A. Five years ago, if you asked me to name two arcane financial subjects that I’d probably never hear discussed in a diner in the Keys, I’d have said ‘credit default swaps’ and ‘trading algorithms.’ During lunch at Mangrove Mike’s in Islamorada a year ago, however, I first overheard someone mention swaps. If that shocking 1,000 point drop in the Dow Jones last Thursday was any indication, you may soon become familiar with the term “high frequency trading,” too.

High frequency trading or HFT is many things – including another example of how Wall Street is more interested in being a casino than a steward of wealth. Simply put, HFT is stock trading done by blazing fast computers at Wall Street firms – some of which are located literally right next to the computers that drive the NYSE and NASDAQ. The powerful algorithms on these HFT machines can create and change orders for stock in milliseconds. It is believed that a handful of HFT firms now account for half of all trading volume on the nation’s stock exchanges.

The problem is that through loopholes in the rules, high-speed traders get an early glance at how others in the market are trading. Seems odd, no? After all, if you learn a big secret about a company, trade on that secret, and then make money a month later, it’s considered insider trading and you’d go to jail. When HFT firms get to peek at the buys and sells of others in the market and then make their own trades split seconds later, however, it’s condoned and encouraged by the major stock exchanges. Not only that, HFT machines routinely take advantage of slower traders…or, in other words, us.

Why the loopholes? The exchanges say to “create liquidity,” or to ensure that large investors can buy or sell positions quickly. As you might have guessed, though, the exchanges also earn fees for allowing sneak peeks.

Did a HFT glitch cause the historic crash of last week? Officially, it remains to be seen. Candidly, though, I’ve got a hunch.

Q. What exactly did Goldman Sachs do to get into such trouble?

A. Late last week, the country’s premier investment bank Goldman Sachs was accused of securities fraud in a civil suit filed by the Securities and Exchange Commission. The SEC claims Goldman created and sold a complicated mortgage investment that was covertly designed to fail.

The investment that Goldman sold to investors was called a synthetic collateralized debt obligation, or CDO, which is essentially a bet on another bet tied to a bundle of very low quality mortgages. Goldman appears to have tricked investors into believing the CDO was being managed by people who wanted mortgage holders to keep making their payments, when in reality it was secretly created by a hedge fund that was the world’s biggest short-seller in the subprime mortgage market. Those guys badly wanted the mortgage holders to default, and they did. Investors lost over $1 billion, while the short-seller made a profit of $1 billion.

Why would Goldman do this? Fees – both from their own role in structuring the deal, as well as those paid by the hedge fund for other services it may have had Goldman provide. Whether or not Goldman made money by actively betting against the same bad CDOs they secretly helped create remains to be seen.

The case is significant for a number of reasons. The first is – and there is really no pleasant way to put this – the SEC has been a consistently horrible regulator for quite some time now. Pursuing this case against Goldman may mean the agency has finally found a spine. It also means the odds of serious financial reform just increased dramatically because Goldman can no longer push back.

This case highlights a major flaw in the business models of Wall Street banks, too. Namely, they treat their customers atrociously. The ultimate outcome of this case is in some ways immaterial. Everything you could ever want to know about how dishonest a big Wall Street bank can be is summarized in this case. And it is far more damaging than a lawsuit could ever be.

“In August 2008 my oldest daughter was 18 and in her first year of college. I sat down and drafted a one page list of what I thought at the time were timeless pearls of money wisdom and gave her the list. It was based on 20 plus years of personal experience and education regarding money management. Anyhow, I came across it last night and after reading it, I still think it represents timeless personal financial planning wisdom. I thought of you and I’ve attached a copy for you. I’m sure it’s pretty basic stuff for someone who manages money for a living but I thought you might like to see what type of advice some parents give to their teens.”

Here was Neal’s list:

-Save first, spend later: have emergency savings, retirement savings, and investment savings plans.

-Pay yourself first, live on what’s left: use automatic investments direct from pay or checking account.

-Live within your means: don’t try to compete with others.

-Be frugal, but not stingy: avoid wasting money.

-Diversify between and within investment classes.

-To excel at something, immerse yourself: educate yourself on whatever you invest in.

-Swear off debt: borrowing money is like wetting the bed, it may feel warm at first but the cold reality hits in soon.

-Do what you love: find work in something you love and it’s more like a hobby than work; there are few things worse than getting up everyday and going to a job you don’t enjoy just because you need the money.

-Know where your money goes: track income and expenses closely and analyze the results periodically.

-Equities build wealth: it’s the best way to build wealth over time.

-Money can’t buy happiness.

-Don’t get too good at the wrong stuff: be good at something that will get you noticed and that has a future for either growth or advancement.

-You can’t reliably beat the market; use index funds and take the average.

-Take risks where you can within your personal risk tolerance: greater risk normally means greater returns, but not always.

-If you can’t afford to lose your investment, don’t invest, save.

-Tap the power of compounding: start saving early.

-Carry small amounts of pocket cash and use small bills to avoid feeling wealthy which may deter needless impulse buying.

-One credit card maximum: for emergencies only and then pay off the balance each and every month.

-You can’t fight the market so join it; use index funds.

-Buy low, sell high: have a target buy price and sell price with reasons for both, and stick to it.

-Don’t follow the herd: if it makes sense for you, do it even if it runs counter to the crowd.

-You don’t know more than the market knows: use index funds.

-The less you pay, the more you keep: look for low costs or fees and/or tax free or deferred investments.

-Always get it in writing.

-Leave your money alone: rebalance your investment portfolio once a year.

-Invest for the long term: stay the course.

-Be humble about what you don’t know: don’t be afraid to ask questions.

-Develop a healthy skepticism: if it sounds too good to be true, it probably is.

-Be careful of the people you trust since by definition they are the only ones that get the chance to screw you.

-Ignore short term market swings: avoid trying to time the market, you can’t.

-Nobody plans to fail, but many people fail to plan: make one and stick to it.

-Real estate has been the secret to getting rich for centuries.

-Avoid speculation: don’t buy anything you don’t want or sell anything you don’t have.

-You can’t get something for nothing.

-Character, not assets, counts the most in the end: don’t lie, cheat or steal.

I think it’s great. What do you think?

A. You may be the kind of person who likes to dabble in stocks. Perhaps you buy a few shares without doing research just because it gives you a thrill. Or maybe you have a small amount to invest and can’t see the point of putting in 40 hours of research to buy $50 worth of shares.

While I don’t want to discourage anyone from investing in stocks, one of the prerequisites should be that you understand how to read a company’s financial statements. If you don’t, that’s a pretty good sign you need some help when investing. If you can read the financials, there are a handful of things you can check fairly quickly that will help identify certain red flags. Below are seven of them. They are not fool-proof ways to spot fraud by any means, but they can be useful in abbreviated reviews.

1. A company’s earnings should be consistent with its operating cash flow. The two won’t be equal but they should move in the same direction and to a similar degree. Watch out if earnings grow much faster than cash flow for an extended period of time.

2. Be skeptical if current assets other than cash are growing. Keep a close eye on increases in inventories and/or accounts receivable compared to sales.

3. Make sure you understand the rationale behind any impairments or write-offs that are particularly large or recurring.

4. Any accounting policy changes should be explained simply and in a straightforward manner.

5. Depreciation and amortization practices should be consistent among competitors. Deferring these expenses over longer than usual periods of time is one way to artificially inflate profits.

6. Watch for dramatic changes in reserves against bad debt. This can signal deterioration in the quality of current assets.

7. Understand how the company makes money. If you can’t explain this to a five-year-old, it may be a fairly complicated business – and that could mean there is more room for management to play games with the financial statements.

A. You’re in luck, dear readers. There is simply no way to teach balance sheet analysis in a 350-word column. The official definition of “current liabilities” itself is 200 words long. My hunch is that many of you would rather get a hot poker in the eye, anyway.

Fortunately, there are many resources out there for the motivated investor – the best being Graham and Dodd’s Security Analysis. I’ll cover just a few highlights here.

And rest easy, math-phobes. There is only one equation you need to remember: Assets = liabilities + shareholders’ equity. Or, the stuff on the left must equal the stuff on the right, so the two sides “balance.” Hey, nobody hires accountants for their creativity.

The balance sheets of companies in the finance, utility and railroad industries are a bit specialized. Most retailers and manufacturers, however, use fairly consistent terminology and formatting. At a high level, then, on the left side are assets, or what the company owns; on the upper right side are liabilities, or what the company owes; and on the lower right side is shareholders’ equity, or what has been invested in the company. Liabilities are listed above equity on the balance sheet to remind you that the debtors have a higher claim on assets than stockholders. So don’t get too cocky. Also remember that a balance sheet is a snapshot at a given point in time, not a record of changes.

In his book, Ben Graham summarized a key point in balance sheet analysis: “The liabilities are real, but the value of assets must be questioned.” Except for cash, the value of assets is often up to management’s accounting philosophies. The value of liabilities is not subjective, however, and it’s usually not worth the effort to scrutinize shareholders’ equity. So to analyze balance sheets well, focus on assets.

While the balance sheet can be a strong indicator of the health of a business, it’s also backward-looking. It doesn’t tell much about future income. We’ll get to that next.

Q. What does it mean to “short” a stock?

A. Buying stock in anticipation of it going up, the way most people traditionally think about investing, is considered “going long.” Shorting is a way to profit from the decline in a stock’s price. Here’s an example.

For several years, Captain Jack noticed an increasing number of passengers wearing brightly-colored, odd-looking shoes called Gatorz. A few weeks ago, Jack noticed a sudden decline in the number of tourists wearing the shoes. He thinks the fad has finally passed, and as a result he expects the company’s stock price to fall.

Jack calls his brokerage and tells them he wants to short ten shares of Gatorz (ticker: CLOG). The brokerage then “borrows” those ten shares, typically from another investor who owns them, and immediately sells them into the market at the current price, in this case, $20. The proceeds from the sale, totaling $200, are then deposited as cash in Jack’s brokerage account.

A week later, Gatorz reports its quarterly earnings and, sure enough, sales of its footwear have completely tanked. The stock falls from $20 to $5. Jack “covers” his short by buying shares on the open market to replace the ones he borrowed from his brokerage. Because Jack shorted CLOG at $20 and covered when it fell to $5, he made $15 per share, or $150 total.

Shorting is similar to asking your brokerage for a loan – only the loan is made in stock, not dollars. When done as part of a traditional long portfolio, shorting can help you profit from both rising and falling stocks. Shorting also comes with some risks, however.

Because a stock’s price can theoretically rise forever, your losses from shorting could be unlimited. Being short also means you’re fighting the general long-term trend of the market, not to mention the effort of a company’s management team. In addition, if the stock you shorted pays dividends, you’ll be required to pay them. For those reasons, shorting is usually better left for professional investors.

Next week I’ll discuss naked shorting. You know you can’t wait.

The Quality of Earnings in 2009

Most investors probably would not think that something as straightforward as the definition of a company’s earnings could be controversial. Welcome to Wall Street, where obfuscation is intentional, clarity is rare and earnings are not always earnings.

Publicly traded companies in the U.S. are required to publish their financial results in accordance with generally accepted accounting principles, or GAAP. A company’s profit under GAAP rules is considered
to be “reported earnings.” However, many companies emphasize a different version of earnings to their investors. Management teams often refer to “operating earnings” under the pretense of better
capturing the underlying trends in their businesses.

That idea makes sense when intentions are sincere. Referring to operating earnings in lieu of true reported earnings isn’t necessarily a bad thing, as the GAAP definition of earnings does include some slop. More specifically, GAAP earnings can include items such as write-offs, gains on asset sales, restructuring charges and goodwill write-downs that are one-time events with no bearing on the company’s core operational results. So when it comes to gauging a company’s true progress, GAAP earnings aren’t perfect.

The problem with relying on adjusted operating earnings, however, is that they can be seriously misleading. There is no industry standard that defines the term. Management teams can literally exclude whatever they’d like to in the operating earnings figures they publish.

An overemphasis on operating earnings, sometime called “Street earnings,” “core earnings,” or “pro-forma earnings” is not new. Analysts usually exclude items that are not part of a company’s normal operations in analyzing the businesses they follow. Since the early 1990′s companies have often emphasized operating earnings over reported earnings to their investors.

What is new, however, is that the operating earnings of many public companies now appear to be either excluding items that they should not be or that are not really non-recurring – to a historic degree.

In other words, companies are claiming things that happen routinely are one-time events in order to prop up the earnings figures they highlight to their investors.

Lately, many individual investors have felt pressure to get back into the market out of fear they will miss out on further gains. Much of that motivation is fueled by pundits and talking heads insisting that “the market is still cheap based on historical earnings.” Investors should understand that while the market as a whole may be attractively priced based on operating earnings, it’s a far different picture when
looking at companies’ true earnings.

The difference between true earnings and operating earnings has never been bigger than it is right now. Standard & Poor’s recently reported that GAAP earnings per share for the 500 biggest public companies is $7.21 per share, while operating earnings are $61.20. That $54 gap is an all-time record.

Why does it exist? Much of it can be explained by huge write-downs in the financial sector in addition to a high degree of write-offs in other industries address as more companies deal with their own impaired assets, too. Job cuts and declining production explains more of the gap. But to be clear, some companies appear to be abusing the notion of operating earnings, too.

Take the case of Alliance Data Systems, a Texas company that manages customer loyalty programs and provides private label credit cards. You’ll notice in the subheading of its most recent quarterly earnings release that the company highlights “cash earnings per share” and not GAAP earnings.

How does Alliance define cash earnings? By taking GAAP earnings and adding back certain expenses, including the cost of stock compensation given to management and employees. It also adds back a chunk of the premiums it pays to acquire credit card portfolios and customer lists. While GAAP considers such premiums the cost of doing business, Alliance considers them an intangible asset – meaning it can amortize them. And because Alliance adds back amortization expenses to get to its touted “cash earnings,” the earnings figure the company is highlighting grows larger – despite the fact that it is an expense that actually reduces profit.

Alliance’s “cash earnings” for the second quarter were 95 cents a share, but GAAP earnings in the period were 51 cents a share. The gap between the two figures was even wider in the first quarter, when Alliance reported “cash” earnings of $1.19 a share compared with GAAP earnings of 45 cents.

Only on Wall Street can a company take expenses, add them back to profits, point to that number as the primary indicator of serious business progress, and then see its shares hit a 52-week high. And would you care to guess what the primary metric is that Alliance uses when awarding its executives with company stock?

Unfortunately, Alliance is not alone in emphasizing non-GAAP earnings. Pfizer is another company with operating earnings that do not provide a picture as clear as you might be lead to believe. Pfizer prefers to publish “adjusted earnings” – ostensibly to ignore the impact from acquisitions – and the Street follows unquestioningly. Pfizer acquires firms every year, though, and even with the big hole in its pipeline that Pharmacia seems to fill, it seems likely that it’s still going to have to acquire growth pretty consistently in the future. If part of a business’ operations is consistently acquiring other firms, shouldn’t that be treated as a regular expense?

Kodak might also be considered a serial offender, in that constant restructurings and repeatedly closing factories over multiple years are not truly one-time expenses. Last year Kodak also adjusted its pension fund assumptions and, surprise, it happened to boost earnings.

In the telecom world, QualComm historically received a hefty percentage of its earnings from investments, as opposed to coming exclusively from the companies’ operations. Those investments had not been doing too well early this year, highlighting yet another reason why investors need to pay attention to the quality of company’s reported earnings.

Why does this distinction matter? Because, as described eloquently here, while the market has increased by more than 50% over the last few months, the actual aggregate GAAP earnings of companies have declined by 6%. Given the gap between actual earnings and the operating earnings figures used by many market commentators, there could be unpleasant surprises in store for investors who blindly buy into the market thinking that it is cheap.

It is not, and knowing the difference is critical.

Q. How concerned should I be about inflation?

A. Be concerned, but don’t panic yet.

Inflation is an increase in the general level of prices of goods and services. When the level of prices rises, a dollar buys less today than it did yesterday. So inflation erodes the purchasing power of money, penalizing people who save.

The rate of inflation depends on growth in the money supply. Because the government has flooded the economy with money to rescue the banking system, it’s very likely we will eventually see higher inflation.

Traditionally, central banks like the Federal Reserve raise interest rates to slow the growth in the money supply and keep inflation in check. Given the amount of money injected into the economy lately, however, there is concern about how fast inflation will rise once it does appear – and how high interest rates will have to be raised in order to control it. Higher interest rates make borrowing money that much more expensive, crimping economic growth.

What’s that mean for investors?

There is no shortage of opinions about the best way to “inflation-proof” your portfolio, but don’t let the tail wag the dog. Those with the most to lose in a surge of inflation will be holders of bonds and other fixed-income assets. Stock investors should consider whether the companies they own are in a strong enough competitive position to pass on any increases in costs to consumers. Commodities like oil, grains and metals also increase in price as inflation rises.

Inflation is the friend of the real estate investor, too, assuming a fixed-rate mortgage. Historically, real estate appreciation has outpaced inflation by a few percentage points a year. By borrowing money through a fixed-rate mortgage, you are using leverage to magnify that gain even more over time.

In addition, while income increases as inflation does, a mortgage does not, so real estate owners will be paying off debt with money that is really worth less than the cash that was originally borrowed. More notably, you’ll also have more cash left over at the end of every month.

Next up, TIB will attempt to sell a rather large chunk of new shares to institutional investors in order to comply with the regulators’ new capital ratio requirements. Though it seemed to cause some anxiety at the shareholders meeting, I don’t anticipate TIB having any problems finding institutional buyers for those shares. Despite its current woes, which have clearly been hard on a lot of local shareholders, TIB does still have a franchise in banking in the Keys. And never underestimate the ability of investment bankers to get a raise done when millions of dollars of fees are at stake. Just how Wall Street works.

Were I already an investor in TIBB, I’d key in on the three slides below, which speak to (1) some signs of progress in the business in Q2, most notably in indirect lending, (2) the intended use of proceeds from the raise, which includes a large cushion and (3) the bogeys management has set as targets to measure success after the turnaround.

While I wouldn’t be a Pollyanna about the road to come for TIB, I wouldn’t necessarily let the despair of large paper losses color my thoughts about the future too much, either.

If you’re considering becoming an investor in TIB at recent prices, I’d recommend doing the same analysis that the institutions who are considering buying shares in the raise are likely doing. There are probably too many variables to put together an in-depth model that anyone could have a high degree of confidence in, but you could certainly model a handful of different scenarios to get some brackets around a valuation. There’s also a rough but reasonable way to determine a ballpark value for shares in the long-term.

More specifically, you could attempt to determine what TIBB’s normalized earnings would look like once it’s out of this current ditch, apply pre-credit-crisis-level loan loss provisions, then account for taxes, TARP dividends and factor in the dilution associated with the pending raise, assuming a share price near today’s. TIBB appears to have had a historical P/E ration of close to 16, too, which could be used as is, or given a haircut as you feel is appropriate. When multiplying the appropriate P/E times that normalized earnings per share figure, you’d get an approximate value for the company in a more normal operating environment. No telling how long it might take the company to reach that state again, but it’s clearly going to take some time.

While I haven’t followed TIBB too closely nor too long, I do think the special shareholders meeting last Wednesday was probably the emotional low point for a lot of locals and the company, too. Water under the bridge now, though. Numbers on the scoreboard will tell the story from here on out.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only. We take no responsibility for the accuracy or content of linked sites.

The basic idea is that if the big banks can sell off their bad assets, they can function again. The banks know this but can’t find any buyers. The government is bringing buyers to the table by sweetening the deal. In one part of the program, big investors can buy toxic assets “legacy loans” with some of their own money and a lot more of the government’s. In the other part, a handful of really big funds will be allowed to buy “legacy securities” – big bundles of repackaged loans – by putting up $500M each. The government will match that with $1 billion more through a special fund that has been closed to private firms until now. Some of that $1B would be non-recourse, meaning the funds are protected if they default. The funds get to cheaply buy just the best assets with borrowed money and no risk of imploding. So, they stand to make an absolute killing.

As pointed out in this New York Times article, the feds have “reached a deal to sell $1.3 billion in mortgages from Franklin Bank, a Houston-based lender that failed last November and was taken over by the F.D.I.C.”

Now if you’re asking yourself, “Why are taxpayers buying the toxic assets of a bank that is already dead?” you’re not alone. It’s one thing for Treasury to be providing large subsidies to private investors to buy toxic assets. That was a seemingly rational way to take toxic assets off the balance sheets of the country’s banks and help the banking system recover from the credit crisis.

But as pointed out in this post on The Baseline Scenario, these particular toxic assets at Franklin Bank already became property of the US government once the bank failed. At that point, the government owned 100% of the upside and 100% of the downside on those assets.

Until last week, that is, when the government through the PPIP program gave half of the potential upside to an investment fund – “Residential Credit Solutions of Fort Worth” – a company founded by a veteran of the subprime mortgage industry. As described above, that company bears no risk under the PPIP program when buying those assets.

In other words: the government gave half of the potential gains from those assets to a company started by an individual who may or may not have helped enable the crisis to begin with – and then kept all of the downside to itself.

Why are we subsidizing investors who are buying the assets of already dead banks? How does this help strengthen the banking system?

I have no idea.

Perhaps you can tell me.

Hat tip to FinanceGuy and RortyBomb, too.

Q. What exactly is causing all these banks to fail?

A. Let’s review the business model of a bank. If you have a checking account or a car loan, you probably already know the basics.

A bank takes in money from one group of people, depositors, lends it to another group, borrowers, and profits from the difference. If a bank borrows money from a depositor at 3 percent and lends it out at 6 percent, the bank has earned a 3 percent spread, or net interest income.

Most banks also make money from fees and other services, typically called noninterest income, which when combined with net interest income comprises the bank’s net revenues.

Much more than other businesses, a bank’s revenue and profits are tied to its balance sheet. You’ll recall a balance sheet is the financial statement that summarizes a company’s assets, liabilities and equity at a specific point in time. The balance sheet shows what is owned, what is owed, and what is left over.

On the asset side of a bank’s balance sheet, you’ll find loans and investments, and on the liabilities side you’ll see deposits and borrowings. One important point to understand about a balance sheet is that while the value of assets may change, liabilities are fixed. Since the amount of assets is always equal to liabilities plus equity, any change in the bank’s assets will be reflected in its equity, too.

If the Bank of Margaritaville had $50 million in both assets and liabilities, but no equity, then a small decline in the value of those assets would mean that the bank could not meet its debts. The bank would become insolvent.

So a bank’s equity is a critical cushion for both depositors and bank shareholders.

What sorts of things would cause that equity cushion to disappear? Bad loans, which effectively reduce the amount of assets on a bank’s balance sheet and therefore its equity, too. A constant barrage of bad loans could eventually drain the equity right out of a bank – if the regulators don’t step in and seize the bank first.

A. I’ve previously mentioned three books that are great for new investors. Those were The Little Book That Beats the Market by Joel Greenblatt, The Little Book That Builds Wealth by Pat Dorsey, and One Up On Wall Street by Peter Lynch. Here are five others that I would view as absolute must-reads for anyone who would like to become a better investor.

1 – The Intelligent Investor by Benjamin Graham. Graham is the father of modern stock analysis and the mentor to Warren Buffett. His writings are so densely packed with insight that it’s almost impossible to take notes. Here’s one of my favorite quotes: “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

2 – Beating the Street by Peter Lynch. The second book by one of the best mutual fund managers of all time contains dozens of mini case studies explaining why he bought certain stocks. It also contains the classic list of “Peter’s Principles,” including gems like, “Never invest in any idea you can’t illustrate with a crayon.”

3 – The Five Rules for Successful Stock Investing by Pat Dorsey. If you do nothing but stick to these five rules, you’ll be miles ahead of other investors. This is a great but still underappreciated book that covers a huge range of material exceptionally well.

4 – Common Stocks and Uncommon Profits by Phil Fisher. This classic explains how to pick stocks with low risk but high potential growth. As opposed to Graham’s numbers-based methods, Fisher advocates a qualitative approach to investing.

5 – The Essays of Warren Buffett, edited by Lawrence Cunningham. This collection of Buffett’s letters to shareholders over the years is unparalleled in terms of learning how to think independently about business, investing and Wall Street.

Finally, while I haven’t finished it yet, I can also strongly recommend Joe Ponzio’s F Wall Street. Joe, too, is a fan of Warren Buffett, and he does a superb job of explaining Buffett’s key concepts.

Q. What is a “moat”?

A. Some businesses are better than others. That simple truth can be hard to remember, especially if you’re rushing to invest in the market out of fear that you’ll miss the latest rally. Keep in mind that what makes a business great doesn’t change from day to day or even year to year. You’ve got plenty of time to slow down and think about moats.

An economic moat is a structural competitive advantage that prevails for a long period of time and is very difficult for a competitor to copy. A moat is important because it ensures a business will be excessively profitable for a long period of time. The longer the period a company will be profitable for, the more that company is worth today. Companies without moats can also see their financial results change for the worse, sometimes suddenly and dramatically.

Wal-Mart is a great example of a business with a wide moat. Because the company controls so much shelf space, it can demand the lowest possible prices from its suppliers. Its sheer size means it gets better terms on store leases and distribution agreements than competitors, too. Wal-Mart is the low-cost leader in the retail industry because it has a structural advantage that would take competitors decades and billions of dollars to match.

Intangible assets can create a moat, too, like the Coca-Cola brand. Businesses whose customers find it too troublesome to move to a competitor have what is called high switching costs. Banks have historically been good investments – the last 18 months notwithstanding – because people are so reluctant to switch.

Businesses like eBay that possess “network effects” also have a wide moat. The buyers come to eBay because that’s where the most sellers are, and vice versa. As a result, eBay receives over 80% of all online auction traffic in the U.S. and potential competitors are unable to lure buyers or sellers away.

To learn more about moats, I’d recommend The Little Book That Builds Wealth by Pat Dorsey. Excellent book, horrible name. It’s a great primer on recognizing competitive advantages.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.

From “Fiduciary Duty Hits The Street – Sort Of” in the WSJ:

“Wall Street finally has agreed to put its brokers under the tougher fiduciary standard for their dealings with customers. Now a fight looms over how tough that standard will be.

As part of its regulatory overhaul, the Obama administration proposed holding brokers who give investment advice to the higher fiduciary duty – a legal standard that would compel them to act in their clients’ best interests. Currently, brokers are held to a more lenient ‘suitability’ standard, which means they can’t put clients in inappropriate investments. Many investment advisers, by contrast, have operated under the fiduciary standard for nearly 70 years.

The changes could transform the brokerage industry by changing the way products are sold and marketed and even how brokers are paid. Requiring brokers to operate under the existing fiduciary standard could force them to recommend more investments that are less costly and more tax-efficient.

They would have to tell clients about any potential conflicts of interest, such as when they stand to gain personally by favoring one product over another. For example, a broker who recommends a mutual fund with a higher fee — and one he gets a bigger commission for selling — would have to disclose that potential conflict upfront.”

I’m thrilled that this change is being seriously considered. Of course, I’m biased, being a registered investment adviser and a fiduciary. But it’s stunning that it has taken this long.

Alas, nothing is set in stone yet. There’s still plenty of time for Wall Street to neuter the bill.

“For years, they’ve opposed the fiduciary duty,” said Barbara Roper, director of investor protection at the Consumer Federation of America, a consumer-advocacy group. “Now they’ve embraced it in order to gut it.”

Here’s the graphic from the WSJ article. Glad to see they made it better than the last one.

On the same topic, there was another article in Barron’s this weekend titled “Relationship Rehab, Washington-Style.” Here it is in its entirety (emphasis mine):

When is a financial advisor not really a financial advisor?

That’s not a trick question. Harold Evensky, a Florida-based investment advisor, points to “feel good” ads run by one brokerage house in recent years showing a broker at the graduation of a client’s daughter. “That suggests that the broker is always on your side, doing whatever it takes,” Evensky says. “In fact, they are legally permitted to put their own interests first, and the obligation is on you to look out for your own interests.”

The Obama administration agrees — and intends to do something about it. In the coming months, members of Congress will take up a new piece of legislation from the administration, the Investor Protection Act of 2009.

The legislation, spurred by the financial crisis of the past year, would force brokers to adhere to the same “fiduciary” standard required of registered investment advisors — a requirement to always put client interests above their own. Brokers, even those called “advisors,” traditionally have been required only to make sure investments are “suitable” for their customers. But most investors, the Treasury Department has said, can’t really tell the difference between the two kinds of advice, and rely on recommendations provided by the two groups in much the same way.

It’s too early to call the outcome of the debate, which will unfold in Rep. Barney Frank’s House Financial Services Committee. But investors curious as to just who is giving them financial advice and how much they can trust that advice would do well to follow the proceedings.

The current requirements — fiduciary for registered advisors, suitability for brokers — were set forth in the Investment Advisors Act of 1940. While the regulations have remained intact, the financial-services industry has undergone dramatic changes in the nearly 70 years since these lines were drawn. Brokers and registered investment advisors now compete much more directly: Brokers routinely offer advice in order to compete with the advisors, and advisors now have ready access to investment products that once were reserved for brokerage-firm clients.

The line separating the two groups is blurring, and many brokers end up acting in a way that’s indistinguishable from the way fiduciaries act. Indeed, brokers are now widely referred to as financial advisors. “Everyone is trying to become the client’s ‘trusted advisor,’ ” says Richard Salmen, president of the Financial Planning Association. “We’ve come a long way from the 1980s, when brokers got their clients into toxic products like some limited partnerships, just in order to pocket big commissions.”

Still, there is a difference between advisors who must act in a client’s best interest and those who probably will — and many investors may not realize that. “Once you provide advice to a client, that client has an expectation that anything you do after that — if you suggest a product or execute a trade — you’ll be doing with their best interests in mind, above your own,” says Ron Rhoades, chief compliance officer for Joseph Capital Management, an investment advisory firm in Hernando, Fla. “When people realize that that might not be true, depending on what kind of firm or advisor you’re working with, it comes as a real shock to them.”

WHILE THE LEGISLATION AIMS to clear up such confusion, the debate over the measure may itself become something less than lucid: It’s already headed toward a hair-splitting exercise over the meaning of the word “fiduciary.”

The Securities Industry and Financial Markets Association, an industry group representing the likes of Citigroup and Merrill Lynch, announced last month that, rather than support the extension of traditional fiduciary duties, it “unanimously supports a new federal fiduciary standard” that would apply to anyone providing investment advice.

Exactly what “new standard” the group has in mind is unclear. But Rhoades, for one, is suspicious. “There is only one fiduciary duty, and that’s the one that is already well-established in case law,” he says. “You can’t have anyone rewrite that and still call it a ‘fiduciary’ standard.”

Still, some securities lawyers suggest that applying the standard definition of fiduciary to all brokers could limit the services provided to investors. Robert Kurucza, a former Securities and Exchange Commission official who now heads the financial-services practice for the law firm Goodwin & Proctor, says it’s entirely possible for a single financial consultant to wear two hats. “If you call someone and suggest that buying a bank stock might be a great idea, but make it clear to them that you only get paid if they agree with you on that, I think that’s fine,” Kurucza says. “And it doesn’t mean that you can’t also be the person they turn to for help figuring out their asset allocation or running a discretionary account.”

Without question, it will take lawmakers and courts a long time to iron out all the issues. In the meantime, says Los Angeles lawyer Fred Reish, “it will be up to investors to question every advisory relationship and understand what the people they are working with are really committed to doing for them.”

Stay tuned. It’s The Fiduciary vs. The Conflicted in a Texas steel cage match that’s sure to go 12 rounds. Let’s hope the good guy wins.

Q. What should I be looking for when I invest in stocks?

A. I’ll continue my answer to last week’s question with a quote from the world’s greatest investor, Warren Buffett:

“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected.’ You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”

That brings me to the first of five recommendations when it comes to successfully investing in stocks.

1 – Buy businesses you understand. Stay within your circle. You need to put the work in to research a company prior to buying shares. But if you don’t truly understand the economics of the business, reading annual reports will likely be pointless. If you are disciplined enough to stay clear of companies you don’t really understand, you’ll avoid one of the most common investing mistakes.

2 – Focus on the moat. In the same way a moat protects a castle from invaders, a company’s competitive advantage leads to long-term excess profitability. If there is no moat around a business, competitors will eventually breach the walls and the company’s profitability will suffer. So will its shares.

3 – Insist on a margin of safety. Your goal should be to buy stocks for less than they are really worth. The difference between the stock market’s price and your own estimate of value is called the margin of safety. As value investors often put it, you want to buy dollar bills trading for fifty cents.

4 – Buy and hold. The costs of short-term trading commissions and taxes can seriously impact your long-term returns. If you buy great companies at low prices, you’ll rarely want to sell.

5 – Do your own homework. There are few places with more conflicts of interest than Wall Street. Don’t ask a barber if you need a haircut, and be very skeptical of Wall Street advice when it comes to investing in stocks.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.

Q. What should I be looking for when I invest in stocks?

A. Let’s tackle this question in two parts. But first, a warning. Wall Street for all its flaws does employ some very bright people. Before you buy a stock, ask yourself if you really know more about it than the PhD hedge fund manager who’s about to sell it. Only one of you is going to have made the right decision.

Now, let’s turn that question on its head and ask, “How can I be absolutely sure I will lose money on the stocks I buy?” Here are five common ways people lose their shirts.

1 – Mistaking speculation for investment. As Warren Buffett’s mentor Ben Graham said in 1934, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

2 – Viewing a stock as a piece of paper. You cannot out-trade the professionals. Think of a stock as partial ownership in a business.

3 – Buying overvalued stocks. There is very little room for error when buying overvalued shares.

4 – Confusing noise with signal. Watching CNBC can be hazardous to your wealth.

5 – Thinking high growth means high returns. Growth can destroy value as easily as it can create it. In fact, I believe high growth is way overrated when investing. Here’s the math behind why I prefer a value investing approach.

Say Corley buys shares in a company for 50% of their intrinsic value, meaning the shares are really worth twice the current stock market price. Assume the company grows its intrinsic value 12% per year by doing nothing more than retaining its own earnings. Even if it takes four years for the market price to reflect the company’s true worth, her investment will still have compounded at 30% per year.

Mathematically, two thirds of that return comes from the gap between market price and intrinsic value closing. Only one third comes from the business value growing. So growth is essential when investing, but it’s less important than buying shares at a low price.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.

Here’s a link to the rest of the clips from the speech, too.

High-frequency trading from Marketplace on Vimeo.  Other articles are in this previous post, too.

Q. Is the recession over?

A. Lean in close. I’ve got something you should hear. There has been a recent flurry of economic data released. If there were one conclusion to be drawn regarding whether or not we’re still in a recession, it would be this:

I have no idea.

I’m not alone, however. The truth is that nobody really knows. Anyone who claims they do is probably trying to sell you something.

There are two reasons it’s a difficult question to answer. The first is that there is a significant lag between the time that the relevant data is collected and the publication of the government’s official conclusions. The recession might have ended at noon yesterday, but we might not find out for months.

The second reason nobody knows when the recession will end is that most economists are horrible at prediction. Keep in mind when watching those talking heads that economists not only failed to anticipate the economic crisis we just went through, but they may have helped cause it, thanks to faulty risk and derivative models.

If the recession is over, it certainly doesn’t feel like it. While the decline in the economy appears to have stopped, all indications are that the unemployment rate will keep rising and people will continue to lose their homes at a high rate until well into 2010. Unfortunately, even if the recession is over in some parts of the country, South Florida will likely be among the last places to recover.

If you think the dour tone of the above would mean bad things for the stock market, however, you might be surprised to know that the stock market has been on a tear. The Dow just had its best July in 20 years. Why, you ask?

Consider the recent stock market rally to be driven more by relief that we’ve avoided a depression than widespread optimism about a recovery. Soon the market will likely start to be driven more by companies’ financial results than the emotion of the last few months. So it’s time to talk more about value investing.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.

Never mind that it’s a backdoor bailout. Think of it as a bubble in new Dodge Durangos.