Money Machine

Gary V. Smith

• Publisher: AMACOM
• Year: 2017
• ISBN:
  9780814438572
• Topic: Commerce
• Subtopic: Actions

This book looks at Wall Street wonders Warren Buffet, Benjamin Graham, and other legends and shares how you can utilize their secrets to unimaginable success!

It's time to put your money to work the smart way and stop chasing quick payoffs that never turn out. That seductive stock tip you just overheard? That's your ticket to flushing your savings down the toilet. The story you saw on a promising new product? Only those who invested before the story came out have any chance of a solid payout.

If you want to succeed in the market, you need to learn how to invest based on value, selecting stocks that will continue to enrich you for years to come. By learning the keys to value investing, Money Machine will teach you how to:

• Judge a stock by the cash it generates
• Determine the stock's intrinsic value
• Use key investment benchmarks such as price-earnings ratio and dividend-price ratio
• Recognize stock market bubbles and profit from panics
• Avoid psychological traps that can trip you up

Investing in the market doesn't have to be reckless speculation. Invest in value, not ventures, and find the financial success all those gamblers are still looking for!

VALUE INVESTING

SEEING THROUGH THE HYPE

If you don’t know who you are, the stock
market is an expensive place to find out.

—GEORGE GOODMAN

On March 11, 2000, I participated in a conference on the booming stock market and the widely publicized “36K” prediction that the Dow Jones Industrial Average would soon more than triple, from below 12,000 to 36,000. James Glassman and Kevin Hassett, two scholars at the American Enterprise Institute, had written a cover story for the Atlantic Monthly and a book published by Random House arguing that “stock prices could double, triple, or even quadruple tomorrow and still not be too high.” Their “conservative” estimate of “the right price” was 36,000. It was a provocative assertion and it was taken seriously by serious people.

The first speaker at the conference talked about Moore’s Law (transistor density on integrated circuits doubles every two years). I listened intently and agreed that technology is wonderful. But I didn’t hear a single word about whether stock prices were too high, too low, or just right.

The next speaker talked about how smart dot-com whizzes were. When you bought a dot-com stock, you were giving your money to clever people who would figure out something profitable to do with it. I again listened intently and I agreed that many dot-com companies were started by smart, likable people. Heck, one of my sons had joined with four other recent college graduates to form a dot-com company. The five of them rented a house in New Hampshire, slept upstairs, and commuted to work by walking downstairs.

What kind of work were they doing downstairs? They didn’t have a business plan. The key phrase was “nimble.” They were bright, creative, and flexible. When a profitable opportunity appeared, these five nimble lads would seize it with all ten hands. I knew that these were terrific kids and that hundreds of terrific kids were looking for ways to profit from the Internet. But I still hadn’t heard a single word about whether stock prices were too high, too low, or just right.

The next speaker talked about how Alan Greenspan was a wonderful Fed chair. The Federal Reserve decides when to increase the money supply to boost the economy and when to restrain the money supply to stifle inflationary pressures. As a cynic (me) once wrote, the Fed jacks up interest rates to cause a recession whenever they feel it is in our best interests to be unemployed.

It is very important to have the Fed chaired by someone who knows what they’re doing. I listened intently and I agreed that Alan Greenspan was an impressive Fed chair. But, once again, I didn’t hear anything about whether stock prices were too high, too low, or just right.

I was the last speaker, and I was the grump at this happy party. I looked at stock prices from a variety of perspectives and concluded that not only was it far-fetched to think that the Dow would hit 36,000 anytime soon, but that the current level of stock prices was much too high. My final words were, “This is a bubble, and it will end badly.”

I was right—eerily so. The conference was on Saturday, March 11, 2000. The NASDAQ dropped the following Monday and fell by 75 percent over the next three years from its March 10, 2000, peak. AOL fell 85 percent, Yahoo 95 percent. The interesting question is not the coincidental timing of my remarks, but why I was convinced that this was a bubble.

During the dot-com bubble, most investors did not try to gauge whether stocks were reasonably priced. Instead, they watched stock prices go up and they invented explanations to rationalize what was happening. They talked about smart kids and Fed chairs. They looked at processing speeds and website visitors.

They didn’t talk about whether stock prices were too high, too low, or just right. This book will explain how to answer that question, which is after all the most fundamental question in investing. The answer—no surprise—is value investing.

SPECULATION VERSUS INVESTING

Separate and distinct things not to be confused,
as every thoughtful investor knows, are real worth and market price.

—JOHN BURR WILLIAMS

Decades ago, investing was haphazard. Investors figured that a stock was worth whatever people were willing to pay, and the game was to guess what people will pay tomorrow for a stock you buy today. Then John Burr Williams unleashed a revolution by arguing that investors could use something called present value to estimate the intrinsic value of a company’s stock.

Think of a stock as a machine that generates cash every few months—cash that happens to be called dividends. The key question is how much you would pay to own the machine in order to get the cash. This is the stock’s intrinsic value. People who think this way are called value investors.

In contrast, speculators buy a stock not for the cash it dispenses, but to sell to others for a profit. To a speculator, a stock is worth what somebody else will pay for it, and the challenge is to guess what others will pay tomorrow for the stock you buy today. This guessing game is derisively called the Greater Fool Theory: Buy stocks at inflated prices and hope to sell to even bigger fools at still higher prices.

Legendary investor Warren Buffett has this aphorism: “My favorite holding period is forever.” If we think this way, never planning to sell, we force ourselves to value stocks based on the cash they generate, instead of being distracted by guesses about future prices. A Buffett variation on this theme is, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” If we think this way, we stop speculating about zigs and zags in stock prices and focus on the cash generated by the money machine.

The idea is simple and powerful, but often elusive. It is very hard to buy a stock without looking at what its price has been in the past and thinking about what its price might be in the future. It is very hard to think about waiting patiently for cash to accumulate when it is so tempting to think about making a quick killing by flipping stocks.

People are often lured to the stock market by the ill-conceived notion that riches are there for the taking—that they can buy a stock right before the price leaves the launchpad. This dream is aided and abetted by get-rich-quick gurus peddling fantasies. I once received a letter that began “Dear friend.” There’s the first red flag: Real friends don’t address you as “Dear friend.” The letter went on, “IMAGINE turning $1,000 into $34,500 in less than one year!” The letter said that “no special background or education” was needed and that “it’s an investment you can make with spare cash that you might ordinarily spend on lottery tickets or the racetrack.” Second red flag: I don’t buy lottery tickets or bet on horses. Where did they get my name? Why did they think I was a sucker? This was getting embarrassing.

The “secret” was low-priced stocks. To demonstrate the “explosive profit potential,” the letter listed twenty low-priced stocks and said that $100 invested in each ($2,000 in all) would have grown in the blink of an eye to $26,611. Not only that, but another stock, LKA International, had gone from 2 cents to 69 cents a share in a few months, which would have turned $1,000 into $34,500. The letter concluded by offering a special $39 report that would give me access to “the carefully guarded territory of a few shrewd ‘inner circle’ investors.”

That was the third red flag. Why would anyone who had a real get-rich-quick system peddle it instead of using it? Why waste precious time selling newsletters for $39? Some self-proclaimed gurus assert that they have made more than enough money and want to share their secrets with others who are as poor as they once were: “If a loser like me can make money, so can a loser like you!” If they are truly rich, why don’t they send us money instead of asking for more?

It is preposterous to think that the stock market gives away money. There is a story about two finance professors who see a $100 bill on the sidewalk. As one professor reaches for it, the other says, “Don’t bother; if it were real, someone would have picked it up by now.” Finance professors are fond of saying that the stock market doesn’t leave $100 bills on the sidewalk, meaning that if there were an easy way to make money, someone would have figured it out by now.

There is truth in that, but it is not completely true. Stock prices are sometimes wacky. During speculative booms and financial crises, the stock market leaves suitcases full of $100 bills on the sidewalk. Still, when you think you have found an easy way to make money, you should ask yourself if other investors have overlooked a $100 bill on the sidewalk or if you have overlooked a logical explanation.

Investors make voluntary transactions—some buying and others selling—and a stock won’t trade at 2 cents if it is clear that the price will soon be 69 cents. Even if only a shrewd inner circle know that the price will soon be 69 cents, they will buy millions of shares, driving the price today up to 69 cents.

When LKA traded at 2 cents a share, there were an equal number of buyers and sellers, neither side knowing for sure whether the price would be higher or lower the next day or the day after that. The optimists bought and the pessimists sold. The optimists happened to be right this time. But to count on being right every time, buying stocks at their lowest prices and selling at their highest, is foolish.

Probably the most successful stock market investor of all time is Warren Buffett, who made about 20 percent a year over some fifty years. This isn’t close to the fantasies concocted by dream peddlers, but it is absolutely spectacular compared to the performance of the average investor, who has made about 10 percent a year.

Some stocks do spectacularly well, just as some lottery tickets turn out to be winners. But it is a delusion to think that you will become an instant millionaire by buying stocks or lottery tickets. A more realistic goal is to make intelligent investments and avoid financial potholes.

The key is to resist the temptation to buy and sell stocks based on wishful thinking about prices. Instead, think of stocks as money machines and think about what you would be willing to pay for the cash they generate over an indefinite horizon. If you do, you will be a value investor—and glad of it.

SEMI-EFFICIENT MARKETS

The real trouble with this world of ours is not that it is an unreasonable
world, nor even that it is a reasonable one. The commonest
kind of trouble is that it is nearly reasonable, but not quite.
Life . . . looks just a little more mathematical and regular than it is;
its exactitude is obvious, but its inexactitude is hidden;
its wildness lies in wait.

—G. K. CHESTERTON

I have a small army of former students who alert me to interesting stories I may have missed. One sent me a Wall Street Journal article titled “Clues Abound for the Small Investor to Divine Market Direction.” According to the article:

The long-term investor can make his decisions based on information easily available in his morning newspaper. Indeed, Thom Brown, managing director of the Philadelphia investment firm of Rutherford, Brown & Catherwood, advises investors to simply read a daily newspaper.

“Look for anything that suggests the direction of the economy,” he says. “Auto sales, for example, give you an idea about how willing consumers are to part with their money.” An expanding economy usually means rising stock prices.

Was this former student pas...