Book Review: Warren Buffett and the Interpretation of Financial Statements

On the advice of a friend, I just recently purchased a book on how to read and interpret financial statements (income statements, balance sheets, and cash flow statements) for publicly-traded companies. Since I wanted to learn how to read these statements in the context of Warren Buffett's style of investing, I found the perfect title: Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage.

The book is a short one, weighing in at only 175 pages of reading. It also includes appendices containing model financial statements, an index, and a particularly useful glossary that not only defines a list of financial terms, but also explains the term's significance when it comes to finding signs of a durable competitive advantage in a company. The book goes through each type of financial statement, line by line, and explains its meaning, possible abuses, and usefulness in determining the health and advantages of a company. After each financial statement is covered, the book also has a few chapters on valuation of stocks, Buffett's equity-bond theory, and when to buy and sell a stock in Buffett style.

Overall, I've found this to be a helpful book that has expanded my knowledge of fundamental analysis of companies. It was an easy and informative read; I ended up finishing it in under 24 hours (which is saying a lot for me!) After reading the book, I summarized what I had learned by skimming each chapter over again and creating a Word document that contains a checklist of things to look for in financial statements when searching for whether a company has a durable competitive advantage.

I currently only own one stock position (it's been almost 4 months since I bought it) that I had researched a fair amount at the time of purchase. Armed with my new and deeper knowledge of financial statements, I did another analysis of the stock's financial statements based on my new checklist. Happily, the stock passes nearly all the line items on my checklist. This has renewed my resolve to hold on to the stock for a long period of time. However, good financials and a bargain price are not the only things Buffett relies on to become so wealthy. Warren Buffett is a believer in investing inside one's own "circle of competence", or "invest in what you know". The stock I own is a uranium mining company. Admittedly, I know very little about uranium mining, the accompanying industry, competition or external factors that can influence the company whose shares I own. In any case, I will hold on to my stock regardless and hope for the best, but in the future I plan on investing within my circle of competence. As Warren Buffett once said, "You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

Coming back to the book review, I would definitely add this book to my list of recommended reading. It remains to be seen how financially beneficial this book will be to me in the future, but my guess is that it will be greatly valuable.

To buy the book from Amazon, click the link below. If all you can see is an Amazon ad, just refresh this page. Disclaimer: If you do so, I will earn a small commission.

The Gold Standard: An Austrian School Contradiction?

One of the chief arguments of the Austrian School of economic thought is that a free market should be allowed to determine prices of its own accord. Fixing of prices leads to adverse effects on other areas of an economy that are not immediately obvious. For a detailed description or if you are not familiar with the argument against price-fixing (a form of economic planning), please read pages 190 to 209 of the following PDF of Economics for Real People by Gene Callahan: http://mises.org/books/econforrealpeople.pdf

In the pages above, the author describes a scenario in which a person proposes fixing the floor price of a stock at $10 per share. A conversation about this topic ensues, outlining why this would be a bad idea. Accepting the premise that fixing prices is a bad idea, I'd like to explore if it's also a bad idea to fix the rate of change of prices. In the example above, this would be equivalent to limiting daily stock price movement to a range of, for example,  -5% to +5%. Suppose the opening stock price is $100. This would mean that a floor price for the stock during that day would be $95 and a ceiling price for the stock during that day would be $105. In other words, fixing the rate of change of a price is equivalent to fixing simultaneous price floors and ceilings.

In my previous blog post "Inflation and the Optimal Money Supply", I outline the case for attributing inflation to rapid changes in the size of the money supply, and how fixing interest rates (a form of price fixing) is equivalent to tinkering with market supply and demand for cash holdings. Many Austrian School economists advocate the return to a gold standard to resolve this problem. In other words, every dollar should be redeemable for the equivalent amount of gold. Since the amount of gold in the world is fixed and only so much gold can be mined per year, then the money supply won't be able to change size so quickly.

One Warren Buffett quote that got me thinking was the following: "[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

If we want the same effects of a gold standard without needing to mine the actual gold, we would simply need some sort of law or restriction that the money supply can only grow by a certain amount per year, similar to how only a certain amount of gold is mined every year. In essence, we would want to fix the rate of change of the size of the money supply, which is a form of economic planning. As I've outlined above, fixing a rate of change of a price is essentially fixing the price to a certain range. Upon realizing this, I noticed a contradiction: the Austrian School advocates against price fixing and economic planning, and the Austrian School advocates a gold standard, which can be seen as a way of fixing the rate of change of the size of the money supply through economic planning. This seems to be a contradiction.

I don't know the answer to this conundrum, nor am I entirely certain that I haven't misinterpreted or mis-stated the beliefs of the Austrian School of economic thought. Comments are welcome, as I would love to know more about this particular topic.

Edit: I've thought of some additional insights on this topic; see my other blog post.

Alternatives to Government Bonds

Just recently, I've decided to sell all my government bonds for three reasons. The first reason is that I believe there could be a government bond price crash on the way. Secondly, I've just finished reading an introductory book on the Austrian School of economics. The Austrian School differs in many respect to the mainstream views of Keynesian economics, one of the most significant being the idea of government deficit spending. Keynesian economics recommends a government borrow money (by issuing government bonds) and spend beyond its current means to kick-start a slowed economy. The Austrian School feels that this is unsustainable, and I decidedly agree. For more details, see the link above to my other blog post about government bonds. My last reason is related to the second: I feel a moral opposition to holding my own government in debt to myself. I disagree with deficit spending, and it doesn't feel right to me, similar to how a banker shouldn't feel right lending more money to an already debt-burdened borrower, knowing full well that the borrower can't pay it back.

So, having decided the above, what should I replace my government bond holdings with? Government bonds are the go-to fixed income investment. They're typically safe (just pretend to ignore what's going on in Europe right now), and make a good hedge against stock market price movements and the risks of the equity portion of your portfolio. After some initial research, I've come up with some possible alternatives to holding government bonds. An alternative should fulfill the same requirements that government bonds do: produce income, provide safety, and price movements are independent of the stock market. Not all the suggestions below fill all the requirements perfectly, but they're what I've come up with so far.

1. Corporate Bonds - Most bond funds have some corporate bonds thrown into their mix. Corporate bonds tend to be riskier than government bonds, but they also tend to have higher yields. Corporate bonds satisfy the income requirement. However, corporate bond prices can take a hit just as hard as the stock market in an economic downturn. At least if a corporation goes bankrupt, the bond-holders are paid off first, then the preferred share holders, then the common share holders, so at least there is some safety.
2. REITs and Real Estate - Many people are still very wary about real estate exposure since everything that happened in 2008. However, if you're holding quality real estate investments that produce income (such as an REIT), rather than buying for the sake of capital gains, real estate can easily make up a significant chunk of a portfolio. Typical model portfolios I've seen on the web always seem to have "just a smidgen" of real estate exposure. If one does proper research, I don't see why real estate can't compose 10-20% of a portfolio. Real estate prices are supposed to move independently of the stock market, although that hasn't always been true in recent years. If safety is important, consider real estate investments such as companies that rent out to grocery stores and other essentials. Even in 2008, people still had to buy food, which means grocery stores were there paying rent so they could supply food.
3. GICs and Market-Growth GICs - While GICs typically offer very low yields, they are still a possibility. Another alternative is the market growth GIC. If you buy one of those, you could earn interest anywhere from 0% to some ceiling, depending on how the stock market performs over that period of time. While your principle is always guaranteed, you should be comfortable with the fact that at the end of the term, you may not end up earning any interest at all.
4. Gold - This last list item doesn't produce income, although I'm starting to give it consideration. Gold prices tend to increase as inflation increases, and governments always seem to be printing more money to pay off their debts and causing inflation. This could make gold a safe investment. There are many ways to get exposure to gold, and I'm researching more on the topic.

My holdings in government bonds currently consist of mutual fund units that can't be sold for 90 days since purchase without incurring an early-sale penalty fee. I intend to stop purchases and wait the 90 days to digest the information I've stated above and to consider alternatives. I might post back again in 2012 about what I decide.

The Coming Government Bond Price Crash

Today, I finished an introductory book on the Austrian School of economic thought. The differences in economic beliefs of the Austrian School compared to the mainstream Keynesian school of thought are quite stark. According to Keynesian economics, when the economy is slowing or has slowed down (recession), the government should use deficit spending and set low interest rates to kick-start the economy again. Ever since 2008, the U.S. federal funds rate has been quite low, and the federal debt has increased significantly. Canada has managed to grow federal debt at a much slower rate, however interest rates in Canada are also quite low.

Because both countries are in relatively large amounts of debt (although to different degrees), both countries have a significant portion of the federal budget devoted to interest payment on that debt. There are three ways a government can obtain income for the purpose of spending: taxes, borrowing, and printing money. Tax increases are quite difficult to implement due to typically fierce opposition. This leaves borrowing, and printing money. Since governments are aware of what can happen if too much money is printed (hyperinflation), printing money may still be used to service debt, but not likely in excess. All that is left is to borrow more money to pay the interest on currently borrowed money. The U.S. debt scare during the summer of 2011 is proof that borrowing will simply continue because it's the only way not to default on interest payments (never mind paying down the principle amount!).

The method through which the government borrows money is to issue government bonds. Individuals and institutions buy these bonds, and receive their principle back plus interest at a later date. As with many other securities, bonds can be bought and sold on the market. Bond prices tend to move opposite of current interest rates at the time. To see why, consider the following. A bond yielding 2% interest is offered on the bond market for a certain price. Interest rates go up, and new bonds being sold yield 3%. Why would anyone buy the 2% bond when they could buy the higher-yielding 3% bond? To attract buyers, the price of the 2% bond must go down. If interest rates were to go down to 1%, the bond yielding 2% is now actually more valuable because it yields more interest. If this is the case, the price for the bond goes up.

As with any market good, bonds are subject to the laws of supply and demand. If there are few bonds being sold (small supply) and lots of people wanting to buy bonds (large demand), prices will tend to go up, and the highest bidders will get to buy the bonds. Conversely, if there are lots of bonds (large supply), and not many people wanting to buy bonds (small demand), prices will tend to go down to try and attract buyers.

At the current moment in time, it is difficult to tell what the demand for bonds is. Some consider bonds a pretty safe investment, and so may want to buy bonds. Others may not want to invest in bonds because they want access to their money right away, or they may not want to do any investing whatsoever due to all the horror stories about the economy not doing well. However, due to the government needing to borrow to service debt, it is safe to assume that the supply of bonds will in the best case stay constant and in the worst case increase.

Given the above statements, it is easy to summarize what will likely happen to bond prices in a chart:

Since it is more likely that the supply of bonds is going to increase, the price of bonds will either stay where it is if there is enough demand for bonds, or the price will fall (either somewhat or significantly). But remember the effect interest rates have on bonds! (Not represented in this chart). If interest rates go up, bond prices tend to go down. Interest rates are already low, and so have nowhere to go but up. So if we factor in that at some point in the future, interest rates will eventually go up, we can conclude that bond prices are in for a plummet at a certain point in time. This point in time will be when there is increased government borrowing and increased interest rates, both of which are almost certain to happen.

Success #3: Back To Business

Well, this blog of mine seems to have been feeling kind of neglected lately. It's because of many reasons, some of which are that I started blogging about finance on my work's internal blog not viewable by the public, I've been very busy with university, and I haven't had many funds available for investing.

Since I only started learning about personal finance about a year and a half ago, my views on how to invest have been constantly changing. In addition, I've been reading some books on value investing, as well as economics. Since it was my birthday in August and I changed from age 22 to age 23, I figured it was time to update my blog title. Not only that, I felt that a theme change would be fitting for my renewal in this blog's interest.

So what can you expect in the future on this blog? I'll be blogging about economics, as well as personal finance and investing. I'm decidedly a big believer in income investing and value investing, and I've learned much about how money is created, what central banks are, and some views on how those should play a role in the economy as a whole. I'll add a new "economics" label for posts so that there is a new category, as well as an "opinion" label. I hope you enjoy Starting Started at 22's revival!