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.

ETFs and Other Mutual Funds

Million Dollar Journey today asks Can You Invest Solely in ETFs? The answer given is, basically, yes. And that is true. You could also live for a week eating only pickles. At least I’m pretty sure.

This is probably as good a time as any to give a quick rundown of the differences between open-end mutual funds and ETFs.

What is usually meant when somebody says “mutual fund” is an open-end mutual fund. Like with all funds, what you own when you own shares in an open-end fund is a proportionate share of a large portfolio of assets run by a management company.

With an open-end fund, you can buy or sell shares only once a day, at a price calculated based on the closing prices of everything in the portfolio. When you buy/sell shares, you are trading with the fund itself. If you buy, your money goes in the fund and new shares are issued to you. If you sell, your shares are cancelled and cash comes out of the fund.

Most open-end funds are “active” meaning that the management company is actively deciding on a day to day basis what to have in the portfolio. A sizable minority are “passive” or “index” funds that simply hold the members of a published index, such as the S&P 500.

ETFs, or Exchange Traded Funds, are similar in that you own shares of a portfolio, but these trade all day long on the stock exchange like a stock. When you buy or sell shares of ETFs, you are trading with another investor who is selling or buying.

For reasons I will spare you, ETFs are always passively managed portfolios.

In both types of fund the management company that runs it gets paid in the form of annual fees, sometimes referred to as “expenses.” (I’m not sure if an “expense” sounds smaller than a “fee”, but it sure does sound more unavoidable.) How much the management company charges varies a lot from fund to fund, but as a general rule, active open-end funds charge the most, followed by ETFs, followed by passive open-ended funds. Additionally, to buy or sell an ETF you would pay a commission to a stock broker.

So if ETFs are, essentially, index funds with higher fees than otherwise identical open-end index funds, why would you invest in them? The short answer is that most people reading this shouldn’t. The long one is that there are a few situations in which it makes sense. Since ETFs trade like stocks you can short them, buy them on margin, and trade them at a moment’s notice. There are also some rather exotic types of assets available as ETFs but not as open-ended funds. But if you are a typical investor looking to hold a vanilla index for more than a week or two, ETFs will only cost you more money.

Bonus Outrage Resolved

If you read my post two days ago on the Wall Street Bonus Outrage you can imagine my relief at the President’s press conference yesterday.

You see, from all this hysteria about excessive Wall Street compensation, partially whipped up by Mr. Obama himself, I was really worried that the President might do something rash, such as, for example, restrict Wall Street compensation.

The new rules will not apply to firms that already have received government aid, will only apply in the future to the recipients of some kinds of help, will only restrict the compensation of a very small number of top executives (who collectively didn’t make much of a dent in the $18.4B that got everybody bent out of shape) and only requires that these few be paid in stock instead of cash, which is fairly typical anyway.

Whew. That was close. Turns out the President isn’t ignorant of how Wall Street works and isn’t a closet bomb-throwing socialist. He’s just a cynical politician willing to kick people when they are down to score political points. Thank god for that.

Phil Town’s Rule #1, Part #2

[This is the second installment of a review of Rule #1, by Phil Town. If you haven't already, you might want to read part 1 first.]

Rule#1 starts with a bang. From page 1:

This book is a simple guide to returns of 15 percent or more in the stock market, with almost no risk. In fact, Rule #1 investing is practically immune to the ups and downs of the stock market – and by the end of the book I’ll have proved it to you.

The First Amendment is a wondrous thing. You can say anything you want in a book (or a blog) and the worst thing that will happen to you is that people will think you are a jerk or an idiot. On the other hand, if Phil Town had started a mutual fund and put this paragraph at the start of his sales brochure, government regulators would have shut him down right away. (Although as a hedge fund he might have gotten away with it for a while. This is almost exactly what Bernie Madoff claimed to be delivering to his clients.)

As I wrote in part #1, there are lots of books that promise a formula for getting rich picking stocks. What makes Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! attractive as a victim of my scrutiny is that most of Town’s “simple strategy” is very specific. So specific, in fact, that I can program a computer to carry it out. I can go back in time and work out what stocks his system would have picked and track their performance. This is what is known in the investment biz as a backtest. It’s the first thing that would pop into the head of a pro being pitched on a system for picking stocks. It is pretty clear that Town’s mind is uncluttered by such concepts.

Town summarizes the core of his system, not all that gracefully, as four Ms: Meaning, Management, Moat, and Margin of Safety. Meaning and Management are squishy subjective things. And squishy subjective things annoy me. By Meaning, Town signifies both that you should understand the business of the company involved and that it should resonate with you in a vaguely moral way. And by Management he means that you should make sure that it has good management. I can’t teach my computer to simulate these two, so they get a free pass.

Moat turns out to be a set of ratios Town calls the Big Five. Four are growth rates: growth in sales, earnings, free cash flow, and book value. And the fifth, ROIC, is strongly associated with growth. (ROIC, according to Town, stands for Return On Investment Capital. Actual investment professionals believe it stands for Return On Invested Capital.)

Town says you should calculate each of the numbers three times, for one, five, and ten year time periods. Then, if a stock has a score of at least 10% on each of these fifteen numbers it is attractive enough to be further considered for purchase. I can only assume that his intent is that his reader should do this by hand, one stock at a time, which would eat up the weekly 15 minute time allotment pretty fast. But with access to the right tools, I can do 1000 stocks relatively easily.

Which is exactly what I did. I took the 1000 largest stocks in the US as of December 31, 2007 and found those that pass the Rule #1 Moat test. There are exactly 20 of them. Which means that only 1 in 50 stocks pass this screen, and there are more screens to come. Imagine what it would be like to use this system without automation, testing one stock at a time. And 12/31/07 is pretty typical. I tested the eight previous years and found, on average, 16 stocks that cleared the screen out of possible 1000.

Of course, the point is to find stocks that will go up, and on this score the screen is marginally better than throwing darts. The 20 stocks that cleared the hurdle at the end of 2007 lost an average of 34.67% in 2008. That’s actually not that bad, as the other 980 stocks gave up 37.53% on average. Including the other eight years of this decade the stocks that met the criteria to pass the Moat test returned an average of 4.29%, against 2.82% for the others. That ain’t terrible, but consider:

1) So few stocks clear the screen that one or two lucky picks can make the whole thing look good. In 2000 the screen only picked 5 names, but two of them, Paychex, up 83% for the year, and Concord EFS, up 71%, did very well. Kick out those two and the average return for the screened stocks for the whole nine years drops to 0.14%.

2) 4.29% is nothing like the 15% returns promised.

3) So few stocks clear this screen, and remember this is only part of the Simple Strategy, that a person has to wonder if this is really a practical methodology for an ordinary investor.

Next up, I will continue with Rule #1′s value screen, the Margin of Safety.

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