By Dan Ferris, editor, Extreme Value

Saturday, October 21, 2006

Why should you be reading him too? Dan's policy of buying valuable assets for pennies on the dollar has helped him compile what may be the best track record in the investment business. For one of his secrets, read on.

Imagine investing in a friend's business.

You invest $10,000. Since it's not a charitable contribution, you want to know two things: when you're going to get your money back, and how much you'll make in profit.

Your friend answers, "I don't really know when you'll get paid. It might be some time in the next six months, but it could be as long as five or 10 years. If things don't work out, you're probably never going to get paid... As to how much, I don't really know that, either. I think there's a chance I'll pay you about $10,000 over and above your initial investment. I hope it'll be more like $1 million, though!

"But if things don't work out, I'll probably just give you back your $10,000, minus a few thousand to cover my losses. If things really go poorly, you'll never get any of your money back."

You'd laugh in his face. You would never go into business under such terms. No serious or semiserious businessman would offer you such vague terms.

Yet, every day millions of investors are offered such terms, and take them. They buy stocks not knowing when or if they're ever going to get paid or how much. As if they were buying lottery tickets.

I think people buy stocks this way because they don't know how to figure out when and how much they're going to get paid from their investments. But it's not really that complicated.

If you're a bondholder, you know exactly when you're going to get paid: Four quarterly interest payments for some specified length of time, at the end of which you get back your principal.

The timing of gains in stocks is not nearly so knowable. In stocks, it's hard to predict when you'll get paid. But there's an easy way to calculate how much you'll earn.

If you buy a stock for 50% of what it's worth, you can expect to make double your initial investment — some day. If you buy at a 75% discount, you can expect to make four times your money. At a 33% discount, you'll make about 50%, and so on.

The idea is always the same. Once you know the value of a stock, the price you pay determines roughly how much you can expect to make.

An obvious question is, "what if you're wrong about your estimated value?" Bill Nygren at the Oakmark fund once provided me with a good answer. He insists on paying 40% less than his estimate of a company's value so that he'll have a sizeable enough margin for error.

When a stock reaches your estimate of its value, that's when you sell.

Few brokers or other investment advisers will ever tell you to sell. Many of them are content to take advantage of their clients' ignorance. If you sell at a profit, and the stock goes higher, they're afraid they'll look dumb. If you sell at a loss and the stock comes back, your broker or adviser is probably afraid that you'll be furious.

As long as you're holding, your hope is alive. The incentive of brokers and advisers is to keep you holding and hoping at all times.

Obviously, you're never going to make any money holding and hoping. You have to know when to sell. To know when to sell — really know, and not just guess — you have to determine value.

That's what I do in the pages of Extreme Value each month.

When can I expect to get paid? How much can I expect to make? Answer those two critical questions, and you'll always know when (if) it's time to sell. If you were in any other business, you'd demand at least that much.

Investing should be no different.

Good investing,

Dan Ferris

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IT FINALLY HAPPENED

It's When You Get Paid That Counts

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