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The Magic Check

May 25, 2006 by  


By Bob Wood

Suddenly, domestic, and foreign stock markets have become rather volatile, not an altogether unexpected event for self respecting Bears like me. As usual, this up-tick in volatility finds many in the financial media asking whether this change signifies just a normal bout of profit taking and another wonderful opportunity to load up on stocks with newly lowered prices — or something more ominous. Neither do I know, though the Bulls will surely offer opinions that support buying stocks as they fall. Actually, I think the entire discussion is pointless, and, maybe, so should you. I will, to use a currently popular phrase, “stay the course” I have chosen.

Well, maybe that sounds rather stupid, doesn’t it? I might want to think about it a little longer. OK, that’s long enough!

I still think I am right. But I can almost hear howls from investors everywhere at how wrong this looks. We all know that a rising tide lifts all boats, while an ebbing tide lowers them. So if the markets face persistent selling, as in this past week (May 14), all stocks will fall with the tide, won’t they?

Well, that’s a good point. Even bearish investors look forward to the day when we can buy cheap stocks selling at discounts to future earnings and dividend payouts. In the absence of such wonderful buying opportunities, investors must do unnatural things, such as waiting patiently — in cash. Or, even better, they could go in search of great investment ideas, though finding opportunities in foreign markets or offbeat asset classes like commodities takes real work.

But as markets around the world have become much more inter-related, due to globalization and the emergence of China as another large buyer of exports, the ebbing tide of U.S. stocks becomes something of a global phenomenon, as well. And traditional diversification methods are suffering more than ever.

So what’s a patient investor to do in these changing times, called ‘’the most difficult in modern times’’ by fellow realist, Richard Russell? Perhaps a good suggestion might be to think more like the most successful investor of our time, Warren Buffett, and divorce yourself from the old-world way of investing — anything from pre-2000, that is!

And what I suggest should offer reasonable comfort in trying times when stock markets around the world suffer drops with potential to be stronger and deeper than any seen previously. (Might this situation result from the sheer tonnage of hot money in the hands of today’s hedge funds managers—28-year-olds obsessed with quarterly performance numbers?)

My best advice is to stop thinking like an investor and start thinking like a business person. After all, what is a stock but a share in a business whose future profits you hope to enjoy? Now, as alarming as that might sound if you get your information from CNBC promoters, it really is what buying into the stock markets meant in the distant past.

Small business owners make up a large portion of those who became wealthy over time, a result of hard work and perseverance. But many only see the end results, the lifestyle achieved by someone with long experience as a business owner and now enjoying passive income from a lifetime of work. And we all want something like that, right? The ability to watch our bank accounts rise smoothly over time and then receive a nice monthly check to supplement other retirement income?

And we’d be glad to offer sums of cash now to build that passive income source later, wouldn’t we? And that process lies at the heart of what investing should be, though it is in direct opposition to what promoters at brokers and banks say about investing. They want to facilitate the exchange of cash now for income streams later. The promoters want to help you strike it rich now by making smart bets that send your new stock buys to their target prices in short order.

The fact that this method has seldom, if ever, worked in the past seems to mean nothing. Playing the greed instinct seems to pass from generation to generation. But it’s easy to separate yourself from what has never worked to what has almost always worked. Trust me: if you want to improve your investing performance, don’t talk to a broker! Instead, ask a successful small business owner for help.

One thing you can count on when working with a successful business owner is a powerful respect for the value of a dollar, such as it is any more! And better than anyone, the business owner understands how to earn and accumulate enough for an investment fund. And most importantly, trading your hard earned cash for an uncertain and risky set of assets is best done with an eye on what you can reliably expect in terms of pay back over time.

In times like this, the “Magic Check” concept illustrates a tool I always use when honing in on a possible stock buy. It helps a lot to keep me in the right frame of mind, not unlike what the famed Buffett says when asked how he chooses one investment over another.

But it’s crucial to understand one thing, and this is rarely part of any conversation heard on CNBC. When a promoter offers a free “top pick” like Microsoft, the first thing I think is, “Is that really the very best idea you have now, out of thousands of available options — from stocks, bonds, mutual funds, real estate, gem quality diamonds or cash?”

And in the case of Microsoft, for instance, how do I know I will be repaid in terms sufficient to justify this exchange of my hard earned cash? Is there a consistent payout of dividends, a sharing in profits disbursed to me over time — or am I just waiting and hoping that, someday, I can sell my shares to another investor at a higher price? Well, if you’re counting on that last hope, you’re not investing. You are gambling!

Another point that must be central to your thinking when buying a stock is whether you would buy the entire company and take it private, if you had enough money. After all, if you wouldn’t commit all your money to this one idea, why would you buy even one share? I sure wouldn’t, and I’m sure that Buffett, or any other worthy business person, wouldn’t either.

So while the markets are going nuts, up, down and up again, and sometimes down in nasty ways that keep you awake at night, what to do? For me, the Magic Check concept solves much and allows me to sit patiently, while others panic and make bad decisions.

Here’s how it works. Your broker or a TV promoter offers a stock like Microsoft as his top pick, since, he says, it is selling at a discount to valuations for the past five years and has another new operating system due out next year, which will spur new computer buying. Here’s where you ask yourself this one question: If you could, would you buy the whole company and take it private, forever to enjoy the earnings and income generated by the company, offset, of course, by the risks of being one of several in the same business?

Just as your friend, the successful business person would do, if considering purchase of rental property or any other type of investment, simply make the same kind of assessment. What’s in it for me? What are the risks, and is this really the best thing I can do with my money? Is this really the best thing available — out of the thousands of options I have? Can I see myself owning this company — and will I get a fair return?

In the case of Microsoft, the answer to these questions is a loud ‘’No’’! First of all, how much risk should an investor take to get a first-year 5% return on his investment? The current P/E for Microsoft is close to 20, meaning that you pay $20 for each dollar of earnings, yielding a smooth 5% return in year one.

Would your business owner friend make a deal like that? Would the risks of owning a company besieged by competition (say freeware from Linux) sound smart? Does a single digit growth rate justify those risks against that first year yield? I don’t know about you, but for a 5% yield, I’d buy a C.D. from my local bank and go sit on the beach, knowing that I will get the same return — plus all of my initial investment back at the end of the term.

If I’m going to risk my hard-earned savings, now sitting secure in the bank and potentially invested in an income producing asset like a bond or utility stock, I expect to hear a better offer. And if someone makes such an offer, theoretically, I would want to buy a lot of it. In fact, I would be willing to buy the whole thing and take it private. I could write the amount on my Magic Check to secure the asset as my own, paying the backer of my check, over time, from earnings in my new company. And my worries about the stock market’s going up or down would vanish. What I would care about is what’s going on in my company, and its market price will forever be determined by how well it’s run and how well it provides profits to me, the owner.

And while the most commonly touted stocks, like Microsoft, fail this test miserably, other options are always available to consider. One such option that I have been buying in recent weeks is KHD Humboldt Wedag (KHDH). Now, of course, if I hear that any reader bought shares in this company, based only on this article, I will find out who you are and call you at 3 a.m. every day for a month, asking over and over why you would buy a stock based on what “some guy said” — and nothing more in the way of due diligence! Read this paragraph again please.

Anyway, this company passes the Magic Check test nicely indeed. I could write my check for the company’s market cap, so it would probably cost about $350 million to buy the whole company — or every share. Since the company has a cash hoard of about $230 million, I’d get a nice rebate after taking my place in the big chair in the fanciest office. So my net investment is only about $120 million.

The company has no worrisome debt burden and made a little less than $3 million in the most recent quarter, down from about $5 million in the same quarter last year. So if we can expect normalized earnings this year, say something in the middle or $16 million range, that looks rather good, considering my net purchase price, doesn’t it?

And since the company is in the business of selling high tech equipment to cement and coal mining industries in India and China, how do my prospects look in terms of future demand? Pretty good, I’d say, and I like that potential future competitors would have to make very large investments to compete with me. With Microsoft, a couple of really smart kids at a tech school anywhere in the world can compete with almost no up-front investment. All those kids need is the right venture capitalist to get them off and running.

So for a company like KHDH, I could instantly write my Magic Check for the required amount, take the company private and allow current managers to do what they do best—in the tradition of Mr. Buffett. And I would go through the same exercise for every other investment on the long side of my managed portfolios, whether it’s ConocoPhilips, Anglo American, CVRD or any of the others on my short list. Would you agree?

Have a great week

Bob

8-22

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