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The Importance of the Rules and Dangers of Breaking Them

There’s a harmful statement many entrepreneurs are fond of listening to “rules are made to be broken”.  If that’s the case you’re following the wrong set of rules.  Effective rules are designed to give you the best results.  Consider traffic laws if you started driving on the opposite side of the street what would happen?  It would create chaos and slow everyone down, it might work in a small situation but on average respecting and following the traffic rules helps traffic to flow better for everyone.  The same is true for business and investing.

At Richucation we make a point of teaching the universal rules.  Lots of sources preach rules that are a bit like “don’t put your elbows on the table”, they might be conventionally accepted by they aren’t truly important in the modern age at least not in most situations.  But there are essential rules in business and investing, rules designed to ensure you are consistently growing and making money, you can break them now and again and get away with it but it’s unwise because in the aggregate you’ll end up losing out.

All too often I’ve made this mistake, allowing an employee to do something that breaks the rules to encourage them to take risks, unfortunately they were risking my money not their own, we lost money and I should have intervened.  Getting involved in a business whose foundation wasn’t solid, at first it seemed great, the lie I’d allowed myself to believe, and ultimately it lost money.  Skipping the process of acquiring security on an investment relying on the integrity of the participants and strength of the venture to move forward.  Or failing to put something in writing for mutual agreement, or proceeding without getting an agreement signed and then discovering the terms I expected weren’t honored.  The list goes on, the point is rules such as these, unwritten and even unknown though they might be for most are designed to facilitate success and it’s unwise to violate them.

What are some examples of these rules?

  • Buy/engage with a margin of safety
  • Don’t get involved in something you don’t understand, increase expertise to expand where you operate
  • Test small then scale
  • Get great quality data and use it to make your decisions

As you explore business and investing, wealth building, you’ll learn there are certain foundational essentials and that you shouldn’t avoid these.  Don’t get involved in a non-repeat business.  Get involved in businesses based on growth first, only then consider price, people with high integrity have no problems putting agreements in writing.  The list goes on, suffice to say there are rules, but more importantly you must stick to these rules, at times there will be emotional pressure or perhaps a sense of rebellion to break them but don’t, they are meant to be followed not to restrict you, but to enhance your success.  When you don’t follow them, the tendency is to lose time, opportunity, and money, you might gain a little in some way that’s easy to rationalize, but it’s nothing compared to what could have been gained if you’d just followed them.

Have a question about the fundamental rules of business and wealth building?  Want to run a question, thought or idea by us?  Feel free to contact us by clicking “Ask a Business Question” in the lower right corner of the screen.

Dreams vs Goals

Dreams and goals both are a critical part of achieving results in our lives.  Dreams tend to drive and inspire us while goals keep us on track and give us concrete direction.  All too often though within personal and business development circles the two aren’t separated in a meaningful way.  We’ll hear comments such as “make sure your goals are SMART – Specific measureable actionable results oriented with a timeframe” but then apply that same logic to dreams, which is impractical and a waste of time.  Dreams have a definite place but it isn’t the same.

So what are goals and what are dreams and what’s the difference?

Think about the concept of scoring a goal, it comes from sports and is defined clearly by goal posts, it ideally does meet the SMART standard we find in MBA programs (others have expanded on the term to include “SMARTER” or “SSMART” in an attempt to improve).  The general concept is this you must be able to clearly determine when you’ve achieved a goal, you must be able to take concrete action steps towards a goal, you must be able to apply accountability to a goal since that’s part of its usefulness, but most importantly goals are like milestones they allow you to develop a plan or strategy to get there.  All of these features are very practical and can help to guide project management initiatives to make them happen and hence the accountability, etc. are worthwhile.

But what’s a pre-requisite of being able to develop a plan to reach the goal?  Knowing specifically what it might take to get there in fairly concrete terms.  In other words goals work very well for desired results within your bounds of knowledge where a minimum of education is required in order to determine the path.  This is partially why goals are generally best laid out fairly short term because there are too many unknown variables the longer the timeframe.  General timeframes are possible say in the case of a large construction project where the details of the end product and the process to get there are clearly laid out but in the likes of an Agile development model or a start-up where there is a great deal of uncertainty it’s best to keep goals as defined by the “SMART” paradigm to much nearer term.

By contrast dreams are useful to give us a loose guiding direction from which we build goals.  Dreams are what we have when we want something but we don’t know how to get there, they can be far off and nebulous.  It isn’t necessary that they be specific, crystal clear, have timeframes, are results oriented, measurable, or actionable.  A dream could be a feeling and trying to turn it into something else often isn’t helpful because that feeling drives us.  A dream could be something we have no idea how to achieve today but can inform a very vague general direction.  Dreams can be far off.  We can say to ourselves “I want to be like that” and then formulate short term goals that we believe will bring us in that direction but may not then we can continually correct and continue.

For most people something like “I’d like to be a billionaire” is a dream not a goal.  It’s impractical to set a timeline on it.  It is deceptive because it is by its nature specific and measureable but trying to treat it as a goal rather than a dream is useless because we are so far removed as not to have a clear concept of how to get there and hence it distracts us from the present moment where we can make a real difference.  Unless you’ve already got a $100 million net worth treat billionaire status as a dream not a goal.  Start by creating immediate goals near where you are at and simply use the dream to inform the rough direction.  If you’ve never made $100k/yr. get your cashflow and personal situation under control with a $10k/mo. Or $30k/mo. goal, which can actually be actioned out and achieved accordingly.  If you’ve reached that level aim for $10 million then $40 million then $100 million and so on.

Bill Gates never set out to be a billionaire in fact he didn’t believe it was possible given his vehicle but he was very focused on dominating and succeeding in his space and that dedication led one step at a time to his billionaire status.  He targeted $100 million in revenue stating “you can’t build a software company past that point and I will prove it to you”, then later told a friend “I think I can get us to $500 million in sales but won’t be able to handle it after then because people will want more and I have no idea how”.  Today Microsoft does tens of billions per year in annual revenue.

Big dreams become real through focusing on the present.  The most capable performers set very specific short term and process oriented goals.  Follow their example.

If you need inspiration or guidance follow along with us, like us on Facebook, subscribe to updates and contact us with business or wealth building questions you might have.

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When the “Sell if it Drops 10%” Rule is Stupid

Should I sell when the stock drops?

If you spend much time studying stocks and investing you’ll eventually run into this risk management rule some people swear by “if a stock you’re holding drops by 10% no matter what else is the case, sell!”

We’ve covered the subject of risk at length but to summarize some key points:

  • Risk consists of two parts the probability of loss and the severity in the event of loss
  • Most traders don’t employ strategies that reduce the probability of loss and think only about reducing the severity of loss – this of course is stupid because if you’ve got a losing % even if you lose 2% at a time you’ll eventually bleed yourself dry, which is why we don’t buy lottery tickets
  • Most traders employ a severity of loss protection that includes two key points: never risk more than say 2% of your portfolio on a given trade, employ stop losses to ensure you can’t lose more than a certain amount
  • Most retail investors use diversification and asset allocation to minimize their risk

Generally, you’ll notice we advocate two positions when it comes to investing:

  1. Average Investors – For those who don’t want to spend time mastering investing stick with dollar cost averaging a strong diversification and asset allocation mix, hold long term and forget about it
  1. Sophisticated Investors – For those who want to learn to master investing the more diversified you are the less likely you are to beat the market so focus on highly concentrated well researched investments following the investment rules we teach

You’ll notice neither of these philosophies involve employing the 10% loss and sell rule.  Why not?

The basis of the rule is preventing loss but the underlying assumption of it is you don’t know when you invest that what you’re investing in is fundamentally solid and we patently disagree with this approach.  We don’t believe you should invest if you don’t know with a high degree of certainty what you’re investing in is fundamentally solid and we advocate a lot of learning and diligence to ensure this.

Selling if it drops 10% makes sense for people who are trading based purely on technical or even based on speculative investment analysis for example people who invest in uncertain growth stocks.  The reason is because it takes a disproportionate gain to make up for a loss for example a 50% drop requires a 100% rise to recover while a 90% drop requires a 1000% rise to recover.  The theory is a 1000% gain is highly unlikely.

Value investing suggests quite the opposite premise that if the asset’s value is solid then the lower it is the better investment it is because the upside is greater and chance it is undervalued is greater.  In other words the chance of a gain isn’t based on how much the asset needs to increase in price in percentage terms but rather what the underlying intrinsic value is.  If the intrinsic value is 1000% higher than the current price then given time it will eventually go there and you’ll earn a significant return.

In other words if you’re confident of a durable underlying value in the asset you’ve purchased the lower an asset drops in price the more interested you should be in buying and if the value is intrinsic then you’d be crazy to sell based on a 10% decline because it’s got an ever greater chance of increasing.

There is a caveat to all of this.  We certainly make mistakes from time to time so instead of selling when a stock you’re holding drops 10% you should re-examine the company to ensure your underlying assumptions are accurate and the intrinsic value is indeed what you estimated it to be.  If you discover you were in error either the value isn’t what you thought or the underlying asset isn’t durable and is decreasing in value with not guarantee of coming back then you should sell but selling should be based on fundamentals of the underlying company not a decrease in price.

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Which is the better investment? IBM vs BNS Jan 2016 Part 2

Scotiabank BNS

Continued from part 1

So how come I’m saying IBM is likely to outperform BNS midterm?  Again, understanding the second part of the analysis that it’s a business not a stock.  It happens at the moment this is reflected in each company’s return on equity ROE but this isn’t always the case (BNS ROE 14.05%, IBM ROE 103.55%) but the PEG ratios would have you believe differently since the IBM PEG is 1.21 while the BNS PEG is a more attractive 1.02).

Mid term the value of a stock is much more a function of the ability to compound growth than it is to produce simple returns.  For more details, see our article on compounding vs simple growth.  In simple returns BNS and IBM are very comparable around 9.2 P/E means expected annual simple return of 10.87% (slightly higher than the market average of the S&P long term including dividends).  If you simply held the stock and each year those earnings continued then you’d expect over the long term to receive those profits (this is again a crude analogy because of course the profits won’t all be distributed at least in the short run).

But we aren’t concerned with simple annual returns, we’re concerned with compound annual returns, which means what can the company do to take that 10.87% and grow it further?  If you bought a bond that paid you 10% return and reinvested the profits then year 2 you’d make 11% on your original investment, then 12.1% and so on by year 6 it would actually be 15%/yr return on your initial investment.  So 15%/yr on your initial investment after 5 years is what we consider a 10% compound rate of return whereas with a simple return after 5 years you’d still be earning only 10%/yr.  When investing in stocks this is a function of how much the company is able to grow.

How you’ll be able to determine the company earnings or earning potential is based on applying the formula for profit.

Let’s look at BNS and IBM and compare how much they’re able to grow.

BNS is a huge Canadian bank in a saturated highly competitive market with very few large players.  It’s also a very well established market meaning it’s very unlikely Scotia bank will gain or lose substantial market share.  Further, the Canadian market isn’t likely to grow much (you’d expect it to grow in proportion to demographics so as the population rises you’d expect the company’s sales to grow accordingly but this won’t be a large amount perhaps a couple percent per year (latest data puts the Canadian population growth rate at 1.2%/yr)).  The market size on a per person basis should grow slightly due to inflation so you’d expect to include those figures about another 2%/yr.  You’d also expect over the long haul for a well managed company to find ways to increase operational efficiencies driving down costs slightly and thereby increasing margins though some of these will probably be eaten up by competition but again these will be minor perhaps a 2%/yr. gain unless something dramatic happens.

If you’re counting we’ve so far got a collective growth of 5.2%/yr. (this would be the rate of compounding in theory).  There are three other possible sources of growth:

  • They could grow into other markets – BNS is the most international of the Canadian banks with particular strength in Latin America and those markets are definitely higher potential growth markets than Canada so this presents some upside opportunity for BNS

 

  • They could offer new products or services to the existing market – the problem is what might these be? They are already in the business of deposit taking/transactional banking, loans, credit cards, processing, brokerage accounts, investments, investment banking, insurance, etc.  What else is there really?  Growth opportunities here are minimal

 

  • They could reinvest the profits by purchasing other companies and thereby increasing their cashflow or simply putting the money to work in the market – this is likely and will probably produce a couple % growth

In other words because of reinvestment and growth into other markets we’d expect probably another 2-4%/yr growth ball parking the annual rate of growth at somewhere around 8% perhaps a little more and perhaps a little less without factoring in the effects of the business cycle, which means this should hold true over a fairly long but not necessarily short term.

So you’ve got a rate of return of 10.87% but that rate of return is greater than the rate of growth so we’d expect it to drop slightly on a compounded annual basis over time.  This is especially true because they are paying out almost half of the return in the form of dividends and therefore unable to compound it.  Barring some major acquisitions, which are possible but also fairly unlikely these numbers won’t likely diverge dramatically in the long term.

Let’s compare this to IBM.  IBM is already ahead because there’s a 1% difference in dividend rates (somewhat of an indication they have more of an ability to reinvest their capital than BNS does or why not return the money to shareholders?).  What’s IBM’s market environment?

Again, theoretically, we’d expect them to grow with inflation, find ways to increase the productivity within the business (probably more so than BNS due to the nature of the business and because margins should scale better in a more IP oriented company), and grow with the population.  The difference is in IBM’s case that it is in several markets that are growing quite dramatically or at least have considerable growth potential.

For example, the cloud computing market is growing at a rate of 33%/yr. with IBM being one of the major players meaning if IBM simply maintains their market share we would expect that portion of their business to grow at 33% per year!  There’s no way BNS can come close to matching that.  Other markets are growing as well for example the server market grew by 6-17% depending on whose numbers you look at.  In other words in IBM maintains their market share they’ll grow at a rate far exceeding BNS…but will they and will they grow their market share in any of those key segments?

In certain sectors their market share is growing such as cloud and their a company that’s uniquely positioned with their services supporting their other key business areas meaning in certain sectors it’s hard to compete with them for all but a few players.  The risk to IBM is they could fall behind in fact they have slipped with decreasing revenues largely driving the decline in their stock price but fortunately not at the expense of their P/E ratio in fact quite the opposite it’s become increasingly attractive.

Without going into substantially detailed analysis about how IBM makes money, the direction of the market, etc. it’s difficult to compare how they’ll fare vs competitors in the market many of which markets are emerging and various players such as Microsoft, Amazon, and Oracle have unique offerings and differing approaches to the market.  But there is one big indicator the average person can use.  Warren Buffett owns and continues to load up on IBM shares.  Why is this important?

Buffett is exceptionally good at predicting the long term growth of a company and he doesn’t buy companies he doesn’t have a very strong reason to believe will beat the market in the long term.  This alone is a good indication for IBM combined with the growing market yet very stable business model.  It’s a riskier investment in the long term than BNS but given all the above factors it wouldn’t be surprising to see around 15%/yr. compounded returns in the mid term.  This isn’t something you can tell simply by looking at the financial statements, you need the understand the business and the business environment.

Suffice to say if BNS compounds at a rate of 8%-9%/yr. and IBM compounds at a rate of 15%/yr. then over 5 years IBM is a substantially more attractive buy than BNS even though within the next 6-24 months BNS is almost certainly the better buy.

 

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Which is the Better Investment? BNS vs TAC Jan 2016

TAC-transalta

We previously examined IBM vs BNS to consider the difference in short vs mid term strategy and the impact of compounding.

Now we’ll look at two other somewhat similar companies, at least similar by certain metrics.  BNS and TAC.

Let’s start with how they’re similar.  Both at 5 year lows.  Both relatively stable predictable businesses.  Both with low P/E ratios.  Both paying relatively high dividends.  Both profitable.

Here we get into some substantial differences and the purpose of this article is to contrast some misnomers that might seem good on the surface but on a risk weighted basis are likely to get you into trouble.

TAC has a P/E of 6.74 while BNS is 9.25.  TAC pays a dividend of 17.30% while BNS pays a dividend of 5.23%.  TAC has a P/B of 0.51 while BNS has a P/B of 1.32.  By all of these measures TAC looks to be the better buy but is it the case?  Let’s dig deeper.

First, I always believe in ignoring dividends when investing, they are a bonus not the focus of investing they risk swaying you to buy an inferior company.  This being said there’s a big warning sign with the TAC dividends…the dividend exceeds the earnings.  Meaning it is physically impossible for the company to sustain these dividend levels long term.  Either earnings have to increase or the dividends have to decrease, probably quite substantially, there’s simply no way around it (I’d expect to see the dividend rate cut in half sometime in the near future).  In other words the dividends advantage isn’t one you can rely on looking forward any substantial time period.

What about the P/E ratio though surely this is better?  Yes, if the P/E ratio reflected the likely ongoing earnings of the company the company would be radically under valued.  The problem is this is the trailing P/E ratio the forward P/E is 16.89 while the BNS forward P/E is 5.83.  In other words while BNS is expected to substantially increase profits during the next 12 months TAC is expected to see profits decrease by more than 50% in the next 12 months.  I happen to believe for a variety of reasons that TAC will eventually recover based on understanding their business (assuming it isn’t purchased) but these numbers make the outlook in the short term (anywhere from 6-24 months) pretty mild.

Further, while TAC has low margins and profits with high debt (debt interest is currently wiping out roughly half of the operating income) BNS has massive profits, substantial cash reserves, and strong margins.  In other words BNS is a much safer bet than TAC, which is definitely struggling.  When the stock price is struggling but the company is not as in the case of BNS at the moment, you’ve got a fantastic buying opportunity.

But what about the price to book ratio?  Aren’t you paying more for BNS than it’s worth and far less for TAC than it’s worth?  The TAC price to book is definitely very favorable and worth considering closely (I’ve previously expressed that TAC is likely a good mid term investment).  First, as I’ve discussed on many occasions book value isn’t necessarily a good estimate of the value of a company since it fails to account for substantial intangible assets.  That’s being said it is relatively accurate for a company like TAC (less so for a company like BNS).

The fact is one of two things will have to happen.  Either the book value will need to decrease whether from losses or depreciation or the company’s stock will over time need to rise to properly reflect the true book value.  This is true for TAC but not for BNS, which isn’t under valued measured by the book value.

What’s the concern?  The near to mid term profitability of TAC is questionable and recently adopted new regulations mean the company is going to be phasing out some existing power plants, thereby potentially reducing their asset to liabilities ratio in the long term.  In other words the extent in a reasonable period of time to which the stock is likely to recover based on the book value is somewhat questionable.

The real question for TAC is will the lower profit levels sustain themselves as a new, lower normal, will profits continue to fall, or will earnings rise?  The company is an optimal target for a buy out and announced in mid 2015 that a buyout offer was being considered.  Would this be favorable for investors?  It would almost certainly see an immediate jump in the share price but whether this was profitable would depend at what price point you entered and at what price point the offer was made.

All round BNS is an extremely safe and solid bet whereas TAC is much less certain in the short term though likely will beat the market in the mid term.

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Which is the Better Investment? IBM vs BNS Jan 2016

IBM

This week I examined two companies from different contexts in considering investment opportunities (for those who follow in the last week the Dow dropped about 1000 points and presented a lot of great buying opportunities) these were Scotia Bank (ticker symbol BNS) and IBM.  Since there’s a very valuable lesson here it seemed like a good idea to share the analysis.

On the surface according to my typical methodology BNS and IBM seem very comparable.  Both are at 5 year lows.  Both pay relatively high dividends (about 5% for BNS and 4% for IBM depending on which day you bought).  Both have P/E ratios of slightly over 9 (IBM slightly lower than BNS but not meaningfully so).  Both are low by comparable industry standards.  Both are large well established companies.  Both have forward P/E ratios lower than their existing P/E ratio suggesting profits will increase in the next 12 months.

In spite of these factors the two are quite different as investments (both fairly attractive, but quite different).  If you were going to choose which to invest in, which would be the better choice?

There are two key lessons here:

  1. Your time horizon/investment strategy will determine in part what investment is best for you
  2. When you’re investing you are buying companies not stocks

Let’s start with this point about investment strategy and time horizon.

Warren Buffett passes up opportunities every day where stocks go up in relatively short order why?  There are lots of reasons but he has a particular investment philosophy, which is based on long term not short or even mid term results.  This is because he aims to buy a company and reap the rewards resulting in less ongoing work.  This allows him to own a much larger portfolio of companies because he doesn’t have to keep such a close eye on them as if he was investing short or mid term.

Let’s ask the flip side of question if Warren Buffett is turning it down does it mean it’s a bad investment?  Not at all, it might be a great investment for someone who is applying a different strategy or maybe has a different timeframe.  People make money every day investing with a different strategy from Buffett and they consistently beat the market.  There are multiple ways to invest successfully.  You’ve got to decide what’s best for you.

How does this apply to the BNS vs IBM analysis?

According to my analysis BNS is likely to do better than IBM short term.  This is based on two things primarily.  The first is the forward P/E ratio of the company, which is generally pretty accurate for large predictable well established companies like banks especially Canadian banks is MUCH lower than the current P/E ratio and the difference between current and forward is much greater for BNS than IBM.  If BNS earnings rise as predicted it’s highly unlikely the stock will remain down.

Further, because the P/E ratio is lower one would expect a higher midterm return than the P/E ratio of IBM (this is somewhat of a crude analysis but gives a reasonable outlook).  Loosely speaking it works like this.  If you take 100 and divide by the P/E ratio then assuming the earnings remain consistent you should expect over the midterm to earn a simple return that as a rate of return because the profits are ultimately the money of the shareholders (loosely the book value of the company should be growing by that much each year and this can’t continue to grow for long without the value of the stock continuing to grow at a comparable rate).  This of course assumes the P/E ratio is an accurate reflection of the earnings of the company, which it isn’t perfect something like Buffett’s concept of owner’s earnings tends to be more accurate but for the sake of simplicity this will do for preliminary analysis.

I should mention when we’re talking about short term I’m generally referring to a period ranging from a few months to a couple years and when I say midterm I’m referring to a period of typically around 2-5 years with anything more especially in 10-year range being long term (anything much beyond the 15 year range I’d consider extremely long term and is much more difficult to predict).  Long term will typically mean going through at least one business cycle, while mid term will generally involve merely a phase of the business cycle and short term is based more on the buying and selling cycle of a company.  Knowing this allows different insights into probable price behavior.

The second reason I believe BNS is a more probable bet in the short term is because of the nature of the businesses, which is a major Canadian bank is very consistent, the valuation shouldn’t fluctuate much and nor will earnings or the market.  We’re in a rare situation where two factors are simultaneously affecting BNS causing the stock to take more of a tumble than it probably deserves.  IBM is somewhat different because it’s in markets that are rapidly changing hence there’s more opportunity for a company to come into or fall out of favor with the market, which is what’s happening to IBM at the moment in spite of most of the company’s fundamentals not changing.

Understanding this plays into the second point we discussed, which is you’re buying a company not a stock.  If you don’t understand the company, you’re likely to miss a lot in the stock and make many errors long term.  I can make those predictions with some measure of accuracy because I’m not simply looking at the stocks themselves, I’m looking at the companies and the markets they are in.  If you’re ignoring these factors you’re likely to run into a lot of problems.

Continued on part 2

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Grinders and Growers

When deciding to go into a business or launch a new product, service, or business area there’s essentially 4 things to ask:

 

  1. Is there demand and if so how much?
  2. Can I buy it for substantially below the market value and how much?
  3. How much and easily does it scale?
  4. How much durability does it have?
It’s usually easy to find things for which there is a market demand and you can buy for below market price.  Virtually any reasonable business has a marketing budget that is sufficient to earn a profitable income.  However, for the most part these are difficult to get big with because there’s a lot of competition and effort unless you catch a short term wave.  These businesses are what we call “grinders” meaning to grow them you’ve got to grind it out day after day.

 

The grind is required in any business but a business that’s a grinder won’t have rapid organic growth.  The #1 thing that’s required to make a grinder business successful, the differentiator is marketing.  You can 100% grow these businesses large and successful but it’s usually a fairly long path.  In the right industries you can sometimes accelerate this path through aggressive acquisitions but then you get into playing a different game, which is applying the above criteria to buying companies rather than just products.

 

The reverse type of business are growers.  Growers are defined by compelling differentiation.  Because they are differentiated they have low competition and if they are compelling can benefit from rapid organic growth as word spreads about them and inbound customers are very substantial as compared with grinders that tend to benefit most from a lot more outbound marketing relative to growers.

 

This is in the DNA of the company if you’ve got a grinder your fate is to grind, these can be great companies but you need to be aware of the importance of the constant push.  If you’ve got a grower you’ll still have to grind, you’ll face other challenges but the push for the market will be less intense making it easier to scale faster provided all other variables hold true.  Essentially, Silicon Valley is largely an environment where entrepreneurs are constantly starting new companies in search for growers and VC firms are investing little bits looking for one that will take off and they can run with it to make all the other work worthwhile. This in contrast to the general business formation environment where most people create grinders to provide them with a living and a lifestyle but without the intention of scaling rapidly into something huge.

 

If you’d like assistance in evaluating an opportunity please contact us.  Click “ask a question” in the lower right corner of the screen and we’ll be happy to assist however we can.
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Today is a Day Watch Lists Pay Off! Buying Opportunities!

For those who don’t follow the markets this morning following an 8.5% drop in the Shanghai stock market the Dow dropped the fastest it has ever fallen in history, over a 1000 point loss before recovering down 588 at the close of the day.

For those who follow my commentaries on the market you’ll know as the Dow rose to 18 000 points I considered it quite expensive and risky as well as found it difficult to find deals (oil at the start of the year when it dropped below $50/barrel and then rose to $60/barrel in fairly short order was the one major exception, which is now much lower and again represents a fairly strong though somewhat less certain buying opportunity).  Over the last couple months the market has gradually come down and a few stocks have started looking more attractive.  Unfortunately, they’ve lacked a margin of safety so I’ve been sitting waiting and watching today those opportunities finally popped up.

 

Going through the Watchlist

There’s a big lesson here.  If you didn’t have a watch list and suddenly had to start looking for great buying opportunities you’re in trouble because that research takes time.  I have a set of stocks I follow and advise everyone else to do so as well.  I know these are solid companies, I know approximately what they are worth, how they perform, etc.  What this means is now when the market shifts dramatically I can act quickly.

 

“Aren’t you worried about it going lower?”

A friend asked me this question earlier today.  The answer is “no”.  But rather than just saying so let’s figure out why.

Is there are good chance the stocks will drop lower?  Definitely!  In fact I’d probably say it’s around a 60% chance they’ll go lower.  Then why am I not worried?

There are only a few reasons to worry about the price dropping lower:

  1. You’ve got a scarcity mindset where you are worried you’ll miss out on that extra bit of return
  2. You’re worried it will continue dropping and you’ll lose money
  3. You’re worried about how the time horizon will be affected by the drop and the losses that could ensure

Let’s explore these in reverse order.

Worry about the time horizon

This is a fair concern, the time horizon matters for one of two reasons.

First, you can’t afford to hold long term – say because you’re trading options with time decay, or you’re buying with leverage, or you’ll have a relatively short term need for the money (maybe to pay for a new house or a car or post secondary education or retirement, etc.)  With respect to leverage and options that isn’t my game so it’s a non-issue, hence not worried but yes those would be legitimate concerns for those who were trading options or using leverage.  The issue of needing the money within a short to mid term time horizon again, it’s a very valid concern.  If say the shares drop an additional 10% and you’re forced to sell before they record you could be forced to crystalize this loss.  If you follow the Richucation wealth building strategies you won’t be in this position because part of the strategy involves building a reserve fund, getting out of debt, and building a solid base of assets to draw on before engaging in investments like these.  Hence again, not worried.

Second because you’re concerned the longer time horizon will mean a lower relative rate of return and consequently you’ll have an opportunity cost associated with the investment (ie. there are or will likely be better opportunities).  This is likewise is a fair concern there might be an opportunity cost.  My philosophy in this is much like picking tops and bottoms, I can’t do it, it’s too much hit or miss so instead I’m looking for a good deal and then don’t experience scarcity about it.  I benchmark a risk weighted return and so long as it meets my target standards I’ll go for it I believe worrying about what is “best” will just lead to emotions, which undermines good investing.  So once again, no worries.

Worry about a continual drop and ultimately losing money

There will be one of two ways you’ll lose money.  Either you can’t afford to wait for the stock to recover or it won’t recover.  We’ve already addressed the issues about being able to afford waiting but here are some additional details.

In general the stock will recover to within a margin of safety of the fair market value for a very stable company in relatively short order (usually within 6-24 months so I need to be willing and able to hold that long and for the reasonable projected returns based on the differential between the fair market value net of margin of safety and the current share price).  The exception to this is going to be where the earnings of the company drop meaning the fair market value drops (please consult my books and other posts on the subject).  In other words the danger this time horizon will be extended out much further arises from the possibility of a significant drop in profits for a protracted period of time.  In other words as part of my assessment and due diligence I have to consider carefully what the likely outlook for the profits of the company are.  I’ll do this by examining the business model, profit trends, examine the forward looking P/E, possibly examine the company’s return on equity (ROE), the competitive environment, management (especially management changes), and environment the company finds itself in.  For example does it have debt and is it likely to need to incur more debt?  Are there commodities on which the prices are based that will affect either costs or revenues?  For example, if I was looking at an oil stock and oil was at $100/barrel (especially at an all time high or historic high compared to the recent past (last couple years) then I’d be concerned there might be a drop in oil prices, which could result in a decrease in earnings, which could sustain a longer term dip in the value of the company and consequently a stock recovery.  This is all part of due diligence, understanding what you’re investing in and being able to assess why the stock is down in order to determine if this is likely part of a long term negative earnings trend.

For example, the stock of car manufacturers Nissan, Mitsubishi, and Toyota are currently down in some cases with very attractive P/E ratios.  Why?  Largely based on the slowdown in the Chinese economy, which sparks fears of less demand for cars and consequently lower P/E ratios, this is reflected to some extent in much higher forward P/E ratios for the respective companies than current P/E ratio.  This is genuinely a troubling forward looking trend and could signal a long term drop in earnings.  Likely, those companies will survive and remain profitable but won’t be valued as high as they were over the last several years.  On the other hand we could look at AFLAC or CIBC.  The former is a US insurance company providing supplementary insurance to individuals and groups in the US and Japan.  Insurance is a pretty predictable business where it is highly unlikely to see massive swings in either revenues or expenses.  The exposure the company has to China is minimal.  In other words it is highly unlikely earnings will fall much if at all in fact they are likely to rise slightly (as reflected by their forward looking P/E) if only due to reinvesting earnings to say nothing of the market growing, great efficiencies due to technology, etc.  They won’t grow a lot but they are likely to grow some, which means their fair market value is likely to rise and the stock isn’t likely to remain very low very long.  CIBC is in a similar situation.  It is a Canadian bank, highly regulated with little exposure to China in a very predictable industry in a market where there’s essentially an oligopoly and major market changes are unlikely.  It is highly likely they’ll see minor earnings increases, nothing dramatic but also not a drop, meaning the fair market value of the company will remain relatively stable and if the stock is under-priced (which with a P/E below 10 it certainly is (I’d expect a P/E of between 11 and 12 for a Canadian bank) it should recover within a reasonable time frame.

This ties into the second concern, which is the price of the stock won’t recover that the company will fall to zero or be bought up at very low levels putting the shareholders into an uncertain situation since who does the acquiring is unknown etc.  This is the reason for using a model where we choose stable companies where the dangers of the company vanishing within a short to mid time frame are close to zero.

Because these are the types of companies I’m looking at I’m not worried.

Scarcity on missing that extra bit of return

Here we get to the heart of the concern of “what if it drops more?”  There’s a belief the company is solid and undervalued, it’s going to recover it’s just a question of when and how much…but what if we buy today for $10/share and we could have bought tomorrow for $9/share.

This is bad thinking.  This is greedy thinking.

It might drop further, you could average your way in by buying some today and if it drops buying more tomorrow and so on.  It might drop tomorrow but then again it might rise tomorrow.  Without a close examination of technicals and being on top of it it’s impossible to say and I don’t try to guess.  I don’t try to make more than anyone else off a given investment I aim to make consistently great risk weighted returns.

I know great buying opportunities come up relatively infrequently and if you want to take advantage of them you need to be ready and jump on them when they show up.

Warren Buffett has a story he tells about this kind of situation.  He ranks it as his worst call ever.  He didn’t buy Wal-mart shares thinking they would drop a bit more so held off.  He said he figures that decision has cost him about $5 billion.

Yes, the stock might drop more and if you’ve got relatively good data that this will be the case go ahead and wait or inch your way in rather than buying all at once.  That isn’t my philosophy unless I’ve got a lot of options that are all fantastic and relatively great.  In that case I’ll diversify and in those situations I can afford to slide in more gradually.  But as a general rule I’ve found decisiveness when a great deal comes up is important and I don’t worry about whether I could have gotten a slightly higher rate of return.  To me the most important thing the thing that lets me sleep well at night is knowing I got a solid risk weighted rate of return and aim for consistency believing the consistency will pay off more than attempts to squeeze out that last little bit.

So to conclude that’s how come I’m not worried about the stocks dropping lower.

If you’re interested in more details, have questions, would like assistance please contact us by clicking “Ask a business question” in the lower right corner of the screen, we’re here to help.  Also check out other blog posts and our books offering detailed information on these and other wealth building topics.

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Why is business valuation so hard?

There are entire books, courses, consultancies dedicated to valuing businesses.  Yet, in spite of these there is very little credibility to those valuations with it being difficult to assign a fixed value to even large stable companies.  A business is ultimately valued based on the same principles as anything else, based on supply and demand meaning in theory it’s worth what someone is willing to pay for it and so the question often becomes “what’s the normal level someone would be willing to pay for it? And how do you figure that out?”  There are industry norms, small businesses depending on the industry, size, and assets tend to be valued at a 3 times multiple of earnings, a small accounting firm might be 75% of one year profits, sometimes various discount formulas are used.  Large public companies tend to start around 10 times earnings and then vary depending on trends, assets, industry, etc. but these are very arbitrary and generic assessments, the type that are likely to get you into trouble.  What’s the trouble?  Why the inconsistency?

A business is valued essentially from one perspective only, ROI.  In other words when considering what to pay for a business, what the business is worth the question is what will the return be for the investment relative to other opportunities?  Though it’s generally not on the mind of most investors, entrepreneurs, and business owners, the basic comparison to be made is government or equivalent bonds.  In other words government bonds tend to be a very certain, nearly as certain as you’ll get (assuming here we’re talking about AAA bonds) return.  A similar retail comparison would be lending money on an insured mortgage or loan to value first position mortgage where the security is virtually absolute and will cover the potential losses.  Understandably, a business is expected to produce a substantially higher rate of return than such bonds, why?  Because there’s substantially more risk.  In other words the balance being struck is the perceived risk relative to the apparent return, this is where we start to see the difference between the returns offered in a small business vs. a large public company.  In a small company it tends to be less stable and thus uncertain, in a large public company there’s generally an established infrastructure, brand, system, etc. and thus greater consistency in the long term performance, though neither generalization is accurate.  In a sense you might say purchasing at a 3 times multiplier (a theoretical 33% return) vs. say a 3% return on government bonds is a statement that “The risk of the business is 11 times greater than that of the bonds” (it’s not quite that simple but it communicates the general idea).

There’s an added complexity when it comes to a business that isn’t present in most other purchases such as real estate, bonds, or commodities.  The value of anything is contextual, meaning it is worth different amounts to different people in different times and places, however, nowhere is this more profound than with a business.   Think about Microsoft acquiring Skype for $8 billion.  Was it worth it?  Debatable, but how could it possibly be worth it when Skype wasn’t producing any profit?  The answer lies in Microsoft’s ability to use what Skype had (something like 160 million users) to extract more value than Skype could alone.  How?  Being able to sell other Microsoft products to them for a start.  Or the ability to decrease development and marketing costs associated with trying to capture that same market share from Skype.  Or the ability to keep competitors such as Google or Apple out (at the time of the acquisition Apple was driving forward aggressively with Facetime and the only real mobile competitor product was Skype).  This concept of leveraging an asset within the context of another company to be worth far more than it is worth outside that company is the root of most acquisitions that occur at outrageous multipliers (the other is the value of durability in dominating a market space).

On the one hand you have the uncertainty of the business’ future performance, which is often almost complete speculation.  (I was involved in the sales process of one of my companies recently and remarked at how ridiculous the idea of using multipliers as a means of valuation was given the fact that in a business such as this one revenues and profits could easily double or be reduced by half after a change of ownership or management and consequently it was laughable to look at the scenario as though there was some kind of predictable return in the future).  On the other hand you have the context of what it’s worth to the buyer and the market, which can vary wildly.  The combination of these factors make valuing businesses in general to be a virtually impossible feat.

Where then does this leave us?

Warren Buffett offers what is perhaps the most profound insight into business valuation.  Essentially, his position is you can’t accurately value most businesses; there is simply too much uncertainty at least as an outside investor.  Instead, you need to focus on businesses that are like bonds or cashflowing real estate; they have a stable long term outlook.  These he defines as businesses with a “durable competitive advantage”.  Such an advantage is often difficult to quantify and might come in many forms depending on the scale of the company, but it must have some advantage that’s extremely difficult to crack, sufficiently so that the costs don’t make it worth the returns and consequently the business is likely to endure for an extended period of time or perhaps even grow.  If a business is consistent and stable you can assign a valuation to it and those valuations should be directly comparable to the rate of return of bonds.

The other case where business valuations are possible with a certain accuracy is when there’s a current asset whether tangible or intangible that will have an immediate value for the business making the acquisition.  This might be a customer base, it might be technology, or might be infrastructure, a brand, or a team.  In each of these cases a calculation can be made based on how valuable they’ll be to the new owners within a margin of error and make a decision accordingly.

Beware anytime someone comes to you with a fool proof method of business valuation, it can be dangerous but because it is so challenging it is also perhaps the greatest opportunity for market inefficiencies.

To learn more about buying businesses, business valuations, investing, business growth and wealth building follow our articles and information or contact us with any questions you might have to receive personalized answers.

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When The Cat Is Away The Mice Will Go Play

There is a holy grail of business pursued by many who don’t love what they do and that is the idea of a business that runs without you.  Arguably, a good business, a strong business, should run without the owner to a certain extent.  It’s possible to achieve this feat in even small businesses if you have well trained staff, strong systems and can easily keep an eye on details.  This is almost never truly hands off in the absolute abdication sense but can certainly become low maintenance requiring no more than  one to four hours per week to maintain.  Ironically, there’s a bit of a sweet spot it seems in most businesses where this can be achieved beyond which more energy is required and below which more energy is required.  However, what you’ll learn is it is never so straight forward on a sustainable basis.

Energy input is required for growth, you can either put it in yourself or you can have someone else put it in, but one way or another it is required and if it’s to be to your benefit you’d better provide at least enough energy to direct it.  This brings up a very important principle, not so much a rule because it isn’t always true, but it’s a generally wise assumption.  People will tend to act in their self-interest.  People also tend to fall into routine.  What does this mean for you?

If you ignore your business one of two things will tend to occur, perhaps not immediately, perhaps not universally, but in general it will take place.  Either people will get lazy doing what they can get by doing as opposed to pushing the boundaries to do better, or they will take advantage of what is given to them to benefit themselves.  Three real examples from businesses I’ve owned:

  1. Staff were given a list of duties to complete daily and standards to live up to, certain amounts of work they were expected to get done by the end of each shift, however, in the absence of an on-site manager staying on top of what was done and what wasn’t done they started to slip, they’d leave something for the next shift, they would fail to get it all done, they’d let the standards of how well they were doing one thing or another slip, all of which cost us money

 

  1. Staff would clock themselves in for additional hours, not that they were lying about being present but the company really didn’t need them if everyone was doing their job efficiently,the business had no policy to pay them for those hours, they weren’t authorized to come in during those hours and it would cost the company money for them to be there for extra non-revenue generating hours

 

  1. Some staff would steal clients for their own private work outside the company taking them for on the side services competitive with what the business was offering saying “the prices will be lower”

These are startling examples from just one company of the kinds of things that occur when you’ve got absentee management, when there isn’t someone actively in place watching the numbers, the staff, the performance constantly.  It’s sometimes under appreciated by small business owners just how much difference being on top of the details constantly can make in a business.  In the case of extra staff hours I audited the time sheets and discovered inefficiencies due in part to staff spending extra time beyond what they should be and partially due to inefficient scheduling was adding an additional 20% to payroll costs, all of which would be pure profit with the right management.  In the case of staff who slacked off the estimate was somewhere around an additional 5-10% boost in revenue if the staff were only diligent.  These are small examples but they are also short term examples, factors such as these erode and grow building momentum until they eat a company, a $10 000 monthly profit can quickly turn into a loss if not carefully monitored.

There’s an expression that “people respect what you inspect”.  It doesn’t necessarily have to be you doing the inspection but there is an enormous cost to not remaining on top of the numbers and the people, not constantly optimizing and tweaking.  When you are absent people behave differently, they think and feel differently, they start talking in ways you probably won’t like.

Bottom line, for any business to succeed at a high level it needs effective management, whether you or someone else make sure there’s a manager in place who takes ownership, has the will and the skill to make the organization thrive.

If you’ve got business management or growth or any other questions we’d love to hear from you.  Contact us with your questions.