As I recommend, Steven revalues his holdings at least every quarter.  While revaluing Target using comparables Costco ($COST), Wal-Mart ($WMT), Family Dollar ($FDO) and Macy’s ($M) he noticed that the intrinsic value had declined by a material amount, which is currently at $63.70.  Steven freaked out and called me into his office wondering what was going on with the seemingly stable company:  why had their intrinsic value declined so much between quarters?

The answer lies in the relationship between Target’s FY 2011 Cash flow Statement and our Buffet Formula.  ValueMyStock reduces annual net income by subtracting out annual capital expenditures, which are cash outflows not recorded (expensed) on the income statement.  To get a true picture of the cash generated versus the cash spent each year we perform the following calculation in the Buffett Formula:

Net Income + Depreciation – Capital Expenditures = True Cash Position from Operations

Target’s capital expenditures jumped from $2,129,000,000 in 2010 to $4,368,000,000 in 2011, while their net income was virtually unchanged.  The True Cash position would obviously be lower for 2011 than 2010, which reduces the intrinsic value.  Until Target reported their 2011 results on January 27^th we were valuing them on 2010 results.

What Does This Mean?

Once we uncovered why the valuation had changed we had to figure out what this means for Steven’s holdings.  A review of the 2011 Annual Report taught us that Target opened 21 new stores in 2011 compared to only 13 new stores in 2010 – almost double the number of new locations!  Since new stores are a capital expense we found the reason for the almost doubling of capital expenditures.

I would not label Target a value stock based on their 2011 results, as the stock is no longer undervalued based on the Buffett Formula.  Steven should NOT automatically sell his holdings, based on the following conclusions:

• Target has wide appeal to a large number of consumers
• Target has expanded its presence by opening new locations
• As the nation continues to rebound following the recession we expect consumer spending to increase
• Target just has a lower intrinsic value –it is not in danger of going out of business
• The price at which Steven bought Target was low enough that it made sense for him to continue holding the stock

Let this be a lesson to the new value investors – stay on top of your valuations as even large stable companies like Target can change without notice.  Just because the intrinsic value has decreased does not mean rush to sell your holdings – weigh other factors before selling, but if you feel that your opportunity in the stock has disappeared, then sell and move on to the next undervalued stock.

I have found a few undervalued energy and energy-services companies that returned a handsome profit.  Chesapeake is not one of them.  In fact, I never invested in Chesapeake.  Some of my local value investing friends kept hammering me for my opinion of Chesapeake – I could tell they wanted me to approve of their infatuation with it.  It appeared undervalued a number of times over the past five years and in Oklahoma City their massive community presence was unreal.  I never invested in them for two reasons – McClendon seemed like an unnecessary gambler and Chesapeake carried HUGE loads of debt.  Just enough other investors felt the same to keep their price held to reasonable levels.

When they should have been investing in revenue-generating assets McClendon and Chesapeake were busy buying shopping mall real estate and other non-energy related items all over Oklahoma City.  They were also busy buying up a lot of underperforming assets from other Oklahoma energy firms when oil was approaching $150 per barrel.  This doesn’t seem like sound business to me in an already competitive industry.

Well, now it looks like I can say “I told you so.”  McClendon has Reuters, the SEC and the IRS breathing down his neck for a controversial “Founders Program” where he received a portion of all wells owned by Chesapeake.  He was taking out personal loans against his ownership to help support a now-revealed $200 million hedge fund he was running out of the Chesapeake headquarters.  Sounds like distractions and conflicts of interest to me.

Shares of Chesapeake were down almost 14% on the news, their largest drop in three years.  Even though they have contributed a lot to the Oklahoma City community in jobs and public works, as a value investor I am glad I never bought into this company.

The discussion of growth investing versus value investing will be addressed in a separate blog.  This entry will show you how I find stocks using value investing, which is my only strategy and the strategy used throughout ValueMyStock.

Value Investing

Value investing is purchasing stocks that are underpriced and selling the stocks when they reach equilibrium, which is called intrinsic value.  Think of this as the “true value” of the company. Intrinsic value is based upon historical performance and the prices of the nearest competitors.  An analogy is flipping houses – the investor looks for a home with an artificially depressed price, maybe performs a few small updates and sells the house for a profit.

I recommend purchasing stocks that have a 30% or greater margin of safety, meaning the stock is currently selling for at least 30% less than its intrinsic value. Hold the stock until the price climbs to the intrinsic value. A stock will constantly move toward equilibrium, or it’s intrinsic value, as the market buys when it is undervalued and sells when it is overvalued.

Solutia Inc. (SOA) 

The chart above shows value investing at work.  I valued SOA in early 2010 and calculated an intrinsic value of $24.42.  I purchased shares on 02/04/10 for $13.58.  I continued to hold these shares, even though the stock price declined below $13 in the summer of 2010.  I sold the shares for $24.61 on 01/06/11 for a 78% return.  The stock price did continue to rise, even becoming slightly overvalued in 2011, but I do not worry about that – I took my 78% return and invested in another undervalued stock.

Value investing is an easy concept to understand but difficult to practice.  The human nature, which responds more strongly to fear than joy, makes us self-destruct when it comes to investing in stocks.  I have seen new value investors immediately sell off their holdings the minute their stock decreases in price.  If the underlying fundamentals of the company have not changed, a price decrease is just stocks on sale.

Finding Undervalued Stocks

The most time-consuming aspect of value investing is simply finding undervalued stocks.  Fortunately ValueMyStock has made this much easier with our RoboScreener, which applies our Valuator formula to all stocks each day.  Search for stocks with a margin of 30% or greater and confidence of 90% or higher.  Find five stocks that meet these criteria – these are your candidates for further analysis.

If you are not a subscriber of ValueMyStock, or if you want to go beyond the RoboScreener, you can use any of these free public screeners.  Depending on the screener, I use some or all of the following criteria to select candidates for further research:

• All sectors and industries, although I generally avoid the Financial and Conglomerate industries
• P/E ratio between 2 and 12
• Stocks at 52 week lows
• Debt/Equity ratio less than 50% (lower is better)
• Profit Margin greater than 10%
• Return on Investments greater than 10%

Before adding candidates to your research list, always check to make sure the company has positive earnings.  Companies in a current loss cannot be valued.  Check the stock’s summary page in Yahoo! or Google Finance – if it has negative EPS and “n/a” for P/E it is in a current loss.

Analyze Your Candidates

You may have a list of five or 50 stocks to analyze; it does not matter.  Now you are going to dig deep into each company to calculate an intrinsic value.  Find four comparable companies for each candidate.  You can select these on your own or use the top four returned in our Valuation by Multiples and Valuator formulas.  These comparables should be the closest competitors you find for each candidate.  Their size, products, geographical presence and customers should as similar to your candidate as possible.  An example of good comparables for Merck (MRK) would be Pfizer (PFE), GlaxoSmithKline (GSK), Novartis (NVS) and Sanofi (SNY).

Value your company using your selected comparables using our Valuation by Multiples formula.  If your confidence index is 90% or greater, then you found quality comparables.  If the index is below 90% look for ways to strengthen your comparable basket.  Any candidate that returns a confidence index of 90% or higher and has margin of safety of 30% or higher in Valuation by Multiples will be retained for the next step.  Stocks not meeting these criteria are discarded.

Run the remaining candidates through the Buffett Formula.  Discard any candidates that return less than a 30% margin of safety.  The remaining candidates are ready for the final step, which will bring together both Valuation by Multiples and the Buffett Formula.  Run each of them through the Valuator formula using your comparables.  If the candidate still returns a minimum 30% margin and minimum 90% confidence, it is probably undervalued.  The intrinsic value calculated in Valuator is your target selling price.

The Human Element

So your stock appears undervalued on numbers, but is there a reason why the stock is undervalued?  There might be a legitimate reason why investors are holding down the price of your candidate.  Take at least 30 minutes per candidate to research headlines for news that may be the reason your candidate was beaten down.  The latest 10-Q or 10-K is required reading – find it for free on the SEC’s website.  Look through the company’s outlook, risk factors and pending litigation.  Review the candidate’s two-year stock chart – do you see any sharp price decreases or increases?  If so, find the date of these price changes and look up the company’s headlines for that date.

Use common sense during this research.  A company facing a lawsuit that would materially affect the company is risky.  A company that lost 25% of its contracts last year is risky.  Keep in mind that bad news is not always bad, or is often times just a temporary setback.  I find stocks will generally be over-punished for bad news.  For example, consider a manufacturing candidate that has an employee strike at a major plant and investors send the stock price down by 35%, yet the production lost due to the strike is estimated to be less than 35% of the company.  When the strike ends you can bet that the stock price will increase as investors buy back in.  Be on the lookout for things like this – these are buying opportunities.

Choosing the Best Undervalued Candidate

What if you have multiple candidates that come back undervalued, but you can only afford to buy one of them?  Use these ideas to rank your candidates:

• Consider the candidates with the highest margin of safety (most undervalued).
• Run each company through Tobin’s Q.  A Tobin’s Q less than 1 is a strong indicator that the company is undervalued.  Consider the candidates with the lowest Tobin’s Q.
•  Rank each company using their trailing dividend yield.  Consider the candidates with the highest dividend yield.

Making the Purchase

If your research checks out, then purchase the desired candidate(s) and hold them until the intrinsic value is reached.  I recommend setting an alert or trigger on your brokerage account to let you know when your stock is approaching intrinsic value.

Before You Buy

Before getting too excited about buying stocks, be sure you have funded your brokerage account.  The days of having to buy round lots (buying shares in multiples of 100) are over – you can get started with as little as $500.  Be sure the money has cleared your account and is ready to use for purchasing stocks.

You need a strategy.  Without a strategy you might as well hit the tables at the nearest casino – your chance of success will be equal.  Most strategies fall under one of two theories:  1) Value Investing and 2) Growth Investing.  Success can be found in either strategy, although historical test have shown Value Investing has outperformed Growth Investing on a long-term basis.  The next blog installment (101.4) will address choosing a strategy.

Selecting Stocks

I recommend building a list of at least five candidates.  I never buy the first undervalued stock I find, and sometimes I won’t buy any.  When I have cash to invest I will conduct my research without time constraints.  Do not rush a stock purchase just because the price is increasing; take one day or even one week to research your candidates before making a purchase.

Know what you are purchasing.  Describe the company to your friend, spouse, or even better, to your kid.  If you cannot accurately describe what this company does you should not buy it, regardless of how good it looks on paper.  There are plenty of opportunities in industries and companies you can understand.  Also avoid companies whose value is derived from financial assets such as loans and derivatives.  The true value of these companies can be very difficult to calculate.  We saw during the Lehman Brothers collapse in 2008 that financial companies can tank your portfolio due to the difficulty of truly understanding their assets.

Baby Steps. It's a Big World of Investing.

Know your selling price…before you buy.  This is the most common mistake made by investors of all levels of experience.  Regardless of your strategy know at point you will exit this stock.  Make the exit point a price, not a time, as you cannot predict market forces.  All things equal, choose the company with the most attractive exit price.

Making the Purchase

Once you have selected your stock you will need to enter your purchase request.  You will most likely see two prices for your company:  the “bid” price and the “ask” price.  Be sure you understand the difference:

Bid:  The bid is the price that you can sell your stock for.

Ask:  The ask is the price that you can buy a stock for.

Learn more about Bid and Ask.

Ensure you have enough money in your account to cover the purchase plus commission.  For example, you want to purchase shares of ABC.  You have $1,000 to spend and you want to spend it all on ABC.  Your broker charges a commission of $7.99 on purchases and sales.  The “ask price” of ABC, or the price it is selling for, is $23.34 per share.

$1,000 – $7.99 = $992.01

$992.01 / $23.34 = 42.5, or 42 shares

You can purchase up to 42 shares of ABC (I do not recommend purchasing fractional shares).

All online brokers will have a “Trade” command.  This command will contain options such as stocks, bonds, mutual funds, EFTs and options.  Choose “Stocks” and select “Buy”.  Enter the ticker symbol of the stock you wish to purchase and the appropriate number of shares.  Be sure order type is “Market”, which will result in an immediate purchase of your company at the current market price.  Those who are sensitive to any movements in purchase price can choose a “Limit” order and stipulate the ask price to buy at, but be aware that with Limit orders your purchase may not happen if your ask is not meet, even if it is only a penny or two away from the market price.  All brokers allow you to review the order for between 30 and 90 seconds.  I stress reviewing the ticker symbol and estimated purchase total during this time; you don’t want to purchase the wrong company.  Confirm your order and you are a proud owner of stock.

Monitoring Your Purchase

I recommend keeping your portfolio to 12 companies or less.  For the same reason as only buying companies I understand I also like to keep my portfolio easily manageable.  You should always know which companies you are invested in.  Check your portfolio at least once a week and pull up your stocks in Yahoo! Finance or Google Finance at least once per week, reviewing the headlines of your companies for anything newsworthy.  Review your selling price every quarter, updating it as necessary.

A cool feature offered by most online brokers is an automatic buy/sell feature.  I use TD Ameritrade, where they are called “Trade Triggers™”, and I take advantage of these on every stock I buy.  These auto-commands can protect you from missing your exit price.  Using the ABC example above, say you plan on selling ABC at $58.00 per share.  Enroll ABC in an auto-sell command with $58 as your condition for selling; when ABC hits $58 your shares are automatically sold.  This is great for those who occasionally check their accounts or spend hours each day away from their computer.  I set my commands to expire each quarter, which forces me to revalue my holdings and enter my updated selling price as a trigger.  I also enjoy tracking my purchases in a custom Excel Spreadsheet, which allows me to see all my lifetime of purchases, returns, dividends and more in one location.

Selling

Your stocks will be sold either through the automatic triggers (if enacted) or a process very similar to the buying process described above.  If manually selling you will choose “Sell” and enter the ticker and number of shares you wish to sell (you will be selling all shares in the specific company).  On manual sells I sell on “Market” orders rather than “Limit” orders, although you can argue that my enacted Trade Triggers are really preset limit orders.  During business hours the transaction is completed immediately and the sale proceeds are available for a subsequent purchase.

Buying and Selling Intelligently

The next education post will help you choose a strategy for selecting stocks and calculating your exit price.

One of these is Joel Greenblatt.

Joel Greenblatt

Joel Greenblatt built most of his wealth from the late 1980’s to the early 2000’s.  He graduated from the The Wharton School at the University of Pennsylvania in 1979 and received an MBA in 1980.  Joel Greenblatt and John Petry founded the Value Investors Club, a website where investors are approved through an application process.  The members exchange formulas, analysis and special situation investment ideas.  Membership in this highly prestigious group is capped at 250 members, and the club awards $5,000 to the member who submits the best idea each week.

In 1985, while serving as the chairman of the board for Alliant Techsystems, he founded the hedge fund Gotham Asset Management with $7 million.  While managing Gotham is became famous for his generic-titled “Magic Formula”.  The idea of this formula was to create a quantitative investment strategy for picking stocks.  The formula was made public in his best seller “The Little Book that Beats the Market”, published in 2005 (after he had already millions with his strategy).  The Magic Formula produced returns of 30.8% from 1988 to 2004, beating the S&P 500’s return of 12.4%.

Investment Strategy

Greenblatt buys “cheap and good companies” with a high earnings yield and a high return on invested capital.  He finds these companies by looking at the return a company generates on its capital and at the firm’s earnings yield, which is similar to the inverse of its P/E ratio.  According to Greenblatt, beating the market is not complicated if an investor maintains a consistent approach, exercising discipline, patience and confidence when picking stocks to purchase.

Greenblatt’s Magic Formula

 His formula is not so much a valuation formula, but better used as a stock screener or potential value indicator (much like Tobin’s Q).  This formula ranks stocks from 1 to 50 with 1 being the most attractive stock and 50 being the least attractive.  This formula can be both a stand-alone stock screener or combined with other screeners.

The first step is to exclude certain companies.  The exclusion criteria is:

• Exclude all companies with a Market Cap less than $50 million
• Exclude all companies in the Financial sector.
• Exclude all companies in the Utilities sector.
• Exclude all foreign companies.

Once the above exclusion criteria is in place, the next step is to determine the remaining company’s Earnings Yield and Return on Capital:

• Earnings Yield = EBITDA / Enterprise Value.
• Return on Capital = EBITDA / [Fixed Assets + (Total Current Assets – Total Current Liabilities)].

The next step is to rank the remaining companies by highest earnings yield and highest return on capital.  The rank order will be determined by:

• Add the earnings yield and return on capital together for each company.
• Sort by highest to lowest.
• Assign a numerical value to the top 50 companies.  1 will represent the top company, then 2, and so on.

Current Status

 Greenblatt’s formula is still widely used by funds and financial journalists searching for long ideas.  Much like Warren Buffett’s philosophy, Greenblatt’s common-sense conservative screen is applicable in any type of market.  The team at ValueMyStock uses it behind the scenes on some of our own purchases and are incorporating it into a robust combined formula we will roll out in 2012.  I encourage you to set aside two hours, open up Excel and see what you find using the Magic Formula.  I’m sure you will find some real gems to consider.

To refresh on brokers, here is an excerpt from my previous entry:  “Stocks are purchased through a broker.  The broker acts a middleman between the stockholder and the rest of the market.  With today’s technology the concept of a “stockbroker” is changing from a flesh-and-body broker to an automated system.  Online stockbrokers, commonly known as “discount brokerage houses”, dominant today’s broker market.  All offer discounted stock trading, generally for $9.99 or less per trade.  Most offer research tools and investor education, although the value of these tools and education is subjective.  An investor can hold both regular and retirement accounts, such as IRAs, with these brokers.  All accounts can be used to purchase stocks and mutual funds.”

Choosing a Broker

In 99.9% of all cases I recommend investors open an online brokerage account instead of a live stockbroker.  Your costs will be much lower and the amount of control you exercise over your investments much higher.  Choosing an online broker can be daunting for the beginner, as they all claim to have the best tools, trading platforms, and so on.  Barron’s, a well-respected financial publication, publishes a review each year of the top online brokers.  I highly recommend reading through their March 2011 review before selecting a broker.  Here is a list of some of the most popular online brokers – if you don’t have the time to research you can just pick one off of this list.  Each one should satisfy your needs:

- E*Trade

-TD Ameritrade

-Scottrade

-Fidelity

-Schwab

Most of the major online brokers will also have small offices throughout the U.S., although I use TD Ameritrade and have never visited an office.  Scottrade has a number of offices and probably has one close to you.  The others tend to be in major metro areas.

Opening Your Account

All brokers have links on their home pages for opening an account.  You do not need any money to open an account, but you will want to fund it pretty quickly, so I advise waiting until you have your funds ready before opening an account.  I suggest starting a new account with no less than $500.  You can also rollover a current or previous 401(k) into a Traditional IRA and enjoy all the privileges of owning stock in your retirement account.

You will have to choose what type of account and what services you will need.  Unless you are opening or rolling over a retirement account (IRA) you should select a regular taxable account.  You will be asked if you want to trade options and trade on margin.  I do not recommend beginners trade options or trade on margin, so decline these choices.  You will be asked a number of personal questions, especially related to your knowledge of finance and employment.  Most of these are post-September 2011 controls put in place by Homeland Security to prevent funding of terrorist cells.  If you are married I suggest opening your account as a joint account with survivorship; this will ensure your spouse can handle your account in the case of hospitalization or death.

Once you have entered your personal information you will be asked how you want to fund your new account.  The easiest (and fastest) way is to have the funds in your checking account and choose to ETF your funds from your checking to your new broker account.  Linking the two accounts will allow you to transfer funds back and forth at will in the future.

If you are opening your account via rolling over a previous retirement plan into an IRA there are a few more steps involved.  Upon opening the account either you or your broker (you will be informed which one) will need to contact the company holding your retirement plan – this company and the broker will execute the rollover.  DO NOT withdraw a check from your current retirement account manager, as this could result in an “early withdraw” triggering taxes and a 10% penalty from the IRS.

Coupons and Promotions

Many online brokers offer promotions to entice new customers.  These promotions include a number of free trades, cash back or premium services.  I highly recommend researching on Google any brokers you are interested in (for example, search “Scottrade Promotion Coupon New User”).  You can probably save yourself $50 to $100 with a five minute search.  Also check with friends who may already trade stocks, as most brokers offer referral programs that can benefit both you and your friend.

Buying Your First Stocks

Once your account is open and funded you are ready to begin trading.  Stay tuned for the next entry, where I discuss selecting and buying stocks.

The average reader, and probably quite a few investors, would guess Barack Obama.

The answer is Ron Paul.

On the surface Ron Paul embodies the very core of pure free enterprise:  lower regulation, lower taxes, leaner government and free trade.  I myself believe our country would be better if some of Paul’s less-radical ideas were adopted.  But when investors look deep into their souls and really study what makes this country great, their insides turn at a few of Ron Paul’s deeply-held convictions.

A perennial presidential candidate, each year Paul’s support base grows and his donations climb upward.  Placing third in the Iowa primary and notching a solid second place in the New Hampshire primary, only to have the mainstream press and the “establishment” still snub him, outraging his supporters and solidifying the “us against them” attitude embodied by his followers.  The truth is Ron Paul will never be President of the United States.  The leaders of this country know it, the (educated) media know it, and the “smart money” investors know it.  There is no systematic conspiracy to shut out Ron Paul, just a fear that giving him airtime and attention will fan the flames of Paul’s populist and dangerous ideas.

Let’s take a look at two of these dangerous positions that unsettle the investment community and will keep Paul out of the White House.

Two Ideas Investors Wish Paul Would Drop Like a Hot Potato

Paul is not ashamed, not wishy-washy, not a flip-flopper.  He is concise and clear in his message and his personal life and decisions reflect his stated political views – virtues we like in our leaders.  The problem is the positions, not the man.  Two of Ron Paul’s positions, as copied from his official campaign website:

“As President, Ron Paul will lead the way…by”:

• “Fighting to fully audit (and then end) the Federal Reserve System, which has enabled the over 95% reduction of what our dollar can buy and continues to create money out of thin air to finance future debt.”

• “Legalizing sound money, so the government is forced to get serious about the dollar’s value.”

Why Auditing and Keeping the Federal Reserve is Good for All

I do not know anyone who disagrees with regular audits of the Federal Reserve–we can all agree with Paul on this point, but abolishing it would send America’s economy back to the 19^th Century.

The Federal Reserve (“Fed”) is the central banking system of the United States.  The Fed was created in 1913 as a result of 100 years of boom-and-bust cycles.  Imagine every decade going through swings more intense than 2007 through 2010.  This is what America experienced before the Fed was created.  The worst period spanned the end of the Civil War to 1907.  There was no FDIC insurance, no SEC, no government agency monitoring the economy.  We had the Treasury who printed money and Congress who spent money.  During these wild swings account holders would make a “run on the bank”, withdrawing all of their funds.  Done out of fear, this led to a number of bank collapses, which only fanned the flames of more fear and panic.  Families lost their entire savings, small investors lost the benefits of banking functions, farmers lost the ability to borrow money—it was not a happy time for the average American.  This pattern helped created the great wealth disparity of the early 20^th century.  A few wealthy individuals (Rockefellers, du Ponts, Vanderbilts) were able to profit from these wild swings while the rest of America teetered on the edge of poverty.

The Federal Reserve was partly established so that the average person could have faith in their bank.  The Fed monitors the health of the banking system and holds funds for emergency lending to banks that are prone to collapse (ie, bailouts).  The country needed a central bank that could provide liquidity to the financial system.  But the Fed does not print money.  America’s banking and currency structure is unique – the Treasury prints money and the Federal Reserve handles how it is distributed.  Despite being added to the U.S. Government over 100 years after the birth of the US, the Federal Reserve fits nicely into the system of checks and balances envisioned by the founding fathers.

The Federal Reserve has two high-level responsibilities, or a “dual mandate”–maximize employment and keep prices (inflation) stable.  The Fed does not exert direct control over these two responsibilities; it cannot tell private companies when to hire nor what prices to charge.  The Fed has limited and indirect control over the economy through the manipulation of interest rates, bank reserves and buying bonds from private banks.  When Ron Paul claims the Fed “creates money out of thin air” he is referring to the three tools available to the Fed:

1)  Raising or lowering short-term interest rates.  Setting interest rates is the most visible and important tool because it essentially sets the “wholesale” cost of money. When money is cheaper (interest rates are low), it tends to move more quickly through the system. So when the economy is sluggish, a rate cut perks things up. When the economy is thriving, raising rates prevents the economy from picking up too much speed. An economy moving too fast has too much money in the system, which feeds inflation.

2)  Raising or lowering the amount of reserves that banks are required to hold in their accounts. Raising reserves means banks have to hold onto more money, which tends to tighten credit. This works fine as long as the borrowing under management is coming from banks. These days, most credit is coming not from banks but from the global money markets, where bonds are bought and sold and the market sets interest rates.

3)  “Open Market” transactions.  Open market transactions are more limited, but have a more immediate impact. The Fed turns to these when the financial markets get into trouble, as they did during the recent financial crisis. The specific mechanics of open market moves are simple.  The Fed operates a trading desk in New York through which is can buy or sell bonds. If it buys bonds, the dealer that sold them gets cash in return. That cash then flows through the system. If the Fed wants to reduce the amount of money, it sells bonds from its account — taking cash from the dealer that bought them and taking it out of the system (or “draining” money.) The Fed maintains its own account, so any money being “injected” into the system is not coming directly from the tax dollars collected by the Treasury.

It is incorrect to say the Fed “creates money out of thin air.”  The Fed’s tools only allow it to manipulate the current tender, not print money.  When interest rates are lowered and borrowing becomes easier it can seem that money is being created.  The reality is people are spending more instead of keeping their money in savings, leading to more money in the system.  When the Fed buys bonds on the open market, it is injecting actual cash into the system – but the money already existed, as the Fed obtained that money by previously selling bonds.

Just like any government agency the Fed is not a perfect entity.  It was highly criticized for not acting swiftly enough during the Great Depression.  It is now criticized for acting too broadly during the 2007 recession.  Like America’s history it is an ebb and flow of forward progress.  The Fed should be audited just as any private company should since they serve the needs of both the public and private for-profit banks.  The Fed is an important part of our economy and for the most part has performed a commendable job of keeping inflation and employment stable.  Paul’s rants against the Fed are firmly rooted in populism—Paul knows the average American has no idea what the Fed does and can use that lack of knowledge to build fear about the Fed.  The Fed has managed a level of prosperity (1940 to present) unprecedented in the history of the world.  “Smart money” investors know that ending the Fed would send the country’s monetary management into chaos and end any chance for America continuing this tenure of prosperity.

The Gold Standard

Paul calls it “sound money” but the street term is the “gold standard.”  The gold standard refers to a requirement that every US dollar be “backed up” by a hard currency, whether coins or bullion.  Whether silver or gold, America operated with a hard-money standard from colonial times until 1931, when the official gold standard was abandoned during the onset of the Great Depression.  Paul claims that the dollar should once again be backed by gold and/or silver – that a currency without a hard-specie backing is bound to crash and burn and leads to hyperinflation.  This is another populist argument used by Paul that would send this country on a crash-course to B.C. times.

There are many disadvantages for using a hard-currency backing for the US dollar.  Following our discussion of the Fed, the main disadvantage is that a gold standard limits the flexibility of the Fed’s monetary policy by limiting their ability to expand the money supply, and thus their ability to lower interest rates.  Economic historians blame the gold standard of the 1920’s for prolonging the Great Depression.  Adherence to the gold standard prevented the Federal Reserve from expanding the money supply in order to stimulate the economy, fund insolvent banks and fund government deficits which could “prime the pump” for an expansion. Once the US went off the gold standard, it became free to engage in such monetary endeavors.  It is true that fiat currencies (money that derives its value from government regulation or law, not precious metals) lead to inflation.  But if a country has a strong central bank such as the Fed inflation can be kept in check and allowed to rise at an acceptable rate.  The average rate of inflation in the US over the past 25 years is approximately 4% – an acceptable compromise when considering the disadvantages of the gold standard.

Precious metals such as gold and silver served as early forms of currencies because they were 1) available but not plentiful and 2) had an almost infinite lifespan.  In B.C. times where most business was done between people within a community or between neighboring communities this was fine.  In today’s global environment major economies hold vast reserves of each other’s currencies.  This leads to a shared “peg” of value, meaning that most markets and economies are somewhat dependent on each other, and the value of their currency is supported by the trade done within and between countries.  This is what people mean when they say a “global economy” and why Europe’s current debt crisis is affecting our stock market.

It sounds patriotic and “of the American spirit” to not be reliant on any other currency or economy, but this is one of the best things that happened to world relations.  A leader of one country is much less inclined to declare war on another country if their economies are undeniably intertwined.  Look at the belligerent countries of late, such as North Korea and Iran:  they foster isolationist attitudes regarding trade and currency.

Outside of speculators betting on public fears about the dollar (fears fanned by Paul), our fascination with gold is waning.  Warren Buffett has a great perspective on gold:  “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”  The only reason gold has any value is people’s fear that their fiat currency may become worthless.  Outside of speculating gold has lost the luster it had with past generations.  As the world emerged from poverty and continues to become middle class people now value things or currencies.  When people have a paycheck flowing into the house they become less interested in the form of the currency, just as long as it will purchase the things they want.  Compare old church hymns (…walk the streets of gold…) to today’s music (…it’s all about the Benjamins…) to see what currency America now holds as desirable.

Returning to a gold or silver standard would put our economy in reverse and set back 100 years of progress, just as ending the Fed would do.  Yes, it would kill inflation and reduce government manipulation, but just the shock of adopting any hard-currency standard (especially when none of our trading partners are on a gold standard) would kill businesses, create unemployment and create uncontrollable runs on banks and necessities such as groceries.  It would guarantee that you, your children and your grandchildren would either live in poverty or constantly teeter on the edge.  We can answer today’s monetary issues with tools less intense than returning to a hard-currency standard.

Love the Man, Hate the Message

There is a lot of love for Ron Paul.  He has energized a disenfranchised base of young, libertarian and curious voters.  He has also taken advantage of their lack of financial education and lack of trust in government.  It is a shame, as he has some great points and could make a fine candidate if he abandoned his populist rhetoric.  I chose just two of his positions – there are others rooted in populism that give financial minds pause, such as refusing to raise the debt ceiling and eliminating the IRS and basically all individual taxes.  They sound good in a debate or in a speech to young, unemployed voters, but some of his other positions would be just as damaging to our economy as the two outlined above.  This is why Ron Paul gets no love from investors.

•  Long-term price stability has been described as the great virtue of the gold standard.  The gold standard limits the power of governments to inflate prices through excessive issuance of paper currency.  Under the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible as the money supply can only grow at the rate that the gold supply increases.  Economy-wide price increases caused by ever-increasing amounts of currency chasing a constant supply of goods are rare, as gold supply for monetary use is limited by the available gold that can be minted into coin.  High levels of inflation under a gold standard are usually seen only when warfare destroys a large part of the economy, reducing the production of goods, or when a major new source of gold becomes available.  In the U.S. one of those periods of warfare was the Civil War, which destroyed the economy of the South, while the California Gold Rush made large amounts of gold available for minting.
• The stability of the gold standard fosters economic prosperity.
• The gold standard provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade.  Historically, imbalances between price levels in different countries would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the “price specie flow mechanism.”  Gold used to pay for imports reduces the money supply of importing nations, causing deflation and a reduction in the general price level for goods and services, making them more competitive, while the importation of gold by net exporters serves to increase the money supply, causes inflation and an increase in the general price level, making them less competitive.
• The gold standard acts as a check on government deficit spending as it limits the amount of debt that can be issued. It also prevents governments from inflating away the real value of their already existing debt through currency devaluation.  A central bank cannot be an unlimited buyer of last resort of government debt. A central bank could not create unlimited quantities of money at will, as there is a limited supply of gold.
• A gold standard cannot be used for, what economists call, financial repression.  Newly printed money can be used to purchase goods and services, and to discharge debts, at no cost to the printer. This acts as a mechanism to transfer the wealth of society to those that can print money, from everyone else. Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation.  In 1966 Alan Greenspan wrote “Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.”  Financial repression negatively affects economic growth.
• The gold standard benefits savers by preventing their savings from being devalued or destroyed through inflation, and by rewarding them with higher real (inflation adjusted) interest rates. In the US and United Kingdom, from 1945 to 1980 negative real interest rates have cost lenders an estimated 3-4% of GDP per year on average.
• The gold standard tends to limit credit booms and the resulting boom bust cycle because of the inelastic supply of money. There is no central bank to print ever increasing amounts of money which act as fuel for the boom, and overextended banks fail sooner as there is no central bank to bail them out, causing credit to contract and ending any booms that do occur.

Disadvantages

• The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons and arguments have been made that this amount is too small to serve as a monetary base. The value of this amount of gold is over 6 trillion dollars while the monetary base of the US, with a roughly 20% share of the world economy, stands at $2.7 trillion at the end of 2011.  Even in the unlikely prospect that all mined gold could be turned into coin, a return to the gold standard would result in a significant increase in the current value of gold.
• The unequal distribution of gold as a natural resource makes the gold standard much more advantageous in terms of cost and international economic empowerment for those countries that produce gold.  In 2010 the largest producers of gold, in order, are China, followed by Australia, the US, South Africa and Russia.  The country with the largest reserves is Australia.
• Although the gold standard has brought long-run price stability, it has also historically been associated with high short-run price volatility.  It has been argued by, among others, Anna Schwartz that this kind of instability in short-term price levels can lead to financial instability as lenders and borrowers become uncertain about the value of debt.
• Deflation punishes debtors.  Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. Lenders become wealthier, but may choose to save some of their additional wealth rather than spending it all.  The overall amount of expenditure is therefore likely to fall.
• Mainstream economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns.  Following a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabilize the economy in times of economic recession.  Such reason is often employed to partially blame the gold standard for the Great Depression, citing that the Federal Reserve couldn’t expand credit enough to offset the deflationary forces at work in the market.
• Monetary policy would essentially be determined by the rate of gold production.  Fluctuations in the amount of gold that is mined could cause inflation if there is an increase or deflation if there is a decrease.  Some hold the view that this contributed to the severity and length of the Great Depression as the gold standard forced the central banks to keep monetary policy too tight, creating deflation.
• James Hamilton contended that the gold standard may be susceptible to speculative attacks when a government’s financial position appears weak, although others contend that this very threat discourages governments’ engaging in risky policy.  For example, some believe that the United States was forced to contract the money supply and raise interest rates in September 1931 to defend the dollar after speculators forced Great Britain off the gold standard.
• If a country wanted to devalue its currency, a gold standard would generally produce sharper changes than the smooth declines seen in fiat currencies, depending on the method of devaluation.
• Most economists favor a low, positive rate of inflation. Partly this reflects fear of deflationary shocks, but primarily because they believe that central banks still have some role to play in dampening fluctuations in output and unemployment. Central banks can more safely play that role when a positive rate of inflation gives them room to tighten money growth without inducing price declines.
• It is difficult to manipulate a gold standard to tailor to an economy’s demand for money, providing practical constraints against the measures that central banks might otherwise use to respond to economic crises.  The demand for money always equals the supply of money. Creation of new money reduces interest rates and thereby increases demand for new lower cost debt, raising the demand for money.

No one is born knowing how to invest in stocks.  Even those born owning stocks (as some lucky kids are) still need to know how to manage them.  Many people talk to me about stocks and investing, but when I press further many of them know almost nothing about investing basics.  According to recent Gallup polls stock ownership in the U.S. is between 54% and 63%.  This misleading study gives the appearance that half the nation invests in stocks.  The truth is that most stock ownership is largely indirect through products such retirement plans and mutual funds; most Americans have never actively managed a portfolio of individual stocks.

Stocks have been traded for over 200 years.  The modern idea of publicly traded stocks began in 1792 at a meeting between twenty four large merchants. At the meeting, the merchants agreed to meet daily on Wall Street to daily trade stocks and bonds, thus creating the New York Stock Exchange (NYSE).  Stock trading is monitored by the Securities and Exchange Commission (SEC).  The SEC makes sure public companies report their financial results properly and ensures fair trading practices.

This is the first entry in what is a series of blogs educating the first-time investor.  Readers are not required to have a background in finance or even be a college graduate.  A little self-education and common sense will grow your wealth much more so than savings accounts and mutual funds.

Ownership

Stock is literally ownership.  Stockholders own some percentage of a company’s assets and earnings.  Stockholders are also referred to as shareholders since stocks are sold by the share.  The percent of ownership is calculated by dividing the Number of Shares Outstanding by the Number of Shares held by the investor.

Companies can raise money by issuing bonds (debt financing) or selling stock (equity financing).  Debt is a future obligation for the company since the debt must be paid back, plus interest.  Equity means ownership, which does not have to be paid back.  Stock ownership lasts as long as the company remains publicly traded or until the stockholder sells their shares.

Owning stock comes with some privileges, such as voting rights in company matters and limited liability.  Stock agreements are written so that the passive investor (as opposed to a decision-maker in the company) cannot be held personally responsible for the actions of the company.  An investor who invests in a company that commits a crime or violates environmental law will not be taken to jail or sued.  The value of their investment in the company (their shares of stock) may become worthless, but they are never out more than their investment.

Brokerages

Stocks are purchased through a broker.  The broker acts a middleman between the stockholder and the rest of the market.  With today’s technology the concept of a “stockbroker” is changing from a flesh-and-body broker to an automated system.  Online stockbrokers, commonly known as “discount brokerage houses”, dominant today’s broker market.  Examples include:

• E*Trade
• TD Ameritrade
• Scottrade
• Fidelity

There are many more brokerages.  All offer discounted stock trading, generally for $9.99 or less per trade.  Most offer research tools and investor education, although the value of these tools and education is subjective.  An investor can hold both regular and retirement accounts, such as IRAs, with these brokers.  All accounts can be used to purchase stocks and mutual funds.

Opening an Account

Stay tuned for the next entry, where I will discuss opening a brokerage account and trading stocks.

As everyday investors we try to understand what we invest in, but we do not know the intricacies of industries in which we have never been employed.  Therefore our valuations are a “best guess” based on public information about our target company – which is why I require a minimum margin of safety of 30% to account for potential errors in my valuation.  But what if you do know everything about a specific industry – the suppliers, cost of raw materials, marketing channels and sales outlook?  Wouldn’t you expect to have a much more accurate valuation?  Who does know this much about an industry?

The answer is your target company’s competitors.  Competitors buy each other out quite often. Sometimes it is just to remove a threat to future growth, but often times it is because they can acquire the competitor’s sales at a discount.  In other words, Competitor A is attractive to Competitor B because A is undervalued.  I have had a number of my purchases acquired by competitors for prices fairly close to my own target selling price.  For me, this is excellent confirmation that my approach is accurate.  A couple of my best examples:

1.  Phelps Dodge.  Phelps Dodge (PD) was purchased by Freeport-McMoran in March 2007.  I valued PD at $119 and purchased my shares in July 2006 for $80.02.  A $126.46 per share offer was made on November 20, 2006, sending the stock from around $70 per share to over $120.  I sold on November 20, 2006 for $122.57, a 53% return in four months.

2.  Gehl Company.  Gehl Company (GEHL) was purchased by Manitou BF S.A. in 2008.  I valued GEHL at $25.92 and purchased my shares in February 2008 for $18.33.  A $30 per share offer was made on September 8, 2008.  I sold on September 8^th for $29.52, a 60% return in seven months.

Acquisitions are not quite as plentiful in today’s economic environment due to restrictions on lending and many companies sitting on cash until the economy picks up again.  I anticipate seeing a flurry of acquisitions in the next few years as companies use their excess cash to snap up undervalued peers, which means we will have another measuring stick for value within industries.