Pearl Invest

“Many people believe that the stock exchange is some kind of a casino and the only way to make money is to buy a stock cheap and to sell it to a higher price. Worse still is that many of these people also believe that you can get rich at the stock exchange very quick, they buy a stock because they believe that it´s gonna triple within the next weeks. However unfortunately that doesn´t work in most instances and in the end the people often sell their stocks with a loss.

That´s really stupid because in being interested in participating in the earnings of a company these people prefer to play a game with many other idiots who all evaluate the worth of the company every single day. Warren Buffett once said that when he buys a stock he actually never wants to sell it again. But what does he mean with this statement ? How can you make money at the stock markets when you don´t sell your stocks again ? The answer is you buy stocks with a high dividend yield.

In September 2008 for example Warren Buffett bought Goldman Sachs Goldman Sachs stocks at 115 USD. Actually now he could sell these stocks again and make a profit of 55 %. But he won´t do that, because Goldman Sachs pays him a dividend of 10 % on his stocks year for year for year. So Warren participates in the earnings of Goldman Sachs instead of taking care what others would pay for his shares.

Another fact is that a constantly high dividend yield is always a good sign for a sound company, because if a company is able to pay it´s investors a high dividend it has made high profits. Also Warren Buffett once said: “If a business does well, the stock eventually follows.” So if a dividend is getting higher and higher every year it´s a sign that the profits of the company are also getting higher and higher every year, which leads to a higher stockprice.

Last but not least there are many studies which underlie that stocks with a high dividned yield perform better than the total market.

One of Warren Buffett´s ways to success is the enormous concentration on a special industry. Bill Gates a good friend of Warren always wanted him to buy Microsoft stocks in the 90´s. We all know that the investment in Microsoft stocks wasn´t a bad one in the year 1990 and although Bill Gates the CEO of this Microsoft was a good friend of Warren, he did´t want to have them.

The reason for that was because the stocks were not in Warren´s sphere of competence. In Warren Buffett´s view every good investor should have a personal sphere of competence. This sphere of competence includes the industries and types of securities the investor is quite good at. Warren Buffett for example is at home in the insurance sector the consumer industry and the food industry and he would never buy a stock of a industry he doesn´t know.

In Warren Buffett´s view it doesn´t depend on the size of the sphere of competence of an investor it depends on the knowing the borders of your sphere of competence. This proceeding has several advantages:

1. It´s much easier to predict the trend of the industry you invest in.

When you are at home in a special industries, you know the effects of external happening on it. For example when you are at home in the chemistry industry you know that a high oil price could affect that hole industry in this or that way. When you are at home in the auto industry you know that a high or weak dollar could have this or that effect on the industry.

2. It´s easier to compare companies witch each other and to say if a company is under or overvalued.

Nowadays it´s very hard to say what´s the worth of a company. Of course we could easily have a look into the balance sheet and calculate the net asset value of the company, but there are always stocks of industries which cost a multiple of what they really earn and what their real net asset value is. Stocks of the IT industry for example usually cost a multiple of what stocks of the food industry cost. The reason is because people belive that the growth opportunities are the best there. So, when you are at home in a special industry you can compare companies which each other and you can say weather the company is cheap or not.

Warren Buffett once said: “Be fearful when others are greedy and greedy when others are fearful”, as I explained in chapter I the irrational Mr. Market, sometimes the estimations of companies are just irrational and do not reflect the true value of a company. This is because the people are too greedy when the price levels are high, because they also want to benefit however they are also too fearful when price levels are low because they already lost money or heared that others did that.

After the fall of Lehman there were a lot of stocks which had been terrible cheap just because the people were fearful that the company could also fall under chapter 11. One of these stocks for example was Las Vegas Sands NYSE:LVS. Sands had to stop their projects in Macao because they ran out of liquidity. The stock felled from 138 $ and a market capitalization of 91 BN $ in the year 2007 to a terrible low value of 1.77 $ and a market capitalization of 1.16 BN in 2008. Although Sands had big losses it was really not very sound that the worth of a company collapsed from 91 BN to 1.16 BN within one year. Today the sands stock has recovered to 15 $ again which is a plus of nearly 900 % from the low of 2007.

But the question I ask myself is are there sill any hot deals we can profit from ? To answer this question we should take a look at the sector the crisis rampaged best. The financial sector.

I took a look at this sector and found 4 stocks which could be interesting.

1. AIG Current Price 40.05

2. Fannie Mae Current Price 1.77 $

3. Freddie Mac Current Price 1.97 $

4. AMBAC Current Price 1.64 $

All of these stocks have nearly lost more than 90 % of their former market capitalization. The first 3 of them received a lot of help from the government and the net asset value of these companies is horrible. This is one side, but the other side is that the risk of a insolvency of one of this companies is not as high as many people think ( except Ambac perhaps ) and the bargains of these companies are still working. So I would recommend to have an eye on these stocks because in my opinion they are cheap enough to be the pearls of the month.

Price Earnings Ratio (P / E Ratio) :

The price earnings ratio or p / e ratio provides information about the earnings of a company in relation to the stock rate respectively the market capitalisation of a company. The p / e ratio is interesting in order to get information about the how much profitability you get for your dollars. A rule of thumb implies that a p / e ratio of 15 is optimal a p / e ratio above 20 implies that the company is too expensive or we could say overvalues and a p / e ratio under 10 is too cheap respectively implies that a company is often in trouble.

Ways to calculate the p / e ratio:

For example, if a stock is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined p / e ratio (usually shown as Not applicable or “N/A”); sometimes, however, a negative p / e ratio may be shown.

Another way to calculate the p / e ratio would be:

For example if the value of the market capitalisation of a company is 1 million $ and the total annual earnings amount to 100000 $ the p / e ratio is 10.

But we have to be careful by using the p / e ratio because of several reasons.

1. When the p / e ratio of a company is very low it´s often the case the earnings of a company are going to fall and drag the low p / e ratio below.

2. The values the price earnings ratio is calculated on are mostly values from the past which don´t reflect the current situation of the company anymore.

However what is the p / e ratio good for ?

The p / e ratio is always interesting when we want to have a quick and dirty look at the current estimation of a company. At the times of the dot-com bubble in the year 2001 we could see many estimations where the p / e ratio was above 100. That means that the expectations to a company are very high, but the real earnings of a company didn´t correspond this high expectations, yet (in the most cases it´s also not very likely that they ever will). So the p / e ratio can give us quick information weather a stock of a company is undervalued or overvalued.

In this Chapter we want to discuss why value investing works, but at first I want to do a little experiment. Image we trow a coin 6 times and everytime we do that we either get head (H) or a number (N), so what do you think which sequence is more likely to appear ? (H), (H), (N), (H), (N), (N)   or  (H), (H), (H), (H), (H), (H) the fact is that they are statistically completely similar. So what we can learn from this experiment is that the most people, despite they are well in numbers and stochastic would say that the first sequence is more likely to happen, because for them it´s not sound that the head of the coin appears six times in a row.

However why is this experiment interesting in order to understand why value investing works ? Well because that shows us that humans have their own subjective view of how the things are and these views are reflected in the sometimes strange movements of the stock markets. The Israeli psychologist Daniel Kahneman for example has won the Nobel price in economics for his work on behavioral finance, in which he discovered that irrational movements of the markets are the result of the collaborative opinions of single persons. Benjamin Graham the spiritual founder of the modern value investing described this phenomena with the help of the insane Mr.Market. He wrote, imagine there is a guy who comes to your home every day, just to tell you the price of your stocks. Actually this is a fine thing wouldn´t there be the fact that Mr.Market has a serious problem, because sometimes he is far too optimistic and tells you that your stocks will reach the heaven soon. And sometimes he is so the most depressive man in the world and predicts that your stocks will be worth nothing anymore soon. What Mr.Graham describes is just the behavior of the crowds. When they see that the markets are going up they want to participate on that, but when they see that the markets are falling they are feared to loose their money and start to sell their securities.

In order to explain how the reactions of the average investor are I took the following 10 years chart of the German stock index DAX.

1. The average investor starts to buy mostly overvalued stocks because he wants to participate at the rising markets.

2. The rally is over and the most winnings of the most average investors are zero again.

3. The average investor thinks that this was just a little break of the rally and buys again.

4. The markets are crashing the average investor sells his stocks and is frustrated.

5. Because the average investor is frustrated from his losses he made in 2003 his just starts to buy stocks in the year 2007 again and the whole game starts from scratch.

So the reason why value investing works is that value investors don´t care about subjective market fluctuations. Everything which counts for them are objective facts about the companies they buy. So the company is in their opinion undervalued because the for example the market capitalisation is worth far less than the actual assets of the company are.  Actually they don´t care about stock rates, because they know that they struck a bargain and on the long run the market will realize that.

The genius investor Warren Buffett once called it “buying one dollar for 70 cent”, the Margin of safety which was developed by the brilliant man Benjamin Graham in 1934. The precept of the margin of safety is very logic and works as follows.

Most people believe that the stock markets are rational, so that the stock-rate always reflects the actual value of a company. But that´s not true , you can prove that very easily. We you look back to the big ups and downs in times of a market crash. It´s definitely not logical that a company looses 60 % of its value and wins 120 % back in a short period of 2 years while the earnings constantly grow by 5 %. So we can conclude that the markets are irrational because sometimes the people become too afraid and sell very cheap stocks and sometimes they are just too optimistic and buy too expensive stocks. It´s not very intelligent but most people like to follow the herd.

But now, let´s get back to the margin of safety. If you know that the stock markets are irrational then why don´t make profit of it? First you look for very unpopular “cheap” stocks, the market capitalisation has to be far below the intrinsic value. That could be companies in trouble, after they reported bad news or complete industries with problems.

Now you calculate the value of the company in order to do that you can use different methods. 1. The Earning-capacity value 2. The Net asset value 3. The liquidation value. So for example, if you calculated that the intrinsic value of a company has the value of 100 Million USD, but the market capitalisation just lies at 70 Million USD, you get a margin of safety of 30% or 30 Million USD. You buy this stock and when the market capitalisation achieves the intrinsic value again you sell it.

Note: The margin of safety has not to be exactly 30 percent, but the higher it is the safer is the investment.