Arohan’s investing life

After evaluating different options, I have decided that p2p lending on Prosper.com offers excellent opportunity to earn returns better than a CD or a money market account. I may be late to the bandwagon as many personal finance bloggers have already signed up at Prosper, but I did take time to carefully review the activity on Prosper before committing my money to it

To me, it appears to offer multiple benefits

1. Opportunity to earn better interest than traditional cash accounts. It is true however, that the principal is not as safe as it would be in a CD or a money market account, but a lender can choose to take on only the risk that he or she is comfortable with. Prosper provides much data about the borrower that you can use to gauge the risk, including credit rating, past payment history, verified income, etc
2. It is also my bit to help good qualified borrowers access to capital where they may have been unable to access it from traditional sources like banks due to the fallout of the credit crisis

I seriously believe that p2p lending networks like Prosper have the potential to cause a serious change in the way credit markets work in US. It may take some more time, but the critical mass is building

If you would like to sign up as a lender on Prosper.com, I would appreciate if you use the following link to do it. This would put $25 in your account as initial capital for free and would also earn me a similar amount as a referral fee.

Related posts:

1. Fed interest rate cut is actually good for the economy
2. Investing in 401K plans - when is it not worth the trouble
3. Fed trying to break the back of the credit crunch
4. Leucadia National bottom fishing in the credit industry ruins
5. Recession is here! What should an investor do?

Warren Buffett is the super investor of our time and probably the best known investing celebrity. Even a small investment in Buffett’s holding company, Berkshire Hathaway, when Buffett took the helm, would have made any investor a millionaire many times over. In 1965, when Buffett took control of the company, a single Berkshire Hathaway share was changing hands at around $16. Today it trades at $128,000 (and has traded as high as $151,000 in recent past). This is a return of almost 800,000%. A $1000 investment in Berkshire shares in 1965 would be worth $8 million today. This investment has compounded at the rate of 22.7% annually for over 40 years

Alas, Mr Buffett is close to retiring. He has already picked his successor is in the middle of what can be termed as a very keenly watched succession planning exercise where he is slowly disposing off his holdings and therefore relinquishing control of the holding company. He is adamant however, that any successor to his position will continue the invesment philosophy that he espouses. Berkshire Hathaway could still be a good long term hold but a new investor may very well ask the question: are there any other investment similar to Berkshire Hathaway that I can buy now and hold for long term and expect great returns?

Before we attempt to answer this question, we should review what makes Mr Buffett such a successful investor. What makes up his investment strategy? The genius of Buffett does not lie in devising elaborate and highly sophisticated strategies that the hedge funds are so enamored with. He does not seek to take advantage of every sliver of in-efficiency that the market throws up (although that can be a great wealth creation tool in itself: to wit, George Soros). His genius lies in the common sense approach he takes to his investments, the simplicity of it, and immense patience. Most can understand his approach to investing, very few have the patience to sit still and do nothing, which is what is needed to let your investments mature and bear fruit. My take on his approach boils down to 3 simple principles:

1. Pay less than the actual worth
2. Use judicious leverage
3. Wait

Let’s look at these 3 principles in brief detail:

Pay less than the actual worth: This comes to us naturally when we shop. Buying a stock is no different. The problem is that there is no MSRP on the stock price. So how do you judge the worth of the stock or the company you are considering acquiring? We all know the price. Market sets the price. But what is the value or worth of the stock?

To figure this out, one has to almost always look at the assets that the company has. These assets can be in the form of book value, or patents or brands that can be monetized. In rare situations, you may be able to find a company that has more cash (minus debt) on the books than its entire market capitalization (yes, they still exist), in which case it is easy to see that the company’s liquidation value is higher than the stock price. However, in most situations like this you will find that the company has assets that are just not valued correctly (maybe real estate carried at cost where market value may be significantly higher in orderly liquidation) , or may be a de-facto monopoly in an industry that produces ‘basic’ products, or may be brands that can be monetized but the market has not ascribed any value to it. In some variants of these situations, one will find, that the company is priced at such variance to its book not because of its ‘hidden’ assets but more due to visible signs of distress in its business. Is it just incompetent management, that once replaced will go a long way towards restoring the business health? Maybe a temporary slip-up?

Use judicious leverage: To me, this can occur in two distinct manners. First is when you can borrow money with as little risk as possible and use it for investment alongside your own money. Investors can already borrow money on margin for investments, and that is what most hedge funds do, however, that money is not risk-free. For that to be risk-free, your investment will have to be risk free. (Come to think of it, if you can borrow money at low enough interest and invest with a 10×1 leverage in treasuries, you will generate returns that will give any hedge fund a run for its money). What Buffett does is to invest the float generated by its insurance companies (which is excess capital over what is reasonably needed to meet claims). While not completely risk-free, it is pretty close (as long as the insurance business is run profitably). If you own a profitable business, this is akin to taking the free cash flow and using it for investment purposes

The second way that Buffett uses leverage is a bit subtle. He prefers to buy businesses that are scalable with very little additional capital investments. If you are able to buy a company that is profitable today but only uses part of its capacity now, imagine how profitable the company would be if you grow it and start using 100% of the capacity. This is leveraging your existing assets to generate growth. Of course, the company has to be in an industry where such growth is possible (or should have some advantage that it can use to gain market share in a stagnant industry)

Wait: The toughest of it all. If you buy a business at a price lower than its worth, and/or, you buy a business that has a potential to grow without much additional expenditure (growing profit margins), than what you need to do is to give time for the market to realize the true worth of the business and the business to realize its full profit potential. Waiting is an integral part of this investment process. One cannot expect overnight riches this way. The whole investment theses is built around giving the investment time to mature. If one gets bored waiting, find a hobby (like bridge!) or get a day job to pass time or better still, actively participate in the businesses you bought helping them along the path that you envision (tough to do if you only bought a few hundred shares)

A side note: Financial media falls over backwards extolling the virtues of buy and hold method of investment. It is important to realize that a blind buy-and-hold is not a guarantee of investment success. A lot of ground work needs to be done in selecting your investments before the buy-and-hold principle can do its magic

Additional side note: Taxes are a drag on compounding. Dividends are taxed twice. Long term investors should almost always prefer investing in businesses that compound capital internally (meaning, reinvests in growing its business or portfolio) over a business that prefers to pay out dividends, unless in a tax advantaged account.

In Part 2 of this article, we will examine a few investors (and their investment vehicles) against the principles outlined above and see how close they come to matching Warren Buffett. You may be surprised to find that using same/similar principles, one can arrive at a very different investing style and still be very successful. Stay tuned …

Related posts:

1. Why Warren Buffett is richer than the Hedge Fund managers - a tale of two business models

A quick note regarding several investments that were recommended (and the author took a personal stake at the time of recommendation).

WSCI: WSI Industries was recommended as a growing metal working company with excellent prospects. I took a position in the company in the $4-$5 range several months ago. In the last one month, I have liquidated my entire position in the company in the $9-$10 range for close to a double. Very satisfying return for a few months work. The stock today is trading close to $14. If I had held for another month, I could be looking at a triple instead of a double. But I have no regrets. The company is approaching 40 PE and is getting quite frothy at these levels even if you take into account their projected growth for the next few years.

CFC:I am still holding Countrywide. If you recall, the play here was to buy Countrywide as a cheaper way of getting into Bank of America. The risk is that the Bank of America acquisition of Countrywide may not close. I am still comfortable in my position and will continue to hold

WM: I am still holding Washington Mutual and am currently underwater. However I am willing to wait out the current crisis of confidence as I think the company is taking the right steps to ensure that it survives
C: I have since my last writing on Citigroup increased my position in the company. The company is very quiet on what they are doing to improve their capital structure. However, they recently entered in an agreement to liquidate a part of their debt portfolio (to private equity) for about 10% discount. I think the company will correct course and come out stronger than many expect and in 3-5 years time should reward a patient investor handsomely

Additional notes: I have also increased my stake in BAM (Brookfield Asset Management), MKL (Markel), ACAS (American Capital Strategies), LUK (Leucadia), SLT (Sterlite Industries) and added positions in BRKB (Berkshire Hathaway B shares) and EPI (Wisdomtree India ETF)

Please note that if you choose to act on any of the recommendations/ideas outlined above, make sure that you conduct your own due diligence and understand the risks you are taking. I am not a financial advisor

Related posts:

1. Bought Countrywide and WaMU …

Senator Barack Obama outlined his economic policy highlights today, were he to become the next President of United States. His position on Capital Gains taxes is quite alarming and can have a profound effect on the US economy if it becomes a reality

Senator Obama is willing to increase the Capital Gains tax rate to 25% range (but definitely not more than 28% according to him). Ostensibly the higher tax revenue will go towards funding more government social programs

Double Taxation: All will agree that taxing dividends is a form of double taxation. Dividends are paid out of the after tax earnings of a business. It is however worth noting that taxing capital gains is also, maybe a bit subtly, a form of double taxation. Stock price of a company over a long term is directly linked to the growth of the business’s equity. Positive Net Income increases the the equity of a business. When the business pays taxes on its net income, the equity of the enterprise is decreased, thereby decreasing the value of the stock that an investor holds in the company (meaning the capital gains to the investor are reduced because the company pays income taxes on its income). This is the first instance of taxation (although indirect) on the investors assets. The second instance of taxation of course occurs when the investor sells stock and realizes a capital gains

In my mind, double taxation is simply wrong and just serves to discourage investment activity which is crucial for any capitalist economy to work. Much as I fault the current administration in many of the things they have done (or not done), they were on the correct path of reducing (and hopefully ultimately eliminating) the capital gains tax

Now back to Mr Obama’s proposal to raise the capital gains tax. I can think of many implications it has for the business environment in this country.

For investors:

• Low capital gains tax rate was an indirect way of encouraging the citizenry to migrate to an ‘Ownership model’ and invest in public assets. With Mr Obama’s proposal, owning stocks will become less attractive
• Countless studies have shown that over long term, stocks as an asset class outperform all other publicly investable asset classes. This is specially true if you compare the long term tax-adjusted returns of various asset classes. With increased capital gains tax rates, this gap will shrink. While this may not be a immediate game changer for young investors who have a long time frame, it is certain to change age based asset allocation models with people moving to more conservative assets earlier than they currently do (as the risk/reward ratio becomes worse and risk appetite lessens). This of course is a problem magnified when you consider that the older investors typically have more money invested in the markets. This may have an unintended result of depressing stock prices over a long term and therefore make owning stocks even less attractive
• Venture funding and Private Equity are essential to the business eco-system in this country. It drives innovation, new business models, new products, provides liquidity to the markets so inefficiency in the system is continuously removed by various restructuring and other market machinations. Firms in this industry take a long view and extraordinary risks for that capital gain when they execute their exit strategy. Raising taxes on this industry will put a damper on the startup and SMB activities thereby taking the shine off the core growth engine of the economy. Mr Obama will indeed need more money to fund social programs as the job creation in this country will slow down and those social programs will be in great demand.
• Growth companies will be pressured to return capital earlier in form of dividends or other distributions as investors become indifferent to dividends versus capital gains AND as the companies themselves see some lessening in attractiveness of reinvesting in other growth projects

For Businesses:

• As investors demand higher returns to compensate for the increased government’s take, businesses will likely increase their exposure to the debt markets, leveraging up their balance sheets. More interest payments and possibly more dividend payments imply a reduction in the balance sheet quality and a reduction in the risk appetite for the businesses
• more stakes in American companies will be sold to overseas investors who may not be burdened with such high capital gains taxes in their countries

For the general public:

• Less employment, less asset ownership, more social programs, bad deal all around

This may sound alarmist, but the fact is that all this will come to pass. It will not happen overnight, more like a slowly boiling frog. Of course, when this starts being a problem, Mr Obama will have ended his term and it will be someone else’s mess to fix …

All this will come to pass as a large portion of our workforce (babyboomers) will leave the workforce and retire.

Senator Obama is a likable candidate and will bring Statesmanship and Oratory back to the office and may even be a hit on the international circuit but with policies like this he will surely destroy the economic standing of USA in the globe. Oh, and more regulations that he espouses will not help

Better increase your allocation to international assets if it becomes likely that he may be the next President of USA

Related posts:

1. Why Warren Buffett is richer than the Hedge Fund managers - a tale of two business models
2. Global markets decline - is there a value in international diversification?
3. Recession is here! What should an investor do?
4. Investing in 401K plans - when is it not worth the trouble
5. On Banks and writedowns

Two interesting articles/stories caught my eye today

The first one talks about the mind boggling 2007 total compensation (earnings + stock) to Blackstone Group’s co-founder Stephen Schwarzman. According to this AP story, his compensation in 2007 was $350.7 million and along with stock grants valued at $4.77 B during Blackstone’s IPO, his total takeaway was $5.13 Billion in 2007 alone

With earnings like this, it is no surprise that many hedge fund managers are now counted among the Forbes Global Richest list.

This brings us to the second article that examines what would have happened if Warren Buffett had followed the hedge fund model of compensation instead of just staying with his equity position in Berkshire Hathaway and let the investment compound. To quote from the FT article,

At “2 and 20″, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent.

It is basically saying that if Buffett had followed the Hedge Fund model of compensation, his accumulated wealth would have been just 10% of what it is today

The difference is in the business models. A hedge fund manager primarily derives his income from fees. The assets of the hedge fund are owned by investors in the fund and only a part of the growth in the value of this asset works towards increasing the net worth of the hedge fund manager. For Mr Buffett, and indeed many entrepreneurs, net worth is primarily determined by the equity stake in the business that they own. Equity ownership lets the business income continue to compound in the business. As the business grows, the net worth of the owner grows correspondingly (the story would have had a different ending if Buffett had kept diluting his stake in Berkshire Hathaway by continually bringing in new investors like a hedge fund does)

Also to note (and a point unaddressed by the FT article) is the effect of taxation. While a hedge fund manager pays taxes each year (capital gains or income, a matter of controversy for sure but not relevant to this analysis), Mr Buffett will only pay taxes if he sells his equity (again, the fact that his charitable actions have helped him avoid taxes altogether is besides the point)

If you are a superlative investor (like Mr Buffett or like many of the better hedge fund managers), business ownership model of Berkshire Hathaway will generate greater wealth over a long period of time. Sure, running a hedge fund will get you to great riches quickly (adding lot of investors quickly, in the years where the fund does very well, etc), but it is not a superior wealth creation machine over long term

Maybe that is why Warren Buffett long ago discarded the investment partnership model. Or maybe another reason why Blackstone, Fortress et al. are now choosing to go public bestowing large equity stakes on their founders

Related posts:

1. Stock investors, who is the next Warren Buffett - Part 1
2. Obama has a plan to slow down the economic growth engine of US
3. Countrywide sellout too cheap?