strategy fund 21 s r o

strategy fund 21 s r o, strategy, fund, 21, s, r, o



So let’s begin.  We’re going togo into business together.  We’re going to start a company and we’re going to start a lemonade stand and now I don’t have any money today, soI’m going to have to raise money from investors to launch the business.  So how am I goingto do that?  Well I’m going to form a corporation.  That is a little filing that you make withthe State and you come up with a name for a business.  We’ll call it Bill’s LemonadeStand and we’re going to raise money from outside investors.  We need a little moneyto get started, so we’re going to start our business with 1,000 shares of stock.  Wejust made up that number and we’re going to sell 500 shares more for a $1 each to aninvestor.  The investor is going to put up $500.  We’re going to put up the name andthe idea.  We’re going to have 1,000 shares.  He is going to have 500 shares.  He isgoing to own a third of the business for his $500.

So what is our business worth atthe start?  Well it’s worth $1,500.  We have $500 in the bank plus $1,000 becauseI came up with the idea for the company.  Now I’m going to need a little more than $500,so what am I going to do?  I’m going to borrow some money.  I’m going to borrow from a friendand he’s going to lend me $250 and we’re going to pay him 10% interest a year for thatloan.

Now why do we borrow money instead of just selling more stock?  Well by borrowingmoney we keep more of the stock for ourselves, so if the business is successful we’re goingto end up with a bigger percentage of the profits.

So now we’re going to takea look at what the business looks like on a piece of paper.  We’re going to lookat something called a balance sheet and a balance sheet tells you where the companystands, what your assets are, what your liabilities are and what your net worth or shareholderequity is.  If you take your assets, in this case we’ve raised $500.  We also have whatis called goodwill because we’ve said the business—in exchange for the $500 the personwho put up the money only got a third of the business.  The other two-thirds is ownedby us for starting the company.  That is $1,000 of goodwill for the business.  Weborrowed $250.  We’re going to owe $250.  That is a liability.  So we have $500 incash from selling stock, $250 from raising debt and we owe a $250 loan and we have acorporation that has, and you’ll see on the chart, shareholders’ equity of $1,500,so that’s our starting point.

Now let’s keep moving.  What do we need to do to startour company?  We need a lemonade stand.  That’s going to cost us about $300.  That is calleda fixed asset.  Unlike lemon or sugar or water this is something like a building thatyou buy and you build it.  It wears out over time, but it’s a fixed asset.  And thenyou need some inventory.  What do you need to make lemonade?  You need sugar.  Youneed water.  You need lemons.  You need cups.  You need little containers and perhapssome napkins and you need enough supplies to let’s say have 50 gallons of lemonadein our start of our business.  Now 50 gallons gets us about 800 cups of lemonade and we’reready to begin.

Let’s take a new look at the balance sheet.  So now we’ve spent$500 on supplies.  We only have $250 left in the bank, but our fixed assets are now$300.  That is our lemonade stand.  Our inventory is $200.  Those are the suppliesand things, the lemons that we need to make the lemonade.  Goodwill hasn’t changedat 1,000, so our total assets are $1,750 and we still owe $250 to the person who lent usthe money.  Shareholder equity hasn’t changed, so we haven’t made any money.  All we’vedone is we’ve taken cash and we’ve turned it into other assets that we’re going toneed to succeed in our lemon stand business.  

So let’s make some assumptions abouthow our business is going to do over time.  We’re going to assume we’re going tosell 800 cups of lemonade a year.  That’s not a particularly ambitious assumption, butwe should assume the lemonade business is fairly seasonal.  Most of the lemonade sellswill happen over the summer.  We’re going to assume that each cup we can sell for $1and it’s going to cost us about $530 per year to staff our lemonade stand.  

Sonow let’s take a look at the income statement, so the income statement talks about the profitability,about the revenues that the business generated, what the expenses are and what is left overfor the owner of the company.  So we’ve got one lemonade stand.  We’re selling800 cups of lemonade at our stand.  We’re charging $1, so we’re generating about $800a year in revenue and we’re spending $200 on inventory.  There is a line item herecalled COGS.  That stands for cost of goods sold.  We have depreciation because our lemonadestand gets a bit beat up over time and it wear out over five years, so it depreciatesover 5 years.  We’ve got our labor expense for people to actually pour the lemonade andcollect cash from customers and we have a profit.  We have EBIT and that is earningsbefore interest and taxes, of $10.  That is kind of our pretax profit for the business. We didn’t make very much money because

strategy fund 21 s r ois kind of our pretax profit for the business. We didn’t make very much money because you take that pretax profit of $10 and youcompare it to our revenues.  It’s about a 1.3% margin.  That is not a particularlyhigh profit.  Now we’ve got to pay interest on our debts and we have a loss of $15 andthen we don’t have any taxes, but at the end of the day we still lose money.  

Sothe question is, is this a particularly good business?  Well we’re losing money andour cash is basically going down over time.  Is this a business we want to stay in?  Nowthe cash flow statement takes the income statement and figures out what happens to the cash inthe company’s till, so when you put up $750, some money goes to pay for a lemonade stand. Some money is lost selling the product and at the end of the day we started with $750and now we only have $500.  Let’s look at the balance sheet.  What has happened? Our cash has gone down from 750 to 500.  Our fixed assets have gone from 300 to 240. That means our lemonade stand is starting to wear out.  Goodwill hasn’t changed. We still owe $250 and our shareholder’s equity is now down to $1,490, so it was the1,500 we started with minus the $10 we lost over the course of the year.  

So shouldwe continue to invest in the business?  We’ve lost money in the first year.  Is it timeto give up?  Well let’s think about it.  Let’s make some projections about whatthe company is going to look like over the next several years.  Let’s assume thatwe take all the cash the business generates and we’re going to use it to buy more lemonadestands so we can grow.  Let’s assume we’re not going to take any money out of the companyand we’re not going to pay a dividend.  We’re going to keep all the money in the companyand reinvest it.  Let’s assume that we’re going to—as we build our brand we can chargea little more each year, so we’re going to raise our prices about a nickel, five centsmore for each cup of lemonade each year and then we’re going to assume we can sell 5%more cups per stand per year.  So we’ve got built in growth assumptions. 

Nowlet’s take a look at the company.  So if you take a look at this chart you’ll seein year one we started out with one lemonade stand.  We add one a year and then by yearfive we’re up to seven because we’ve got a big expansion plan.  Our price per cupgoes up a nickel a year and our revenue goes from $800 and starts to grow fairly quicklyand the growth comes from increased prices for cups of lemonade and it also comes fromopening more stands.  So by year five we have almost $8,000 in revenue.  Our costsare relatively constant, which is the lemonade and the sugar.  That’s about $1,702.  Wehave depreciation as more and more stands start to wear out over time.  We’ve gotlabor expense, but by year five the business is actually doing pretty well.  We went froma 1.3% margin to over a 28% margin.  The business is now up to scale.  We’re startingto cover some of our costs.  We’re growing.  We’re still paying $25 a year in interestfor our loan and we have earnings before taxes, after interest of $2,300 by the end of year5.  So we put $500 into the business.  We borrowed 250 and by year five we’re makinga profit of $2,300.  That sounds pretty good.  Now we have to pay taxes to the government. That is about 35% and we generate net income or another word for profits of $1,500 by thefifth year and about a dollar a share.  

So if you think about this our friend put up$500 to buy 500 shares of stock.  He paid a dollar and after five years if our businessgoes as we expect he is actually making a dollar a share in profit.  That sounds likea pretty good deal.  So what has been the growth?  The growth has been fairly dramaticover the period and that is what has enabled us to become a successful business.  Nowthese are just projections, but if they’re reasonable projections this might be a businessthat we want to start or invest in.

Now let’s look at the cash flow statement.  Soas the business becomes more and more profitable we generate more and more cash and the cashbuilds up in the company.  We go from $500 of cash in the company to over $2,000 of cashover the period.  The balance sheet, again, the starting balance sheet had shareholder’sequity of $1,490, but as the business becomes more profitable the profits add to the cash. They add to the assets of the company.  Our liabilities have not changed and the businesscontinues to build value over time.  So again by the end of year five we’ve got $4,000of shareholder equity and that’s almost three times what it was when we started.
Now is this a good business or a bad business?  How do we think about whether it’s goodor bad?  One thing to think about is what kind of earnings are we achieving comparedto how much money went into the company.  Now this is a business that we valued at $1,500when we started.  Someone put up $500 for a third of the company.  We gave it a $1,500value.  By the end of year five it’s earning over $1,500 in earnings, so that’s overa 100% return on the money that we put into

strategy fund 21 s r oover $1,500 in earnings, so that’s overa 100% return on the money that we put into the company.  That’s actually quite a highnumber.  We spent—let’s talk about return on capital.  We’ve spent $2,100 in capitalbuilding lemonade stands and we earned $2,336 in year five on the capital we invested.  That’sover 100% return on capital.  That is a very attractive return.  Earnings have grown ata very rapid rate, 155% per annum.  This is really a growth company and our profitabilityhas gone from 1.3% to 28.6% by year five and that sounds pretty attractive and it is.  

Solet’s look at the person who put up the loan.  Well that person put up $250 and thebusiness has been profitable.  We’ve been able to pay them their interest of 10% a year,$25 a year and they’re happy because they put up $250.  They’re getting a 10% returnon their loan and the business is worth well more than $250.  We’ve got more than thatin cash.  As a result, they’re in a safe position, but they’ve only made 10% on theirmoney.  

Now let’s compare that with the equity investor, the person who boughtthe stock in the company.  That person earned a dollar a share in year five versus an investmentof a dollar a share, so he is earning over 100% or about 100% return on his investmentversus only 10% for the lender.  So who got the better deal?  Well obviously the equityinvestor.  Now why did the equity investor, why do they have the right to earn so muchmore than the lender?  The answer is they took more risk.  If the business failed thelender is entitled to the first $250 of value that comes from liquidating the company, soif you sell off the lemonade stands and you only get $250 the lender gets back all theirmoney.  They’re safe.  They got their 10% return while the business was going.  Theygot back their $250, but the equity investor, the person who bought the stock is wiped outbecause they come after the lender.

So what is the difference between debt and equity? Debt tends to be a safer investment because you have a senior claim on the assets of acompany and it comes in lots of different forms.  You’ve heard of mortgage debt ona home.  That’s a secured loan secured by a house, but you could have mortgage debton a building for a company.  There is senior debt.  There is junior debt.  There is mezzaninedebt.  There is convertible debt, but the bottom line, it’s all debt.  It comes indifferent orders of priority in a company and the rate your charge is inversely relatedto your security, so the better the security and the less risk the lower the interest rateyou’re entitled to receive.  The more junior the loan the higher the interest rate you’reentitled to receive, but you can avoid the complexity.  All you need to think aboutis debt comes first.  It’s a safer loan, but you’re profit opportunity is limited.

Nowthe equity also has their varying forms.  There is something called preferred equity or preferredstock.  There is common equity or common stock and again stock and equity are basicallysynonyms.  They’re options, but really not worth talking about today.  The importantpoint is that equity gets everything that is left over after the debt is paid off, soit’s called a residual claim.  Now the good thing about the residual claim is thatbusiness grows in value if you don’t owe your lender anymore, but all that value goesto the stock holder.  So the question is why was the lender willing to take only a10% return when the equity earned a much higher rate of return and the answer is when thebusiness started there was no way of knowing whether it would be successful or not andthe lender made a bet that if the business failed they could sell off the lemonade stand. It cost $300 to make it.  They would have some lemons, some lemonade.  Even if theysold it at a much lower price than the dollar they originally projected the lender feltpretty comfortable that they would get their money back, whereas the stockholder is reallytaking a risk.  They were betting on the profitability of the company and they weretaking a risk that if it failed they would lose their entire investment, so they wereentitled to get a higher return or have the potential to have a higher return in the eventthe business we successful.

So let’s talk about risk.  Lots of different wayspeople think about risk, but the one that we think is the most important—you knowa lot of people talk about risk in the stock market as the risk of stock prices movingup and down every day.  We don’t think that’s the risk that you should be focusedon.  The risk you should be focused on is if you invest in a business what are the chancesthat you’re going to lose your money, that there is going to be a permanent loss.  Whenyou’re thinking about investing your own money, when you’re thinking about one investmentversus another don’t worry so much about whether the price moves up and down a lotin the short term.  What matters is ultimately when you get your money back will you earna return on your investment.  

How do you think about risk?  Well one way to thinkabout risk is to compare your risk to other

strategy fund 21 s r o you think about risk?  Well one way to thinkabout risk is to compare your risk to other

strategy fund 21 s r oyou think about risk?  Well one way to thinkabout risk is to compare your risk to other alternatives, so you could buy governmentbonds and government bonds are considered today the lowest risk form of investment andthe US Treasury issues 10 year, 3 year, 5 year debt.  There is a stated interest rateand today a 10 year Treasury you earn about a 3% return.  So you give your government$1,000 and you get $30 a year in interest.  At the end of 10 years you get your $1,000back, so that’s very, very safe and that sort of provides a floor.  Now obviouslyif you’re going to make a loan you can lend money to the government and earn 3%.  Wellif you can lend money to a lemonade stand you want to earn meaningfully more, so inthis case the lender is charging a 10% rate of interest.  Why 10%?  Because they wantto earn a nice fat spread over what they can make lending to the government because a startuplemonade stand business is a higher risk business.

Equity investors sort of think about things similarly,so the higher the valuation—the more risky the business the higher the rate of returnthe equity investor is going to expect and the lower the risk business the lower thereturn the equity investor is going to expect and equity investors don’t get interestthe same way a lender does.  What equity investors get is they get the potential toreceived dividends over the life of a company.  

Let’s talk about raising capital. You started this lemonade business.  Now the point of this was to make money in thefirst place.  The business is doing very well yet I, having started the business comingup with a name and the concept, hired all the people, I’ve made nothing, right.  Sothe business has grown in value, but where is my money?  I need money to buy a car forexample, so I want to buy a car for $4,000.  What are my choices?  What can I do?  Wellwe’ve taken all the cash the business has generated.  We’ve reinvested it in thebusiness.  Now the good news is we’ve taken all that money.  We’ve been able to useit to buy more lemonade stands and these lemonade stands are more and more productive and it’sgrown the value of the business faster and faster.  Now my alternatives could includedinstead of growing the business so quickly, instead of investing in more lemonade standsI could simply have paid dividends to myself.  Now the good news about that is I get moneyalong the way, but the bad news about that is the business wouldn’t grow as quicklyand if you have a business as profitable as this lemonade stand company and you just opena new lemonade stand and people earn—we can earn hundreds of dollars in each new standit makes sense to keep investing.  

Well how do I keep my business going and growing,taking advantage of the opportunities, but take some money off the table?  How do Ido that?  Well I could sell the company, so I could sell my lemonade stand business. I started this one in New York.  Maybe there is someone in New Jersey who wants tobuy me, consolidate with my lemonade stand company.  Well the problem with that is onceI sell it I can no longer participate in the opportunity going forward and I believe inthis business.  I think it’s going to be very successful over time.  So that’s onealternative.

The other alternative is I could pay a dividend.  We have by yearfive, over $2,000 sitting in the bank, so I could pay that money out to the shareholdersof the company, but that would really slow my rate of growth going forward because Icouldn’t afford to build and buy more lemonade stands and it’s not the $4,000 that I needin order to raise money.  So I’m going to look at taking a business public.  What doesthat mean?  Well first of all, before we take our business public we want to thinkabout what it’s worth.

It’s year five.  We’ve been doing a good job.  We’vegot a business that is profitable.  Everything seems to be going well.  Well the problemis I’ve got some personal needs.  I’ve started this company.  I’ve taken all the cash thebusiness generates.  I’ve reinvested the cash in the business.  I bought more andmore lemonade stands.  The growth is accelerating.  I feel great about it, but I need money. How do I get money?  What do I do?  Well I’ve got a company that generates a lot ofcash each year, but I’ve been reinvesting the cash, so one alternative is perhaps Idon’t grow as quickly.  I don’t buy as many lemonade stands and I start sending thatmoney back to me in the form of a dividend.  So each year I pay out some amount of cashin the company.  My need is really greater than that.  There is only about $2,000 inthe company today.  If I sent that out that is half of what I need to by a car.  So howdo I get the rest of the money or how do I get more money?  Well I could sell the company,so that’s one alternative, but the problem there is I’ve got this really good business. It’s growing really quickly.  Why would I want to get rid of it at this point?  Sowhat should I do?  

The other alternatives, other than selling 100% of the business isto sell a piece of the business and I can

strategy fund 21 s r oother than selling 100% of the business isto sell a piece of the business and I can do that privately.  I can find an investorwho wants to buy a private interest in the company and if the business is worth enoughI can sell them a piece of the business and we can be successful.  The other alternativeis I can take the business public.  Everyone has probably heard of an IPO, an internetcompany is going public, people getting rich on an IPO.  What is interesting is an IPOdoesn’t make someone rich.  All it really does is it takes a business that they alreadyown and it sells a piece of it to the public and it gets listed on an exchange like theNew York Stock Exchange. 

An IPO, the abbreviation stands for initial public offeringand it’s initial because it’s the first time a company is going public.  Going publicmeans you’re selling stock to the broad general public as opposed to finding one investorbuying interest in the company and its offering because you’re offering people the opportunityto participate and the way to do that actually is you get a good lawyer.  You get a goodbank, investment bank.  It’s going to be your underwriter and you’re going to puttogether a document called a prospectus, which is going to talk about all the risks and theopportunities associated with investing in your company.  It’s going to have historyof how the business is done over time.  It’s going to have the balance sheet that we talkedabout.  It’s going to have income statements from the previous several years.  It’sgoing to have cash flow statements and investors are going to read that document and they’regoing to learn about whether this is a business they want to invest in and how to think aboutwhat price they want to pay for it. 

When you decide you want to take your businesspublic you’re going to have to reveal a lot of information to the public in orderto attract investors to participate and the Securities and Exchange Commission they’regoing to study this prospectus very carefully.  They’re going to make sure that you discloseall the various risks associated with investing in the company and you’re also going tohave an opportunity to talk about the business.  It’s some combination of a marketing documentas well as a list of the appropriate risks that people should consider before buyingstock in the company.  That takes time to prepare.  It costs money to prepare.  You’regoing to need good lawyers.  You’re going to need a good investment bank and you’regoing to go through a process where you’re going to make a filing with the FCC with acopy of the initial what’s called registration statement for the offering or the prospectus. The FCC is going to comment on it and eventually you’re going to have a document that youcan then sell shares to the public.

That is kind of an exciting time for you becausewhen you sell shares to the public that’s really, in most cases, the way to get theoptimally high price for the company, but you don’t have to sell 100% of the businessto the public.  In fact, typically you only sell a small percentage.  You get to keepthe rest.  You get to keep control of the company, but you get to raise money in theoffering and you can use that money to buy the car that we were talking about before.

Nowbefore you decided to go public or even to sell it at all it’s probably a good ideato figure out what the business is worth.  So let’s talk about valuation or how tovalue a business.  One way to think about the value of your business is to compare itto other similar businesses.  Now the stock market is actually a pretty interesting placeto look.  Now the stock market is a list of companies that have sold shares to thepublic and you can look in the New York Times or the Wall Street Journal or online, on YahooFinance or Google or other sites and look at stock prices for Coke, for MacDonald’sand what those stock prices tell you is what the value of the company is.  And how doyou figure out the value of the company?  Well you look at where the stock price is.  Youcount how many shares are outstanding.  The shares outstanding will be listed in variousfilings with the FCC.  You multiply the shares outstanding times the stock price.  Thattells you the price you’re paying for the equity of the company, so if you go back toour example of our little lemonade stand we have 1,500 shares of stock outstanding.  Wesold them for a dollar initially, one-third of them to an investor and the business initiallyhad a value of $1,500.

So what is the business worth today?  Well one way to lookat it; let’s look at other lemonade stand companies.  Let’s assume other lemonadestand companies have sold either in the private market, the public market for a price of 10times earnings or 10 times profit, so that will give you a sense of value.  You couldlook at the stock market if there are other examples of a business similar to a lemonadestand company.  Perhaps a company that sold soda every month would be a good example,but let’s use a comparable example.  So let’s assume another lemonade stand companyis trading at 20 times earnings in the stock market.  Well we earned a dollar per sharein year five.  If we put a 20 multiple on that dollar the business is worth, accordingto the comparable about $20 per share.  We’ve got 1,500 shares outstanding.  We multiply1,500 times 20.  Now our business is worth $30,000.  So we had a company that startedout at 1,500, five years later it’s worth $30,000.  That’s actually quite good.

Wellhow do we raise $4,000 if that’s the appropriate value for our business?  Well if we sold200 of our shares, 200 of our shares that are today now worth $20 a share we could raisethe $4,000 that we are talking about.  Now what would that do?  What would happen ifwe sold 200 of our shares in the market?  Well our interest in the business would go downbecause today we own 66 and 2/3 percent or 2/3 of the company.  A third is owned byour private investors.  Well if we sold stock in the market, if we sold 200 of the sharesthat we would own our ownership would go from 67% to 53%, so the good news there is we’dstill have control of the business because in most public companies owning a majorityallows you to control the business going forward, but because the company is now owned by publicshareholders you have to make sure their interests are properly represented, so you have to havea board of directors, a group of individuals who represent the interests of the shareholderswho have a duty to make sure that their shareholders are treated properly and you wouldn’t havethe same degree of flexibility you had when you were a private company because you haveother constituencies that you need to think about.

Now the benefit of the IPO isthe stock would now be liquid.  There would be a market where it would trade in the publicmarkets and then over time if I wanted to sell more stock I could do so or if new investorswanted to come in they could buy stock and our stock would now be liquid.  It wouldmake me feel better about this business in terms of my ability to at some point exitor if a I wanted to raise more money I could sell stock fairly easily in the market becauseeach day you could look up the price either on the web or in the New York Times or otherwiseand you could figure out what your business is worth.

Okay, now how does this matterto you?  Now the purpose of the example of our lemonade stand is just going to give youa primer on what companies are, what they do, how they earn profits, what the variousreports they provide to investors so investors can figure out what they’re worth and thepurpose of this lecture is to give you a sense of some of the things you need to think aboutwhen you’re thinking about investing perhaps some of your own money whether you want toinvest in a lemonade stand or you want to invest in a company on the market, so a fewbasic points to think about.  One of the most important is if you’re going to bea successful investor it makes a lot of sense to start early.  Now that’s kind of a hardthing.  Today you’re probably a student.  You don’t have a lot of spare money.  Well let’s assume at 22 you have a pretty good job.  Instead of spending your moneyon gadgets or a fancy apartment or not so fancy apartment or going out and drinkinga fair amount you put some money aside and you start investing money.  Let’s say youcould save $10,000 at 22 and you can earn a 10% return on that money between now andthe time you retire.  What would you have in 43 years?  The answer, if you put aside$10,000, you don’t save another penny and you invested it in your and you earned 10%on your money each year you’d have $600,000 in year 43 and the reason for that is wellin year 1 your $10,000 will become 11, in year 2 your $11,000 would grow by 10% andso you would be earning interest not just on your original principle, but you’d earninterest on the interest you had earned the previous year and that compounding effectallows money to grow in an almost exponential fashion.  Now obviously if you earn morethan 10% you can earn even higher returns.

Now that’s if you put $10,000 aside at 22 you’dhave $600,000 in 43 years.  That’s pretty good.  What is you had to wait until youwere 32 when you earn the same 10% per annum?  The problem there is by year 33 you’donly have $232,000.  Maybe that is not enough to retire, so the key thing here is if you’regoing to be an investor one of the most valuable assets you have today as someone who is 18or 19 years-old is your youth.  You want to start early so that your money can growover time.

Now what if you could earn 15%?  I’ll give a you better sense of howpowerful compounding is because remember at 10% for 43 years you’d have $600,000.  That’spretty good, but if you earned 15% you’d have over 4 million.  Now you’re in a prettygood position and so obviously making smart decisions about where you put your money hasa huge difference in what you’re retirement assets are.  Now obviously if could put asidemore than $10,000, if you could put aside $10,000 each year then you’re wealth wouldbe quite enormous.

Now just for fun if you were one of the world’s great investors,Warren Buffet being a good example, if you could earn 20% per year for 43 years you’dhave 25 million dollars.  Again the original $10,000 investment would increase about 2,500times over that period of time just by earning a 20% return.  Albert Einstein said the mostpowerful force in the universe is compound interest, so the key is start early, earnan attractive return and avoid losing money and you’re going to have a very nice retirement.

Okay,now let’s talk about the risk of losing money.  Now let’s assume that in orderto try to get a 20% return you took a lot of risk and it turns out that every 12 yearsyou lost half your money because you just made—you hit a bad patch in the market oryou made dumb decisions.  Well your 25 million dollars at 20% would now only be worth a millioneight in 43 years, so a key success factor here is not just shooting for the fences,trying to get the highest return.  It’s avoiding significant loses over the period. 

Okay, so as Warren Buffet says rule number one in investing is never lose moneyand rule number two is never forget rule number one, so if you can avoid loses and earn anattractive return over time you’re going to have a lot of money if you can stick atit for a long period of time.

So how do you be a successful investor?  Now I’massuming that you’re not going to go into the business of investing.  I’m assumingthat you’re going to be a doctor or a lawyer.  You’re going to pursue your passion, butyou’re going to have some money that you’re going to save over time and I’m going to giveyou my advice on the topic.  It’s not necessarily definitive advice, but it’s the advice Iwould give my sister, my grandmother on what she should do if she were in the same position. I think that’s probably the right way to think about it.  

So number one,how do you avoid losing money?  What are the good places to invest?  My first pieceof advice is despite the story about the lemonade stand I’d avoid investing in lemonade stands. I’d avoid investing in startup businesses where the prospects are not very well knownbecause again you don’t need to make 100% a year to have a fortune.  You just needto invest at an attractive return 10, 15 percent over a long period of time.  Your money growsvery significantly.  So how do you avoid the riskiest investments?  My advice wouldbe to invest in public securities, invest in listed companies, companies that tradeon the stock market.  Why, because those businesses tend to be more established.  Theyhave to meet certain hurdles before they go public.  The stocks are liquid, so you canchange your mind if you want to sell.  If you invest in a private lemonade stand it’shard to find someone to take you out of that investment unless that business becomes fabulouslyprofitable.  So that’s piece of advice number one, invest in public companies.  

Numbertwo, you want to invest in businesses that you can understand.  What I mean by thatis there are lots of businesses that you come in that you deal with in the course of yourday in your personal life, whether it’s a retail store that you know because you likeshopping there or it’s a product, your iPad that you think is a great product, but youhave to understand how the company makes money.  If the business is just too complicated,you don’t understand how they make money, even if they’ve had a great track recordI would avoid it and a lot of people thought Enron was an incredible business because itappeared to have a good track record, but very few people understood how they made money. It was good to avoid it.  

Another very important criterion is you want to investat a reasonable price.  It could be a fabulous business that is done very well over a longperiod of time, but if you pay too much for it you’re not going to earn a very goodreturn investing in that company.  The last bit is that you want to invest in a businessthat you could theoretically own forever.  If the stock market were to close for 10years you wouldn’t be unhappy.  What do I mean by that?  Again if you’re goingto compound your money at a 10 or 15 percent return over a 43 year period of time you reallywant a business that you can own forever.  You don’t want to constantly have to beshifting from one business to the next.  And what are businesses that you can own forever? Well there are very few that sort of meet that standard.  Maybe a good example is CocaCola.  What is good about Coca Cola?  It’s a relatively easy business to understand. You understand how Coke makes money.  They sell a formula or syrup to bottlers and toretail establishments and they make a profit every time they serve a Coca Cola.  Peopledrank a lot of Coca Cola for a very long period of time.  The world’s population is growing. They sell it in almost every country in the world and each year people drink a littlebit more Coca Cola, so it’s a pretty easy business to understand and it’s also a businessthat I think is unlikely to be competed away as a result of technology or some other newproduct.  It’s been around long enough.  People have grown used to the taste.  Parentsgive it to their children and you can expect it will be around a long period of time.  Ithink that’s one good example.

Another good example might be MacDonald’s.  Youmay not love MacDonald’s hamburgers.  You may or you may not, but it’s a businessthat it has been around for 50 years.  You understand how they make money.  They openup these little—build these little boxes.  They rent them to the franchisees.  Theycharge them royalties in exchange for the name and they sell hamburgers and French friesand you know what?  People have to eat.  It’s relatively low cost food.  The quality ispretty good and they continue to grow every year.  So I think the consistent messagehere is try to find a business that you can understand that’s not particularly complicatedthat has a successful long term track record that makes an attractive profit and can growover time.

So what are the key things to look for in a business as I say that lastsforever?  Well you want a business that sells a product or a service that people need andthat is somewhat unique and they have a loyalty to this particular brand or product and thatpeople are willing to pay a premium for that.  Another good example might be a candy business. While people are going to buy generic versions of many kind of food products, flour, sugar,they don’t need to have the branded product.  When it comes to candy people don’t tendto like the Walmart version or the Kmart version.  They want the Hershey chocolate bar or theCadbury chocolate bar or the See’s Candy.  They want the brand and they’re willingto pay a premium for that and so that’s I think a key thing.  You want the productto be unique.  You don’t want it to be a commodity that everyone else can sell becausewhen you sell a commodity anyone can sell it and they can sell it at a better priceand it’s very hard to make a profit doing that.

If you’re investing for the longterm you want to invest in businesses that have very little debt.  In our little examplebefore we talked about our lemonade stand.  There is $250 worth of debt.  That didn’tput too much pressure on the lemonade stand company, but if it had been $1,000 and wehit a rough patch the business could have gone out of business for failure to pay itsdebts.  The shareholders could have been wiped out.  So if you can find a companythat can earn attractive profits, that doesn’t have a lot of debt or they generate vastlymore profits than they need to pay the interest on their debt that is a safe place to putyour money over a long period of time.

You want businesses that have what people callbarriers to entry.  You want a business where it’s hard for someone tomorrow to set upa new company to compete with you and put you out of business.  I mean going back tothe Coca Cola example.  Coca Cola has such a strong market presence.  People have cometo expect when they go to a restaurant they can ask for a Coke and get a Coke.  It’svery hard for someone else to break in.  Of course there is Pepsi and there are othersoda brands, but Pepsi has been around a long time and Coca Cola and Pepsi have continuedto exist side by side over long periods of time.  It’s going to be very hard for someoneto come in and come up with a new soft drink that is just going to put Coca Cola out ofbusiness, so when you’re thinking about choosing a company make sure that they sella product or a service that is hard for someone else to make a better one that you’ll switchto tomorrow.  Look for something where people have real loyalty and they won’t switchand it doesn’t—even if someone offers the same, similar product for 20% less theystill want the branded, high quality product.  

You also want businesses that arenot particularly sensitive to outside factors, so-called extrinsic factors that you can’tcontrol.  So if a business will be affected dramatically if the price of a particularcommodity goes up or if interest rates move up and down or if currency prices change. You want a company that is fairly immune to what is going on in the world and I’lluse my Coca Cola example.  I mean if you think about Coca Cola it’s a product thathas been around probably 120 years.  Over that period of time there have been multipleworld wars.  There has been all kinds of you know, development of nuclear weapons,all kinds of unfortunate events and tragedies and so on and so forth, but each year thecompany pretty much makes a little bit more money than they made before and they’regoing to be around and you can be confident based on the history that this is a businessthat is going to be around almost regardless of whether interest rates are at 14%, whetherthe US dollar is not worth very much or the price of gold is up or down.  Those are thekind of companies you want to invest in, in the long term, businesses that are extremelyimmune to the events that are going on in the world.

Another criteria, if you thinkback to our lemonade stand company, as we grew we had to buy more and more lemonadestands.  Now those lemonade stands only cost $300 each, but imagine a business where everytime you grew you had to build a new factory to produce more and more product and thosefactories were really expensive.  Well that company might generate a lot of cash fromthe business, but in order to grow you’re going to have to just reinvest more and morecash into the business.  The best businesses are the ones where they don’t require alot of capital to be reinvested in the company.  They generate lots of cash that you canuse to pay dividends to your shareholders or you can invest in new high-return, attractiveprojects.  

So the key here is low capital intensity, so let’s talk about a low capitalintensity business.  Maybe the best way to think about a low capital intensity businessis to think about a high capital intensity business.  If you think about the auto industrybefore you produce your first car you have to build a huge factory.  You’ve got buya lot of machine tools.  You have to make an enormous investment before you can sendyour first car out the door and those machine tools wear out over time and as you make moreand more cars you have to invest more and more in the factories, so it’s a businessthat historically has not been very attractive for the owners of the business.  If you lookedat the price of General Motors’ stock 50 years ago it actually hasn’t changed meaningfullyeven up until the last several years before it went bankrupt.  If you ignored the mostrecent period up through the bankruptcy of GM very few people made money investing inGM over a 40 or 50 year period of time and the reason for that is that GM constantlyhad to reinvest every dollar that they generated to build better and better factories so theycan be competitive.  

If you compare that to Coca Cola while Coca Cola there arebottling companies around the world a lot of those bottling companies aren’t evenowned by Coca Cola.  What they’re really doing is they’re selling a formula and inexchange for that formula they get a royalty on every dollar that is spent on Coca Cola. Those are the better businesses. 

Another good example might be American Express.  Ifyou think about the American Express card when you take your American Express card andyou buy something American Express card gets a few percent of every dollar that you spend. So you put up the capital and they get a several percentage point return on that.  Theyget 3% of so of what you spent.  So businesses where you own a royalty on other people’scapital are the best businesses in the world to invest in.

I guess the last pointI would make is that if you’re going to invest in public companies it’s probablysafest to invest in businesses that are not controlled.  A controlled company is kindof like our lemonade stand business that we took public.  The problem with a controlledcompany unless the controlling shareholder is someone you completely trust, unless thereis someone that has a great track record for taking care of so-called minority investors,the non-controlling shareholders it can be a risk of proposition to invest in that businessbecause you’re at the whim of the controlling shareholder and even if the controlling shareholdertoday is someone that you feel comfortable with there is no assurance that in the futurethey might sell control to someone else who is not going to be as supportive of the shareholdersof the business.  So it’s not that you just—you can simply have a profitable businessand a business that has done well.  You have to make sure that the management and the peoplethat control the business think about you as an owner and are going to protect yourinterests.  So these are some of the key criteria to think about.Now when are you ready to start investing money?  My guess is you’re a student.  Youprobably have student loans.  Perhaps you even have some credit card debt.  You’regoing to graduate.  You’re going to get a job.  So you don’t want to jump rightin and while you have a lot of debt outstanding start investing in the stock market.  Thestock market is a place to invest when you’ve got a good—you have money you can put awaythat you won’t need for 5 years, maybe 10 years.  So if you’re paying relativelyhigh interest rates on your credit cards you definitely want to pay off your credit cardsfirst before you think about investing in the stock market.

You student loans areprobably lower cost than your credit cards, but again here my best advice would be ifyour student loans are costing you six or seven percent well if you pay them off it’sas if you earned a guaranteed six or seven percent return and you’re just better offgetting rid of your credit card debt and even your student loan debt before you commit alot of material amount of money to the stock market.

So what do you do with your moneywhile you’re waiting to invest?  The answer is you pay down your debt and you want tohave—even once you’ve paid off your credit card debts, perhaps you paid down your studentloans, you want to have enough money in the bank so that even if you were to lose yourjob tomorrow you’ve got a good 6 months, maybe even 12 months of money set aside.  Sothese are some pretty high standards and obviously therefore these make it harder to start investingearlier, but the safest course of action in order to be a successful investor is be as—haveas little debt as possible.  Be comfortable having some money in the bank, so if you loseyour job tomorrow you can live until to find your next opportunity and once you’ve achievedthose goals then put aside money that you don’t need to touch.  If you can do thatthen you can be a successful investor. 

So let’s talk a little bit about the psychologyof investing, so we’ve talked about some of the technical factors, how to think aboutwhat a business is worth.  You want to buy a business at a reasonable price.  You wantto buy a business that is going to exist forever, that has barriers to entry, where it’s goingto be difficult for people to compete with you, but all those things are important, buteven—and a lot of investors follow those principles.  The problem is that when theyput them into practice and there is a panic in the world and the stock market is headingdown every day and they’re watching the value of their IRA or their investment accountdecline the natural tendency is sort of to do the opposite of what makes sense.  Generallyit makes sense to be a buyer when everyone else is selling and probably be a seller wheneveryone else is buying, but just human tendencies, the tendency of the natural lemming-like tendencywhen everyone else is selling you want to be doing the same thing encourages you asan investor to make mistakes, so a lot of people sold into the crash of ’87 when infact they should have been a buyer in that kind of environment.  

So that’s whyI talked before a little bit about why it’s very important to be comfortable.  You wantto be financially comfortable.  If you have student loans you want to have a manageableamount of debt.  You probably don’t want to be paying any—you don’t want to haveany revolving credit card debt outstanding.  You want to have some money in the bankbecause if you’re comfortable then the money that you’re risking in the stock marketis not going to affect your lifestyle in the short term.  As long as you don’t needthat money tomorrow you can afford to deal with the fluctuations of the stock marketand the fluctuations, depending on who you are can have a big impact on you.  Peopletend to feel rich when the stocks are going up.  They tend to feel poor when the stocksare going down and the reality is the stock market in the short term is what Ben Grahamor even Warren Buffet called a voting machine.  Really stock prices reflect what peoplethink in the very short term.  If affects the supply and demand for investors, buyingand selling stocks in the short term.  Over the long term however, stocks tend to reflectthe value of the businesses they own.  So if you’re buying businesses at attractiveprices and you’re owning them over long periods of time and those businesses are growingin value you’re going to make money over a long period of time as long as you’renot forced to sell at any one period of time.

To be a successful investor you have to be ableto avoid some natural human tendencies to follow the herd.  When the stock market isgoing down every day you’re natural tendency is to want to sell.  When the stock marketis actually going up every day your natural tendency is to want to buy, so in bubblesyou probably should be a seller.  In busts you should probably be a buyer and you haveto have that kind of a discipline.  You have to have a stomach to withstand the volatilityof the stock markets.  

The key way to have a stomach to withstand the volatilityof the stock market is to be secure yourself.  You’ve got to feel comfortable that you’vegot enough money in the bank that you don’t need what you have invested unless—for manyyears.  That’s a key factor.  

Number two, you have to recognize that the stockmarket in the short term is what we call a voting machine.  It really represents thewhims of people in the short term.  Stock prices are affected by many things, by eventsgoing on in the world that really have nothing to do with the value of certain companiesthat you’re investing in, so you’ve got to just accept the fact that what you owncan go down meaningfully in value after you buy it.  That doesn’t necessarily meanyou’ve made an investment mistake.  It’s just the nature of the volatility of the stockmarket.

How do you get comfortable?  Well the way you get comfortable with the volatilityis you do a lot of the work yourself.  You don’t just buy a stock because you likethe name of the company.  You do your own research.  You get a good understanding ofthe business.  You make sure it’s a business that you understand.  You make sure the priceyou’re paying is reasonable relative to the earnings of the company and we talkedbefore a little bit about earnings and how to look at a value of a business by puttinga multiple on earnings.  A more sophisticated way to think about a business is to—thevalue of anything is actually the amount of cash you can take out of it over a very longperiod of time and people do build models to predict how much cash a business will generateover a long period.  That is probably something a little bit more complicated than we’regoing to get into for the purpose of this lecture, but maybe another way to think aboutit would be helpful.

So when you by a bond and you get an interest rate, so todaythe 10 year Treasury pays about 3%.  You’re earning 3% on your investment.  When youbuy a stock that’s trading at a multiple of its profits or a so-called PE ratio ora price to earnings ratio let’s say of 10 times it’s very similar to a bond.  Infact, if you flip over the PE ratio, you put the E on top, what the business is earningand you put the price that you’re paying for the stock on the bottom it’s what theearnings are per share over the price you get what’s called an earnings yield andyou can compare that earnings yield to for example the 10 year Treasury, so a companytrading at a 10 PE is actually trading at a 10% earning yield, so you can actually thinkabout stocks or buying equity in a business as very similar to buying an interest in abond.  The difference is in the bond you know what the coupon is going to be.  Youknow that 3% interest rate every year for the next 10 years.  With stock you don’tknow what the coupon is going to be.  The coupon in the stock is how much profit itearns and you can try to project that profit based on the history of the business and whatthe prospects are, but that profit is going to move up and down every year.  Now hopefullythe long term trend is up and so the way I think about the decision between buying abond or buying a stock is I want to make sure that the earnings yield, that earnings pershare over the price I’m paying for the stock is higher than what I could get owning a Treasuryand that earnings yield is something that’s going to grow over a long period of time.

Nowif you had a business that was growing at a very, very high rate very often—or growingits profits at a very high rate, very often people are prepared to pay a pretty high multipleof those profits.  Why, because they expect that earnings yield to grow, so if you hada business you might even pay—it might be cheap some day to buy a business at 30 timesits profits or a 3% or a 3.3% earnings yield if you think that 3.3% is going to grow ata high rate and eventually get meaningfully higher to a 5, a 6, a 7, a 8 or 10 percentrate.  Those kinds of investments are much riskier.  The higher the multiple generallythe higher the risk you take because you’re betting more on the future of the business. You’re betting more on the future profitability.

So my basic piece of advice in recommending theMacDonald’s and the Coca Cola’s of the world are to find businesses that where you’regoing in yield your earnings yield is high enough that you don’t need to be right abouta very high rate of growth into the future in order to earn attractive rate of return. 

Okay, so the few key success factors for being an investor in the stock marketare one, do the homework yourself.  Make sure you understand the companies that you’reinvesting in.  Two, invest money that you won’t need for many years and three, limitthe amount of—don’t borrow money certainly to invest in the stock market and limit thatamount of leverage, if any, that you have as an investor.

Okay, so after this brief40 minute lecture I wouldn’t just jump in immediately and start investing in the stockmarket.  You have some work to do.  There is some books you can read and we’re goingto provide you with a list of recommended books at the end of the lecture that willhelp you learn more about investing.  Almost everything you need to know about investingyou can actually read in a book.  I learned the business from reading books as opposedto reading books and the experience associated with starting small and investing in the stockmarket.

Let’s say this is just not for you.  I don’t want to invest, buy individualstocks.  It just seems too risky.  I don’t have the time to do my own research.  Whatare your alternatives?  Well you alternatives are to outsource your investing to others. You can hire a money manager or you can hire a group of money managers and there area couple of different alternatives for a startup investor.  The most common alternative ismutual fund companies.  So what is a mutual fund? 

A mutual fund is I guess technicallyit’s a corporation, but where you buy stock in this corporation and the manager selectsa portfolio of stocks.  So what they do is they pool together capital, money from a largegroup of investors.  So say they raise a billion dollars and they take that money andthey invest in a diversified collection of securities.  Now the benefit of this approachis that with a tiny amount of money, even less than $1,000 you can buy into a diversifiedportfolio managed by a professional manager who is compensated to do a good job for youinvesting in the market.  So mutual funds are a good potential area for investment. The problem is there are probably 7, 8,000, maybe 10,000 different mutual funds and someare fantastic and some are not particularly good, so you need to do research to find agood mutual fund manager in the same way that you need to find individual stocks, so it’snot just the easy thing of just invest in mutual funds.

So here are a few key successfactors in identifying a mutual fund or a money manager of any kind to select.  Numberone, you want someone who has an investment strategy that makes sense to you; you understandwhat they do and how they do it.  They’re not appealing to your insecurity by usingcomplicated words and expressions that you don’t understand.  If they can’t explainto you in two minutes what they do and how they do it and why it makes sense then it’sa strategy you shouldn’t invest in.  Number two and this is not necessarily in this order. This probably should be number one, is you want someone with a reputation for integrity. Again if you’re starting out you probably want to invest in some of—a mutual fundthat is sponsored by some of the larger mutual fund complexes as opposed to a tiny littlemutual fund that is privately—by a mutual fund company that you’ve never heard of. There is some benefit in the larger institutions that have—you can be more confident thatthey’re not going to steal your money.  You want someone, an approach where the investorinvests money on the basis of value.  Now this sounds kind of obvious, but value investinghas a very long term track record and there are other kinds of investing including technicalinvesting where people are betting on stocks based on price movements, but I highly recommendagainst those kind of approaches.  So you want someone making investments where they’rebuying companies based on their belief that the prospects of the business will be goodand that the price paid relative to what the business is worth represents a significantdiscount. 

You want to invest with someone that a long term track record and I wouldsay 5 years is the absolute minimum and ideally you want someone who has 10, 15, 20 yearsof experience investing in the markets because there is a lot that you can learn being along term investor in the market.  You want someone who has a consistent approach, wherethey haven’t changed what they do materially year by year, that they have a stated strategythat they’ve kept to thick and thin that has enabled them to earn an attractive returnover their lifetime as an investor and I always say in some way most importantly you wantsomeone who is investing the substantial majority of their own money alongside yours.  Obviouslyit shouldn’t be that they’re investing your money.  This is what they do for you,but for their money they do something meaningfully different.  You want someone whose interestsare aligned with yours.  If it’s a mutual fund you want them to have a lot of moneyin their own mutual fund.  If it’s a hedge fund, which is a privately sold fund for investorswho have higher net worth you want a manager who is investing alongside you as well.  

Ihave a strong aversion to strategies that require the use of leverage, so in the sameway you want to invest in companies that use very little debt you want to invest in investmentstrategies that you very little leverage.  If you can avoid leverage and invest inhigh quality businesses or invest with high quality managers it’s hard to lose a lotof money versus the use of leverage.  Lots of money can be lost.

Now in the sameway when you’re building a portfolio of stocks where you don’t want to put all ofyour eggs in one basket and you want a reasonable degree of diversification and the more sophisticated,the more work you do, the higher the quality the business is you invest in the more concentratedyour portfolio can be, but I would say for an individual investor you want to own atleast 10 and probably 15 and as many as 20 different securities.  Many people wouldconsider that to be a relatively highly concentrated portfolio.  In our view you want to own thebest 10 or 15 businesses you can find and if you invest in low leverage, high qualitycompanies that’s a comfortable degree of diversification.  If you invest with moneymanagers you probably don’t want to put all your eggs in one basket there either andhere you probably want to have two or three different, perhaps four different alternative,mutual funds or money managers, so again there you have some degree of diversification inyour holdings. So we spent the hour.  We started with alittle lemonade stand company and the purpose of that was to give you some of the basicson how to think about a business, where the profits comes from, what revenues are, whatexpenses are, what a balance sheet is, what an income statement is, how to think aboutwhat a business is worth, how to think about what the difference between what a good businessis versus a bad business, how debt offered is generally higher, actually lower risk,but lower return, how equity investors or investors who buy the stock or the ownershipof a business have the potential to earn more or lose more and we use that background asa way to think about-

We use that as the—just as the basics to get someone ofthe vocabulary to think about investing and we talked about investing in the stock market. We talked about ways to think about how to select investments, how to deal with someof the psychological issues of investing.  We covered a fair amount of ground in arelatively short period of time. 

Now I entitled the lecture Everything you Needto Know about Finance and Investing in Less Than an Hour.  Well it really isn’t everythingyou need to know.  It’s really just an introduction and hopefully I didn’t misleadyou, induce you to watch this for an hour, but there is a lot more that can be learnedand there is wonderful books that can teach you on the topic, so I think what is interestingabout investing whether you choose this as a fulltime career or not if you’re goingto be successful in your career you’re going to make some money and how you invest thatmoney is going to make a big difference in the quality of life that you have and perhapsthat your children have or the kind of house you’re able to buy or the retirement thatyou’re going to be able to enjoy and we talked about the difference between a 10%return and a 15 and a 20% return over a very long lifetime and what impact that has interms of how much wealth you create over the period, so investing is going to be importantto you whether you like it or not and learning more about investing is going to have a bigimpact on your quality of life if money is something that you need in order to meet someof your goals.  

So I recommend this as an area worthy of exploration and the moreyou learn about investing the more—these same concepts while they’re useful in decidinghow to invest your portfolio they’re also useful to you in thinking about decisionslike buying a home, making decisions in your line of work, if you’re a lawyer whetherto hire additional people, these kinds of calculations and thought processes are helpfuland they’re helpful in life and I recommend that you learn more.  So take a look at thereading list and good luck.