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Income Investment Ideas; Useful even for the growth investor. April 15, 2009

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Once you get away from the idea of total diversification and the use of indexed or mutual funds one can start to think in very different terms about their investments.  One of those old and conservative ideas that has stood the test of time is every portfolio needs to be investing in income producing products.  Ben Graham, writing in the early 1970s spent much time talking about bonds as an alternative to equities, but since then there have been other possibilities opened up.  Real Estate Investment Trusts, Limited Partnerships, Master Limited Partnerships, and Preferred Stock as well as traditional bonds can be invested in to produce income.  Each of these come with their particular risk level dependent upon what it is that is backing the interest or dividend payout.  But like Ben Graham has instructed us risk is relative to the underlying company so the bonds of one company paying 4 1/2% can be more risky than equities of another that has been beaten down in price but has good underlying fundamentals.  Graham suggests that a 50% income producing products with 50% equities is a good starting point.  He further suggests that at times you might go as low as 25% equities when they are expensive or as high as 75% when they are cheap, like now.

I recently purchased a small amount of a income producing master limited parnership (MMP) to add to my income producing side because I am below that 25% level.  At my purchase price the current dividend payout is over 9%.  This adds on to my ownership of HCN which at my purchase price is now paying a dividend of 12%.  At current prices is has a dividend of over 8.5%.  Now I tell you this not to get folks to follow my particular investment advice, but to demonstrate to people what one could do if they were to think beyond bonds for their income producing investments.  There is nothing wrong with bonds, even government bonds which are the only investment I would consider safe, but I am reaching for better yield with what I consider lower risk.

Now I made a mistake a couple of years ago and didn’t follow Graham’s rules and invested mainly in equities.  Had I followed his rules and had a much higher amount of income producing investments when stocks were relatively expensive, I would be much better off now with income coming in.  Note: to take the income or to reinvest it is a decisions that can be changed as your needs change.

The more I learn about investing, the more I talk to people about their finances, the more I work with people to improve their financial lives, the more I realize that the old ideas that have stood the test of time, ideas communicated by folks like Benjamin Graham and Warren Buffett, are the ones that should guide us.

As your wealth accumulates over time you should increase the amount [not necessarily the percentage] of income producing products.  Eventually you will accumulate enough so that if you don’t reinvest the dividends or interest you can live off of the proceedings.  It should be the primary goal to get to that point as soon as possible.

******Note, one should never invest in companies based on what any blogger, financial advisor, relative, friend, etc. tells you is a good investment.  Always do your own research, come to your own conclusions.  Shafer Financial does not have a license to dispense specific investment advice, therefore anything he posts should not be acted on without doing one’s own due diligence.  This blog is for amusement purposes only.************

The Failure of Passive Investors! April 13, 2009

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“The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task. The minimum return goes to our passive investor, who wants both safety and freedom from concern.  The maximum return will be realized by the alert and enterprising investor who exercises maximum intelligence and skill.”

Benjamin Graham in The Intelligent Investor

He continues, “In many cases there might be less real risk associated with buying a ‘bargain issue’ offering a chance of a large profit than with a conventional bond purchase yielding 4 1/2%.”

And from his student Warren Buffet we get these ideas:

“Wide diversification is only required when investors do not understand what they are doing.”

“Diversification is protection from ignorance. It makes very little sense for those who know what they are doing.”

“Why not invest your assets in companies you really like?  As Mae West said, ‘too much of a good thing can be wonderful.’ ”

So we see from these highly successful investors that passive investing has from the beginning been a failing strategy.  As Ben Graham instructs us, investing passively in mutual funds [which is what most people do], we should only expect meager returns [that is what the data tells us actually happens].  If we should only expect meager returns, then why expose ourselves to the market risk?

So, the data instructs us, as well as successful investors, on rule #2 for investing; If you want to invest in the equity markets you must become an active [intelligent] investor, otherwise take the conservative route and lower your expectations.

For those who missed rule #1; Build reserves or [financially] die!

On energy and buy and hold; A few thoughts for investors April 8, 2009

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As I have noted before, Warren Buffett has gone strong into energy investments.  From large  scale wind power, to batteries and electric cars, to shale oil, to conventional power, Warren has made substantial investments.  Traditionally, economic activity required both power and real estate.  Now with the internet the real estate section has been slightly diminished, but the need for power has not.  If anything we are even more dependent on power to run all those servers around the world.  His thinking is succinct, economic activity requires power; even though we are in a trough for economic activity our power needs will increase over time.  Look around at your own home and compare it to what it looked like 20 years ago.  Computers, modems, printers, fax machines, flat screen TVs, are all part of the average home now.  They all require power.  Now if you are like me, you have done things to reduce your power consumption like fluorescent light bulbs or more fuel efficient cars or have gone to cheaper natural gas.  And certainly there are technological advances coming down the pike that will help folks become more efficient [smart grids, smart homes, etc.], but overall the trajectory is for more energy usage.  From an investor perspective, I believe Warren is right and energy might be a great place to put some of one’s investment dollars for the long run.

Buy and hold is dead has been screamed from the rooftops on the back of the “lost decade” of equity investing.  However this is far from the truth.  I would argue that index investing combined with buy and hold strategies should be illuminated for the poor strategy it was.  Latest Dalbar Inc. study points out this.

Equity Mutual Funds                           Asset Allocation Strategies

5 Year Return

-2.84%                                                                       -2.99%

10 Year Return

-1.57%                                                                        -1.26%

20 Year Return

+1.87%                                                                        +1.67

That is what a severe bear market will do to those strategies, something everyone knew, but was afraid to admit.  Now here is the problem.  These strategies are designed to reduce overall variation, skewed to the upside.  After this bear which reduced share prices to half their value, you need some huge returns [totalling 100%]  to get back to the peak point.  Simply put, indexed mutual funds are not designed to do that.  In short, indexed funds are designed to reduce overall variation, but doesn’t protect against systemic [market] risk that we see every few years.  It protects you against huge mistakes in stock picking, but not against anything else in return for diminished potential returns.  A faustian bargain if there ever was one.  But this is not the buy-and-hold strategy talked about by Warren Buffet and others!

Buffett et al. suggest that one buy stocks with good fundamentals [cash flow, excellent product lines, low debt, good management, enough history to have a solid upward trajectory, etc.] when they are cheap relative to their history and then hold on until something changes fundamentally about the company.  You are buying businesses, so the analysis should be done about the business not the stock, and patience should be exercised before buying.  This strategy requires patience on both the buy and sell side as well as actively following the stock.  Buy a stock with the thought that the stock market will be closed for 10 years according to Buffett!

That is the buy-and-hold strategy, not buying-and-holding index mutual funds! And that is not dead, probably the only strategy that is still alive!

More on Berkshire Hathaway March 11, 2009

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One of the tribe’s members, Joshua, posed a question about Warren Buffett and his age.  Joshua is young and wonders if  long term Berkshire Hathaway is good for him.  I liked the question so much I chose to dedicate a whole post to it!

Joshua, I think you are asking two questions here.  First, what are the long term prospects of Berkshire Hathaway?  And secondly, what happens when Buffett bows out?

As regular readers know Berkshire Hathaway makes money in two broad ways.  First, is underwriting in the various insurance products offered.  Secondly, is by investing the float of the premiums.  Now, the remarkable story of Berkshire is based on success in both sides of that equation.  It is not talked about much, but Buffett’s long time partner Charlie Munger[age 85], is as much responsible for the success as the more well known Buffett.  The success of Berkshire is really about much more than Warren Buffett.  He also gives credit to his mentor, Graham, and his theories of finance.  Warren also talks about the managers of the businesses Berkshire owns and how remarkable they are.  The bottom line is to think that Berkshire Hathaway is all about Warren Buffett is to miss the point of how the business succeeded.

So to the question can Berkshire Hathaway succeed without Warren Buffett at the helm, I answer, that is the wrong question.  The question should be has Warren Buffett and Charlie Munger  identified the right people to step in when they are done?  Now we do not know who has been picked, other than somebody has been picked.  There is much speculation that for the insurance side it is Ajit Jain who runs some key reinsurance divisions at Berkshire now.  According to Buffet, Mr. Jain has performed brilliantly and produced underwriting gains even in the most difficult climate.

No doubt there is much concern over who will take over.   But in the short run does it really matter?  When Buffett steps down, there might be a short term drop in stock price, but if you are a Berkshire owner and believe in the same investing strategy as Buffett/Munger, then you believe the value is in the cash flow and success of the business.  And short term there will be no change to the cash flow in that as all 68 non-insurance businesses will still be running and since most investments are made for the long term there should be no immediate investment changes where large mistakes could multiply.

So in short there should be no change in intrinsic value for the company. 

Now long term no one can predict for Berkshire or any other company.  So as always one has to watch closely, monitor financials, and make sell decisions based on fundamental negative changes.  Now there is a viewpoint that it is not Warren Buffett who is so much more talented than the rest of the investment world, but his strategies which came from Ben Graham, and were pursued so relentlessly by Buffett/Munger.  If that is the case, and Buffett states it is, then as long as he finds someone that can do the same, Berkshire will be fine.

My gut reaction is that until proven otherwise, Berkshire is the gold standard to which other companies need to be compared to.  No doubt down the line, there could be another company or two that will emerge as a new gold standard.  But that is individual investors responsibility to analyze!  If the uncertainty of Buffett’s age is too much for you to handle, then don’t invest!  But make sure your reticence is not ageism!

 Note, if ever you wondered about the madness of markets, Berkshire Hathaway B’s (BRKB) going up almost 20% in one day based on no news is proof!

*******Never invest based on what anyone else tells you to!  Always do your own research.  Always make your own decisions and live with them.  Blogs are notorious for giving out BAD advice.  Shafer Financial is not a Registered Investment Advisor, has no licences to sell stocks or bonds, nor does the SEC think Shafer Financial is an investment expert.*******************************

Some additional thoughts on Warren Buffett March 5, 2009

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Here’s an example of recency bias.  Since 2000 the book value for Berkshire Hathaway has increased 127%.  That’s almost 10% per year.  In that 9 year time period Berkshire has had both its down years (the only ones in Buffett’s history).  Three of those nine years were terrible for the insurance industry [hurricanes, 9/11].  Compare that to the S & P 500 and its 28.3% loss over those nine years!  Oh and by the way the Berkshire numbers were after tax while the S & P numbers were pre-taxes.  Yet, almost universally Buffett is lampooned as a doldering old fool who lost his edge!  Can you say recency bias????

Missed is his move into energy and further movement into insurance.  Insurance is bought to protect against risk.  Do you think that the future might dictate major insurance policies bought by the largest companies in the world to protect against risk?  Do you think they might want to hedge their bets?  Do you think  that one of only seven AAA rated companies would be a place folks might look for that insurance?  And energy, do you think going forward there might be some energy issues?  With China and India (2.3 Billion people) coming on board as fully industrialized nations, do you think there will be a world-wide need for energy?  Does anyone believe energy is going to get cheaper to obtain?

Buffett has a plan.  Remember I have pointed out before that all wealthy people create a plan and stick to it in good times and bad.  The plan, seems simple, but few others have the emotionally capability to put it into play and stick to it.  The plan has been articulated in countless ways and countless times.  From this years letter to investors:

In good years and bad, Charlie and I simply focus on four goals:

(1) maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of

excess liquidity, near-term obligations that are modest, and dozens of sources of earnings

and cash;

(2) widening the “moats” around our operating businesses that give them durable competitive

advantages;

(3) acquiring and developing new and varied streams of earnings;

(4) expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.

Now I ask you, Is Warren Buffett a doldering old fool?

Berkshire Hathaway’s Annual Report March 2, 2009

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Great reading as usual.  Highly recommended for all.  Now for those who had no clue how Berkshire Hathaway makes money here is a very brief synopsis.  Berkshire Hathaway owns several insurance companies which provides them with significant “float.”  The float is premiums paid in advance, that must be set aside to pay out potential claims.  That float is then invested to hopefully get returns above what is eventually paid out in claims.  It requires two skill sets, underwriting at a price that will generate profits and investing for a good return.  Those two skill sets, explain the remarkable returns Berkshire has offered its investors.

First the bad news, Berkshire Hathaway’s book value dropped 9.6% over 2008.  It was its worst year ever.  Only the second negative year out of the last 44 years.  I would imagine the critics will be out in full regalia to do their thing, but few will bother to take a look at his letter or take to time to understand the company.  Although I prefer its normal double digit returns, last year for me was not anywhere near as bad as the critics will make it out to be.

First, the entire loss in book value is not realized losses, but accounting losses.  They came in two areas; derivatives and stocks of other companies owned.  Mr. Buffett devotes a whole section to his report on the derivatives situation, but suffice it to say that most people would not take the accounting losses too seriously.  In fact most investors, even the conservative analysts would have to come to a conclusion that there is a very high probability of these investments being profitable.  The drop in value of the common stock owned was well known in advance and again represents accounting losses, not real losses.  Now some will say he should have sold his financial stocks, but he is Warren Buffet, the person who personified buy and hold.  And despite some people’s expectations he has no working crystal ball.  As bad as a 9.6% loss in book value is, compared to most other companies it is downright good!  State Farm, another insurance based company, saw a 16% drop in their equity portfolio to give a comparison.  State Farm also had an operating loss, as opposed to the operating gains Berkshire made.

Now that we got through the bad news, there is much good news.  As I pointed out there are two components, the investment component and the underwriting component.  As Warren Buffett pointed out in last years letter, many players in the insurance market were undercutting their prices to a point that Buffett predicted real risk issues.  Berkshire refused to play that game, as a result sold less insurance (with the exception of Geico which had a fabulous year gaining market share).  Those companies that priced their insurance too low for the risk are now in real trouble, leaving Berkshire standing virtually alone in some markets.  This should be positive for the future.  And as a result of their underwriting discipline there was a $2.8 Billion operating profit from insurance.

Over the last few years Berkshire has made a major move into energy.  Not only are these companies extremely profitable, but they are gaining market share and becoming the largest wind generated power companies in the US.  He also purchased shares of Conoco/Phillips, which he called a one of his two mistakes last year.  I don’t believe it was a mistake, but he did admit to buying shares a couple of months before oil prices came down driving down the share price.  So short term it was a little premature, but long term I think it will work out fine.  Add this  to his purchase of shares in a Chinese company that is involved in battery technology and makes electric/hybrid cars and you see Berkshire is well positioned to benefit from future energy needs as the price of oil increases. 

The rest of companies owned by Berkshire Hathaway (63) had mixed results last year, with real estate/construction oriented companies having poor years, while others had much better years.  The overall earnings on a per share amount dropped from $4,093 in 2007 to $3,921 in 2008 or 4%.  Not bad in one of the worst years in recent memory for corporate profits!

Berkshire opened up a new line of insurance (BHAC) in 2008, which insures municipal bonds.  All the companies that were in this business prior to 2008 have had substantial problems because price competition caused them to reach into other areas including insuring residential real estate backed mortgages.  These companies re-capitalized, but remain very weak as opposed to Berkshire which is among the strongest companies in the world.  Buffett spends some time in his letter discussing this business.

His second self-admitted mistake was buying into two Irish banks.  This was a real mistake as the value dropped 89%.  Even Buffett makes some mistakes sometimes!  The selling of stocks in 2008 were done to keep liquidity up as it made other investments.  Berkshire still has almost $28 Billion in cash.

Note that Berkshire Hathaway stock price has dropped substantially.  But there is no rational reason for the 40%+ drop.  Book value dropped less than 10% and that is accounting issues and issues with the broader market.  Operating income only dropped 4%.  The two largest businesses, insurance and energy had reasonably good years.  And investments made in 2008 are significant and will provide excellent double digit cash flow going forward.

Bottom line is that Berkshire is positioned to increase its market share in the two main business areas, insurance and energy, while enjoying the cash flow of over 60 different businesses (which returned 17.9% on net worth last year).  It has $58 Billion dollar float on which to invest with last year that cost them less than $0.  It invested $14.5 Billion in three companies (Wrigley, Goldman Sachs, GE) that not only pay double digit returns but have warrants attached that could pay off if these companies stock values go back up over the next 3-5 years.

I couldn’t have been more pleased with the report.  It allayed any concerned I had with the market pushing the stock price down.

 

**************David Shafer and Shafer Financial are not registered investment advisors and they give out NO investment advice.  This blog is for amusement purposes only.  Before putting money in any investment, do your own analysis.  Always get a second opinion. ***********************************************************

For what its worth; not that I am giving any stock advice…. November 21, 2008

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To point out how crazy this bear market is:

As regular readers know I own HCN a health care REIT.  At current prices the dividend payout is an astounding 9%, with a PE ratio of 19.  150 straight dividend payout quarters with regularly increasing dividends.  People turning down 9% dividends in their fear!!!!! Crazy stuff.

Berkshire Hathaway B is around $2660 a crazy low for a stock with it’s profits and cash flow. Its book value is now 1.5. 

There are many other strong companies that are priced as cheap.  But if you were ever thinking about buying BRKb’s now is the time IMHO.  You might never get them anywhere near as low as this again.

 As always do YOUR OWN RESEARCH before investing in any stock!

***Shaferfinancial does not have a license to sell stocks, therefore any advice from him should be considered for amusement only*****

What Buffett is investing in? November 19, 2008

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So many people watch closely what Warren Buffett invests in, that the SEC allows him to delay public notification of his trading, until he has finished his move.  We now have a good idea what Buffett was doing the first 3/4 of the year and it is interesting.

Buffett continues his hard move into energy with the acquisition of Conoco/Phillips shares (COP) .  At the end of March he owned 17.5M and by the end the third quarter he had a total of 84M shares.  This well managed energy company currently has a P/E ratio of less than 4!   

He bought a 2.9M share stake in Eaton Corporation (ETN).  This is a manufacturing concern that calls itself a diversified power management company.  Current P/E ratio of 5.6.

He also has bought a total of 5M shares in NRG energy, a power generating company currently being sought after by Exelon in a hostile takeover.  P/E ratio of 5.6.

He sold shares in Bank of America.  Guess he wasn’t impressed with their purchase of CountryWide!  But he increased his ownership in US Bancorp (USB) to around 73M shares.

Also sold significant shares in Home Depot, Lowes and CarMax.

So what does this tell us?  Buffett is thinking that energy production is going to be the place where we see the greatest returns going forward.  Anyone disagree with him?  He has made multiple purchases in the last two years both domestically and in foreign companies that deal with the energy issue.  Conoco/Phillips is strong in natural gas as well as oil.  Many think that natural gas will be the fuel of choice for long haul trucks instead of diesel, which is driving the foreign oil purchases.  Remember, he recently made a deal with General Electric, which has huge nuclear power plant exposure in Europe.

Buffett still worries about the sub-prime fallout, instead sticking to banks that have little exposure (Wells-Fargo and US Bancorp).  Wells is completing its buyout of Wachovia, minus its poorly performing loans.  His shedding of Bank of America which bought sub-prime bad boy CountryWide demonstrates this.  Wonder if he knows something about Goldman Sachs we don’t?  At least the top management at GS decided to forego their bonuses this year! 

Buffett into energy, huh…….

Housekeeping Friday November 15, 2008

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Just a few things this Friday to tell my readers.

1st, I have added to my positions in both BRKB and HCN.  Just couldn’t resist buying some more Berkshire at bargain basement pricing.  As you know I am a real believer in Warren Buffett’s abilities.  He has invested close to $30B in the last few months.  Most in deals only he can manage to get. I think this will pay off handsomely in a few years.  As for HCN, a REIT, I picked up a few more shares at at price yesterday morning that puts it current dividend yield at 7.6%!  I have been buying HCN for quite a few years now.  This was the most I had paid for shares, but it was at its lowest point since early in the year.  They have paid dividends out 150 straight quarters, which has risen consistently.  My current dividend yield, based on my cost of purchasing, is 12%.  Since I reinvest dividends, this means that that 12% will be compounding every quarter going forward.  If, the dividend continues to rise, my dividend yield will rise with it.  So even if the dividends stay the same for 10 years, my investment will be worth over 3 times what it is now, just from dividends.  If shares values increase then the total return can rival Berkshire’s.  If the shares’ value goes down, then I just accept the dividends as the rate of return.  Its a heads I win, tails I win situation for me now.

2nd, I am taking my family to the beach for a week.  This is an annual event for us.  What this means for the reader is that my postings over the next week will be limited.  For me, it is a time to relax, re-join the sunset tribe, unplug for a few days from the world.

Finally, I am in conversation with a web site designer to put up a new web site for my business.  I have learned much the last year. Working with a real master in the art of the internet will allow me to improve my business.  I will let the reader know as it goes live.

PS My book is completed and will be coming out simultaneously with the new website!

surfer

Warren Buffett; How does he do it? November 11, 2008

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As regular readers know, I believe Berkshire Hathaway is a foundational stock to own.  In other words, I have built my stock portfolio around owning Berkshire Hathaway.  This is of course, exactly the opposite strategy that most financial planners suggest.  Diversification, index mutual funds, asset allocation, is all the rage in financial planning circles.  Other folks, including me, think that you can train your brain to think like Warren Buffett and find success in stock investing.  The Motley Fool guys are always touting stocks that “Warren Buffett would like!”  But can you duplicate Buffett’s strategy?

Well, yes and no.  Buffett’s early strategy has been outlined in countless books.  And many of us have attempted to train our minds to think like he did.  But Buffett had a huge problem around 1990.  When you have a rate of return of over 23% for close to 25 years, your numbers get really, really large.  Buffett, had so much cash flow in his holding company, that he started having problems buying stocks.  When he located public companies that met his guidelines, he found it impossible to purchase enough of the stock before it got out what he was doing and drove the price up.  And not enough of the stock was available to be bought.  In 1995 over 73% of Berkshire’s holdings were in publicly traded stock, that any investor could have purchased.

However, by  July of 2008, that percentage of publically traded stock owned had dropped to 25% of total assets.  What happened?  Well, he started to purchase entire businesses, lock, stock and barrel.  He also started to negotiate “sweetheart” deals with publicly traded companies.  That is what has happened here in 2008.  Deals like the $5B into Goldman Sachs,  $3B into General Electric,  $3B into Dow Chemical and $6.5B into the merger of Mars with Wrigley Jr. Co. all with special preferential terms! Twenty years ago he started to manage Berkshire in this way, but with mixed results.  But, he learned his lessons and all these deals of late have virtually no downside risk to them.  In other words, because of who he is, he can now negotiate deals that individual investors could never dream of.

So where does that leave the individual investor?  First off, his fundamental, value oriented stock selection strategy still works for individuals.  It just won’t work for someone that is moving billions  of dollars around.  Secondly,  even though he has moved on; now having only a minority of assets in publicly traded companies, the individual investor can still take advantage of his new found abilities by purchasing Berkshire Hathaway stock.

So in review, Buffett’s stock picking strategies are still available to the individual investor.  And his favorable deals are also available to the individual investor.

Note, if you want a good laugh read some of the other blogs comments on the quarterly results just announced.  People who have no idea how to analyze a company are making all sorts of claims of his demise.  Then go read his latest letter to his shareholders where he predicts everything that has happened to Berkshire this year.  Since Jan 1, 1989, Berkshire’s book value per share has risen an average of 19.9%, while the S & P 500 has risen around 10%.  So you can say his strategy of buying companies outright and negotiating special deals has done OK! 🙂 

warrenatworksmall