People sometimes make the mistake of asking me for investment advice. They quickly realize their mistake when they receive a blast from Captain Achilles Von Humboldt Blowhard, but by then it’s too late. Maybe by putting it on the internet (where the whole world can see it!), I won’t be so tempted to impart my wisdom at the next cocktail party.
Blowhard’s First Rule: you need the financial services industry, and they’re evil
Chances are, there’s an MBA somewhere in the world coming up with clever ways to fuck you. You specifically. His plan might be to extend easy credit when you need it most, and then jack up your interest rates when you can least afford it. Maybe he’ll offer you a credit card with no limit (but at a 24% interest rate), or maybe he thinks you’re a little more sophisticated and instead offers you a variable rate HELOC that allows you to borrow against your house at the low, low rate of 7% per year (for now, anyway).
You can steer your nest egg safely away from the vultures by refusing to incur any debt that isn’t good debt. Good debt is debt covered by interest that is fixed, tax advantaged, and guaranteed against legal loopholes by the federal government. If you’re like most people, a conventional 30 year mortgage and a school loan are the only good debt you’ll ever hold.
If you do have some bad debt (such as a credit card or a second mortgage), you should pay it off before investing too heavily in retirement. If you’re lucky, you might get your money to grow at 10% per year in the stock market, but that won’t be much good if you’re losing 12% a year on your debt.
Blowhard’s Second Rule: buy one (and only one) house
This is a controversial one, but unless you’re a major landlord, you’re probably going to lose money on that second house. If you must have a stake somewhere other than the place you live, buy land.
But it’s just as crazy not to own the place where you live unless you’re planning to move in the next couple of years. Buying a home is one of the best ways to build wealth, and it starts with how effectively you negotiate your loan. A difference of a quarter of a percentage point can mean tens of thousands of dollars over the life of a loan. Whether you’re buying or refinancing, you should talk with at least 5 lending officers before settling on one.
You can find the rates in your area on Zillow. The rates represent an average, and they are generally lower than what you would get with a zero point conventional loan (since the average homeowner “buys down” the rate with up-front fees called points). Because the rates are averages based on points (typically one point), an above-average negotiator can typically lock in the average rate without paying for points. This is the goal you should keep in mind as you’re shopping your loan.
Should I buy points?
Why does the average home buyer purchase points? Mortgage officers often argue that it makes good financial sense to buy points if you plan to remain in a home for more than 5 years. From a strict Discounted Cash Flow perspective, this is true, but DCF models don’t do a very good job of valuing options. My advice: skip the points.
How big a loan should I get?
Ideally, the entire cost of your house would be covered by the conventional loan, but if you must buy a house for more than the limit for conventional loans in your area, don’t get a jumbo loan. Instead, ask for a conventional and a second, 15-year fixed rate loan to cover the difference. That way, you’ll have the option to pay down the second loan (which will carry a higher interest rate), while retaining the low rate debt on your first. The only advantage that a jumbo loan has over two sets of loans is that, if the Federal Government raises the limit on conventional loans above what you owe on your jumbo, you may be able to refinance your jumbo loan at a lower rate than you could get if you consolidated your first and second. Currently, that difference is about half a percentage point. Unless your second is huge, though, you’re more likely to have paid it off entirely by the time this opportunity rolls around.
How much should I put down?
What if I can’t afford 20%?
If you really can’t afford to put down 20%, you have three viable options:
- Pick a smaller house
- Wait until you can afford 20%
- Rob a bank
#3 may sound extreme, but it’s better to rob a bank than to let the bank rob you through Private Mortgage Insurance, which you’ll have to buy if you put down less than 20%.
Once you’ve locked in a rate, keep shopping. If you can secure a better rate from another lender, you can back out of your first (I did this and ended up saving $20k by going with another lender. The original lender didn’t cry). You might have to pay a few hundred dollars to cover the additional application fee, but this is peanuts compared with what you’ll save with a lower rate.
Happy hunting! …and leave a comment at the bottom of this page if you have questions you’d like me to answer directly.
Blowhard’s Third Rule: get a tax shelter
Remember that MBA in Delaware? There’s someone in Washington who plans to take an even bigger bite out of your ass. If you do nothing, the federal government will take 25-40% of your earnings every year for the rest of your life. And if you still manage to invest a little after that, the government will take an additional 20% of any distributions from your investments. If debt is the quickest way to get poor in America, the quickest way to get rich is to pay the government as little as possible.
Luckily, there are a number of ways that you can delay some taxes and avoid paying others all together. Start with your employer. Most companies with more than 10 employees offer employer-sponsored retirement plans. Under such a plan, you can put at least $18,000 per year of your own money into the stock market (or bonds) without paying a penny in taxes. If you can afford to do so, you should make the full contribution. At the very least, you’ll be holding on to an extra $5,000 per year. If your employer matches your contributions, you’ll get even more out of the bargain. (If your employer doesn’t offer retirement benefits, ask a broker to set you up with a SEP plan).
You can also invest a smaller amount in an IRA. A traditional IRA works just like an employer-sponsored retirement plan: you save the most by not having to pay taxes on your earnings this year. A Roth IRA, by contrast, demands that you pay taxes on your earnings now, but then you never have to pay taxes on that money again. For most people, a Roth IRA is the better option because it forces you to save more (by paying the taxes now). If you’re making a lot of money now and plan to make a lot less when you retire, though, a traditional IRA may be the better solution.
Once you’ve picked your tax shelter, you’ll need to specify where the money goes. Few employer-sponsored plans allow you to invest directly in stocks, but you usually have a healthy choice of mutual funds. The smartest (and simplest) choice is usually to invest everything in a single index fund or exchange traded fund (ETF) that tracks a broad section of the US stock market. Ideally, you would find a small-cap focused index fund or ETF that has management fees that are less than 0.25%. Avoid ‘life cycle’ funds and ‘growth’ funds. These funds generally have high management fees.
Blowhard’s Final Rule: buy some stocks
The Yield Curve shows the annual percentage rates of US Government bonds of various maturities. In a healthy economy, the curve should slope upward and out, like the profile of a wine glass on its side. If the curve is flat or downward-sloping, it indicates that bond traders and investors are predicting a recession.
If you’ve paid off your bad debt and are fully funding all tax-shelters at your disposal, you’re better off than most people. In your IRA, you can now begin to invest directly in stocks (I recommend continuing to invest in small-cap index funds for your brokerage accounts because of the tax costs of trading). The benefit of stock investing is that you’re no longer paying any management fees, and you’re no longer tying your investments to a vehicle that buys stocks when others are buying them and sells them when others are selling them (which, in both cases, is the worst time to make a transaction).
This only works in your favor if you keep your trading to a minimum (that is, buy a stock and hold on to it forever) and diversify. If you need help picking stocks, see our piece on Investing in stocks.
Shortly before I went off to college, my parents offered to match my summer earnings up to $2,000 (the maximum at that time) in an IRA. They also gave me some stock to help me build a nest egg for graduate school. It was a modest gift with an enormous message: this is yours, but if you piss it away, don’t come back for more!
From that point on, I focused on capital preservation through defensive investing. I diversified my portfolio to roughly match the industry composition of the Wiltshire 5000, and I set about building a ‘margin of safety’ with every purchase, by only selecting stocks with solid fundamentals. I had inadvertently pledged myself to Warren Buffett’s #1 rule of investing: don’t lose money. I will spend days (and even weeks) researching every stock purchase, but I almost never look back. It’s the only way I can sleep at night.
My investment process:
I begin with the premise that there is only one thing that matters in business: the Deal. Everything else is leverage. Unfortunately, the average investor is not in a great position to judge the presence of the deal, which is why it is hard (and, some say, impossible) for wall street outsiders to reliably identify the next outperformer. This is the first place where the philosophy of the 19th Century mathematician Carl Gustav Jacobi comes into play. Jacobi famously said: invert, always invert, and this aphorism has somehow made it into the annual reports of the Berkshire Hathaway company. To outperform the stock market, you could try to do what every other investor does and pack your portfolio with stocks that are likely to outperform the market. Or, you could invert this approach and try to create a portfolio that doesn’t contain any underperformers. If you find a company with a strong balance sheet and comfortable margins that is selling at a discount to earnings, you’ve got what Benjamin Graham called a ‘margin of safety’ that will safeguard your capital, even if the underlying business doesn’t meet expectations.
Discerning the ‘margin of safety,’ it turns out, is much simpler than identifying the next deal. I find a good place to begin is my stock screen from Google Finance, which is based on Warren Buffett’s financial philosophy.
After sorting so the stocks with the biggest 13 week price drop appear at the top, I begin the qualitative analysis advocated by Philip Fischer. Essentially, I’m looking for brands that I feel good about that have fallen out of favor for stupid reasons. Using the graphs from Google Finance, I can see when the stock experienced its most recent drop, and I can also see the news associated with that event. Before I move beyond the qualitative stage, I need to be able to explain the reason the stock is out-of-favor, and I should also be able to answer the following 15 questions:
- Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
- Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
- How effective are the company’s research and development efforts in relation to its size?
- Does the company have an above-average sales organization?
- Does the company have a worthwhile profit margin?
- What is the company doing to maintain or improve profit margins?
- Does the company have outstanding labor and personnel relations?
- Does the company have outstanding executive relations?
- Does the company have depth to its management?
- How good are the company’s cost analysis and accounting controls?
- Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company will be in relation to its competition?
- Does the company have a short-range or long-range outlook in regard to profits?
- In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
- Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles or disappointments occur?
- Does the company have a management of unquestionable integrity?
Next, I turn to wikinvest to read the company and industry summaries (which can be helpful in answering the above questions), and then I roll up my sleeves to dig into the financial statements. In general, I’m looking for evidence to support or dispute my qualitative assessment of the company and also to try and tease out a financial story that may have been missed by the news channels. I’ve gotten good enough to be able to roughly guess what the chairman’s letter will say just by looking at the financial statements. I also have a checklist that I cover in every analysis.
- SG&A < 40% gross profits
- Depreciation < 10% gross profits
- Interest payments < 15% gross profits
- R&D expense = low to none
- Top heavy assets (assets at the top of the balance sheet — like cash and inventory — are easy to liquidate, so they give the company a quick source of cash when necessary
- Bottom heavy liabilities (borrowings at the bottom of the balance sheet aren’t owed for a long time, so the company can float on the cheap capital for a while)
- Little or no long term debt
- 5 year retained earnings growth > 10%
- Capex / net earnings < 50% (and preferably 25%)
Finally, I take a look at the Data tab at wikinvest. There’s lots of good information to be gleaned from here. If you hit the EPS link on the right hand side (about halfway down), you’ll see a graph showing the earnings per share for the past several years. As is the case with retained earnings, we’re looking for a long history of growth and stability in these numbers (i.e. not a lot of variation from the upward trend). I will also often look at the percentage of shares held by insiders on the lower right hand side of the page. The bigger that number is, the better.