My time in residency has come to an end, finally after 6 very long years. Nothing seemed final, until the movers came to pack up our home. Luckily this is paid for by the military, I can only imagine what this would have cost if I had to procure everything on my own. As I sit here our home is quiet now for the first time in 9 years, there is nothing left but a desk and the computer I’m typing on, and our two cats.

My wife and kids have moved before me, they made the drive a week ago, while I stayed to facilitate the move, and get all my final out-processing complete. We were very lucky, in that since the military has paid for my training I was able to save enough to put the down-payment on a home where we will be moving to.

We spent a long time agonizing over the pro’s and con’s of the rent vs buy decision. I even considered moving on base for a while, however this is not easy with a large family. Ultimately we came down on the buy side more so for emotional reasons then financial ones. I think that Schiller has a chart somewhere that shows the home price appreciation over 100 year span, and it basically is around the level of inflation. Suffice to say the people who make money by owning homes are in general renting them and not living in them.

I remember taking a real-estate appraisal class in college, which given that I was a Biology major did not really count towards anything. But I stayed in class and asked the teacher one day, almost incredulous as to why a home built 30 yrs ago could be worth just as much as a home built today, it just didn’t make any sense to me. Now he really was frustrated with me and didn’t see why I would be confused. The truth is it’s not, unless you put the capital expenditures into it, to keep it at the level of appreciation that is afforded by inflation. Otherwise you run into the situation that home flippers profit on, finding old homes that have never been renovated. Probably obvious to most people, but it wasn’t so obvious to me back then.

Another factor that has weighed the decision, was the general state of the market, and forward expectations for returns. There was an interesting CNBC interview with Buffett, where he discussed buying a home as a means to short the dollar. I thought this was a really interesting idea and worth examining further.

To short something is to borrow and sell it today with the plan to repurchase it at a future time for less then what it was sold for.  You are borrowing money to buy an asset  and paying it off with a currency that is depreciating in purchasing power over time. I.E the dollar you pay in year 20 is probably worth about 40-50% of the dollar you paid in year 1. It ‘s analogous to taking a large short equity position and covering 1/30th of it per year. There is also the tax advantage of being able to deduct the interest of the loan and the tax shelter for any gains when sold. Definitely interesting when you think about it.

There seems to be a consensus in the value community, depending on who you read, that value is something that can best be found in small cap companies. This is a mantra that has been repeated in one form or another by many many different value oriented investors. It was born out in a famous study by Eugene Fama and Kenneth French. It has been repeated so much that I took it as a truth, it was a strategy that really made sense to me, until recently. What changed my mind? What am I even talking about? Keep reading.

The idea is basically that large cap companies are so visible and followed that it’s impossible to develop an informational or analytical advantage over the other players (large hedge funds, sovereign wealth, family offices, endowments, pensions etc.) They have vastly more resources to devote and so are much more likely to be able to correctly judge the value. Carrying it a bit further, the efficient market hypothesis should pretty much apply in these situations. This means that all the relevant information is baked into the stock price for large companies, including future projections for returns. There should be no alpha to gain.

Conversely small cap stocks are thought to be unloved and under-followed. The small size means that entities that have large amounts to invest cannot make meaningful returns, without spending the effort to analyze thousands of these small companies, and there are just not that many good ones. So they focus their time instead in the big companies where they can put much more capital to work, without worrying as much about liquidity, and without having to worry about filing SEC form 13D. In some cases an informational or analytic advantage can be found, because there are fewer people looking.

People with small amounts of capital should be enticed by the above structural inefficiencies. Small amounts of capital can be put to work in these obscure, small situations.  Meaningful returns can be made. You don’t have to compete against large investors. Why would anyone with small amounts, not want to work in this space? I sure thought it was a great idea for a long time.

First the factors I have described above are well known to many people, value investors in particular.In aggregate all these individual and small investors add up to a collective large competitive force. You are in fact competing against all this talent, looking for opportunity. You are trying to come in before the crowd, purchase some undervalued company, and wait for everyone else to catch on. But as an individual, competing in this pool, what are the chances that a company that appears to be a bargain will be so. I don’t have evidence, but I have a feeling this formerly empty space has become quite crowded, notwithstanding the recent issues surrounding people searching for yield.

Second these undervalued obscure companies by their nature take a long time to mean revert. Since they are less followed, it can take a painfully long time for the critical mass of value recognition to develop. Small companies also have less flexibility, one bad move can really damage the equity.

May I suggest an alternative? What if it were possible to find large undervalued companies. They exist, I can assure you. Sometimes in the normal course of business, bad things happen. Recently Wells-Fargo had a scandal, they cheated millions of people, caused great damage. A couple of questions come to mind. 1. are banks being undervalued as a group due to prevailing but temporary low interest rates? 2. what are the switching costs for existing customers both retail and institutional. 3. does the bank have a large benevolent investor, who has a significant stake and a track record of stepping in either behind the scenes or directly to salvage his investments when big PR problems come about? These factors in combination with the scandal created a very good value proposition in a large liquid company. In this case you don’t need superior information, just a divergent view. An additional benefit is that with so many people looking at the company as soon as the smoke clears, the revaluation will occur, and fairly quickly.

But if everyone is so smart and spending so much energy looking at this stuff, how do these events occur, shouldn’t people be able to figure out that some setbacks are temporary (obviously some aren’t as well). But with all the high paid wall-street types and market efficiency, it seems like sorting should be possible, yet the price still drops with bad news. I don’t have a great explanation, but you can still take advantage.

How about AXP and the loss of the COSTCO account?

I would challenge you to look at the next big scandal or adversity for a major company and ask if the damage is permanent or temporary. Big companies can take damage and not sink (think battleship). Think about 5 years out, will people still even remember the scandal? As John Templeton famously said, the time to buy is when there is blood in the streets.

Something that is well known to value oriented investors is the concept of averaging down. It can be something, if used correctly that can really add to returns over time. But as with anything it’s a dual edged sword.

You can do one of three things when the price of your stock goes against you. (1) you buy more, thus averaging down. (2) do nothing , (3) sell.   (1) presupposes that you have money to buy more, which is why its a good idea to average into and out of positions.  From my own experience , when you find a good idea, that seems undervalued, there is a temptation to buy as much as possible immediately. This should be resisted, in my experience sometimes a value gap closes quickly right after purchase (usually a catalyst was involved). More often then not though, the price will move against you for a period of time. This makes sense, because if you think about it the kinds of stocks we are interested in are ones that have been neglected for some reason. This usually has some momentum to it, it takes time to change the investing public’s perception.

If you do nothing, then you are going to wait for the value gap to correct, collect dividends if the stock pays one, and continually assess and reassess that the story remains intact, and there wasn’t a fundamental flaw in the analysis. As a general rule if a position moves against me by 20% or more, I will completely reevaluate it, to make sure there wasn’t something that I missed. If I’m satisfied that nothing fundamental has changed with the thesis, then I will continue to hold. A usual holding period for me is 2-3 years, sometimes much shorter depending on how long it takes for the valuation gap to close.

If you sell then you are either admitting you were wrong about something in the initial analysis, or something fundamental changed about the business. This is ok. I have saved myself much pain, by admitting mistakes early. The key is to redo the analysis, think it through again. Don’t delay this, as a group value investors seem to be more content to sit on a loss, and it’s ok as long as the thesis is intact. No value investor, likes a permanent loss of capital, it violates the first two fundamental rules of investing (for Buffett fans). Taking a loss is where the humility factor comes in, you have to be humble enough to admit a mistake, learn from it and move on.

In contrast to the sell decision is the decision to average down. This is in essence one of the most powerful techniques available to the value investor to increase returns, outside of leverage. Averaging down requires the conviction of your own analysis  and a deep understanding of the value of what your buying. In another words you have figured out ahead of time, what the entire business is worth, you already bought at a discount to that, and now your buying a bigger discount. This is where risk and return are paradoxically inverse to one another. You have less risk because there is a bigger margin of safety, but there is a higher possible return because the value gap is larger.

Of course if your wrong about the price, then you will be guilty of throwing good money after bad. You will magnify your losses. So it’s critical to be dealing with a business you can understand and value with a range of possibilities that favor gain.

I have been averaging down on several things lately. Some of the largest value gaps I’ve seen since 2008 have appeared in some of the stocks I own. The last 2 years have been fairly tough for value oriented investors, but we will have to see how 2016 goes.

This year has been pretty much status quo, I returned to work after having a year off for research. My wife has worked hard to pay off her student loans, which were finally paid off this month. But otherwise no big changes. My plans for 2016 are to get our car debt paid off, once that is accomplished we will be pretty much debt free. That’s after entering 2015 with over 80k in debt. I say pretty much, because we still have federal tax that we owe from last year, and will probably owe some more this year, although not as much due to changing the withholding on the W2.

I’m far from being the most frugal person on the planet, but I have been getting better about it. I have started to pay attention to the sale signs at the store, now I basically buy what is on sale and plan the meals around that, so what we eat depends on what is on sale that week. Also decided to start doing self haircuts, however this does not really make a big difference, I think YTD maybe have saved 320$ between myself and son. The main benefit is not having to wait in line at the barber shop.

According to the year end summary from Mint.com, I am now worth 80k. Given that I have been working since I was 16 this seems like nothing. But I think that in the next several years my savings rate is going to improve. We have been locked for the past decade in one of the highest cost areas in the US, the D.C area. I have been here for my job, but starting in mid 2017 we will finally be able to move. I suspect the changes in rent alone will allow me to save an additional 10% of my income. Starting in mid 2016 my youngest child will be moving into kindergarten, and ending finally his daycare expense, which is 150/week after the subsidy my job provides. That will be an extra 600/mo for savings and investment.

My wife has finally paid off her student loans, this is after paying 3-4k a month towards them for about 2.5 years. We made this a priority which could be debated if it was the best course, but it’s what we decided. Now she is student debt free. It’s really amazing how long it took to pay off, given how much extra she was paying. When she graduated with her masters degree, she was in the top 1% of her class. She was offered a spot in the PhD program, but we declined, because the student debt would have been horrible, and the final pay would not change much if at all, probably the best financial decision we made so far. Sometimes if you just avoid bad things financially, that goes a long way. My wife has friends that owe several multiples of what she did, I’m not sure they will ever pay it off.

Combined we owe about 40k in car debt, 25k me and 15k her. Really really dumb. I bought a nice SUV 2 years ago for 34k, which was used and half the cost of new, wife got a brand new RAV 4 for 30k. What I didn’t realize was how much my vehicle would depreciate, even buying used. It has dropped in value from 30k to 18k over the past 2 yr. Her’s is probably worth around 20k or so now. The big goal for 2016 is going to be to get the car debt paid off before year end. At which point we will be debt free. I will never buy another expensive car, it’s just not worth it. I’m not sure how to explain it, maybe I was insane at the time. I certainly knew better, but I just ignored the logic side of my brain.
Summary 2015

Gross Income Family: 220k
Additional Savings: 10k
Debt paid off: 100k
Debt remaining: 40k
Investments: 58k (50 in index, 8 k self managed)

Family Net Worth 70k
Savings Rate: 10k/220k=4.5%

Goals 2016:
1. Pay off 80-90% of car debt 40k
2. Invest 10k, into either index or self managed accounts
3. Start TSP investing 2k/year (166/month).
4. Improve savings rate to 10% (22k)

I have spent some time this summer/fall reviewing real estate investing topics. There is so much crap on the internet on this topic, its unbelievable. It seems like everyone and anyone thinks they can get rich with real estate. The hype and misdirection takes a long time to sort through, but since I have waded through all the crap to bring you some simple fundamental principles behind this method of making money. I’ll just discuss rentals for now.

I became interested in this topic probably 12 months ago. There are a number of famous people who got their start with real estate investing. Andy Beal comes to mind. He made his fortune initially buying dilapidated government owned apartment complexes, then turning them around. He later formed his own bank, and made a large amount buying loans at discounts. The Professor, the Banker and the Suicide King is a good book that profiles him to an extent.   The key with all the stories of the successful people was that they were buying for less then the value of the property to begin with, not buying and hoping for appreciation because someone else would like it more.

My conclusion after studying the asset class is that if you have the skill and patience to wait for the correct deal it can be a  worth wile diversification. If you want to go out and buy a house and rent it just so you can say your a real-estate investor, its going to be a waste of time. Many people unfortunately fall into the latter class, because guess what that is the easier path. I want you to remember when you hear the term real estate investor, that to paraphrase Orwell, all investors are equal , it’s just that some are more equal then others.

Some Thoughts/Tips:

1. Its a business– Buying rental properties is a business, plain and simple. If you approach it like a hobby or a “passive income source” you are in for some trouble. The people who make money at this are systematic and have a process they implement. It takes time to build the process, but you can learn it.

2. Know your numbers– You have to understand what the value is that your paying for. Basically the house is an asset that when rented will generate a cash flow. From this cash flow you have to deduct out the expenses of running the business such as insurance, reserve account for repairs, taxes, mortgage payment.  I would suggest that if you can rent the home for 1-0.7% of its value per month it will work out fairly well. In another words a 100k home would rent from 700-1000/month for it to be a property worth your consideration. If you annualized it this will work out to a return of 8.4-12%  of the property value per year, some of that return will go to the mortgage servicing. As the property is paid down more of it will become free cash flow that you can use to either save spend, or acquire more properties. With that said it is fairly tough to find homes that sell for 100k that rent for 1000. It may be done in some markets by buying retail properties ( those listed in MLS and sold by agents), but most of the time you will need your own marketing campaign to find them, and skill in negotiation to get the price to a level that makes sense.

3. You will be managing people– Part of your business will be dealing with the public. As part of this you will need to create criteria for tenant selection, from which you will not deviate. If you do , maybe because you feel sorry for them, you will have a big problem. The legal implications of moving the wrong person into your home can be painful.  Not only can they physically damage the property, and never pay for it, they can also make it very difficult to evict them. By the time it is said and done you can be out thousands of dollars, completely screwing up the value proposition from doing this. The important point is that you set up criteria based on income to rent ratio (I would suggest that rent be no more then 30% of their take home after tax pay), credit history, previous rental history (have they ever been foreclosed on?), and home visit (what does the property they live in now look like, because that is what yours will look like in 12-18 months after you rent to them).

4. Risk– In buying a single home you take a large amount of risk. Lets say that the current tenant moves out, and it takes you 3 months to get the property re-rented, that means you lost 25% of your revenue for the year, say good by to any positive return that year. If you have a run of people leaving this could really eat into the return, this is limited by good tenant screening. There are other types of risk inherent in owning a single asset, environmental risk (hurricanes, fire , hail), area risk (the value falls because of surrounding economic, political or population reasons).

5. Scalability– To do this you have to have the credit to get mortgages in the first place. Second, once you reach a certain number of homes it will be difficult to get financed from traditional sources, ie big banks. Some regional banks/ credit unions will make exceptions, so called portfolio loans. There are also friends and family. Finally there is something akin to running an investment business called syndication. But for most people the upper limit of this will be 2-3 mortgages at any one time. Also the work that goes into managing multiple properties will be rate limiting if you have a job that is more demanding.

Source: http://www.pakwheels.com/blog/free-car-advisory-service-pakwheels-members/

Learning how to maintain a car can save lots of money over the long pull. In addition when a repair is needed that is outside your scope you will be in a much better position to make sure you’re treated fairly if you have some basic understanding of how cars work. With youtube you can find almost every repair you could do easily documented for review.

I started learning about cars as a young kid probably 5-6 or so. My grandfather was a mechanic and worked for a man named Smokey Yunick on some of the first cars that were raced on Daytona Beach and what was the predecessor of NASCAR. I remember him explaining the concepts of engine/transmission operation and combustion cycles. I absorbed a lot from him, but really had no interest in cars until much later. I took a course in high school which was a shop class where we fixed the cars of teachers and students. Probably the most useful and practical course I took. From that basis I taught myself repair from simple maintenance up and to the point of being able to swap out or rebuild engines and some simple fabrication with MIG welding.

The basics of engine operation are fairly simple. The modern car engine runs off a 4 cycle system. Intake, Compression,  Power and Exhaust strokes. Intake is where fresh air and fuel are sucked into the engine (in a specific ratio) as the piston moves down. In the next movement the piston goes up and compresses the mixture. Once compressed the spark plug fires igniting the mixture and pushing the piston down (this is where the horsepower is actually generated). Finally the piston moves up again from inertia and pushes out the old air and is ready for the next intake cycle. To run a engine needs fuel/air in the correct ratio(usually not a problem in fuel injected engines), spark(adequate strength), and compression (no leaking gaskets or piston rings).

Source: http://en.wikipedia.org/wiki/Four-stroke_engine

To start the journey I would recommend getting the repair manual for your car and learn the following:

1. Brake Pad and Rotor Replacement (both disc and drum).
2. Oil Change and Filter
3. Cabin and Engine Air Filter Change
4. Transmission Fluid Change
5. Radiator Coolant Flush and Change
6. Learning how to change a Battery

Learning these things will save you some serious money, for example we took my brothers car in for inspection and it needed new brakes. They quoted us a price of 600 dollars. I was able to do the job in 2 hrs (at a leisurely pace) with about 100 dollars in parts, effectively paying myself 250/hr. If you have more then one car this is multiplied (I have 3 that I’m responsible for the maintenance). Another job that perpetually saves money is oil changes, takes about 10-15 minutes and if you use synthetic oil like I do you will save 30-40 dollars every time by doing it yourself.

I’m not going to create a step by step for how to do this stuff as it’s widely available elsewhere and there are small variations based on make and model. These jobs can be accomplished with simple hand tools for the most part.

The next time you need one of these repairs done give it a shot yourself first. Worst case if you find that the job is to much put it back together and drive it to a shop. By learning and practicing this stuff you can save some money, which will compound and allow you to reach retirement that much sooner.

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Warning more info then you probably care about:
*An aside about the gas blends available at the station. Have you ever wondered about the differences in octane and why to choose one or the other

? 87 vs 91 vs 93. Well here is the simple explanation. Octane is a fuel stabilizer, it prevents premature explosion of the fuel under pressure. Most car engines are designed to run on 87 octane. By designed I mean specifically the compression ratio which is a proxy for how much pressure is generated in the engine prior to combustion (most cars are between 8 and 10 to 1). Some engines particularly the ones in luxury cars use higher compression ratios (between 11-13 to 1), if this is the case the engine needs a higher octane fuel to prevent something called detonation. Detonation is where the air/fuel mixture explodes prematurely and it can harm the engine. It happens because as air is compressed it heats up (the air molecules hit each other more frequently and generate a kind of friction).More importantly, Changing the octane of the fuel does not change the power output of the engine. Meaning if you drive a honda civic your wasting your money by using a higher octane fuel or octane boost from the auto parts store. Race cars particullary ones that are super or turbo charged will use very high octane fuel 100 or higher to combat detonation. But again detonation is a consequence of using higher pressure in the engine, using high octane fuel in a normal compression ratio engine is a waste.

Reading this it turns out it wasn’t as simple an explanation as I thought hence the warning, but at least we were able to avoid the organic chemistry behind octane, maybe another time.

Learning to cut your own hair, for fun and profit. I got the inspiration for this first from a friend who has been doing it for 10 years, I never knew although I am fairly oblivious to fashion. Also I remember from my childhood an uncle who always did this, my parents made fun of him, and gladly paid 15$/person for haircuts. I used to be in the same camp, but my way of thinking has changed. Where we live now haircuts are about 20/person with tip. Myself and my son need a haircut about once a month. My brother also gets one about once a month. Together this is 60/month or 720/year or 7200 over 10 years, add in compound interest and we are probably forgoing 10-15,000 dollars on haircuts alone over the next decade.

Given all that I decided to try an experiment. The steps are as follows. 1. buy a set of clippers, I found a set on Amazon for around 30 dollars made by Wahl, that was fairly well reviewed. 2. Watch some videos on Youtube on how to do self haircuts, for men it’s fairly simple. 3. Try it out, have a broom ready to sweep up afterwards.

The results were not bad, I have given myself a total of 2 haircuts so far (40$), and my son one (20$) so the clippers have paid for themselves. Now its obviously not pro-quality haircuts, maybe I would make an exception for picture day or something but for most intents an purposes the quality is reasonable. My wife and daughter will still be going to the salon, but I feel I have made at least a dent in some unnecessary spending. I will be doing this from now on and invest the savings. I will be looking for other DIY things where I can have a larger impact on spending.

Link to the clippers we used. 

I was watching an episode of Shark Tank last night and started to wonder how the show would be different with different “Sharks”.

Last night I was trying to imagine knowing what I know about Buffett, most of which comes from his biographies and shareholder letters, how he would react to the business pitches. Buffet has three main principles he applies to investment. One of his first principles is stay inside your circle of competence, I imagine he would be passing on the vast majority of the proposals. Some of the Sharks seem to be willing to take a swing at almost any pitch, except for the truly ridiculous. The problem with this is that there are unforeseen problems with the various businesses that you will have no way to anticipate if you are unfamiliar. You can see this in how some of the sharks will pass on businesses that they would have previously invested in, because of past negative experiences (i.e they lost money). One way to avoid losing money is to refuse to participate in investments where you do not have a deep understanding of the risks and how the company makes money.

In particular on the shows I have seen, most of the sharks seem to love the branded consumables (chips,pretzels, cookies, peanuts, peanut-butter etc.) The problem with these businesses is that they truly have very little competitive advantage (another Buffet principle), which is sometimes mentioned on the show, but infrequently. What I mean in this case by lack of competitive advantage is that basically anyone can create another branded consumable and market it. The problem with not having a competitive advantage is that, in financial speak your returns will equal your cost of capital over time (the returns you have to promise or are expected to entice investment). What that means is that every dollar you invest or someone else invests into the business will increase the value of the business 1$, so you are not really getting anything for those extra dollars over time. The reason for this is competition and unless you are investing on terms which greatly undervalue the business your better off spending the money elsewhere.

The last Buffett principle is buy with a margin of safety and it’s hard to tell if the Sharks are doing this or not, because many of these businesses have not earned a profit. The margin of safety principle states that you want a buffer between what you pay and the value of the business. This is to protect against unforeseen business downturns or various problems and hopefully limit or eliminate the chance of major loss. It’s difficult to value a business that has not yet earned a profit, or that has only been in business for a few years. The range of possibilities is so large that even assuming Buffett found a company on the show that met the first two tests, this last one would probably kill the deal. This is because to invest where the range of possibilities includes losing all of your money(if you were willing to take that risk) means a very large discount upfront, probably one that most entrepreneurs would be uncomfortable with.

In summary the three principles that Buffett often talks about are 1. Circle of competence (staying inside it) 2. Durable competitive advantage and 3. Buying with a margin of safety. If he were on Shark Tank I think there would be much less activity and probably hundreds of pitches before he swung as it’s difficult to pass all three tests. This would be more profitable for him, but not make for such great T.V.