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Archive for January, 2006

Do Not Fall For Ponzi Scams!

A few hours ago, I had a friend asking me to evaluate an ‘investment’ opportunity. Apparently, you get paid just for surfing the internet. Well, this concept is not new and I had personally earned a rate of about $0.50 per hr doing it in the past.

The money comes from advertisers but such programs usually fail in the end because such a form of advertising is NOT effective and most advertisers eventually drop out.

The red flag in this opportunity that my friend bought up is that the company, 12dailypro, requires you to put in an ‘investment’ to earn from the surfing. And you can earn 12% per day from it! Such a high rate of return automatically activates the ‘scam’ trigger in me.

Shortly after, I was reading through an investment forum and some people acutally commented that they were willing to put in some money to try out the concept. I was sad (and amazed) that people can actually fall for such scams.

Nevertheless, I felt duty bound to warn as many people as possible.

First, you would want to read this tutorial on the different kinds of scams available.

This second tutorial elaborates on pyramid schemes and ponzi scams.

And lastly, this comprehensive article has a good analysis of “surf and get paid” programs and explains why programs like 12dailypro and studiotraffic are pyramids in disguise.

If you have experience in any of such scams, feel free to share with us your comments.

And if you know of people putting their hard earned money in such schemes, please warn them before they lose all their money!

This year’s letter started with a reiteration of something that was mentioned in the previous year’s letter. Even though undistributed and unrecorded earnings of non-controlled holdings will not be reflected in the accounts, they will eventually be translated into tangible value over the long run.

A note on general acquisition behaviour. Buffett would rather buy 10% of X company at Y per share than 100% of X at 2Y per share. Most corporate managers however, prefer just the reverse. This results in a larger empire, but poorer citizens.

There are however some dazzling exceptions and most of them fall into two major categories.

The first category involves purchase of business that are well adapted to an inflationary environment. These businesses are able to raise their price without fear of significant fear of loss of market share or unit volume. They are also able to accomodate large increases in their volume with only minor addition of investment capital.

The second category involves the mangerial superstar – people who are able to recognise businesses that are “the rare prince disguised as a toad”.

Buffett finds values most easily through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements.

In most cases, undistributed earnings from such companies will produce full value for Berkshire and its shareholders. If they don’t, it could be due to three reasons: (1) the management (2) the future economics of the business; or (3) the price that was paid.

There follows a lengthy discussion on “Equity Value-Added”. To justify an investment in equity, there should be additional earnings above passive investments returns. This is derived from the employment of managerial and entrepreneurial skills in conjunction with that equity capital.

Also, since an equity capital position requires additional risks, we should be getting a higher return for the risk.

When a business is able to achieve this, a dollar of each is usually valued at more than a hundred cents. Conversely, if investment returns of passive instruments are higher than the returns from a business, such a business will be valued at less than a dollar for each dollar.

The bottomline? Interest rates (an inflation rates) would and will affect the valuation of any business.

An ironic situation is that a “bad” business will usually need to retain most of it’s capital to continue operating. Consider if you have a 5% bond and current rates were about 10%. Will you take the coupons from the bond and pay hundred cents on the dollar for more 5% bonds when the same dollar will buy you a 10% bond? Yet, that is what “bad” business are doing by retaining capital. Shareholders would be better served receiving the earnings as dividends and re-investing them elsewhere.

On the other hand, a “good” business with a high return on equity should retain all it’s capital so that shareholders can earn premium returns on enhanced capital.

Two Mistakes That Warren Buffett Made

Warren’s first mistake was in buying Berkshire. Even though he knew textile manufacturing to be unpromising, he bought because he thought the price looked cheap.

This is akin to the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left may not offer much of a smoke, but that puff is all profit due to the bargain purchase.

This approach is foolish unless you are a liquidator.

Firstly, the original purchase price might turn out to be not cheap. Usually, there will be more problems hidden from the surface.

Secondly, any initial advantage from the purchase price will be quickly eroded by the low returns of the business.

Another mistake that Warren made was in buying a Baltimore department store, Hochschild Kohn. It was bought at a substantial discount to book value and the management was good.

It was sold three years later for about the same price that Warren paid.

Always keep this in mind, “It’s far better to buy a wonderful company at a fair price than to buy a fair company at a wonderful price.” Look for both first-class business and first-class management.