Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

I believe value investing is the only rational way to invest. It’s two scoops of common sense, a healthy dollop of skepticism and a commitment to ordering off-menu entrees. While a certain level of analytical ability is required, investing intelligently is not nearly as difficult as Wall Street would like you to believe – if you can keep in mind the other ingredients.

There’s a central concept behind value investing that seems to either resonate immediately with people or pass by them completely. The concept is this: a publicly traded company has two values – its ‘intrinsic’ value, and the value the stock market puts on the business.

Intrinsic value changes infrequently, while stock market value changes every few seconds. By determining the intrinsic value of a company, we can compare it to the stock market’s assessment and buy small pieces of those businesses which are the most underappreciated by the market. Through a value investing lens, the stock market is seen as a tool to be either used or ignored, however you see fit.

The discipline to purchase shares only at prices far less than what they are truly worth is critical for two reasons.

First, it protects you from significant and permanent loss. This “margin of safety” concept is unique to value investing.

Second, buying well below intrinsic value presents the potential for substantial appreciation once the market recognizes the company’s true long-term value. And it never fails to do so, though rarely as quickly as most people would like.

Value investing is a simple concept with surprisingly few devotees. It is also in stark contrast to what Wall Street and academia typically preach.

Where’s the proof ? In at least two places.

First is at the very top of Forbes’ 2008 list of the world’s richest people. There you’ll find Warren Buffett, the most famous practitioner of value investing.

There is a simple math proof, too.

Say Corley buys shares in a company for 50% of their intrinsic value. The intrinsic value of the company then grows 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.

There are three key points here:

1 – Growth is essential, but its less important than buying at a low price.
2 – Value investing effectively provides leverage with less risk.
3 – The quicker the gap closes between intrinsic value and market price, the higher the returns.

Here’s Warren Buffett on value investing:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the
temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

The above article was originally featured in our first Letter to Investors. To subscribe, email me.

I don’t mean building a car – see this guy to do that. I’m referring to a bond that can be converted into stock.

Convertibles are hybrid securities with the features of both stocks and bonds. They usually have lower yields than regular bonds, but an owner receives the right to convert the bond to common stock at an agreed upon price. So, convert owners can receive guaranteed interest payments and still benefit from growth in a company’s stock.

While the market for converts in the U.S. is very liquid, not all companies issue them. Fortunately, you can create your own. You can also think of building your own convertible as a way to create a dividend from a stock that doesn’t pay one. So if building an annuity is not your thing, but you’d like to dip a defensive toe into the stock market, here’s another low fee option.

You can create a “synthetic convertible” by combining interest bearing securities and call options. LEAPS in particular can enable you to benefit handsomely from mispriced assets – if you have a long-enough time horizon.

“90/10″ is one way to build a synthetic convert. That means 10% of the cash you want to invest goes into call options and 90% goes into an interest bearing security, such as a CD, that is held until the options expire.

The options provide built-in leverage and give you the right to buy shares in the company – just like a real convert. The CD limits your downside risk, meaning your loss exposure is limited to the amount of the call premium less the interest you earn on the CD.

That’s all there is to it. A guaranteed return plus the chance for an equity kicker. Now you can impress folks down at the dock. Plus, with an attitude and $20,000 you can go start your own hedge fund.

Morningstar has a good free guide to options for beginners here. There’s more on converts here, too.

Annuities seem to be enjoying a resurgence lately, thanks to the bear market. That’s a shame. Many companies sell annuity products that are so costly in terms of fees and penalties that they seem better suited for funding the salesperson’s retirement than the investor’s. Amazingly, some agents even recommend buying annuities inside an IRA, meaning investors are paying extra to defer taxes…on an account that is already tax-deferred.

I can certainly understand the appeal of secure returns these days, but buying an annuity too often means being locked in to high fees and low returns. You can get the same security and pay zero fees by building your own annuity. Here’s how:

Let’s say you have $50,000 to invest for five years. You don’t want to lose any money under any circumstances, but you’d also like to make some money if stocks go up.

First, find a high yielding five year CD that is insured by the FDIC. Currently, you can find some on Bankrate.com that yield 3.50%. (Rates will likely be higher in the coming months.) If you buy the CD in your IRA, then you’ll create the same tax break found in an equity-indexed annuity.

At a yield of 3.50% you’ll need to invest $42,099 today to have $50,000 in 5 years. (Here’s a calculator.) Take what’s left and invest it in a low-cost index fund like the Vanguard 500.

In five years, you’ll get $50,000 back, guaranteed. If the market goes nowhere, you’ll still end up with $57,901. If stocks earn 7% per year, you’ll have $61,082.

You get the idea. Creating recurring payouts means splitting up the initial sum and investing in CDs with staggered terms. Email me for help plugging in real numbers. And please think hard before buying an annuity.

Additional articles:

The Downside of Market-Proof Annuities.
Consider Annuities – But as a Last Resort.
Retirement Plan Ripoffs.
Added Value – and Anxiety – For Variable-Annuity Owners.
Not So Easy Riders.