I read Warren Buffett’s 2011 shareholder letter in the morning.

It’s been a while since I got hold of Buffett’s writing. The good thing about his annual letters is its consistency. I’ve learned everything about life and investing through reading his annual letters.

It’s a must read for everyone. You can download it free via Berkshire Hathaway’s website. You can also buy the book Essays by Warren Buffett by Lawrence Cunningham. He’s done a good job of dividing the annual letters into different topics.

Buffett’s letter is divided into different portions:

• Presentation of historical book value against the Almighty stock market index, S&P. Buffett uses book value as rough measure of performance.
• Major Highlights for the year. Buffett uses this portion to admit mistakes and talk about major acquisitions. He talks about how his recent acquisitions fared. He also adds a few points about the economy.
• Lessons. He likes to preach a lot. He talks about appropriate accounting methods. He talks about intrinsic values. He also praises Ben Graham here. If you’re a long time reader of his reports, you’ll notice that he preaches the same principles every year.
• Detailed discussion of its major businesses – from railroads, candies, utilities, etc. He further divides it into stocks, insurance, utilities and manufacturing.
• Invitation to the Annual Shareholders meeting. (also known as the Woodstock for capitalists)

I read his lessons first. Then I go through the detailed discussion of its businesses. His business interest is so varied that you can tell which sector of the economy is going to perform well this year.

I believe this year’s letter would be interesting to individual investors. It gives

Buffett discussed three types of investments:

• Currency-based investments like Treasury bonds, corporate bonds, etc. He uses this as a proxy for cash in the bank. Buffett likes to have so much cash. It’s a cushion against uncertainties. It makes him sleep well.
• Assets that don’t produce anything but whose value is dependent on the perception that someone will pay more in the future. Think of gold. It doesn’t produce any cash flow.  Its value is anchored on fear. If people are fearful, it would go up.
• Assets that produce cash flow like businesses, stocks, rental properties, etc. Its value is based on the amount of cash flow it produces.

Buffett likes the third type of investment. The only reason he’ll invest in currency-based is when he’s presented with an attractive yield. Otherwise he’d use it as an instrument to park his cash.

This approach makes sense to individual investors. Invest in something that produces value. Always ask yourself if you’re investing your current money in an asset that will have greater value in the future.

It could be some businesses that will have generate tons of cash for you. If you’re lazy, just buy companies in the stock market and let those managers work for you. It could also be a farm land or a rental property. Anything that produces cash flow is good.

If you can’t find those assets yet, make Grandpa Ernest happy. Stay with cash.

No, he isn’t my grandfather. He’s Warren Buffett’s.

Ernest Buffett ran a grocery store, which he inherited from his father, Sidney Buffett. The grocery store, Buffett & Sons was founded in 1869.

I am assuming that this could be a mom and pop store in Omaha. But I could be wrong. It seems that the store produced two of the greatest investing minds of all time. Warren Buffett used to work there as a kid. He found out later that his Vice-Chairman, Charles Munger also worked there for a while.

What is admirable is that Ernest Buffett never finished high school nor attended business school. He passed on folksy advices to those who worked for him – not from textbooks and finance best sellers.

It was from years of experiences and hard work. But the most important lessons he left his kids is the importance of liquidity.

In a 2010 letter to investors Warren reprinted a copy of his grandfather’s letter to his Uncle Fred, the youngest son.

On the day of Fred’s wedding, Ernest Buffett allotted $200 in an envelope named after Fred. Each year he added something until it reached $1000.

After it was completed Ernest suggested that the money be placed in a safety deposit box. He also said that the couple should only use it for emergency purposes. And replenish after using it.

His advice is not to invest the money despite the lure of earning interest and capital gains. There’s a mental satisfaction of having an accessible $1000 in case something arises. Isn’t it?

No wonder Warren followed this advice to the heart.

He had majority of his company’s cash flow in a safety instrument like the US Treasury. He often joked that when he makes a check it’s the Federal Reserve that bounces.

Why do you need an emergency fund?

• It keeps you sane. It doesn’t matter if it’s recession, depression, boom, bust and etc. You have available cash and it will keep you afloat until the economy picks up. It also allows you to sleep well at night. Talking about mental health.
• It gives you flexibility. In investing you won’t be bothered by short term fluctuation of your investments. You can also take on more projects and investments without worrying if there’s food on the plate.
• It prepares you for unexpected expenses like sickness, repairs, etc. You can cover for these expenses without incurring debt. But please take note of the meaning of “emergency.” It doesn’t mean unexpected discount on the shoes that you planned to buy earlier.

Steps in building the emergency fund

1. The Ernest Buffett method. Place a small amount of money for an interval of time. Remember it took him years before he finally gave the whole $1000 to Fred. Personally I believe this is a good way to build your emergency fund as your current finances won’t be squeezed. Also there’s a feeling of satisfaction after you’ve reached your money goal.
2. The Lottery Winner method. If you won a lottery for $100 million, you can do a lump sum. Or a lost relative suddenly gave you a million dollars. You can also do this if you have received a performance bonus from your employer for a job well done. Be sure that you have the discipline to use the funds for emergency purposes.
3. Residual earnings method. Assuming you’re earning extra income on the side, you can set it aside for emergency purposes. It’s also a good method and quite similar to the Ernest Buffett method. Sometimes there’s a tendency for us to misspend our residual income as these are “extras.” What’s the better use of these funds than to keep it for rainy days.

How much money should you place in the fund? It’s a valid question but there’s no fixed amount.

There’s a rule of thumb that it should be 3-6 months of living expenses. It would be comfortable to have a year’s worth of living expenses.  I’m sure there are people who have funds as much as 3-4 years of living expenses.

It actually depends on how comfortable you are with the cash. I’m sure we all love to sleep well at night, no?

I’ve met a lot of smart people in my industry.

Some have long list of titles added to their names. If you ask them about a certain Finance theory, they will happily discuss them to you. In fact, some give actual example on how to apply those theories.

If you also ask them where the stock market is heading this year, they’ll give you their estimates. Then they’ll cite many catalysts why the stock market will trade at those levels these years.

The younger analysts are the ones who are even bolder with their forecasts. I’ve been in a lot of gatherings to know this. These guys will approach you and ask you about your opinion about their stock pick. If you disagree with them, they will give you reasons why you’re wrong and they’re right. This is despite the fact they haven’t factored in a lot of scenarios.

I also find it amusing that the older analysts are cockier than young analysts. They tend to believe that younger ones are reckless and untrained. It’s normal to see older analysts questioning you on the basis of your experience.

It’s true that investing experience is a good indicator. But people don’t realize that we are all amateurs in a probabilistic field like investing. Looking back at the recent financial crisis, some of the elder analysts have admitted that they haven’t foreseen the crisis. Well, some of the analysts said they have seen the financial tsunami.

I couldn’t agree more. It’s definitely not easy to see the bad things when everything looks OK. Before the market crash, I have seen people talking about steady flows of merger deals until the first crack was heard. The crack was the write-offs from Lehman Brothers.

You’ll begin to wonder that if there full of smart people in the market, why do they fail to figure out if something bad will happen?

One of the answers lies on the bias called overconfidence.

The overconfidence bias is when a person believes that they are 101% certain that they are right when in fact they aren’t.

I have seen it even when I was still in school. Some of my overconfident classmates will tell me that they will have high grades after the semester ends. Self-rating doesn’t help. If you ask your colleague their self-assessment of their work ratings, you’d probably get higher ratings.

In the case of the Almighty Analyst he won’t admit his mistakes until it’s obvious. Then he’ll blame other analysts who didn’t get it right.

In our investing life, we will be confronted with this. We were right about investing in gold when it’s going up. We were right that the way to go is through index funds. We were right because we are confident that our investing views are correct.

I’ve invested in a lot of stocks that went bust. I was right that this now-bankrupt company is too big to fail. I was pretty sure that the government will step in to save this company otherwise the whole system will go bust.

Here are few tips on how we can avoid overcome bias.

1. Always question your assumptions and views. Focus on what will go wrong. Ask an investing buddy to play devil’s advocate. You think stock will go up this year? Ask yourself how it will play up if Europe didn’t get the liquidity they need.
2. Know your limitations. Don’t go into investment opportunities you’re not familiar. I always stick to the sectors that I have working knowledge. I don’t buy things I don’t understand. If you don’t know anything about investments, it’s best to stick with cash. 
3. Listen to other’s views. Find out what you’re missing. When I invested in a regional bank stock that went bust, I ignored the view that it has inadequate capital ratios. I was assuming that it could easily raise funds through asset sales or fund raising. It didn’t happen. Ouch. Sometimes it pays to listen to how other people think of your investments.

It’s not easy at first but if you’re mindful of the biases, you’ll see better results in your investing.

Hope you have a good weekend ahead of you!

The Parable of the Ice

I couldn’t remember the exact year. It was probably 2003 or 2004. I happened to visit a nearby bookstore and found a copy of a book about Marc Faber.

The first cover intrigued me. It was actually the reason why I bought the book. I couldn’t put it down.
It was a parable. Not really a parable. Maybe an analogy of how individuals think.

It’s Marc Faber’s vision.

Here goes. (Note: It’s altered. Not the exact words)

Imagine it’s a bitterly cold day. You went outside your house with your coat on. When you turn a corner you could see a frozen pond.

You ask yourself: Should you risk taking a short cut? You’ll probably get to your destination in 10 minutes. But your logical brain tells you that it’s safer to walk to the bridge but it would take you half an hour to reach your destination.

Here comes a quick problem: Do you take the short cut but risk yourself if the ice breaks? Or do you take the safe and long method?

Then you see a man dipping his foot on the ice. Then the second foot. A young woman followed his lead. Minutes after there are already children skating. It seems everyone is having party on the ice.

The young woman got his confidence from the man. The children from the young woman. And so on and so forth.

Each person has given the confidence to the next person to join the ice party. The more person on the ice the safer it feels.

Seems logical, no?

But wait. You turn around. Then you hear some crack and first scream.

—

This happens to us most of the time. I get a lot of that.

Remember the times that you go to a restaurant and ask for the best seller plate? I do. That’s the first thing I ask when I go to an unfamiliar restaurant.

It’s called the Crowd Mentality Disease. CMD for short.

It’s when we buy something and look at the testimonials of past buyers.

It’s when we ask 10 opinions from different people which will be the best shoes to buy.

It’s when vote a President because he’s leading in the survey. A lot of PR firms do that.

But wait, is there wisdom in crowds?

How could a million people be so wrong about something? Of course, there’s always the feeling of safety when you have other people with you.

There’s a book called wisdom of crowds. I haven’t read it.

Based on my understanding, the book identifies elements for a crowd to be wise. One of the factors is independence. That’s independence from the opinion of others. It means that if you collect diverse opinions to form a valid group opinion, you get a powerful decision.

This is very much different with group-think. In group thinking, people based their opinion on other people. The result is poor and biased decision.

CMD is rampant in finance and investing.

Look at the forums. Take yahoo forums for example. You see two sides of the argument – a bull case and a bear case. When the stock is falling, the bears are the ones actively posting. Conversely, when the stock is rising you’ll see a lot of bulls doing the talking.

I admit I’m as guilty as hell.

I bought a regional bank stock in 2009. Read some few annual reports. I bought it because it’s super cheap, or so I thought. I went through the forums to see how other people think about the stock.

Since I am bullish on the stock that it will recover, I skip the bear comments and focused on the positive ones. I was looking for confirmation that my opinions are valid. It gives me confidence.

But it’s dangerous. I was getting emotional. It’s not easy. I became addicted to the forum boards. When somebody thinks that it’s going south, I was tempted to sell. It’s not easy. And then I’d be happy if someone posts something positive.

Later the bank was liquidated and I lost some money. I should have tried digging on the facts more rather than spending time on forums.

I should have just lost money and spare the nights that I was worried whether the bank would really go south.

How do we deal with CMD in finance?

Have an independent opinion based on facts and your analysis. Shut down the crowd but not totally. Look at the “bear” case if you’re a “bull.

And please stay out of forum boards. How about non-finance related CMD issues? Always question other opinions and build a strong inner scorecard.

Got CMD combat tips? Share your experiences and tips in the comments box.

I haven’t met Warren Buffett. I believe I wouldn’t have a chance to meet him in a lifetime. So this piece is an attempt to discuss what a day in the life of Warren Buffett.

What amazes me is the amount of time he has. He could be out there on an interview, reading financial statements of companies he’s mostly likely interested or answering questions from curious students of investing and shareholders.

It seems that that he has more time than anyone else. This is in spite owning thousands of companies, employing thousands more of people and managing gazillions of money. And of course, generating market beating results.

What’s in a day’s life of a Warren Buffett, investor extraordinaire?

I want to believe that Buffett’s success is not so much on activity but rather inactivity. He focuses on what he believes is important to him. He avoids things  that are non-essential.

Like most successful persons I have read, he has an open schedule. What do I mean by open schedule? It means that there’s no fixed schedule for him. There’s no typical day. I’ve heard stories that he’s easily available over the phone. To the surprise of callers, he usually picks up the phone personally.

Here are the following activities that he focuses on during the week:

• Reading. He likes to read a lot. He reads financial statements. He reads trade journals on banks, oil companies, commodities and stock journals. He updates himself via internal reports from different companies. He reads 3-4 newspapers every day. He reads a lot of books from a wide range of topics.

How does he read so many materials with so little time?

-He separates reading financial statements from newspapers and books. He reads financial statements, journals and reports from his office. After work he usually reads newspapers and books. The key here is to focus on one material at a time. It also helps that he’s a fast reader.

-Focus on reading reports on companies that he understands. If he doesn’t understand a thing, he moved on to the next. This is definitely a big time saver! Why bother on focusing something you don’t even have a clue in the first place?

-Reading time is sacred to Buffett. When he’s in the zone, he completely shuts off everything. He turns the television on but it’s muted. He usually closes his windows. Nothing is important except what he’s reading at that moment.

-Doing away with so the details. Buffett likes to simplify things a lot. He has mental models on quality companies and good prices. In fact, he makes decisions acquiring the whole company in 15 minutes. When asked how he does it, he says it took him years of practice to do this.

• Networking. Networking for him is business. He gets ideas from his network. This is important as it gives him ideas of how the industry or the company is doing. He asks A company about B company. And vice-versa. I think he got this one from Phil Fisher. Fisher calls them scuttlebutt approach. Rather than focusing on financial reports alone, the method gives you a fair picture of the competitive position of a company in the industry.

How does he network?

-Phone calls. When asking ideas from another person, he usually has key questions in mind. He doesn’t waste time asking details about a company. He already did his research. He wants to have a view on how other people look at the companies. These are industry experts or fellow investors.

-Letters. He writes letters a lot. When he’s interested in a company, he writes them. He asks them directly. No fluff. He tells them what he wants and most often times the receiver couldn’t say no.

-Visits. He does company visits in the past. He usually goes to a store and asks a lot of people. That’s how he research companies. He also visits his inner circle for ideas and opinions about a certain companies. He rarely does this today. He gets somebody to do this for him. When he likes a company and he needs research, he outsources this task to somebody else. If you’re Buffett, it’s not easy to go into the plants of a listed company without moving the stock price.

• Teaching. He loves to preach. When you read his annual reports, you’ll get folksy advices on life, investing and everything else. I’ve learned more about investing by reading his letters compared to the time I spent in school. My friend learned about accounting better when he started to read Buffett’s letters. These days he often visits schools and graduate schools these days to talk about anything. It’s a question and answer method. Somebody throws in a question and he expands on the questions. This is also the same format he does on his annual meetings. No projections or estimates. No talking about next acquisitions or targets. And certainly no stock tips.
• Charity. He doesn’t run charitable trusts. He funds them. The Buffett Foundation was run by his late wife, Susie. It’s now on the hands of his only daughter. Also majority of his wealth will go to Bill and Melinda Gates Foundation. He’s hand off. Although his time is spent on encouraging other billionaires to donate and give away their wealth.

That’s probably it. Except on occasions when he’s spotted clubbing with Jayz in New York. Often you’ll see him going to Washington gives advices to President Obama on economic policies.

Buffett Unusual Methods on how we can do more with less:

1. Ability to say no to a lot of things. He doesn’t spread himself too thin. If it doesn’t add value to his life, he usually says no.
2. Focus. He strips down an investment problem and asks if he can handicap the risks. If he can’t, he moves on to the next.
3. Delegation. He delegates the operations to the CEO’s of his portfolio companies. He doesn’t need to communicate with them regularly. In fact, there are managers who haven’t talk to him for years.
4. No meetings. It works best for him as it makes his schedule really flexible. Meetings are legitimate way to kill time.
5. No Facebook. No Twitter. No emails. And no phones. He’s largely disconnected from the online world. Yet he can still manage his companies very well. Imagine Buffett glancing over his iPhone or Blackbery while answering questions from the shareholders or curious students.
6. Inactivity. He doesn’t go out there every day to find the next biggest 10-baggers. He doesn’t have to. Sometimes he can find but often times he don’t. There are usually 3-4 purchases in a year. It’s a laid back approach to investing. Remember the Blaise Pascal principle of sitting still in a room.
7. Associating only with persons he likes. His inner circle is quite small. And keeping them closer to you. He generally avoids people he doesn’t like. It makes his life easier and his working relationship better.
8. Doing what he loves. Money and investing can be boring. You can’t sit and read financial reports whole day without loving it. And yes, he tap-dances to work.
9. Man of habits. Warren Buffett’s activities revolve around those above. He still lives in the same home he purchased in the 1950’s. He works in the same office. He probably goes to the same barber. And also eats at the same restaurant and ice cream bar.
10. Clear definition of success. Money doesn’t equals success. In fact, he said that the measure of success is when people he loves love him back.

I’m not sure if Warren has read any of those productivity books out there. I’m sure he did. But it seems that he practiced simplicity and focus in every aspects of his business and life.

If it worked for him, why can’t it work for us? Don’t you think?

People see David’s victory over Goliath in the biblical account as a fluke Maybe its not. Maybe every underdogs’ upset win over the favorite is not always due to luck.

David came at Goliath with a sling shot and a staff. These were the tools that he knew. Remember he was a shepherd, not a warrior.  So instead of fighting as what Goliath might expect, he brought in shepherd’s rules into the game and won. When underdogs choose not to play by Goliath’s rules, they win.

Any David can beat a Goliath when the underdogs acknowledge their weakness, choose an unconventional strategy and substitute effort for ability. Yes, substituting effort for ability turns out to be a winning formula for underdogs in all walks of life, including little blond-haired girls from Redwood city who almost won the National Junior Basketball championship by playing the full court press the whole game. They refused to play the game the way the rest of the world played it.

In the world of investing, we are all  Davids. Mr. market is goliath. He is composed of all the brokers, financial advisors, fund managers, investments bankers out there. The difference between you and goliath is that you want to make money from the market. Goliath wants to make money from you. Whether you gain or lose, goliath will take his commissions and management fee. Even if you dont invest with goliath, he finds a way. He sends you broker reports to buy or sell, regardless you make money or not. Buy in an uptrend, sell in a downtrend, protect your gains. These are the rules goliath has made for the investing individual.

He will never tell you to buy bargains and hold it for 5 years. Instead he will spot bargains, and tell you sell it after a measly 20% gain. Or he will tell you to hold off buying until prices have slightly recovered. Either way, he makes more money off you over the longer term.

So why do most of us invest following the rules made by goliath? Probably because we have been groomed to value “experts” opinion, and/or that we believe we dont have the skill to be a superior investor.

From David, we learned that we can beat Goliath by replacing skill with massive effort. We must find the willingness to try harder than anyone else. Read, learn, explore, satisfy your curiosities and expand your own circle of competence and beat the market at its own game over the long term.

What’s your game plan against the Goliath named Mr. Market?

photo © 2008 Marlon E | more info (via: Wylio)

It’s easier to pick stocks when they’re cheap, but more difficult to know when to sell.

I believe some value investors believe that the favorite holding period of Buffett is forever. I hope nobody will take it seriously. In fact, there’s an exception to that rule and it only applies to companies that have set of criteria which we will discuss later.

The best scenario is buying a stock that you never have to sell. You buy a stock for less than its worth and it just goes up in value over time from good management and great economics.

Compounding works that way. A 20% gain a year would double your money in 5 years.

However, there are times that we don’t need that kind of stock. Sometimes, these great economics and good management types don’t usually trade at discounts.

But sometimes they do. When there’s a recession or a bear market happens. It’s one in every decade. For the patient investors, they could easily buy these companies at a great discount in an extraordinary times.

Here are the following times when you need to sell your stock:

1. When the stock has traded above its value after a decent run-up. There’s an exception, though. If you believe that the fundamentals of the company can catch up with the prices, you don’t need to sell. These companies are companies with durable economic moats. They tend to follow price and compounded your returns over time. With companies that are economically disadvantaged, you have sell them when prices move higher than their real worth.

2. When the investment thesis is no longer there. There’s always a reason why we buy a stock. It could be because the company is undergoing a major restructuring through asset sales. If that doesn’t push through, you need to re-evaluate your position and think of selling.

3. When your wrong about your thesis or fundamentals have changed. This is hardest part. It’s not easy to admit that you have made a mistake. The moment that you have made a mistake, you have to sell. Regardless if you have to take a gain or loss. Another reason why you have to sell is when the fundamentals are deteriorating. It could be a company that has narrowed its moat and have taken on more risks.

4. When there’s a better opportunity for the use of your cash. There are times when a stock idea offers better risk and reward situation. Sometimes, you need to raise cash in your portfolio to do that. What you’ll do is probably sell those who stocks that have gone up in price and use the proceeds to buy a new stock.

Question: Should you sell when the stock price has declined?

The answer is it depends. If the stock price decline says you’re wrong about the fundamentals (or have deteriorated), you have to sell. If the thesis remains intact, maybe you should hold or even buy more if it’s really attractive.

How about you? When do you think you should sell your stock?

You probably haven’t heard much of Walter Schloss.

He was a former colleague of Warren Buffett at Graham and Newman Corporation during 1950′s.

Despite his outstanding record, he remained low key for years. He has returned 15%, net of fees to investors in 5 decades versus 10% for the S&P 500.

What is more amazing is how he achieved his outstanding record. His laid back approach to investing could cause a cheer for passive investors.

He has never owned a computer and looks at the prices of stock from the daily newspaper. A lot of the financial information he gets came from Value Line and annual reports sent to him by the company.

Amazing, isn’t it?

I’ll list down the things I have learned from Walter Schloss. Although I must say I don’t really practice his approach to investing:

1. Keep it simple. I guess his investment process is similar to Ben Grahan where he uses a checklists to fill on a daily basis. He goes to work before the market opens. Then, he reads his daily newspapers to look at the prices and news. He buys 100 stocks with an equal weighting on his portfolio and based on the checklist that he has. He sells his stocks when they have gone up or they have not moved in the past 3 years. He goes home by 4 in the afternoon before the market closes.

2. Keep the costs low. He’s always on the look out for costs. He never hired research assistants. He shared office with broker Tweedy Browne during his entire career. His major expenses would probably include a type writer (for his partners letters) and supplies.

3. Know your limitations. He admits that he no special skill in assessing management. He doesn’t attend analyst briefings. He doesn’t speak to the company’s management. He based his investment decisions on what he thinks he’s good at: buying stocks when they fall below the value of assets. He buys many of those stocks and they served him well during the 5 decades he invested.

4. Stick to your investment philosophy. Unlike Warren Buffett, he followed Ben Graham’s investment methods very well. He treated it as gospel truth. He buys stocks that falls below net-net working capital or book value. He never bothered to look at the business prospects of the company.

He has provided us with 16 rules of investing, which we could post in our home and office walls.  This is particularly useful if you feel the urge to deviate from your philosophy after having bad runs in the stock market.

At 95, he’s still managing his money and looking for cheap stocks. Talk about loving what you do.

Here’s some of Walter Schloss articles online that might interest you:

Criteria for Liquidations Where Money is Held by Company

Walter Schloss: 65 on Wall Street

Investing Tips from Walter Schloss

Seminar in Value Investing

Factors needed to make money in the Stock Market

The Right Stuff

Yes – you can beat the market with value

Depression survivors weigh in

Columbia Schloss Archives

There’s a lot more but I think the links above should give you an overview of the process of Walter Schloss. If you have more articles about him, please send me an email. I would be very happy to update this article.

photo © 2006 Viri G | more info (via: Wylio)

I like poker.

There’s this thing called poker rush once you’re in a poker table. I’ve been to Casino Pilipino poker clubs here in Manila. And I must say, I love the rush better than the food.

The last time I played there I almost lost my cash money (Note: For gamblers, it’s called bankroll) until I got an unsuited King and Queen.

After all bad cards, you suddenly get a good card once in a while. My strategy is to allow opponents to bring a lot of cash into the pot money if I have good cards. Conversely, I’ll limit my pot participation if I’m not sure if I’m ahead with my cards.

So, I got an unsuited King and Queen. The guy in the middle table raised 3x the big blinds (or the minimum bet). I’m sure that he has big cards or else he wouldn’t bet that big.

What would beat my King and Queen at that time? A pair.

I was thinking either a pair of Kings or Aces. I called the bet. And another player.

I was hoping that my cards would improve in the flop.

Flop was a Jack, Ten and Ace.

I had a straight! I knew that I’m way ahead now but I kept my excitement to myself.

The other player (who didn’t raise) fold. The player who raised went all-in. He must have a set (three of a kind). I was thinking it’s Ace.

And I turned out to that I was right. He had three Aces. I beat him with the Ace.

The rest was history. I had won that night.

What was my advantage? I knew what the other person was holding from his past actions. But poker does give you imperfect information. You can only infer what your opponent’s card but not totally know what his or her actual cards.

The game is similar to the stock market, but more difficult.

You’ll never know the person on the side of trade. If you’re a buyer, you’ll never know whether the seller is a company insider, a key supplier of the company, a top hedge fund manager or Warren Buffett.

The key is to know you have a clear advantage over the other person. Here are three advantages that you should have:

1. Informational. Do you know the company better than the company’s insider? In fact, informational advantage is also applicable to small and under followed stocks. Who knows that the other person could have better information than you and have followed the company longer than you?

Back in the old days, diligent people generate excess returns from spending longer hours in the library looking for bits of information in the company’s filing. They’re hoping that they will get nuggets of information that the market has not discounted the information yet.

2. Analytical. Why would a new economy company priced higher than old economy company? Does that mean that they’re mostly overpriced? Not necessarily. Perhaps, new economy thrives on network economics. The more members that network is, the more valuable it would become. It’s called Moat.

Everybody reads the same newspaper everyday. They get the same information every day. If you want to have an advantage, you need to have a variant view from the market and you must be right. Being a contrarian for the sake of being one is stupid.

3. Behavioral. This advantage is the most durable one. Nobody can teach you how to be rational. It’s hardwired in your brain. If a stock goes down from its highs due to earnings disappointment, do you sell your stock immediately? Do you buy only when the stock is trading higher and sell if it’s lower?

There are many behavioral gaps that we will discuss in the future and we hope to cover it extensively. Sometimes you don’t need a high IQ to succeed in the market, you need a right psychological framework.

Remember the story of Isaac Newton? He said that he can calculate the movement of stars but not the madness of men.

Poor guy.

Had he followed us, he would have avoided the South Sea Bubble.

photo © 2010 Mark Holloway | more info (via: Wylio)

If I tell you a method that could earn you 50% returns a year in the stock, how much would you pay me?

A million dollars?

Ten million dollars?

I hear a Fifty? Fifty million dollars?

You see. I get the ideas from unconventional places.  I found something brilliant while doing some late night rounds in party district of Cebu.

I saw a man selling balut. A balut is a fertilized duck embryo boiled alive and eaten in the shell. If you happen to visit the Philippines, you can stroll the streets at night and you’ll find a vendor pitching balut.

Selling balut can be lucrative. If you’re the only vendor in town, you’ll be on your way to becoming the first balut vendor millionaire. Since I don’t like startups and prefer a established business, I’ll go into the balut business by simply buying out the balut vendor.

First Question: What’s the first rule when buying a business?

Don’t overpay. Even if the business loses steam, it gives enough allowance for the downside.

Second Question: How do we know we don’t overpay for the business?

You compute for the value of the business. Now here’s the breakthrough. Instead of looking at net profit as a tool, we will use Free Cash Flow.

Free Cash Flow is the cash flow left after spending for investments needed to run the business. It’s used to pay dividends, acquire business, reinvest for expansion or pay debt. The higher the free cash flow, the better it would be for the investor.

The next step is to estimate how much free cash flow would the balut business will generate in the future. You see, it’s not about the past but the future.  I know that makes the process a bit complicated.

After estimating the future cash flow, you will now discount the cash flow back to the present. By this time, you will need a rate of return. How do you do that? You compare other alternative investments and what return you will get.

Let’s say that’s 9%.

Warren Buffett loves to use that rate. It’s the return of risk free government bonds. I have noticed that most investors don’t really bother calculating this rate. What they do is come up with different rates and see which one really make sense.

For riskier investments, it should be higher than a risk free security. Probably 10-15% would be enough.

One last thing that we need to calculate is the terminal value. That’s the value if the business doesn’t grow anymore. It’s also called perpetual value or infinite value.

If you add the sum of cash flows and the terminal value, you’ll get the business value of the balut business.

Let’s say the value of the balut business is $1,500. I’ll only buy it if the vendor offers me something between $750-900. If my estimates will be wrong, I still have allowance for misfortune and bad luck.

You see the connection between the stock market? You only buy if its lower than your estimated value.

Oh by the way, it’s not a breakthrough. It’s called Discounted Cash Flow.

Sounds a bell?

Hit me a message if you need more detailed examples.

But I know you get point.