Many people think of the stock market as being akin to a casino.  Truthfully, for many market participants that engage in speculation or market timing, it is very similar to a casino.  This is where Warren Buffett’s mentor Benjamin Graham brought so much value in his epic books Security Analysis and the Intelligent Investor.  In those books Graham emphasized the fact that, stocks are simply fractional shares of a business.  They aren’t just flippant pieces of papers changing hands.  Underneath every business is a balance sheet, cash flows and earnings.  It is these factors that drive long-term pricing.  Market-based activities that are not based on fundamental analysis and thorough research are much more consistent with being speculative in nature.

Graham also came up with the concept of “Mr. Market.”  To summarize, imagine you have an erratic next door neighbor that each day offers you a price to buy or sell a fractional share of a business.  There are some days when your neighbor is extremely optimistic and will pay insanely high prices.  The common stock of a Tesla or Netflix are two great examples of businesses where market participants are willing to pay 200 times earnings for hopes of an optimistic future.  Other days your neighbor is extremely pessimistic.  He reacts to the bad news and thinks the world is going to hell in a handbasket.  On these days he will sell you his stock at incredibly cheap prices.  The market is just that, a market where you can buy or sell.  Prices fluctuate, but as long as you understand that it is the underlying value of the businesses that matters you won’t let short-term market swings and panic define you as an investor.  This is what is so great about value investing.

It is certainly true that most money managers don’t beat the S&P index.  Most mutual fund investors do far worse than the funds themselves because they buy in times of optimism and sell in times of pessimism.  In times when the market is incredibly cheap, an index fund is not a bad investment as it requires very little work.  When the market is expensive, index funds are horrible investments because you can’t avoid losing when valuations contract.  This is why so many people got wiped out in 2000-2003.  They rode the momentum stocks and tech funds up, but prices got out of whack with the underlying fundamentals of the business.

Take a company like Bank of America; currently, the stock trades around $16 a share.  Many people think of Bank of America as being a terribly run bank due to its legal and financial troubles that emerged in the Great Recession.  Bank of America was actually one of the stronger and better run banks before the Countrywide acquisition, which was the worst acquisition in history.  Bank of America has done a great job in cutting costs, delivering profits and emerging from its legal entanglements.  Now those risks are in the past and what you have is a financially strong bank with per share earnings power of $2-$2.50 per year.

Earnings have been lower the last couple of years due to the massive and somewhat questionable legal settlements that have costed tens of billions of dollars.  Earnings will indubitably grow dramatically as margins revert towards the industry mean.  Another issue that has faced the bank is that the current regulatory environment has forced all banks to raise massive amounts of new capital and have less leverage.  I believe that raising was a very intelligent measure and has made the banks far safer than they have been in the past.   Bank of America has 2 times the capital and double the liquidity that it had prior to the Financial Crisis.  It is now in a position where it can begin accelerating returns of capital to shareholders, as there will literally be too much capital.  Historically, it has not been uncommon for a bank to return 50% of its earnings as dividends to investors.  Assuming $2 in earnings and a $16 share price, BAC trades at about 8 times trough earnings and would yield 6.25% with a $1 per share dividend.  The earnings yield is the inverse of the P/E, which means that if the bank were to pay out all of its earnings as a dividend, the yield would be 12.5%.  This is exceptional value when you look at 10-year treasuries that are yielding 2.2%.

Bank of America is an example of an investment that will be improving even in a continued low-growth economic environment.  While some stocks might be overvalued, BAC certainly is not and this is why value investing can be so powerful.  I’m exceptionally confident that we will make very good money even if the market doesn’t really cooperate or show anything like the returns seen in the last few years.  For those of you that are retired or are near retirement, these growing dividend streams will be an essential component to your financial future.  If the stock gets cheaper, we’ll buy more.  In the short-term “Mr. Market” may rule, but over the long-term it is the earnings and financial condition of the business that matters.  Never forget that regardless of the news!

The other thing we do is we sell puts.  Recently we’ve sold $16 puts in BAC that expire in January 2016 for $1.05.  This means that if the stock is above $16 at expiration, we’ll make $105 on $1,495 of “risk” or 7% on the money invested in roughly 4 months.  That is in excess of 20% on an annualized basis.  Our worst case scenario might actually be our best case scenario because if the stock drops below $16 and we end up owning it at a breakeven price of $14.95.  I believe the stock will trade at $25 within 3-5 years and we’ll be collecting massive dividends several years out.  That option which was selling for $1.05 might go up to $1.50 and show a mark to market loss on a down day.  Truthfully it is just noise.  The final outcome, when we get to expiration, will be either A or B.  We are happy either way and that is the key to long-term investment success.  There are fantastic opportunities out there and I’m excited to see where our accounts will be 3, 5, and 10 years from now.  If you ever have any questions or if I can assist with anything please don’t hesitate to call me directly at 805-886-8140.