How I Invest Part II

Linear Technology had their Q4 2010 conference call last Wednesday. I have been a Linear investor off and on since 2000. Linear has the best management in semiconductors. I remember in a 2000 conference call, Linear fiscal 2001 Q1, the CFO said, I forget the exact words, but I took what he said to mean the customers were double or triple ordering, and I sold the stock. I didn’t make out like a bandit but I didn’t loose anything either.

I wanted to upload an excel spreasheet which contains the DCF analysis I did for Linear, but unfortunately wordpress does not allow upload of excel files (!)  So, I exported it as a pdf.   dcf_example   If you want the spreadsheet email me and I’ll send it to you.  I promise I won’t put a macro virus on it.  Anyway, DCF of course is the forecast of the future cashflows of an investment (in this case Linear), discounted for the time value of money, in this case: inflation, riskiness of investment.

The first line lists the year. Up to 2010 are actuals and are not used (directly) for the forecast. Below the year is the discount rate. The discount rate here depends on the risk of the investment and the interest ratefor a risk-free (or nearly risk-free) investment.  To the right, in the K column, is the forecast for year 5->infinity.  I put it at 10% because that’s my best guess at this point.

Lines 10-33 look exactly like Linear’s Income Statement.  Or at least they should for 2008 -2010.  For 2011 and beyond, I forecast the numbers.  I think it is best to use this approach because it is easy (when you use a spreadsheet) and you can see if the company is using gimmicks to pad the earnings statement, when you look into the future and try to decide what each line should be.  I picked Linear for this DCF example because its earnings are very consistent and its margins are incredible.  If the gross margins get below 76% they start taking drastic measures to increase profitablity (fire people, shut lines down, reduce salaries and profit sharing).  Linear is very forthright in calls about what their upcoming tax rate will be and what they forecast revenue growth or decline will be for the next quarter.  They are ususally very accurate. 

DCF is the theoretically correct way to value stocks.  I’ve searched around the web and I haven’t seen a good, clear way regular investors do it.  I’ve seen some strange things in the way people do DCF analysis:

  • extrapolating future performance based upon prior performance
  • having the earnings and dividends grow forever — unless this is a utility, and you are only growing the dividend at a very slow rate, do not do this! If a company grows at 15% forever, it will eventually grow its earnings and dividends infinitely.
  • forecasting earnings for 15 years.  Really?  You know what the world will be like 15 years from now?  I think you should pick a more realistic timeframe.  I picked 5 years but you could argue for a different number.

Keep in mind you want to be pessimistic enough that you discount investments that will not pay off for you. 

You can see that I think LLTC is slightly overvalued at current share price. 

This has been a valuable tool for me and since I started using it as a tool to help screen potential investments, I’ve been much more consistent in my returns.  This is not the optimum screener for REITs and utilities.  I’m still working on that.  (time to read Damoradan again)

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Gluten-Free Buckwheat noodles (for Pizzoccheri)

I have not found a good recipe online for making buckwheat noodles without wheat flour added. Annoying! Anyway, here’s my version. It’s very simple

2 cups buckwheat flour (sift to remove buckwheat bran if desired) + more for dusting, adjusting dough
3 eggs
1 tsp xanthan gum

make a mound out of buckwheat flour. Break eggs into flour. Add xanthan gum. Whisk ingredients together. Knead the dough for several minutes. You can speed this up slightly by using a stand mixer with the bread ball attachment. You need to finish by hand though. The dough should not be sticky and should not break apart. If the dough is sticky add some buckwheat flour. After kneading, set ball aside in a bowl for 20 minutes and put a towel over the bowl. Run through pasta maker. The dough should not tear or break apart when run through the maker. Boil for about 3 minutes.

sunset

how I pick stocks and my investment strategy

I have a colleague who is somewhat wealthy (at least compared to me). His wife confided in me that they were not confident in investing their money by themselves. I recommended a fee-only investment adviser. My friend asked how I pick stocks, and what my investment strategy is.

The best introduction to investing that I’ve seen is Money Chimp. I highly recommend that you read it. If you like to be talked to like a little child, I would recommend Swensen’s Unconventional Success. Swensen is the investment manager for Yale’s endowment. It took a beating in 2008. I thought when I read the book, that his professional investment style, focusing on illiquid investments like timber, private equity, and real estate would run into problems, and I was right. Swensen does make good points that most investment companies are rocking on your dime (be careful with whom you trust your money), it is important to rebalance*, and you should use low-fee ETFs and mutual funds. I’ve basically summarized the book for you.

My personal investment strategy. I am a value investor. I believe in keeping all of my rollover IRAs in Index ETFs by Vanguard. My current 401K is with Fidelity. Their selections are not great but I pick the funds with the lowest expense ratio which meet my balance criteria.

I’m invested in the following funds with the following percentages for my IRAs:

ETF SYMBOL WEIGHT
VANGUARD SMALL-CAP VALUE ETF VBR 20%
VANGUARD EUROPEAN ETF VGK 10%
VANGUARD PACIFIC ETF VPL 15%
VANGUARD TOTAL STOCK MARKET ETF VTI 33%
VANGUARD EMERGING MARKETS ETF VWO 22%

I use Firstrade to invest my rollover IRAs and do my non-retirement investing. I like Firstrade because its trade fees are low ($6.95 at time of writing), they allow you to do dividend reinvestment (more on that later) with no extra fees, and they don’t charge a monthly account maintenance fee. E-Trade is junk. I invested with them a long time ago and I was constantly hit with fees, minimums, etc. E-trade’s trade fee is $9.99 unless you execute > 150 trades in a quarter and then it’s $7.99. No thanks, I’ll stick with Firstrade.

I use Yahoo’s stock screen to initially screen stocks. There are 3 basic valuation methods for stocks: Discounted Cash Flow (DCF), Relative Valuation — Price to Earnings (PE), Price to Earnings Growth (PEG) — earnings relative to some metric, and Options pricing model. I use a Discounted Cash Flow (DCF) approach to value a company as a tool to help decide if I invest in it or not. The best introductory tutorial I have found on DCF is again at Money Chimp. He shows you variations of 2 of the 3 different valuation methods listed above. The humble “guru” of stock valuation is Aswath Damodaran I recommend you visit his site and at least go through the quick tutorial. He discusses all 3 valuation models in as much detail as you could want. Everything from his books is online and free. Cool!

85-90% of my money is invested according to DCF. I screen stocks for value using the Yahoo screener, do some research on the management, and do a DCF analysis. If the price of the stock is less than the DCF analysis, I buy a position. I have price targets. If a stock exceeds the price target, I seriously evaluate selling it. I need to give myself strong justification keeping a stock that exceeds my price target. If I tripled my money in a stock, I used to sell my entire position, no matter what. After I lost big-time on Apple’s upside, I have decided, when a stock hits 3x what I paid for it, I will sell at least half of it, but not necessarily all of it.

I like companies that pay dividends. Dividends return some of the money the company made to its owners, the shareholders. There have been studies which have said that the reason for equity premium (the increase in yield between stocks and bonds) is due to the dividend rate + the rate of increase in the dividend rate. I’m not sure if that is true, but I do like dividends. I participate in dividend reinvestment. Firstrade offers this service for free. Once you sign up for it, all of your dividends are automatically re-invested in that stock. 11 years ago I was really into DRIPs (dividend reinvestment programs). You buy the stock directly without a broker, and the service automatically re-invests your dividends. I have soured on DRIPs because most DRIPs charge large fees for dividend reinvestment and stock purchases, although some are free. DRIPs are a good way to get started in investing, if you find a company which pays good dividends and pays the reinvestment fee for you. DRIPs allow you to purchase a set dollar amount of stock per month, and get the compounding benefit of reinvestment. One company that offers a fees-paid drip is Exxon Mobil.

The remaining 10-15% is invested in what I call ‘Calculated Risk’ I guess you could call all stock picking calculated risk but this would fall into the category where sophisticated investors would use an option pricing strategy to value the stock (see Damodaran). I use a seat of the pants method. Let me give you an example. Just before Thanksgiving 2008, Ford was around $1.50 a share. My Aunt encouraged me to throw 10 thousand into Ford. I said, “Are you high?”, but she listed the reasons why

  • Ford family owned 20% of the company. Not likely to let it go bankrupt.
  • Ford was well financed vs. GM and Chrysler (none had gone bankrupt at that point)
  • Ford was an international company. More so than GM, and especially Chrysler
  • Bailout and concessions for GM would help Ford in its labor negotiations

my Aunt turned out to be right. She put a substantial sum (but money she could afford to loose) into Ford stock, and rode it to above $11. I wish I had listened to her. Stock market investors hate uncertainty. For the most part, the stock market tends to over-value companies for years at a time. When opportunities like this come along, you can make a lot of money by being a shrewd investor.

I’ll show how I do DCF (it’s less complex than Damodaran’s) for stocks that pay dividends and have little to no debt in the next installment.

How to solve the California municipal budget crisis: Outsource

The city of San Carlos is outsourcing its police force to the San Mateo County Sheriff’s Department. San Carlos is a small city with about 28,000 people. At $6.8 million per year, outsourcing police services will save the city $2 Million annually. On its website, the city has notes on its budget. Last year, the police services accounted for approximately 31% of general fund expenses, but will decrease to 25% if the plan goes through. State law prevents the Sheriff’s Department from passing on fee increases to the city except if they relate to costs of patrolling or administering the contract. The city seems to be doing more of the right things, such as creating a second benefit tier for new employees, and winning pay reductions from management employees. Cities in California should look to San Carlos’ example and outsource city services wherever possible.

Interesting article on Chinese workers in 2010

NY Times has an interesting article on the shift in motivation, education, and ambitions of China’s factory workers. Two years ago, a factory with unskilled laborers doing piecework would be pay its employees approximately $5.50 per day. (source: personal conversation with factory manager). Today, her salary would be about $10 per day. Three years ago, factory workers built but had no idea* what it was they were working on exactly. It looks like with the new generation of Chinese factory worker, that that has changed. Quite a change in a few years.

*Bunnie Huang has an excellent blog

bought an SSD drive

I bought an 80GB Intel X25-M Solid State Drive (SSD). Microcenter had a special where the Apricorn clone tool with EZ Gig II disk imaging software was included with the purchase. The problem is that EZ Gig II does not allow you to image the HDD if it is larger than the SSD, which is almost guaranteed to be the case. I re-installed the OS (which goes surprisingly quick) and all of my software (most of which is freeware except Lightroom, which I bought). Anyway, once I got it installed, I ran Crystal Disk Mark:

CrystalDiskMark 3.0 x64 (C) 2007-2010 hiyohiyo
Crystal Dew World : http://crystalmark.info/
———————————————————————–
* MB/s = 1,000,000 byte/s [SATA/300 = 300,000,000 byte/s]

Sequential Read : 179.443 MB/s
Sequential Write : 82.494 MB/s
Random Read 512KB : 137.902 MB/s
Random Write 512KB : 82.524 MB/s
Random Read 4KB (QD=1) : 11.492 MB/s [ 2805.6 IOPS]
Random Write 4KB (QD=1) : 17.018 MB/s [ 4154.8 IOPS]
Random Read 4KB (QD=32) : 13.399 MB/s [ 3271.4 IOPS]
Random Write 4KB (QD=32) : 36.552 MB/s [ 8923.8 IOPS]

Test : 1000 MB [G: 1.0% (0.7/74.5 GB)] (x5)
Date : 2010/07/11 2:37:11
OS : Windows Vista Business Edition SP2 [6.0 Build 6002] (x64)

The write numbers are in the ballpark but the read numbers are a little low. It probably has to do with the AMD 780G rev. 00 Northbridge in my mobo.
The Intel drives are not the fastest with writes but are quite fast with reads, which I think is most important with OS and application images, so it’s kind of a bummer that it’s a little slow. Even still, applications launch instantaneously now (even Lightroom).