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Investment versus Speculation
“An investment operation is one which, upon thorough analysis promises safety of principal and adequate return. Operations not meeting these requirements are speculative.”

Benjamin Graham, The Intelligent Investor, Harper and Row publishers, 1973 , p. 1.
Forward to the Book - In preparing this 5th edition of my book I have been greatly aided by many old friends. Chief of these has been my collaborator, Warren Buffett, whose counsel and practical aid have proved invaluable. . . .

What Makes for a Good Investment?

Fixed Income Securities – Bonds [US Treasury, Corporate, Municipal]

[Target 10-20% of your Investment Portfolio]

Minimal Default Risk, Low number of years to maturity in a low interest rate
environment, high number of years to maturity in periods of high interest rates

In periods of low interest rates – you want to be more of a borrower than and investor in
fixed income securities. In times when interest rates are high, you want to invest cash in long maturing securities that carry high interest returns for many years – avoiding callable bonds in favor of those with fixed maturity dates.
In a rising interest rate environment you will use an interest rate ladder to protect the value of your fixed income investment –i.e., $50,000 to be invested in bonds:
$10,000 --- bond maturing in 1 year
$10,000 --- bond maturing 1 to 2 years out
$10,000---bond maturing 2 to 3 years out
$10,000 --- bond maturing 3 to 4 years out
$10,000 ---- bond maturing 4 to 5 years out
Each year you would rotate out of the near term into the longest maturing bond --- take proceeds from the bond maturing this year and move it into a bond maturing in 5 years.
How you invest in fixed income securities is important because this is where you will park funds while awaiting outstanding opportunities to invest in good, quality stocks.

Slight Digression into Time Value of Money

Mutual Funds [ TIAA-CREF, Closed End fund such as ADX, Open End funds like DTF]
[Target 30-50% of your Investment Portfolio]
NOTE: As a faculty member, because you are actively participating in TIAA-CREF you will be doing a significant amount of mutual fund investing, therefore,
You will need to evaluate management performance, historical returns, type of investing strategy, top 10 holdings, expenses, fees to get in and out of the fund, the current price of the fund in relation to its previous range --- are you buying these shares at a premium or discount?

Ultimately if you are investing --- your strategy should be to obtain the highest return for the least amount of risk, that significantly protects principal, and at the same time has an excellent chance for producing great value.
Investing comes down to obtaining an Asset where its VALUE >>>>> its Price
Just as when you are buying a car, polo shirt, refrigerator, TV, home or couch you will want to get the best quality item at the lowest possible price --- this may involve informational costs, but the reward is well worth the effort. The reason why History, Art, Computer Science, English, Geography, Chemistry, Biology and Physics professors can do so well at investing, sometimes significantly more so than business teachers is because these people tend to ask questions, read annual reports, avoid buying things they don’t understand, and like acquiring good quality assets at outstandingly low prices.

Advantages of Mutual Fund Investing --- If you find some really talented managers who stay in place for 10 or 15 years you can ride their coat tails and make money without having to invest a lot of time seeking outstanding investment opportunities --- however, even in this circumstance you will need to evaluate at least twice a year the performance of these managers to see whether they are on track with what you want in the way of risk and return. A good mutual fund may allow you to reinvest dividends and capital gains back into the operation to generate and even better long term return. [Dividend Reinvestment]

Disadvantages of Mutual Fund Investing --Managers tend to change over time [unfortunately they may retire or answer life’s most significant question ---where will you be spending eternity?] Consequently, actual performance may vary from expected results requiring some active decision making on your part --- if I get a notice that says my mutual fund has a new manager should I stay or leave? What happens if they announce that the investment vehicle is being changed to allow greater “investment flexibility” to enhance growth opportunities in your mutual fund –i.e. we lost a lot of money which we really don’t want to mention, but we have fired the previous manager and we would like you to know that we plan to invest your hard earned dollars in even more riskier investments to get your account back to where it was before – of course, if we lose all your money, we are delighted that we get paid regardless of results. Mutual funds that may have performed spectacularly over the last quarter or year will carry a higher price and the growth in the value of their shares may be due to taking on additional risks and/or market timing. Investing when the shares are higher imposes a greater degree of risk and may produce the results you are looking for --- in fact, if you have a fund that has done amazingly well if might be time to pare your position and go to cash for a while. Leave some money in – maybe 50% of the position, but take the other 50% off the table. Another disadvantage to mutual fund investing is that the managers are making investment decisions for you and those choices may not be your choices. Unfortunately, due to the way positions and performance is reported, you will not know what your manager is investing in until funds have already been committed. So, if your manager decides to take a flier on Facebook you won’t know until many months after a commitment has been made and your mutual fund shares have gone up or down.

TIAA-CREF Website

Stock Investing [Common stock in Brokerage, Traditional IRA, Roth IRAs]

[Target 30-50% of your Investment Portfolio]

With stock investing you are able to decide when, and where to invest, as well as, when to sell your investment. You will not be paying someone to invest for you – so whatever return you obtain will generate dollars to you without any reduction due to management fees. If you lose money it will be based on your own decisions, not those managers who are investing for you. Although many individuals, some “business professionals” seek to invest without a set of investment guidelines – it would appear to be imprudent to do so. [e.g., UNI Foundation, UNI Krause Challenge]
Here are some initial perspectives along the lines of what may constitute a common sense view of investing.

5 Myths of Investing – Every Investor Should Consider

The Efficient Markets Hypothesis applies to stock and mutual fund investing – all possible information about a stock or mutual fund is imbedded in its price – therefore, you can do no better than the general market return and should buy an index fund and forget about mutual fund or stock selection. [If you believe in Efficient Markets you can go home now.]

Investing requires an understanding of economics and finance – one needs a degree (preferably a Ph.D.) in finance and economics in order to be a successful investor.

I don’t need to develop a set of investment guidelines before I start investing in stocks and mutual funds – I know a good investment when I see it.

Investing is a highly technical activity, you need to invest large sums of money and pay an advisor large commissions [i.e., front-end, back-end load with the mutual fund] in order to get above average returns [If you believe this one, think of horse racing and saddle weights].

Diversification when investing reduces risk, therefore the more diversification to my stock portfolio or mutual fund the better – I want to invest in a mutual fund with a 1000 stock positions or more.

Investment Perspectives Gleaned from Berkshire Hathaway Annual Reports

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

"I've long felt that the only value of stock forecasters is to make fortune
tellers look good.”

"Success in investing doesn't correlate with I.Q. once you're above the level
of 25. Once you have ordinary intelligence, what you need is the temperament
to control the urges that get other people into trouble in investing."

"The strategy (of portfolio concentration) we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."

“We think diversification, as practiced generally, makes very little sense
for anyone who knows what they're doing. Diversification serves as protection
against ignorance. If you want to make sure that nothing bad happens to you
relative to the market, you should own everything. There's nothing wrong with
that. It's a perfectly sound approach for somebody who doesn't know how to
analyze businesses.”

“John Maynard Keynes, whose brilliance as a practicing investor matched his
brilliance in thought, wrote a letter to a business associate, F. C. Scott,
on August 15, 1934 that says it all: 'As time goes on, I get more and more
convinced that the right method in investment is to put fairly large sums
into enterprises which one thinks one knows something about and in the
management of which one thoroughly believes. It is a mistake to think that
one limits one's risk by spreading too much between enterprises about which
one knows little and has no reason for special confidence… One's knowledge
and experience are definitely limited and there are seldom more than two or
three enterprises at any given time in which I personally feel myself
entitled to put full confidence.”
Warren Buffett – Berkshire Hathaway Annual Reports

Mark Twain on the Topic of Investing:

“OCTOBER: This is one of the peculiarly dangerous months to speculate in stocks in., the others are July, January, September, April, November, May, March, June, December, August, and February.”

Elements of Diversification
Asset Allocation Concepts:

Two Broad Methods of Asset Allocation: (1) Internal Allocation – where the investor determines the best mix between bonds, and equities (2) External Allocation – where the mutual funds owned by an investor have allocated funds between bonds, and equities.

Internal Allocation – the investor has direct control over allocation and can change an asset mix at will.
External Allocation – the investor has only indirect control over the allocation mix, relies on the mutual fund managers to develop the appropriate asset strategy and the investor may not know immediately of a change in asset strategy [i.e., the mutual fund managers may change the mix over a period of months or quarters.

Two Factors that Impact Returns when Altering Asset Mix:

Unless the mutual fund is in a tax advantage account [i.e., IRA, 401K, 403B or pension plan] a change in asset mix will involve selling securities which may result in capital gains and the payment of taxes
The sale of securities will involve the payment of transactions costs, brokerage fees, for mutual funds – possibly load fees [front-end or back-end fees].

Investor’s should avoid purchasing mutual funds that have front or back-end loads, or high 12-1B annual marketing fees. These charges serve to reduce return below what investors could receive in no-load funds with small 12-1B fees.

Investor’s should also avoid mutual funds that turnover securities often – some funds turnover 80% or more of their investment portfolios in a given year. This churning of investments only serves to increase sale commissions while lowering returns to investors.

Internal Allocation: Two Rule of Thumb Methods – (1) {100 – [Your Age]}% = percent of your total invested assets devoted to equities (2) Age based allocation using the following general guideline table

Conservative 50/50 rule in both accumulation and distribution stages

Allocation Mix [Stocks/Bonds]

                                                  Accumulation Phase                           Distribution [Retirement]

                        Older                          70/30                                                50/50
      AGE

Younger 80/20 60/40

John C. Bogle, Common Sense on Mutual Funds, p. 63, Figure 3.1

Re-balancing to Achieve Desired Asset Mix Over Time

How often should the investment portfolio be re-balanced?

Ridged Strategy: Whenever the mix gets 10% out of alignment – e.g. due to increases in the equity markets, your desired 60/40 mix goes to 70/30.

Advantages – takes emotion out of determining when to rebalance, forces one to recognize profits at some point in time [bird-in-the hand], overtime you will build a decent sized bond fund which can be used to invest in equities in a down market [contrarian investing].

Disadvantages – may require you to rebalance more often increasing taxes[non issue with tax advantaged accounts] and commission costs, you may sell part of a winning equity investment thereby losing the opportunity for greater gain [the cost of insurance].

Flexible Strategy: The desired asset mix may be managed to a position anywhere between 50/50 to 70/30 and depending on market conditions you may have a mix between these ranges.

        Advantages – allows you to take advantage of different market conditions over the
        business cycle, it may also permit you to stay fully invested in a winning
        investment, reduces in investment turnover.

        Disadvantages – adds the element of emotion into the investment strategy [Will you
       commit to re-balancing if the mix goes to 70/30?], you may stay longer in equities
        than you should resulting in loss, you may not build a large enough bond fund to be
        able to fully take advantage of a market down turn in equity prices.

        Whichever re-balance strategy is used – investors should try to alter mix gradually
        over a reasonable length of time rather than abruptly. Gradual change will allow an
        investor to assess the strategy and determine ways to improve the allocation.   One
        caveat if you are uncomfortable with economic or outside environmental issues
        [hurricanes, terrorist attacks] you should take action to lock in profits
        and go to a conservative bond mix [up to 50/50].   You deserve to sleep well at
        night.

Relationship of Time to Mutual Fund Investment Return and Risk

        Golden mean to investing – neither too much invested in equities or bonds.   Too
        much in bonds will lower investment return over an extended period of time.   Too
        much devoted to stocks will lead to a higher of risk of loss that may not be
        recoverable if your time horizon is limited.

Risk and Allocation (1926 to 1997: 71 years)

Stock/Bond Number of Years Average One- Three Year Loss Two Year Loss
Allocation (%) with a Loss Year Loss (%) 1930-32 (%) 1973-74

        100/0                                 20                       -12.3                         -60.9                          -37.3
         80/20                                  19                       - 9.8                         -45.6                          -29.2
         60/40                                  16                       - 8.2                         -30.2                          -21.1
         40/60                                  15                       - 5.5                         -14.9                          -13.0
         20/80                                  14                       - 3.7                         + 0.5                          - 4.9

John C. Bogle, Common Sense on Mutual Funds, p. 59, Table 3-1.

It’s important to have a set of investment guidelines from two aspects: (1) it will help take emotions out of the investment equation allowing you to consistently make informed, rational and objective decisions and (2) as you become more successful at investing you need to consider who will take over for you in the event you proceed to answer life’s major question --- where will I spend eternity?

A Sample Set of Investment Guidelines

1. View the purchase of a company’s stock from the perspective of ownership in a business . You should seek to buy only those companies where there is an established record of earning profits. In general, you should avoid buying stock in any company that is losing money – i.e., negative earnings per share.
2. The company you own should view debt the same way you do in terms of developing a sound financial plan. You should purchase only those companies that have a debt ratio below 30% and a current ratio 1.5 or higher.
3. When purchasing a company you should seek to buy stock that is on sale. The stock should be within the bottom portion of the current year’s 52 week range and be at the low end of the 52 week ranges for 3 out of the last 5 years.
4. Buy companies where the management has a consistent history of making profitable decisions. You should look to buy those companies that have 5 and 10- year annual compound growth rates of 10% or higher in sales and earnings.
5. Purchase companies that have been externally recognized as having a strong business model capable of producing value over the next year at the time of purchase. You should seek to purchase only those companies that have a 1 or 2 in terms of timeliness and 1,2, or 3 in Safety by Valueline. Also the financial safety rating should be B+ or higher at the time of purchase.
6. Given the importance of preserving your investment savings, you should not seek to buy companies that are over-valued in terms of their price earnings ratio [P/E]. You should not buy a stock with a P/E greater than 30.
7. When retaining company stock, you should consider selling a stock that does not continue meeting the criteria laid out in items 1 through 6. In particular, if a company’s stock eventually reaches a P/E of 50 or higher you should definitely consider selling a portion or all of the position.
8. For every sell decision, there must be a buy decision either in another equity or fixed income investment. When making this decision don’t violate items 1 through 6 just to stay invested in stocks. Consider the reasons why you sold your stock and whether it may be time to keep money in cash or near cash securities.
9. In your investment portfolio you should seek to maintain a cash/near cash position of between 20-40% of the value of all securities held. When the market is reaching high levels [e.g. 14,000 on the Dow several years ago], you should seek to take some profits and move them to cash against the contingency of a market down turn.
10. When markets are severely battered, take money from cash/near cash and invest in companies that have all of the characteristics 1 through 6 at prices significantly below their 52 –week ranges for the last 5 years. However, make sure you can commit the funds for a period of 3 to 5 years.
11. Seek to own the best of the best companies at very attractive prices rather than

Chase the latest trend type firm that has a limited number of products or services [i.e., Krispy Kreme, Iomega, Enron].
12. Be patient, don’t panic when markets appear to be rattled – seek to take a disciplined approach to investing. When committing funds into the market buy in increments unless you have are very rare, and unbelievably attractive investment situation –e.g. the Microsoft dividend play of 2005. You should invest small amounts over a long period of time – e.g. if you were to invest $50,000 today, you would want to look at the best possible acquisition now for an initial commitment of $10,000 and then look at moving money into the market in $10,000 increments over the next 6 months. In addition, consider dividend reinvestment and systematic purchases of stock to average down the cost of your positions in a falling market.

13. Seek to buy companies that have a long established record of management making wise decisions that support workers, the development of good quality products and services, and have a clean record of generating accurate and informative financial statements and annual reports. [e.g. Most Admired Companies, see: http://money.cnn.com/magazines/fortune/most-admired/2012/full_list/ ]

However, just as with the US News and World Report Rankings on Colleges and Universities, or that wonderful book – Good to Great: Why some Companies Make the Leap . . . and Others Don’t, see page 7 which lists as being good to great such wonderful firms as, Circuit City [Bankrupt], Fannie Mae [Near Bankrupt], Kroger [Assets of $23 billion against liabilities $19 billion] you need to look behind any ranking system to determine whether the values are in keeping with what you would want to invest in.
14. Be ever vigilant for any indication that management may not be acting honestly or in keeping with its mission statement – if that turns out to be the case --- sell out your position and seek to find other, more responsible companies to invest in. [e.g. Baldwin United, Ohio State Savings, Enron, Worldcom, Bank of America, AIG, Lehman Brothers, Long Term Capital Management, ADM, and the list goes on ---- the history of the US economy shows that there have been times when very poor, misguided managers have emerged destroying shareholder or stakeholder value from cherished institutions [this phenomena was certainly evident in the early 20th century which led to the enactment of Glass Steagall, and the anti-trust litigation during the Theodore Roosevelt and Franklin Roosevelt Administrations --- what makes the current situation distinct is that there now are so many bad managers with a culture of entitlement, lack of interest in serving others and outright arrogance for considering the needs of others that it may be difficult to ever get back to a system that respects the rights of others and places the interests of others above self.
[for a good book on just what is wrong with Wall Street --- read, Frank Partnoy’s FIASCO].

What may be at stake ---- A person will invest funds long term only on the basis that they will receive something of value at some point in the future that is worth more than if they used those same funds today to buy goods and services. If as an investor I am uncertain as to the accuracy of the financial information, the honesty of management, or the quality of the products or services being sold, I simply won’t invest. If we continue to a have leadership problem, investors may refrain from investing altogether --- particularly if they feel like it is a rigged system [e.g. Congress persons and their aids can invest on “insider information.”] The lack of capital investment would have a large negative impact on the financial markets, as well as, the ability of an economy to grow out of a recession. The reason why you have common sense regulation or principles and standards is to provide safety and stability to allow for people to invest. You can’t pretend about safety and soundness, either you have it or you don’t. It’s much like a university, either you have the courses and faculty that defines a university or you don’t. You may be able to offer some good entertainment activities, but in terms of what you say in your mission statement that will depend on the faculty and the curriculum, and the investors [i.e. students and their parents] will have to decide where to spend the money.

The Benefits of Having Wise and Honest Administrators

2011 Berkshire Hathaway Annual Report:
http://www.berkshirehathaway.com/2011ar/2011ar.pdf

Quick Analysis of a Stock to Study MDT

Divergence of Opinion with Respect to JNJ

On Models as Segments of Reality

Introduction to Stock Arbitrage

Helpful Investment Sites:

Individual Stocks:

National Association of Investment Clubs
http://www.betterinvesting.org/public/default.htm
American Association of Individual Investors
http://www.aaii.com/
Investopedia
http://www.investopedia.com/#axzz1prXyMs2H
Motley Fool
http://www.fool.com/
Valueline [Available through the Rod Library Website as Long as It Exists at UNI]
http://www3.valueline.com/secure/vlispdf/stk1700/index.aspx
Note: You will need a UNI login and password to access the service.
Mergent Online – Financial Ratios on Publicly Traded Companies [same caveats as Valueline]
http://www3.valueline.com/secure/vlispdf/stk1700/index.aspx
Standard and Poor’s NetAdvantage Reports [same caveats as Valueline]
http://www.netadvantage.standardandpoors.com/NASApp/NetAdvantage/index.do

Examples of Advisory Information from Brokerages

Investment Advisory on Core Stocks

Investment Advisory on Focus Stocks

Investment Advisory on Dividend Stocks

Mutual Funds:
Morningstar
http://www.morningstar.com/
Investment Company Institute
http://www.ici.org/

Interesting Side Note to the 2011 Berkshire Hathaway Annual Report
This discussion of repurchases offers me the chance to address the irrational reaction of many investors
to changes in stock prices. When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume.

Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano
did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their
operational accomplishments were truly extraordinary. But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.

Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.
Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire
250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we
would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1 1/2 billion more than if the “high-price” repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own
money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough
human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.

In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I will abandon my famed frugality and give Berkshire employees a paid holiday.

Advanced Topics In Financial Planning and Investing: Thursday, April 12, 2012

Integration of Tax Planning Cycle with Investing

Introduction to Stock Arbitrage

Basic Information on Corning April 2012

Valueline Listing on Corning 4 11 2012

Standard and Poor's General Report for Corning 4 11 2012

Standard and Poor's Analysis on Corning 4 12 2012

Quick Analysis of Corning as of 4 11 2012

Quick Analysis of Medtronic Several Years Ago

Basic Introduction to Stock Options

Characteristics of Stock Options

Futures and Options Trading Strategies