R-Squared Energy Blog

Pure Energy

Investing in Ethanol: A Case Study of Terrible Investment Advice

Comically Terrible Timing

In June 2006 I read an article at Financial Sense that promoted ethanol as a great place to put your money:

Investing in Ethanol: A “New” Stock Play on Soaring Energy Prices and Why Now is the Time to Invest in this “Fuel of the Future”

Among the gems in the article were these:

Strap on your seatbelt… an alternative energy source is set to take the world by storm. In this research report, we’ll take a close look at the booming ethanol industry… and how investing in ethanol could prove to be an extremely profitable move for investors.

With a mandate from the U.S. government and the obvious need for change, we see this as a fantastic opportunity for investors to earn serious profits.

Take a look at recent investments made by some of the richest and most successful people in the world:

* Bill Gates, the richest man in America, allocated $84 million into Pacific Ethanol, Inc. (Nasdaq: PEIX), a company poised to control a considerable share of the ethanol industry.

Not So Fast

Mary Puplava at Financial Sense had asked me if I would contribute an article there, and I had procrastinated up to that point. But the article above prompted me to write a rebuttal. I told Mary that investors “are going to get trounced” if they take the advice from that article, and I wrote to her in an e-mail that “fundamentally something like Pacific Ethanol is a very poor investment (despite what Bill Gates thinks).” My rebuttal:

Ethanol Investing Counterpoint

In the three months following that rebuttal article, ethanol stocks fell across the board by about 40%, including Pacific Ethanol which I highlighted in the article. (An analyst at one brokerage firm told me that they advised clients to sell ethanol stocks after reading my article). I followed up a few months later with:

The Ethanol Bubble has Burst

I am getting around to the point here, which isn’t actually to argue that I am a financial genius. (As a matter of fact, my portfolio since last summer looks like almost everyone else’s: Down sharply). No, what I want to focus on here is just how that article – and investors like Bill Gates – could have missed so horribly with ethanol stocks. The reason this is pertinent is that I get an e-mail every week or so from someone wanting to know which cellulosic ethanol play I would recommend. For similar reasons to why I disputed that 2006 article on investing in ethanol, the answer is “none of them.”

Why the Advice Was Wrong

The initial article was correct on one key point: On the back of mandates and heavy subsidies, the ethanol industry was poised to grow dramatically. But there were two really big problems for prospective investors wishing to capitalize, and a third if you happened to be an investor in Pacific Ethanol. First, the fact that ethanol has to be mandated to gain market share should have been a strong tip-off that the economics didn’t look all that good. The companies simply were not poised to compete in the marketplace, hence the mandates.

Then there was problem number two: Producing ethanol isn’t rocket science. The barriers for entry into the marketplace are low, meaning competitors were going to sprout up everywhere. I documented a number of cases where complete amateurs decided they were going to get into the ethanol business. I can assure you that complete amateurs don’t go around building oil refineries, because the capital costs and technical challenges pose a very high barrier that Bob the Dentist and his buddies aren’t going to overcome by pooling their money and channeling their passions.

So as a result, ethanol capacity was overbuilt, there was too much competition, and margins vanished. This has led to a wave of ethanol bankruptcies and plant closings. In hindsight, it is clear that ethanol was not the place to sock away your money.

Pacific Ethanol faced an additional challenge: They built their plants far from the raw materials needed to run the plants. I could foresee that an ethanol plant in Iowa could put ethanol in Pacific Ethanol’s backyard for cheaper than they could do it themselves after the logistics of corn imports and DDGS exports were taken into account. The fall for Pacific Ethanol has been steep. Once boasting a market capitalization of over $1 billion (in 2006), that has now fallen to $23 million. Bill Gates eventually decided that Pacific Ethanol wasn’t what he thought it was, and sold out his shares.

The Game is Now Cellulosic Ethanol

So now here we sit in 2009, and many now want to know how to make money with cellulosic ethanol – the next big thing. As I told someone last week, “this is a low margin business.” Why do you think the government not only has to mandate ethanol, but then put extra mandates and goodies in for ethanol made from cellulose? Because the economics look horrible. No producer is going to be able to gain a decided advantage over others. There will be producers of cellulosic ethanol. That technology exists. It just doesn’t exist economically, and nobody is going to do it and make consistently high margins.

Take Verenium, for instance. There was a recent story in the news that they have teamed up with BP on a cellulosic ethanol venture:

BP and Verenium form cellulosic ethanol venture

Within that story was a little detail that I found interesting:

The joint venture expects to break ground on the Florida site in 2010, the press release said, and the estimated construction cost for this 36 million gallon-per-year facility is between $250 million and $300 million.

Ah, capacity and capital costs. That’s the sort of information we can put to good use. What do we find? Capital costs for this 2300 barrel a day facility amount to almost $130,000 per daily barrel. (To put that scale into perspective, a 60,000 barrel a day oil refinery is considered to be small). The following is starting to become a little dated, but I still like it for its relative comparisons:

Capital Costs of Fuel Facilities
Source: EIA Annual Energy Outlook 2006

When someone argues that coal-to-liquids companies might make for good investments, for instance, I point out that capital costs are about double those for gas-to-liquids (GTL), and those GTL projects are being canceled because their costs are too high. So think now about the capital costs of this Verenium venture, and consider the fact that corn ethanol plants with a fraction of the capital costs are going bankrupt. This is not to say that Verenium won’t successfully produce cellulosic ethanol. I just predict that the economics will not allow them to compete with other energy options, and they will live or die by the mandates. Likewise, I believe the same is true for most companies that have aspirations of making ethanol from cellulose.

Are There Any Investment Opportunities Here?

OK, I did say ‘most companies.’ I am hedging a bit, because some company might come up with something slightly advantageous. Will this make cellulosic ethanol a high-margin business for them? No, and if you want to play this game, you are trying to pick a winner out of a pack of losers. Safer in my opinion to stick with a sector that looks like an overall winner.

Look for a company that enables cellulosic ethanol. Buy the company that makes the novel enzyme for cellulose hydrolysis or the membrane system for the separation, not the company that uses them to make ethanol. Profit margins on the former might be good. Profit margins on cellulosic ethanol will at best mimic those of other commodity energy sources.

February 22, 2009 Posted by | ethanol, Financial Sense, investing, Pacific Ethanol, PEIX, personal finance | 34 Comments

Investing in Ethanol: A Case Study of Terrible Investment Advice

Comically Terrible Timing

In June 2006 I read an article at Financial Sense that promoted ethanol as a great place to put your money:

Investing in Ethanol: A “New” Stock Play on Soaring Energy Prices and Why Now is the Time to Invest in this “Fuel of the Future”

Among the gems in the article were these:

Strap on your seatbelt… an alternative energy source is set to take the world by storm. In this research report, we’ll take a close look at the booming ethanol industry… and how investing in ethanol could prove to be an extremely profitable move for investors.

With a mandate from the U.S. government and the obvious need for change, we see this as a fantastic opportunity for investors to earn serious profits.

Take a look at recent investments made by some of the richest and most successful people in the world:

* Bill Gates, the richest man in America, allocated $84 million into Pacific Ethanol, Inc. (Nasdaq: PEIX), a company poised to control a considerable share of the ethanol industry.

Not So Fast

Mary Puplava at Financial Sense had asked me if I would contribute an article there, and I had procrastinated up to that point. But the article above prompted me to write a rebuttal. I told Mary that investors “are going to get trounced” if they take the advice from that article, and I wrote to her in an e-mail that “fundamentally something like Pacific Ethanol is a very poor investment (despite what Bill Gates thinks).” My rebuttal:

Ethanol Investing Counterpoint

In the three months following that rebuttal article, ethanol stocks fell across the board by about 40%, including Pacific Ethanol which I highlighted in the article. (An analyst at one brokerage firm told me that they advised clients to sell ethanol stocks after reading my article). I followed up a few months later with:

The Ethanol Bubble has Burst

I am getting around to the point here, which isn’t actually to argue that I am a financial genius. (As a matter of fact, my portfolio since last summer looks like almost everyone else’s: Down sharply). No, what I want to focus on here is just how that article – and investors like Bill Gates – could have missed so horribly with ethanol stocks. The reason this is pertinent is that I get an e-mail every week or so from someone wanting to know which cellulosic ethanol play I would recommend. For similar reasons to why I disputed that 2006 article on investing in ethanol, the answer is “none of them.”

Why the Advice Was Wrong

The initial article was correct on one key point: On the back of mandates and heavy subsidies, the ethanol industry was poised to grow dramatically. But there were two really big problems for prospective investors wishing to capitalize, and a third if you happened to be an investor in Pacific Ethanol. First, the fact that ethanol has to be mandated to gain market share should have been a strong tip-off that the economics didn’t look all that good. The companies simply were not poised to compete in the marketplace, hence the mandates.

Then there was problem number two: Producing ethanol isn’t rocket science. The barriers for entry into the marketplace are low, meaning competitors were going to sprout up everywhere. I documented a number of cases where complete amateurs decided they were going to get into the ethanol business. I can assure you that complete amateurs don’t go around building oil refineries, because the capital costs and technical challenges pose a very high barrier that Bob the Dentist and his buddies aren’t going to overcome by pooling their money and channeling their passions.

So as a result, ethanol capacity was overbuilt, there was too much competition, and margins vanished. This has led to a wave of ethanol bankruptcies and plant closings. In hindsight, it is clear that ethanol was not the place to sock away your money.

Pacific Ethanol faced an additional challenge: They built their plants far from the raw materials needed to run the plants. I could foresee that an ethanol plant in Iowa could put ethanol in Pacific Ethanol’s backyard for cheaper than they could do it themselves after the logistics of corn imports and DDGS exports were taken into account. The fall for Pacific Ethanol has been steep. Once boasting a market capitalization of over $1 billion (in 2006), that has now fallen to $23 million. Bill Gates eventually decided that Pacific Ethanol wasn’t what he thought it was, and sold out his shares.

The Game is Now Cellulosic Ethanol

So now here we sit in 2009, and many now want to know how to make money with cellulosic ethanol – the next big thing. As I told someone last week, “this is a low margin business.” Why do you think the government not only has to mandate ethanol, but then put extra mandates and goodies in for ethanol made from cellulose? Because the economics look horrible. No producer is going to be able to gain a decided advantage over others. There will be producers of cellulosic ethanol. That technology exists. It just doesn’t exist economically, and nobody is going to do it and make consistently high margins.

Take Verenium, for instance. There was a recent story in the news that they have teamed up with BP on a cellulosic ethanol venture:

BP and Verenium form cellulosic ethanol venture

Within that story was a little detail that I found interesting:

The joint venture expects to break ground on the Florida site in 2010, the press release said, and the estimated construction cost for this 36 million gallon-per-year facility is between $250 million and $300 million.

Ah, capacity and capital costs. That’s the sort of information we can put to good use. What do we find? Capital costs for this 2300 barrel a day facility amount to almost $130,000 per daily barrel. (To put that scale into perspective, a 60,000 barrel a day oil refinery is considered to be small). The following is starting to become a little dated, but I still like it for its relative comparisons:

Capital Costs of Fuel Facilities
Source: EIA Annual Energy Outlook 2006

When someone argues that coal-to-liquids companies might make for good investments, for instance, I point out that capital costs are about double those for gas-to-liquids (GTL), and those GTL projects are being canceled because their costs are too high. So think now about the capital costs of this Verenium venture, and consider the fact that corn ethanol plants with a fraction of the capital costs are going bankrupt. This is not to say that Verenium won’t successfully produce cellulosic ethanol. I just predict that the economics will not allow them to compete with other energy options, and they will live or die by the mandates. Likewise, I believe the same is true for most companies that have aspirations of making ethanol from cellulose.

Are There Any Investment Opportunities Here?

OK, I did say ‘most companies.’ I am hedging a bit, because some company might come up with something slightly advantageous. Will this make cellulosic ethanol a high-margin business for them? No, and if you want to play this game, you are trying to pick a winner out of a pack of losers. Safer in my opinion to stick with a sector that looks like an overall winner.

Look for a company that enables cellulosic ethanol. Buy the company that makes the novel enzyme for cellulose hydrolysis or the membrane system for the separation, not the company that uses them to make ethanol. Profit margins on the former might be good. Profit margins on cellulosic ethanol will at best mimic those of other commodity energy sources.

February 22, 2009 Posted by | ethanol, Financial Sense, investing, Pacific Ethanol, PEIX, personal finance | 34 Comments

Let’s Talk About Personal Finance

This is a digression from my normal posts on energy and the environment. As I have said before, this is not a blog on investing or personal finance. Despite that, finance and energy often intersect, so it is a topic that comes up frequently. It is a topic that I am frequently asked about via e-mail, especially in today’s economic climate. Maybe my experience can help someone else avoid some of the mistakes I made. This is not advice directed at the advanced investor. They would have learned these lessons long ago. This is addressed to the average family who may have a negative savings rate, and is struggling to make ends meet.

The idea was spawned by a recent story in The Guardian:

Subprime crisis: US foreclosures bring homelessness to the middle class

Homeless people living in cars and mobile homes across the US are being joined by a new breed: the middle-class. As mortgage foreclosures continue rising month on month, growing numbers of middle-class professionals are losing their homes and downsizing from four bedrooms to four wheels.

Guy Trevor lost his job as an interior designer when the market contracted, thanks to the mortgage foreclosure crisis. “I see myself as a casualty of a perfect storm,” he said. “The people sleeping at the parking lot are very friendly. They’re just like me – they come from normal, everyday homes. I think a lot of people in this country don’t realise that they, too, are a couple of pay-cheques away from destitution.”

I am going to sharply disagree that Guy Trevor lost his job due to the mortgage foreclosure crisis. My guess is that he lost it due to poor financial planning. And while there are exceptions, generally this should not happen to anyone. So I want to give some advice on managing personal finances. What are my qualifications to do this? Let me give you a personal history.

My Personal Finance History

When I was growing up, I was always working and trying to save money. I bought my first pickup with money I saved from working a paper route for 2 years. I mowed lawns, picked up aluminum cans, and have worked pretty consistently since I was an 11-year old on my paper route. I was a born saver, and not a spender. I dreamed of one day becoming a millionaire. I did not want to rely on Social Security for my retirement income, as was the case with all four of my grandparents.

Putting aside the judgment of whether this was a noble goal for a child, in my 9th grade algebra class I finally saw that it could be realized. My 9th grade algebra teacher, Mr. Moore, taught us about compound interest. This was one of the most amazing discoveries of my life up to that point, and a definite life-changing event. If I only saved $2 a day, and averaged a paltry 5% of interest, I could accumulate $130,000 by the time I turned 60.

Not a fortune, but then again I am only saving $2 a day and only getting 5%. If somehow I could manage a 10% return, then my $2 a day ended up being $600,000 by the time I turned 60. And if I could manage some real savings – say $100 a month, or $3.33 a day (at the time I was making about $200 a month) – then I would have a million dollars when I turned 60. For the first time in my life, I could see a path to my goal that didn’t involve winning the lottery, or otherwise striking it lucky on some long shot.

The power of compound interest has been at the core of my financial planning since that school day in 1981. I knew the ingredients to wealth: 1). Live below your means, so you can save some money. 2). Save the money in a “do not touch” account; 3). Maximize your long-term returns.

Since that time, things have gone mostly according to plan. However, I have made some mistakes. As a 20-year old I was working full-time for Campbell Soup Company in Paris, Texas, but I was also going to college full-time and putting myself through school. (I worked the night shift – 10:30 to 7 a.m. – and then got up and drove an hour to college). I had accumulated about $30,000 from saving and investing my earnings (I had “discovered” mutual funds), and this was almost twice my annual earnings at Campbell Soup. I was well ahead of schedule for my goal of a million dollars by the time I turned 60.

But then I made one of the biggest financial errors I have ever made. I bought a brand new Toyota 4×4. Of course the payments were only $330 a month, but over the course of the payments this would consume half of my savings to that point of my life. And if you do the math since then, that new truck and subsequent higher insurance payments has cost me close to $100,000 (what I could have earned had I invested the money). On the other hand, this time period also saw me make a wise (or perhaps lucky) move. Due to the volatility leading up to Black Monday, I sold all of my mutual funds on the previous Thursday, October 15, 1987. (I made a similar defensive move earlier this year that has saved me a lot of money).

During my 20’s, I graduated from college and decided to go to graduate school. Those were some lean times, but even then I managed to save money. My graduate stipend – for teaching and doing research – was $12,000 a year – a pretty big pay cut from my Campbell Soup days. I was married, and rent was going to cost us five to six hundred dollars a month. So, with the money we had saved up as a down payment, we bought a condo. Instead of $600 rent payments, we had a $200 mortgage – and I eventually sold it for a profit.

While in graduate school, I researched the cheapest foods I could get without starving my wife and me, and we watched every penny. I ate grits on a number of occasions, and I would go to the $2.99 Pizza Hut buffet and eat enough for lunch and dinner. My wife and I once got into a fight because she bought a trash can for the kitchen. We had been using paper sacks. She took the trash can back. This was the reality of a situation in which I was determined to live below our means.

By the time I was 30, I had graduated, had two children, and was working as a chemical engineer. My wife – based upon a mutual decision – would stay home and raise the kids, and that has been the case for the past 15 years. Our savings at the time amounted to more than a year’s salary, and I was generally on target to reach my million dollar goal. Then I made major strategic error #2.

Technology stocks were booming, and I was seeing some pretty clueless people get rich. AOL, JDS Uniphase, Cisco, Amazon.com, PMC-Sierra, Ciena were among the hot stocks of the day. I read story after story of why these companies could only go up: It’s technology, for crying out loud!

So, about that time two things happened. I took my first expatriate assignment to Germany, and as a result I had to sell some of my mutual funds. Unlike some of the mutual fund companies, ETrade had no qualms about me having an online account from Germany. So I started trading tech stocks. (In fact, I started out with chemical companies, made some fast money, got overconfident, and jumped into tech stocks with both feet).

Initially, I made some fast money, and decided this was pretty easy. I started investing on margin. But then things turned down. If JDSU was a buy at $200 a share, it was an absolute steal at $150. Down to $100? I wished I had more money to put into it so I could average my cost down. Do you know what JDSU trades for today? About $12, and that still carries of forward PE of over 30.

This incident was the second defining moment of my financial life. I returned to the U.S. at the end of my expat assignment, and I pondered the future. My fast-track to a million dollars had been derailed. I almost felt like I was starting from scratch. So I made some decisions. First, I knew that engineers in the oil industry earned more money than engineers in the chemical industry. Further, I felt like oil production was going to peak in the not too distant future, and the oil industry was probably going to be printing money as prices skyrocketed. So, I left the chemical industry and joined the oil industry.

Second, I decided that I would never again invest in things that I didn’t understand. I still can’t tell you exactly what JDS Uniphase does. Something with the Internet. But I don’t understand the field well enough to distinguish the pretenders from the contenders.

Third, I vowed that I would always understand the risks. I shun investments that I deem as high-risk, even though I may be giving up substantial rewards. Moderate returns for moderate risk have been better for me than high returns that go along with extreme volatility and an occasional disastrous year.

Finally, I decided to invest only for the long-term. No more market-timing for me. I would evaluate a company based on the fundamentals and my expectations of where trends were heading (e.g., the health care sector looks good as the Baby Boomers age) and invest accordingly.
Those principles have guided my financial planning since then. I have not had a down year since 2000. In hindsight, as a result of my strategic error with the tech stocks, I developed a sound financial plan that has been very good to me. I am probably better off now than had I not taken such big losses in 1999-2000 because of the way it caused me to change the way I invested.

Financial Rules That I Live By

Here are some of the rules I live by:

1. Live within my means. That means that I don’t typically make purchases on credit that would take time to pay off. If that means I drive a crappy car – and I have driven crappy cars before – then that’s what I do.

2. No credit card debt. While in some cases it may make sense to carry credit card debt (e.g., you got 0% interest for six months), you have to be disciplined. You never want to carry a balance with a > 10% interest rate. You will have a tough time keeping your head above water.

3. Save a minimum of 10% of my income. Over the years, that has probably been closer to 30% for me. I have always maxed out my 401K every year that I worked. I maxed out IRAs, Health Savings Accounts, and Education Savings accounts. Saving that money pre-tax has the added advantage that money that would have gone toward taxes is now accumulating returns.

4. Do my own taxes. Doing your own taxes can give you a lot of insight into how to manage your finances in a way to minimize the take of the tax man. Study all of those deductions, and make sure you are taking the ones you are entitled to take. For most people, doing your own taxes should not be that difficult. Take last year’s tax return and start from there. If you get stuck, the IRS has various hotlines to help you out. Even if you can’t complete it by yourself, you will learn something by going through the process.

5. Invest in things I understand. For me, that’s primarily energy-related, but I also invest in sectors (like health care) that I think are well-positioned for the future.

If you are already buried in debt, and now struggling under higher food and energy costs – then it will be difficult to put your financial house in order. My advice would be a cut in your standard of living, followed by elimination of any high interest debt as quickly as possible. Don’t try to invest money in anything if you are carrying a credit card balance at 17% interest. Get that paid off first. Then start saving a little each week before you think about bumping your standard of living back up.

Remember, the sacrifices you make now are intended to lessen the need to make sacrifices later. Eat, drink, and be merry may be a lot of fun, but even better is to eat and drink in moderation, save some money as a result, and prosper in the long run.

July 8, 2008 Posted by | economics, investing, personal finance | Comments Off on Let’s Talk About Personal Finance

Let’s Talk About Personal Finance

This is a digression from my normal posts on energy and the environment. As I have said before, this is not a blog on investing or personal finance. Despite that, finance and energy often intersect, so it is a topic that comes up frequently. It is a topic that I am frequently asked about via e-mail, especially in today’s economic climate. Maybe my experience can help someone else avoid some of the mistakes I made. This is not advice directed at the advanced investor. They would have learned these lessons long ago. This is addressed to the average family who may have a negative savings rate, and is struggling to make ends meet.

The idea was spawned by a recent story in The Guardian:

Subprime crisis: US foreclosures bring homelessness to the middle class

Homeless people living in cars and mobile homes across the US are being joined by a new breed: the middle-class. As mortgage foreclosures continue rising month on month, growing numbers of middle-class professionals are losing their homes and downsizing from four bedrooms to four wheels.

Guy Trevor lost his job as an interior designer when the market contracted, thanks to the mortgage foreclosure crisis. “I see myself as a casualty of a perfect storm,” he said. “The people sleeping at the parking lot are very friendly. They’re just like me – they come from normal, everyday homes. I think a lot of people in this country don’t realise that they, too, are a couple of pay-cheques away from destitution.”

I am going to sharply disagree that Guy Trevor lost his job due to the mortgage foreclosure crisis. My guess is that he lost it due to poor financial planning. And while there are exceptions, generally this should not happen to anyone. So I want to give some advice on managing personal finances. What are my qualifications to do this? Let me give you a personal history.

My Personal Finance History

When I was growing up, I was always working and trying to save money. I bought my first pickup with money I saved from working a paper route for 2 years. I mowed lawns, picked up aluminum cans, and have worked pretty consistently since I was an 11-year old on my paper route. I was a born saver, and not a spender. I dreamed of one day becoming a millionaire. I did not want to rely on Social Security for my retirement income, as was the case with all four of my grandparents.

Putting aside the judgment of whether this was a noble goal for a child, in my 9th grade algebra class I finally saw that it could be realized. My 9th grade algebra teacher, Mr. Moore, taught us about compound interest. This was one of the most amazing discoveries of my life up to that point, and a definite life-changing event. If I only saved $2 a day, and averaged a paltry 5% of interest, I could accumulate $130,000 by the time I turned 60.

Not a fortune, but then again I am only saving $2 a day and only getting 5%. If somehow I could manage a 10% return, then my $2 a day ended up being $600,000 by the time I turned 60. And if I could manage some real savings – say $100 a month, or $3.33 a day (at the time I was making about $200 a month) – then I would have a million dollars when I turned 60. For the first time in my life, I could see a path to my goal that didn’t involve winning the lottery, or otherwise striking it lucky on some long shot.

The power of compound interest has been at the core of my financial planning since that school day in 1981. I knew the ingredients to wealth: 1). Live below your means, so you can save some money. 2). Save the money in a “do not touch” account; 3). Maximize your long-term returns.

Since that time, things have gone mostly according to plan. However, I have made some mistakes. As a 20-year old I was working full-time for Campbell Soup Company in Paris, Texas, but I was also going to college full-time and putting myself through school. (I worked the night shift – 10:30 to 7 a.m. – and then got up and drove an hour to college). I had accumulated about $30,000 from saving and investing my earnings (I had “discovered” mutual funds), and this was almost twice my annual earnings at Campbell Soup. I was well ahead of schedule for my goal of a million dollars by the time I turned 60.

But then I made one of the biggest financial errors I have ever made. I bought a brand new Toyota 4×4. Of course the payments were only $330 a month, but over the course of the payments this would consume half of my savings to that point of my life. And if you do the math since then, that new truck and subsequent higher insurance payments has cost me close to $100,000 (what I could have earned had I invested the money). On the other hand, this time period also saw me make a wise (or perhaps lucky) move. Due to the volatility leading up to Black Monday, I sold all of my mutual funds on the previous Thursday, October 15, 1987. (I made a similar defensive move earlier this year that has saved me a lot of money).

During my 20’s, I graduated from college and decided to go to graduate school. Those were some lean times, but even then I managed to save money. My graduate stipend – for teaching and doing research – was $12,000 a year – a pretty big pay cut from my Campbell Soup days. I was married, and rent was going to cost us five to six hundred dollars a month. So, with the money we had saved up as a down payment, we bought a condo. Instead of $600 rent payments, we had a $200 mortgage – and I eventually sold it for a profit.

While in graduate school, I researched the cheapest foods I could get without starving my wife and me, and we watched every penny. I ate grits on a number of occasions, and I would go to the $2.99 Pizza Hut buffet and eat enough for lunch and dinner. My wife and I once got into a fight because she bought a trash can for the kitchen. We had been using paper sacks. She took the trash can back. This was the reality of a situation in which I was determined to live below our means.

By the time I was 30, I had graduated, had two children, and was working as a chemical engineer. My wife – based upon a mutual decision – would stay home and raise the kids, and that has been the case for the past 15 years. Our savings at the time amounted to more than a year’s salary, and I was generally on target to reach my million dollar goal. Then I made major strategic error #2.

Technology stocks were booming, and I was seeing some pretty clueless people get rich. AOL, JDS Uniphase, Cisco, Amazon.com, PMC-Sierra, Ciena were among the hot stocks of the day. I read story after story of why these companies could only go up: It’s technology, for crying out loud!

So, about that time two things happened. I took my first expatriate assignment to Germany, and as a result I had to sell some of my mutual funds. Unlike some of the mutual fund companies, ETrade had no qualms about me having an online account from Germany. So I started trading tech stocks. (In fact, I started out with chemical companies, made some fast money, got overconfident, and jumped into tech stocks with both feet).

Initially, I made some fast money, and decided this was pretty easy. I started investing on margin. But then things turned down. If JDSU was a buy at $200 a share, it was an absolute steal at $150. Down to $100? I wished I had more money to put into it so I could average my cost down. Do you know what JDSU trades for today? About $12, and that still carries of forward PE of over 30.

This incident was the second defining moment of my financial life. I returned to the U.S. at the end of my expat assignment, and I pondered the future. My fast-track to a million dollars had been derailed. I almost felt like I was starting from scratch. So I made some decisions. First, I knew that engineers in the oil industry earned more money than engineers in the chemical industry. Further, I felt like oil production was going to peak in the not too distant future, and the oil industry was probably going to be printing money as prices skyrocketed. So, I left the chemical industry and joined the oil industry.

Second, I decided that I would never again invest in things that I didn’t understand. I still can’t tell you exactly what JDS Uniphase does. Something with the Internet. But I don’t understand the field well enough to distinguish the pretenders from the contenders.

Third, I vowed that I would always understand the risks. I shun investments that I deem as high-risk, even though I may be giving up substantial rewards. Moderate returns for moderate risk have been better for me than high returns that go along with extreme volatility and an occasional disastrous year.

Finally, I decided to invest only for the long-term. No more market-timing for me. I would evaluate a company based on the fundamentals and my expectations of where trends were heading (e.g., the health care sector looks good as the Baby Boomers age) and invest accordingly.
Those principles have guided my financial planning since then. I have not had a down year since 2000. In hindsight, as a result of my strategic error with the tech stocks, I developed a sound financial plan that has been very good to me. I am probably better off now than had I not taken such big losses in 1999-2000 because of the way it caused me to change the way I invested.

Financial Rules That I Live By

Here are some of the rules I live by:

1. Live within my means. That means that I don’t typically make purchases on credit that would take time to pay off. If that means I drive a crappy car – and I have driven crappy cars before – then that’s what I do.

2. No credit card debt. While in some cases it may make sense to carry credit card debt (e.g., you got 0% interest for six months), you have to be disciplined. You never want to carry a balance with a > 10% interest rate. You will have a tough time keeping your head above water.

3. Save a minimum of 10% of my income. Over the years, that has probably been closer to 30% for me. I have always maxed out my 401K every year that I worked. I maxed out IRAs, Health Savings Accounts, and Education Savings accounts. Saving that money pre-tax has the added advantage that money that would have gone toward taxes is now accumulating returns.

4. Do my own taxes. Doing your own taxes can give you a lot of insight into how to manage your finances in a way to minimize the take of the tax man. Study all of those deductions, and make sure you are taking the ones you are entitled to take. For most people, doing your own taxes should not be that difficult. Take last year’s tax return and start from there. If you get stuck, the IRS has various hotlines to help you out. Even if you can’t complete it by yourself, you will learn something by going through the process.

5. Invest in things I understand. For me, that’s primarily energy-related, but I also invest in sectors (like health care) that I think are well-positioned for the future.

If you are already buried in debt, and now struggling under higher food and energy costs – then it will be difficult to put your financial house in order. My advice would be a cut in your standard of living, followed by elimination of any high interest debt as quickly as possible. Don’t try to invest money in anything if you are carrying a credit card balance at 17% interest. Get that paid off first. Then start saving a little each week before you think about bumping your standard of living back up.

Remember, the sacrifices you make now are intended to lessen the need to make sacrifices later. Eat, drink, and be merry may be a lot of fun, but even better is to eat and drink in moderation, save some money as a result, and prosper in the long run.

July 8, 2008 Posted by | economics, investing, personal finance | 20 Comments