Nelson Smith

Freelance writer. Contrarian investor. Watcher of baseball. Owner of financialuproar.com. At least my mom thinks I'm funny and/or handsome.

Nov 262014
 

Many commentators have called the payment protection insurance (PPI) scandal the worst to have happened in the history of the UK banking industry. So far thousands of people have made PPI claims to get back the fees on mis-sold policies, and many more are set to do so. Indeed, while the banks have so far set aside in excess of £18billion to make repayments, many expect the final figure to exceed this by far.

PPI Explained

PPI is a form of insurance intended to cover the monthly repayments on a loan, mortgage or other credit agreement in the event the consumer is made redundant or is not able to make repayments because of illness or injury. It was discovered, following investigation by the then Financial Services Authority, that many policies were mis-sold to customers. This has led to the current PPI claims scandal, which shows no sign of slowing down.

Have I got PPI?

You can’t be sure unless you have fully checked all your loans, mortgage and credit agreements over the last 10 years or so.  Look carefully over old paperwork or if you no longer have that to hand, check on your credit report which will list all agreements you have ever had.  PPI is called called ASU (Accident Sickness and Unemployment) cover and Loan Protection Cover, amongst other names.

Remember, it is quite possible that you have more than one PPI policy and, with an industry average refund so far of £2750, it is definitely worth checking to ask yourself – have I got PPI and see if you could make a claim.

Who Can Make PPI Claims?

Anyone who can prove that they were mis-sold a policy can make a PPI claim and get back the fees on mis-sold policies, plus compensation. When taking out a loan the borrower should have been given a full explanation of their right to shop around for the best PPI deal; in many cases this was not done and, instead, the customer was led to believe they needed to take the lenders – more expensive – policy. If this happened to you, you are entitled to claim back the fees on your PPI policy.

Moreover, if you were not even aware that you had the PPI then you are very likely to have been mis-sold the policy. A large part of the scandal was the secret inclusion of the insurance product on to customer’s loans without their prior knowledge or consent.

To make your claim for PPI compensation, you can go to your lender and apply for a refund through their complaints procedures.  Another way to make a claim for your mis-sold PPI is to use the services of a claims company who would sort the matter out for you.

Nov 262014
 

Eddie’s new day is Wednesday. (Checks calendar) Hey wait. That’s today. Here he is. 

Let me pose a fictitious story to you to illustrate a very important point.

Jane works at a local grocery store as a produce manager.  She excels at her job because she is knowledgeable, driven, and charismatic.  On the last day of 2011, she sat down with Bob, her accountant, to discuss her finances.  Bob informed her that she made $80 000 over the year.  Jane was happy and they both said goodbye.

On January 1st, 2012, Jane leaves her job at the grocery store to open her own produce store.  She worked hard to build a customer base and has managed to stay afloat.  At the end of 2012, she sits down with Bob again.  He informs her that her profit from her store was $60 000.  Bob and Jane say goodbye.

Jane then speaks wither friend John, who is an economist at a financial services firm.  She explains her situation and that she pulled in less money than last year working at the supermarket.   Although she made less money, she said that Bob calculated her profit to be $60 000.  John said the profit of her self-employment was -$20 000.

Who was right?

Both were right.  Bob gave her the figure of her accounting profit.  At her store, Jane’s revenues less expenses was $60 000.  John, taking opportunity cost into account, calculated the negative figure.  The reason why it was negative is because the opportunity cost of Jane opening her store was her salary at the supermarket was $80 000.  To obtain economic profit, opportunity cost must be subtracted from her revenues.  Jane essentially took a $20 000 pay cut to open her own store.  Bob was right because he gave her the figure of accounting profit whereas John gave her economic profit.

Both are useful.  Bob’s figure conveys the fact that her enterprise has a positive income and cash flow, which is important in Jane’s decision making processes.  If her accounting profit was negative, she would likely be in serious trouble.  If she can live off of $60 000, then she is doing relatively well.  John’s figure is important to her decision making processes as well.  Economic profit serves as an effective contrast between two options: keep her store or go back to the supermarket.  Is her independence and the expectation of future profits worth the $20 000 she gave up?  She must decide.

Why this is important is because we should take opportunity cost in making decisions regarding our time and money.  What is the opportunity cost of sleeping in until 2 pm on weekends and doing nothing productive?  It could be the higher salary you could attain if you took some continuing education courses.  What is the opportunity cost of not getting your oil changed regularly?  The cost associated with a hefty repair bill due to poor maintenance.  What is the opportunity cost of driving across town to get $5 off an item you can purchase at a store close to home?  The tank of gas you burned to drive across town and the time you invested to do it.  You get the idea.

I keep harping on opportunity costs because recognizing them is critical in ensuring you are at your most productive and spending time on high value projects.  If financial freedom or independence is important to you, which I assume it is based on your readership of this blog, then you probably require much more money than what you have now.  To achieve the wealth you desire, you need to scale your thoughts and subsequent actions to match the enormity of your endeavor.  To this end, I have the following observations, expressed in do and do not form:

DO thoroughly understand the concept of opportunity cost, and how it relates to accounting and economic profit.

DO reflect on the implications of opportunity cost on your current allocation of time and money.

DO NOT think that clipping coupons and combing flyers will make you wealthy; it will never.  I will jump off a tall bridge the day I read Fortune 500 and read about a billionaire who made their fortune by clipping coupons and putting their money into a Tangerine Savings Account at 2 point something percent.

DO focus on the revenue aspect of your income statement and focus less on cutting expenses.

DO NOT get a menial part-time job to cover expenses unless you are teetering on bankruptcy.

DO invest strategically, particularly in assets that are difficult to quantify the payoff, such as education and skills upgrades.

DO read biographies of highly successful people, rather than the tales of “successful” PF bloggers.  (PS This also includes my lifeless blog, as I am discovering that the opportunity cost of writing for it may be too high).

If you want to get yourself into the right mindset, ask yourself what you would do if you wanted to retire in 5 years rather than 20 or 25 years.  Treat the 5 year stipulation as fixed or unalterable and research options that will put you into that ballpark.  I like the franchise and real estate route and leveraging a corporate structure, but that is for another day.

Nov 242014
 

A few weeks ago I was asked to take part in a personal finance expert sort of panel over at Boomer and Echo, AKA the only adult man in the world who willingly spends time with his mother when he isn’t trying to bum smokes or to sucker her into taking care of his kids. You’re a bigger man than I, Robb.

Robb ended up asking 15 of us what our opinion was on borrowing to invest. He “got” a letter from a “reader” (fact: 99% of those are made up) who was thinking of borrowing money at 3%, buying Canadian Oil Sands at an 8% yield, and pocketing the difference. Naturally, a good 80% of the 15 experts he chose to interview thought it was a bad idea.

The big negative, of course, is risk. If you have $20k to invest and you borrow an additional $20k, things can go very badly if you’re wrong. If oil goes down to $50 a barrel again and Canadian Oil Sands has to cut the dividend, that’s gonna turn out very badly. Hell, if oil stays at $50 for a year, Canadian Oil Sands isn’t just cutting the dividend. It’s toast.

In that situation, your $40k original investment might only be worth $20k, plus there’s no dividend left to pay the interest. Thus, borrowing to invest can be a pretty easy way to lose your entire principal and eventually get you into the poorhouse.

Sorry, I lapsed into one of those debt is evil guys for a second there.

So I understand the thought process of not borrowing to invest in one individual stock. Portfolios exist for a reason, even if I think that owning 40 stocks is too many. Diversifying the risk away from one stock is good.

But what about borrowing to invest in many stocks? Or a rental house/principal residence with an additional suite? Or to lend out to many people at a higher interest rate? There’s certainly a case to be made about that.

Let’s back up for a minute. There are two ways to get rich. You can:

1. Increase your income

2. Decrease your expenses

A lot people start out with step 2. Most North Americans live a lifestyle so opulent that there’s plenty of meat to cut from the bone. They have closets full of clothes they don’t wear (O.M.G. THIS HOUSE HAS A WALK-IN CLOSET! I AM IN HEAVEN.). They regularly “purge” and “donate” all the useless crap they no longer want, only to replace it with new crap. We continue to buy brand new cars because apparently slightly better reliability is worth hundreds of dollars each month. And I still see perfectly healthy people with no dependents buy life insurance as some sort of investment. “Buy buying now, I’ll save in premiums later!” But… never mind.

There’s a lot of confusion with step 1, and thus many people don’t get anywhere past the basics when it comes to increasing their income. Side hustles are great, since the majority of people go home after work and plunk their ass on the couch. Everyone needs relaxing time, but just about everybody can carve a couple of hours a day to put towards increasing income.

As we all know, there’s a limit to cutting your expenses. You still have to eat, clothe yourself, and get to work. So we have a choice. Should we try and do those things in the cheapest way possible, or should we work on increasing our income so spending $10 on a meal out hardly matters?

For me, the choice is simple. Figuring out a new way to save 14 cents per serving on pizza doesn’t excite me. Getting paid dividends by the pizza company in exchange for giving them money? THAT’S WHAT I’M TALKING ABOUT, BITCHES.

Say I bought 100 shares each of Boston Pizza (TSX:BPF.UN) and Pizza Pizza (TSX:PZA). For a capital outlay of approximately $3,500, I’d get myself monthly income of approximately $17 for a very long time. Sure, there’s a chance each business suffers, but stocks tend to go up over time.

Say I borrowed an additional $3500 to buy 100 more shares of each. I would have doubled my monthly income to $34 while spending $8.75 per month in interest, assuming a 3% loan. If I used both dividends to pay off the loan, I’d be paying off approximately $280 per year.

Okay, but what if I was more aggressive? Say I did my research and came up with a portfolio of 20 names with an average yield of 5%. I have $50k of my own money, and a friendly banker is willing to lend me $50k more. Because I want to maximize the growth of this portfolio, let’s assume I reinvest those dividends, Using $300 per month from my cash flow to make loan payments.

Assuming no growth in the portfolio, here’s what the investment would look like in 5 years.

Value of loan: $32,000

Value of portfolio: $127,628

Total interest paid (remember, this can be wrote off): $6,642

Assuming you’re in the 25% tax bracket, it’ll cost you just under $5,000 in interest (over 5 years, so about $1000 per year) to grow a portfolio by $13,000 more than what you would have just by taking your capital and investing it. And that’s assuming it just grows by the value of the dividends. Over time it’ll most likely do better, especially if you choose undervalued stocks.

This is exactly what I’m talking about. If you borrowed to invest and got just a 5% return, you’re miles further ahead than the person who just invests their savings. Portfolios do go down sometimes, but chances are it’ll continue to go up.

Which brings me to my main point. The easiest way to supercharge your passive income is to borrow to get more of it.

Saving your ass off to accumulate capital is great. Everyone who saves their ass off to accumulate $25k in capital a year gets a Financial Uproar® brand thumbs up. But what’s easier? Scrimping and saving for years to get capital or borrowing it from a bank?

Smart leverage has been around for generations. Embrace it. If you’re not comfortable with stocks, buy a duplex and rent out the other half. Buy a franchise and get your friend to run it, splitting the profits. As long as there’s a reasonable enough expectation for net returns twice as much as the interest you’re paying, do it.

Don’t go nuts and borrow every penny you can get your hands on. Pay attention not only to the amount of leverage you have (I wouldn’t go over 50%, myself) but also your ability to repay if things go poorly. If your investment only makes 3% and not 6%, it’s not so bad if you can still make the payments. That gives you time to either find a buyer, or see if it was a reasonable expectation of recovery.

There’s an element of risk. If you’re not comfortable with taking a few risks, then don’t bother borrowing to buy anything. But at the same time, this is probably one of the easier ways to make more passive income. Over time, chances are you’ll do well at it.

If there’s interest, I’ll elaborate in the future on this, even coming up with a model portfolio. If you’re interested, send me a note or leave a comment. 

Nov 212014
 

(Plus links. Stay tuned for them at the bottom.)

Friend of the blog John Robertson (author at Holy Potato, AKA one of the blogs I link to every week) wrote a small little e-book a couple of years ago, called Potato’s  I reviewed it here. It was a nice little guide explaining the basics of RRSPs, TFSAs, and all that jazz. I’m sure my shout-out led to him selling thousands of books.

Well, apparently that wasn’t good enough for him. Like some sort of ambitious guy, he basically scrapped it and started over, creating a much more in depth volume, calling it The Value of Simple. Like the first book, it’s aimed at beginning Canadian investors, going through all the steps needed to go from schmoe who can’t invest or even tie his own shoelaces to Captain Handsome who knows his way around a balance sheet, if the ladies know what I mean.*

*Your results may vary.

Included are step-by-step guides to:

  • The basics of investing, including asset classes, and the different types of accounts
  • An extremely detailed guide to opening TD E-Series accounts, Tangerine Streetwise mutual fund accounts, and Questrade accounts.
  • Even more detailed guides to trading ETFs or funds for each type of account. There are pictures.
  • Figuring out when to invest in a RRSP or a TFSA.
  • Transferring funds between brokers
  • Asset allocation
  • Rebalancing
  • And so on

Like The Wealthy Barber, The Value of Simple is a great book to give to your brother, kid, friend, co-worker, or mistress who knows nothing about investing. It lays out the basics without going into the painstaking detail that makes people throw up their hands and not want to bother.

The only thing I didn’t like (and I fully admit this is nitpicking a little) is the section on something called Norbit’s Gambit. That’s when you buy the U.S. version of a stock or ETF on the Toronto Stock Exchange and then sell the Canadian version, which should give the investor a cheap and easy way to exchange U.S. Dollars to Canadian ones.

There’s nothing wrong with the advice, except I don’t think it belongs in a book that’s called The Value of Simple. But really, that’s the only thing I’d change. It’s a good enough read, and it makes a good gift for someone you know who’s just getting started with this stuff. Getting them to read it might be a different challenge. I suggest holding their eyes open with toothpicks. Hey, it works in cartoons.

The book isn’t officially out until December 1st, but I’m pretty sure John is happy to take your money beforehand.

Or, if you’re a cheap-ass like me, John has graciously offered a copy to give away. So, if you’re in the market for a free book (and a free gift from Nelson), just go ahead and leave a comment. We’ll leave the contest open for a week, so get crackin’, yo.

Time for links

Sandi Martin decided to blog again, after approximately 8.4 years of doing other things (it says she’s a fee-only financial planner. Whatever that is.) like clouding up my Facebook feed with pictures of her children. Anyway, she has some thoughts about the new bunch of robo-advisors, which I am only just realizing aren’t Robocop.

Over at Earn. Save. Grow. (AKA the crappy cousin of Boomer and Echo), our homey Robb asks who is to blame for your financial woes. I blame the patriarchy, and cute squirrels, in that order.

Don’t Quit Your Day Job has some pretty shocking stories about asset forfeiture, which is a pretty boring term that really means “when the government steals crap from you because they feel like it.” The story about the guys who beat Las Vegas video poker is especially good. Land of the free my ass, America.

I wrote more words about Penn West Energy over at Motley Fool. I picked up some shares at $4.72 at the beginning of last week. They are now at $5.00. I am a jenius.

I also wrote about Fairfax Financial, which is a lot like Berkshire Hathaway. Prem Watsa is the guy in charge, and he’s pretty interesting. Plus, he owns Reitmans, BlackBerry, and Penn West. Just like me! We’re practically besties.

A few weeks ago, a guy by the name of Anton Ivanov was making headlines on prominent finance sites for being a 27-year old “self-made” millionaire. It turns out he was lying about the self-made part. Check out this story for all the cringe-inducing details.

(Budgets are Sexy also wrote about this guy)

Earlier in the week I wrote about a tiny micro cap called Jaguar Financial. I am now the proud owner of 58,000 (Edit: 54,000, not 58,000) shares. So yes, I just bought more BlackBerry.

And finally, here’s a story about a vasectomy going horribly wrong. Lots of fun mental pictures there.

Have a good weekend everyone.

Nov 202014
 

It’s Eddie, and it’s more interesting than last week.

Last week I gave what was likely a boring example of a solution to sunk cost fallacy using the example of developing an oil & gas property.  This was based upon a previous post explaining the concept of sunk cost fallacies.  This week’s post gives more individual solutions to sunk cost fallacies and how to avoid them.

Avoid careers with defined-benefit pensions – oft lauded by uneducated personal finance bloggers, jobs with DB pensions are rife with the sunk cost fallacy bias. DB pensions are sometimes thought of as ‘golden handcuffs’ by PF bloggers, but they don’t even get the golden part correct (in my opinion, a prudent person who has career flexibility through a DC pension or contract work will develop more skills and get more economic benefits through progressive salary increases than a similar employee with a sole employer with a DB pension).  An employee with a company or in a career with DB pension scheme is susceptible to a weighty decision if their career prospects or job satisfaction decreases considerably: should I stay with my company in a dreadful job for X years and wait for my pension or do I leave for greener pastures?  Avoid doing this to yourself and go for a DC pension or none at all.

On a personal note, I left the army and its “gold-plated” pension after 10 years of service.  Since I left the military a year ago, I’ve more than tripled my take-home pay but have no pension.  However, my decision was a poor one because I don’t have a DB pension (queue the sarcasm).

Fail Early and Fail Often – this is an oft-quoted maxim of entrepreneurs and a principle of the Lean Start-up methodology.  The basic principle is that it is better to validate a business idea with a minimum viable product early with low sunk costs rather than investing lots of time and money into a product that nobody may want.  While I am not completely sold on the entire Lean methodology (aka fad) for several reasons, there is inherent logic to this principle.

This notion can be readily applied to education.  Take for example a person who, at the beginning of their college career, is adamant about becoming a lawyer.  To get the best GPA and make their application more attractive to law schools, they take “easy” undergraduate courses in a degree that has lower job prospects but increases their chances of getting into a JD program.  However, if they discover in first year law school that they in fact despise it, they are faced with a terrible decision: continue into a career that they will likely despise or take another program that will get them a good job that they will enjoy.  The magnitude of this choice and the effects of sunk cost fallacy would have been drastically reduced if they would have obtained a relevant degree with promising career prospects.  Every step in an educational or professional endeavour should be viable in isolation.  Also, test your assumptions as rigorously as possible before you begin.

Continue to learn about finance, not personal finance – personal finance, as a subject, quite one-dimensional and boring the way it is presented on blogs and in books.  One can only write so much about simplistic subjects such as loyalty programs, credit cards, index investing, emergency funds, RRSPs etc.  My complaints aside, a prudent disciple of personal finance – and life strategy – should study some topics in finance.  Relating to the subject matter in question, one should know or have familiarity with the following:

The difference between fixed and variable costs

Operating leverage (not financial leverage)

The effects of fixed and variable costs on the payback period, operating margin, and profitability on increasing and decreasing levels of output

The risks, benefits, and costs associated with choices with high fixed or high variable costs

For your knowledge, a higher fixed cost business has higher operating leverage, greater losses at lower output and greater profits at higher output, a higher payback period, and generally higher risks compared to a high variable cost business.

Nov 172014
 

We’ve all concluded that BlackBerry is the best, right? Everyone hold up your Passport phones and wave them around like you just don’t care!!!

You all don’t have Passport phones? What in the actual hell is wrong with you? They’re the best. They have a full keyboard, and access to the Android store for apps, and some program that works like iMessage but with all your texts, plus John Chen is handsome and I heart him very much. No, YOU have an unreasonable man crush.

As I’ve mentioned, oh, once or twice before, I have a small position in BlackBerry. I’m currently underwater by about 8%. As I write this, the price of the stock is $12.48 on the TSX. It might be different by the time you read this because for once I’m actually planning ahead. I continue to like the company, even though I bought way too early. My boy Johnny is cutting costs and doing what it takes to turn the ship around.

The biggest move so far is dumping Celestica in favor of Foxconn, which has better manufacturing capacity. This allows phones to be made a couple weeks before they’re sold, instead of having to stockpile a whole bunch because Celestica needs the time to produce what’s needed. This is obviously better for inventory control, as evidenced by the huge write-offs from the Z10 and Q10 devices.

The new Passport phone is selling well. It looks like the company sold about 600,000 of them during the last quarter, and reviews are good. It should get a bit of a bump going into Christmas, since that tends to be a big time of year for any phone. Why do you think they’re always released in September? Additionally, low expectations also helped BlackBerry. When everyone thinks you’re practically bankrupt even a modestly successful launch can be good.

BlackBerry has other things going for it too. The balance sheet is still solid. Cash makes up approximately half of its market cap, and the debt is convertible to equity in the future, making it less of an issue. Prem Watsa still owns a mountain of shares, along with some of the aforementioned debt. And it continues to make headways in areas that aren’t phones, like its QNX software which is in a lot of in-dash entertainment systems in new cars.

Plus, rumors are swirling that the company is about to enter into a partnership with either Lenovo or Xiaomi, which I’m not even going to try and pronounce. That would open it up to China, which would be helpful. Selling a million phones to a billion Chinese wouldn’t be that hard. The stock would soar on news of that.

There are two ways you can play BlackBerry. You can either buy the stock (or the debt), or you can do it via a tiny investment company called Jaguar Financial. (H/T to this tweet for alerting me to the company in the first place)

Jaguar trades on the Toronto Venture Exchange, for a whole $0.02 per share. The market cap is $2.1 million, but it has a net asset value of $4.8 million. That’s approximately a book value of $0.044 per share, meaning the shares are trading at a 56% discount to book. (edit: it’s actually better than that. BlackBerry trades 9.3% higher than it did on September 30th, the date of the last financials. You’re getting BlackBerry shares close to 40 cents on the dollar.)

Jaguar has had success in the past. It has shown nice profits investing in Hudbay Minerals, Thallion Pharmaceuticals, Virtek Visions, Kinbauri Gold Corp, and others. Don’t be alarmed that you haven’t heard of these companies. Small companies are where the market inefficiencies lie. It’s just important to know that it has had success in the past, including payout out some of these gains as a special dividend in 2011.

What does the portfolio consist of now? Well, there lies a bit of a problem. Management isn’t exactly transparent in saying what it owns. You can get the gist of it from the latest filings, but there’s no true snapshot of what it owns. At this point this isn’t so important, but it would be nice if management was more transparent. The company has $5 million in assets. There’s no reason to be so secretive.

Here’s what it owns:

  • 69% BlackBerry
  • 31% other stuff, including some derivatives

Pretty simple, right? That simplicity is good.

If you’re going to invest in this company, look at it this way. As of September 30th, Jaguar owned approximately $3.3 million worth of BlackBerry. You’re paying $2.1 million for the whole company. Meaning, you’re paying $7.94 per share of BlackBerry, plus getting the other 31% of the other stuff for free. If you’d buy BlackBerry at these levels, then Jaguar is a screaming buy.

And like I mentioned, the price has gone up since then, so it’s an even better deal. The BlackBerry stake is now worth $3.61 million. That means that you’re actually paying just $7.26 per share of BlackBerry today, November 12th, when I’m writing this. And again, you’re getting $1.5 million worth of other assets for free.

Jaguar has some problems. I’d like for it to be more transparent in what it owns, and it’s paid some pretty excessive consulting fees during 2014. Also, if you look at its history on the TSX before being demoted to the Venture Exchange, it’s pretty lackluster.

The CEO is also involved with a company called Northern Securities, which ran into some issues with the Investment Industry Regulatory Association of Canada (IIROC). The IIROC accused Vic Alboni of not properly disclosing some capital leases while part of Northern Securities. He was eventually fined $600k and barred from serving as a “Ultimate Designated Person”, whatever that means. But on the plus side, he is one of the largest shareholders in Jaguar. Insiders own 23.5% of the company.

Ultimately, Jaguar is still a pretty good way to get exposure to cheap BlackBerry shares. There’s enough of a margin of safety in it that you’re getting the BlackBerry shares at a pretty good discount, plus exposure to the other stuff. If BlackBerry does sign a deal with Lenovo or Xiaomi, Jaguar’s shares could pop and the discount to NAV could narrow.

Disclosure: Position in BlackBerry. No position in Jaguar yet, but it could happen.

Nov 132014
 

It’s Eddie time, y’all.

Last week, I described and we explored the notion of sunk cost fallacy.  There have been many business articles written about sunk cost fallacy, yet many propose no solutions other than to be aware of it.  In this week’s article, I will propose some ideas to overcome sunk cost fallacy.

The best way to reduce the effects of sunk cost fallacy is to evade it altogether and not find yourself in a position where one has to contemplate it.

One method is through modularization. This idea is from my business mentor, who is an executive at a prominent and successful oil & gas producer in Calgary.  While we did not discuss sunk cost fallacy directly, he described how his company develops projects vice one of his competitors.  There’s no escaping numbers, but I’ll try to keep it simple.  Bear with me and follow my logic.

The decision revolves around how to develop an oil property.  It can either be done building one large plant at one time or by building it in phases that produce oil individually.

Table 1: Economics of an Oil Property

ABC Corp XYZ Corp
Project Benefits $10 billion $10 billion
Strategy Build 1 large plant Build a modular plant in phases
Project cost $7 billion 5 plants @ $1.5 billion each = $7.5 billion
Duration 3.5 years 1 year per phase
Net Present Value $3 billion $2.5 billion

Based on this information alone, the ABC strategy is better.  It results in a higher NPV and takes less time.  The cost of developing the plant and extracting the oil are lower.  Given the equal benefit to both projects, ABC Corp’s project is better.  Simple right?

However, the risk to ABC Corp’s strategy is much higher and is more susceptible to a manager faced with a sunk cost fallacy decision.  This is because it takes the entire project cost to realize one dollar in revenue.  If the project spends $6.9 billion and stops, there is no possibility of seeing revenue.  If the economic fundamentals of the project change midway through the project (say a drop in oil prices), the company is forced into a situation with implications of sunk cost fallacy.  Should the project continue despite it being ridiculously unprofitable?  Or do we cut our losses at $3.5 billion?

Management at XYZ Corp will not face such a daunting decision.  By building the plant in phases, albeit at higher costs, they give themselves the option to make more logical stops along the way.  If the economic fundamentals of the project take a turn for the worse, their maximum loss is less than $1.5 billion.  Or, despite the fundamentals being worse, the current phase of the project may still be worthwhile to develop given the relatively small amount of money needed to finish the next phase.  Although XYZ Corp will pay a higher cost to develop the project, they give themselves ‘outs’ over the duration of the project that allow them to better react to the changing economy and gives them more flexibility than ABC Corp.  Furthermore, modularization does not trap XYZ Corp into a situation where sunk cost fallacy can flourish.

Modularization is an effective way to avoid situations that present decisions where the magnitude of sunk cost fallacies can be high.  By investing small amounts based on market conditions and providing flexibility in decision-making, sunk cost fallacy can be avoided.

Note: the example outlined above is for demonstration purposes only and contains many inconsistencies from a finance perspective.  It is meant to illustrate the purposes of sunk cost fallacies and is not entirely accurate of the true costs and benefits of both strategies (for example, the revenue that each phase would produce as each is completed).  Take it in the spirit in which it was intended.

Nov 122014
 
"I'll meet you back here in 18 years when my wife is in charge."

“I’ll meet you back here in 18 years when my wife is in charge.”

Like our buddy Bill’s “problem” back in 1998, most accounting problems aren’t so bad. People huff and puff for a while, stuff looks like it’s about to get real, and then things go back to being normal again.

We can look at accounting scandals in one of two ways. They’re either intentional, or accidental. The intentional case involves an outright fraud. The accounting department knows the books aren’t right, but either the CEO puts pressure on the department to hit a certain number, or the CFO does it in order to hit bonuses. The unintentional case involves doing things a bit aggressively, and then finding out about it afterwards, either by a new CFO or during an audit.

The unintentional case is exactly what happened with Penn West. The company got a little too aggressive classifying operational costs as capital costs, which led to it citing a funds from operations number that was a little higher than it really was. That’s bad, obviously, and the company has since restated the affected numbers.

But how bad is it? Funds from operations isn’t even a GAAP value. There are certain liberties an accounting department can take with it. It’s all fine and good until the new CFO comes in and wants to do things “right”. This lasts for a few years until the new CFO wants to hit a certain number, and the cycle repeats itself.

We do this in all sorts of ways in our own lives. How often do you round up with pointing out something like your salary? Or round down when explaining to your spouse how much those new shoes cost? This is human nature, and it will continue forever. That’s one of the reasons why you should always insist on a margin of safety when buying a stock.

Recently, a company called American Realty Capital Properties (NASDAQ:ARCP) has been in the news, thanks to the CFO and one other guy intentionally inflating the REIT’s funds from operations number. The company immediately whacked the CFO and had a conference call to ease concerns, but it didn’t matter. The stock is down 30% since the scandal hit.

It’s easy to draw the difference between ARCP and Penn West. Or is it? Sure, one group did it on purpose, but there’s a fine line between helping your FFO number come at the best possible number and starting out with a number in mind and then doing everything you can to get to get the results to match it.

Depending on your perspective, an accounting scandal can either be a good buying opportunity or a good reason to sell immediately and never visit it again. Most investors tend to go for option B, which usually explains why a stock will sell off 30-50% even at the whiff of something improper happening with the books. Never mind that improper stuff happens all the time and people don’t get caught. We need to focus on the here and the now, dammit.

I took a look at ARCP last week when I first heard about this and ultimately passed. The company has grown like crazy since its IPO a few years ago, and word is it was bidding aggressively when assets come up for sale. That kind of growth at all costs mentality doesn’t appeal to me, so I didn’t get as far as cracking open an annual report.

But the whole situation got me thinking a couple of days later when I read about Proctor and Gamble’s problem in Argentina. Essentially, Argentinian authorities are accusing the company of over billing $138 million in imports in order to get money out of the country. Considering Argentina’s mess of an economy, I’m not entirely surprised.

This news came out on November 3rd. How did P&G’s shares do that day?

I’ll spare the suspense. They went up. Collectively, the market yawned at the allegations. Which got me thinking. What exactly is so special about this scandal that caused investors to not care?

There are a few possible explanations. It’s crazy Argentina and therefore doesn’t matter is certainly one. It isn’t really an accounting scandal, it’s more like a lying to a government scandal. And it just affects a small amount of the company’s business rather than the whole thing. But still, a scandal is a scandal. Why will investors dump a company like Penn West for a minor thing, yet not care in the slightest when P&G does something similar?

Here’s the point. Most accounting “scandals” aren’t a big deal. The company gets in trouble, corrects things, and ends up paying a token fine to regulators. It’s not a big deal. If you look at buying stocks that, after accounting scandals, are priced attractively, I think you’ll do well. A study done in 2002 isn’t exactly compelling evidence, but it shows that an investor would have beaten the market by nearly 20% if they would have bought a month after each scandal and sold a year later. It only covers 9 stocks, which is part of the problem, but I think this would work out well. Somebody should start an index of this. Hell, maybe it’ll be me.

Anyway, don’t be scared of accounting scandals. Be wary, and insist on a margin of safety, sure, but don’t be scared to buy.

Nov 112014
 

Hi kids. Nelson here. Today we’ve got a guest post from Rob Pivnick, who works for Goldman Sachs. This automatically makes him the smartest person who has ever visited this blog by a factor of ten. He wrote a book called What All Kids (and adults too) Should Know About . . . Saving & Investing. I haven’t read it, but Rob seems pretty smart. I’m sure it’s a good gift for your favorite millennial. Take it away, Rob. 

tiger

It’s a tiger. Or maybe a lion or wolf. And it’s bearing its fangs. And growling a terrifyingly menacing growl that makes the hair on the back of your neck stiffen. Predator saliva is dripping from those fangs, perhaps mixed in with remains of its last hapless victim.  You are a caveman or maybe a hunter from tens of thousands of years ago. Your life is at stake. What do you do? Fight or flight?

Money-Brain Connection

The hypothalamus in your brain is working overdrive with your nervous system and your adrenal-cortical system. You are sweating and trembling. Your hands are shaking. Muscles tense. Pupils dilate. Your body is processing the danger in lightning speed as your body tenses up and becomes more alert as it releases adrenaline into your bloodstream. Your heart rate and blood pressure increase. Your body actually shuts down non-essential systems (like digestive and immune) so you can more properly focus on the danger. Several dozens of hormones are released into your body that prepare you to deal with the threat.  You must do something. Or you could die.

It is the same bodily response that occurs when you wake in the middle of the night to the crash of a window breaking in your home – a burglar. Do something.

And, surprisingly, a similar response occurs in your body when the stock market has a really bad day. Behavioral finance experts call it “myopic loss aversion” – it’s the “fight or flight” of the investor world. And it is what causes most investors to “do” something instead of making sound decisions to stick to their long term plan. Instead of fangs and growling, however, investors see their long term goals and dreams vanishing. Early retirement . . . gone. Vacation homes no longer a reality . . . just pictures in a magazine. College savings . . . vanished.

Behavioral Finance – Is Loss Aversion Thwarting Your Investing Results?

You see, investors feel more pain from losses than pleasure from gains, which causes them to take a very short term (myopic) view of the market.   You may recall the feeling of nausea in your stomach the last time you checked your portfolio after a few days of huge losses. Take, for instance, the five or six trading days starting the second week of October. Volatility shot through the roof. Domestic equities fell over 7% from their September record highs. You had to “do” something about it, right? The result: most investors likely sold precisely when they should not, because they fear a big loss. It’s panic selling.

In 2008, a record was set for the most outflows of dollars from domestic equity funds because investors panicked (the market was, after all, dropping like a rock). What happened next? The market has been on an unprecedented climb since then, with returns reaching almost 200% from the market low. As of the date of this blog, it’s still climbing. And many investors missed out on that recovery.

Emotional Investing

Jump In and Out of Markets at Your Own Peril

The numbers don’t lie. Investors make emotional decisions that severely handicap their investment returns.  The historical average market return is around 8.5%. But somehow the average investor’s return is only 3-5% (depending on the source) because they get caught up in media hype and fear. Rational thinking disappears in times of stress. If you lost sight of your long term goal and panic sold and missed just the ten best days in the market over the last twenty years, your annual return dropped to around 5.5%. If you were unlucky enough to miss the thirty best days, your return was less than 1%.

Best Investing Advice – Stick To Your Long Term Plan

But you have a long term plan so stick to it. If you check your portfolio after every down day in the market, you open yourself up to reacting to myopic loss aversion. And your reaction is irrational precisely because you have a long term plan that you are ignoring.  You fear big losses.  But stay the course and do not react to sharp market declines. Fight the tendency to “do” anything that deviates from your plan. And do yourself a favor, do not check your portfolio as often. Then you will put yourself in a position to have to “do” anything and you will not react to the volatility.

Oh, by the way, if you did panic and sell after the early October drop, you missed the market’s best weeklong gain in over two years immediately after (almost 5%). In total since the drop, the market has rung up over a 9% return. I hope you did not miss out.

Rob Pivnick is an investor, entrepreneur, attorney, residential real estate investor and financial literacy advocate.  Rob has both a law degree and an M.B.A. from SMU in Dallas, TX.  He is a member of the board of directors of the Texas affiliate of the national Council on Economic Education.  Professionally, Rob is in-house counsel for Goldman, Sachs and Co. and specializes in finance and real estate.
 
Rob’s book, “What All Kids (and adults too) Should Know About Saving & Investing,” targets young adults/millennials with vocabulary words, fun facts, “Did you know?” sections, and 14 key takeaways. Statistics, charts and graphs from expert sources bolster the information. It aims to help students develop proper habits for saving and investing for long term. Not get rich quick. Chapters include budgeting, debt, setting goals, risk vs. reward, active v. passive strategies, diversification and more.  Visit www.whatallkids.com for more information. Twitter: @RPivnick.
Nov 102014
 

Say whattttttttt? Nelson, stop with the confusies. Your title is HARD.

Last week, Bank of Canada Governor Stephen Poloz made headlines for suggesting that the kids these days should BUCK UP AND GROW A PAIR by taking unpaid internships, especially if they’re living for free in their parents’ basement. Here’s his full quote for context:

… And the problem, of course, is the longer [finding a job after graduation] takes, then the more likely it is that a brand new graduate is more attractive to an employer and the folks that have been taking this thing hard and have not been able to engage in the workforce are scarred by it. And that makes it harder for them to engage with a good match where they’re most productive.

So we know that the labour market does not deliver its fulsome outcomes with a high efficiency, the high productivity matching until it’s actually running pretty hot. When it’s running cold like it is, it doesn’t.

So we have to be patient for that. And when I bump into youths, they ask me, you know, “What am I supposed to do in a situation?” I say, look, having something unpaid on your CV is very worth it because that’s the one thing you can do to counteract this scarring effect. Get some real life experience even though you’re discouraged, even if it’s for free. If your parents are letting you live in the basement, you might as well go out and do something for free to put the experience on your CV.

But anyway, our belief is that, over time, as the growth happens, there’s sort of a natural draw for those kids to get those new jobs. The vast majority of those jobs that new recruits get are in new companies, young companies. And we’re just beginning, I think, to have the right environment to get that. So we have to be patient.

(Notice how Poloz says “even if it’s for free” and get skewered for suggesting everyone should work for free? Way to overreact, everyone.)

These comments caused quite the… uproar (tee hee hee) from youth who are oppressed, underemployed, or just plain angry. Various responses to Poloz’s comments said that unpaid internships suck, that a lot of youth don’t have the luxury of living in their parents’ basement for free, and pointed out that he didn’t have to work for free at any point in his life, even though logic would dictate that one of Canada’s top bureaucrats probably stood out enough as a kid to not have to worry about stuff like this. “Normal” kids don’t tend to become the head of the central bank.

So what’s the deal? Is Poloz right?

Yes. Well, sort of. Struggling youth should do work for free. I’m just not sure they should do it in a structured environment.

I’m about 80% through Steve Wozniak’s autobiography. It’s a pretty enjoyable read, even though it’s obvious that he was an engineering genius who just happened to stumble upon the right thing at the right time. If it wasn’t for teaming up with Steve Jobs during a certain point in history he’d just be a moderately successful guy who built things for Hewlett Packard. To his credit, Wozniak fully admits this.

Wozniak’s experience is useful to this discussion because of what he did as a kid. It was clear he was smart. When he was 11, he built an intercom system so he and all his chums could discuss going out in the middle of the night to commit shenanigans. That might be more impressive than anything I’ve ever built. And he was 11.

But he didn’t stop there. Woz spent years of his childhood building gadgets, designing computers on paper, reading technical journals, and so on. Those skills might have translated into him getting paid sometimes, but for the most part he did that work for free. By the time he was in his early 20s, he had the skills to get a job with HP, dropping out of college in the process. How much of his success would you attribute to his college education? I’d put that percentage pretty low.

Hell, even YOUR BOY Nelson did the same thing. I researched stocks on my own for a decade until people paid me to do it. I had an interest in personal finance for damn near 15 years before I ever earned a dime off it. Sure, I didn’t pursue it, but that’s not the point. I put in years of unpaid work before getting paid. Now I’m in the position of being able to make a decent living talking about something that I enjoy.

Do you see the huge difference between what I’m talking about and showing up at a company one day and declaring that you’ll work for free? With my plan you have complete control over what you’re learning, rather than going to get coffee for some VP who just enjoys having a moron go and get him coffee. What’s more valuable — learning the stuff you’ll need to succeed or a bland “we didn’t hate you” reference letter from some middle manager?

From a hiring perspective, would you hire the guy with the unpaid internship, or the guy who worked a retail job but spent his evenings and weekends immersed in some related project? If I hired for a bank, you better believe I’d hire the guy with a successful finance blog over the guy with the internship. If I was hiring a software engineer, I’d be more excited about a candidate that could show me things he’s accomplished on the side. In today’s world of everyone going to college, it’s not good enough to get a degree and think you stand out. Work experience will always matter, and unconventional work experience will always matter more.

Do I think you should work for free? You’re damned right I do. But, like I always preach, do it intelligently. Control your own work, and come up with stuff you can be proud of. Don’t expect employers to magically hand you a job after completing 8 weeks of unpaid busy work at your uncle’s friend’s company. Take the path less traveled. It’ll work out, even if it takes a while. It’s not easy, but things worth accomplishing rarely are.