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After trying to put together some examples I realized I was starting to recreate many of the books I have read.  Rather than reinvent the wheel,  please read the books I have read. Focus on the titles in red on this page: http://www.hughessolutions.com/investing/investing_books.html.  I will still post from time to time and the advice I have already posted remains true. Stay invested :).

I spend most of my time looking at stocks.  However, one of the largest “investments” (I’ll explain the quotes in a bit) in most peoples lives is their home.  How do you know if the right move is to buy or rent?

First, I define an investment as something that (should) appreciate in value over time, is seen as having value to others, and any money I put into it makes it more valuable.  So why the quotes?  Because really a house is a liability.  You must put money into it in the form of insurance, taxes, paint, roofing, and other general upkeep just to maintain the value.  Stated a different way, you do not get $1 of added value for every $1 you put into your house.

So why would anyone buy a house?  Realistically it is a psychological security for most people and often makes no financial sense.  You buy a house because your grandparents owned a house, your parents owned a house, your friends own houses - it is the accepted norm of the American Society.  The American Dream. 

There are tax advantages to buying a house.  You can deduct your interest payments and often the sales tax when you bought the house. 

So back to the original question - when does it make sense to buy a house?  Like I said in prior postings, I like to think of just about everything in my life as an investment.

The bottom line in my mind is it only makes sense to buy if you can’t rent for cheaper or if you have some advanced understanding of housing markets (which I do not) and believe the house will appreciate faster than usual.  Most housing markets have historically appreciated in the 3-6% range.  The S&P 500 appreciates at a 12% rate.  Which return would you rather have? 

Now if you are renting for $1000, does that mean you should wait until you can get a house for $1000/month mortgage payments?  No!  First, you usually have to provide a down payment.  You have to figure out if your return on investment makes sense.  Would you be better off investing that down payment?  Second, your taxes will usually be in your favor if you own a home.  Lastly, you have insurance, taxes, and maintenance costs you don’t have with a rental.  So how does this all add up?

Let’s start with the down payment.  If you put down $10,000 you are in theory losing around $1200/year in gains you would have from the S&P 500 (or $100/month.  That means your mortgage would have to be $900/month in order to be comparable to your $1000/month rent.

Next come taxes.  This is going to vary widely based on your personal taxes.  I use Turbotax, and one of the nice things is it is easy to create a copy of last years taxes and put in some fictional mortgage interest deductions to see how it affects your taxes.  BE SURE NOT TO REFILE THOUGH, THIS IS JUST FOR PURPOSES OF FINDING OUT YOUR TAX ADVANTAGE FOR BUYING A HOUSE, NOT FOR UPDATING YOUR RETURN!!!!!  Let’s say you paid $1000 last year but after inputting the fictional mortgage deduction you now get a $200 return.  That is a $1200 swing in your favor, or $100/month. 

So where are we? We have a $1000/month rent vs. a $1000/month house ($1000/month mortgage - $100/month down payment + $100/month tax advantage = $1000/month)

But we aren’t done.

Call your insurance company and find out how much your insurance would be for the house you are looking at.  Is it more than your current renters insurance?  How much.  Maybe it is an extra $120/year or $10/month.  Now you are up to a $1010/month house cost.

Finally, how much will it cost to maintain this place?  Figure 1 to 3% annually.  If you are looking at a $100,000 house, that is $1000 to $3000 per year.  I’m pretty handy and would be able to do a lot on my own so I would lean toward the 1% value.  Use your best judgement based on your own experience.  This adds around $100 more per month.  That puts us at $1110/month or $110/month more than current rent.  So how do we bring this inline?  Buy a cheaper house!  Reduce the mortage costs as the rest will stay nearly the same.  A good estimate is it costs you $7 per month for every $1000 financed.  To reduce the mortgage by $100/month, take roughly $14,500 off the price of the house you are looking for. 

One you run through this a few times with your values you can figure out what is the realistic mortgage amount you should be looking for.  The key question then is are their houses you like for that price?  If their are, I say it is a good time to buy.  If not, you should wait.  You may never find anything that makes sense, and that is OK.  Personally, I haven’t found anything where I live.  But here is a key.  Don’t look where you live.  Remember this is an investment.  Can you use the same calculations to find a rental property?  Do the same thing but instead of using your rent as the comparative value, use the amount you can “invest” each month.  If you can invest $500 a month, try to make the monthly payments $500. 

You may notice two things missing. 

1) I don’t account for appreciation of the property.  That’s on purpose.  If you are buying a house vs. renting, the primary thing I am looking for is a lateral move on monthly costs.  Housing is not liquid and historically appreciates at 3-6%.  You may make money, you may lose money.  The key is to contain your costs and hope for small appreciation over time.  In my opinion housing is not a great investment.  It is more of an alternate use for monthly costs.

2) I don’t add any rental income for the rental scenario.  This is complicated for several reason.  First, you need to take into account that you will not have 100% occupancy.  Second, the taxes change from a mortgage deduction to rental income minus any upkeep deductions.  The reality for more rental owners is that you don’t make a high % of return unless you have a TON of equity and can change rent far above your monthly payments.  They way we found properties in the above scenario will not lead you to a property with this type of advantage and you will most likely break even at best.

Bottom line - you should only buy if the total monthly cost to own is less than your total monthly cost to rent.  The larger the difference, the better. 

The market has been down significantly in the last week.  This is a great opportunity to revisit stocks you watch and see if they are a better buy now.  Many of them may be down 10 or 20%.  You have to ask: Did anything significant happen with the company to justify that reduction?  Are all the basics the same as they were before the decline?  Would I have bought them before the decline?  Does it make sense to buy them now?

Many companies get dragged around in positive and negative directions simply because of overall investor sentiment towards stocks in general.  Often nothing has actually changed with the company itself.  If it was a good buy yesterday, it may be an even better buy today.  If you already own a great stock, maybe this is your chance to buy more at an even better price.

One thing a down market is not: It is not a time to look at your portfolio and ditch the losers.  You need better reasons than fear to sell.  You should understand when your investment has gone from great, to good, to fair, to poor and know when you plan to get out.  I usually plan to get in when it is good and stay unless it goes to fair without much hope of going back to good or great. 

In a down market, you can find great companies at a good price.  This has been a big part of the success of Berkshire Hathaway.  As brilliant as Warren Buffet may be, he would not have made as much had Charlie Munger convinced him of this fact.  Value investing still applies to companies selling at close to fair market value.

I’ve had a lot of time to think lately.  First, I had the long drive.  Next, I had a day of Jury Duty.  Thinking time is good, it helps you collect your thoughts.  I was thinking back on the stocks I have bought and sold and remembering how I found them.   Several of the best performers (and a few of the so-sos) I found while looking at competitors of the original stock I was interested in.

Google and Yahoo finance pages give you great lists of the primary competitors to a company you are evaluating.  Be sure to check out these companies as well.  Often some of the smaller or less known players turn out be be in better financial shape and have better management.  Bigger is not always better with stocks.  Remember, the goal is % return, not identifying and buying monopolies. 

Think about Microsoft.  They have been on top for a long time.  A huge percentage of software companies are trying to take aware their market share in one form or another each and every day.  Some of these Markets may be places where Microsoft does not do well, chooses not to play, or doesn’t even know they exist.  Their competitors may have an advantage in this area.  Heck, there are even markets where Microsoft will tell it’s customers “this is too small for us to get involved but Vendor XYZ does great in this area, go to them”.  That company has a huge advantage.  Not only are they chipping away at Microsoft, Microsoft is actually handing them business.  Now, if that company is well run, makes good money, and has the other qualities of a sound investment, you may have spotted a gem by looking at the primary companies competitors. 

This is true for suppliers as well.  Interested in owning a company that sells batteries?  Look at where they get their materials.  It may shock you to find out that a huge percentage of the raw materials used to make Lithium Batteries, for example, all come from 1 company in South America.  They don’t make the batteries, they don’t sell the batteries, but they do provide the raw materials to almost ALL the companies that do.  Everyone needs to go to them.  In theory, they have “moat” making it difficult for a competitor to step in and take away their customers.  Does the rest of the company check out?  In this case it didn’t.  However, you must be open to exploring these spurs.  This is how you can find things no one else is looking at.

I must admit I missed a recent opportunity here and didn’t buy because I couldn’t complete all my homework in time.  I was investigating a tablet manufacturer that I’m sure just about everyone can name.  One of the suppliers produces all the chips for the tablets, phones, and many other devices used by this company.  At the time this supplier’s stock price was reasonable, their prospects looked good, but I did not complete the rest of my evaluation before others caught on and sent the stock price skyrocketing.  This happens.  Don’t play the “if I only…” game.  Realize that in fact you were able to correctly identify a great investment.  The timing didn’t work out this time, but keep at it and some day it will.

For reference, I typically only have about 5-7 trades per year.  These are almost always “buy” trades, I rarely sell.

I like to look at who is running the company.  Is this someone that has a track record of looking out for share holders?   Are they in it for the pay check or do they really care about the company?  How much of the company do they own? Where else have the worked?  How did those companies function while they were there? 

The internet is a great source of info on corporate leaders.  Many larger companies will have detailed bio’s on their websites or in their earning reports.  You still have to do some research outside of what the company presents to make sure the person is legit. 

Warren Buffet calls this aspect “owner mentality”.  Basically, do the executives treat the company as if they own the whole thing?  Steve Jobs is a great example of an executive who has “owner mentality”.  He is not there for the pay check.  He is 100% committed to growing Apple.  He treats it like he owns the entire thing.  He wants the shareholders to be happy and make money. A competitor would not be able to lure him away.  He understands the business.  These are all qualities I look for in an executive. 

This is all well and good for large companies, but how do you determine this info for smaller companies.  Easy, just call the company and ask.  Sometimes this works, some times it doesn’t  Often they will point you to some resource with backgrounds on their execs.

Again, this is not the only aspect to investigate for a stock.  But sometimes it can be a clear indicator NOT to buy the stock.  

To give you an example, I once owned a stock which I won’t name.  This was a small company and I thought it had great potential.  Everything I looked for checked out.  About a year in, the CEO stepped down and a whole new executive team came in.  Any time there is a major change I like to reevaluate the company.  The new execs were brought in to grow the company.  When I looked at their past bio’s though, they had a long history of taking big paychecks and creating little return for investors. I sold the stock for a small profit.  It has been several years and I still keep tabs on the stock.  It has not moved at all, still trading in the same range it has for years.  The company has grown and so has the pay of the execs.

I did a lot of driving over Memorial Weekend, nearly 2500 miles.  It gave me a lot of time to think.  Among the things I thought about were investing.  How do I find the stocks I eventually purchase, when do I decide to sell them, and what underlying patterns exist between my activities. 

The conclusion: there is no exact pattern.  There are a set of questions and paths I follow and over time this continues to change depending on the environment.  The key is to build a tool set with a variety of exercises to expose different aspects of the stock.  Know when your tools apply and when they are irrelevant.

Let’s start with P/E ratio.  This is the ratio of the stock price to the companies earnings.  Is the stock is trading at $100 per share and had a profit of $5 per share, it would have a P/E ratio of 20. 

My background is in “value investing”, but I have expanded the concepts I use over time.  In value investing, typically you want to look for a low P/E ratio. 

But what does that mean?  I like to reverse the ratio and think of it like an “interest rate”.  In my above example the P/E ratio is 100/5, or 20.  Flipping that to Earnings/Price, you get 5/100, .05, or 5%.  Although it isn’t accurate, I like to think that if I put $100 into this company, they would turn it into $105 within a year.  Is that what actually happens?  No!  Should you make investing decisions on this alone?  No!  So how does this help?  It helps compare two companies in the same sector against each other and against other investments.  For example, I could buy a US Government Bond that gives me a 3% return and is guaranteed by the US Government.  Should I buy my fictitious company with the 5% return?  Probably not.  First, I have to pay taxes on the 5% I get from the company which may drop the actual return to the 3% range.  Now my two choices are even and P/E buys me nothing.  However, if I had a company with a P/E of 100/20, or 5, I may be in better shape.  Let’s flip it back to Earnings over prices, 20/100, or .2 or 20%.  20% before taxes is a LOT better than 3% I can get from the government.  So should I buy it?  There isn’t enough info to tell and we need to look at other factors.  However, in this example the stock with the P/E of 5 (or 20%) would be the front runner over the one with a P/E of 20 (or 5%).

Traditional value investing would have you look at low P/E stocks as a starting point to locate good purchases.  I still use this as a good starting point to start finding stocks.  There are a few things to note here:

1). The stock with a P/E of 20 (or 5%) is nearly equivalent to the US Bond at 3% (due to taxes).  So why would I choose one over the other?  The bond will always return 3%, nothing more and nothing less.  The stock will fluctuate.  It may go up, it may go down.  There is risk involved in the stock.  It must be deeply scrutinized to determine if the risk will eventually pay off with the stock.

2). This only works for companies that have earnings.  You can’t calculate the P/E ratio if the earnings are 0.  Should these stocks be excluded?  No!  Back to my original point - you have to have a set of tools to use and have to know when they apply and when they don’t.  There are plenty of awesome stocks with no earnings for various reasons. 

I’m still putting together a fake company to show you how I work the numbers, but I want to get you thinking about other stuff while I do that as it will likely take me some time. 

Mythbusters is a great show.  How many episodes have you watched where they have totally disproved something everyone believes to be true?  It happens pretty often.  Investing is no different and if you can spot where people believe the wrong thing, this is your opportunity to investigate and find a way to exploit it for money. 

Think about this.  For thousands of years most people thought the earth was flat.  But there were a few people that said, “No, I have evidence it is not”.  Columbus took advantage of this and found “the new world” full of all sorts of riches.  On the flip side, there are also people that find wrong evidence but believe it is right and this leads to disaster.  There are probably some other sailors that thought the world was round, but instead of going West, they went North and froze to death.  You don’t hear much about them.  So how do you avoid disaster?  Make sure you look at the facts and don’t let your emotions blur your interpretation.  Use multiple sources of information and validate them all.

Here is a more relevant example.  Back in 2008 there was a “mortgage meltdown” that took out most of the stock market with it.  Everyone was panicked, there emotions got the best of them.  Again I will use Coke (symbol KO) as my example.  Coke has nothing to do with mortgages, lending, banking, or any other related industry.  The Coke stock price took a huge hit and was down double digit %s along with everything else.  But why?  Emotions!  Coke was doing fine before the mortage meltdown, during the meltdown, and after the meltdown.  Nothing affected the day to day operations of Coke and was not likely to affect future prospects of Coke.  People drink Coke whether they are loosing their house, just lost 50% of their networth, and are homeless.  In fact they may even drink more.  This is the a buying opportunity if everything else with the company checks out (brand+current value+future).  Coke was not the only opportunity during the meltdown, there were tons of them. People were scared of the stock market in general at this time and it created a huge buying opportunity for people who recognized everyone else was wrong.

Question things as they happen.  There are frequently advantages to be had.  Look at the fact, not just your beliefs.  Some of the things you have been taught are wrong, but everyone believes them and you can use this to find investments everyone else is avoiding.

The third piece of the puzzle is figuring out what the future will look like for the company.  You want to find a company that can basically take $1 and turn it into more than $1 by growing itself over time.

Just like finding the current value of a company, there are a billion different ways to do this.  I’ll point you back to the books again on this one: http://www.hughessolutions.com/investing/investing_books.html.

I like to build up a range of values, just like I did for the current value of the company.  This may seems mathematically intense but don’t let it overwhelm you.  It really is simple. 

I often start by going back to Ben Graham, the guy started it all, and do a simple calculation to “reverse depreciate” the future value of the company.  Don’t let the name scare you, with tools like Microsoft Excel, this is easy to do.

I’ll build up some solid examples and walk you through them over time so you can see how Brand+current value+future value can help you spot stocks that should lead to solid gains over time.  This is about 80% of what I base my decision on when purchasing a stock or deciding to sell a stock.  The other 20% is about 100 smalls things I look at like who is running the company and what are their backgrounds?  How did their previous companies do?  What are their competitors?  Do their competitors hold an advantage?  Maybe I should look at their stock?  The list goes on and on and I will post all that info too in due time.

For now, think of the 3 areas at a high level and see if you can start pulling together some ideas of stocks you think may fit the bill. 

This is a tough one to cover concisely in a single post, we’ll explore it in broken down chunks over time.  Here are the basics.

Once you have found a company with a good “Brand”, you need to figure out how much you would pay to buy the whole company today if you have the money.  Why the whole company?  If you divide the amount the entire company is worth by the number of outstanding shares, you can arrive at a price per share.  This is what the company is “worth”.  There are many assumptions and exceptions about this statement, but let’s just ignore those for now.

Here is an example to clarify where we are going with this topic.  Suppose you magically figure out the entire company you are looking at is worth $5,000,000.  There are $1,000,000 shares outstanding.  That means each share is worth $5.  Now when you look the symbol up on Google Finance or Yahoo! you may see it trading for $4, $7, or just about any other value.  You know based on the simple math above that you probably don’t want to pay more than $5 per share and ideally you would like to get it for less.  Remember, it is always better to buy something on sale if you can.

You can find the number of outstanding shares on just about any listing site, in the companies quarterly or yearly earnings, and probably numerous other places.

But how do you determine the amount a company is worth today?  The reality is you can’t determine the exact amount for a wide variety of reasons.  Because there is no exact way to determine the amount, many people have come up with many methods.  The key in my experience is to not rely on just 1 method.  Use several methods.  This will give you a range of what you think the company is worth.  I often use the same method with several different values to get a range even for just that method.  As long as you use several ways to calculate the values and get a good range, you can be fairly confident about the worth of the company.

There are far too many ways to calculate the worth and I don’t plan to cover them because they have been covered in better detail than I could summarize in many books and many places online. 

The two I mainly use are:

reproduction cost - how much would it cost to rebuild the company from the ground up?

book value - what does their accounting say the company is worth?

Anything written by Ben Graham will cover these topics pretty well.  There is also a great book called “Value Investing from Graham to Buffet and Beyond” by Greenwald, Kahn, Sonkin, and Van Biema. 

I have listed many other books on my website:  http://www.hughessolutions.com/investing/investing_books.html.

It will take some practice to run through the exercise of building up this data for a company.  It is not that complex and you don’t have to crunch that many numbers.  Some companies are so simple you can even figure it out just by looking at their financial statements and not writing anything down.  I still do however, because I often forget and there are items you will want to add or remove from the equation as you discover them.

Brand plus the companies current value: You should now start seeing a picture if the company you are looking at is a good investment or not.  But we aren’t done yet.  Finding  good stock is like a treasure hunt, it takes time and there are clues everywhere.  You need to look at each one of them closely.