HOW WARREN BUFFETT CREATES 35% ANNUAL DIVIDEND YIELDS

Warren Buffett has a secret: His portfolio delivers gigantic cash flow which he reinvests into other long-term gigantic cash flow yields that compound billions at 20% per year or higher, year after year after year.  

The power of compounding yields is often discussed but rarely understood.  For example, every fund manager out there knows about compounding but almost none use an investment strategy which has compounding as an integral part of the strategy and therefore, almost no fund managers beat the market rates of return much less achieve 20% or higher annual cash flow.  So how does Buffett do it and why can't the other Big Guys follow his obviously successful lead?

The first reason is that Buffett has an iron grip on his capital and fund managers don't.  Buffett doesn't have to deal with investors pulling their capital out of his fund because they don't like the short term, quarterly results compared to other fund managers.  This is why Buffett dumped the Buffett Partnership in the 60's and created Berkshire Hathaway as his investment vehicle.  Limited partners and investors in mutual funds can take their money out and force a fund manager to sell off 'long-term' investments at bad prices.  Investors in Berkshire can only drive down the price of the stock when they sell.  They can't take the capital of the company like partners and fund investors can. With total control of his capital, Buffett can think long-term.

You and I have the same exact ability.  We don't have to answer to investors whose emotional reactions to market swings can screw up a long-term strategy. We can do what Buffett does – buy with a focus on a ten-year time span.

The second reason is that Buffett focuses on cash yield.  Fund managers focus on stock price.  Cash yield is the flow of cash from the investment to the investment owner.  Buffett owns companies through Berkshire so that the excess cash flow of the investments can flow up to Berkshire without taxation.  Fund managers aren't in the investments for cash flow.  They are looking to increasing prices for their returns.  The difference is amazing in terms of compounding growth rates.

Let's say a Buffett investment produces a 4% cash yield from excess cash flow after he makes the investment and that the company is growing earnings at 10% a year.  What that means is that the cash yield is growing at 10% per year.  In 10 years the cash yield will be 10% on the original investment.  However, the actual cash yield is much higher than that because each year the cash flow to Buffett returns a small part of his original investment, meaning that 10 years later he has received back a big chunk of his original investment and his actual basis (remaining investment) in the business is much less than the original.  

This is what actually happens: Year 1 he gets back 4.4%.  Year 2 he gets back 5%.  Year 3 he gets back 5.5% and so on.  By the 10th year, this business will have returned about 70% of the original investment and it will have grown its cash yield on the remaining investment capital to a return of almost 35% per year and still growing.

Rule #1 investors do the same thing Buffett does.  We buy with a high yield because the company is on sale.  We take the dividend and reinvest it elsewhere at the same high yield and the recovery of capital from the dividend reduces our basis and increases our cash on cash yield.

This is the biggest secret to getting rich that I know of.  Buy a wonderful company on sale.  Reduce the basis with the dividend.  In ten years achieve yields of 20% to 35% per year on remaining basis.  Reinvest the returned capital in other, similar investments year by year.  Eventually your entire portfolio will have a yield of 20% per year and every year that yield will grow far in excess of inflation and you can sit on a beach someplace doing whatever you want forever.  

Now go play.

 

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Phil Town is an investment advisor, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.

  • PatientWealth

    Phil – do you find that the benefit from reinvesting the yield outweighs the taxes paid on the dividends?

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  • Joey2

    Thank you, Garrett!

  • Ray

    Yes, most definitely. I have been using what we have learnt to make some money. The nice thing about the cash flow thing is that you can make some cash and use the cash to keep buying your wonderful business while it is going down in the down market. Even though you are not making a huge amount of money, you don’t see a losing month either. Once the market picks up, you will see your account growing almost everyday. That’s good life 🙂

  • Garrett

    🙂 Ray!!
    (Rulers, Ray was one of the super exceptional Rulers who won the ticket to attend Phil’s beta test “Rule #1 Cash Flow” while in Atlanta)…
    So Ray…there I was just about 3 1/2 hours ago stuck in a traffic jam in Baltimore…so I turned on my computer and made $300 (pending the May 19th Expiration) on some Iron Condors. That made me feel better about being stuck in traffic. 🙂
    Hope you’re taking steps to apply what you learned in Atlanta. Shoot me an email if you have some more questions.
    To Your Wealth!
    Garrett

  • Ray

    Garrett,
    I have been around and have never missed your wonderful posts!

  • Garrett

    Hey Ray! Been wondering where you disappeared!
    Yes…if we don’t get a market sell off, then we’re looking for an “Event Driven” factor that makes our Wonderful Company not so wonderful in the near short-term to our Mutual Fund Managers, but has great potential for us Rulers!
    Off to Fly!
    To Your Wealth!
    Garrett

  • Ray

    I think this topic has been brought up every now and then on this blog. We want to buy a wonderful business at a discount. And we only get the discount when there is a sell off situation. And there must be something wrong to create the fear among investors. The key is to identify the reason for sell off and decide whether it is a long term or short term thing and whether it has changed the fundamentals of the company. If we find the reason is short term and it does not change the fundamentals of the company, we have a golden opportunity of getting in. Two recent examples are short-term high cotton price caused a negative earning to GIL and short-seller-attack to BRLI. Quite a few Rulers made some good money out of these opportunities.

  • Garrett

    Joey2,
    You are correct that you’d want to re-evaluate your R#1 company each quarter. If the CEO had previously expected earnings to grow at 20% but this time reports that earnings may only grow at 15%, you’d definitely want to re-calculate your MOS / PBT.
    But your question really goes to the heart of investor psychology. I’d suggest your read Shiller’s “Irrational Exuberance” to learn more about some studies he discussed regarding how investors make decisions.
    No company goes up forever and there will be bumps in the road. During these quarterly updates, you’ve hired your CEO to report to you about what’s going on inside your company. This is your opportunity to re-evaluate your 4M’s.
    What makes this difficult is when you’re just starting out and you don’t have a lot of cushion between the price you bought and current stock price. When you’re up 10% the psychology of investing tells us that we’ll do more to protect our profit and end up getting out. Then you find yourself vacillating about giving away some profit or buying more…tough to do mentally. I think a lot of newbie Rulers rarely hold on to see their company make it to Sticker price.
    I think Gildan is a good example because we’ve discussed it on the blog.
    We came to the conclusion that GIL had an MOS somewhere between $25 – $30. Sticker then about $50 to $60.
    GIL’s been messing around trying to break that $30 ceiling and if you bought at $25 maybe you watched it go to $28 for a 10.7% profit. Then it starts to find resistance and it drops to $26.50. Do you sell to lock in that remaining 5.7% profit?
    I wouldn’t – not if I believed GIL was a $50 to $60 Company…UNLESS…I had something else that I was ready to invest and get another quick 5% or 10%. This is what you might have to do as a R#1 Trader when you’re starting.
    How about DECK? Entirely different situation as far as I’m concerned. It wasn’t at MOS…no “Green Zone” so I wouldn’t want to stick around if the price started to drop after a 10% correction. I’d get out because it might crash hard…and that’s what it did.
    Now look at DECK – It bounced 10% off that $50.00 floor in a 2 trading days…will it last? Don’t know. But if I had more money in my account, I would have considered selling PUTs at $45.00 pr so and watching to see if the $50.00 Floor was made of rubber and catch that 10% bounce.
    I read somewhere that once Buffet buys a company he really doesn’t care what the price does. That’s a guy who KNOWS the value.
    Phil would summarize that with “Now Go Play!” because if you’ve done your homework, you should’t have to worry about the day to day fluctuations.
    Ironically, I love Panera, but have never owned it (no MOS). If Panera’s CEO said wheat and yeast prices went ballistic, I believe I’d be able to see the forest through the trees and realize that in 6 to 12 months those issues would be resolved by great MANAGEMENT.
    The important point is you have to be rational and ask yourself, “Do I believe this company is worth Sticker and can it continue to grow at 15% per year over a 10 year period?”
    Now, let’s just take this one step further into the Options World.
    Shuki correctly brought up the point that with options you’ve got more work to do. I’d agree…and I love it. I’m not a day-trader by any stretch of the imagination, but I will consider managing my Options strategies at least once a week…sell something here, open something there, close something else. It’s a lot easier to stockpile with a Rule #1 Options education and lower my basis by doing strangles, straddles, condors, spreads, etc…
    The reason I do these things is because I know the difference between a 15% ROI and a 20% ROI over a 20 year period. The millions I’d earn is well worth my time to become a more knowledgeable and sophisticated investor.
    Plus, I’ve done lots of other things that require a lot more of my time – Like owning real estate and dealing with renters! AARRGG!…It’s kind of tough to beat the money I can make as a Rule #1 Investor versus owing multiple properties and dealing with people who don’t care about my home or refuse to make rental payments.
    Now all I do to check on my “Rule #1 Business” is log onto TradeKing and read my Company’s Press Releases that get forwarded to my email…and post to you guys so that I keep my head in the game!
    To Your Wealth!
    Garrett

  • Shuki Sasson

    Thanks Garrett, I am impressed with your enthusiasm and energy. I try to keep things simple as much as I can. I invest in companies that it is very clear to me that I will succeed.
    The numbers are important but I was willing to invest in a rail company even though I had only 40% MOS since I understood their business very well and I think their growth is the bag.
    Maybe one day I’ll do options…

  • John Duncan

    @ Garrett – I’m willing to bet money I have the same put option as your May 19 put! I have another one just below that one as well. LOL!

  • Joey2

    Hi Garrett,
    two of my favorite companies reported earnings on may 1st. One did disappoint (a little) one didn’t. The strange thing is that the price of the first one didn’t go down while the shares of the 2nd did. Anyway.
    My question is the following: Usually we LOVE when the price goes down – in a weak market. If the price goes down because of weak earnings and/or weak forecasts – wouldn’t it be necessary to re-evaluate the MOS and not just get a new tranche? And be really careful?
    If our MOS of a wonderful company was – let’s say – $100 and the reported growth and the outlook is weak, would we really get in if the price goes down to $100?

  • Stephan

    Garrett because of your great posts about options I´m getting more and more interested.
    Can you recommend me a good book about options ?
    I´m still hoping you or Phil are going to write a book about rule 1 option trading.

  • Perry

    Thanks for the replies. Your strategies make a lot of sense and I am hoping that (in the future) I can put them to use after I have some practice with them.

  • Garrett

    Perry, your question “in the situation where the stock price goes down, I am assuming you would sell back the 5 call option contracts?”
    If I understand your question correctly, I would have previously “bought to open” 5 Call Option Contracts…(a debit in my account) therefore you’re saying, “Now that XYZ has gone down in price, my CALL contracts aren’t worth as much. So wouldn’t you want to sell those to get something for them?”
    Yes, I would want to “Sell to Close” my 5 Call Contracts resulting in a small “Credit” to my account…unless I believed there was still time for the stock to recover before the contract’s expiration. Remember, in that example, I never used my money (in a sense) to buy those call contracts. I “created it” buy selling puts on a stock I wanted to own should it go down in price.
    Good question.
    To Your Wealth!
    Garrett

  • Garrett

    Thanks Perry! I really appreciate the feedback. It’s very difficult to post something meaningful with this limited format and inability to use pictures, graphs, etc.
    In regards to the “green zone”, yes…8 year PBT however…it must ALSO be at or below my MOS. Once XYZ goes above 8 year PBT and/or MOS, I’m done buying more of it. That’s why I’ll sell PUTs below MOS at the Floor and WANT it to go down further so I can own more.
    Let’s use XYZ as an example. I want to own it at or below $25.00 because that is the 50% MOS price. If it appears to be trending on a floor at $25.00, I’ll buy one chunk just in case it runs up away from me. Then I’ll sell PUTs below that $25.00 Floor…maybe at $20 let’s say…It hits $28.00…great I’ve made money, but only a little because I didn’t get the other 66% of my cash into it. Bummer. But if it drops to $20.00, I can buy more and my basis will be about $22.50. Then I can keep selling PUTS (if I have enough money to cover my position) below those floors that will lower my basis should the contract expire worthless. If the stock just hovers between $20 and $25 then I can keep selling PUTs below those prices to collect premiums…overall lowering my basis.
    Once I own the stock, my game is all about lowering basis, lowering basis, and lowering basis. We do that via collecting dividends (if it kicks one off) and using Rule #1 Option strategies.
    To Your Wealth!
    Garrett

  • Garrett

    Good stuff Shuki…always appreciate getting your perspective. You’ve made me a better investor thanks to reading your posts and letting me know about Weinstein’s book.
    To Your Wealth!
    Garrett

  • Garrett

    Abe, been wanting to comment earlier about this post…it’s a great one and thanks for taking the time to share your thoughts on this. I bet a lot of Rulers can relate…I know I can from my past experiences!
    To Your Wealth!
    Garrett

  • Garrett

    Moncho,
    You’ll get it. But don’t try to understand everything at once. That’s the biggest problem when starting this options stuff. I tried and almost gave up…thank God I did not. Stick with this:
    Learn how to successfully “Sell to Open” 1 Put Contract for $0.XX cents at the XXX month Expiration for XYZ Company.
    Then learn how to successfully “Buy to Close” that same contract so you know how to lock in profits or get out of a position that is going against you.
    You’ll also come across terms like “net credit, net debit, mid-point, natural, and even”…you’ll be confused about that for awhile too…don’t worry…it’s no big deal. Just everything new for the first time takes a lot of effort.
    I learned a real lot of this stuff just by sitting down for hours and hours writing out what everything meant and what would happen if I did X and got a result of Y.
    In fact, I was doing what a broker would call a “complex option strategy” but I didn’t know they had names like “butterfly” or “strangle” or “straddle” or “iron condor” or “bull put spread” or “bear credit spread” or “Vertical Call Spread” or “Vertical Put Spread” (which I later learned was the same thing as other things), “calendar spreads”…
    I was just sitting in hotel rooms after flying and thinking about how I could buy/sell a CALL or buy/sell a PUT at some strike price and some expiration month to manage my outcome.
    The first time I did a “Bull Put Spread” and a “Bear Call Spread” I just thought it made a lot of sense. I didn’t even know it was called anything. I later learned by mistake that it was an “Iron Condor.” I thought I was some genius for figuring it out.
    When you sell or buy a contract you are selling an “obligation” or buying a “right” and you may or may not own the “underlying security” which would be the stock. Some accounts require you to own the stock. Others do not. And before you do any options trading, you have to fill out a bunch of forms about how great you are at doing this and how long you’ve been doing it. That way Etrade or whoever can say, “hey…he signed these documents and said he knew what he was doing.”
    I started out with selling puts. That taught me how to enter an order correctly. A “naked put” is what it’s called. Phil has posted about that before and we only, only, only do that when we want to own the company at a better price. If you had sold a naked put on DECK at $62.50 you might be one sad dude when you woke up the next morning and you saw it dropped to $50.00. You’ve got to know how to get yourself out of that kind of situation before it happens.
    To Your Wealth!
    Garrett

  • Garrett

    Danny, We’re allowed to think in the cockpit…so no worries about that! Nothing in my Flight Operations Manual that says we can’t think about other things or talk about Rule #1 when above 10,000 feet!
    The FAA has a rule that below 10,000 feet all communication is “sterile” meaning that it can only be related to flying the aircraft. I’ve done a lot of Rule #1 Training flying at 40,000 feet from Baltimore to San Diego…like today on over a 5 hour non-stop flight!
    Try meeting a new person each week and sitting 2 feet from him for 3 days for at least 9 hours a day and you can learn a lot from someone!
    🙂 Garrett

  • Garrett

    Shuki,
    This is a really fair question because I do post so much on the blog. I would love to post everything I’m doing. Wow!…there’s just so many cool things you can do to create better ROI’s, lower risk, and create cash flow. And it appears from reading your posts and the books you’ve told me to read that you got a good grip on a strategy that works well for you.
    Like that little strategy I set up on April 30th for today’s earnings report. I posted about it somewhere on the blog as a little “options breadcrumb.” I sold a Put and used that money to Buy a Call. That was awesome! Totally awesome! The stock went up on earnings and I never invested a single dollar of my own money. It was literally “created” out of thin air! I’d love to teach that. Because I was in my “green zone” I didn’t care if the stock dropped…I would have loved it…I would have owned it at a better price that it was trading. And if it stayed flat after earnings, I didn’t have any money invested in it in the first place. Finally, if it went up, the CALL that I bought would give me the right to buy it at the lower price for a profit. For me, it was a no lose opportunity. None of my own money was used and yet I made a very nice profit (if I close out the position tomorrow.)
    But I digress as usual…
    Phil has been kind enough to let me post on his blog while headlining some of my comments. The problem is there are some boundaries that I can’t cross because they could indirectly cause a problem for Phil with the SEC – believe it or not…and maybe even little ol’ me! I’ve been notified via email from higher ups that because I post so much that I need to be careful about what I’m posting – like giving advice without a license. Phil was a river guide and I’m just a pilot. That’s my disclaimer in a nutshell.
    So I’m kind of just filled with all this energy and would
    love to share it all with you. We could go nuts having a lot of fun evaluating companies together. I hope to have the opportunity to be more open in the future, but those doors are still closed at the moment.
    I’ve posted before that a place to look for those Rule #1 Companies that are on sale is in the “Red Zone” Industry.
    Phil’s TownToolBox and subscription based services like Investools.com will list what sectors or industries the big money is flowing…or not flowing. According to Investools, this week the bottom 10 “Red Zone industries” include oil and gas, metal mining, coal, non-metalic mining, iron and steel. Lots of commodity stuff.
    That’s where I’ve been looking to invest. I’m only trying to own about 4 companies. And I don’t want all 4 in the same industry if I can avoid it. Once you nail down an industry, you’ll want to find which one of the several companies is the best one to own. And then from there I try to build my story about owning company XYZ. Maybe it’s slow growth in China or a temporary spike in Cotton prices…like Gildan…an event driven price drop that the Big Guys can’t handle for a few quarters, but we little guys can buy at a big discount.
    If one of the companies I want to own has no MEANING to me, then I hit the library and Seeking Alpha articles until I do understand the company/industry. Then each day, I read the Seeking Alpha’s “Today’s Articles on the MACRO View.” and I get daily emails on a few companies I own or want to own so I know what’s going on with them. Keep in mind not everything from Seeking Alpha is good…some of it can be crap too.
    I always appreciate reading your posts, Shuki, when you do write up something. You’ve always got good insight into helping me think better.
    To Your Wealth!
    Garrett

  • Stephan

    When I am searching for a Rule 1 company and find one with real good numbers and a great management my next step is to think of events that can hurt my rule 1 company. For example for profit education businesses like apol can be hurt real bad by government changing regulation for student loans. Car producers like Ford or construction companies like Foster Wheeler can be hurt by recession. Oil companies are hurt of falling oil prices. Deck is hurt if celebrities stop wearing Uggs. So where do I invest my money. I think there are few events that would stop people from eating at Mc Donalds, drink Coke or Pepsi, stop buying coffee or eat wings. The same is true for online casinos. Most customers in the online casino I invested my money come from countries like syria, egypt and iraq, although most people are poor in this countries. So I mostly invest in companies like bwld, cmg, mcd, ko and sbux if I can get this stocks at a real good price.

  • Moncho

    Garrett,
    Safe flying.
    I am working on fully understanding PUT’s as they seem to coincide better with what many of us FEAR, our wonderful business not “performing” so wonderful which allows us to start stockpiling.
    Great Days!
    Moncho

  • Moncho

    Heck yeah Aubrey is one PITA of a CEO. I wish I had gotten out of CHK (in SIMPLE IRA) a while back too.
    Based on FAC’s, market sentiment plus numerous articles @ seekingalpha.com over the last month, I was able to buy at $16.90 which lowered my cost basis enough to get out with
    a 1.5% profit. Not a awe inspiring Rule#1 play (aka lucky
    gamble based on better than average research) but it
    worked. Don’t plan on doing that anytime soon. Although looking at a possible type of play with HLF.
    Great Days!
    Moncho

  • iloveangels (Anne)

    WOW!!!
    Thanks Abe.
    I just did what you advised. I openned the comments RSS feed in Firefox (does not work in EI, as far as I could tell). Then I indicated to send RSS to my Outlook. It works great!
    All the best to you!
    🙂 Anne

  • Mike M.

    Aubrey takes the cake for sure! I’m just glad I sold off most of my CHK a while back. It’s staging a nice rally today.

  • Abe Silk

    Hi Anne,
    What I do to see recent updates is follow the website’s RSS feed. If you go to the top of this page, right under the Amazon, Barnes and Noble, and Borders links is a heading that says “Follow Phil Town.” If you click on the link that says “comments” that is next to an orange icon, you can get updates right in your email. Most websites (especially blogs or articles) have this feature. It’s pretty cool.

  • Abe Silk

    Or Aubrey McClendon, CEO and (former Chairman) of Chesapeake Energy: http://money.cnn.com/2012/05/01/markets/chesapeake/

  • sue

    you are welcome. We are all here to learn from and help each other. I like the pointer idea.

  • iloveangels (Anne)

    Thank you so much Sue and Kristo,
    I am just now noticing that you had replied to my PotashCorp questions, though I have been looking at this board daily, I just missed them, somehow…
    If anyone has any pointers on looking at most recent replies on the forum, I would really appreciate it.
    All the best to you each in your endeavors!
    🙂 Anne

  • Garrett

    🙂 Rulers, off to fly so maybe late tonight I can answer some of your questions. Yesterday my dad had another quick lesson. He says if he can learn how to be a Rule #1 Investor at 72 then anyone can. He laughed about how long it’s going to take him to really get a grip on all this stuff. But he’s asking good questions so I know Dad’s on the right track. Nothing about Rule #1 Investing is rocket science. But it does take a daily discipline and desire to learn and believe in yourself despite mistakes.
    Options can be summarized with 4 things that we do and only do.
    1) Buy a PUT
    2) Sell a PUT
    3) Buy a Call
    4) Sell a Call
    Once you understand one of those 4 steps…like “Sell a Put” which Phil has introduced, then you can build upon that foundation.
    To Your Wealth!
    Garrett

  • Moncho

    Garrett,
    Ohhhh Boy!, is Phil shaking his finger at you! HaHa 🙂
    All this options talk and getting many many people excited, including myself.
    That’s OK though, I will stand with ya! 🙂
    Great Days!
    Moncho

  • Moncho

    Hello Abe,
    I really enjoyed reading this post. I tend to agree with you on all of your points.
    MOAT and MANAGEMENT are the two M’s I have the most issues with. MOAT can be rather subjective as you have pointed out and I have made a couple mistakes in that area.
    As for MANAGEMENT, well, after reading many (not all) of BRK.A Letters to Shareholders, I still get a “snake oil salesman” feeling when hearing CEO’s speak even if the numbers line up to what their saying. Are they just feeding me BS or actually genuine? I guess that just takes time and more research. Don’t want the CEO pulling the rug out from under me. The funny thing is, we can see truly bad CEO’s easily. Check out MDRX’s CEO. Oh what a character.
    Great Days!
    Moncho

  • Moncho

    Hello Garrett,
    Thank you very much for the explanation. I did much more reading and youtube watching over the weekend about options and your example has helped solidify a couple out there questions about the inherent risks in selling PUT’s. It also helped explain “roll out and down” a little better too.
    Also, still a little fuzzy if someone, whether it be the buyer, seller, or brokerage actually owns the physical asset the options is being traded on? Kinda like the Tulips or Wheat of the farmers?
    It’s weird how I can hit a baseball really well, but I’ll be darned if I can figure out how to hit a nail with a hammer! 🙂 I will eventually get it with enough thought and study.
    Great Days!
    Moncho

  • Perry

    One more question, in the situation where the stock price goes down, I am assuming you would sell back the 5 call option contracts?

  • Perry

    This post makes so much sense that my mind is blown away. I’ve never looked at options the way that you are describing, and the more you are leaving these breadcrumbs, the hungrier I am getting to learn more about them.
    In regards to the “green zone” that you are referencing to, is that essentially the price of the stock that will yield an 8 year PBT or better?

  • Shuki Sasson

    Hi Garrett, could you be kind enough to tell us what are your positions (companies you are invested in)?

  • Garrett

    Moncho,
    It depends….That’s a really good answer when dealing with Options.
    It depends because of your level of trading allowed in the account you own.
    I manage 4 accounts. Some mine, some others. The more you do this stuff the more people will start asking you to help them.
    Some of the accounts have restrictions. For example, in one account, let’s say I want to sell 1 PUT Contract of Panera for the May 19th Expiration. PNRA is currently trading at $157.60. That’s not MOS…so this is just an example.
    1 Contract is 100 shares. If I sold the $155 PUT for the May 19th Expiration the Bid/Ask is $2.40 / $2.50. That means if the broker isn’t allowing me to us any leverage, I’d have to make sure I have $155 x 100 =’s $15,500 dollars in that account to cover my position should PNRA drop to $155 by May 19th. That’s kind of like putting the money in escrow. The broker has zero risk in the transaction. He makes money if PNRA drops, goes up, or stays the same because he gets a commission fee. Good deal for him.
    Maybe you sold this PUT at the mid-point…which is in the middle of the bid/ask for $2.45.
    You would have collected $245 for selling the PUT. I like to think of that as $245/15,500 =’s 1.58% ROI in 19 days IF, IF, IF, IF your contract expires worthless to the buyer because PNRA doesn’t drop in price.
    Now let’s look at company XYZ..Sticker is $310.00. PBT is 8 years…MEANING, MOAT, MANAGEMENT…all 5 stars…yada, yada, yada. MOS is $155.00
    Let’s say you have $100,000 in your account. You want to pre-determine how much capital you are going to allocate into your Rule #1 Company.
    I think at $100,000 or less, you should stick with owning one company and only buy another if you couldn’t get all your money allocated into it because it jumped above your MOS and went above “The Green Zone”
    As a Rule #1 Investor here’s how I’m going to look at buying into this. My plan is to make 3 to 4 investments into my Rule #1 Company. Phil calls this a “tranche” or a “chunk”.
    XYZ is selling for $157.00 and is at a Floor. I’m selling PUTs below the Floor maybe at $155 for this first chunk. The PUT premium pays $2.45 or $245 per contract or I’m getting a discount of $2.45 cents per share. Think of it however is intuitive for you.
    I decide I’m going to allocate $25,000 to $33,000 for my first investment. If I’m selling PUTs, then I need to think how many I can sell and still be covered if the price drops.
    2 contracts =’s 200 shares x $155=’s $31,000 and I’ll receive $2.45 x 2 =’s $490 when I sell these contracts.
    Now…I WANT THE PRICE TO GO DOWN!!! See how cool this is as a Rule #1 Investor using Rule #1 Options!!
    If XYZ goes up, I never bought it at $155.00…and all I made was $490.00. And I still had $69,000 of cash that was lazily sitting in my account not working for me. All I made was $490.00 on $100,000… pathetic return of .049%
    But if XYZ goes down…then I get to buy it at $155.00 and my basis is actually $155 – $2.45 =’s $152.55. XYZ has to drop to $152.55 for me to break even. I didn’t violate Rule #1.
    Now, let’s say it dropped the next day to $155.00. I can now buy back that contract (that will result in a loss…it’s called “Buy to Close” and then I can “Sell to Open” 4 contracts…stockpiling…at $150. This will result in some credit to my account because I’m only buying back 2 contracts (a loss) but I’m selling 4 contracts (which will make up for the loss and result in a credit).
    Do I have the capital to cover my position? Let’s see…4 x 100 =’s 400 shares x’s $150 =’s $60,000. Yep…I do. I’m stockpiling.
    Now what if the price wasn’t a floor…it was like DECK and tanks big time. Now I’m really happy!
    The price is $140. I buy back my 4 contracts (at a loss) but I sell 8 contracts at $140.00. Can I cover my position?
    140 x 8 contracts x 100 =’s $112,000.
    Oops…I can’t sell 8 contracts. I either need more money or I’ll have to sell 7 contracts. 7 x 100 x 140=’s $98,000.
    Ok…Is $140.00 REALLY the floor? I hope so…because at this point I’m KIND OF ALL IN…not really though…because I didn’t buy XYZ yet. All I bought is an obligation to buy it at $140.00.
    What if XYZ drops to $120 (panic all around…world falling apart scenario. I don’t have any more money in my account to get more and I’m on the hook for 700 shares at $140.00.
    Well, now I’m going to either have to commit to buying at $140.00 OR I can buy back 7 contracts and let’s say that each contract is selling for $30.00 (I’m far, far way now from our little $2.45 cents that we started and that’s the way this works!!) That’s 30 x 7 x 100 =’s $21,000. I have a tough choice. I either take a $21,000 loss or buy in at $140.00 and wait for my Rule #1 Company to correct back in price. $100,000 – $21,000=’s $79,000 left in my account.
    Is $120 REALLY the floor? If it is, I could take $79,000 and go all in. Let’s see: $120 per share / $79,000 =’s 658 shares. Or I could sell another 6 contracts for 600 shares at $115.00 PUT…Is that really the floor?
    I kind of wanted to go through this so you can get a glimpse into the complexity of managing options and allocated capital as you get more experience.
    Remember, this stuff can go irrational either way…that’s why we need to KNOW our Industry and make sure our company has MEANING to us. If you can’t stockpile, then stick with Rule #1 Trading.
    To Your Wealth!
    Garrett

  • Garrett

    Hello Rulers!
    One of my Rule #1 Companies will report earnings tomorrow. I’m in one of those typical situations where I haven’t allocated all the capital that I want to invest in this company so I’m hoping the price will go down because I’m already in the “Green Zone.”
    The problem is that it’s already at a pretty good price. And any moderately favorable news could send the stock price up and then I’m stuck making a little money instead of a lot of money.
    That’s why Rule #1 Investors like when their Rule #1 Company is getting hammered by the Big Guys in some industry. When that happens, we can keep buying in at low prices as it channels between some trend. The longer it does that, the more confidence I have that the Floor is a floor and the ceiling is a ceiling.
    Since I want to own more of this company, I sold PUTs for the May 19th Contract expiration – just a little bit below the current price. And if the price drops, I’m ok with that. I want more of it at a better price. But if it goes, up…well, I want the RIGHT to buy more of it so that if it should start to run away from me, I can own it too.
    Rule #1 Investors put themselves in a Win/Win situation. When I sold those PUTs, I collected money immediately. And at the same time, I bought the same number of CALL contracts for the May 19th Expiration. Buying a Call takes money out of my pocket (a Debit) because I bought a RIGHT to own it. Likewise, Selling a PUT enters me into a contract which OBLIGATES me to buy it at the strike price I sold it. Taking on that OBLIGATION is what I’m getting paid to do. It results in a CREDIT to my account. I’m insuring someone else’s loss…his fear is my investment because I believe the future is going to be great for company XYZ in two years and I don’t give a hoot about how bad my Rule #1 Company is performing in this quarter. I don’t have to report my losses to anyone but myself. And I’m willing to show a loss if I believe I’m buying something that will appreciate and make my life better in a few years.
    What’s great about this is I bought CAlls (debit) and I sold PUTS (Credit) on company XYZ for the May Expiration. And the net result was it didn’t cost me anything do to that. The money that came in when I sold the PUT was used to buy the CALL. Cool, huh? That’s using Other People’s Money and one way to create wealth.
    Here’s why I did that:
    If company XYZ drops in price after earnings, I can own it at a better price. And if it drops a REAL LOT in price, I’ll “Roll Down and Out” to June’s Expiration and wait for it to go even lower. No money lost because I can stockpile when I “Roll Down and out” for a credit…but only if I have enough money to keep buying it as it’s going down. Let’s say I sold 5 contracts. I could buy those 5 contracts back at a loss, but then I could sell 10 contracts (stockpiling)for a credit for June’s Expiration.
    If company XYZ goes up in price, then I have the RIGHT to own it and make a profit. The contracts I sold will probably expire worthless to the person who bought them from me…he didn’t need to use his insurance (kind of like when you buy car insurance and you didn’t wreck your car…are you mad about that? No. But you still buy insurance for when you do)
    If Company XYZ stays the same in price after earnings…so what? I didn’t make money and I didn’t lose money. And that is definitely following Rule #1.
    To Your Wealth!
    Garrett

  • Stephan

    Shuki Sasson I never said I don´t want to invest.I am in the market since the late 90s. At this time I have stocks in a czech casino (private equity) paying me a 20 % dividend a year and I have stocks in livegamebet.com (will go public this year).
    I agree that the US will have a great future but there are a lot bumps in the road.
    I recommend reading Phils post from August 2011: http://philtown.typepad.com/phil_towns_blog/2011/08/bad-macro-means-watch-out-below.html
    Now let us discuss what changed since then.
    US unemployment 1 % better now, Europes unemployment worse (who is going to buy the US exports).
    The US like Europe is still overregulated.
    European debt is much worse now and there will be more haircuts for bond investors in Europe.
    Are US banks free of PIIGS bond positions?
    Chinas demograpy will become a big problem in the future (I recommend reading Steve Cortes, Against the Herd: 6 Contrarian Investment Strategies You Should Follow)
    US debt is now 15.6 trillion and growing fast.
    Food and gas prices are sky high.
    US consumer confidence is better now (69 vs 59, in 2000 it was 140) but has fallen a bit since last month.
    I am confident that the US will come out ahead, therefore i sold my euros and bought US $.
    But I prefer to wait until stock prices are coming down, if I am wrong and stocks will skyrocket in the next month so be it.
    Greetings from Germany

  • Garrett

    Rulers,
    Wow…great posts. Really awesome to read the different opinions and get different perspectives from individuals from other parts of the world.
    I think Stephen is right…DECK needs to be re-evaluated in light of their earnings report.
    I always look at the MACRO view to just give me the big picture. If there is a lot of FEAR, maybe I’ll wait to see if I can get a chunk at an even better MOS because the TREND is your FRIEND.
    I think Rule #1 Investors can summarize all this DECK stuff with the basics. Find a Wonderful company that is run by great MANAGEMENT which is on sale for 50% with a PBT of 8 years, has a definite MOAT and has MEANING to YOU!
    Most of us agreed DECK was NOT at MOS. So investing in DECK from a purely discounted Sticker Price was a Rule #1 Violation…unless you really, really knew the biz.
    Lots of good stuff on the blog to comment on. If I have time tomorrow, I hope to post some thoughts.
    You guys ROCK!
    To Your Wealth!
    Garrett

  • Shuki Sasson

    See the following article:
    http://seekingalpha.com/article/408621-s-p-500-sector-p-e-ratios
    The trailing PE is around 14, this is not expensive.
    For every stock you brought with HIgh PE I can give 100s that are with low PE.
    Oil at $40 was one time short lived anomaly in 2008…
    The Euro Zone is going to struggle for years!
    So what do you think people are going to think when you post all this negative perspective?
    Are they going to be encouraged?
    Being a Bear is an easy stand since if things become better no one can come to you with complains…
    But if you are a Bear and you don’t want to invest what are you doing here in the first place?
    You probably very negative since you live in Europe, but Europe going to recession doesn’t mean that the US going to recession…
    With both China & US on track US economy has a a good chance of good years ahead.

  • Stephan

    Shuki Sasson maybe you are right about the OIL & GAS revolution. But in order to make the extraction of new oil reserves profitable (especially oil sands) you need a high oil price. I don´t know where the oil price will be in the next years maybe higher or maybe much lower like the collapse of the oil price in 2008 from $ 145 down to about $ 40. It is true that the US economy is coming back, but Europe is in a recession. The unemployment rate in Europe is at a record high.You have 25 % unemployment in Spain, 10 % in Italy, 22 % in Greece and I don´t know if China´s economy can grow as fast as it used to in the past. It is not my intention to spread fear, but I´m talking about risks for the global economy.
    And in my opinion stocks are not very cheap at the moment, if you look at the P/E ratios for example CMG (58), AMZN (186), S&P 500 (23.40; mean 16).

  • Shuki Sasson

    No one can reliably tell what the future may bring… See Nassim Nicaulas Taleb “The Black Swan”.
    However, there are some encouraging facts about the prospect of the US economy. About 1/2 of all world OIL reserves (1.4 Trillion Barrels) and huge amount of Nat Gas are in US waiting to be extracted.
    This will create about 2 millions new direct jobs and additional five millions in direct jobs. The economy is going to boom in the next decade!
    I have already seen the OIL & GAS revolution affect in two of my three holdings KSU and TITN (my third holding is a direct play on US OIL CXO).
    Stop spreading fear and take into account that a positive future most likely occur!
    About DECK, the recent collapse may present a good entry point. My style is to wait for the downtrend to finish (wait for a breakout and change of trend) and then buy (if you want to read more on how to do that read Stan Weinstein Book Secrets to making profit in Bull and Bear markets).
    My calculations shows that $39 is a good entry too.
    Saying all of the above, I am very happy with my holdings and I have no extra money to invest so I’ll pass on DECK.
    Cheers, To our wealth!

  • Abe Silk

    Hey there Rulers. I wanted to share some thoughts I emailed this morning to a fellow Ruler who was (and is) down in the dumps about losing 25% on his DECK trade, and who was starting to doubt himself and R#1.
    I think you’re being too hard on yourself. A few thoughts:
    a) Don’t fret, I’m not sure that DECK was a Rule 1 play. Obviously it’s easy for me to say that because I’m not currently in DECK, but it is a stock that I’ve done well with in the past, and two things kept me out this time. For one, Phil posted that he didn’t think DECK had a moat. Also, I didn’t think DECK was at MOS. So, the guru specifically questioning a stock’s moat publicly, and no MOS, plus my distrust of the overall market (and wanting to take money out of play rather than put it in), was enough to allow myself to take a pass on Deckers.
    How does my good fortune help you? It doesn’t really, but I wouldn’t lose faith over this mistake. First of all, who knows, the stock could bounce back up next week. Or next month. Or (this is 100% hypothetical on my part because I’ve seen NOTHING to suggest it’s remotely true) it could be a buyout target for Nike or Adidas or another much larger company who really want Uggs. The point is that you can afford to wait it out because you don’t have finicky investors you need to convince not to withdraw their money.
    c) More and more, I think, the hardest part of R#1 investing is identifying moats. As a purely intellectual exercise, I understand competitive advantages, but it’s a lot harder to understand them in practice and in context. Moats are also the most subjective part of a Rule 1 analysis. Management is usually reasonably straight forward. Number crunching is number crunching. Growth rates are a bit subjective, but at this point we know what’s reasonable and what isn’t. Meaning is important, but it’s either there or not. Moats are much tougher because identifying them requires really doing your homework on the company itself and its competitors. Also, in order for growth rates, etc to remain consistent, it’s crucial to nail the moat. I’d love to see Phil write some more about moats in a new blog post.
    c)Don’t give it up and invest in solely in ETFs. I invest for myself, for my parents, and have in the past for a girlfriend or two here and there. There are tons of things I don’t pretend to understand, but by simply focusing on companies with rock solid numbers, management I couldn’t find a reason not to trust, and whatever moat I was able to identify, I’ve been able to do a lot better than the market averages. ETFs and index funds force you to invest in lots of bad companies with no moats, poor management, and bad numbers. Or they force you to bet against good companies with large moats, great management, and beautiful numbers. You don’t want to do either of those things.
    Hope you find this helpful,
    Abe

  • Stephan

    Kapil I think now we have to recalculate the mos price for DECK. The CEO of DECK said at the conference call that the protected earnings for 2012 will be about 10 % lower. At the moment I dont know the right eps growthrate for DECK so I cant calculate the sticker price for DECK. At the moment I am more concerned about the whole picture of the stock market in the near future. I think after the presidential elections the new (or the old) president will have to cut spending. And the Fed will have to slow down the printing press or the United States might end up like Greece or Spain. When the cheap money supply comes to an end I think the stockmarket will nosedive. Additionally the Euro Crisis is coming back harder as before, if Spain fails then we can see probanly a big stock market correction. Therefore I think the best we can do is to sit in cash (I traded my euros in $ when the exchange rate was eur/usd = 1.43) and wait.
    Greetings from Germany/Bavaria

  • Chip and Stephen,
    So now it is trading at MOS – $50-$52 and it is new Floor. Is it buy at this price or you see it might get hammered more.
    Kapil

  • Chip

    Stephan, I was in a similar situation as you with DECK. I had entered at $65 and, after thinking about that entry, was not happy with that price. I knew that it was not at MOS, and I felt that I would be able to get in at a lower price at some time in the future. The stock was hanging around the 67 – 69 range for a while, so I decided to set a stop at the mid 66 range and was stopped out, probably around the same time as you. After this, I decided to wait to see what the earnings report was going to show…. really glad I did!
    To answer Garrett’s question on what I learned. I am going to try to be much more patient when making an entry and, make an entry at a MOS that is in my comfort zone.

  • Moncho

    Garrett,
    Options are still really fuzzy for me and still searching for my own wolf but am doing a lot of research online.
    The one question I have with regards to options, especially with your example above, in order for a PUT or CALL to exist, doesn’t someone actually have to OWN the shares to be PUT or CALL?
    Great Days!
    Moncho

  • Danny

    I hear ya it’s not entirely comforting that Garrett’s up there thinking about volatile options vs flight safety either… i say half jokingly

  • Shuki Sasson

    Hi Garrett, I have read books on options and played with them a bit…
    It requires ten times the attention and ten times more tolerance to volatility than stocks.
    A person that has full time job better not deal with them. With rule#1 companies you still can make good money.
    My view of the US economy for the 2010’s is that the OIL & Gas revolution is going to boost it like the Internet revolution boosted the 1990’s. The OIL & Gas revolution will create two millions direct jobs in the US directly and additional five millions indirect jobs.
    In such a booming economy stocks will do great! So rulers try to find excellent companies in good price and invest in them. It is that simple…
    I don’t think Warren Buffet did any technical analysis and I don’t think he is a big player in the derivative market, still he made a great fortune.
    Keep it simple!

  • Mike M.

    4% yield for cliffs too

  • Kristo

    I did an excel analysis of POT to compare,
    and came close to your numbers.
    Equity Growth avg (10 yrs): 19%
    Avg P/E (8 yrs – ignore the oldest): 20
    Free cash flow growth: unreliable
    Sales growth avg (10 yrs): 19%
    EPS growth (8 yrs): 45%
    With the latest EPS = $3.24 (this
    year’s current estimate), a 15% growth rate
    and a P/E of 20, the MOS price is
    $32.40
    which is quite close to your calculation.
    The payback time with an EPS = $3.24 and with
    a 15% growth rate is less than 8 years for a
    share price near $43.
    Your numbers look good.

  • Stephan

    Last week when I was stopped out at $ 66.49 and the stock went up to $ 68 I was angry at myself because I set my stop too tight. Now I can only say thank god I was stopped out. I made $ 1200 profit on this trade and therefore on tuesday I thought I can afford a little gambling with DECK. I bought 100 stocks at $ 67.33 and set my stop at $ 66.33 so my loss would be only $ 100 plus trading costs. 2 hours later I was stopped out again. So I ended up with a net profitof $ 1080. For the next weeks or months I stay out of the stock market until some stocks I really like and understand (bwld, sbux, cmg) crash.

  • Garrett

    Rulers,
    One last point. I love when ya’ll have the integrity to say “I lost X% on Company XYZ.”
    We have all lost money. Here’s an assignment. If you owned DECK, would you post what your story was before and what you’ve learned since this earnings report?
    And remember, money is a commodity. It can be created. And there’s a lot of it out there. Stick with Rule #1 and you’ll make up for those lessons.
    Finally, it’s only money. I believe I’ve survived some financial failures because I believe the following principle:
    Life (and Investing) is 10% of what happens and 90% how you react to it. Yesterday, I met co-worker who was in her late twenties when she was diagnosed with cancer. She beat it. Then two years later, it hit her again. More radiation, more puking, more chemo, more hair loss, more lost income, more medical bills…Yet She beat it again. My heart just goes out to people like that. When I find myself bitching because I’ve made some poor financial decision, I pick myself up pretty quickly and recall a few core beliefs I have about life and myself. Like this one which I mentioned several times in my posts:
    You are your greatest and most valuable asset.
    To Your Wealth!
    Garrett

  • Garrett

    Rulers,
    So…DECK is interesting after their earnings report, yes?
    We need Phil to post another headline so we can read more commentary just on DECK. Lots of lessons to be learned and questions to be answered.
    For me, my story on DECK (prior to this earnings) was that this was a Rule #1 Trade not a Rule #1 Investment. I would try to profit off a bounce on a floor and sell it for a few bucks profit. I didn’t believe it was at MOS, but I liked that it had a 52 week low.
    I sold some PUTs below the perceived floor. When DECK went up in price, I bought my PUTs back. The difference between what I sold my PUTs and bought my PUTs was profit. This was as if I had sold car insurance to someone but then my buyer realizes that he doesn’t really need it. Therefore, I buy it back from him at a discount from what I sold it to him. This closes out the contract making it null and void. I don’t have the risk of him destroying his car and he gets some, but not all, of his money back. It never had time to go to expiration. The difference between what I sold it to him and what I bought it back at a discount was my cash flow profit. Let’s say I sold it to him for $300 and I bought it back from him for $100. My profit was $200.00.
    Here’s what’s interesting. When I originally looked at DECK I saw that there was a short term floor at around $60-$65. Then I sold puts in that range. The next floor was at the 5 year scale of $52.18 according to FIBs and just eyeballing it around a $50.00 floor.
    And wowzers…when I drew the FIB on there…it just nailed it right at the $52.00 line. Pretty cool since that where it gapped after earnings. Awesome when the technical analysis works out like that.
    In hindsight, this could have been a really good Options play. I didn’t do the following because I was out of DECK before the earnings report. But there was some evidence that DECK was either going to go up or down a lot based on this earnings.
    One possible Options strategy would have been to Buy a PUT and BUY a CALL at the money before earnings released. In this instance, you’re hedging that DECK is going to gap one way or the other. You’ll lose money on one side of your trade, but you’ll make up for that on the other side of your trade…so long as it jumps up in price enough. Using a few contingency orders on your PUTs and CALLs, you’d sell to close out one side of your position if the value of your contract changed some specified amount. This is kind of like telling someone “Heads I win, Tails you lose!”
    The above is pretty advanced stuff. No way am I trying to teach that on the blog. But you can look up “Straddle Options Strategy” and “Strangle Options Strategy” to further your R#1 Options education.
    The big lesson here is this…know your story. If the story changes, GET OUT. I think we all agreed DECK was not at MOS. That left a lot of room for it to drop on an earnings report. Since we didn’t have MOS, I wasn’t going to stick around to “see what happens” on the earnings.
    DECK was a WIN/Lose proposition at $60.00 for a Rule #1 Trader. If it went down, you’d be killing yourself for NOT buying it at MOS and taking the fat loss. If it went up, we’d be making a few bucks and thinking we’re really smart to have bought it at the $60.00 Floor.
    With earnings being around, I’d seriously have to ask myself, “Am I going to be flying at 41,000 feet unable to get out of this trade before it tanks?” This was one of those times where you have to be on alert to GET OUT. Personally, I perceived DECK to be too much of a risk vs other opportunities that I perceived where I could invest my money. But I did think there was opportunity with DECK off a quick bounce and then get out. I had a story and I stuck to it.
    Rule #1 Investors place themselves in a Win/Win situation. In a typical Rule #1 Investment, DECK would be at MOS and a PBT of 8 years or less. The MOS would already be at a Floor. We’d be “in the green zone” as Phil says. If DECK goes up, we make money. If DECK goes down, we’re buying it at an even better price and loading up. That folks, is a simple Rule #1 WIN/WIN strategy!
    To Your Wealth!
    Garrett

  • Garrett

    Rulers,
    This is just a repost from the other day. This post got buried so fast that I thought some more experienced Rulers who are trying to learn more about options may never see it. The blog format prevents any real education in teaching options so I just try to drop a few breadcrumbs here and there to help you understand a few simple concepts using stories. I think a ridiculous story is easier to understand than some option definition.
    Garrett said…
    Hi Kapil!
    Options generally expire on the third Saturday of the month, but the last day to trade them is Friday before the market closes. So on our calendar, we’ll mark May 18th as the most important day.
    I’ll make the safe assumption that you have car insurance. And for simplicity, let’s say that you renew your car insurance policy once a month for $100.00
    I bet you were glad that you didn’t wreck your car this month…and I bet that you’ll buy that car insurance next month too and still hope you don’t wreck your car.
    All this time, you’re buying something that you really hope you don’t have to use. And while money is coming out of your pocket it must be going into someone else’s pocket. However, in the above example, I really knew I was going to be using that car insurance policy…and you didn’t!
    In the above instance, someone sold me car insurance. I have no idea who that person was, but he gave me THE RIGHT to wreck my car if I wanted. So you can understand these concepts better, imagine that I was going to use my old car in a demolition-derby county race!…And he had no clue! Oh well…to bad for him!
    I have several car races lined up for the next 4 weeks. I get ready to take my car out and Mr. Put Seller says to me, “Whoa! Mr. Put Buyer (also known as “Garrett”)…where you going with that car of yours?”
    I say, “Hi Mr. Put Seller. I’m actually heading out to the demolition derby car races. I’ve got 4 races lined up this month and the last one is on May 19th.”
    Mr. Put Seller looks at me pretty nervous. He says to me, “Mr. Put Buyer, I can’t let you do that. I sold you that car insurance and if you take it to that race, you’re definitely going to need it because you’ll wreck your car. And I’m going to have to spend even more money fixing your car up. That’s to risky for me. I thought you were a good guy…but in fact…you’re dangerous! How ’bout you just give that contract we signed back to me.”
    I smile at Mr. Put Seller. “No way Mr. Put Seller. When you sold me that contract and collect my $100.00 you took on the OBLIGATION to insure me and that gave me the RIGHT to use my insurance.”
    Mr. Put Seller knows I’m correct. A contract is a contract and he’s stuck insuring a crazy car driver.
    Mr. Put Seller says to me, “Well, Mr. Put Buyer, since you won’t just hand that contract over to me, will you let me “Buy To Close” it back from you for $100.00.?”
    Initially, this seems kind of fair. After all, I got to use his car insurance policy for a week and now he wants to buy it back from me. So I’d get that $100.00 I paid him.
    But if I do that I won’t be able to go to drive my car in the race. I’m going to need more money from him to compensate for my not being able to have fun in that car race.
    “Mr. Put Seller, when I “Bought to Open” that car insurance contract from you I was really looking forward to using my car in the race. If I were to “Sell To Close” this car insurance contract back to you then you’d have to “Buy to Close” it back from me so that I can never use it again. My problem is I really want to go to those races. If I don’t go to those races, that means my wife is going to want to go out for Sushi every week and I’m going to need more money. Would you consider “buying to close” out this contract from me if I were to “sell to close it” back to you for $400.00 so that I can have enough money to take my wife out for sushi this month?”
    Mr. Put Seller thinks about this. If he doesn’t take my offer, it could possibly cost me $2000.00 to fix my car…maybe more…maybe less…all he knows at this point is that it’s going to cost him something because I’ve got 4 races lined up and this contract doesn’t expire till May 19th.
    Mr. Put Seller knows he’s stuck in a bad place. He sold insurance to a risky person like me when he didn’t really even want to own my car should it get wrecked. He’s NOT a Rule #1 car insurance seller. If he were, he’d see my car and know that right now before the race comes, it’s not bad at all. He could have his MANAGEMENT team fix it up for a few dollars, flip it, and sell it for a profit.
    Mr. Put Seller says, “Alright, I will give you $400.00.” He now takes off his hat that said “Mr. Put Seller” and replaces it with “Mr. Put Buyer” when I except his offer. He rips up the contract immediately making it null and void and I place on my head a new hat that says, I am a “Mr. Put Seller.”
    Our contract is over. He never actually bought the car and I never got to go to the race. In the end, our original “Mr. Put Seller” lost $300.00 ($400 he gave me minus the $100 I gave him)). I, of course, bought the contact for $100.00 but because things didn’t turn out the way non-Rule #1 Car insurance salesman wanted, I profited $300.00 (He gave me $400 minus the $100 I spend to buy the contact =’s $300)
    So Kapil, in this instance the contract was actually traded…not the actual car (in this example the car is the stock or “underlying security”). In the options world, this buying and selling of contracts happens all the time. As conditions change in the market place, these contracts change their price constantly and rather violently at times. A lot of contracts never make it to expiration because buyers and sellers often change hats back and forth as conditions change.
    Chew on that concept for awhile and do some YouTube watching on options!
    To Your Wealth!
    Garrett
    Reply April 26, 2012 at 12:29 PM
    Chip said…
    Garrett, you crack me up! I’m sitting here reading your post and laughing. I was just imagining the Racer being a hillbilly with a thick country accent, scratching his belly…. and the insurance salesman being an uptight businessman in a suit. Great post!
    Reply April 26, 2012 at 08:50 PM

  • Mike M.

    Phil was referencing the investing site that is still being developed so it’s not currently publicly available.

  • iloveangels (Anne)

    Hi Rulers,
    I have been studying various pages on this blog, and today I took a closer look at:
    http://philtown.typepad.com/phil_towns_blog/2012/03/from-mike-m-cliffs-natural-resources-drew-carey-isnt-the-only-one-who-thinks-cleveland-rocks-.html
    I am wondering how I can get/buy a subscription to http://www.ruleoneinvesting.com , as I would like to check my calculations for PotashCorp, that I posted about earlier, with the utility that it looks like is there.
    Is the http://www.ruleoneinvesting.com utility that Phil shows on the CLF analysis link I mentioned the same as is offered on http://www.investools.com? Maybe I should see if I can get a trial subscription to that and try it out.
    Thank you for any suggestions you can give me.
    All the best to you each in your endeavors!
    Anne (iloveangels)

  • Mike M.

    Good stuff Sue. Let’s hope the stock gets hammered!

  • sue

    POT reported a disappointed but not surprise 1Q results today. But the stock price didn’t drop a lot, only 3%. I expect that the price goes down further in the near future, such as $38, which is the year low of POT and a buyable price (payback time 6.5).
    The following is my brief summary of POT 1Q result:
    04/26/2012-1Q
    Revenues -$1.746 billion, down 23 % ($2.2 billion, Y/Y)
    – KCL: Sale 1.2 million tonnes (was 2.8 MT 2011-1Q; production 1.575 MT). Ave price =$ 435(19% up Y/Y).
    – Phosphate P (Sale 0.9 MT; production 0.486 MT). Ave price =$ 607(9% up Y/Y).
    – Nitrogen P (Sale 1.3 MT; production 0.68 MT). Ave price =$ 383 (4% up Y/Y).
    Earning-$491 million, down 33% ($732 million, Y/Y), EPS = $ 0.56
    – KCL: Gross margin $327 Million (was $743M 2011-1Q); due to high price, low sale volume)
    – P (Gross margin $152 M/ $150M Y/Y)
    – N (Gross margin $219 M/ $203M Y/Y)
    Outlook
    – KCL and P purchasing will be accelerated in 2Q
    – EPS 2Q = $0.9 – $1.10 (was $0.96, 2011-2Q); 2012 Year =$3.2 -3.6 (revised from $3.4 -4.0)
    – KCL 2012 sale 8.8 -9.2 MT (revised from 9.0 -10 MT)
    – Gross Margin $2.6 -2.9 Billion (revised from 2.9 -3.3 bi)
    – P & N 2012 Gross Margin $1.3 -1.5 Billion
    4/26/2012
    – Downgraded by National Bank, from performance to Underperformance. Target price was marked down from $45 to $42.
    4/23/2012
    – Downgraded by Lazard Capital, from overweigh to N.

  • Greg

    I’ve been following CLF for a while. I know that a lot was posted recently regarding RIO and that some feel that it’s a Rule # 1 Co. I need to do more regarding CLF but for a long investor who likes a good dividend, CLF is hard to beat especially at the current price. I’m truly expecting it to reach the lower 60’s and bounce off the floor of what I see as 59 and change. I am optimistic about their growth in China as the rest of the world is believing that China’s growth slow down means they are going to stop all development. Recently China has had to admit the problems with the largest Hydro-electric Dam (Three GOrges Dam) in the world and the issues such as erosion and structural failures. I imagine this project and general upgrading on infrastructure make CLF a solid buy at their current prices. I know that dividends are not a sexy way to make a lot of money, but I’ll have to consult Warren had see how they’ve panned out so far for him. Any company that increases their dividend 123% demonstrates to me that they have the investor at the center of their target group and desire to please them.

  • Moncho

    Hello Rulers’
    Anyone else frustrated that the Big Boys won’t allow our “wonderful businesses” to go down? 🙂
    Its unfortunate that my SIMPLE IRA won’t let me do options, especially on STRA. With my limited knowledge of options, I want my July $70 PUT but I can’t have it. I would love to own STRA at $70 or less.
    Currently for-profit education is flowing with “blood in the streets” and will continue for the next year or so but I believe it is based on “unjustified popular prejudice.”
    Come on Boys, give me CLF for $62 tomorrow…
    Great Days!
    Moncho

  • iloveangels (Anne)

    oops.. I meant it has good reviews at glassdoor 🙂

  • iloveangels (Anne)

    Thank you so much Moncho!
    I just looked at the only Wonderful Company I have found for ME and it has good reviews at glasswindow: Potash Corporation.
    I did some number analysis on Potash Corp (POT) using msn as desribed in Phil’s books.
    I got an MOS PRICE of
    $34.98
    It’s now at about 42… so I’m waiting and looking for my next Wonderful Company.
    Best to you all!
    Anne (iloveangels)
    Here are some of my calculations… hopefully they will post…
    RE:
    Equity Growth Rate (BKPS: Book Value Per Share) (R1 72, 73, 74) (PBT 70)10-year growth rate
    15.15%
    Resource 1 > http://investing.money.msn.com/investments/key-ratios?symbol=POT&page=TenYearSummary
    Resource 2 > http://www.paybacktime.com/mypaybacktime/calculators/equity-growth-rate.aspx
    Sticker Price (R1 147, 150, 154) (PBT 95. 109)
    1. Current EPS
    3.51
    Resource 1 > http://investing.money.msn.com/investments/financial-statements?symbol=POT
    2. Estimated (future) EPS growth rate (Past Equity Growth Rate: R1 150)
    Past Equity Growth Rate | Analyst’s Prediction | Lower of the two:
    15.15 % | 17.30% | 15.15 %
    Resource 1 > Already calculated past Equity Growth Rate earlier (see previous calculations)
    Resource 2 > http://investing.money.msn.com/investments/earnings-estimates?symbol=POT
    Future EPS
    $14.83
    Resource 1 > http://www.paybacktime.com/mypaybacktime/calculators/sticker-price-and-mos.aspx
    3. Estimated (future) PE (PBT 96)
    19% (average from below)
    Resource 1 > http://investing.money.msn.com/investments/key-ratios?symbol=POT&page=TenYearSummary
    This gives Future Value Per Share
    $281.77
    Resource 1 > http://www.paybacktime.com/mypaybacktime/calculators/sticker-price-and-mos.aspx
    4. Minimal acceptable rate of return from this investment (PBT 96)
    15%
    RESULTING STICKER PRICE
    $69.65
    MOS PRICE
    $34.98
    CURRENT PRICE (21 April 2012)
    $43.93

  • Moncho

    Dear Rulers,
    I notice some “fear” in a few posts over the last week and it reminded me that we should always be looking for more info on the inner workings of our wonderful businesses. The more info we have on how it is run and what values management possess, the easier it is to make an informed decision.
    A “tool” I have added to my arsenal for inside company info is
    glassdoor.com Reading reviews from employees and how they feel about their jobs can be of some small benefit.
    I don’t know about others, but I like hearing from individuals on the inside and what they think about their management, especially in sectors I have no experience in like mining.
    Being Rulers, we need to look for ways to reduce FEAR and KNOW WERE RIGHT about our companies. By getting an inside look, albeit possibly skewed, by current employees is just one more tool for our success.
    Great Days!
    Moncho

  • Benjamin “Tulsa”

    Garrett, you were in tulsa and didnt hit up me up???? what gives.?
    ha. Everyone, to rephrase Phil in another way is you are buying an equity/bond. For example coke. you buy it at 70 dollars. The eps is 5.00 with a dividend of 2.5 (i think). Thus, you reduce your cost bases of 70 by $2.5 the first year. Now, the Eps is growing at 10% every year for 10 years. so as Phil said, compound the eps or dividend out for 10 years, add each year up and reduce that cost from the initial purchase. So in this case it might be close to 40 dollars removed from 70$ purchase price. So now your cost basis is 30 dollars with a dividend of around 6.5% each year, wow. now calculate your return…
    It what phil did not mention is where would the stock price be in 10 years,, it could easily be in the 100 plus range,, you never know. Because Mr Market is going to go crazy at some point down the road.. !!!!..
    That is compounding cash flow returns you have to love !!!

  • Chip

    Interesting article on BP. I know some of you out there are watching it. Personally, I think the author is being a little harsh about the whole thing. I think BP had already prepared for this.
    http://seekingalpha.com/article/516431-3-oil-gas-stock-to-consider-now-1-to-avoid

  • Garrett

    Hello Rulers,
    I just spend another hour with Dad on the phone. He’s 72 and opened an account with Trade King. He wants to learn more about how to create Rule #1 Cash Flow to supplement their retirement income and use Rule #1 Options to lower his risk.
    Dad says he’s probably my toughest student. He says if he can learn this then I can probably teach anybody. He’s asking great questions which is a good source of feedback for me that he’s on the right track.
    Today we looked at Floor and Ceilings and how we can use that information to make smarter Rule #1 Cash Flow decisions and then we looked at how we can use Rule #1 Options to lower our existing basis on our R#1 Companies.
    Since Mom and Dad are big Exxon holders, they benefit from XOM’s dividend to supplement their retirement income. Dad could sell XOM for a profit, but then he’s going to lose that Dividend income. Also, he could buy more shares of XOM based on “The Tools”, but if he does that now, he’s going to raise his basis because he already owns it at a great price. So we discussed ways to lower his basis by using Rule #1 Option Strategies. Should XOM drop a lot in price, Dad would be in a win-win situation. He could buy XOM at a great price and if it doesn’t drop, he will lower his basis because of the cash he earned by selling derivatives.
    Investing Rule #1 Style means “No Fear!” Our only fear is we didn’t make as much money as we wanted or the price didn’t go down enough before we could buy more of it!
    At this point, Dad’s wants to achieve a high enough ROI that he won’t have to touch his principle. He wants to leave something behind for those wonderful kids he has!
    If a 72 year old can understand Rule #1 and get excited about it, I’m pretty confident a kid in high school could too.
    To Your Wealth!
    Garrett

  • JT

    Thanks for all the replys everyone. This info really helps.

  • Eli

    Garrett, I think someone commented already when using charts you’ve to specify the time frame Daily, Weekly or Monthly?
    Thanks!

  • Eli

    Garrett, I think someone already commented that you have to specify the time frames used, Daily, Weekly or Monthly?

  • Stephan

    Thank you Garrett for the link. Great article. Usually I set my stops around 4-5 %. But because of all this debt and euro crisis going on I´m a bit nervous. This time I was too chicken-hearted. But I think there will be a lot of good opportunities in the next couple of months ahead. I think Spain will be the next state who needs help and then the euro crisis will be back bigger than before.
    Maybe we can see the next stock market crash very soon.

  • Garrett

    Cliff G and Stephen,
    So you got sold out of DECK. And for the moment, you have “Rule #1 Trader’s Seller Remorse.”
    The way you solve that is you either know the value of what you’re buying or you don’t.
    Now, we at least agreed that DECK WAS NOT at MOS. That right there was enough of a reason for me to not go dumping big money into this.
    And on top of that, I had to consider if this was a good use of my capital. As it is, I’m trying to stockpile other companies that have no risk to me. Do I want to tie money up in DECK when it’s not at MOS and has MOAT issues? No…I do not.
    So the story I posted (your story might have been different) was that I saw this as a short-term trade because DECK was a fundamentally good company, trading at a 52 week low because of a disappointing quarterly earnings report.
    The unknown was if the floor would become a ceiling as it could possibly drop even more on price. I suspected it would possibly rebound back up to $70 or higher once the big guys decided to get back in.
    I’ll post what I did now that it’s after the fact. Because I post a lot on here, I don’t want newbie Rulers doing something I’m doing. That’s not the point of the blog. It’s to learn from each other and become better investors.
    I originally liked the idea of owning DECK around a tentative $65.00 floor, but I wasn’t going to ride this down buying more of it because I didn’t believe it was at MOS price.
    When it dropped below $65.00 I sold immediately. However, I sold puts at the May 19th $62.50 Strike Price. By selling the PUT, I could keep the premium (or close it out for a profit) if DECK went up in value. If DECK continued to drop in price, I could take my PUT and “Roll down and out” to a lower strike price and further out into the future while still not violating Rule #1.
    As it is, at the moment, DECK is on 3 Green Arrows. So, personally, if I were a Rule #1 Trader, I wouldn’t have had such a tight stop loss. I think 3% to 4% would have been reasonable…you have to use a little thinking and see how much DECK changes in price on a daily basis. After all, you bought this based on your technical analysis of a Floor and then you sold it right when the 3 Green arrows said, “BUY”. Again, nothing wrong with that because you made money. That’s awesome. Just keep a journal of why you did what you did so you can learn from the experience.
    So now you find yourself in that uncomfortable situation where you’re asking yourself “Will it go down again?” or “Will it ride up without me?” or “Should I buy more now at a higher price?”
    I wouldn’t beat myself up to much about getting out of DECK early. I would, however, want to find another company that I can keep funneling my money into and get those nice 5% or higher returns in short time spans. That’s called “increasing the velocity of money.”
    Here’s a really good article I found on Seeking Alpha that might help further your R #1 Education. I think this guy has read Payback Time!
    http://seekingalpha.com/article/506961-avoiding-expensive-mistakes-made-by-rookie-ira-investors-how-to-open-a-long-position-cheaply
    To Your Wealth!
    Garrett

  • Stephan

    I think 3 % is the minimum. Maybe there will be a pullback on monday so we can buy back the stock.

  • Cliff G

    I did the same thing, set my trailing stop loss at 1% and sold at 66.81 before the price shot up. I think I’ll start using 2-3% trailing stop losses in the future.

  • Kristo

    JT
    I look at the technicals using google and have noticed
    that you do have to be careful about what time period you
    are using. Phil has provided the settings in days. I notice
    the tools call it “periods” so it changes depending on
    the view you choose. The “arrows” change, so you must use
    the right time period to get the arrows that represent the
    30-day moving average, and the MACD, and SSTO in days.

  • Stephan

    I bought DECK for an average price of $ 64 the last week.
    And today I was so stupid to set my stop to tight (at $ 66.49).
    I was stopped out today with a profit of $ 1200 and after I was stopped out the stock went down to $ 66.11 and after that up and up and up.

  • Garrett

    JT – gotta go…so I’ll be brief:
    Phil defaults the MACD to 8,17,9. That works really well. In order to prevent getting whipsawed, adjust your MA to the 30 day. When something like DECK drops real fast and then starts to level out, I’ll switch my MA (NOT MACD) to a 10 day so I and look at corresponding volume to see if it looks like a breakout. If the volume surges on a MA Green Arrow, then odds are in my favor it will go up.
    To Your Wealth!
    Garrett

  • JT

    Hi Rulers! Sorry to detour this thread but I had a question about the tools and settings. I noticed a few weeks ago a few people were watching DECK and using it to trade with the FAC’s as well as the standard MACD settings etc. I use Scottrade and noticed that when I have it set for long term macro view with a 3-6 month timeline and the MACD in weeks I don’t get the 3 green arrows yet. With a MACD in days 8,17,9 then the I get the 3 arrows on April 17th. I assume the tools are fairly subjective based on your strategy. I had the conservative approach because I didn’t want to get whipped in and out. Still, on April 17th I could have entered at $62 and now it’s nearly $69 and I am still not getting the signal to buy. That seems like too large of a deviation to me. Last, it bounced right when it hit a 52 week low in a huge way. It felt like all the big guys have their algorithms set to enter when that happened. Is that fairly common? Any advice is greatly appreciated.

  • Garrett

    Actually Jason, if your R#1 Company is kicking off a substantial dividend then I’d want to include that as part of my “BVPS Growth Rate.” And it’s really nice that Phil’s Towntoolbox at http://www.ruleoneinvesting.com does that for me. Phil calls it “BVPS+Divdend Growth Rate”
    Phil calls the following the “MOAT COMPOUND GROWTH RATES”
    Here’s Exxon’s. The following are for 10 year, 7 year, 5 year, 3 year and 1 year Growth Rates:
    BVPS+Dividend Growth Rate: 15.0%, 14.7%, 14.7%, 17.6%, 15.9%
    EPS Growth: 14.%, 11.6%, 4.8%, -1.3%, 35.1%
    OCPS Growth: 13.3%, 9.2%, 6.3%, -0.9%, 20.3%
    Sales Growth: 13.5%, 11.6%, 11.3%, 5.4%, 26.9%
    Rule One Moat Score 75
    To Your Wealth!
    Garrett

  • Jason D

    Thanks for the reply Garrett!
    Ok, so basically you’re saying that dividends don’t really play any part in Rule 1 calculations, it’s just icing on the cake if a Rule 1 company has it?

  • Danny

    Hi guys – great topic, when the company is profitable and can grow by reinvesting profits in the same way with highly probable success – a la Coke – then you don’t want them to give you a dividend beyond the excess profits.
    Most ceo’s, once the business is clicking, don’t have an interest or the time to invest successfully outside their industry, this is where you’ll see a lot of stupid aquisitions, etc. So even though dividends are a taxable event, you want to get the $ out of their hands and into yours…
    …if the company you own has a better overall investor then you (aka a Buffett type) well then you’re better off letting him keep working it and defer your taxes! The bigger the cash stash the more important it is to have a capital allocator within the company. Right now we see Apple’s 100billions at face value… if they hired Buffett to invest and left the rest of the business to operate the exact same way, the company could double on the announcement.. Obviously this won’t ever happen but it is happening over at Berkshire with +70 stand alone companies pumping cash to the Oracle just as Phil described

  • Garrett

    Ojonas,
    You’re correct. It’s always a great thing if your company is growing so fast that they need the money for more Panera Bread stores or Buffalo Wild Wings Restaurants. However, some companies just can’t grow like that anymore. Take Exxon – Exxon is presently competing for AAPL as the largest company in the world. It’s just not going to be doubling in size every 5 years (15% Growth Rate) so we expect them to kick off a dividend to us owners.
    For a good example of a bad company handing out dividends for the wrong reasons re-read that section in Rule #1 where Phil uses GM as an example of how they borrowed tons of money and then used it to write dividend checks to the shareholders…all just a ruse to make it look like things were just fine. I’d post the page to save you a few minutes, but I don’t have a copy with me at the moment. That’s a great example of MANAGEMENT totally giving the shaft to the owners.
    To Your Wealth!
    Garrett

  • ojonas

    Don’t we just want the company to pay out dividends if we think that is better than that they are reinvesting the money into the business in hope of a good ROIC?
    If the wonderful company can use the cash to grow the business instead of paying the shareholders a dividend, isn’t that a good thing? This is of course assuming the company we are investing in is truly a wonderful business and as such company can utilize the dividend money internally for a better return than we could using the dividends somewhere else.

  • Moncho

    Garrett,
    Thanks. That is what i was kinda thinking but just wanted to verify.
    Moncho

  • Garrett

    Moncho,
    Rulers don’t like DRIP’s because we don’t want to automatically buy more shares of our R#1 Company if it’s above our MOS. Instead, take the cash and invest it in something else or of course you can buy more shares if your R#1 Company is still below MOS.
    To Your Wealth!
    Garrett

  • Moncho

    Hello fellow Ruler’s,
    Seeing as how Phil has brought up dividends, my question is whether or not join my Rule1 company’s DRIP plan or take the cash and invest it in another excellent company I want to own?
    I have scoured both books but couldn’t find my answer so if I missed it could someone point me to a page number.
    Rule#1/PBT logic tells me, take the check and buy more of my wonderful company if it is at 70% of Sticker or less. If over, save the cash and invest other ways.
    Great Days!
    Moncho

  • Garrett

    Jason,
    Phil might chime in on your question…but I’m sitting in a hotel room in rocking Tulsa, Oklahoma evaluating my portfolio trying to figure out how to lower my basis on certain holdings…So I’ve got a few moments here.
    Regarding your question “Should we specifically look for Rule 1 Companies with a dividend or should we just snap up every true Rule 1 Company we can find?”
    The answer is “No.”
    If that were the case, and you believed AAPL was a Rule #1 Company, you would have never owned it. Or how about Panera, Buffalo Wild Wings, etc…? Don’t pass up on a Rule #1 Company that has MEANING to you because it doesn’t give a dividend.
    The Dividend is that Rule #1 Sweetner…gotta love it when you find a Rule #1 Company and it kicks off a dividend too!
    Dividends are great when you find a Rule #1 Company that’s at a phenomenal discount and you can load up on it. Then 10 to 20 years from now it’s still growing at 15% and you’re sitting on 1 million dollars worth of Company XYZ and getting a nice fat dividend regardless of where you live or what you’re doing.
    Me…my wife and I will be sleeping in a tent on some mountain range in some remote part of the world eating freeze dried food out of our backpacks because that’s our idea of living the dream! 🙂
    To Your Wealth!
    Garrett

  • Jason D

    Just wondering…
    How does dividend play into the calculations we learned in your two books? Should we specifically look for Rule 1 companies with a dividend, or should we just snap up every true Rule 1 company we can find?

  • Garrett

    Phil,
    My dad first introduced this concept to me years ago as a shareholder in Exxon (XOM). Unfortunately, “when I was a boy of 14 my father was so ignorant I could hardly stand to have the old man around. But when I got to be 21, I was astonished at how much that old man had learned in just 7 years.”
    – Mark Twain
    To Your Wealth!
    Garrett

  • Sergio Cruz

    Thank you Phil. Always amazing reading and superb lesson. Much appreciated.
    Cheers.