proof brand every Monday night by GoToWebinar.
I am an associate professor of finance of the AACSB Accredited Graduate School of Business at the University of Puerto Rico. My research appears in some of the most prestigious academic journals in the field of investments including the Journal of Financial Research and Financial Management. This work is highly regarded on both Main Street and Wall Street. My research on investment newsletter returns was considered so important to investors that it was featured in the CFA Digest.
The Certified Financial Analyst (CFA)is the most prestigious practitioner credential in investments on Wall Street.
Prestigious finance professor Bill Christie of the Owen School of Business of Vanderbilt University and then editor of Financial Management felt that our study was valuable to financial society. We showed that the average investment newsletter is not worth the cost of subscription.
I am the lead researcher on the Puerto Rico Act 20 and 22 job impact study. This was signed between DDEC secretary Alberto Bacó and Chancellor Severino of the University of Puerto Rico.
(See Brown, S., Cao-Alvira, J. & Powers, E. (2013). Do Investment Newsletters Move Markets? Financial Management, Vol. XXXXII, (2), 315-338. And see Brown, S., Powers, E., & Koch, T. (2009). Slippage and the Choice of Market or Limit orders in Futures Trading. Journal of Financial Research, Vol. XXXII (3), 305-309)
I hold a Ph.D. in Finance from the AACSB Accredited Darla Moore School of Business of the University of South Carolina. My dissertation on futures market slippage was sponsored by The Chicago Board of Trade. Eric Powers, Tim Koch, and Glenn Harrison composed my dissertation committee. Professor Powers holds his Ph.D. in finance from the Sloan School of Business at the Massachusetts Institute of Technology [MIT]. Eric is a leading researcher in corporate finance and is a thought leader in spin offs and carve outs.
Dr. Harrison is the C.V. Starr economics professor at the J. Mack Robinson School of Business at Georgia State University.
He holds his doctorate in economics from the University of California at Los Angeles. Glenn is a thought leader in experimental economics and is the director of the Center for the Economic Analysis of Risk.
Tim Koch is a professor of banking. Dr. Koch holds his Ph.D. in finance from Purdue University and is a major influence in the industry.
My dissertation proved that under normal conditions traders and investors are better off entering on market while protectingwith stop limit orders. The subsequent article was published in the prestigious Journal of Financial Research now domiciled at Texas Tech University — a leading research institution.
I earned a masters in international financial management from the Thunderbird American Graduate School of International Business. Thunderbird consistently ranks as the #1 international business school in the U.S. News & World Report, and BloombergBusinessWeek.
I spoke at the 2010 annual conference of the International Association of Business and Economics (IABE) conference in Las Vegas, Nevada. The research presented facts regarding price changes as orders flow increases in the stock market by advisory services.
I spoke at the 2010 Financial Management Association [FMA] annual conference in New York on investment newsletters. The paper was later published in the prestigious journal “Financial Management.”
I presented an important study named “Do Investment Newsletters Move Markets?” at the XLVI Annual Meeting of the Consejo Latinoamericano de Escuelas de Administración (CLADEA) in 2011 in San Juan, Puerto Rico. The year before that I presented my futures slippage research at a major renewable energy conference in Ubatuba, Brazil.
I spoke at the Clute International Conferences in 2011 in Las Vegas, Nevada. The research dealt with the price impact of newsletter recommendations in the stock market.
I presented a working paper entitled “The Life Cycle of Make-whole Call Provisions” at the 2013 Annual Meeting of the Southern Finance Association in Fajardo, Puerto Rico in session B.2 Debt Issues chaired by Professor LeRoy D. Brooks of John Carroll University. Luis Garcia-Feijoo of Florida Atlantic University was the discussant. I chaired the session entitled “Credit And Default Risk: Origins And Resolution.” Then I was the discussant for research entitled "NPL Resolution: Bank-Level Evidence From A Low Income Country" by finance professor Lucy Chernykh of Clemson University and Abu S Amin of Sacred Heart University and Mahmood Osman Imam of the University of Dhaka in Bangladesh.
That same year I presented the same study to the Annual Meeting of the Financial Management Association in Chicago, Illinois. I did so in session 183 – Topics in Mergers and Acquisitions chaired by James Conover of the University of North Texas with Teresa Conover as discussant. I chaired session 075 – Financial Crisis: Bank Debt Issuance and Fund Allocation. Then I was the discussant for TARP Funds Distribution: Evidence from Bank Internal Capital Markets by Elisabeta Pana of Illinois Wesleyan University and Tarun Mukherjee of the University of New Orleans.
I am a member of the MBA Curriculum Review Committee, the MBA Admissions Committee, The Doctoral Finance Admissions Committee, the Graduate School Personnel Committee, and the Doctoral Program Committee of the School of Business of the University of Puerto Rico.
I am the editor of Momentum Investor Magazine. I co-founded the magazine with publisher Daniel Hall, J.D. We have published three issues so far. Momentum Investor Magazine allows me to interview very important people in the finance industry. I interview sub director Suarez of the DDEC responsible for the assignment of Puerto Rico act 20 and 22 licenses for corporate and portfolio tax reduction in the third edition. Then I interview renowned value investor Mohnish Prabia in the upcoming fourth edition — to be made available via Udemy. Valuable stock market information will be taught throughout.
In October of 2010 I arranged for the donation to The Graduate School of Business of the University of Puerto Rico of $67,248 worth of financial software to the department that has been used in different courses. This was graciously awarded by Gecko Software.
I have guided thousands of investors to superior returns. I very much look forward to mentoring you as to managing your investments to your optima! –Scott
Dr. Scott Brown, Associate Professor of Finance of the AACSB Accredited Graduate School of Business of the University of Puerto Rico.