Two Carnivals to Read

Posts from this blog appear today in two carnivals, the Carnival of Everything Money hosted by The Penny inflatable castlesDaily and the Personal Finance News carnival at Peak Personal Finance.

Click, read, and enjoy!

Lotteries and Money Advice

Two posts this morning mention lotteries. Jabulani Leffall at WiseBread starts with a great quote “That buck that bought the bottle coulda’ struck the Lotto.” and proceeds with an excellent riff on the snake-oil-salesman aspect of personal finance gurus. Mighty Bargain Hunter then asks “Did Powerball tickets beat the S&P last year?” They didn’t, or at least didn’t on average. Your mileage may vary.

Apparently, a decent slice of Americans believe that winning the lottery is their most likely route to even modest wealth. According to the survey cited by MBH, 21% of them think that winning the lottery is the most practical way they have to accumulate several hundred thousand dollars. To be fair, 55% thought saving over time was the best course. And we don’t know how likely members of the 21% thought winning the lottery was, only that they thought it was their best shot.

People buy lottery tickets and become rich every day. A non-crazy and only modestly stupid person might reasonably conclude that buying a lottery ticket is a good way to become rich. Given ticket sales, the number of possibly sane but at least modestly stupid people must be very large.

I do not know of any personal finance experts who advise buying lottery tickets. Much as they specialize in repeating back what their audience already believes (or wants to believe) this would be a bit much. But the experts often make the same illogical jump as the modestly stupid person. There exist people who got rich by doing X, so doing X is a good way to become rich.

The fallacy is exploded by the great pile of worthless lottery tickets. Doing X may have made a few rich, but it also may have made many poor. If I wasn’t so horribly cynical, I might be surprised at how many people fall for this. The money guru points to the rich people who started their own business or bought real estate with no money down and the audience nods its head and agrees that yes, this is the way to wealth.

It is said that lotteries are a special tax on those who can’t do math. I agree, although I would change “can’t” to “won’t.” Much of the personal finance establishment is built on fees charged to those who can’t or won’t think logically. Even the august Millionaire Next Door spent three years on the bestseller lists and moved close to three million copies without, apparently, anybody noticing that its premise was fundamentally flawed. Just because a characteristic is shared by millionaires it does not follow that adopting that characteristic is likely to make you a millionaire.

Phil Town’s Rule #1, Part #3

[This is part 3 of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1 and/or Part 2 first.]

Last time I walked through the third of Town’s Four Ms. Today it’s the turn of the fourth, Margin of Safety. As a concept and phrase, margin of safety has a long and august history. Benjamin Graham, Warren Buffet’s mentor and the founding father of modern value investing, coined it in the 1930s. The idea is that if you buy a stock at enough of a discount it is hard for things to go wrong. To be specific, if you buy it for less than liquidation value, the value of the company’s tangible assets less its debts, then the worst case scenario is that the company will go out of business, auction off what it owns, and make you whole. That is quite a safety net.

Graham was writing and investing in the Great Depression and its aftermath. Even by today’s measures, the bargains available in the stock market in the 1930s and 1940s were inexplicable. Stocks that sold for less than book value were common. So when Graham talked about margin of safety he was making a pretty convincing “what’s the worst that could happen?” argument. Buy something for half of what it is really worth, and even assuming things go badly, you have a big cushion to fall back on.

Things have changed a lot since the concept of margin of safety was born. Looking for stocks you can buy for less than liquidation value is not a viable strategy. When Town talks about a margin of safety he is not suggesting that there is a liquidation value safety net, he is just making the argument that if a stock is cheap enough the cards are stacked in your favor. That is not a terrible way to invest, but it is not about safety. What he is saying is that you should buy cheap stocks because they tend to go up. Which is true. The trick is deciding which stocks are the really cheap ones.

There are lots of ways to do this, ranging from the exquisitely complex to the brutally simple. Entire books have been written on the topic. Town’s methodology is definitely on the simple side, although still more bother than it is worth.

The most annoying part of his valuation method is that he calls the value that gets calculated for the stock not the “true value” or “fair value” but “sticker price.” What could be more jarringly inappropriate? A sticker price is what a car manufacturer puts on the sheet of paper glued to the window of a new car in the forlorn hope that somebody, somewhere, will pay that much for it. Why not just call it the “unrealistic goal price?”

In a nutshell, Town instructs the reader to value a stock as follows. 1) Project earnings per share ten years from now. 2) Project a price/earnings ratio for ten years from now. 3) Use the future earnings and future price/earnings ratio to back out a price for the stock in ten years. 4) Discount that back into today’s dollars.

I will not repeat Town’s specific instructions for coming up with earnings projections, future P/E ratios, and the like. Suffice it to say that all are somewhat questionable, often obscure, and easily expressed as computer code I can use to test it.

Backtesting this value portion of Rule #1 is actually easier than the growth part. With fewer numbers as inputs, it runs faster and lets more stocks pass. But passing stocks are still pretty rare. Only 45 of the 1000 met the cutoff on December 31, 2007. That’s more than passed the growth test, but it’s still fewer than 1 in 20. (Again, running this without computer automation would be at best torturous.) And how did the passing stocks do? Not so great. The 45 lost an average of 47.19% during 2008, against an average loss of merely 37.01% for the other 955.

For the nine years 2000-2008, Town’s Margin of Safety screen selected an average of 51 stocks at the start of each year and on average they lost 0.27% over the next 12 months. The stocks that did not make the cut rose an average of 3.00%. That’s really pretty dismal. Any worse and I might suggest that shorting these names was a reasonable strategy.

Of course, Margin of Safety is not meant as a stand-alone. Town would have you invest in stocks that pass both the growth (Moat) and value (Margin of Safety) screens. So how many stocks passed both screens as of 12/31/07? Just one: Cognizant Technology. It lost 46.78% last year.

Overall, of the nine years of the sample, four (2000, 2002, 2004, and 2007) had no stocks at all that passed the two screens. The other five years had a grand total of 11 names that qualified. As it happens, some of those picks did pretty well. Others did poorly, but the average annual return was 14.77%, a little more than 10% better than the unselected members of the 1000 did in the same years.

And so what? This is hardly an actionable plan for putting your money to work in the stock market, given that there is nothing at all to buy half the time. And finding these needles in a haystack is not really practical without specialized software. Nor is this, with such a tiny sample, evidence that Rule #1 works after all. And Town is not done yet. There are still more parts to this “simple strategy for successful investing in only 15 minutes a week.” Stay tuned.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]

Bonus Outrage Resolution Understood at WSJ

Today’s Wall Street Journal carries a column by Jason Zweig in which he reveals that the action that the President announced on Wednesday to address the Wall Street Bonus Outrage will have no practical impact. Apparently it takes three days for people who work at the Wall Street Journal to understand what is immediately obvious to those that work on Wall Street. To be fair, it takes almost a day for unemployed hacks like me to get around to posting on a topic.

Frugal Friday 2/6

It’s Friday again, so here’s the weekly roundup of frugal hints from around the blogosphere. Just to make it clear, these are selected with the intent of finding ideas you haven’t seen before. Lots of sites tell you not to go grocery shopping hungry. It is the useful blog that gives tips on making a meal of free samples in the store.

We start with a cautionary tale. As all citizens of Frugal Nation know, Denny’s gave away free Grand Slam breakfasts this past Tuesday. And as some may have noticed, they failed to specify one to a customer. A reporter with the Chicago Tribune attempted the obvious act of frugality, consuming 5 Grand Slams before 9AM. The results were not as joyful as you might have expected.

I don’t know if that feast of free cholesterol inspired self-reflection, but there were quite a few posts this week wondering if this frugality thing might not be bad for society. For example, Almost Frugal, which as you may know is written by an American living in the French Alps, had a post entitled The Ethics of Frugality which mused that buying the cheapest item available might be sending American jobs to China.

As this is the first week of February, lists of money saving hints for Valentine’s Day were everywhere. They mostly just repeat the same old stuff about handmade cards and single roses instead of a dozen. But Sound Money Matters had a list that cut to the quick by starting with the suggestion that you just skip the holiday entirely. Failing that, push it back a week when restaurants are much less crowded and gifts have been seriously marked down. And SavingAdvice.com has an original list of Valentine’s Day Tips for Gals. Obviously, what most guys want from their gals costs no money at all, but the post does come up with a few alternatives, including allowing your man to teach you how to change the oil on your car.

If you are a frugal user of candles, presumably because you want to save money on both lighting and heating, you will appreciate Little People Wealth’s tip: store your candles in the freezer. They will burn more slowly.

Speaking of heating, Zen Personal Finance had a series of three posts with a total of 13 ways to save money on your heating bills. The first twelve are pretty obvious, but the last one in the last post suggests saving money on heating by not eating out, because your stove will create heat when you cook. Further, the blog points out that “If your thermostat is near the kitchen, you will save money.” How true. Sadly, my thermostat is not near my kitchen. But I have remedied this by putting an electric space heater right under it.

The best frugal post of the week comes from Gather Little by Little, which provides a list of 25 uses for dryer sheets, none of which involves a clothes dryer. This, of course, is particularly important for the truly frugal, who save money by hanging laundry on a line to dry. Inevitably, this results in a growing stock of unused dryer sheets, which can really clutter up a storage closet. These 25 uses will have you putting a dent in that backlog in no time. For example, did you know that to reduce odor you can “Scrub incoming dogs or cats (especially wet ones) with a dryer sheet before they come back into your home.” All wet cats love being rubbed down with scented foam sheets.