The Most Treacherous Bridge in the World

Only a Hope to Trust:
 
One of my favorite scenes in the Lord of the Rings films is the flight over the bridge of Khazad-dûm. Our heroes have traveled through the dark for days, hoping to trust that the light of Gandalf's staff would shield them from the evil dwelling in the shadows. As the companions’ grim journey through the mines nears the end, they are approached by a being so foul, so terrifying, that the entire chamber seems to be simultaneously lit aflame and filled with the blackness of its presence: the Balrog of Morgoth.

“This foe is beyond any of you. Run!” Gandalf cries. The nine heroes race through twist and turn, hardly daring a backwards glance at the malevolent presence that pursues them. Finally they reach the bridge. The bridge of Khazad-dûm arches through the shadow like a warped backbone, fearsome and challenging. Beneath the bridge falls a void, unfathomable in depth, filled with the mysteries of the enemies of Middle Earth – yet to cross this overpass is the only source of reprieve from the monstrosity charging behind them.

This is often how people feel about investing.

Many sources site that the most treacherous bridge in the world crosses the Hunza River in Pakistan. The Hussaini Hanging Bridge (pictured below) was built decades ago as a way for mountain locals to cross into town. In Jan. 2010, a landslide struck the Hunza valley, causing locals to race the rising river to cross the bridge.  Those that did not make it across the river were forced to flee their flooding homes and take refuge in the mountains until help arrived.

Hopefully our financial decisions are not as extreme as crossing an old bridge, abandoning our homes, or being chased by a Balrog - but it can often feel that way. On one side of the bridge lies dire straits (not the band, which would not be terrifying but, in fact, awesome) and on the other side are security and peace of mind.

Choose Your Eggs Wisely:

Last week, I wrote about a couple of metrics (P/E and PEG) that can help remove these fears about investing and minimize guesswork. So what are some other ways to reduce risk without feeling like you are watching a slug climb a mountain? Investing needs to be fun, right? Want to know why mutual funds ultimately climb over the long run? Diversification.

The beauty of modern investing is in the flexibility we as investors have. Does it not still blow anyone’s mind that we can purchase a company whilst sitting at home in our jammies? *Side note: sometimes I wonder if we are becoming numb to the grandeur of technology. Anyway, the size of your portfolio no longer limits the diversification you can attribute to your account. ETFs (Exchange-Traded Funds) are a perfect example of this. An ETF is a fund that holds a variety of assets (such as stocks, commodities, and bonds) and trades openly on the market just like a stock.

In 2008, the SEC voted unanimously to pass three new rules which would “increase investor choice by eliminating a barrier to entry for new participants in this fast-growing market, while preserving investor protections.” What they did redefined modern investing. In 2008, the SEC…

a)      Eliminated the need for ETFs to gain approval from the SEC to trade individual shares of the fund.

b)      Eliminated the need for ETFs to gain approval to trade outside NAV (Net Asset Value). NAV is an entity’s assets minus liabilities – in this case the entity is the ETF.

c)      Allowed ETFs to purchase >3% of another investment company’s shares.

Go SEC! Essentially what this did was open the doors to a brave new world of possibilities regarding ETFs. ETFs were no longer limited to mimicking major indices, and investors were given a vast pool of options from which they could choose. The new legislation made them subject to market sentiment on the fund as a whole as opposed to just the individual assets that made it up. Now the market has exchange-traded funds that range from precious metals (such as DBP) to information technology (such as VGT) instead of simply tracking the DJIA.

A New Way to Trade:

While ETFs still have management fees associated with them, they are typically not as large as mutual funds. Additionally, there is not a minimum investment to purchase shares and these funds are far more liquid than traditional index funds. If you are not sitting on a pile of cash – as very few of us are – this is an awesome way to diversify without being “nickel n’ dimed” out of an investment. So don’t let the Balrog sneak up on you while all your savings are stuck in your local branch’s 0.002% interest savings account – the power of compounding doesn’t really apply at those rates. Diversifying will provide the safety net so you can feel confident crossing this financial bridge. More of the differences between ETFs and mutual funds here.

Next week: How do I choose the right ETF and do some funds do better in different types of accounts?

Do buy, or not do buy...Baidu

Very few people can claim that they do not remember their first experience with Google (GOOG). Whether it was finding a way around reading Shakespeare cover-to-cover for high school English class or checking to see how many slices of pizza it would take to wrap the circumference of the earth, every internet-using American has found their use for Google. In June 2000, before the company even went public, Google announced the first-ever billion-URL index. Take a moment and consider that number - 1,000,000,000. One billion slices of Sbarro pizza, from tip to crust, could wrap around the circumference of the earth 63 times. In four years, Google octupled that index - over one web address searchable for each person on the earth.


Impressive growth was the story for this internet company. In back-to-back years the company grew their earnings by over 240%, skyrocketing it into its role as the number one search engine of all time. From 2000-2010 the internet population in the US doubled from 124,000,000 to 240,000,000 users and the online percentage of the overall population climbed from 44% to 78% . Not only were the number of users growing, but the time spent online per user was seeing explosive growth as well. It seemed that content was infinitely pouring into the World Wide Web, and the speed to process it was doubling every couple years. The ground was fertile for a motivated, young internet company.

Now apparate 8,200 miles across the Pacific Ocean to China. According to the latest statistics, China currently has 564 million internet users - more than twice as many as the US. The craziest part? That is only 41% of China's population of 1.3 billion. Insert Baidu (BIDU). In layman's terms, Baidu is the equivalent of China's Google. The company was incorporated in 2000 by tech entrepreneur Robin Li and has since been a huge success. As of Q3 2012, Baidu held a firm position at the top of the search engine industry with an 80% share of the market in China.

Intelligence Investing:
Let's pause right there for a moment and talk about some of the principles of intelligence investing. Intelligence investing is the same as value investing (buying into solid stocks when they are down) minus the shame one feels for shopping at Walmart. One of the main tools used in this technique is the price-to-earnings ratio (P/E). The formula is simple:

Common Stock Share Price / Earnings per Share (EPS)

So basically, if ABC company profits $1 million and has 1 million shares, the EPS will be $1. If the current share price is $20, the P/E would be 20. Different industries have different average P/E ratios due to the industry's growth potential. For example, a small tech company will likely have a higher average P/E ratio than a large utilities company because the market is anticipating faster growth. 

So if P/E ratios depend on the industry, how do you know you've found a good buy? One way is to look at historical P/E ratios for the stock or the five-year average. For a steady stock with predictable growth, like McDonald's (MCD), a current P/E ratio that is lower than the 5-year average could signify a great opportunity to buy. This information can often be found on your broker's website. The information below was pulled from Fidelity:

Since the 5-year average (16.35) is similar to the current P/E  (17.85), we can assume that Mcdonald's is fairly priced (if not slightly overvalued).

Another way to see if this low P/E'd stock is a winner is by glancing at the PEG (price-to-earnings growth) ratio. The PEG ratio is calculated by dividing the P/E ratio by the annual EPS growth. If our ABC company is growing at an annual rate of 20% (remember, the P/E is 20) then the PEG would be 1. Having a PEG of one generally means that the P/E ratio is appropriate for the given earnings growth. As a PEG ratio creeps closer to 0, it indicates that the stock is undervalued and may produce higher returns*.

*Don't be ridiculous - having a low P/E and PEG will not produce positive returns 100% of the time. All of these numbers are metrics, not mathematical proofs.

My Take:

 There are very few tastier-looking fish in this pond. Baidu has taken a recent fall due to increased competition from fellow Chinese software company Qihoo 360 (QIHU) and has also tracked downward alongside the Shanghai Composite Index over the past year. I believe the fears of competition are overblown. Even if Qihoo were chipping away at Baidu's titanic market share, internet penetration rates are still only at 41% in China - where the US was 12 years ago. With that kind of growth potential I might just go over to China and start a search engine myself. The chart below shows that growth (although trending lower) is still at explosive levels. Google is still considered a groundbreaking company, but current growth levels are not near what Baidu's are.

Baidu's recent fall has put its P/E ratio at a mere 19. This is compared to its five-year average of over 53. It is rare to find lower than this company's PEG ratio of 0.64 in the tech sector (except Apple, at 0.51, but that is another blog post for another day). Oh, and did I mention? Baidu has over $5 billion in cash. 

Disclosure: I am not receiving any compensation from any of the companies mentioned. I have positions in MCD, BIDU, and AAPL. I have no positions in GOOG, but I wish I did.