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  • How To Beat The Market

    Whenever you hear someone say they have a way to beat the market, your first reaction should be extreme skepticism.

    If someone claims they can beat the market over time, they should have an audited investment record that proves it. If it is not audited, it is not reliable.

    While many people that claim they can beat the market are trying to scam naive people, there are some people that do beat the market by a large margin over time. Warren Buffett is the most well-known, but there are many others.

    The reality is that there are ways to over-perform. However, you not only have to be very skilled at identifying great investments, you also have to know where to look.

    And in addition to knowing where to look, you must have the right temperament. There are many brilliant people that are not good investors because they do not have the right temperament. I know someone that is very wealthy that pulled all of his money out of the market in 2009 near the bottom of the crash and didn't put his money back into the market until a few months ago. The market is up 100% since the bottom of the market in 2009. Having the right temperament is critical.

    Having the right temperament is something you will have to develop on your own. I can, however, offer you places to look for the best opportunities to find mispriced securities-emerging markets, arbitrage, micro caps, out-of-favor companies or industries, and spin-offs.

    Small-caps and micro-caps. There are only 438 large caps in the U.S. but they are probably responsible for 90% of what the financial media talks about. There are 829 mid caps and 931 small caps.

    What are most of the publicly traded stocks though? They are micro-caps. There are 4124 micro caps in the U.S. If you are not looking at micro-caps and small caps you are ignoring 81% of publicly traded stocks in the U.S.

    Large and talented investors like Warren Buffett cannot invest in a company worth $50 million. The first reason is because it is a waste of time investing $5 million when you have $20 billion in cash to invest. The other is because if you invest $5 million into a small company like that, you will drive the share price up because you are creating strong demand for it by accumulating 10% of the company. It might take 3 months to purchase $5 million of stock without driving the share price too high. For this reason, small companies are overlooked by large investors and can become significantly undervalued as a result. (As a side note, Warren Buffett invested mostly in small and mid-caps when he was a young investor and had a hedge fund. He moved to buying bigger companies because he didn't have a choice)

    Emerging markets. Many investors don't look at investing into specific companies in China, S. Korea, Brazil, and India, even though these places have many very strong companies that are growing rapidly. There is certainly greater risk investing in a foreign country because of currency differences, government regulations, different accounting standards, etc. However, there are many great businesses in these countries with ethical management and these businesses occassionally become significantly undervalued.

    Arbitrage is a good way to earn great returns if you don't do it a lot and only take advantage when there is a great opportunity. An arbitrage opportunity just means there is a way to make a profit from a price discrepancy. An example: A company called Homeowners Choice (HCII) has a preferred stock (HCIIP) that is convertible into common stock at any time (1 share preferred converted into 1 share common).

    A few months ago, the preferred stocks was at $10 and the common was at $12, even though the preferred was technically safer and paid a higher dividend. Arbitrageurs could have bought the preferred and sold short the common, earning a 20% return when the prices of the preferred and common converged.

    People in arbitrage usually use leverage to maximize returns. So imagine you had $100,000 and borrowed $100,000. You put $200,000 into HCIIP and sold HCII short. When HCIIP and HCII converge, you get .2 x $200,000 = $40,000. You only had $100,000 of your own cash, so your return was 40%. Not bad for a few weeks worth of work. Even if you didn't use leverage, a 20% return in a few weeks with almost no risk is pretty good.

    Arbitrage is not easy for non-professional investors. It is very time consuming doing the research to find these rare opportunities and timing is everything in arbitrage. I only find about one great arbitrage opportunity a year, so when I do, I load up on it big time.

    Buy a controlling stake. This is what private equity firms do as well as "activist investors". Activist investors buy enough shares to get seats on the board of directors and then force management to make changes, with the goal being improved efficiency and maximized profits. When you are directly involved in management not only does it reduce the risk of your investment, but it increases the potential for you to make changes you feel will maximize returns. Of course, only very large investors can buy controlling stakes.

    Preferred stocks will over-perform in a flat or declining market. If you are getting 8% a year in dividends from a preferred stock, while the stock market is flat or negative, you are going to beat it. Not only are preferred stocks safer, but they are also smart investments for people looking for income in retirement.

    Investing during crashes. I would never recommend trying to time markets, but if there is a panic and the stock market just declined 20% and you have cash sitting around, that would be a great time to find companies to invest into.

    Spin-offs are a way companies try to enhance shareholder value. Imagine you have a company with two lines of business. One is making $1 million a year and the other loses $500,000, so your total income is $500,000.

    You should sell or spin-off the company that loses money and your profits will double. If your profits double, the share price will likely go up a lot too.

    If there was a spin-off, you'd hold the stock in the company with $1 million in profits and sell the stock from the company that loses money.

    Do not diversify. If you are only allowed to invest into one stock every 5 years, you will make darn sure that stock has a very high probability of doing well before you invest.

    If you are only allowed to invest into 3 stocks, you will make sure they are 3 phenomenal opportunities. After that, if someone says you are now allowed to invest into 30 companies, why would you want to? Why put money into your 29th and 30th best idea? Wouldn't it make more sense to put more money into your top 3 ideas?

    Almost everyone on the Forbes 400 list made their money from one company.

    Jun 11 10:00 AM | Link | Comment!
  • Is Buffett The Greatest Investor Of All Time?

    Warren Buffett has a huge fan base and is often spoken of as the greatest investor ever. But is he really the greatest investor of all time?

    I have the utmost respect for Mr. Buffett and he has had more influence on my life than any other person besides my parents. He is undoubtedly a phenomenal investor and arguably the best of the last 50 years, but to say he is unequivocally the best in the history of the world is unfairly ignoring other legendary investors such as Andrew Carnegie, Jay Gould, John Jacob Astor, and many others.

    Greatest Investors Alive

    If you perform a Google or Bing search for lists of "greatest investors of all time" Warren Buffett is almost always at the top of the list. However, you will notice a huge bias in these lists: all are from the late 20th Century and based in the U.S.

    One article high on search engines is titled "World's 10 Greatest Investors". All ten were from the U.S. except Hungary-born George Soros who has been a U.S. citizen for 50 years. Li Ka-Shing was not on the list, even though he is a self-made billionaire worth $22 billion and George Soros is worth $14.5 billion. Why is Li Ka-Shing not mentioned? Even more importantly, why is he not studied by more investors?

    Carlos Slim is the richest person in the world and ten years younger than Buffett. Carlos Slim also has a strong case for being the "greatest investor alive".

    Great Investment Thinker vs. Great Investor

    Philip Fisher and Benjamin Graham are often on the lists of greatest investors of all time. Both were definitely two of the greatest investment minds ever and made significant contributions to investment thought in the 20th Century. They also were very good investors. However, calling them the greatest investors ever in practice may be too generous.

    John Bogle made significant contributions to investing as well with his popularization of low-cost index funds. Harry Markowitz made contributions to investment thought with his work on Modern Portfolio Theory. However, including them on a list of greatest investors in practice is just plain inaccurate.

    Warren Buffett is a rare case of being one of the greatest investment minds ever and one of the greatest investors in practice.

    Comparing Investors throughout History

    Comparing investors is not as easy as designating the winner the person with the most money or highest return. Investors come from different time periods and countries with different circumstances. They also work with different quantities of money (e.g. it's harder to invest $10 billion than $10 million) and work for different entities (hedge funds, mutual funds, holding company, etc.). For example, David Swensen runs Yale's $20 billion endowment fund and has achieved remarkable success. If he had a hedge fund instead of working for Yale, he would be a billionaire.

    Benjamin Graham had an investment partnership that operated during the Great Depression. Evaluating his success at investing versus someone who operated from 1980 to 1999 cannot be achieved by simply measuring who had a higher average annual return. Earning 15% annual returns from 1980 through 1999 would have been mediocre and could have been achieved by investing in an S&P 500 index fund. Earning 15% annual returns from 1929 to 1949 would qualify you as one of the best investors of the 20th Century.

    Even if you account for how much an investor beats the market you still have to consider other factors within different time periods, such as information and opportunity. In the 1930s news was not instantaneously available to investors via computers and television. Also, back then you couldn't just click on the "Investor Relations" link on a company's website to read the 10-K; you had to find a hard copy. When you did get ahold of a hard copy the financial documents were much less transparent and thorough.

    The NY Stock Exchange (NYSE:NYX) was formed in 1792 and there were very few companies listed on the exchange; therefore, investing was done mostly through private businesses prior to that time. Finding "excess returns" during this period is impossible. If we had to compare Buffett to someone such as Stephen Girard we have little information to go on. One of the few pieces of information we do know is that Girard accumulated $7.5 million in the early 1800s, which today would be about $97 billion (measured as wealth relative to GNP). Buffett today has a net worth of about $50 billion.

    Greatest Investors in History

    While it is hard to unequivocally call Buffett the "greatest investor today" because of Carlos Slim and other multi-billionaire investors such as James Simons, John Paulson, and George Soros, it is definitely impossible to call him the greatest in history.

    Andrew Mellon and Jay Gould were both worth more than Buffett (in terms of wealth relative to GNP). Jay Gould would be worth approximately $79 billion and Andrew Mellon would be worth $57 billion (Andrew Mellon's brother Richard would also be worth $57 billion). Jay Gould may have earned his money in controversial ways, but if investing is "expending money for the purpose of profit" then Jay Gould was one of the best. Andrew Mellon was brilliant at operating companies from an early age, in addition to being a brilliant investor.

    Buffett's appeal to the average investor is his success at buying publicly traded stocks, his wit and sense of humor, and his sensible investment philosophy. He appeals to the media for the same reasons. He is constantly interviewed on television, there are dozens of books about him, and he shares his thoughts in his shareholder letters and annual meetings. President Obama quotes him, one of his closest friends is Bill Gates, he is the third richest man in the world, and some of his businesses are household names. He is a celebrity. He is everyone's favorite investor.

    No one has ever heard of James Simons because the average investor cannot invest like him and no one knows what he is buying or selling.

    What is an Investor?

    Warren Buffett has 99% of his net worth in one company. Larry Ellison of Oracle (NYSE:ORCL) and John Chambers of Cisco (NASDAQ:CSCO) also have almost their entire net worth in one stock. To say Warren Buffett is an investor but Ellison and Chambers are not would be to change the definition of an investor.

    One might argue that Berkshire (NYSE:BRK.A) is a company with dozens of other companies so Buffett really is diversified even though 99% of his money is in one stock. The problem with that argument is that almost every large company is made of different lines of business and companies. Oracle and Cisco have both bought dozens of other companies. Oracle gets the bulk of its revenue from software, Cisco from networking and Berkshire from insurance. In fact, most of the fortunes on the Forbes 400 list and most of the great fortunes throughout history were built through holding a very large stake in one company.

    Allocating money outside of a company is also not the only form of investment. Using free cash flow to expand operations is definitely an investment. John D. Rockefeller and Standard Oil were phenomenal capital allocators. Standard Oil would buy out competitors or open up near them, undersell them, and drive them out of business. Investing in competitors or to destroy competitors was a brilliant strategy that led to Standard Oil becoming a monopoly. One could argue John D. Rockefeller was the greatest investor ever. His net worth today would be roughly $225 billion.

    Investors are often thought of as stock pickers, but publicly traded stocks are only one form of investment. Private businesses are certainly investments. Bill Gross is not a stock picker but is one of the best investors today because of his talent for investing in bonds. Putting money into apartments, office buildings, shopping malls, condos, raw land, and houses are all forms of investment. John Jacob Astor became wealthy from his fur business and expanded his wealth by investing in New York City real estate. He sold his entire fur business and invested all of his money into Manhattan in the 1830s right when Manhattan was starting to boom. That was one of the most brilliant investments in U.S. history.

    Some of the best investment decisions in the last 10 years came from Mark Zuckerberg's holdings in Facebook. Sure, he didn't put much money into it, but his ability to not give up too much ownership to other early partners and investors, raise additional capital without diluting ownership, and never sell out were all brilliant investment decisions. Steve Jobs' investment in Pixar was definitely one of the best investments in the last 25 years. He bought Pixar for $10 million in 1986 and sold it to Disney (NYSE:DIS) in 2006. Jobs received 138 million shares of Disney in the deal, worth about $5.5 billion today.

    Many people limit themselves by thinking investing is just picking stocks. The greatest investors in the history of the world all owned control of companies and were involved in management--including Buffett.

    The Wealthiest People in U.S. History

    The book "The Wealthy 100: From Benjamin Franklin to Bill Gates" by Michael Klepper and Robert Gunther list's the wealthiest 100 people in U.S. history. The authors use wealth relative to GNP at the time to rank people. Nearly everyone on this list should be considered an investor-the exceptions being those who inherited most of their wealth or married it. Here is the complete list (

    Below is an updated version of the top 21:

    in 1000s(Wealth:Today's
     GNP)Dollars (Billions)
    1John D. Rockefeller18391937$1,400,00065225
    2Cornelius Vanderbilt17941877$105,00087168
    3John Jacob Astor17631848$20,000107136
    4Stephen Girard17501831$7,50015097
    5Andrew Carnegie18351919$475,00016688
    6A.T. Stewart18031876$50,00017882
    7Frederick Weyerhaeuser18341914$200,00018280
    8Jay Gould18361892$77,00018579
    9Stephen Van Rensselaer17641839$10,00019475
    10Marshall Field18341906$140,00020571
    11Henry Ford18631947$1,000,00023163
    12Andrew W. Mellon18551937$350,00025857
    13Richard B. Mellon18581933$350,00025857
    14Bill Gates1955 $56,000,00026156
    15Sam M. Walton19181992$22,000,00027553
    16James G. Fair18311894$45,00028052
    17William Weightman18131904$80,00028651
    18Moses Taylor18061882$40,00028651
    19Russell Sage18161906$100,00028751
    20John I. Blair18021899$60,00028951
    21Warren Buffett1930 $50,000,00029250

    Who Is The Greatest?

    You can decide who you think is the greatest. John D. Rockefeller has the strongest case. If he didn't get out of the produce business and invest into oil, the name Rockefeller would not be synonymous with great wealth today.

    The Rothschilds were definitely brilliant investors and the wealthiest family in history. Andrew Carnegie was a brilliant investor and one of the wealthiest people to ever live.

    Warren Buffett is my favorite investor and one of the most successful investor's in the history of the world-but a strong case can be made that the many other investors who achieved greater wealth and results should be ranked higher.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    May 26 6:40 PM | Link | 3 Comments
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