Roth IRAs for long-term wealth

Most humans have a tough time investing today for rewards 30 years down the road, which is why few are able to leverage the power of the eighth wonder of the world (compound interest).

If you want an easy way to get started, look no further than the Roth IRA.

Assuming your income is currently taxed at 33.3%, here’s what a one-time pre-tax investment of $5,500 will get you after 30 years of compounding from a standard investment account versus a Roth IRA…

onetimeroth

And here’s the picture if you make that same deposit every year for 30 years…

annualroth

A few additional gems about Roth IRAs…

  • Unlike traditional IRAs, there are no required minimum distributions so investments can continue compounding tax-free
  • Withdrawals can be made tax and penalty free before age 59.5 on what you put in, making a Roth IRA the most powerful savings account
  • A Roth IRA can be maxed out with 50% more investment dollars than a traditional IRA
  • The little-known self-directed Roth IRA allows you to invest in real estate and other alternative investments in a tax-sheltered vehicle

Warren Buffett on Boards and Managers

This is a series of posts exploring the investment philosophy of Warren Buffett, as detailed in his book The Essays of Warren Buffett: Lessons for Corporate America.

Corporate Governance: Boards & Managers

CEOs usually aren’t held to the same performance standards as subordinates for the following reasons…

  • CEO performance standards seldom exist
  • CEOs lack an immediate superior whose performance is being measured
  • The boss of a CEO is a Board of Directors that rarely measures itself or is held accountable for substandard corporate performance
  • There is social pressure for congenial relations between the Board and the CEO, making criticism of the CEO’s performance taboo

It’s ironic, and often devastating for business results, that an inadequate CEO is far more likely to keep their job than an inadequate secretary.

To counteract the tendency toward congenial relations between the Board and CEO, directors should regularly meet without the CEO present.

Desirable directors must possess three qualities: Business savvy, interest in the job, and a shareholder orientation. The lack of any one of these qualities can negatively impact shareholder well-being.

The “independence” of directors can be influenced by the fraction of their annual income attributed to the fees they receive for board service. If this fraction is significant, acting in the best interest of shareholders can be thwarted by self-interest.

Berkshire does several things to make its managers more effective. First, it eliminates all of the nonproductive activities normally associated with the job of CEO. Second, each CEO is offered a simple mission: Run your business as if…

  • You own 100% of it
  • It is the only asset that you will ever have
  • You can’t sell it for at least a century
  • Accounting considerations are insignificant when making decisions

Many CEOs are heavily incentivized by short-term performance, but since Berkshire shareholders have a very long investment horizon, their CEOs are asked to manage for maximum long-term value.

Although the small daily actions of managers are imperceptible, the cumulative effect of delighting customers, eliminating costs and improving offerings can lead to an enormous long-term competitive advantage. These are the moat-widening activities that have led to Berkshire’s success.

Warren Buffett on Full and Fair Disclosure

This is a series of posts exploring the investment philosophy of Warren Buffett, as detailed in his book The Essays of Warren Buffett: Lessons for Corporate America.

Corporate Governance: Full and Fair Disclosure

According to Buffett, full reporting means providing all of the important facts about current operations and the CEO’s unfiltered view of the long-term business outlook. Fair reporting means getting information to all owners simultaneously.

The following are red flags when it comes to reporting…

  • References to EBITDA, as if capital expenditures don’t matter
  • Accounting methodology that is unclear, perhaps intended to hide something
  • Growth rate predictions from CEOs, which can corrode management behavior

The last point is particularly important. It’s not uncommon for CEOs to pursue uneconomic operating maneuvers in order to meet announced earnings targets. Once that stops working, a variety of accounting games can be played to make the numbers work. Fudging like this can quickly snowball into fraud. Lofty predictions by CEOs are a distraction from long-term value creation.

Here are four warnings for investors…

Watch out for companies displaying weak accounting. If a company doesn’t expense options or has unreasonable pension assumptions, management is likely taking the low road behind the scenes as well.

Emphasizing EBITDA (earnings before interest, taxes, depreciation and amortization) implies that depreciation isn’t really an expense. Since the cash outlay that depreciation represents is paid up front before the acquired asset has created any value for the business, depreciation is a particularly unattractive expense and not simply a bookkeeping formality.

If a footnote or managerial explanation is difficult to understand, it might be that the CEO doesn’t want you to understand it. For great examples, dig up Enron’s descriptions of certain transactions.

When a company trumpets earnings projections and growth expectations, be very suspicious. Earnings in the real world don’t advance smoothly. Managers who promise to make the numbers can easily be tempted to make up the numbers.

Seth Klarman on Investment Alternatives for the Individual Investor

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

Investment Alternatives for the Individual Investor

In order to be successful as an investor, a significant and ongoing commitment is required. There are three alternatives for those who do not wish to manage their own investments: mutual funds, discretionary stockbrokers, and money managers.

Mutual funds are attractive in theory as they combine professional management, low transaction costs, liquidity and diversification. In practice, mutual funds do a mediocre job of managing money.

Most mutual fund managers participate in the short-term relative-performance derby. Since management compensation is based on assets under management (AUM) instead of fund performance, there is a fear of losing clients if short-term relative performance is poor. This incentivizes managers to go along with the investment crowd, which is a sure recipe for mediocrity.

A few mutual funds have a long-term value-investment orientation, and these funds are worth seeking out if you decide to pursue this route. The Mutual Series Funds and the Sequoia Fund, Inc. are two examples.

In selecting a stockbroker or money manager, it’s critical to evaluate the validity of their investment process (does it make sense?) and their integrity (do they do what they say they will do, and is it in your best interest?). Do they manage their own money in parallel with client money? This “skin in the game” shows that a manager has confidence in their investment approach. Have assets under management grown exceedingly large? Sharp increases in AUM tends to adversely affect returns.

Here are some questions for evaluating past investment performance of managers…

  • How long is their track record?
  • Was it achieved over several market and economic cycles?
  • Was it achieved by the current manager?
  • Does it represent the complete results of the manager’s entire investment career?
  • How did the manager perform in down markets?
  • Was performance the result of one or two great successes or numerous moderate winners?
  • Is the manager currently using the same strategy that resulted in prior successes?
  • Was the manager fully invested at all times?
  • Was leverage used?

It’s easy to compare managers by investment returns, but it’s more useful to compare how much risk those managers incurred to achieve their returns. This can help in evaluating how much past success was due to luck versus skill.

This post concludes my summary of Margin of Safety by Seth Klarman.

Next up: The Essays of Warren Buffett

Seth Klarman on Portfolio Management and Trading

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

Portfolio Management and Trading

Portfolio management involves trading activity, regular review of one’s holdings, maintaining appropriate diversification, hedging when beneficial, and managing portfolio cash flows and liquidity. What follows are insights on each.

Liquidity

Although liquidity usually isn’t of great importance for a long-term oriented portfolio, the opportunity cost of illiquidity can be high so the value investor should strive for an appropriate balance between liquid and illiquid assets.

Diversification

The number of securities that will effectively reduce portfolio risk through diversification can be as few as 10-15 holdings. Diversification is not about how many different things you own, but how different the risks are in the things that you own.

An investor will achieve better performance by knowing a lot about a few investments than by knowing a little about each of a great many investments. This is consistent with Warren Buffett’s “Punch Card” approach.

Hedging

Hedging can be an effective strategy to reduce risk of loss. When the cost of hedging is reasonable it can allow investors to take advantage of opportunities that would otherwise be too risky. An example of hedging might be selling interest rate futures to reduce downside risk in a portfolio of interest-rate-sensitive stocks.

Trading

Trading is the process of taking advantage of bargain opportunities when prices are significantly discounted from underlying business value. When such opportunities do not exist, trading tends to be detrimental to investment success.

Buying

It is crucial that investors develop an appropriate reaction to price fluctuations. When prices are falling, investors must resist the tendency to panic. When prices are rising, investors must resist the tendency to become overly enthusiastic.

Are you willing to average down on a security, or buy more at lower prices? If not, you probably shouldn’t buy it in the first place. Consider buying a partial position in new holdings so you can average down if prices decline.

Selling

Spotting bargains is often easier for value investors than knowing when to sell. It’s impossible to know exactly what a security is worth, so how can investors be sure when the gap between price and underlying value has disappeared?

Fortunately there’s one simple rule for selling: all investments are for sale at the right price.

Decisions to sell must be based on your best estimate of underlying business value, and how the price/value gap with your current holding compares to other investment opportunities. Investors might also consider the tax treatment of gains when making selling decisions.

Seth Klarman on Areas of Opportunity for Value Investors

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

Areas of Opportunity for Value Investors: Catalysts, Market Inefficiencies, and Institutional Constraints

Investment bargains usually aren’t easy to find. If they were, many other investors would find them and bid up the price to the point where they weren’t bargains anymore.

Finding bargains often requires digging deeper by uncovering hidden value or comprehending a complex situation.

It can be profitable to seek catalysts that close the gap between stock price and underlying business value. The decision to liquidate a business is a catalyst that leads to total value realization for shareholders. Spinoffs, share buybacks, recapitalizations and major asset sales are catalysts that lead to partial value realization.

While value investors are always hunting for bargains, catalysts that narrow the gap between price and underlying value are one important means of realizing profits on bargain purchases.

Catalysts also reduce investment risk by shortening the time it takes to achieve returns, giving investors less exposure to market fluctuations or adverse business developments.

Attractive investment opportunities for value investors can often be found where most investors aren’t looking such as corporate liquidations, complex securities with unusual contractual cash flows, rights offerings, risk arbitrage, and spinoffs. Examples of each are provided in Margin of Safety.

Seth Klarman on the Challenge of Finding Attractive Investments

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

Investment Research: The Challenge of Finding Attractive Investments

The investment process begins with knowing where to look for opportunities. A good investment idea is rare and valuable, and is unlikely to come effortlessly from the recommendations of Wall Street analysts.

Where might a value investor hunt for bargains?

  • Computer-screening techniques can help to identify stocks selling at a discount from liquidation value
  • Mergers, tender offers, and other risk-arbitrage transactions can be found in the daily financial press (Wall Street Journal and New York Times) and in specialized newsletters
  • Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers may be profitable as asset-conversion opportunities and can be found in the financial press
  • Reviewing the WSJ’s leading percentage-decline and new-low lists may turn up out-of-favor bargains
  • Share price can plunge when a company eliminates its dividend
  • Institutional investors may sell off securities involved in risk-arbitrage transactions as these conflict with their mission to invest in ongoing businesses
  • Institutional investors are often unwilling to buy or hold low-priced securities regardless of relationship between price and value
  • Small companies that are infrequently traded are ignored by analysts and may be mispriced
  • IRS rules make it attractive to realize capital losses before the end of each year, which can cause stocks that declined significantly during the year to decline further regardless of fundamentals
  • Nobody understands a business better than management, so insider buying may reveal bargains

Value investing is a contrarian activity. What the crowd is buying has been bid up in price on the basis of optimistic expectations. Value is likely to be found in what the crowd is selling, unaware of, or ignoring.

Value investors who act against the crowd are rarely proven correct right away, and can suffer paper losses for some time. Success requires a long-term orientation and skillful valuation.

Seth Klarman on the Art of Business Valuation

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

The Art of Business Valuation

“Security analysis does not seek to determine exactly the intrinsic value of a given security. It needs only to establish that the value is considerably higher or considerably lower than the market price to justify an investment action. For such purposes an indefinite and approximate measure of intrinsic value may be sufficient.”  -Benjamin Graham, Security Analysis

Value investors buy at a discount from underlying value, which necessitates an assessment of business value. According to Seth Klarman, there are only three useful methods of business valuation.

The first is net present value (NPV) analysis, which is the discounted value of all future cash flows that a business is expected to generate.

The second is liquidation value analysis, or the expected proceeds if a company were to be dissolved and the assets sold off.

The last useful method of business valuation is stock market value, which is an estimate of the price that a company or its subsidiaries would trade in the stock market.

NPV analysis is one of the most accurate and precise methods of valuation when future cash flows are predictable and an appropriate discount rate can be determined. The trouble is that future cash flows are often highly uncertain and discount rates can be somewhat arbitrary.

To perform NPV analysis, one must attempt to predict a future that is not reliably predictable. This is why investors need a margin of safety which is achieved through conservative projections and then investing at a substantial discount from the resulting valuation.

The liquidation value of a business is a conservative measure of value based only on tangible assets. Some value investors use “net-net working capital” to approximate liquidation value. Net working capital is current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year). Net-net working capital is net working capital minus long-term liabilities.

Earnings per share (EPS) is a common valuation metric for investors, but it is highly susceptible to manipulation and accounting vagaries. Managements are aware that many investors focus on growth in EPS and it’s simple enough to massage earnings to create a consistent upward trend. An analysis of cash flow is more representative of the true economics of a business.

Valuation is complex and the results are imprecise, but you can only find bargains if you have some sense of what a company is worth. The techniques listed above are the best available.

Seth Klarman on the Root of a Value-Investment Philosophy

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

At the Root of a Value-Investment Philosophy

The value-investment philosophy is built around three core elements. Value investing is a bottom-up strategy based on identifying undervalued investment opportunities. Success is measured by absolute-performance instead of relative performance. What can go wrong (risk) is at least as important as what can go right (return).

The majority of professional investors use a top-down approach to investment selection. They try to predict the future and translate that prediction to investment implications. Success depends on predicting the unpredictable more accurately and faster than many other bright people.

Value investing, on the other hand, does not involve forecasting. You simply buy a bargain and wait. When bargains aren’t available, hold cash until bargains show up.

Important questions for value investors…

  • What is the underlying business worth?
  • Will underlying value endure?
  • What is the likelihood that the gap between price and value will narrow?
  • Given the price, what is the potential risk and reward?

Seth Klarman on The Importance of a Margin of Safety

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

Value Investing: The Importance of a Margin of Safety

Value investing is the practice of buying assets at a discount from underlying intrinsic value and holding those assets until price becomes more reflective of underlying value.

A successful value investor must be able to analyze underlying value and have the discipline to buy only when sufficiently discounted assets are available.

Margin of Safety
The reduced likelihood of loss (and increased likelihood of gain) when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

The lower the price compared to underlying value, the greater the margin of safety.

Many factors can cause security prices to depart from underlying value…

  • If a stock joins/exits a market index, it will be purchased/sold by index funds regardless of how price relates to underlying value
  • If a stock price rises on increasing volume, technical analysts may bid up the price further
  • If a company experiences rapid growth, it may trade at a high “growth” multiple
  • If a company has disappointing recent performance, it may be dumped by many investors at once thereby depressing the price below underlying value
  • If an investor gets a margin call, he/she may be forced to sell regardless of how price compares to value

You want a formula for investment success? Learn how to determine the underlying value of securities, then buy the ones selling at a significant discount. Hold until price rises to match value or until a better bargain comes along. Rinse and repeat.

Determining underlying value is where things get interesting. Stay tuned!