Cabot Wealth Advisory 10/25/12 – The Warren Buffett Approach

I dislike politics–mostly because I shy away from controversy. I enjoy a good discussion, but I’m not the combative type. And I don’t like watching Obama, Romney or any other politicians jumping at the chance to get in front of a camera and lash out at their “opponent.” Usually nothing positive comes from a negative approach when the rhetoric is half true at best.

If you’re like me, you’re fed up with the political mud slinging and can’t wait for the November 6 election to finally arrive. And here’s another reason to look forward to the election to pass: In the past, the stock market has almost always rallied during the week following the November election, no matter who wins.

Warren Buffett has weighed in on who he wants to see win, but he’s quick to point out that whoever wins, the U.S. economy will strengthen during the next several years because the American free enterprise system is alive and well and has worked splendidly during our 200-year history with the exception of a few minor glitches. He sees no reason to believe that America will fall apart during the next century or two.

Why am I mentioning Warren Buffett’s name? Because he is the real topic of my meandering missive today.

Warren Buffett is someone I admire not only for his legendary investment skills, but also for his intelligence, wit, down-to-earth personality and generosity. Known as the “Oracle of Omaha,” his investing prowess has propelled him to become one of the wealthiest people on the planet.

Buffett graduated from the University of Nebraska-Lincoln with a B.S. degree in Business Administration. He then enrolled at Columbia Business School after learning that Benjamin Graham, author of one of his favorite books, The Intelligent Investor, taught there. He earned an M.S. in Economics from Columbia Business School in 1951 at the age of 20.

In 1954, Buffett convinced Benjamin Graham to hire him as a securities analyst in New York. When Mr. Graham retired two years later, Buffett started his own investment company. His initial investments in Berkshire Hathaway, a textile manufacturing company based in New Bedford, Massachusetts, and GEICO General Insurance Co. became huge investment successes and provided the foundation to generate large investment profits and cash flows. The profits and cash flows were then invested in additional stocks. This simple formula snowballed into millions and then billions of dollars in capital under management.

The profit formula was simple, but Buffett’s investment strategy was more complex. He never strayed from what he learned from his mentor, Benjamin Graham: Wait patiently for the stock price to decline to the desired level, buy when the stock price is well below the value of the company, and hold the stock forever.

Warren Buffett stated clearly: “The basic ideas of investing are to look at stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.”

For additional information on Warren Buffett’s fascinating story and investment strategies, click here.

I want to touch on another, related subject: Value versus Growth. I have always advised my readers to divide the stock portion of their portfolio into 50% value stocks and 50% growth stocks. I find, though, that many Cabot Wealth Advisory readers prefer to load up on growth stocks and disregard slow-moving value stocks.

Yet now is a great time to invest in conservative, dividend-paying, undervalued companies because they’re selling at bargain prices!

If the stock market continues on its merry roller-coaster ride, value investors can take advantage at both ends of the spectrum: Buying when it dives and selling when it soars.

If you want to invest like Benjamin Graham and Warren Buffett, here are eight guidelines to get you started in the right direction.

For this Cabot Wealth Advisory, I combined Warren Buffett’s and Ben Graham’s criteria for choosing stocks. To find investment opportunities for you, I looked for stocks with:

1)  Free cash flow more than $20 million – cash needs include dividends, operating expenses, capital improvements and research.
2)  Net profit margin more than 15% – a good indicator of growth sustainability.
3)  Return on equity more than 15% – a barometer of future appreciation.
4)  Discounted cash flow value higher than current price – Standard & Poor’s is a good source to find discounted cash flow estimates.
5)  Market capitalization more than $1 billion – small companies not allowed.
6)  Standard & Poor’s rating of B+ or better – indicates financial stability and steady growth of earnings and dividends.
7)  Positive earnings growth during the past 5 years with no deficits – very important to adhere to.
8)  Dividends currently paid – always important and helps your return, too.

I screened our Benjamin Graham Common Stock Database and found two high-quality companies that fit our criteria. Both companies are leaders in their sector, and both have excellent future prospects.

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American Express (AXP: 56.86), established in 1850, is a leading global payments and travel services company. Beginning in 1994, the company divested its ancillary businesses (including Lehman Brothers) to focus on credit cards and travel services.

International revenues make up a large part of AXP’s business. Increasing card spending and higher travel commissions spurred rapid growth during the past two years.

Sales and earnings declined in 2008 and 2009, but rebounded to record levels in 2011. AXP’s strong balance sheet and low customer defaults helped the company weather the recent recession. I forecast sales growth of 9% and EPS growth of 10% during the next 12 months, similar to the preceding 12 months ended 9/30/12.

The company’s new technologies in digital and mobile payments will help produce solid growth during the next several years. A stronger or more stable global economy could spur more spending by businesses and consumers, thereby boosting AXP’s revenues more than expected.

American Express shares are undervalued at 13.2 times latest EPS. AXP shares are low risk and offer a dividend yield of 1.4%. Warren Buffett’s Berkshire Hathaway owns 13% of AXP.

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UnitedHealth Group (UNH: 55.66) is a U.S. leader in health care management and provides a broad range of health care benefits and services, including health maintenance organizations (HMOs), point of service (POS) plans, preferred provider organizations (PPOs), and managed fee for service programs.

Gains from the rising Medicare population will be offset by future rate cuts in Medicaid and Medicare during the next several years. The recent acquisition of XLHealth, which serves seniors with special needs, will add to 2012 EPS and beyond.

In July, the U.S. Defense Department awarded its Tri-Care contract to UNH. The five-year contract will provide a noticeable boost to UNH’s sales and earnings.

UNH is gaining market share by lowering costs and increasing services to customers. I forecast revenue and EPS (earnings per share) growth of 8% during the next 12 months ending 9/30/13. At 11.1 times latest EPS of 5.00, UNH shares are undervalued. The 1.5% dividend yield and Very Low Risk rating make UNH an excellent investment choice.

I will continue to follow American Express and UnitedHealth Group and other blue-chip, high-quality companies in my Cabot Benjamin Graham Value Letter. My next issue, coming soon, will focus on undervalued stocks with low price to book value ratios. I hope you won’t miss it!

Sincerely,

J.Royden Ward
Editor of Benjamin Graham Value Letter

If Markets Are Unfair and Wall Street is Corrupt, Why Invest?

by Alexander Green, Investment U Chief Investment Strategist
Monday, September 10, 2012

The truth is a casualty in almost any election. But perhaps especially this year due to the tightness of the presidential race.

However, it’s not just the candidates getting tarred and feathered by political bombast, heavy-handed rhetoric and over-the-top political ads. It’s the free-enterprise system itself.

If you’ve paid any attention at all this year, you’ve heard four things:

1. Wall Street caused the financial crisis
2. Capitalism hurts the poor and middle class
3. Markets are driven by selfishness and greed, and
4. The free-enterprise system is inherently unfair

This is a troubling development, one that has serious implications for our economic future and your investment portfolio. So let’s take a closer look at these claims.

Are Wall Street firms responsible for the financial crisis? In part, yes. CEOs Jimmy Cayne of Bear Stearns, Dick Fuld of Lehman Brothers and Hank Greenberg of AIG all failed to understand the huge risks their firms were taking. Shareholders and employees suffered mightily as a result. There was plenty of collateral damage, too.

But these business leaders – and others like them – aren’t solely to blame. Politicians on both sides of the aisle spent years weakening lending laws to allow almost anyone to buy a home whether they could afford one or not. The Federal Reserve took interest rates too low for too long, making mortgages dirt-cheap and priming the real estate bubble. And plenty of Americans got caught up in the hoopla, figured they could get rich in a hurry by flipping a house using borrowed money they couldn’t reasonably repay. There is plenty of blame to go around.

Capitalism hurts the poor and middle class? Nothing could be further from the truth. Hundreds of millions around the world have been pulled out of poverty by the free-enterprise system. The evidence of history is clear. There is nothing that creates prosperity like capitalism. Have “the 1%” benefited more than most? Yes, but not because they somehow cheated the rest of us. Over the past 100 years, the U.S. has evolved from an agricultural economy to a manufacturing economy to a knowledge economy. Those with higher education and more technical skills are in greater demand.

This is a particularly nasty downturn but when the economy recovers – as it will – demand for all sorts of jobs will increase. In the meantime, how do you raise up the wage earner by pulling down the wage payer? As a young man, I worked maintenance on a truck terminal, the night shift in an auto-parts warehouse and a lot of other unglamorous, low-paying jobs for high-net-worth individuals. Yet never in my wildest dreams did I believe that sticking it to them would somehow benefit me.

The idea that markets are driven by greed is another misnomer. When does self-interest become greed? And who – in a free society – should tell you when you have enough?

Of course, it’s never you or me who is greedy. It’s always the other guy. The truth is, all markets are driven by rational self-interest. This is “the invisible hand” organizing society that Adam Smith praised more than two centuries ago. In The Wealth of Nations, he said, “It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest.”

There is nothing the least bit immoral about this. Free markets are about voluntary exchange for mutual benefit. Capitalism promises that you can have anything you want if you just provide enough other people with what they want.

But is the free-enterprise system unfair? It is undeniable that the rewards of capitalism are unevenly distributed. And some income redistribution is necessary to pay for the state and to finance a social safety net for the needy. But let’s also talk about the fairness of keeping the fruits of your labor. If the top federal income tax rate returns to 39.6% and you add in the average state income tax of 6%, plus Medicare and Social Security taxes, the government will take over 50% of many entrepreneurs’ income.

When you start or expand a business, you are taking a risk, one that could generate a loss for which you are solely responsible. But if you work hard or smart (or both) and are successful, is it fair for the government to take most of what you earn? (And that’s before sales taxes, property taxes, sin taxes and so on.) I don’t believe that’s the kind of republic the Founders had in mind when they pledged their lives, their fortunes and their sacred honor in what was largely a tax revolt against the king.

I mention these widespread misconceptions because if you truly believe the economic system is rigged, financial markets are unfair and Wall Street is corrupt, why invest? And if we don’t have a dynamic, growing economy to throw off hundreds of billions in tax revenue, where will we get the money to pay for essential government services?

I understand why candidates in both major parties are under attack, but I don’t get the hostility toward the free-enterprise system itself. What do we do after we strangle the goose that lays the golden eggs?

Good Investing,

Alex