Limit Your Costs and Risks, Some New Year's Resolutions

As investors we cannot generally control the prices of the assets we invest in. We can control only two things: our risk exposure and the costs we incur. All else being equal, minimizing these ensures better returns. With this in mind, below is a list, New Year's resolutions as it were, of things we can all do to limit our costs and our risks. The list is compiled from my own mistakes and those I've observed others making. I've mentioned some of these before in previous posts. They may seem obvious, but time and again we see smart people make silly mistakes.


1. Are you overpaying for a service? If you can do the same thing at an equally reputable broker for less than at your current broker, why wouldn't you?

2. Limit the commissions you pay as a percentage of your investment to as little as possible. If you pay $10 in commissions to buy $250 worth of stock, for example, your stock has to go up 8% for you to break even. In other words, you pay $10 to buy and $10 to sell. Your position has to appreciate $20 in value for you not to lose any money when you sell.

3. Are you paying an account maintenance fee? Why? There are plenty of equivalent institutions that don't charge fees. If your IRA has a fee, switch to one that doesn't. If your bank account charges you fees, get a new bank account that offers the same features and is free.

4. If you invest in an index mutual fund or ETF, is there another index fund that is basically the same but charges less fees? In most cases there is. Most Vanguard products, for instance, charge less fees than competitors. So if you're using a competitor's products, you might be overpaying. For example, why pay 0.2% in fees with the iShares Total Market ETF (IYY) when you can pay 0.07% for a similar fund with Vanguard (VTI)? Granted that in real terms the difference is negligible and for small amounts probably unnoticeable, but the iShares ETF is almost three times as expensive for pretty much the same thing. With other funds, such as bond funds, where yields are important, the fund fee can take a big chunk out of your returns.

For mutual funds, avoid funds that charge you fees for buying and selling. There are plenty of mutual funds out there with similar strategies that don't charge any transaction fees. For example, why go with a growth stock mutual fund that charges a 3.5% load when you buy when you can get a growth stock mutual fund that doesn't charge you anything to buy it? With that second mutual fund you are 3.5% ahead of the first one right away.

5. Do you subscribe to publications that you can read for free on the internet, or that you may already be paying for? Is the cost of the physical product worth it?


1. Never invest in something (stock, house, bond, art, etc) just because someone else says it's a good idea. It doesn't matter if it's a newsletter, a guru, someone on TV, a family member, etc. The person's track record doesn't matter either. You must do your own homework. This homework does not involve reading or inquiring about others' opinions on the investment, although these are good for confirmation and to get ideas. It involves, rather, forming your own opinion based on facts. For example, if an analyst says XYZ will earn $4 per share next quarter, take that as an opinion. If XYZ announces that it was awarded a new contract valued at $x, take that as a fact.

2. If you give your money to someone else to invest for you (mutual fund, portfolio manager, hedge fund, etc), make sure you understand their strategy. If necessary, have someone explain it to you. Never give your money to someone else because you don't understand or their strategy is too complex for you. If you can't understand the strategy, on what basis do you think investing with that particular manager is a good idea? While track records are good indicators, past performance does not equal future success, and past performance can be fabricated. You should only entrust your money to others when you understand the strategy and having someone else implement it for you is cheaper/less time consuming than doing it yourself.

3. Never keep your assets in one place.

This includes a single money manager, a single institution, and a single asset class. That is, don't keep all your investments in one fund; don't keep all your cash at one bank (or in one place, like in your house); don't own only stocks (or bonds, or commodities, etc), and among each asset class don't only own one (real property is probably the only acceptable exception).

If you invest in your employer (e.g., you can buy stock at a discount or are given shares as compensation), do so as little as possible. If your employer prospers, it's true that you won't participate in the appreciation of its stock price, but you'll be more likely to keep your job and maybe get a raise or bonus (the company is doing well, right?) If your employer experiences problems, you face a greater chance of losing your job and your investment will suffer. If your employer goes out of business, not only will you lose your job, you'll also lose your investment. Think of Bear Stearns and Lehman Brothers. Don't invest where you work, unless it's your own business. If it's your own business, make sure to invest in other places just in case something goes wrong.

4. Don't keep more in any account than you are insured against. For example, don't keep more than the FDIC limit at your bank. Don't keep more at your broker than insurance protects.

5. Limit your losses. After a certain point, it can take a very long time to recoup losses. For example, suppose you own stock XYZ, which has lost 30% in value since you bought it. For you to break even, XYZ has to go up 42.85%. If you've lost 50%, as another example, you have to gain 100% to get back to even.

Take one of my mistakes. I've been bullish on General Electric (GE) for some time, despite all the warning signs. I bought the stock for an average cost basis of $31.31 per share. In October, when the stock was at $20.11, I finally came to my senses and sold. That's a 35.77% loss (slightly less because of the dividends I received). Had I kept the stock, it would have to go up 55.69% for me to break even from that point. I'm glad I didn't keep it, for its last close was $15.97. If I still owned GE, I'd be down 48.99%. The stock would now have to go up 96% for me to break even.*

There are different reasons for selling a stock. Chief among them is whether you think the money will earn a better return elsewhere. If you have a losing stock but think that it has the best chance, among all other options, of growing your money, by all means don't sell. Put differently, if you'd buy the losing stock today (for valid reasons--not a pure gamble), there's no reason to sell.

6. When you decide to invest in something, say a stock, have a plan and a reason for buying. Why are you buying the stock? Why now? When will you sell?

It's an interesting psychological phenomenon, as soon as we find a stock we think is a good investment most of us want to buy it right away. Never rush to buy anything. If it's a good deal today, it probably will be tomorrow. If you find a stock you like, don't chase it. Let it come to you for the price you want to pay. Remember, if it gets away, you don't lose any money, and every day offers new opportunities.

One thing to consider here is writing (selling) cash secured puts. A put is a contract that gives the buyer of the contract the right to sell the writer of the contract an asset for a certain price within a certain time. Puts generally go up in value when their underlying asset falls in value (one can use puts instead of shorting stocks).

Let's use Boeing (BA) as an example. Say you want to buy 100 shares of BA stock, which is currently trading around $40.53 a share (last close). And let's say you want to buy it now. Unless you have some sort of timing system that tells you when to buy your stocks, there's no reason to act immediately. But let's say you feel you must.Your total cost, if you buy the stock now will be $4053 plus whatever you pay your broker.

One way to minimize your downside risk is to sell 1 put on the stock, say a month or two out, at the strike price you want to buy the stock, in this case $40. Selling the February 2009 put at the 40 strike will place around $320 into your account, minus broker commissions.

If BA trades under $40 a share between now and when the put expires on February 20, 2009, your put will be exercised and you'll get 100 BA shares for $4,000. Since you were paid $320 for the put, your total cost for the 100 shares is $3680, plus broker fees. It's as if you paid $36.80 per share (will be slightly more because of broker fees).

Had you bought BA in the regular way, for $40.53 a share, and the stock went down, you'd be losing money. Using the put to buy the shares, on the other hand, unless BA goes under $36.80, you don't lose any money.

Now, let's say you were correct that BA would go up. The stock has to go up over $43.73 between the time you would have bought and when the put expires for buying the stock outright to be better than using the put strategy.

In short, if you want to buy a stock right away, for no reason other than you just discovered the stock, sell a put for each 100 shares you want to buy at the strike price at which you'd buy the stock anyway. You either get the stock for the price you wanted plus a cash bonus, or you are compensated for the lost opportunity if the stock gets away. In this case, you make almost 8% if BA gets away from you.

Note that BA is just an example. Although it's in my dividend stock portfolio, I don't know one way or another if it's a good stock to buy right now. (It just raised its dividend, but there are concerns that because of order cancellations and production delays the current dividend rate is unsustainable.)

7. Just as you shouldn't chase a stock on the way up, don't chase it on the way down. The only way one can buy a stock at the bottom is through luck. While selling puts is one way to avoid risk, doing so in a bear market comes with its own risks. That is, stocks can fall much farther and faster than you anticipate. While selling puts can offset your losses, it may be harder to get out of your positions and may lead you to incur more losses than if you simply bought the stock in the regular way and sold it.

*Some may find a contradiction between what I say here and what I've written in the past (here, here, here and here) on owning dividend paying stocks forever. I don't believe there is one, but as this post is already too long (I didn't have time to write a shorter one), I'll leave that for another day.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.


Luck, Some More Thoughts on Dividend Paying Stocks

My previous ruminations on dividend paying companies can be found here, here and here.

What do you think of the following "investing" strategy?

Put money (not needed for the next five to ten years) away to invest as you would normally. Place it in the highest yielding, safest asset (e.g., a money market account, high yield savings account, a short term CD). Figure out how much of the original amount (leave any interest you earn alone) you're willing to lose per year for the chance to gain that amount, e.g., 5%, 10%, 15%, 20%.

Once each year, take that portion out of your safe account, and go to a casino. Find a roulette table and bet the entire amount on black or red. You have a 47.37% chance of winning, and a 52.63% chance of losing. Say you take 10% of your investing money. If you win, you'll have a 10% gain for the year (not counting taxes), plus whatever you earned in interest as well as savings on broker costs you would have paid trading stocks, and minus the cost of going to the casino. If you lose, you'll have a 10% loss, minus whatever you earned in interest and would have paid in broker commissions plus the cost of going to the casino.

The lucky practitioner of the above strategy will handily beat the market. Since the odds favor the house, however, the average person will lose money at the casino. Whether principal will be lost will depend on how much interest gains offset "investing" losses and expenses. For example, if your safe account earns 5% interest for the year (after taxes), and your gambling losses and expenses amount to 2%, you'll be up 3% for the year. If you earn 5% in interest, but your losses and expenses amount to 12%, as another example, you'll lose 7% for the year. You don't lose principal when your losses and expenses are lower than what you've gained in interest after taxes.

As far as strategies go, I don't think the above is any worse, or much different from investing in individual non-dividend paying stocks. It might even be better, as far as your odds go.

Picking a long term winning stock is in all cases a matter of luck, unless you can see the future. No one knows what will happen in five years, or ten, twenty, etc. A company that looks great today may not be around in ten years. A company that looks great today and still does so ten years from now may have a lower stock price then than it does today, even if its earnings grow.

Examples are easy enough to find. As I mentioned in a comment here, take a look at Google (GOOG) and Apple (AAPL). Google traded over $300 a share when its earnings were around $5 a share; it traded over $400 a share when its earnings were around $9 a share; and it traded over $700 when earnings were $13 a share. Now that its earnings are around $15 a share, Google is trading around $310.17 (last close), at the same level as when earnings were three times lower. Apple was around $150 when earnings were $3.90. Now, when earnings are $5.36, the stock is at $90.

Or take a look at Cisco Systems (CSCO). Below are charts of its earnings per share and price per share for the last ten years. The two bear little relationship.

Buying Cisco in 1999 and holding it until today would result in a loss of around half your principal, while the company quadrupled its earnings per share. (Note that holding it longer, say since the early 1990s, would have resulted in an awesome gain.)

There are many other, similar examples. You have to know when to buy and when to sell. Research can certainly help. Perhaps you would have avoided Cisco in 1999 because its P/E was around 100, but you would have missed the big gains to come, as the stock tripled in price from January 1999 to March 2000.

The point here is that how well you do in long (or short) term investing is a matter of luck. This is true of all stocks (and other asset classes). With dividend paying stocks, however, there is one big difference. You don't have to trade. While knowing when to buy is important (to lock in your yield), you don't have to sell to realize all your gains. Non-dividend paying stocks are useless unless you sell them (that's what infuriates me about share buybacks),* so you have to be lucky twice--when you buy and when you sell. Stock prices have little to do with earnings. They have all to do with expectations and optimism/pessimism. People usually buy when they're optimistic about a stock, and sell when they're pessimistic, which seems like a recipe for buying high and selling low.

Many will say, OK, that's probably true, but you can get way bigger gains with non-dividend payers because they grow much faster. I agree 100%, but would still rather own a dividend payer, because with a non-dividend payer you have to know when to sell.

Consider Cisco again. It grew its earnings 4.22 times from 1999 through 2008. Procter & Gamble, as a comparison, grew its earnings 2.8 times over the same period. Cisco's stock lost almost 50% during the ten years, while Procter & Gamble gained almost 50%. Procter, which traded around $45 a share (split adjusted) at the beginning of 1999 also paid $10.1925 per share in dividends during the period, that's a 22.65% gain without having to sell your stock (not very much, but you'd get nothing while holding a non-dividend payer). Stock price appreciation, along with dividends received amount to a 70% gain for Procter over the ten years, beating Cisco by around 120%, even though Cisco grew earnings faster. The time to sell Cisco was in 2000. Few people figured that out before they lost money on the stock.

Note that Cisco kills Procter & Gamble over the longer term in share price performance. Buying the stock in 1990 and keeping it until now would have increased your investment around 200 times. Selling it in 2000 would have increased your investment 800 times. And that's the thing--when do you sell, and when do you buy? Earnings have continued to increase over the last ten years, but the share price plunged. Do you sell now or keep holding it? You get nothing as you wait, and what if the stock continues going lower?

With a dividend payer you don't have to worry about that. As long as the company remains strong, either having stable or increasing earnings, you get paid to hold its stock. Procter & Gamble's 22.65% dividend return over the last ten years is on the lower end of those dividend paying stocks that have done well. Frontline (FRO), another stock in my dividend portfolio, for example, has returned over 600% in dividends over the same period (a little shorter, actually).

Getting back to the above casino "investing" strategy, one complaint against it could be that it's not investing. As I noted previously, though, unless you buy stock directly from a company you're not really investing either--you're just buying a piece of paper from some other person; the company benefits indirectly, if at all. With a non-dividend payer, you're hoping the Ponzi scheme we call the stock market survives at least until you decide to sell your stock, and that people are willing to bid the stock's price up while you're holding it. On the other hand, the dividend payer gives you cash for owning it, no matter what is happening to its share price. With the best dividend payers, you never have to sell.

Since you have to trade non-dividend payers to make money, and no one knows where a stock's price is going next, you're gambling. And what do you do with that money once you sell? If you invest it in another stock, you're gambling some more.

As long as you're gambling, the casino strategy is not much different. One thing in its favor is that you can calculate its expectable outcome before proceeding, since all the probabilities are known. You also don't have to worry about doing research or watching the daily ticker.

As the odds of losing are greater than those of winning in the casino strategy, it is a losing strategy over the long run. Nevertheless, as most investors, including professionals, tend to lose money on individual stocks or at least underperform the market, there's a good chance that the casino strategy may outperform most retail investors' portfolios composed of individual non-dividend paying stocks. If a losing strategy outperforms, maybe it's best to avoid picking individual non-dividend paying stocks.

That's why I favor index investing over individual stocks, and dividend payers over non-dividend payers.

* Some of Cisco's earnings per share growth has come from share buybacks. (Less shares = higher earnings per share even if actual earnings stay the same). Had the company used those billions of dollars to pay dividends instead of buying back shares, it would have been a better stock to own over the last ten years.

Disclosure: At the time of writing, I owned PG and had an open order on FRO.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.


Index Linked CDs, Are They Worth It?

In this new era of extremely low interest rates, is it possible to get a decent return without taking on too much risk?

One way to limit your losses and stay in the stock market to participate in any upward gains is to take a loss upfront by buying puts on your stock positions. But how would you like to participate in the stock market's returns with no risk to your principal? Index linked certificates of deposit, or ICDs, promise to let you do just that, and are starting to be recommended by some financial advisors. Although they have been around for years, ICDs are relatively obscure and not widely available.

ICDs are similar to regular CDs, in that they are FDIC insured and sold by banks. As long as you stay within FDIC limits, you cannot lose your principal (unless the FDIC goes bust).

ICDs differ from regular CDs in how your returns are determined. These certificates of deposit are linked to stock market indexes, most commonly the S&P 500 or the DJIA but also the Nasdaq and even currency and commodity indexes, and their rates depend on how the index does. ICD maturities usually range from one to five years, and any interest due is usually determined at maturity.

ICDs differ from bank to bank. Some typical offerings provide from 85% to 100% participation in the index's gains. So, if the market goes up 10% from when you buy the ICD to when it matures, you could potentially get from an 8.5% to a 10% return. If the market goes down between the time you buy the ICD and when it matures, you get your principal back. Some banks have in the past offered a minimum return no matter what the market does. In such a case, you would get a gain even if the market goes down.

The only risks appear to be losing to inflation and giving up sure gains in equally safe investments like regular CDs or Treasuries. But there are a few things to note.

One thing to look out for is how the bank measures an index's return. Say the S&P 500 is at 1,000 when you buy your ICD and is at 1,200 when the ICD matures. Had you bought the individual stocks or the ETF (SPY), you would have a 20% gain plus dividends (which should be around 2 to 3% per year). Would you receive a 20% return on the ICD? Probably not.

For example, the bank may measure the index's return by averaging the index's closing prices for a certain period (maybe every trading day, or a set of specific "pricing" days, etc). Using the above example, the S&P 500 may be all over the place between the 1,000 when you buy the ICD and the 1,200 when the ICD matures. It may be around 800 for a while, who knows. It can turn out that the average closing price during your holding period is well below 1,200. Let's say it's 1090. Your return on the ICD would thus be 9%, even though it's "100% linked" to the S&P 500.

There are other considerations. For example, holding SPY for over a year and selling it for a 20% gain should give you a smaller tax bill (capital gain) than a 20% gain on an ICD (ordinary income). With the ICD you also miss out on the dividends you would have received if you owned the stock index. If the market is higher when the ICD matures than it was when you bought the ICD, the ICD will most likely underperform. If the market stays flat, you will probably get little to no return with the ICD, which may be smaller than the dividends you would have received with the stock index. That's better than losing money in stocks, but a regular CD might outperform an ICD in every case.

The fine print may have other qualifications. For example, there may be a cap on gains or the bank may be able to call the ICD when a certain event occurs. The market can go up 100%, but if the cap is at 11%, that's the most you can make.

Liquidity is something else to think about. If you own the ETF and suddenly need the money, you can sell it as soon as the market opens or in extra hours trading. Whether you lose any money on the sale depends on the ETF's market price. With the ETF, you have the option of selling a portion of your stake. If you own the ICD and need the money, you are likely to incur a withdrawal penalty and possibly face a delay before you get your money back. If you would like to redeem a portion of your ICD rather than the entire investment, that may be difficult or impossible. If the bank goes out of business, it may also take a while to get your money.

Related to liquidity, since the interest you earn with most ICDs is paid at maturity, you will not get current income from most ICDs.

The question then arises, given all these uncertainties (except for the fact that you won't lose your principal), why would anyone want to buy these products? The only answer I can think of is to try to beat inflation. Pinning returns to stocks while giving up some of the upside potential in exchange for no downside risk (in terms of principal, not purchasing power) can be a way to do that. I Savings Bonds ($5,000 a year limit) and inflation protected bonds seem a better way to go, however.

Unless you find an ICD with a guaranteed minimum return you'd be happy with, it's probably not worth the trouble.

If you are interested, below are a few banks that offer ICDs. These are not recommendations. They are posted for your convenience. Please read the fine print carefully, do your own research, and consult your financial or tax advisor to see if it is the right thing for you.


Harris Bank

Stanford International Bank (Not clear if FDIC insured)

Washington Mutual (Chase)

Wells Fargo

Weymouth Bank

This is obviously not a complete list. Small local banks are probably the largest sellers of ICDs, so if you are interested, see the banks in your community.

Disclosure: At the time of writing, I own puts on SPY. I also own Wells Fargo stock, on which I wrote calls.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.


Dividend Portfolio Update

Here is this month's update of the Buy and Hold Forever Dividend Portfolio. This and all future updates will be posted here. The spreadsheet tracking the portfolio is available on the original post and here.

In accordance with the results of a poll, where I asked whether Coors (TAP) should replace BUD in the portfolio, TAP has been added at Friday 12/12/08's closing price. The $350 that was originally used to buy BUD was used to buy TAP. The rest of the BUD sale proceeds ($41.47) will count as a dividend.

Here are the other dividends received since the last update:

BNI 10-Dec-08 $ 0.40 Dividend * 3.93 = 1.572

FRO 5-Dec-08 $ 0.50 Dividend * 11.006 = 5.503

JNJ 21-Nov-08 $ 0.46 Dividend * 5.706 = 2.62

KO 26-Nov-08 $ 0.38 Dividend * 7.944 = 3.0187

MCD 26-Nov-08 $ 0.50 Dividend * 6.042 = 3.021

PEP 3-Dec-08 $ 0.425 Dividend * 6.139 = 2.609

UNP 26-Nov-08 $ 0.27 Dividend * 5.242 = 1.415

WMT 11-Dec-08 $ 0.238 Dividend * 6.271 = 1.49

Update 1/6/09:

CPB 18-Dec-08 $ 0.25 Dividend * 9.223 = 2.30575 -1.194

DOW 29-Dec-08 $ 0.42 Dividend * 13.118 5.50956 2.0956

GE 24-Dec-08 $ 0.31 Dividend * 17.94 5.56 2.0614

KFT 23-Dec-08 $ 0.29 Dividend * 11.995 3.47855 -0.021

MO 22-Dec-08 $ 0.32 Dividend * 18.239 5.836 2.336

PM 23-Dec-08 $ 0.54 Dividend * 8.052 = 4.348 0.848

USB 29-Dec-08 $ 0.425 Dividend * 11.741 = 4.9899 1.4899

VNQ 24-Dec-08 $ 0.935 Dividend * 8.432 = 7.88 4.38

Update 2/9/09:

AXP 7-Jan-09 $ 0.18 Dividend * 12.727 = 2.29086 - 1.20914

BA 4-Feb-09 $ 0.42 Dividend * 6.677 = 2.80434 1.97434

CHD 5-Feb-09 $ 0.09 Dividend * 5.923 = 0.53307 -2.43693

INTC 4-Feb-09 $ 0.14 Dividend * 21.834 = 3.05676 2.61676

PFE 4-Feb-09 $ 0.32 Dividend * 19.763 = 6.32416

OKS 28-Jan-09 $ 1.08 Dividend * 6.356 = 6.86448 3.36448

PG 21-Jan-09 $ 0.40 Dividend * 5.423 = 2.1692 -1.3308

SI 23-Jan-09 $ 2.023 Dividend * 5.819 = 11.771837 8.271837

T 7-Jan-09 $ 0.41 Dividend * 13.074 = 5.36034 1.86034

VZ 7-Jan-09 $ 0.46 Dividend * 11.796 = 5.42616 1.92616

WFC 4-Feb-09 $ 0.34 Dividend * 10.279 = 3.49486 3.48486

XOM 6-Feb-09 $ 0.40 Dividend * 4.722 = 1.8888 0.2788

YUM 14-Jan-09 $ 0.19 Dividend * 12.065 =  2.29235 -1.20765

Disclosure: At the time of writing, I owned JNJ and have a limit order for FRO.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

The Amusing Madoff Scandal and Other Ponzi Schemes

Bernard Madoff, former chairman of the Nasdaq, has apparently been running a Ponzi scheme. According to some, he stole $50 billion--$1 billion for each of his 50 respected years on Wall Street.

The news coverage of this latest Wall Street scandal amuses me. It's shocking, commentators say, that something like this could have happened. The only shocking thing is that more individuals and firms on Wall Street haven't been accused of/caught running Ponzi schemes. After all, what types of individuals work in the financial sphere? Isn't greed one of the primary qualifications? Finding a fraudulent investment business on Wall Street is about as surprising as finding a liquor cabinet empty after entrusting it to an alcoholic.

Another amusing aspect of the Madoff scandal is who the victims are. Henry Blodget, the ever entertaining host of Yahoo! Finance's Tech Ticker (not a stranger to scandal himself), reported that some of Madoff's investors knew something fishy was going on. That's why they invested. No one could produce such high, steady returns year after year with such a safe investing strategy. While they were being cheated, they thought Madoff was cheating others through insider trading. Serves them right. It won't be at all surprising if all these thieves in their own right get compensated for their losses by their government friends. (It would be nice if innocent victims were compensated, though.)

A Ponzi scheme is a simple thing. The thief sets up a fake investment enterprise, and persuades his friends, coworkers, etc, to invest in it. He then sends them statements or even cash dividends, showing that the investment is going well. This attracts more money from the original investors and new ones. Should any investors wish to withdraw their money (in normal circumstances most won't, because their statements show that their investment is doing well), the money from newer investors is used to pay them. Early investors who decide to withdraw their money are paid by the funds new investors deposit. On it goes, until the thief's greed is satisfied and he makes off with the money or there aren't enough new investors to fund the redemptions of earlier investors.

The latter is what happened to Madoff. Losing money everywhere else, too large a number of his investors were forced to redeem their deposits. If the markets hadn't crashed, it's quite possible Madoff's scheme would go on much longer, and some of his investors could have made money (if their orderly withdrawals coincided with equal or larger new deposits).

This brings me to some of the Ponzi-like schemes almost all of us participate in.

Stocks: We buy paper with the hope that some sucker in the future will buy that paper from us for more than we paid. (Perhaps not quite as true with dividend paying stocks.)

Social Security: The money deducted from our paychecks isn't put away for our future use. Rather, it is used to fund currently retired workers. When we retire, those who work then will fund our SS payments. If this isn't a Ponzi scheme, I don't know what is: early investors are paid by the contributions of new investors. The entire thing is based on the premise that there will be more and more workers in the future. It's far from certain that this premise is true.

Our Economy Before the Credit Crisis: People took out loans on their houses and bought junk. When their houses rose in value, they took out larger loans, repaid the old loans (early investors paid off with the deposits of later investors), and bought more junk. Repeat this a few times. Then some of the loans reset at higher interest rates and couldn't be paid back (more redemptions than can be funded by new investors). This triggered more loan defaults, and the buying of less junk, which resulted in more defaults.

Government (and Corporate) Bonds: You buy a government bond. The interest the government pays you comes from the money it borrows from others, that is, other bond buyers (and to a lesser and lesser extent tax revenues). When your bond matures, the government pays you with more borrowed money (and to a lesser and lesser extent from tax revenues).

Insurance (car, medical, loan default, unemployment, stock broker, etc): This is just like Social Security. We pay a premium to the insurer in exchange for compensation when an event insured against occurs. When the event insured against happens (doctor's visit, stolen or damaged property, etc), the insurer funds our compensation from others' premiums. That is, it's like having new investors pay for the redemptions of earlier investors. If the insurer has too many claims, it won't be able to pay all its clients. Some state unemployment funds are facing this problem. As unemployment rises, they have to pay out more benefits while the premiums they collect get smaller. The last workers, while paying everyone's benefits, will get nothing when they lose their jobs.

Bank Deposits: Not quite a Ponzi scheme, but close. We put our money in the bank, and the bank is supposed to invest it. Put another way, the bank borrows money from us and lends it to others. At some banks we get interest for our trouble. Withdrawls are funded mostly by new depositors, or with other borrowed money. Should a large enough percentage of depositors want their money back at once, the bank will fail. Assuming there's no insurance, not all the money will be returned, as some of the bank's investments will not be good ones.

There are many more Ponzi schemes, I'm sure.

As long as there is confidence, a Ponzi scheme can work for a long period of time. Nevertheless, its design is such that it cannot work indefinitely. Either confidence is lost or it grows too big to be sustainable, and the whole thing collapses. Ponzi scheme collapse isn't just possible. It's inevitable.

So what do we do? Press our policy makers for reforms. Build systems that aren't pyramid schemes. And if you're forced (or choose) to participate in Ponzi schemes, try to get paid in cash or real assets that you can use even if no one wants to buy them from you. For example, if investing in stocks, prefer dividends. Convert some of that cash into stuff you can use just in case cash becomes worthless, etc.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.


Does Technical Analysis Work? Let's Try It Out

There are three general opinions of technical analysis: (1) it is a science that works, (2) it's a pseudoscience that works because its practitioners all do the same thing when a chart is a certain way, or (3) it's a bunch of hogwash.

I'm somewhere between (2) and (3), but am more open to (1) after tracking Adam Hewison's predictions on spot gold for a couple of months. I would like for (1) to be true, as would most people, for obvious reasons.

Certain chart and volume patterns are supposed to foretell a stock's (commodity's, ETF's, etc) future price movement. Occasionally, if I come across such chart patterns I'll post about them. Then, I'll check back after a while to see how the predictions turn out. With enough such experiments, it'll hopefully be possible to either confirm or deny (3).

Since a stock can go either up or down from any given point, there's a 50% chance for each prediction to turn out correct (I'm ignoring the possibility that it'll stay the same). If technical analysis doesn't work, predictions should be right around 50% of the time. If it works, predictions will be right or wrong the significant majority of the time. What constitutes a significant majority of the time will be determined by the number of predictions made. If it seems wrong to say that technical analysis works if it's wrong almost all the time, remember that it is just as hard to be wrong most of the time as it is to be right most of the time when you have a 50% chance of being right or wrong. Put another way, if it's wrong most of the time, technical analysis can be very useful, as we can do the opposite of what it predicts.

A major thing that can skew results is that I can easily misread charts. For this reason, I'll stick to the so called archetypal patterns: double top, double bottom, head and shoulders, cup and handle, etc, that are easy enough to identify with software.

Today, I'll look at two chart patterns, the "double top" and the "double bottom."

The double top chart has two peaks that are roughly around the same level, with a moderate dip in between. It is supposed to be a bearish signal when the stock goes below the level of the dip between the two peaks.

Here's one stock that has a double top chart: American Capital Agency (AGNC). The pattern manifested over the last seven or so days, in the right corner of the image below. AGNC closed at 19.13 on 12/10/08. Let's see where it will be at the end of next week.

A double bottom is essentially the opposite of a double top. It is two about equal dips with a moderate peak in between. The chart is supposed to be a bullish indicator when the stock's price goes above the peak.

Drugstore.com (DSCM) closed at $1.19 on 12/10/08. The double bottom for DSCM started out in mid November:

So, let's see how these stocks do in the near future. We're looking for DSCM to go up and AGNC to go down.

Disclosure: I hold no positions in the securities mentioned above.

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ETF Portfolio Underweighting US December Update

The Model ETF portfolio's original description and list of holdings is here. All updates, like this one, are available here.

As of this update, the ETF portfolio and the S&P 500 are about even, each down almost 30%.

The best performer in the portfolio has been the Vanguard Total Bond Market ETF (BND). It has returned almost 2% since the portfolio was started in August.

The portfolio's inflation protected bond holding, IPE, did not pay dividends since October, although it is supposed to pay monthly. Say hello to deflation. The Consumer Price Index has been negative or zero since August.

If the current deflationary environment continues, BND will probably go up a little. Worried investors are driving long term bond yields lower almost each day.

In the longer term, it's hard to see how we won't have major inflation. At that point BND will probably fall sharply, while IPE will do well. The portfolio's commodities holding, RJI, should also do well when inflation reasserts itself. In the near term, however, it looks like it's going lower.

Dividends received and reinvested:

BND $0.296 * 6.7813 = $2 [75.84] 0.02637 more shares

BWX $0.122 * 17.3177953 = $2.1127710266 [50.26] 0.04203682902109 more shares

WIP $0.204 * 14.27516 = $2.91213264 [44.58] 0.067426085667979 more shares

Fresh $500 invested:

VEU $240 total 8.191126279863481 shares at 29.30 1972.66/44.371126279863481 = $44.458

RWO $100 total 4.460303300624442 shares at 22.42 1124.16/30.512502300624442 = $36.842602711643022

RJI $160 total 28.169014084507042 shares at 5.68 1481.92/151.308746084507042 = $9.794

SPY $500 total 5.686 shares at 87.93 12000/97.853 = $122.63

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.


Ultra ETFs Are Not For Long Term Investing

Historically, the market's tendency is to go up. That's one reason why inverse and ultra inverse ETFs are for short term trades only.

Some may think, however, that since the market tends to go up over the long term, leveraged long ETFs should outperform their regular counterparts. The thinking may be, for example, that if stocks have historically returned 8% per year, a leveraged ETF tracking those same stocks, should return 16%. After this thought comes, "why buy the S&P 500 (SPY) when I can do twice as well with the leveraged S&P 500 (SSO)?" If the S&P goes up x% a year on average over the long term, the leveraged ETF should go up 2x% a year over the same period. Seems like a no brainer.

This kind of thinking would be wrong. Don't be tempted by leveraged ETFs for the long term. Why? Although they go up twice as much as the index they track (there are now leveraged ETFs that go up three times as much), they also go down twice as much when the index falls. As it takes more, percentage wise, to get back to even, leveraged ETFs can lag significantly after their index goes down.

For example, if an index (or an individual stock) falls 25% in value, it has to go up 33.33% to get back to even. Say XYZ is $100 per share. It loses 25%, and is now $75 per share. It needs to gain $25 to get back to $100. While that $25 was 25% of $100, it is 33.33% of $75.

Suppose ABC is a leveraged version of XYZ, and its performance corresponds to twice the daily performance of XYZ. When XYZ falls 25% in value, ABC falls 50%. While XYZ has to gain 33.33% to get back to where it started, ABC has to gain 100%. Say ABC started out at $100 per share. After losing 50%, it's down to $50 per share. To get back to even, it has to gain $50, or 100% of its value.

Now, suppose XYZ, after losing 25%, gains 33.33%. It started out at $100 per share, went to $75, and is now $100 again. ABC, which tracks twice the daily performance of XYZ, will not get back to even. Say it starts out at $100 per share, just like XYZ. When XYZ loses 25%, ABC loses 50%. When XYZ then gains 33.33%, ABC gains 66.66%, which is well below the 100% required to get back to where it was. In this example, ABC starts out at $100 per share, goes to $50 per share, and then goes up to $83.33 a share. While XYZ is unchanged from when it started, the leveraged ABC is down $16.67.

Here's a real life example. The Diamonds Trust (DIA) tracks the Dow Jones Industrial Average (DJIA). Its daily performance is supposed to correspond to the daily performance of the DJIA. So, if the Dow goes up 5%, DIA is supposed to go up 5%. If the Dow goes down 5%, DIA is supposed to go down 5%. The Ultra Dow 30 (DDM) also tracks the DJIA, but its daily performance is supposed to be double that of the index. So, if the Dow goes up 5%, DDM should go up 10%. If the Dow goes down 5%, DDM should go down 10%.

Imagine you bought both at their 52 week highs: As of 12/4/08, DIA's high was $137.90, and DDM's was $96.29. Recent price in this example is as of market close on Wednesday 12/3/08.

Bought: $137.90
Recent: $86.04
Down: 37.6%
Required gain to get to even: 60.27%

Bought: $96.29
Recent: $30.84
Down: 67.97%
Required gain to get to even: 212.22%

If the DIA gets back to $137.90 a share, DDM will be somewhere under $66 a share, still down some $30. While the Dow has to gain 60.27% from Wednesday's close for DIA to get back to its 52 week high, DDM won't get back to even until the Dow goes up around 106%!

This sort of thing is a major reason why many investors like to limit their losses to a certain percentage. (William O'Neil, for example, limits his losses to 8%.) The more something falls in value, the harder it is to get back to even. As stock indexes never go straight up, long term investors should avoid leveraged ETFs.

Disclosure: At the time of writing I owned puts on SPY.

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Considering Going Short on Credit Cards and Long on Agriculture

I mentioned in October that I planned to buy puts on Discover (DFS) because of current and impending credit card defaults. The stock hovered between around $10 and $12.50 before dropping below $7. I thought I missed my opportunity. (Why am I trying to time the buying of puts? Although I think DFS will eventually go to $0, July is the farthest out put available right now and I don't think it'll happen that soon. I don't short sell because I think it's riskier than puts, and the government loves to change the rules.) Now that DFS is again above $10, I have another chance. If American Express (AXP) continues going up, I might buy puts on it too (but I don't think it'll go out of business).

Besides my own doom and gloom thoughts on the matter (here and here), here's a great op-ed on Minyanville.

Some quotes:

The most amusing part of CEOs begging Congressmen for $25 billion is the assumption that there's $25 billion to give. The United States has no money. It's broke. It already spent $10.6 trillion more than it has.

"The second-largest merchant-vendor for credit card use is now McDonalds."

The unemployment rate is currently 6.5%, according to U-3 government figures. The broadest U-6 measure, which includes discouraged and marginally attached workers, is 11.8%. If you're still discouraged and jobless after 1 year, the government ignores you in its calculation. How convenient. If these workers were to be included, the unemployment rate is currently 16%.

The dollar's plunge seems inevitable, given the soaring national debt. Meanwhile, the world's population is increasing, and its grain supplies are at historic lows. Farmers are having trouble getting loans to buy fertilizer. That means lower crop yields. As long as demand stays constant or grows, this points to higher agriculture prices.

Although stocks at last appear fairly valued, they can go lower. I have a target allocation fund in my Roth IRA. I'm thinking of selling it (at a loss of course) and using the proceeds to buy agriculture. I already own the Rogers Agriculture Index ETN (RJA), which is also down from when I bought it. I'm unwilling to buy more of it, because of the now very real risk of bank and sovereign bankruptcy. I'm not saying that Swedish bank SEK will default. I don't know one way or the other. But right now it's probably safer to avoid buying bonds (ETNs are bonds). When I find a suitable replacement, I'll make a post on it.

Disclosure: At the time of writing, I owned RJA.


Frontline's Earnings

Frontline reported its earnings for the third quarter 2008 today. I wrote about a week ago that I would be surprised if the report were not a good one. Whether the report was a good one depends on how you look at it.

Earnings per share were $1.39, $0.20 lower than the analyst consensus and around 67% lower than last quarter. However, earnings per share this quarter were over 4.6 times higher than the same quarter last year.

Daily rates averaged $74,700 for VLCCs. This is down from $86,300 a day last quarter, but up significantly from the $36,000 daily rate recorded in the third quarter of 2007. Average Suezmax daily rates were $62,700 in the third quarter of 2008, down from $72,000 in the second quarter, but up from $25,000 recorded in the third quarter last year.

Besides the analyst earnings miss (if one looks at what the analysts say at all, it's probably better to look at the lowest estimate), the disappointing news is that the dividend will be $0.50 a share for this quarter. Some will view this as a dividend cut. That's one way to see it. But the company does not have a stable dividend, and determines its payout each quarter based on earnings and future outlook. If the recession does not turn into a depression and/or the demand for oil eventually increases, dividend payments will be higher in the future.

For November, the company reports that its costs are $34,700 for VLCCs and $24,800 for the Suezmax fleet daily. As this does not include capital expenditures and loan repayments, costs can increase if FRO is unable to refinance its loans as they mature--a possibility with today's fragile credit market. Costs can also increase if docking fees, etc go up. Avoiding Somali pirates, for example, may make trips longer and more expensive.

Lower demand for oil and more tankers competing for transporting that oil will probably lower daily rates in the coming year. Daily rates in the third quarter were very volatile. VLCC rates were as low as $29,500 per day (below current costs) and as high as $164,000 per day. Suezmax rates were as low as $41,500 a day and as high as $153,000. If rates average at the lower end of these ranges, as is likely, the dividend may be lower in the coming year.

Frontline owes around $1.4 billion for new builds that it'll pay for over the next four years, having already paid almost $400 million. The company expects to receive 18 new build ships (10 VLCCs and 8 Suezmaxes) by the second quarter of 2012. "If credit market doesn't improve before 2012 [the company's] dividend capacity [may be reduced] temporarily," Frontline stated in its most recent report.

The outlook is grim, and the share price can certainly go lower. The company's average P/E for the last five years is around 4.7. The high estimate for 2009 is $6.17 a share. The low estimate is $2.10. If FRO continues trading around 4.7 times earnings, earnings estimates suggest a share price range of around $10 to $30. Investor pessimism/optimism can, of course, alter the P/E dramatically. For example, the trailing P/E right now is under 3.

I hope the share price falls, because I want to buy some shares. I'll look to start buying small amounts after the ex-dividend day, which is December 5, 2008, but will hold off on any big purchases until the economic picture is bleaker (which would potentially signal a turnaround).


1929 and Now

I previously wrote about how we got into this mess here. A number of articles have since sprung up, comparing 1929 and the 1930s to now, and arguing that we shouldn't be that worried. Things will be tough, they say, but they won't be depression tough. I thought I'd go over a few of their points that I didn't find very reassuring.

A depression is unlikely for the reasons in the bullet points, according to the articles:

  • With no deposit insurance, people lost around $140 billion in savings as about 9,000 banks failed in the 1930s. Today, by contrast, we have the FDIC. Of the bank failures so far, all insured deposits have been recovered, along with about half of people's uninsured deposits (and this figure could well rise).
FDIC is certainly helpful. But here are some potential problems. If more banks fail, as is expected, the FDIC will require more funds. Congress will, of course, recapitalize the FDIC. Meanwhile, all the bailouts (what's the total now? $7 trillion?) are putting a serious strain on the government's already stressed balance sheet. It's possible, and getting likelier with each new bailout (the latest $800 billion plan to buy mortgages, credit card debt, etc apparently doesn't even need Congress to pass anything), that the United States could itself go bankrupt. Our losses by way of currency devaluation can easily offset any benefits from deposit insurance.

Moreover, how much do Americans actually have in savings? The savings rate has been at historic lows, and has even been negative in recent years.

It is true that capital gains are not part of the calculation. However, our markets have lost trillions of dollars. A lot of the money that went into the stock market rather than savings accounts in the last few years has evaporated. Far more Americans own stocks today than did in the 1920s. There haven't been very many capital gains on houses recently either.

Add to the low savings rate a massive amount of debt. Before the Great Depression, total debt was 260% of GDP. As of the end of June 2008, total debt was 356.5% of GDP. Before the US fell into the Great Depression, it was a net creditor nation and ran trade surpluses. Today, we are the world's largest debtor nation, and are running trade deficits. We are also involved in two expensive wars, which was not the case in the 1930s (until World War II came along).

  • Before the great depression, most households had only one wage earner. Today, on the other hand, most households have two wage earners. One spouse's paycheck makes the family's burden a little less as the other spouse searches for work.
Real wages have declined for years. In many cases it now takes two wage earners to adequately support the family. It certainly helps that one spouse still works, but it may not be enough for many families. Looking for work is becoming more difficult with each passing day.

  • Before the Great Depression, there were no safety nets. Today, by contrast, in addition to FDIC, we have things like unemployment insurance, Social Security, Medicare, and private pensions.
That's true, but how long do these things last? Some states are already running out of unemployment insurance money. According to the National Employment Law Project, as of November six states don't have enough to cover a year of payments, eight states have about six months of reserves left, and five states have less than three months of reserves left--they are insolvent. As unemployment grows (remember, we're probably only at the start of this thing with regard to job losses), more states will experience trouble.

Those unemployment insurance trusts in trouble now are forced to borrow from the Federal government, which is itself running huge deficits. They are also considering decreasing unemployment benefits and increasing unemployment taxes on those still fortunate enough to be working. Both of these will curb consumer spending, resulting in more job losses. It sucks when the bad things reinforce each other.

Social Security and Medicare have been in trouble for years, but will probably continue to function. Social Security income will probably be taxed more.

Private pensions are worrisome. With businesses going bankrupt or being otherwise unable to pay benefits (which were under funded to begin with and have suffered more losses as stocks have crashed) to retired workers, the responsibility of paying pensioners falls on the Pension Benefit Guaranty Corporation (PBGC). The entity was established by Congress in 1974 to protect pensioners whose employers cannot pay their pensions. It's supposed to protect around 44 million US workers.

As pretty much all government agencies, the PBGC has been run by idiots. Early this year, it was estimated that the entity had a deficit of $14 billion. To make up for this shortfall, the PBGC doubled its stock allocation to 45% of its portfolio and added another 10% to such investments as hedge funds. I guess that plan didn't work very well. Sooner or later, the PBGC will have to be bailed out by the Federal government, have to lower benefits, and/or increase premiums for those companies (decreasing in number) that still pay it to insure their pensions.

So yes, we do have a safety net. It seems, though, that it has holes big enough for many people to fall through.

  • Stocks have not declined as much in value as they did during the great depression. Foreclosures and the unemployment rate are not yet up to Depression era levels either.

That's true. But that's not an argument for why we won't have a depression. It only indicates that we're not there yet (and let's hope we won't ever get there).

  • While the government at the start of the Great Depression did boost spending and brought emergency relief to companies and individuals, it also raised taxes, raised interest rates, and imposed tariffs on imports, starting a trade war that collapsed global trade. By contrast, our leaders have learned much from history. They have acted quickly with a stimulus package (and more to come), bailed out Fannie Mae, Freddie Mac, AIG, and Citigroup (more to come), and have cut rates to historic lows (not much more to come).

Our leaders are idiots (I'm not claiming to be any smarter than them), and if our economy's health depends on them, we're probably screwed. The same people who got us into this mess are the ones who are in charge. Obama's appointees are cut from the same cloth, more likely to bail out their Wall Street friends than do what is right. Does it make sense to try to solve a problem caused by excessive borrowing by borrowing more?

While he may change his mind, two of Obama's big promises were protecting American workers from globalization (another Smoot-Hawley Act perhaps?) and raising taxes (on capital gains, and the rich).

Supposing Obama won't follow through on these potentially destructive policies, what's he going to do? More bailouts, more government spending, and the like? I hope it makes everything all better. But will it? (And what's to prevent other countries from putting up their own tariffs and walking away from trade treaties?)

The system is clogged. Consumers can't borrow anymore. Their credit lines are maxed out, and they owe more on their mortgages than their houses are worth. Banks are now wary of lending, and there's a good possibility they don't really have any money left to lend. An estimated 72% of our economic activity comes from consumer spending, much of it with borrowed money. That percentage will shrink, and not because of growth in other areas of the economy.

It's plain that we don't manufacture very many things anymore. Cars are one of the few major things that we do produce here. But sales are plummeting. The troubled big three employ around 355,000 American workers. Ten percent of US workers, however, are employed in a related industry (suppliers, dealers, local businesses, media companies that depend on auto advertisements, etc). Either the big three automakers go bankrupt, and an estimated 5.5 million jobs are lost over the next two years (estimated by GM, so the real number will hopefully be much smaller), or the government pays their expenses (because sales sure won't pay for them) and we have zombie car companies.

As the banks have lined up, so have the automakers. The homebuilders are right behind them with their hands out. Who's next? Bailing these companies out prevents others from taking their place, because of too much supply. Japan, which kept its banks from failing by stuffing them with money, still hasn't recovered from its housing bubble. It's taken 20 years.

It all comes down to this: the more bailouts, the more the government has to borrow. The more it borrows, the more likely it will go bankrupt and/or the dollar will collapse. All the current solutions aim to return us back to business as usual. If they succeed, we'll have a small boom, as fake as our last boom, and then another, more painful bust.

Some, like famed investor Jim Rogers, argue that if we stop trying to prevent the collapse--stop bailing out the gamblers, the irresponsible, and the incompetent at the expense of those who saved and followed the rules, we will have a major recession from which we come out stronger. Pain is inevitable. Taking it later rather than now will be far more painful. South Korea, for example, let its corporations fail in its last financial crisis. Now it's one of the world's fastest growing economies.

I don't know who's right, but things look grim no matter how one looks at them. I hope Ben Stein is right and there's only a few billion dollars worth of troubled assets out there.

It will soon be time to start shorting long term Treasuries (TLT). The ETF just made a new 52 week high. It seems that interest rates will have to rise, either because of attempts to lower the coming bout of inflation or because of a collapse in bond prices. US government bonds are pretty much the only asset class that has held up during the crisis. Sooner or later its bubble will burst too.


Dividend Portfolio Update

As I might not have time later this month, and because Anheuser-Busch (BUD) was bought by InBev for $70 a share, I decided to update the Buy and Hold Forever Dividend Portfolio. This and all future updates will be posted here. The spreadsheet tracking the portfolio is available on the original post and here.

I didn't think BUD would be bought at all. And if it were bought, I didn't think it would happen so soon. I said in the original portfolio rules that if a holding was bought for cash, that would count as a dividend. That feels like cheating somehow now that it's actually happened. Should BUD be replaced by Molson Coors (TAP)?

The original criterion for including stocks in the portfolio was that they are dividend paying household names. Now that BUD is gone, and I like beer so much that all brewers are equally familiar to me, I don't really know what brewer to put in its place. International companies will probably have a bigger dividend payout, but they are much harder to track. Moreover, for many investors it can be difficult to buy stocks on the international markets. The best replacement, in my opinion, would be the new company Anheuser Busch-InBev, which trades in Brussels. Rather than having a headache doing currency conversions and tracking the daily price, however, I prefer to replace BUD with TAP, if it is replaced at all. (InBev trades on the Pink Sheets too, but the dividends are difficult to track.) (If BUD's replaced, $350 will be used to buy TAP. The rest, somewhere over $40, will count as a dividend.)

There is a poll addressing this question to the right of this post. If you're reading this by email or on some other site because the post has been reproduced there (without my permission, I might add, unless it's on Seeking Alpha), you'll find the poll here. It closes on December 1.

In addition to updating the spreadsheet for the dividends received so far, I've added "Share Price Value" and "Share Price Return." This is just to keep track of the great Ponzi scheme known as the stock market. Since we're keeping the stocks forever, "Total Dividend Return" is the preferred measure. You'll notice that the "Share Price Return" is currently greater than the "Total Return," which incorporates dividends. You'll also notice that the dividend return is negative. That's because commission costs were counted as dividends when the portfolio was started (it started with a negative one percent return). Over time, "Total Return" will be greater (and hopefully positive!) than "Share Price Return."

Here are the dividends received so far (ex div dates used):

3M (MMM)
19-Nov-08 $ 0.50 Dividend *5.443 = 2.7215

17-Nov-08 $ 0.24 Dividend *7.904 = 1.89696

Boeing (BA)
5-Nov-08 $ 0.40 Dividend *6.677 = 2.67

Chevron (CVX)
14-Nov-08 $ 0.65 Dividend *4.692 = 3.0498

Church & Dwight (CHD)
6-Nov-08 $ 0.09 Dividend * 5.923 = 0.533

Con Ed (ED)
7-Nov-08 $ 0.585 Dividend * 8.079 = 4.726

Duke Energy (DUK)
12-Nov-08 $ 0.23 Dividend *21.368 = 4.9146

Du Pont (DD)
12-Nov-08 $ 0.41 Dividend *10.924 = 4.4788

Enbridge (ENB)
12-Nov-08 $ 0.282 Dividend *10.116 = 2.852712

Exxon Mobile (XOM)
7-Nov-08 $ 0.40 Dividend *4.722 = 1.8888

Intel (INTC)
5-Nov-08 $ 0.14 Dividend *21.834 = 3.05676

Microsoft (MSFT)
18-Nov-08 $ 0.13 Dividend *15.674 = 2.03762

Overseas Shipholding (OSG)
5-Nov-08 $ 0.438 Dividend *9.313 = 4.079

Pfizer (PFE)
5-Nov-08 $ 0.32 Dividend *19.763 = 6.32416

Target (TGT)
18-Nov-08 $ 0.16 Dividend *8.724 = 1.39584

United Technologies (UTX)
12-Nov-08 $ 0.385 Dividend *6.368 = 2.4517

Wells Fargo (WFC)
5-Nov-08 $ 0.34 Dividend *10.279 = 3.49

If you catch a mistake, please post a comment here or email me.

I've received several requests from people who would like to use the spreadsheet for their own purposes. That is, they want something that has all the formulas, so all they have to do is put in their own tickers, share numbers, and purchase prices. I'm happy to oblige. Email me and I'll send you an Excel spreadsheet.

Disclosure: At the time of writing, I owned WFC.


You Don't Know Whether Buffett Lost His Touch!

Yahoo! Finance's front page has yet another article that has me infuriated. First it was the 29 year old housewife who is the paragon of a saver and early retiree. Now this.

The article in question asks whether Warren Buffet has lost his touch. It recounts what it calls three of Buffett's mistakes.

The first mistake, the article states, is Buffett's investment in Goldman Sachs (GS). Buffett invested $5 billion in the company in September, getting a 10% dividend. He also received the right to buy $5 billion worth of Goldman stock at $115 per share within the next five years. As Goldman was trading at $64 a share, the article concludes that Buffett lost over $2 billion.

I don't get it. Did Buffett exercise his warrants to buy $5 billion worth of GS stock? No. Did the warrants expire? No. Did he even pay anything for the warrants? So how did he lose money? (It actually shows how smart he is, not buying the common stock.)

What about the sum he invested in Goldman (and GE) preferred stock? Buffett is getting $500 million in dividends every year from GS. Excluding taxes, if GS survives and keeps paying, Buffett will get all his money back in ten years. If Goldman calls the shares (it has the option to buy the preferred shares back at a 10% premium), Buffett will make $500 million in addition to the interest payments he receives up to that point.

Buffett's second mistake, the article says, is that he thought that Congress' passing of the bailout bill would make his investment succeed. The S&P 500 is down 25% since Buffett lent money to GS, and 21% since the bailout was passed. Berkshire Hathaway's (BRK-A) stock is down 30% off its 52 week high, the article also notes. I'm not quite sure what Berkshire's stock has to do with the bailout or the Goldman investment (it's down for a number of reasons, including owning businesses that are exposed to the depressed housing sector), but the article's point is that Buffett made a mistake because the market is down since the bailout passed.

It's been only two months since the bailout has passed. While Paulson seems to change his mind every day about how to proceed, that doesn't mean the bailout and Buffett's investment are failures. Two months is not enough time to make a judgment one way or the other.

Buffett's third mistake, the article argues, is his NY Times op-ed. "'Buy stocks, cash is trash,'" the article paraphrases. Buffett's cash is trash philosophy did not fare very well, says the article. You see, over the last 10 years T-Bills have returned 30%. Thus, "If your money would have been sitting in cash for the past year, you'd be able to buy most everything on massive discounts."

I am shocked. Had the person who wrote the article actually read the op-ed, he would see that Buffett has been all in cash in his personal account for a long time. Now that stocks are trading much lower, and the government printing presses are running at full steam, Buffett thinks stocks will outperform cash over the next 10 years. He doesn't know if stocks will go up tomorrow, or a year from now. But he's going from all cash to all stocks if stocks stay at their current levels. He's doing pretty much what the article implies is the right thing. But that's his third mistake. Why? And anyway, (at least the article acknowledges that) it's been a month since the op-ed. We'll know in 10 years whether Buffett is right about stocks being better than cash.

The third mistake claim is just ridiculous. The first two claims are very common in the investing press. When someone's portfolio is down (no matter over how short a period), they're a fool. If they're up, they're a genius. You can't call Buffett a fool. So the next best thing is to ask whether he has lost his touch.

Has he lost his touch? Maybe. I don't know, and neither do you. It's only been two months! His investing horizon is years, decades. We can say he lost his touch if GS goes out of business or stops paying him dividends. That hasn't happened yet.

If Yahoo! keeps publishing such garbage, they might as well invite me to write for them.


What's the Point of Share Buybacks?

I suggested in some previous posts (like here) that share buybacks are a good idea. Some further thought on the subject has made me reconsider.

When we buy stock on the open market (i.e., from all sellers that are not the company), the company whose stock we buy benefits only indirectly, if at all. A company's share price (market cap, actually, because it makes no difference if for example a $100 billion company's stock is priced at $50 or $100) matters only when it sells its shares and when another entity tries to buy the company.

In theory, share buybacks should increase the value of the shares that remain outstanding (or in the float if the company doesn't cancel the shares it buys back). There are a couple of general reasons for this view. (1) Given the same investor demand for the shares as existed before the buyback and a lower supply of shares because some have been bought back, the shares should rise in value. (2) A company buying back shares increases some per share figures (like sales and earnings), decreases others (P/E, Price/Sales, etc), and signals to investors a number of things (e.g., management is optimistic about the future, thinks the shares are undervalued, the company is in a good enough financial position to use cash in such a way, etc). It may lead investors to want to buy the shares, thereby increasing the shares' value. That is, a buyback not only decreases supply, it may boost demand.

In practice, it is hard to tell what effect a share buyback actually has. When a company buys back its shares and they rise, we cannot really say that this is the result of the buyback. If the company is doing well, its shares might rise just for that reason, regardless of any buyback. On the other hand, there are plenty of examples of companies buying millions or billions of dollars worth of their shares every year while their stock price drifts ever lower. Maybe the share price would decline faster without the buyback, but there's no good way to tell.

Why do companies buy back their shares? Unless the company decides to go private, it has to be for the shareholders, based on the theoretical reasons mentioned above. This is because from the company's standpoint, the share price does not matter unless the company sells shares. There is no benefit to the company if its shares go higher and no real detriment if its shares go lower, unless it sells shares. When making a secondary share offering (and perhaps selling stock to investors directly--although this doesn't affect anything unless a lot of stock is sold in such a way), the higher the company's market cap, the better for it. That's because it can raise more money. The lower the market cap, the less money the company can raise.

This is not to say that share price does not matter in other circumstances. It does, for it can affect things like, for example, how current and potential customers see the company. A rising share price may keep old customers and help get new ones. A falling share price may do the opposite. But in terms of a share buyback, I don't think share price matters. If the company is doing well and investors think it will continue to do well, the shares will probably rise for the same reason as the company gets new clients. If business is going poorly, the shares will fall for the same reason the company will lose customers. Share buybacks will not help either situation, and, regarding the latter, the money could be better spent more directly, say on advertisements.

I find it a little funny when a company says it's buying back its shares because they are undervalued. That they are undervalued suggests that they will be fairly valued in the future. Why would you want to buy undervalued shares? Silly question, right? Because you want to sell them later for a higher price. That's pretty obvious.

If you want to keep the shares (of a non-dividend paying stock) forever, it doesn't really matter if they're undervalued or overvalued because you'll never sell them and won't suffer a capital gain or loss. It will only matter what your expenditure is. But if you plan to spend $x in total and the only variable is the number of shares you end up buying, it doesn't matter how the shares are valued when you buy them, unless you plan to sell them later. (What's the point of buying and holding a non-dividend paying stock forever? I don't know, and have been wondering about this.) It is different with a dividend paying stock, of course, as the more undervalued it is, the better the yield you can get. So buying undervalued stock makes sense, from the investor's point of view--you either want to sell the stock in the future to someone else for a higher price, or you want a good dividend yield if you decide to keep the stock forever.

But does this make sense from the company's point of view? It's buying back shares because it thinks they're undervalued. So it wants to sell them later for a higher price? (Some companies buy back their stock with borrowed money. Can this ever be smart if they don't plan to sell the shares later?) Do you want to invest in such a company? Investors hate having their stake diluted, unless it's for a good reason.

There are three general situations in which a company issues new shares. (1) A development stage company needs extra money for R&D or to build a plant, (2) growth: a partial or all stock merger with or acquisition of another company, or money needed for a new or bigger plant, more ships, trucks, real estate, etc, and (3) survival: the company does not currently have enough cash to sustain its operations. (We can add a fourth reason, but this would be a rare one: the company thinks its shares are overvalued and decides to sell.)

A company in situation (1), unless management is stupid, would never have made share buybacks. If management is stupid, the new share offering won't be successful because of the previous buybacks.

A company in situation (3) likely has already seen its share price plunge. Share buybacks in the past, likely for a higher price than the company now offers, do not help. All the banks that had share repurchase programs come to mind here.

Situation (2) is probably the only time when a company can issue new shares and sell them for more than it paid in an earlier buyback. But had it not done the buyback previously, would it really make much of a difference in terms of the company being able to issue more shares now so that it can expand? If investors think the expansion is a good idea, the company's secondary offering will be successful even if it never bought shares back in the past. If investors think it's a lousy idea, past share buybacks will probably not make the new share offering's reception any better. So even here share buybacks may not make sense. When seeking to buy undervalued shares, it seems, a company is better off going after another entity's shares rather than its own.

Instead of spending its money to lower the number of its shares being traded, the company has better options. If providing value for investors is the impetus, maybe giving them the cash instead is better. A share buyback may do nothing for the stock's price. And even if it does, the shareholder has to sell in order to benefit. A dividend, on the other hand, rewards the shareholder and allows him or her to stay invested in the company. The company can also use the cash to service its debt (if it has any), try to hedge its costs (e.g., a beer producer might buy wheat futures), invest in the undervalued shares of another company, or keep it in a safe place for future opportunities or a rainy day. A company in situation (3) might not be in such a dire predicament if it kept the cash rather than buying its own shares.

To put it in a slightly different way:

When you buy shares you either intend to sell them later for more than you paid, or keep them forever. They are of no use to you if you keep them forever unless they pay a dividend. A company cannot pay itself dividends, and the amount of money it saves by not having to pay dividends on canceled shares pales in comparison to how much it costs to cancel the shares. (For example, if the dividend yield on the shares is 5%, it will take 20 years before the company saves money on the transaction if the dividend payout stays the same.) So keeping the shares forever is no benefit to the company. To derive a benefit, it must sell the shares for higher than it paid for them.

Investors like share buybacks because the share price might rise as a result and because their stake in the company increases. That the share price will rise because of a buyback is a questionable assumption. Apart from enjoying a potential rise in the share price (yes, earnings per share increases because there are less shares, but unless the share price goes up correspondingly, you should not care one bit), having a greater stake in a company means having greater voting power. But for most investors, going from having 0.00001% of the vote to 0.000011% does not matter. (One may argue that a smaller share count means more dividend money is available for each share. For example $5 million spread out over 20 million shares will give a bigger payment per share than if it's spread out over 20.5 million shares. I agree. But why couldn't the company have used the money it spent on those 500,000 shares to increase its total dividend amount instead? The end result would be the same--greater payout per share--but the investors who kept the shares would get the extra money rather than the ones who sold.) Having a slightly greater stake in the company, then, means squat for most investors.

So, if the company keeps the shares forever, investors get pretty much nothing except greater ownership in a company with less cash (and/or more debt), and the company gets nothing. If the company decides to sell the shares later, on the other hand, the greater voting power derived from the previous buyback is erased. As investors hate dilution, the share price might suffer as well. In the end, a company might end up in a better position because of share buybacks, but not enough to make buybacks better than other options.

What's interesting is that share repurchase programs usually run at full steam when things are good and the share price is rising, and are canceled when things get tough and the share price falls. But the best time to invest in a company, as we learn from the best value investors, is when its share price has tumbled. And this is precisely the time when the company is struggling and can't buy its shares. So much for buy low, sell high.

Management, give me a dividend, pay your firm's debt, or keep a fund for the future if you don't know what to do with the extra cash. If the company's shares are undervalued, use your own money to buy them.


Another Look at FRO & OSG, Some Thoughts on NAT

Frontline (FRO) and Overseas Shipholding (OSG) are each down almost 50% since I looked at them in August. Now that their share prices have come down significantly, they are worth another look.

While the broader market has tumbled as well since August, Frontline and OSG have significantly underperformed.

I wrote in August, that "tanker oversupply may lead to a fall in spot rates, even if demand for oil remains constant." This remains my view, but add to it a drop in oil demand and oil production. It looks like investors are anticipating something like this, for earnings at the shippers so far have been improving. OSG, for instance, reported an increase in earnings in the most recent quarter, primarily on higher day rates for its VLCCs (Very Large Crude Carriers). FRO is scheduled to report next week, and I will be surprised if its earnings disappoint.

As far as estimates for tanker supply go, the consensus is that over the next few years it will grow by 4 to 5% annually. Historically, tanker demand has grown less than 2% per year. Given the worldwide recession and OPEC's production cuts, there will probably be less oil to transport in the next year, if not for a longer period. (OSG's management thinks the next good year will be 2010.) With more ships ready to transport that oil, it is hard to see how day rates will not decline, at least in the near term. This means lower earnings for both FRO and OSG, and probably substantially smaller dividends for FRO's shareholders.

The tanker supply glut may not be as bad as expected, however. Many new ship orders may be canceled due to the credit crisis. OSG's management estimates that almost a third of all orders will be canceled. This is potentially good news for day rates. It is not good, however, for those tanker companies that will lose their deposits when they cancel. Looking at Frontline's upcoming report will tell us whether it will be one of the companies forced to cancel. OSG should do fine, and may have the opportunity to take advantage of its struggling peers.

Near $30 a share, FRO is starting to look very tempting. Its long term shareholders say that the shares have paid for themselves. Indeed. Back in August 2001, FRO traded under $14 a share. While its share price has more than doubled since then (which is very good, especially considering that the S&P 500 and DJIA have negative returns for the same period), FRO has paid out over $69 per share in dividends. That's one of the reasons I put it in my model dividend stock portfolio. Depending on the coming earnings report, and if the stock stays under $30, I'll be looking to start building a position in FRO.

OSG, with its cleaner balance sheet, also looks tempting. I wrote in August that I might buy a speculative stake at $50 per share. I'm glad I didn't. While the dividends are more stable than FRO's and the yield is now a nice 5%, if all goes well FRO will probably outperform on that front. While increasing its dividend recently, OSG seems to prefer to use its spare cash on share repurchases. It has wasted millions buying its shares for an average price over $70. Using that money to repay debt, or giving it to shareholders would probably have been better.

For a cleaner balance sheet and a potentially higher dividend (probably between 8 and 10% next year), one might consider Nordic American (NAT). The company seems to be a great play on China's future growth. It also has no debt and relatively lower costs (in some cases substantially lower) than its competitors. NAT's small fleet is composed solely of Suezmax tankers. Last quarter, it cost around $9,000 a day to run the fleet. The company recorded average day rates of almost $64,000. While costs may rise and day rates will likely fall, NAT seems best positioned to whether the recession and take advantage of any struggling competitors by buying up their assets for cents on the dollar.

Yet, I am wary of buying NAT--for the silliest of reasons. It seems Jim Cramer has been talking up the stock, and even had its CEO on his show. I try to avoid buying what Cramer recommends, especially when it seems like a no brainer. So far NAT, while down, has outperformed the market and the other two oil shipping stocks mentioned. I don't see why it can't continue to do so. If so, I won't be along for the ride. If NAT falls to $15, I might consider it for my portfolio.

Disclosure: At the time of writing, I had no positions in the above mentioned securities.


Holiday Gift Ideas for or by Investors

With the holidays right around the corner, I thought I'd mention a few gift ideas for those trying to please the investors in their families, and for those who are investors trying to impart their values. I think the ideas listed below are better (from the investor's point of view) than the latest gadget, the cute little booties babies always seem to get, or the ugly sweater or socks no one ever wears in public. The gadgets, usually expensive, become obsolete quickly. Baby clothes, if ever worn, end up in the attic, along with all the other useless relics we collect over our lifetimes. Sweaters are only worn at family gatherings to please the gift giver. You get the idea.

Savings Bonds

One staple of gift giving, to the dismay of many American children throughout the years, is savings bonds. There are two types that you can get, EE and I. You can buy them online at Treasury Direct and at most banks. The minimum purchase for both is $25 (though it may be $50 at a bank). For both, the annual purchase limit per individual is $5,000.

Here are some facts about both (Treasury Direct has all the info):

EE Bonds
  • Fixed interest rate, determined by taking six month averages of five year Treasury market yields and multiplying the figure by 0.9.
  • Rates for new bonds are adjusted every six months, in May and November.
  • The rate announced November 2008 is 1.3%.
  • The interest is compounded every six months.
  • Must be held for at least one year.
  • If you redeem them within five years of purchase, you lose three months of interest.
  • If you buy the bonds in paper form, you pay half their face value. They are worth full face value 20 years after purchase.
  • Exempt from state and local taxes.
  • They stop paying interest after 30 years.

I Bonds
  • Interest rate determined by combination of fixed rate and inflation (determined by the consumer price index).
  • Both rates for new bonds are adjusted every six months, in November and May.
  • The fixed rate announced November 1, 2008 is 0.7%. The inflation rate, announced at the same time, is 2.46%. This makes for a composite rate of 5.64% (more info at the Treasury site).
  • Must be held for at least one year.
  • If you redeem the bonds within five years, you lose three months' interest.
  • Earn interest for 30 years.
  • They increase in value each month and interest is compounded twice a year.
  • No state or local tax on interest earned, and federal tax can be deferred until redemption. Estate, inheritance, and gift taxes (federal and state) still apply.
Shares of Stock

Another gift investors might appreciate receiving or giving, is shares of stock. There are a few websites that sell stock certificates. These include One Share, and Frame-A-Stock.

While the idea is a good one, I would avoid such merchants. As far as I know, you can only buy one share at a time. Unless you think the stock certificates will have separate value as collectibles (which they might), it's not worth paying all the fees (framing, transfer, shipping, etc) to buy just one or a few shares. Apart from the upfront costs, there is another difficulty. The receiver of the gift will have to do some paper work later on if he or she decides to sell the shares. Also, it would be a little hard to reinvest dividends on those stocks that pay their investors.

So, if you would like to buy shares of stock for someone (particularly children), I suggest you open up a trust account at a discount broker for them and buy the stock there. While not as presentable as framed and gift wrapped stock certificates, you can buy more shares for the same amount you would spend on the certificates. Also, all dividends would go into that account, which would make it easier to keep track of and reinvest. If you pick the right stocks (an index ETF or mutual fund would probably be better--something you can't do with the stock certificate merchants) for a child, when he or she turns 18 there may be a nice sum waiting for him or her. (For example, if you invested $100 into Philip Morris 20 years ago, those shares will receive around $75 worth of dividends next year, if the payout remains the same. The account would now also have shares of Kraft and Philip Morris International, which also pay dividends. The account would receive more per year in dividends than was originally invested.) This would teach the child the value of investing over long periods.


There are many business/investing games out there. People either love or hate these. Two of my favorites are Railroad Tycoon 3 and Trevor Chan's Capitalism 2.

In Railroad Tycoon, you play the CEO of a railroad company. You lay tracks, buy and maintain trains, transport goods, mail, and people, buy and build factories, farms, hotels, power plants, etc, all while compete against other railroads (either computer players or other humans in network games). You can issue bonds and shares, and buy and short sell stock of other rail companies.

Once you have enough shares of another company, or if you are a particularly good manager, you can buyout your competitors. The stock market portion of the game is loads of fun, particularly catching your opponents in short squeezes. The heart of the game, though, is about managing costs and maximizing profits. There are various scenarios in the campaign mode, as well as open scenarios that you can make for yourself. It's fun and very educational.

In Capitalism 2, you are the CEO of a company. There are various campaign scenarios and ones that you can construct yourself. You can own real estate and media stations, mine and sell raw materials, manufacture goods, sell your own and other companies' goods as a retailer, trade stocks, or do all of these things. There are dozens of products. If you want to manufacture high quality ones (price, quality, and brand name affect demand) you must do R&D or purchase the technology from your competitors, if they're willing to sell it to you (you can also try to merge with them by buying up their stock). Just as in Railroad Tycoon, you can issue shares and borrow money, and set your dividend rate. There is no short selling, unfortunately.

The game is so deep, from hiring a CFO, a marketing and/or a technology officer, to training employees, to producing goods in one city with cheap labor and selling them in another with higher prices, to selecting a brand strategy and advertising your goods, etc, that it and its predecessor (Capitalism 1) have been used in business schools as teaching aids. It is quite addictive and makes one appreciate just how much goes into running a company.

Both these games have dated graphics, but unlike with first person shooters, this is not very important.


There are lots of investing books out there. Investors may appreciate such a gift. Note, however, that there are some investors who are so frugal they would appreciate it more if you borrow the book from the library.
Subscriptions to Newsletters and Business Periodicals

There are all sorts of investing newsletters and periodicals out there. Investors may appreciate each of these. Try to look for those with free trials, so that if the gift receiver does not like it, you can get them something else without spending more money. Personally, I think investing newsletters are a waste. Periodicals can be good, but they are often available for free on the internet. For example, why subscribe to Money magazine when you can pretty much read all of its articles on CNN's website?


This least thoughtful of gifts is often the most appreciated. The gift receiver can do whatever he or she likes with cash, whether buying something with it or investing it.

From all of the above, I would prefer to receive cash. As for giving, I'm getting I Bonds for those of my family members who have trouble saving. My girlfriend's brother will probably not be very happy with this, but instead of eating Subway sandwiches (that's where most of his money goes) he'll have some pocket change and a smaller belly a few years down the road.

Do you have any other ideas? Please post a comment.