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.

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 …

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

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

Let me start by saying that for average employees investing in a 401k plan makes absolute sense. A typical American worker is not a savvy investor, neither is a disciplined saver. A 401K plan offers discipline and a conservative selection of investment options that may not offer spectacular returns, but are also less likely to result in significant losses (as long as the investments are diversified). And on top of this, if the employer offers a matching contribution, it would be downright financially irresponsible to not take advantage of it.

Earlier this year I embarked on an entrepreneurial journey and one question has kept bugging me. Should I create a 401K plan that I as an owner will participate in. Offering 401K plans for my employees is a business decision but for me to participate in the plan is just a question of figuring out whether it makes financial sense. I prepared a simple model to aid me in my decision and have come to realize that for me personally (and possibly for many others who meet the criteria laid out in the rest of the article) a 401K plan is NOT the best way to save and invest.

From a business perspective, any dollars that my business puts in my 401K account is an expense. But so are any dollars that my business decides to pay me as salary. I can use the dollars that my business would have contributed to my 401K plan (including whatever company match is established for the plan) and just pay those dollars to me as (an increase in my) salary. Therefore, for the business it is a moot point (actually the business can save some money in 401K plan maintenance costs if you are the only employee).

So the question that I need to tackle now is whether it makes sense on a personal level.

Here are the following assumptions that I consider to be true in my situation and which is possibly true for many of my readers:

a. I consider myself to be an above average investor that can generate annual returns atleast 2% above what an average 401k plan funds would generate over long term (which can be approximated to the market return minus the average fund expense ratio)
b. My investments are reasonably tax efficient. This is not hard to do with a value style of investing where one tends to hold the investments for atleast a year or more (qualifying for a lower capital gains tax)
c. My intent is to generate significant personal wealth through investments and my businesses and I want my investments to be liquid and available if I choose to start enjoying the fruits of my labor earlier than the government prescribed retirement age
d. I expect to be in a significantly higher tax bracket in the future than where I am now, and
e. Part of my investments will be in private businesses and assets

The following numeric assumptions were made in my model:
1. long term market returns = 10% average per year
2. Average dividend yield = 2%
3. My personal overperformance over the market = 2%
4. Personal income tax rate = 30%
5. Dividend tax rate = 15% (in the taxable account)
6. Capital gains tax rate = 15% (in the taxable account)
7. Early withdrawal penalty = 10% (for a 401k account withdrawal)

To set up the model, I assumed the two scenarios

Scenario 1: Invest $100 per month in a 401K account, investments yield 2%, capital growth = 10% for an effective growth rate of 12%

Scenario 2: Pay $100 per month in income to me, pay 30% tax on the income, invest the remaining $70 per month in a taxable account, investments yield 2%, capital growth 12%, Dividend tax paid = 15% on the 2% yield for an effective growth rate of 13.7%

With these scenarios:

- at the end of 10 years, my 401K balance was (in future dollars) $23,004 and my taxable account balance was $17,811

Assuming both accounts were liquidated for cash at the end of 10 years, my 401k proceeds were $13,802 (after 30% income tax on the entire balance and 10% early withdrawal penalty) and my taxable account proceeds were $16,533 (after 15% capital gains tax, tax on dividend is assumed to be paid from the dividend yield as we go)

- at the end of 25 years, my 401K balance was $187,885 and my taxable account balance was $178,621

Assuming both accounts were liquidated for cash at the end of 25 years (and still before the retirement age), my 401K proceeds were $112,731 and my taxable account proceeds were $155,911

Assuming 25 years took me past the retirement age and so I did not have to pay early withdrawal penalty, then my 401K balance was $131,519

Conclusion: It appears that under certain conditions it is better to invest in a taxable account compared to investing in a 401K account. Of course, for one to achieve this, the person has to be financially disciplined and a savvy investor, and be willing to look beyond public markets for investments. Most people are none of these and therefore a 401K plan makes sense. For some, they are better off looking away from these plans. If your goal is financial security in retirement and you do not have time to manage your investments judiciously, go the 401K route. If your goal is to create substantial wealth before you retire and are willing to put time and effort and are a savvy investor, maybe taxable investments are a better choice

Final word: A Roth IRA, if one qualifies, may still be better than taxable investments, specially due to the fact that dividends are reinvested tax-deferred. But again, if one constructs a taxable portfolio carefully one can minimize dividends (letting the company reinvest for capital growth) and still come out ahead

I would like to hear your views around this. Please speak your mind