The One Dollar Premise

“When stock can be bought below a business’s value, it is probably the best use of cash.”

Every year, a new strategy appears, claiming to be the secret to stock market success. Some are profitable for a time, even spectacularly so. However, trends eventually lose their momentum, reality intervenes, and yesterday’s win leads to failure tomorrow. Cycles of booms, bubbles, and busts repeat in all markets, from Dutch tulips and Florida real estate to dot.com companies and collateralized mortgage obligations (CMOs).

The most successful long-term investors avoid the temptations of fads, esoteric formulae, and schemes, preferring the simple for the sizzle. They rely on common sense to make investment decisions rather than following the crowd. Warren Buffett started investing in 1956 with $100, became a millionaire in 1962, and a billionaire in 1985. In 2020, he was acknowledged as the world’s sixth-wealthiest person with a net worth of $81 billion (after giving $37 billion to charity the previous fourteen years. For his success, he earned the sobriquet, “Oracle of Omaha.

Buffett’s investment philosophy is surprisingly simple and based on a few basic tenets:

The best returns are achieved by companies producing the same product or service for several years.
A company must produce a product or service that is (1) needed or desired, (2) has no close substitute, and (2) is not regulated. Buffett believes these characteristics enable a company to maintain or increase prices without losing market share or unit volume.
Companies without the ability to reinvest excess cash at above-average rates should return that money in dividends or share buy-backs to the shareholders.
Every dollar of retained earnings should create at least one dollar of market value (The One Dollar Premise).
Buy the stocks of companies that earn above-average returns at prices far below their intrinsic value.

Calculation of the One Dollar Premise

Anyone with access to historical results and the time to spend in the exercise can make a quick calculation of the return on retained earnings:

MV_i = (MC_e – MC_b)/(RE_e – RE_b)

MV_i = market value increase (decrease) per $1 retained earnings
MC_e = market cap at the end of the period
MC_b = market cap at the beginning of the period
RE_e = retained earnings at the end of the period
RE_b = retained earnings at the beginning of the period

Subtract the retained earnings balance from 3, 5, or 10 years past. For example, Alphabet (Google) had retained earnings in 2014 of $75.06 billion and $152.12 billion in 2019. In the 5-year, the company kept $77.06 billion of profits in the company.
Compare the market value today with the market corresponding to the beginning year of the retained earnings above. Alphabet’s market cap was $357.55 billion at the beginning of 2015, with $920.32 billion in 2019. Market value increased $562.76 billion during the five years.
Compare the increase in market value with the increase in retained earnings. In this case, Google produced $7.30 in increased market value for each $1.00 in retained earnings.

While knowing that Google does make excellent use of its retained earnings, a comparison with other companies – in and outside its industry – is a more reliable indicator of management’s prowess. A similar calculation for Coca Cola and Deere & Co provides additional insight:

A comparison of different periods highlights the difference in management’s ability to create value in various industries:

While the above figures suggest that all three companies are adept at reinvesting their retained earnings, Coca-Cola would seem to be the best investment. However, when looking at the compound average increase in stock value of the last five years, COKE provided its owners with the least market appreciation with a CAGR of 9.25%. Looking at stock appreciation alone, Deere would appear to be the best buy based on their average of 17.43% over the five-years. In comparison, Google was second at 11.9% during the same period.

The Importance of Intrinsic Value of a Company

The objective of fundamental analysis is to determine the intrinsic value of a company. A ratio of the intrinsic value with the market price is an indicator to buy or sell. Buffett recommends buying a company only when its intrinsic value is higher than its market price. While Buffett’s One Dollar Premise is one indicator of value, relying on a single indicator is not recommended.

The table above compares three ratios for Coca-Cola, Deere & Co, and Alphabet (Google). Deere & Co produced the highest 10-year return on equity (ROE) but has the lowest price/earnings multiple (PE), a sign that investors believe the company’s future earning potential is less than Coca-Cola or Google. Coca Cola produced a higher 10-year ROE than Google but has a lower PE. Since each company’s use of leverage is different, investors need to understand how debt affects future earnings.

Fundamental investors rely on hundreds of financial statement calculations to identify candidates for purchase, akin to looking for the “needle in the haystack” since there are more than 6,000 publicly traded companies. The process is arduous because market prices continuously change, and each price change can affect the result.

Final Thoughts

Professional investors rely on massive databases and sophisticated computers to perform the heavy lifting of data collection and analysis. Many supplement their experience with complex logarithms to make comparisons and suggestions. Fortunately, non-professionals today have access to many of the same tools used in the big investment houses.

An investment adviser like wealthX, using Artificial Intelligence (AI), continuously updates and recalculates hundreds of financial ratios and relationships – including Buffett’s One Dollar Premise – to make investment recommendations to their clients. A low monthly membership fee allows investors to benefit from the same strategies employed by the Oracle of Omaha.

June 20, 2014January 2, 2024

Stretching Your Income to Meet Expenses

If you just retired, congratulations. You’ve received the gold watch, relished the looks of co-workers who envy your new freedom, and begun to plan that long-awaited European tour you had always hoped to take. Life is good, but you do have concerns – mainly, whether your future income can sufficiently cover your basic living expenses, plus those little extras that make retirement special.

Financial experts generally calculate that you need between 70% and 85% of your pre-retirement income to maintain your lifestyle. Even if you were diligent about saving during your working years, it’s likely that your investment portfolio has not yet fully recovered from the recession, and returns are still lower than you expected them to be. How do you ensure that your nest egg is big enough to meet ongoing expenses?

Significant Future Income Increases Are Unlikely

Your future income will be a combination of Social Security benefits and the systematic liquidation and withdrawal of your retirement assets over the remaining years of your life. At age 65, you can expect to live, on average, another 19.1 years, according to the Centers for Disease Control and Prevention (CDC). If you are genetically gifted, however, you may live to 100 or longer – the number of centenarians in the U.S. rose to 53,345 in 2010, a 65.8% increase from 1980.

Your initial retirement calculations were probably based upon an annual withdrawal rate of 4% of asset value, a figure most financial planners had generally agreed would provide a stable income for 30 years. Nowadays, however, that percentage is considered by some to be too liberal. Recent studies have suggested that in the current economic environment, withdrawing income at a 4% rate could increase the risk of depleting your assets during your lifetime. Since the level of your future income is uncertain and may be lower than originally anticipated, it would be prudent to reduce your living expenses where possible so that less income is needed to provide the same quality retirement for your remaining years, however long that may be.

Read more . . .

February 18, 2014January 3, 2024

Day Trading for a Living – Benefits and Risks

In the days before personal computers, instantaneous communications, and sophisticated software, many Wall Street brokerage firms employed veteran traders to sit and interpret the paper tapes of stock transactions that spewed from mechanical tickers across the city. These traders, known as tape readers, would note the price and volume pattern of individual trades in the hopes that they could identify opportunities for quick profits. For example, if the latest trade of a stock differed significantly from previous trades in either price or volume, this might be interpreted as the work of insiders acting before news that could affect the company is announced. The tape readers would then act similarly, hoping their intuition was correct.

Since that time, the stock ticker has been replaced by a massive electronic network capable of analyzing and reporting trade data throughout the world. That technology has led to changes in the way the investment industry functions. One of the more unique positions in today’s landscape is that of the day trader.

Definition of Day Trading

By definition, day trading is the regular practice of buying and selling one or more security positions within a single trading day. No position, long or short, is held overnight. Day traders frequently deal in thousands of shares, often with leverage, and look for small-percentage profits on each trade – often less than $1 or $2 per share. They take positions based upon their analysis of a stock’s probable price direction within the trading period.

Popular day trading strategies include the following:

How to Choose the Best Stock Market Investment Strategy

According to a recent Pew Research report, more than one-half of people aged 30 or older have investments in the stock market and 80% of those making $75,000 per year or more have equity investments. These investments include individual stocks and bonds, as well as mutual funds and exchange-traded funds (ETFs).

While many suffered from the sharp decline in the market in 2008 – it lost 38% of its value – the S&P 500 closed above 1,800 on November 22, 2013, more than doubling its low of 721 on March 11, 2009. As investor confidence returns, many analysts predict that the market is going to continue its bullish behavior well into 2014 and beyond. Whether you select individual stocks or bonds or rely upon an investment manager to do it for you, it is important that you choose an investment approach fitting to your attitudes and goals.

Components of Investment Success

The optimistic outlook for stocks provides a great opportunity for existing and new investors to review strategies and adjust investment philosophies to optimize their future results. Financial experts agree that investment success is highly dependent upon the following activities.