There is overlap between this section and the Mutual Fund ...



The Other 5%David P. Kirch, PhD, CPA To my wife, Chris and my daughters, Debbie, Suzie and Cindy and their familiesThere are two aspects to money;knowing how to make it, andknowing how to spend it.If you have one of these without the other, you are doomed to a life of misery.Uncle PhilKirch’s First Law The financial worth of anything is equal to the present value of its future cash flows.A TruthEvery time you substitute a comma for the period in the first law, it will surely cost you dearly!!AcknowledgementsI would like to thank David Dennis of Otterbein University, Chris Yost of Ohio University and Chris Kirch of Ohio University for their most helpful editorial comments. I also acknowledge the helpful input of the numerous students who have added their valuable insights and suggestions. All of these have made this a much better product.IntroductionThe original title of this work in a different era was “Save the Poets.” The purpose of the work was to allow true workers, including housewives, laborers and yes, even doctors, to live a life pursuing their passions without monetary worry. If they were able to save and invest 10% of their earnings each year, after several years of wisely investing their money, they will be able to pursue their true passions without financial concerns. This was the basis of the most fun course I ever taught- Greed 101.But now I have a more satisfying reason to prepare this work. You, my three daughters and your husbands and families, are my primary audience. I am now doing the investing for you, but I will not be here forever. I have written this to introduce you to investing. I realize that Debbie and Cindy have seen a lot of this before, but it has been a while. And for Suzie, this is brand new stuff. So I am writing this assuming that you are starting out knowing or remembering nothing.I am also writing this for other readers. I plan for it to be an appendix in my graduate level accounting course. If you are in this course, you will find a lot of what follows very simplistic. Wade through it. There is some real wisdom buried in some of this simplicity. Remember my primary audience, my daughters and their families is not at the same understanding of financial terms and systems as you are.I am also writing this to select undergraduates. If you are one of these, you have been given this with a responsibility. The purpose and the responsibility is to give you a life of less financial stress. In return for this gift, you must not use this financial power just for you. You must use some of it to make this world a better place for my grandchildren to grow up in. As long as one child is starving, or is sick without care, you have a responsibility. Later in the paper we will talk about one of the greatest investors, David Tepper. Mr. Tepper gives huge portions of his money to make the world better. I expect the same from you. That is the cost of this “free” book. A book that really sets you up for what is to follow is “The Richest Man in Babylon” by George S. Clason. It is the best book on money management available.A final word. Many will read this and think it has some good points. To the extent that you follow what is here, you will be become rich. Period. If you think it has some good points and so apply some of the applications, you will become somewhat rich. Period. This works. Period.Preliminary ConsiderationsWhat is Common Stock?We will be discussing investing in the “common stock” of companies. We will do this either through a mutual fund (described later) or by directly buying the shares, or “common stock” in a company. So what is common stock? Common stock represents ownership in a company. It is called “common” to differentiate it from other, more exotic forms of ownership such as “preferred stock.” Say you have an idea and want to start a company. You need $12,000, and you have zilch. To get the company started, the $12,000 has to come from somewhere. The bank tells you to take a hike. So you follow the usual path for raising initial capital, you find some investors. To entice the investors, you offer them ownership in the new company. As we said, you have no money, but the idea and the passion for success is yours. You give yourself 20% of the company and find investors sold on your idea who are willing to give you $12,000 for the other 80% ownership of the company. Let’s say you price the shares at $15 each (this initial price is entirely up to you and your investors). Now you get 200 shares and the investors get 800 shares and the business starts. If someone new wants to own a piece of your company, they can only buy it from you or one of the original investors. They cannot buy shares from the company. As the fortunes of the business rise and fall over the ensuing years, the price others are willing to pay to own a piece of the company rises and falls. So any time you are buying common stock through Fidelity, Schwab or one of the other brokerage houses, you are buying it from people who currently own stock, not from the company. This is a gross simplification, but hopefully explains the basics of common stock. Why not hire someone to do it for me?Now this seems to be getting complicated and you might wonder why I don’t just suggest you hire a financial advisor to take my place. Because 95% of financial investors fail to do better than random picks would do over a ten year period. “How can that be?” you ask. “How could they survive?” “Don’t people know this?” Money managers sell themselves on everything but results. They are always very personable and exude knowledge and confidence they most likely do not have! They will talk about the low variability of their stock selections, of how they are ranked with some peer group or another……. anything but how they did compared to the S&P 500. (This is the gold standard we will be using to gauge our investments- it will be explained soon). In other words, for most of them (95%), because of their ineptitude coupled with their fees, they cannot sell themselves on the only thing that really matters- how well they did compared with how you could have done yourself. Notice what is missing from the following ad-There is no mention as to how they did compared to against the market. Did they earn more than you would have, had you randomly selected your own stocks? If you currently have a money manager or financial advisor, ask him or her how their advice has done compared to the S&P 500 over the last five years. If they tell you that you that the S&P 500 is not what they measure themselves against, or start talking about “risk adjusted,” “peer groups,” “alphas,” or any other such terms you do not understand- read this book, fire the advisor, and take over your own future!Getting StartedNotice that if 95% of money managers fail to beat the market, that means that 5% do beat the market. The focus of this work is mainly on finding those 5%. When that part is finished, I will include a section on how to evaluate stocks you may have selected on your own. Another question to be addressed is raised by the above ad. Notice the last sentence, What assurance do we have that measuring past performance of the managers of different investment opportunities have any predictive value about the future? Academic research seems to be mixed on this. There is the school of thought which is known as the “efficient market hypothesis” which purports that any investment returns in the stock market are the result of chance- that the price of a stock is based on all the known and unknown factors about that stock and its future. Further, people who consistently beat the market, (see Warren Buffett below) are simply very lucky individuals. Other research points toward exceptional individuals’ continued ability to outperform the general markets. All this does not really matter. In the real world we know Warren Buffett exists and can no more ascribe his continued success over the last 50 years to chance than we can believe that we happen to be here by chance. And, if it is the bottom of the ninth, the bases are loaded, there are two out and you are losing by one run, do you want a batter at the plate who has hit .220 in the past or one who has hit .350? ‘Nuf said. Argument closed.Investing is both an art and a science. I can, and do in this paper, teach you the science part. Warren Buffett says that the worth of any investment is worth the present value of all the future cash flows discounted at the appropriate rate. This is the science part. You must start with that. And that is what you will learn in this paper. After that, the art part kicks in. This is selecting between alternatives generated by the science part. I tell students that this is the difference between Warren Buffett and myself. We both apply the science part in the same way. His application of the art part has been about $50 billion better than my application!!! Rate of Return and CompoundingBefore I start, I want to be certain you understand what is meant by “rate of return.” If you put $100 in the bank and it pays 2% interest annually, at the end of one year you would have $102. Your return is the 2% interest. If you left it and the interest it earned in the bank for a second year, you would have $104.04 at the end of the second year. You would have earned 2% on the original $100 plus 2% on the $2 you earned in interest last year. You still have a return of 2%, but it is now compounding- being applied to the original investment plus all the interest earned since you first made the investment. This is called compounding. In all our calculations in this paper we assume you leave the money in, and thus, the rate you are earning is calculated using compounding. It is possible to work backwards in these calculations. From the returns we get on an investment, we can figure out what the rate of return we are earning is. For instance, in our above example, if we knew that we invested $100 and had $104.04 at the end of two years, we can use our calculators to find that we are earning 2% interest compounded annually. We will go into how to do this in a later section. Anytime we are talking about “return” or “rate of return” you can equate that with the interest we are earning. If you skip ahead to the section on the S&P 500, you will find its annual Rate of Return has been 7.36% since 1950. This means that it has earned on average, 7.36% per year on every dollar invested since 1950. Another thought before we go on………..When you have excess money, you have numerous options with what to do with that money. You can, of course spend it. This is the most biologically satisfying alternative. Because our far back ancestors did not have refrigerators or ways to save food, immediate consummation made the most sense--- food rots! (See the book “Mean Genes.”) So we begin with a deck stacked against us. We are preprogramed to spend, to dissipate our assets as soon as we acquire them - before they spoil. And this predisposition is in our subconscious mind, which tends to control us without our knowledge. So we begin the battle with our brain working against us.Now let’s look at some Other Considerations. First the options: Where can we put our excess money? Should we use it to pay off school and other debts? Put money down on a home? There are pros and cons here. There are tax deductibility issues and other considerations. How much should be allocated elsewhere is for you to decide judiciously. But at least 10% of your gross income must be invested in your future, in the concepts of this paper!You may find that the interest you are paying on something is more than you can earn on your investments. But think about that. If you pay off high interest loans, will you really save the extra money you save or will you spend it? Let’s avoid this dilemma- save 10%. Period!! Is this open ended? How much do you need to save? This brings us to Your Number?Your Number A popular exercise these days is to calculate how much you need to have to retire comfortably. So what is your number? Follow along. We start with four major assumptions. First we assume that you would like to retire on $100,000 a year in today’s dollars. This amount of money will go much further in your retirement because you will not have the everyday expenses you had when you were working. For instance, the amounts you spend on clothing, gas, lunch and other work-related expenses will be much less and possibly some of the expenses will disappear altogether! Second, we assume that the minimum you will earn on our investments over your lifetime is the 7.36% that the S&P 500 returns. (We will get to what the S&P 500 is shortly).Third, we will assume a 2.2624% inflation rate. (This is the average inflation rate over the last 100 years. The current rate, as I write this, is 1.5%.) Finally we will assume a 22% tax rate. We will ignore any social security payments you may get as my generation might have eaten them all up by the time you are ready for them! And you can factor them into the worksheet presented in the Appendix. Based on these assumptions, our formula for your magic retirement fund is (retirement annual needs/(1-tax rate)X(expected return – rate of inflation)For you this number calculates asAnnual Income needed(1-Tax Rate) X (Return Expected – Inflation Rate) For us100,000 (1-.22)X(.0736 - .022624) = 100,000 .78 X .050976= 100,000 .03976128= $2,515,009.58So you will need about $2,515,000 in investments earning 7.36% per year to retire on $100,000 per year (in today’s dollars). At this amount and this rate of return, you can live and stay retired forever and never eat into your principal. The bad news is that that is a lot of money. The good news is we have a lot of time. But we have work to do……………………Turning off the straight road for a moment…..Risk and ReturnI would like to take time to describe another aspect of investing- risk versus return. Say you have the option of putting your money in a federally insured bank earning less than 1%. This is our starting point and carries no risk. From this ultra-safe extreme we move up the investment spectrum. At the other end of the spectrum, we have the ultra-risky, ultra high return investments. Federally Browns Insured Bank win super bowlSay you are betting that the Browns win the Super Bowl. At this writing the Sports Books put the odds of this happening at 17,500 to 1. See on the above chart that for this proposition, the risk is huge and the reward is huge. Is the reward commensurate with the risk? That is the question!!!The potential income from an investment must be considered along with its inherent risk. Basically, the more the potential income, the higher the risk. This is not a uniformly equal relationship. This is akin to player poker. If we can find that the reward outweighs the risk, we go with the investment. A caveat- I use the following in the classroom. If I give you an opportunitythat has a 50% chance of winning a certain bet and, if you win, it pays off at 4-1, how much would you bet? Your normal answer would be Back Up the Truck baby!!- all you can get! The math says that for a $100investment with a 50% chance of winning, the payoff should be $200. But we said it pays 4-1 so the actual payoff will be $400 if we win. We would get richquick taking investments like this. But what if the investment could only bemade if you invested all the money you have or will ever have? Now you mustreweigh the risk/reward in light of the commitment. Students invariably say they would only take such a risk if the chance of success were 90% and the payoff was at least 10-1. (Women students generally want even more, male students tend to be more prone toward a lower risk/reward. We will discuss gender investment differences later in this paper.)So we will balance the risk/reward with diversification. If we could make 50 of these “bets” for 1/50 of our total lifetime income, we would be much more prone to step up to the table. More chances, or more different bets is known as diversification. (See the footnote 13 on Systematic and Unsystematic risk).And weighing the risks includes weighing the integrity of the group presenting the so called investment opportunity. In other words, are the potential risks and potential returns being presented to us accurately? Conversely, it is possible that the potential investment is in an area we are familiar with and we might be better able to assess the potential risk/reward than that presented by the group or individual proposing the investment. We will have a whole lot more to say about that later.Before we go on, let’s look at the competition for your investment dollars. There are mutual funds, master limited partnerships, investment trusts, commodities, gold, silver, oil, beans, hogs, real estate, rentals and thousands more opportunities to invest in (including the Browns winning the Super Bowl). All investment propositions have experts who would be there to help you access your opportunities---for a price. We have shown that the great majority of these investment advisors are unable to beat our randomly selecting our investments. So when we say “beat” the market or random selection of investments, what are we talking about?How are we to measure our returns???If we are to study and invest, we need a standard to measure our success against. If one gets returns of 8%, that is great until they realize that others got 10%. But what if some others only got 4%? How are we to measure how we did? We will measure ourselves against the stock market as a whole. Our surrogate, and that most commonly used in studies of returns, is the S&P 500.What is the S&P 500? Wikipedia says it clearly.S&P 500From Wikipedia, the free encyclopediaThe?S&P?500, or the?Standard & Poor's?500, is a?stock market index?based on the?market capitalizations?of 500 leading companies?publicly traded?in the U.S. stock market, as determined by?Standard & Poor's. It differs from other U.S. stock market indices such as the?Dow Jones Industrial Average?and the?Nasdaq?due to its diverse constituency and?weighting methodology. It is one of the most commonly followed equity indices and many consider it the best representation of the market as well as a bellwether?for the U.S. economy.[4]?The?National Bureau of Economic Research?has classified common stocks as a leading indicator of business cycles.[5]The S&P?500 is maintained by Standard & Poor's, a division of?McGraw-Hill?that publishes a variety of other stock market indices such as the?S&P MidCap 400, the?S&P SmallCap 600?and the?S&P Composite 1500. It is a?free-float capitalization-weightedindex HYPERLINK "" \l "cite_note-S.26P500Methodology-3" [3]?and has several?ticker symbols: ^GSPC,[6]?INX,[7]?and $SPX.[8]The S&P 500, Standard & Poor’s 500, is based on the stock prices of 500 large companies whose stock is traded on U.S. stock markets. The number of shares of each company included in the S&P 500 is weighted according to the size of the company (market capitalization weighting). From 1950 to today each dollar invested in the S&P 500 earned an average compound rate of return of 7.36%. For each investment we consider, we will measure it against this standard. If our investment does not earn this, we will pass. Risk as said earlier, is an important consideration. We will assume that the risk of our investments will match that of the risk of the S&P 500. Over the investment opportunities we will consider, this is a valid assumption.Warren BuffettBefore I start on evaluating investment opportunities, I would address the elephant in the room- Warren Buffett. You probably know of this man. He is the first or second richest person in the world. His company, Berkshire Hathaway, which you can buy, has beaten the S&P 500 by 7.5 % per year over the last 30 years. So that means that, over the last thirty years, you would have earned 14.86% on your money as opposed to earning the 7.36% of the S&P 500 over that time period. With that rate of return, why should I write anymore? Buy Berkshire Hathaway and forget it! Alas, there are two problems with this approach.First, Warren Buffett is older than I am. So I might be here longer than he will. I believe his returns are based on his abilities. When he is gone, there is no reason to believe the returns will continue. Second, Berkshire Hathaway is now a huge investment company. It is much easier to generate superior returns for smaller investment funds than it is for large ones. When he began, he could buy companies and stocks of any size. Now he needs huge investments to even move the needle of his returns a little. I think his current criteria is that the investment must be at least $200,000 for him to consider it. The following is from Investopedia:GrowthCompounding?is important to Warren Buffett's success. To make his radar screen, a stock investment must have a high likelihood of achieving at least a compound annual earnings growth rate of 10%. When he started four decades ago, Buffett had a wide range of stocks available to him that met or exceeded his minimum return requirement. Back then, however, the size of Buffett's investment portfolio was much more manageable.Today, being so large and successful is a problem even for Buffett. His challenge lies in how to compound such large sums of money at ever increasing rates. To continue generating high-level compound returns on a massive portfolio, Buffett must take very large positions and only select from the best of large cap stocks. As such, the stocks that meet his threshold have narrowed dramatically.In mid 2007, for example, Buffett added to his holdings in US Bancorp?(NYSE:USB)?by 59.1% or almost 14 million shares, but the impact to his portfolio was just 0.74%. He added to his holdings in Sanofi-Aventis?(NYSE:SNY)?by 326% for a total of 3.5 million shares, but the impact to his portfolio was just 0.18%.?For these two reasons, we shall pass on Berkshire Hathaway. (You might note that I have invested some of your funds in BRK-B). So it is time to start…….Opening a brokerage accountBefore we can start investing, we need to have a brokerage account. The broker is the company that executes the trades for us. I currently have accounts at Fidelity and Charles Schwab. I find having two brokerages is helpful in that it allows me to have two sources of information. Brokerage house accounts are not insured. Is it possible that a brokerage house could go down and you lose all your money? I don’t think so……….. still I have two.So you need to go online to one of the brokerage house home pages and open an account. As you are filling out the application, there will be phone numbers you can call to get assistance.Alternatively, you can go to the local office of one of the big firms and fill out the application there. Compare fees across the different alternatives, but stick to one you have heard of. Stock trades should cost no higher than $10 and mutual fund trade commission should be no higher than $75. A lot of the mutual funds can be traded free at brokerage houses.Yes, we will get to what a mutual fund is……Right now……Our first choice is to invest in what are known as mutual funds.. Mutual FundsThese probably are the best way to invest in the stock market while minimizing the risk of individual stock investments.What they are is……. The simplest way to explain mutual funds is to start by defining them as grouped investments. Say you, and a group of the family, wanted to invest in some companies. If you wanted to invest in say five different companies, you could put your money together and then as a group buy shares in the companies. For reasons detailed later, it is more efficient for you to buy shares in the five companies as a group. Here is a detailed example of how a mutual fund works. Debbie, Suzie, Cindy, Kylie, Josh, Ryan and Colton get together and decide they want to invest in the stock market. They each bring the following to the table-Debbie Invests$10,000Suzie Invests 10,000 Cindy Invests 10,000Kylie Invests 4,000Josh Invests 3,000Ryan Invests 2,000Colton Invests 1,000Total$40,000They have selected Dad (note the capital D!!) to be the one who manages and makes the decisions for the group. Dad does all the legal work and he forms “Pappaw’s Aggressive Growth Mutual Fund.” Looking at it on an individual basis, for each $100 you have invested in the fund, you get one share in the new mutual fund. SoDebbie Owns 100 sharesSuzie Owns 100 Cindy Owns 100Kylie Owns 40Josh Owns 30Ryan Owns 20Colton Owns 10Total 400 shares outstandingDad invests the funds of Pappaw’s Aggressive Growth Mutual Fund (herein after referred to as PAGMF), as follows Price Shares Stock Symbol per share Purchased Total Cost Amer Cap Mortgage (MTGE) 20.71 386 $7,994.06 Phillips Petroleum (PSX)57.16 140 8,002.40 Prudential Life (PRU) 77.53 103 7,985.59 Lincoln National (LNC) 41.76 192 8,017.92 Qualcomm (QCOM) 68.28 117 7,988.76 Total 39,988.73And the fund has $11.27 in cash. As an owner of the mutual fund for each 1 share of PAGMF you own, you in effect own: Price Stock Symbol Own Per Share Value Amer Cap Mortgage (MTGE) .955 shares 20.71 $19.995 Phillips Petroleum (PSX) .35 shares 57.16 20.001 Prudential Life (PRU) .2575 shares 77.53 19.964 Lincoln National (LNC) .48 shares 41.76 20.045 Qualcomm (QCOM) .2925 shares 68.28 19.972 Cash 0.027 Total $100.00The $100 per share is known as the “Net Asset Value per Share” (accountants would also refer to it as the “book value” per share). This is the amount you could sell your share back to PAGMF for should you decide to get out.We readdress the question of why you would not just invest in the shares yourself? Three reasons:First, you cannot buy fractional shares of a company. So the above distribution of your $100 would be impossible. Second, buying small lots of many stocks would eat you up in commissions. Our commission is $8 per trade from Fidelity and this amounts to 1/10 of a percent for a $8,000 stock purchase. For a $100 stock purchase, it would amount to 8%!!! Third, we are not in the business of picking stocks. By forming a mutual fund, we can select an individual to take the time to pick and buy and sell our stocks. Dad is doing all of this for free. Normally this is a paid position and we will cover this aspect of mutual funds later.A couple of other points….Our mutual fund is open ended. That means if you want to invest more money in the fund, you just send it in to our office and you get more shares at the Net Asset Value of each share at the time your money is received. Our fund is a no-load fund. Many mutual funds have what are called front end loads. (There are other types of loads that will be touched on when we discuss mutual fund expenses). The typical “front end load” is from 4.5% to 8%. The load is typically used to pay the sales people who sold you the fund! So if you invest $100 in an 8% front end load fund, $92 is invested for you and $8 goes to the sales staff or broker. Some load funds maintain that they generate superior performance, but I have been unable to substantiate that claim. I also find it hard to fathom how paying a sales staff out of your money can affect the performance of the managers of the fund. To the extent that a portion of the front end load goes to the mutual fund itself, there is an argument that it reduces the overall expenses charged by the fund to the investors. We will tackle this argument later in the paper when we discuss fees and expenses. For now, we will always avoid load funds. Now let’s look at the stocks a month later CurrentTotal Market Price Current Market Stock Shares Cost Cost Per ShareValue (MTGE) 386 20.71 $7,994.06 $ 21.02$8,113.72 (PSX) 140 57.16 8,002.40 58.24 8,153.60 (PRU) 103 77.53 7,985.59 77.83 8,169.49 (LNC) 192 41.76 8,017.92 41.97 8,058.24 (QCOM) 117 68.28 7,988.76 68.74 8,042.58 TotalStocks $39,988.73 $40,537.63 Cash 11.27 11.27 Total Fund Value $ 40,000.00 $40,548.90The fund increased in value by 548.90 ($40,548.90 – 40,000.00). The “Net Asset Value” per share is now 40,548.90/400, $101.37225. We are not ready to say if this is good or bad. We must address such questions as “How did this compare to the return of the S&P 500?” We will address this more fully later. Investing in Mutual Funds vs the S&P 500The evidence: The most recent DALBAR study found that in the 20 calendar years ending in December 2011, the Standard & Poor's 500 Index had a 7.8% compound rate of return. In that same period, the average investor in U.S. equity mutual funds earned just 3.5%.You now know what a mutual fund is. Next we will now address how to find or select mutual funds.Selecting a Mutual FundAt the end of 2012, there were 7,238 mutual funds available to investors. New funds are being created at the rate of about 500 per year. About 1% of the funds in existence die or go out of business each year. Could we just pick one of the mutual funds and go on about our business?Charles D. Ellis, a consultant to large institutional investors, discussed the challenge his profession faces in a recent article in the Financial Analysts Journal called "The Winner's Game.” He noted that, "Most investors are not beating the market; the market is beating them. ... And it's much, much harder to beat the market after costs and fees." Ellis found that the percentage of mutual fund managers who lag their relative index, after fees, is 60 percent in any one year, 70 percent over 10 years and 80 percent over 20 years. The numbers speak for themselves: only one in five managers beats the index over the long run!And; The evidence: The most recent DALBAR study found that in the 20 calendar years ending in December 2011, the Standard & Poor's 500 Index had a 7.8% compound rate of return. In that same period, the average investor in U.S. equity mutual funds earned just 3.5% .$100 invested at the return of the average mutual fund, 3.5% over 20 years would grow to $198.98, while the same $100 invested at the return of the S&P 500, 7.8%, would grow to $449.13- more than double! And that is just matching the S&P- what if you could beat that?!?And, I believe the above referenced research way overstates the return of the average mutual fund. It has a research flaw- what we in the academic world call “the survivorship bias.” It is based on funds that survive for 20 years. If a fund fails during that period (most probably because it is doing way below normal), it is not counted in the research at all.Types (Categories) of Mutual Funds There are many different types of mutual funds. Some invest only in certain industries, certain commodities, certain countries, and others invest only in companies of a certain size. There are load and no-load funds, There are open ended and closed ended funds. So what’s a mother to do?Appendices 1 and 2 are the Yahoo Profile and Performance information for a fund I currently own- Yacktman Fund Service Class (YACKX). We will use it as an example as we step through the selection process. I will snip parts of the appendix as we go through the selection process. So let’s get started…..first Step One, Type of Fund If you did a search (we will get to that in a minute) of the most successful mutual funds over the last five years, you would find most of the funds at the top of the list invest in the health care area. Over the past 10 years this area of the economy has grown significantly. Any fund that invested only in stocks of companies in this area during that period did exceptionally well. But does that past performance predict the future? I think not because, even if the manager of the fund is exceptional, he or she is limited as to the investments they can make- health care related stocks. These funds are appropriate only if you believe that the health care area is going to substantially outperform the market (the S&P 500) in the future. So which types of funds should you focus on? I initially wrote “Invest in General Equity Funds, not industry specific funds,” but then I ran some screeners and found some Industry Specific funds did exceptionally well over long periods. I would restrict my selection to funds not too restricted in their investment selections. Thus, I would avoid gold funds, but healthcare focused funds might be fine depending on the management. We will talk about this later.Step Two- Invest only in no-load mutual funds. Funds have different kinds of loads. Some funds charge you a fee if you sell the mutual fund too early. This period is typically 90 days, but can be longer. Others charge you a load when you sell. We will look at these when we consider fees and expenses later. For now, only no-load meet our criteria. The following example is from Yacktman Svc, a fund I am invested in. See Appendix 2 for the full pages I am abstracting from here. Note that Yacktman is a no-load fund.Step Three, Performance, Invest only in funds that have beaten the S&P 500 over at least the last five years. If the fund has been open longer, it must have beat the S&P for all years it has been open. The beating of the S&P 500 must be a statistical certainty. Many funds advertise that they beat their peers or that they ranked in the top 20% of the Morning Star category….. none of this hogwash matters. How did they do against the S&P? - That is all we care about. These returns are only good, however, to the extent they beat the S&P 500. Se we will compare them in the following table.To September 1, 2013, Standard and Poor’s 500 Return Compounded Annual Rate Of ReturnOne Year 17.48%Three Years 14.15Five Years 7.79Ten Years 5.48 Fifteen Years 2.59So we need to compare Yacktman’s returns with these- S&P500 Compounded Annual Rate Of Return YacktmanOne Year 17.48% 20.71Three Years 14.15 17.13Five Years 7.79 15.15Ten Years 5.48 10.80 Fifteen Years 2.59 n/a (not available)And we find that the fund is consistently beating the S&P, so this fund is a viable candidate assuming it meets the other criteria which are explained in the coming pages. Notice that Yacktman substantially exceeds the returns of the S&P for all the periods except the last- they haven’t been around 15 years. I also like to look at the returns over the years. For instance here is YacktmanOn the next page is another fund (WBSIX) fund that has good returns on the surface, but take a look at how the fund did year by year. William Blair Small Cap Growth INotice how the returns for each year are more variable. Living through 2007 and 2008 with this fund was probably hell, even though in the long run you would have come out ok. I like to avoid hell whenever possible.Step Four, Management Tenure. When you look at the performance of a mutual fund, it is extremely important that the management which produced this performance still be in place. There are enough good managers out there that we do not have to go with unproven talent. Notice for the Yacktman Fund, found on the profile page- From this, we know we are dealing with the management that got the above performances. We will only consider the performances of a mutual fund for periods it was managed by the current manager. Step Five, Minimum Investment, When we find some of the better funds, we sometimes find that they require a minimum investment of $25,000, $50,000 or even $100,000 and higher! (For example, see LMNOX, minimum investments is $1,000,000). As we are starting off slow, let’s keep our minimum investment to $10,000.For Yacktman- found on the profile page So we are OK here. Note at the bottom it says that Yackx (symbol for Yacktman) can be purchased from 105 brokerages. We always have the choice of sending our money directly to the fund or investing through a brokerage house (such as Fidelity, Schwab and so forth). We will usually choose to invest through the brokerage house, even if there is a small fee involved, because it is much easier to buy and sell the fund without a lot of paperwork, signature guarantees, and so forth. The highest fee I have ever paid for a mutual fund purchase through a brokerage house is $75, and many of them charge no fee at all.Step 6, Morningstar Ranking. Morningstar ranks funds from 1 (lowest quality) to 5 (highest quality) based on the riskiness and return. It is a complicated system. We will simplify it by requiring 3 stars or more.What about expenses? For each of the funds, the management charges a fee plus expenses are paid. These amounts can vary greatly. Hedge funds (which will be addressed later) typically charge 20% of the income and 2% of the assets! There are strategies for investing built around choosing funds with the lowest expense ratio. I really do not care about the expenses. All results are reported after taking expenses into account. So if we have superior performance after expenses, does the level of the fees and expenses really matter?Said another way, Derek Jeter cost the Yankees $17,000,000 for the 2013 season. I will play short for much less. Which of us will give the Yankees the better return on their money?? Actually we find Yachtman lower than its peers. But again, we don’t care.Screening for a fund. Now that we have our criteria, we need to go out and find the best mutual funds. To do this we use what is known as a mutual fund screener. There are plenty of these around. Put “mutual fund screener” in a Google search, and you will get 2,700,000 hits! Actually very few of these are actual mutual fund screeners. The most obvious hit is the Yahoo screener, but I have never been able to get that one to operate correctly for me. I have found Morningstar and Kiplinger’s the most helpful. I will illustrate using Morningstar mutual fund screener. has a basic and a premium screener. The basic is free, and that is what we will use. When we go to the above link, we get what is displayed on the following page. Now we go down through setting our criteria as defined above. Now we hit show resultsGo up to the top left where it says “Snapshot” and change that to “Performance”These are now in alphabetical order. Go to the sixth column and click on 5-Year Return, and this will rank them by 5 year returns.Note that at the bottom of the chart we have the S&P 500 return to compare each of the funds to. A couple of points here. First, because we had a ten-year performance criterion, we only got funds that had been available for ten years or more. On the next page are the results of the same search, but with only funds that have been available for five years or more. If you hover your mouse over the fund’s name, the symbol will appear at the bottom of your screen.Notice now that several new funds make our list. In fact the top two funds (Oceanstone and Rydex 100) are funds that did not appear in our previous screen. We take a further look at these. We find that Oceanstone is hard to purchase. It is only available from one brokerage house, DailyAccess Corporation, RTC, so we pass on them. Rydex Dynamic turns out to be a fund which attempts to mimic the performance of the NASDAQ two times. We now turn to Berkshire Focus? This is a fund run by Malcolm Forbes III. This fund is not connected with Berkshire Hathaway or Warren Buffett. This is basically a fund run by the editor of Forbes magazine. While we were studying this fund, we found a contradiction in the returns reported by Yahoo and Morningstar. Yahoo Finance had the following: This presented a troublesome dilemma…whom do you trust??MorningstarYahooYear To Date 31.60% 23.99%One Year 20.53% 15.90%Three Years 18.72% 22.66%Five Years 23.60%15.95%Ten Years 13.08%11.27%These differences are significant. I did a search of many other sites that present mutual fund performance and found similar significant differences. I researched the problem further and found an possible explanation on Moningstar’s site.Why might Morningstar’s total returns be different from those I get from other sources?At times the total returns that we calculate for a mutual fund may differ from a total return calculated by another data provider or from one supplied by the fund itself. Some possible reasons for this include:Time period differences : often the difference is due simply to time-period discrepancies. For example, a fund that issues its annual report in late 2004 for its fiscal year ended September 30 may list a 2004 return based on the period from October 1, 2003 to September 30, 2004. Because we calculate annual total returns for all funds on a calendar basis, to allow valid comparisons between funds, the 2004 return we list for a fund won’t match its fiscal-year-end calculation. Similarly, some newspapers and financial magazines may choose slightly different dates or may publish preliminary data in order to fit their publication schedules.Calculation differences: Morningstar calculates total returns by reinvesting all distributions at the NAV (price per share) on the reinvestment date used by the fund. We then compound the funds monthly returns and annualize the figure for time periods greater than one year. Other firms may employ different methodology. For example, some services reinvest all dividends at month-end prices. Morningstar takes the extra step to obtain the actual reinvestment price that an investor in the fund would receive for reinvesting distributions into additional shares. When reinvestment prices are not available, we assume reinvestment at the market price on, or as close as possible to, the dividend-payment date.I have decided to go with Morningstar. Berkshire Focus is definitely a fund we should consider. Now let’s look at the results of the screener again (page 30). Notice that many of these funds are “sector funds.” In other words, they invest in only certain sectors or industries. Notice the predominance of mutual funds which focus on the health-care industy at the top of the above list. We probably do not want to limit ourselves in this way. We will look at funds other than these that are so restricted in their investment alternatives.I have created four tables to further analyze our selections. All of this data is presented in one Table in the Excel appendix to this paper. It is easier to use the one table, but I couldn’t fit it here, so we will work with this table by table. The first table is a listing of the mutual funds, their symbols, and the returns as presented in the Morningstar Screener results. All of these fit our criteria at first glance (no-load, manager tenure, performance better than S&P 500, lower minimum investment, and 3 star rating or higher.) Had we looked at the second and third pages of the Screener results, we would have found even more funds that meet the criteria. We now need to proceed to pick our mutual fund(s) from this list. The second table presents the same returns but with the added columns for Manager Tenure, Morningstar Stars, up Years and down years. The up Years and down Years are important because they allow us to do a first pass at the variability and associated return risks of the fund.In fact, this facet of the funds’ performance is so important that we extend the analysis to look at how the funds did year by year. That is the following table (and I hope you have good eyes!)Now, from the above, which one looks the best? We had previously eliminated OSFDX, but if we had not, we would have eliminated it here because its 5 year return was mainly generated in one year, 2009. Again we found it is hard to purchase (offered at only one brokerage). If we go back to our analysis of YACKX, note at the bottom of the Investment Information, YACKX can be purchased at 105 different brokerages. These are places like Fidelity, Schwabb and so forth- the ones we use. OSFDX is available from only one brokerage house and it is not one we use. If you click on the “1 brokerages,” you get DailyAccess Corporation RTC, which is a retirement service corporation and not even a brokerage.It is important that we buy a mutual fund through a brokerage house. If you buy it directly from the fund there is a lot of paperwork involved in both the buying and the selling. If you buy it from Fidelity, Schwab or one of the big houses, these operations are taken care of by a click of the mouse.So now we have our candidates. We have eliminated one on technical grounds and maybe several because they are too concentrated in one industry. Now this is where the art part kicks in. As I consider these, I compare the year by year with the S&P. Some of the higher return funds have more down years compared to the S&P. On paper, picking the best return seems to be the road to great riches. But remember, we have to live through the up and down years day by day. We do not want any investment that causes us to lose sleep or to take away our attention from our real job. After I looked at all of these, I would choose Dreyfus Opportunistic Small Cap Fund (DSCVX). But at this point, your judgment is as good as mine. I do not think you can go wrong if you have gotten this far using the tools prescribed.Before we exit this section, a final word about the science. Notice in our initial screening we eliminated funds that were limited to certain sectors. In this case, the highest rate of return funds seemed to be linked to health care. We decided this was too restrictive. You, on the other hand, might know the health care industry and believe that it will outperform the general market over the next several years. Based on this, you might want to include these funds in your selection process.How do we buy the mutual fund(s) we have selected? All brokerage houses are slightly different in their applications. But they all have similar options and mechanics. You want to buy online. If you call the brokerage house to trade the mutual fund for you, they will probably charge you an additional fee. As we try to buy our selected mutual fund(s), we may run into additional problems. For instance, we find when we try to buy our first choice, DSCVX, that it is closed to new investors. Successful funds sometimes close themselves to new investors, usually to keep their size at a point where the manager feels he or she can be effective. We discussed this when we were discussing Warren Buffett. We might find other restrictions that did not show up in our initial screen. We have to just move on to our next best selection.Since our first choice, Dreyfus Opportunistic Small Cap Fund (DSCVX) is closed to new investors, and our second choice, PIXAX was only open for redemptions, we will use for our example our third choice, PIXDX, PIMCO Fundamental IndexPlus AR Fund Class D.Let’s buy some….If you have trouble with the below instructions, just call your brokerage and ask them to step you through the process. They will not charge you for that as long as you are executing the trade yourself online. The following is directed toward those with a Fidelity account. It is assumed that other brokerage accounts would have similar screens and processes. Log on to your brokerage account and find a section marked “Trade”. If you hit the drop down, one of the options is “mutual funds”Hit continueNow type in the fund symbol and the amountNow hit “Preview Order”When you hit “Place Order,” the order is in. The trade will be executed at the close of business either today or at the end of the next business day. You can still cancel the order up to the close of today’s market. So now we know how to buy a mutual fund. You want to continually track your mutual funds against the S&P 500. I suggest doing this on a quarterly basis. If your fund lags behind the S&P for a while, do not be concerned. There are normal ups and downs in the markets and in the relationship of even the best mutual funds when compared to the market.When you track your mutual fund, run the screener again. It could be that new better mutual funds are available. Do not get into the game of switching mutual funds often. But if yours is starting to lag, and there are better ones available…………………….Before we move on, we must address one other issue that affects some of you. If you are involved in a retirement plan that gives you limited investment options, what do you do?Finding the Best of the WorstAs I write this, both Suzie and Cindy are involved in retirement plans that provide limited choices in mutual funds they can invest in. For many reasons, I am certain that none of the ones available will turn up on the mutual fund screen that you ran. So if you have a list of mutual funds you are allowed to invest in, the selection process requires a little more work on your part. Somewhere in the material you are given about your 401(k) or whatever retirement plan you have is a list of the available mutual funds. For each of the mutual funds available to you, you need the symbol. Many times, this is difficult to obtain as many of the funds available to retirement plans are not available to the public. The names of these funds are usually followed by the notation “institutional shares” or something similar. We are slowed down by this hindrance, but we are not stopped. First, many of these “Institutional Funds” have a version available to the public. We must push the person in charge of the 401(k) investments to give us the information we want. They will probably be reluctant. The information is obscure for a reason- to stop us from doing what we are trying to do. If they claim there is no way to find the information, ask to talk to a supervisor or someone higher in the organization. If this tactic does not work, we go to plan 2. You need to find the name of each of the fund advisors. You will recall that this information was critical to our earlier evaluation-Once we have this information, we can research what other funds this particular manager manages and see if we can gauge the effectiveness of the manager.Some way we need to be able to rank the funds. The following is a template Manager ?Return?Name of FundManagerTenure3 Year5 Year10 Year????????????????????????????????????????????????S&P 500We need to have the S&P 500 for the same periods. We can get this from and other sources.To the extent possible, apply all the other filters we talked about earlier. Avoid industry specific funds unless you know the industry and are confident of its future. The point of this section is that gauging the effectiveness of the funds you are to choose is much harder in this restricted world of opportunities. It just requires more ingenuity on your part. You will remember that small differences in returns are magnified over the time to your retirement. Might be the difference between driving a Prism and a Mercedes during your retirement years. You may need to get pushy, even rude when pursuing the needed information. But maybe you want more involvement in the markets. Maybe you are becoming interested in the area and would like to learn more. Finding Derek JeterThe stock market is the only place in the world where amateurs can play against world class players. No-limit poker is another that comes to mind. However, in the stock market, you do not know who you are playing against when you invest. In poker, you can choose to sit down and play the best, or you can pick a game with lesser quality candidates. This latter is not possible in the stock market. So no matter how great we think we are at picking stock, it would probably be an excellent strategy to mimic the picks of the great ones. This is kind of like backing an excellent no-limit player instead of playing against him or her. Investing with other Great MindsThere is overlap between this section and the Mutual Fund section. As we found, many of the “5%” run mutual funds (funds that beat the S&P 500 over sustained periods). A second class of investment managers who exceed the 5% are those who run other types of investment funds. Most predominately among these are “Hedge Funds.” From Investopedia we have the definition of a ‘Hedge Fund’ asAn aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.So these are kind of like mutual funds but there are major differences. According to the SEC;Unlike mutual funds, hedge funds are not subject to some of the regulations that are designed to protect investors.As a result, most hedge funds require large initial deposits, wealth tests, restrictions on withdrawals and other onerous requirements.They are mainly for the very rich. One would think that the very rich would be more discerning in their selection of investment vehicles, but this does not appear to be the case. The follow graph is from an article in Businessweek (“Hedge Funds Are for Suckers”) shows the return of hedge funds in general lag behind the S&P 500 returns. Quoting from the article So being rich does not insulate you from the ineptness of financial advisors in general. The incompetence just doesn’t hurt as bad financially. But there are some true stars operating in this arena. In fact, the best hedge fund managers far outperform the best mutual fund managers. Before we go too far into finding the best, we will look at the source of our information. As with mutual funds, we will grade the performance of hedge fund managers on how they did compared to the S&P 500. To gauge their effectiveness, we need to know what they have invested in.Hedge funds are required by the SEC (Section 13f) to report their holdings to the government every quarter. These reports are due within 45 days of the end of the quarter. The reported information is public information, and thus, is available to us. These filings are available from many sources on the internet, including the SEC itself. We will use the website . I have found this the easiest to navigate. This site also analyzes the reports in very useable ways. These include a scorecard, listings of buys and sells of particular stocks by the hedge fund managers and so forth. A major concern is that the information we receive on the 13f can be up to 105 days after the fact. In other words, a hedge fund can sell a stock on Jan 1, and we do not get the information about this trade until May 15, (45 days after the end of the quarter.) While I have been immolating David Tepper for quite a while and been successful with this strategy, my success is only antidotal evidence. So I tracked all of David Tepper’s investment from December 31, 2006 to today, and tracked how he did compared to the S&P 500. The following table details the results of this analysis. The full “scoreboard of his investments is included in Appendix __.The rest of this section uses information from . Wherever possible, I will use the free section of the site. Using the reported information, Gurufocus (from now on referred to GF) keeps track of how the different funds have done over the years. So let’s find us a good manager. First go to Go to Gurus (two over from Home), and click on the little arrow for the dropdown. On the dropdown, click on “Scoreboard”Now go to the 10-year (right under PerformanceClick on the 10-year % and the data will sort 10-year % from best to worst. (You might have to click it twice to get the best first).For the past ten years, David Tepper has the best return at 30.5% per year. Over that same time period, the S&P 500 returned 1.5% per year. David Tepper is actually the manager whose picks I copy the most, so we will use him to work through our process of replicating the picks of the great. Who is this David Tepper fellow?Not that it matters, but David Alan Tepper?(born on September 11, 1957) is an American?hedge fund?manager and the founder of?Appaloosa Management. His?investment?specialty is distressed companies. In recent years he's become known as a?philanthropist, his largest gift going to Carnegie Mellon University, whose?Tepper School of Business?is named after him. He earned his?BA?in Economics from the?University of Pittsburgh?in 1978 and his?MBA?(then known as an MSIA) from Carnegie Mellon in 1982. For the 2012 tax year, Institutional Investor’s Alpha ranked Tepper No. 1 for earning a $2.2 billion payday. Why can't we just send him the money?David Tepper’s Appaloosa Management, is closed to new investors.Go Type in a nameDavid Tepperpush GoNow go to the tab at the top and select Profile/PerformanceInvesting PhilosophyHe is a distressed-debt specialist, was once considered to be the hottest investor on wall street.Total Holding HistoryPerformance of Appaloosa Investment LP IYearReturn (%)S&P500 (%)Excess Gain (%)20102215.066.92009132.7226.46106.32008-26.72-3710.33-Year Cumulative108.1 (27.7%/year)-8.3 (-2.9%/year)116.4 (30.6%/year)20078.885.613.3200625.8615.7910.15-Year Cumulative185.1 (23.3%/year)12.1 (2.3%/year)173 (21%/year)200520.554.9115.6200433.811221.82003148.8228.7120.12002-24.8-22.1-2.7200166.75-11.978.610-Year Cumulative1335 (30.5%/year)16.3 (1.5%/year)1318.7 (29%/year)20000.04-9.19.1199960.892139.91998-29.1928.6-57.8199729.5433.4-3.9199678.462355.515-Year Cumulative3680.8 (27.4%/year)170 (6.8%/year)3510.8 (20.6%/year)199542.0637.64.5199419.031.317.7199357.6210.147.5See the Columns“Return %” is David Tepper’s annual rate of returnLook at 15 Year Cumulative 27.4% average annual rate of return per year for 15 years up to 2010. The S&P 500 return is 6.8% per year for the same period so cumulative difference is 20.6% per year over 15 yearsTepper 27.4 Less S&P 500 6.8 Tepper outperforms by 20.6% per year!!!!Said another way If you invested $100 in S&P 500 Stocks 15 years ago you would have $268.27 today. And if you invested that same $100 in David Tepper stocks 15 years ago you would have $1,660.39! So using Tepper picks your return is 6 times more than the S&P 500 and remember very few money managers can even equal the S&P!!!So the study is worth the effort!!!So now how do we start to invest with David Tepper. His picks are available to the public 45 days after each quarter. This is part of the SEC filing requirements (Form 13f ). Now go back to Gurufocus. David Tepper Stock PicksI only printed the first page as that is the where all the “buys” and “adds” are for this quarter.Using the stock picksFirst notice above that his first three picks are not really stocks but are ETFs. Let’s not go into what those are. We go down to the first stock that is a real company and is a Buy. This is Chicago Bridge and Iron. Actually he had nine new buys during the quarter:Chicago Bridge & IronAxiall CorpHertz Global Holding Carnival Corporation Terex Corporation Trinity IndustriesThese are the stocks we will buy. We could weight our purchases by the impact column in some way, but since they are good enough for Tepper, they are good enough for us. Assume we have $10,000 to invest. We will divide it evenly between the six stocks.Here are the symbols and current market prices for each of these stocksAXLL36.79 HTZ27.15 CCL37.57 TEX32.83TRN45.40We have to worry a little about the impact of the brokerage fees on our purchase. With fidelity, the commission is about $10 per trade. If we account for this in our calculations, we can spend $1,990 on each stock. The commission we will be paying is $10/$2,000 or .005%. Here is what we are buyingAXLL$1,990/36.79 = 54 shares HTZ 1,990/27.15 = 73 shares CCL 1,990/37.57 = 52 shares TEX 1,990/32.83 = 60 sharesTRN 1,990/45.40 = 43 sharesNow go to your Account at We go to quotes Note that the “Bid” (how much people are offering for the stock is $36.76 and the “Ask” (how much sellers are asking for each share) is $36.79. These are close enough that when we buy we will buy at “market.” This is usually the “ask” price.So hit “Trade” It will be noted that we placed this order “at market”What this means is that we agree to buy the stock at the current market price. In the above example you will see a “Bid” of $36.77 and an “Ask” of $36.85. What this means is that potential sellers are currently offering to buy (bid) the stock at $36.77 per share and potential buyers are offering to sell (ask) the stock for $36.85 per share. (Note that this are slightly different from those above. The bid and ask numbers are constantly changing, and, in fact, changed as I was copying the pictures presented). If you enter a “limit order” in the order category, you can specify how much you are willing to pay. If you enter a “market order” as we did, you will probably buy the stock at the ask, $36.85. Limit orders cause us to continually watch the stock to see if our price has been accepted. They generally tend to allow us to buy the stock at a lower price; however for this work, we will pay a slightly higher price. This allows us to know the order has been executed (we have bought the stock), and thus, we can get back to our regular job. A further caveat- we only enter orders when the stock market is open. When you place an order when the market is closed, it executes first thing when the market opens. At that time the spread between the bid and the ask tends to be very high, and it is very easy to overpay for the stock.Now hit preview and you will getNote that the market is moving as you begin the trading process. You will see that the bid and ask above are different than they were when we began the process, about a minute ago.And finally hit “Place Order”Then check the “Order” Page to find out the price you paid. Keep an Excel spreadsheet with the following informationDateActionNameSharesPrice Per ShareTotal PriceS&P 500 on Date of Purchase?10/09/2013BuyAXLL10036.98 3698.00 1,657.50?Extra StuffDreams vs goalsSection to be added later “?One of the most important but one of the most difficult things for a powerful mind is to be its own master.?”— Joseph AddisonThe best argument for mutual funds is that they offer safety and diversification. But they don't necessarily offer safety and diversification.Ron Chernow?Read more at? fund managers are trapped in this rather deadly vicious circle: the more successful they are, the more money flows into their mutual fund. Then, it is more difficult for them to beat the market averages or even to match their own past performance. Ron Chernow ................
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