Author: A.T.

“You write, in discussing the Beardstown Ladies, that it’s almost impossible to beat the market consistently. But what about Buffett? Surely it isn’t all just commission savings. He does seem to make good investments at the right prices.” -D.G.G.

Indeed he does. Warren Buffett is smarter than almost anybody . . . completely single-minded in his efforts . . . boosted by the financial leverage in his great and savvy insurance businesses (he gets to invest the premiums until you crash your car or the earthquake hits) . . . and the beneficiary, by now, of a couple of self-fulfilling special advantages. (People all take his calls; potential acquirees enjoy a certain cachet and might accept a lower price in Berkshire stock than in the stock of just any old company; once Buffett invests/anoints, the world follows.)

So Warren is clearly real, but an exception.

Still, many of today’s young investors can learn a lot from his example. Buffett never traded in-and-out, never made a nickel that I know of buying puts and calls . . . it’s been good, thoughtful, patient investing, with a great premium on value and the quality of management. My friend Roger Lowenstein wrote a wonderful Buffett biography not long ago, and there are other good books on him as well.

You have heard of the Truth In Lending law. The idea is to provide interest-rate information honestly and consistently so that people know the interest rate they’re paying and can sensibly compare loans.

Now comes reader Erik Sten with a refinement.

With regard to those “2.9% financing or $1,500 cash back” deals one so often sees, Erik suggests that the 2.9% may not be 2.9% after all. Accepting that it means paying $1,500 more than necessary for the car, that foregone $1,500 really should be considered part of the cost of financing the car.

So what is the interest rate really?

Say you are buying a $12,000 Ford Escort LX 4-door, which is more or less the example Erik supplied me with last summer. The dealer was offering 2.9% or $1,500 cash back. The regular 48-month car-loan rate available to people with good credit at the time, Erik says, was 8%.

Well, on a $10,500 48-month car loan (assuming you were financing all but $1,500 of the $12,000 purchase), the payments are $231.95 at 2.9% and $256.34 at 8%. So you save $24.39 a month or $1,170.72 in interest over four years. But you don’t save $1,500 – and what you do save, you don’t save all at once. No, the prevailing interest rate would have to be 9.4% or so for a 2.9% rate to save you $1,500 over four years. And because $1,500 up front is better than $1,500 spread out over four years, the “true” interest rate would have to be nearly 10.5% for this 2.9% rate to represent an equivalent saving.

Still not terrible, and not necessarily something to pass laws or enact regulations over. But to the extent the 1.9% and 2.9% financing deals make the average car buyer even less likely to pay cash, and thus even more likely to pay what may amount to 10% interest that’s not tax-deductible, it compounds a common consumer error; namely, someone who unwittingly earns 5% in a savings account (which may be 4% or less after taxes) while at the same time paying 10% to finance a car. Borrowing at 10% to earn 4% is no quick way to get rich.

Is truth-in-auto-lending a problem? Worth a crusade? Let me know your thoughts and I’ll pass them on to Erik.

“When I bought my last car, I offered to pay cash a la your friend Joe. Apart from any financial incentives to the dealer, the dealership’s general manager strongly recommended I finance at least part of it. In light of your column I realize it may have been for his own financial gain, but he told me that the owners of the dealership NEVER pay cash for their inventory, even though (according to him) they have it many times over. Basically, he said why risk your own money when you can risk the bank’s? I thought (perhaps naively) that if it was good enough for them, it should be good enough for me. Love to hear your thoughts on that one.” -Steven E. Rubin, MD

How is the bank risking anything when you take out a car loan? In the first place, they have the car as security; in the second, they have your personal guarantee. (To a lender, those initials after your name stand for Many Dollars.)

No, the only question is whether the 10% you pay, say, is greater than the after-tax return you expect to earn investing this borrowed money; i.e., can you borrow at 10% and earn 11%. And the answer, after tax, is: no. (Sure, it’s possible; but the odds are definitely against you.)

If it was one of those “2.9% or $1,500 cash back” kinds of deals (and I’m sure you would have mentioned it if it was), then you would still have been better off not borrowing. But in this regard, I owe one of you, Erik Sten, a crusade.

Tomorrow: I’ll explain.

From Scott Mains: “About a year ago my wife and I purchased a new car using a similar tactic to Joe. [As described recently in Joe Beats the Bank, Joe financed his car because it’s an option on which the dealer makes money. He then paid off the loan in full the next month. – A.T.] We went him one better though. When we purchased our vehicle we charged the down payment to our credit card, which pays a flat 1% back, and then of course paid it off in full when the bill came in. By getting the 1% back on the down payment, it offset the interest we had to pay for borrowing the balance of the money for one month. This also gave us an extra couple of weeks to sell the stock we had earmarked to pay for the car.”

I once got into quite a row with a car dealer over the size of my down payment. I wanted to make it at least $5,000, to get the frequent flier miles. He forced me down to $1,000. The rest, an hour or two later when they delivered the car, I paid for with a check.

From Rock Hopper (which I’m guessing may not be his real name): “Before you write an article about cheap ways to get cars via the Internet, do some research, especially on Auto-By-Tel. I have had poor service, as have friends. The sales pitch is awesome, the delivery is customer specific. I have heard both sides of the coin.

“For example, when I submitted my request, I was called back by a dealer, with a price, but for a car with the wrong options?!?! I thought the purpose was to get the car you want. Please just ask around, I think you will find other horror stories. [As horror goes, I’d call this particular example pretty tame. – A.T.]

“When looking for a new car, showing a dealer a printout of your http://www.edmunds.com dealer pricing info can save you a lot of time. If the dealer wants to play that game, they will. If they get rude, go somewhere else. Showing them that you have the info upfront is a lot easier than spending the day with them, then getting to the pricing, and totally annoying the dealer by showing him you’re not a total dolt.

“As for the extended warranty, I, for one, am sold on them. Unfortunately, the 94 Ford Taurus that we bought with 25K miles has had $3K worth of repairs over the 2.5 years that we have owned it. We still have 30K miles left on the warranty that we paid $1K for. You might say that I should buy a more reliable car? One would think that the best-selling automobile would be reliable. In general, it has been, but the (nearly constant) little things add up to big bucks, and the warranty has worked out well for us.”

From Mike Gavaghan:“Obtaining a car loan when we have sufficient stock savings is certainly the same as buying stocks on margin. Indeed, I’ve always planned on borrowing against my stocks, rather than selling them, when the time comes to buy another vehicle. Wouldn’t this give me a low interest used car loan with tax deductible interest? There are, of course, additional risks whenever an investor carries a margin balance. But, based on your article, I’m worried that there is something more fundamental that I’ve overlooked.”

Nope, Mike. You’ve nailed it. You’re not overlooking a thing.

Few things are as infuriating — or dangerous — as a short squeeze.

There is this preposterous stock, I won’t mention any names, at 90, up from 70 up from 30 up from 8, and it’s just such an obvious short. It has no sales, no earnings, the boss has disappeared or turned out to have a criminal record — and still the stock goes up.

If it sounds impossible, you’ve never observed, let alone been caught in, a short squeeze.

Who’s buying at these prices? You marvel.

Four kinds of people:

• Scared short-sellers who’ve already lost so much they just can’t stand one more sleepless night, so they buy shares to cover their short. I know a guy who lost $19 million this way.

• Short-sellers who have no choice. The equity in their accounts has put them below margin requirements, so they must cover some of the short, like it or not.

• Short-sellers who are forced to cover when the lending broker recalls the shares and no other shares can be found to borrow. (Sometimes participants in a short squeeze will even instruct their brokers to switch shares from their margin to their cash accounts in order to tighten the squeeze and drive the price higher. Stock in a cash account cannot be loaned out.)

• Speculators who sniff blood. They know the stock is a complete piece of junk but gamble that the bubble won’t burst for another 30 or 40 points. If they buy enough, their own buying may drive up the price, forcing more short-sellers to buy also — to stem their losses or meet margin calls — driving the price higher still.

As a rule of thumb, a good time to short a stock is when you can’t. No more shares are available to borrow.

But even if you could, shorting is not for the faint of heart or inexperienced. Puts are safer but will be priced very high in a short squeeze (because put-sellers realize the stock could drop like a stone at any instant). And synthetic shorts — writing a call and simultaneously buying a put, which gets around the unavailability of stock to borrow — is both expensive and risky.

There’s nothing un-American about shorting stocks, but there’s lots about it that, for all but a few, makes it inadvisable.

“How do short-sellers’ brokers find stock to borrow? Is there an electronic system offering stock to lend? Is there a market, so that thinly traded stock or other stock that’s being squeezed gets more rent than just the dividend income?” –David Williams

When you sell stock short, you are selling shares you don’t own, hoping they will go down. Your broker just borrows someone else’s shares for you to sell. Eventually, you have to buy them back and return them (unless you’re really lucky and the stock goes all the way to zero and disappears, in which case there’s nothing to return). If you can buy the shares back for less then you got for them, you make a profit; if you have to pay more, you suffer a loss.

But where do brokers get shares to lend short-sellers?

The first thing they do is look to see whether one of their other customers holds the same stock in a margin account. Anyone with a margin account has signed an agreement authorizing the broker to lend his shares. He will not know they’ve been loaned, and he needn’t worry about it either way. He’ll still get his dividend (it will come out of the short-seller’s account); he will still be able to sell at a moment’s notice. (The broker will just replace the shares by borrowing someone else’s shares. Or, if that proves impossible, he’ll “buy in” the short-seller, forcing him to cover his short — typically at a loss — and return the shares. This doesn’t often happen, but it definitely can. It’s one more risk of the hazardous short-selling game.)

Brokers love short sales, because although you take all the risk, they typically get the interest on the proceeds of the stock you’ve sold. That’s right: you shorted 1,000 shares of some stock at $50; well, that means the broker got $50,000 in cash money in return . . . but you won’t find that money in your account. It’s earning interest in his account, whether he be a deep discounter or the most expensive full-service firm on the block.

(Active, pushy customers can sometimes twist arms and, if they do enough short-selling, persuade their brokers to share some of that interest. But few even know to ask and fewer still will be told yes. If you do $20,000 a year in commissions, say, well, that might be a different story.)

If your own broker doesn’t have shares of stock in one of his other client’s margin accounts to lend you, he will call around to find a broker or institution that does have shares to lend. Harvard, with its $10 billion endowment, makes some good money this way.

When a broker or institution lends stock, the “rent” it charges is interest on the value of the shares. In other words, your own broker has to split some of the largess with the lender (making him all the less eager to share any of his share with you).

I don’t know of an electronic listing of shares-to-lend. (Knowledgeable readers: chime in if I’m behind the times.) So far, anyway, it’s more a matter of my broker’s picking up one of the dedicated lines he’s got to the stock-loan departments at other shops. If the other shop does have stock to lend, it will be lent at whatever is its then prevailing rate. And, yes, they do charge more for hard-to-borrow shares. If it’s GM that everybody owns and few bother shorting, it might be one percent or even just half a percent interest. But if it’s some stock people are desperate to borrow, the lender may even charge more than the prime rate (in which case the broker not only won’t share anything with his big-time short-seller customer, he’ll actually charge a little something).

Tomorrow: Beware the Short Squeeze

“Years ago, I read one of your books that explained the Rule Of 72. This was one of the most important pieces of knowledge I ever acquired. It put me on the road to understand money and I am proud to say that I am retired at 55 and love it. I would like to ask some advice on another matter. I recently retired and have about 1000 shares of the company that I worked for. It recently hit an all time high of 57. I am afraid of a big market correction, but want to wait until January 1999 because of heavy taxes. The stock more than doubled in price and is considered a cyclical. What is the best way to hedge against a big drop in price until January of 1999?” -Bruce Kern

It’s hard for me to see how the Rule of 72 was important to your success, but I’ll take credit for anything. (That reduction in crime rates? My doing.) So I guess the first thing I’d better do is reiterate for other readers this handy rule of thumb: To determine how long it takes money to double at a given rate of growth, divide that rate into 72. If you own something that earns 4% after tax, it will take about 18 years to double – 72 divided by 4. At 9%, about 8 years – 72 divided by 9. At 24%, about 3 years – 72 divided by 24.

The Rule of 72 is easy. The 24% return – that’s the part I wish I could take credit for. (And of course the Rule of 72 is not original with me; it was the discovery of some 72-year-old Babylonian investment banker.)

As to your 1,000 shares of stock, I wonder whether you won’t have the same feeling early in 1999 – wanting to push the taxable sale into January 2000. But taking your question at face value, you have a few choices.

SHORT AGAINST THE BOX – NO MORE

The old way to do this was called shorting-against-the-box. You’d sell short 1000 shares of GE, say, rather than sell your 1,000 shares of GE, and thus not expose the sale to tax. You’d be long and short 1,000 shares at the same time, so have zero exposure to profit or loss; yet you would not be deemed to have sold your stock. This venerable old loophole has at long last been retired by the latest tax law.

At least for most of us.

If you own 100,000 shares of the stock, or a million, call an investment bank and ask about “collars” and other such tax- and disclosure-avoidance devices that may still be legal but shouldn’t be. To us small fry, these opportunities are not available.

BUY PUTS

You can buy 10 puts on your stock (each put represents an option to sell 100 shares) so that if it goes down, you’ll profit at least partially, if not equally, from the decline. (Indeed, buy 50 puts and you’ll be thrilled by even the slightest dip.) But buying puts stops the clock on your holding period (as shorting-against-the-box also did), so it’s not a way to protect yourself while waiting for a short-term gain to go long-term – it will never go long term, if it hasn’t already, so long as you own puts on it.

Mainly, buying puts is not cheap. You pay a price for this protection.

WRITE CALLS

You can sell (“write”) 10 covered calls against your stock, getting an immediate, fully taxable “premium” for giving someone the right to buy it from you. (They’re “covered” calls because your exposure is covered by ownership of the underlying shares. You can also write naked calls on a stock you don’t own – but please call a good psychiatrist before doing so.)

Say you write the January 60s for $3½ — $3,500. You are giving the buyer the right to buy your stock at 60 — which you won’t mind too much because it’s only 57! — any time until mid-January. If the calls expire worthless, because your $57 stock never exceeds 60, so no one wanted to exercise them, you get to keep the $3,500 (less ordinary income tax) to cushion any drop in the stock.

If your stock should be 43 in January, you won’t be out $14,000 for having held on ($43,000 versus the $57,000 you could have had today), but more like $11,500.

Then again, if the stock should surprise you and be 95 in January, your stock would have been called away at 60, leaving with you with $63,500 before tax instead of $95,000.

Writing covered calls works best with a stock you expect to be weak for a while but want to hold on to for the long run. (Even then it is tough to win in the long run, because every once in a while, you get blindsided by a huge drop or increase in the stock that you didn’t expect. Either way — huge drop, huge spike — you’re left feeling rueful.)

SHORT SOME SIMILAR STOCK

You can’t short against the box, but you can short some stock you think is likely to perform similarly to your own. Notice how “the oils” or “the semiconductors” often seem to follow similar paths? Well, maybe you could short $57,000 worth of some stock very much like your own. But I wouldn’t, for two reasons.

First, if you “win,” you still lose. Let’s say both stocks drop 20% by January. So your lost profit on the original shares is offset by your profit on the short-sale. You might think the only costs are the commissions; but since all gains on short sales are treated as short-term, even if you have been short 40 years, you could wind up converting what would have been lightly taxed long-term gains on the first stock into fully-taxed short-term gains from the short sale.

Second, you could get really hosed. Say you owned Ford and shorted GM, or vice versa, and then one of them wound up doing very well at the expense of the other (or just wound up doing very well while the other did poorly). Your $57 stock could go down just as you feared, but the similar stock your shorted might go up. So now you’ve lost some of your profit on the first stock and have a loss on the second. Ugh.

SO YOU KNOW WHAT?

If you think the stock is overpriced and don’t want to risk its going down, one not-terrible strategy, especially if it’s already a long-term capital gain, is to sell it and pay the tax.

Tomorrow: Short-Sale Mechanics
Then: The Short Squeeze

“In December we had bad weather and my car was totaled. I needed to find a replacement and checked out Edmunds on the net. Of course, the first thing I did was look up my old car to “baseline” my buying decision. When I got there, I found an ad from auto-by-tel that offered to find me a car at a competitive price. I clicked the ad, searched for my old make and model, and found a deal (basically 1/2 the miles, 50K versus 95K, at a 10% premium over my insurance payment for the totaled car). I received a call from the dealer that night and my wife and I drove an hour-and-a-half to look at it (the dealer’s benefit from using the Internet) and bought it on the spot. I asked the dealer if most of his Internet customers were like me and he said yes. ‘They call ahead, drive in, and drive their new car home.’ It was an awesome haggle-free deal that I have recommended to friends.” -Andrew Beauchamp

Couldn’t have said it better myself . . . except that I typically buy used cars, not new.

I wonder whether this phenomenon – the better car price with less hassle via the Internet – is reflected in the calculation of the Consumer Price Index. Well, it’s not. But over the years, Internet shopping will definitely be sharpening competition, cutting out middle-persons, and bringing down the prices actually paid.

“Why is it dumb to buy annuities? Fidelity has a plan that you can buy and trade stocks and money market funds within the annuity. With this plan you can escape capital gains. Why would this be dumb?” -Frank Cardinaux

First off, I doubt Fidelity has quite the plan you describe. When I called to ask, they couldn’t find it. At almost any brokerage house, you can set up an IRA or Keogh Plan (if you qualify) within which you can trade stocks . . . but that’s not an annuity.

Annuities do shelter your income and gains from tax until withdrawal, and that’s appealing, but:

• There’s no telling what the tax code will be decades from now, but historically, long-term capital gains have been taxed only about half as heavily as ordinary income. And guess what: annuity income is fully taxed as ordinary income, even if it was produced from long-term capital gains. So annuities wind up converting what could be lightly taxed long-term capital gains into more heavily taxed ordinary income at withdrawal.

• Annuities frequently entail sales charges and management fees, as well as a charge for a life insurance component that’s not terribly valuable. So you have a lot of drag on your performance.

• Typically, it’s a hassle, at least, and expensive, at worst, to switch funds from one annuity to another, so you give up some control over your money when you buy an annuity.

• Once money is in an annuity, there are restrictions on withdrawing it.

Most independent financial advisors agree: the purchase of variable annuities (the kind that are essentially tax-deferred stock mutual funds) rarely makes sense. But that doesn’t stop an army of eager sales people from selling many tens of billions of dollars worth each year. (Nor should it discourage you too much if you’ve already bought one. It may not be the greatest investment decision you ever made, but just saving the money in the first place is 80% of the game-you did a good thing.)

We all hate paying taxes so much that we often go to great lengths to find ways not to. In the Seventies, it was crazy tax shelters that had so many sales charges and fees, and so little economic justification, that much of the time you would lose 100 cents on the dollar trying to avoid paying 70 cents on the dollar in taxes. In the Nineties, it’s variable annuities. They’re not nearly as bad as many of those crazy tax shelters were. But they’re still not as good, for most people, as investing outside an annuity.

TAX

“Last year I purchased stocks on margin. I understand that the interest on the margin account is tax deductible, but so far I have not found someone to tell me where in the tax forms does one write off the interest against any capital gains. Can you please point me in the right direction?” -Bernie Kemp

Let me point you in two directions. First, Schedule A, line 13. Second, either Taxcut or TurboTax, the inexpensive software packages that will step you through all this. (My sentimental preference is Taxcut, but they’re both outstanding.)

SPRING TRAINING

“A friend and I just finished creating a virtual stock exchange that trades securities based on baseball players and teams. Demand drives the stock price, but the stocks are ultimately cashed out according to seasonal performance. Think Fantasy Baseball with market forces thrown in. There are a couple other virtual stock markets out there, for movies and celebrities; I think the concept will become popular because it gives people a chance to have fun with their knowledge of a subject. If you’re interested, it’s at http://majorleaguemarket.com.” -Travis

And if you prefer to bet on movie stars: www.hsx.com.

SCRABBLE

“I was pleased to find your reference to Scrabble. I’m a member of the National Scrabble Association and play frequently in their tourneys. If you are interested in Scrabble clubs or tournament Scrabble, send an email to info@scrabble-assoc.com. By the way, while it is always situationally dependent, the generally accepted tradeoff value for an S is 11 points and for a blank, 30.” -Aaron

Ah, situationally dependent. But there will be few situations where you find me parting with an S when it adds only 11 points to the best score I could get without it. As for the blank, especially early in the game, it can almost always be counted on, after a few turns, to provide a 7-letter Scrabble, so – with situational provisionality – I stick by my 60 points for the word or I won’t use it.

The real issue here, I think you will agree, is whether the blanks “stay down.” Officially, they do: once played, a blank remains on the board representing whatever letter the player chose. Fine. But when I can, I get opponents to play the house rule that allows either of us to pick the blank back up whenever one of us has or gets the letter the blank stands for – R, let’s say – we can grab the blank back up off the board, replacing it with our R, and use it again.

This serves three purposes:

• It makes the game fairer. With only two blanks, there is a 50% chance one player will get BOTH. So half the time one player has a HUGE advantage. But when you can pick the blank back up, the two blanks may wind up doing the work of three or four or five or six blanks in the course of the game. It’s still possible one player will get them all, but the odds of that are sharply lower (and beyond the ability of anyone on the planet to calculate).

• It makes the game more challenging and exciting. It adds an additional element of strategy. (If you were going to use the blank to make either ZONE or ZONK, you’d probably want to make it a K, which your opponent is less likely to have, lest he immediately grab it with one of his all-too-common E’s.) And given how exciting blanks are to begin with – one’s heart pounds at receipt of a blank – the more the merrier.

• It makes me win – because I remember this rule and pounce. Others sometimes forget it and leave the blank sitting there even when, three turns later, they actually do pick up the K.

The other main house rule, if I ever lure you over: if you get three of the same letter – three I’s or three U’s being the worst, but even three N’s or anything else – you are allowed to throw in one, two, or all three of them without losing your turn. Hey: it’s the same for both of us, so why should it give me an edge? It’s just more fun, like a Get Out of Jail Free card in Monopoly or a hard rather than a soft ball in squash.

What has any of this to do with money? I like to play for $1 a point.