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.

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.

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.

On real estate in Key West:

The local real estate market has been active…lots of showings, and lots of properties on the market. Even with historically low interest rates, many buyers are using cash. There have even been lots of closings, mostly distressed properties and mostly lower-priced. But occasionally, there is the $2+ million transaction, too. I would have to say, in spite of much heartbreak out there, that properties are moving. Bittersweet…great for buyers, not so much for sellers.

In Old Town Key West:

1214 Catherine Street was reduced again! Combined with 1212 Catherine St, the 6-8 units generate about $120,000 annually, and you can buy the complex for under a million. Pay cash and that’s 12+% on your money to take over ownership, same tenants, no changes. Finance 75% and still clear $5,000 per month! What am I missing?

Spoken like a value investor. Must be something in our genes.

As described in the article, when assets in a fund fall below certain “breakpoints,” management fees as a percentage of assets increase.

So it could very well be the case that you, my dear mutual fund investor, not only saw your holdings decline in value by 50% last year, but you may have also paid taxes forced onto you by your fund…and now the fees you pay as a percentage of your assets could be going up, too.

You’d think that mutual fund companies might see an opportunity in that scenario to make it up to their investors by, for instance, lowering the breakpoint, or waiving the fee increase for their most loyal investors. At the very least you might think the fund companies would let their investors know that expense ratios will be increasing. Alas, neither will happen.

Mutual funds are broken.

A. Yes, if winning means maximizing the amount of money you take home, not picking the right suitcases.

Here is my advice: 

Forget about winning the million dollars. The odds say it just won’t happen. The object of the game should be to beat the mysterious Banker, not win the million dollars. To do that, you need to think in terms of expected value.

It makes no difference which suitcase you pick. Each has the same probability of having any one particular number in it. As a contestant, then, you should add up all the dollar amounts on the board at any time and divide by the number of choices left…or in other words, take the average.

The Banker is doing the same thing – figuring out the expected value (or in this case, the average) of all the choices left and then coming up with a number that is higher or lower than that value. If the number he offers to pay you is higher than the expected value (or average) of all the numbers you computed on the board, then you should take his offer. If not, keep playing.

Most people on the show are playing the wrong game – trying to win the million dollars. It’s not going to happen. Beating the Banker is the best you can do.

Try to figure out those expected values the next time you’re watching. You might be surprised how quickly you get the hang of it.

E-mail me if you have a question.

Why I Fired my Broker. The intro says it all: “With his 401(k) in ruins, our correspondent visits investment gurus, hedge fund managers, and a freakish Arizona survivalist with one question in mind: How can the ordinary investor recover?” Sent in from Jim in Key West.

The Quiet Coup. How the finance industry has effectively captured our government. From the former chief economist of the International Monetary Fund, currently the blogger behind the terrific Baseline Scenario. From Kurt in D.C.

Over the Hedge. The journalist who first questioned Enron’s earnings looks at hedge funds, their exorbitant fees and the egos of those who manage them. Best quote: “They weren’t the gods you made them into, but they aren’t the whale turds they’re being portrayed as now.” From Marilyn in Key West.

And this, via Frank in Tavernier, on Understanding Derivative Markets:

“Heidi is the proprietor of a bar in Detroit. In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi’s drink now, pay later marketing strategy and as a result, increasing numbers of customers flood into Heidi’s bar and soon she has the largest sale volume for any bar in Detroit.

By providing her customers’ freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume and profits increases massively.

A young and dynamic vice-president at the local bank is very impressed with Heidi’s phenomenal increase in sales and profits, recognizes these customer debts as valuable future assets, and increases Heidi’s borrowing limit.

He sees no reason for undue concern since Hedi is so profitable and he has the debts of the alcoholics as collateral.

At the bank’s corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide. Investors looking to get rich quick don’t don’t bother to look into the investment deep enough to really understand the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics.

Prices continuously climb, and the securities become the top-selling items for some of the nation’s leading brokerage houses.

One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due to his negativity), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar.

Heidi demands payment from her alcoholic patrons, but being unemployed, they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and files for bankruptcy.

DRINKBOND and ALKIBOND drop in price by 90 %. PUKEBOND performs better, stabilizing in price after dropping by 80%. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans.

The suppliers of Heidi’s bar, having granted her generous payment extensions and having invested in the securities, are faced with writing off her debt and losing over 80% on her bonds. Her wine supplier claims bankruptcy, and her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers.

The bank and brokerage houses are made whole by the government following dramatic round-the-clock negotiations by leaders from both political parties. The owners and employees of the beer and wine supplier are out of work, but get a $13 a week stimulus from the government. The funds required to bail out the banks and brokers are obtained by a tax levied on employed middle-class non-drinkers.

Finally an explanation we can understand.”

A.  The basic idea is that if the big banks can sell off their bad assets, they can function again. The banks have known 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 nonrecourse, 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. Thus, Wall Street likes the plan.

However, the plan still might not save the banks, which will be left with the assets the funds don’t want. And if the banks ultimately fail while the managers of those big funds clean up…well, start selling pitchforks to the mob, cuz those AIG bonuses will look like change in the sofa cushions.

Have a question?  E-mail me at this address or use this form.