Hi, I'm Bill Ackman. I'm the CEO of Pershing Square Capital Managementand I'm here today to talk to you about everything you need to know about finance and investingand I'm going to get it done in an hour and you’ll be ready to go. How to Start and Grow a Business So let’s begin. We’re going to go into business together. We’re going to start a company and we’regoing to start a lemonade stand and now I don’t have any money today, so I'm goingto have to raise money from investors to launch the business. So how am I going to 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 Lemonade Stand andwe’re going to raise money from outside investors. We need a little money to get started, sowe’re going to start our business with 1,000 shares of stock. We just made up that number and we’re goingto sell 500 shares more for a $1 each to an investor. The investor is going to put up $500. We’re going to put up the name and the idea. We’re going to have 1,000 shares. He is going to have 500 shares. He is going to own a third of the businessfor his $500. So what is our business worth at the 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 friend and he’sgoing to lend me $250 and we’re going to pay him 10% interest a year for that loan. Now why do we borrow money instead of justselling more stock? Well by borrowing money we keep more of thestock for ourselves, so if the business is successful we’re going to end up with abigger percentage of the profits. So now we’re going to take a look at whatthe business looks like on a piece of paper. We’re going to look at something calleda balance sheet and a balance sheet tells you where the company stands, what your assetsare, what your liabilities are and what your net worth or shareholder equity is. If you take your assets, in this case we’veraised $500. We also have what is called goodwill becausewe’ve said the business—in exchange for the $500 the person who put up the money onlygot a third of the business. The other two-thirds is owned by us for startingthe company. That is $1,000 of goodwill for the business. We borrowed $250. We’re going to owe $250. That is a liability. So we have $500 in cash from selling stock,$250 from raising debt and we owe a $250 loan and we have a corporation that has, and you’llsee 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 start our company? We need a lemonade stand. That’s going to cost us about $300. That is called a fixed asset. Unlike lemon or sugar or water this is somethinglike a building that you buy and you build it. It wears out over time, but it’s a fixedasset. And then you need some inventory. What do you need to make lemonade? You need sugar. You need water. You need lemons. You need cups. You need little containers and perhaps somenapkins and you need enough supplies to let’s say have 50 gallons of lemonade in our startof our business. Now 50 gallons gets us about 800 cups of lemonadeand we’re ready 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 ourfixed assets are now $300. That is our lemonade stand. Our inventory is $200. Those are the supplies and things, the lemonsthat we need to make the lemonade. Goodwill hasn’t changed at 1,000, so ourtotal assets are $1,750 and we still owe $250 to the person who lent us the money. Shareholder equity hasn’t changed, so wehaven’t made any money. All we’ve done is we’ve taken cash andwe’ve turned it into other assets that we’re going to need to succeed in our lemon standbusiness. So let’s make some assumptions about howour business is going to do over time. We’re going to assume we’re going to sell800 cups of lemonade a year. That’s not a particularly ambitious assumption,but we should assume the lemonade business is fairly seasonal. Most of the lemonade sells will happen overthe summer. We’re going to assume that each cup we cansell for $1 and it’s going to cost us about $530 per year to staff our lemonade stand. So now 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 over for the owner of the company. So we’ve got one lemonade stand. We’re selling 800 cups of lemonade at ourstand. We’re charging $1, so we’re generatingabout $800 a year in revenue and we’re spending $200 on inventory. There is a line item here called 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 toactually pour the lemonade and collect cash from customers and we have a profit. We have EBIT and that is earnings before interestand taxes, of $10. That is kind of our pretax profit for thebusiness. We didn’t make very much money because youtake that pretax profit of $10 and you compare it to our revenues. It’s about a 1.3% margin. That is not a particularly high profit. Now we’ve got to pay interest on our debtsand we have a loss of $15 and then we don’t have any taxes, but at the end of the daywe still lose money. So the question is, is this a particularlygood business? Well we’re losing money and our cash isbasically going down over time. Is this a business we want to stay in? Now the cash flow statement takes the incomestatement and figures out what happens to the cash in the company’s till, so whenyou put up $750, some money goes to pay for a lemonade stand. Some money is lost selling the product andat the end of the day we started with $750 and 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 startingto wear out. Goodwill hasn’t changed. We still owe $250 and our shareholder’sequity is now down to $1,490, so it was the 1,500 we started with minus the $10 we lostover the course of the year. So should we continue to invest in the business? We’ve lost money in the first year. Is it time to give up? Well let’s think about it. Let’s make some projections about what thecompany is going to look like over the next several years. Let’s assume that we take all the cash thebusiness generates and we’re going to use it to buy more lemonade stands so we can grow. Let’s assume we’re not going to take anymoney out of the company and we’re not going to pay a dividend. We’re going to keep all the money in thecompany and reinvest it. Let’s assume that we’re going to—aswe build our brand we can charge a little more each year, so we’re going to raiseour prices about a nickel, five cents more for each cup of lemonade each year and thenwe’re going to assume we can sell 5% more cups per stand per year. So we’ve got built in growth assumptions. Now let’s take a look at the company. So if you take a look at this chart you’llsee in year one we started out with one lemonade stand. We add one a year and then by year five we’reup to seven because we’ve got a big expansion plan. Our price per cup goes up a nickel a yearand our revenue goes from $800 and starts to grow fairly quickly and the growth comesfrom increased prices for cups of lemonade and it also comes from opening more stands. So by year five we have almost $8,000 in revenue. Our costs are relatively constant, which isthe lemonade and the sugar. That’s about $1,702. We have depreciation as more and more standsstart to wear out over time. We’ve got labor expense, but by year fivethe business is actually doing pretty well. We went from a 1.3% margin to over a 28% margin. The business is now up to scale. We’re starting to 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 incomeor another word for profits of $1,500 by the fifth year and about a dollar a share. So if you think about this our friend putup $500 to buy 500 shares of stock. He paid a dollar and after five years if ourbusiness goes as we expect he is actually making a dollar a share in profit. That sounds like a pretty good deal. So what has been the growth? The growth has been fairly dramatic over theperiod and that is what has enabled us to become a successful business. Now these are just projections, but if they’rereasonable projections this might be a business that we want to start or invest in. Now let’s look at the cash flow statement. So as the business becomes more and more profitablewe generate more and more cash and the cash builds up in the company. We go from $500 of cash in the company toover $2,000 of cash over the period. The balance sheet, again, the starting balancesheet had shareholder’s equity of $1,490, but as the business becomes more profitablethe 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$4,000 of shareholder equity and that’s almost three times what it was when we started. Good vs. Bad Businesses 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 earningsare we achieving compared to 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 $1,500 value. By the end of year five it’s earning over$1,500 in earnings, so that’s over a 100% return on the money that we put into the company. That’s actually quite a high number. We spent—let’s talk about return on capital. We’ve spent $2,100 in capital building lemonadestands and we earned $2,336 in year five on the capital we invested. That’s over 100% return on capital. That is a very attractive return. Earnings have grown at a 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. So let’s look at the person who put up theloan. Well that person put up $250 and the businesshas been profitable. We’ve been able to pay them their interestof 10% a year, $25 a year and they’re happy because they put up $250. They’re getting a 10% return on their loanand the business is worth well more than $250. We’ve got more than that in cash. As a result, they’re in a safe position,but they’ve only made 10% on their money. Now let’s compare that with the equity investor,the person who bought the stock in the company. That person earned a dollar a share in yearfive versus an investment of a dollar a share, so he is earning over 100% or about 100% returnon his investment versus only 10% for the lender. So who got the better deal? Well obviously the equity investor. Now why did the equity investor, why do theyhave the right to earn so much more than the lender? The answer is they took more risk. If the business failed the lender is entitledto the first $250 of value that comes from liquidating the company, so if you sell offthe lemonade stands and you only get $250 the lender gets back all their money. They’re safe. They got their 10% return while the businesswas going. They got back their $250, but the equity investor,the person who bought the stock is wiped out because they come after the lender. So what is the difference between debt andequity? Debt tends to be a safer investment becauseyou have a senior claim on the assets of a company and it comes in lots of differentforms. You’ve heard of mortgage debt on a home. That’s a secured loan secured by a house,but you could have mortgage debt on a building for a company. There is senior debt. There is junior debt. There is mezzanine debt. There is convertible debt, but the bottomline, it’s all debt. It comes in different orders of priority ina company and the rate your charge is inversely related to your security, so the better thesecurity and the less risk the lower the interest rate you’re entitled to receive. The more junior the loan the higher the interestrate you’re entitled to receive, but you can avoid the complexity. All you need to think about is debt comesfirst. It’s a safer loan, but you’re profit opportunityis limited. Now the equity also has their varying forms. There is something called preferred equityor preferred stock. There is common equity or common stock andagain stock and equity are basically synonyms. They’re options, but really not worth talkingabout today. The important point is that equity gets everythingthat is left over after the debt is paid off, so it’s called a residual claim. Now the good thing about the residual claimis that business grows in value if you don’t owe your lender anymore, but all that valuegoes to the stock holder. So the question is why was the lender willingto take only a 10% return when the equity earned a much higher rate of return and theanswer is when the business started there was no way of knowing whether it would besuccessful or not and the lender made a bet that if the business failed they could selloff the lemonade stand. It cost $300 to make it. They would have some lemons, some lemonade. Even if they sold it at a much lower pricethan the dollar they originally projected the lender felt pretty comfortable that theywould get their money back, whereas the stockholder is really taking a risk. They were betting on the profitability ofthe company and they were taking a risk that if it failed they would lose their entireinvestment, so they were entitled to get a higher return or have the potential to havea higher return in the event the business we successful. So let’s talk about risk. Lots of different ways people think aboutrisk, but the one that we think is the most important—you know a lot of people talkabout risk in the stock market as the risk of stock prices moving up and down every day. We don’t think that’s the risk that youshould be focused on. The risk you should be focused on is if youinvest in a business what are the chances that you’re going to lose your money, thatthere is going to be a permanent loss. When you’re thinking about investing yourown money, when you’re thinking about one investment versus another don’t worry somuch about whether the price moves up and down a lot in the short term. What matters is ultimately when you get yourmoney back will you earn a return on your investment. How do you think about risk? Well one way to think about risk is to compareyour risk to other alternatives, so you could buy government bonds and government bondsare considered today the lowest risk form of investment and the US Treasury issues 10year, 3 year, 5 year debt. There is a stated interest rate and todaya 10 year Treasury you earn about a 3% return. So you give your government $1,000 and youget $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 obviously if you’re going to make aloan you can lend money to the government and earn 3%. Well if you can lend money to a lemonade standyou want to earn meaningfully more, so in this case the lender is charging a 10% rateof interest. Why 10%? Because they want to earn a nice fat spreadover what they can make lending to the government because a startup lemonade stand businessis a higher risk business. Equity investors sort of think about thingssimilarly, so the higher the valuation—the more risky the business the higher the rateof return the equity investor is going to expect and the lower the risk business thelower the return the equity investor is going to expect and equity investors don’t getinterest the same way a lender does. What equity investors get is they get thepotential to received 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 inthe first place. The business is doing very well yet I, havingstarted the business coming up with a name and the concept, hired all the people, I'vemade nothing, right. So the business has grown in value, but whereis my money? I need money to buy a car for example, soI want to buy a car for $4,000. What are my choices? What can I do? Well we’ve taken all the cash the businesshas generated. We’ve reinvested it in the business. Now the good news is we’ve taken all thatmoney. We’ve been able to use it to buy more lemonadestands and these lemonade stands are more and more productive and it’s grown the valueof the business faster and faster. Now my alternatives could included insteadof growing the business so quickly, instead of investing in more lemonade stands I couldsimply 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 I do that? Well I could sell the company, so I couldsell my lemonade stand business. I started this one in New York. Maybe there is someone in New Jersey who wantsto buy me, consolidate with my lemonade stand company. Well the problem with that is once I sellit I can no longer participate in the opportunity going forward and I believe in this business. I think it’s going to be very successfulover time. So that’s one alternative. The other alternative is I could pay a dividend. We have by year five, over $2,000 sittingin the bank, so I could pay that money out to the shareholders of the company, but thatwould really slow my rate of growth going forward because I couldn’t afford to buildand buy more lemonade stands and it’s not the $4,000 that I need in order to raise money. So I'm going to look at taking a businesspublic. What does that mean? Well first of all, before we take our businesspublic we want to think about what it’s worth. It’s year five. We’ve been doing a good job. We’ve got a business that is profitable. Everything seems to be going well. Well the problem is I've got some personalneeds. I've started this company. I've taken all the cash the business generates. I've reinvested the cash in the business. I bought more and more 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 lotof cash 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 andI start sending that money 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 in the companytoday. If I sent that out that is half of what Ineed to by a car. So how do I get the rest of the money or howdo I get more money? Well I could sell the company, so that’sone 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 thispoint? So what should I do? The other alternatives, other than selling100% of the business is to sell a piece of the business and I can do that privately. I can find an investor who wants to buy aprivate interest in the company and if the business is worth enough I can sell them apiece of the business and we can be successful. The other alternative is I can take the businesspublic. Everyone has probably heard of an IPO, aninternet company is going public, people getting rich on an IPO. What is interesting is an IPO doesn’t makesomeone rich. All it really does is it takes a businessthat they already own and it sells a piece of it to the public and it gets listed onan exchange like the New York Stock Exchange. An IPO, the abbreviation stands for initialpublic offering and it’s initial because it’s the first time a company is going public. Going public means you’re selling stockto the broad general public as opposed to finding one investor buying interest in thecompany and its offering because you’re offering people the opportunity to participateand the way to do that actually is you get a good lawyer. You get a good bank, investment bank. It’s going to be your underwriter and you’regoing to put together a document called a prospectus, which is going to talk about allthe risks and the opportunities associated with investing in your company. It’s going to have history of how the businessis done over time. It’s going to have the balance sheet thatwe talked about. It’s going to have income statements fromthe previous several years. It’s going to have cash flow statementsand investors are going to read that document and they’re going to learn about whetherthis is a business they want to invest in and how to think about what price they wantto 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’re going to need good lawyers. You’re going to need a good investment bankand you’re going to go through a process where you’re going to make a filing withthe FCC with a copy of the initial what’s called registration statement for the offeringor the prospectus. The FCC is going to comment on it and eventuallyyou’re going to have a document that you can 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 keep the rest. You get to keep control of the company, butyou get to raise money in the offering and you can use that money to buy the car thatwe were talking about before. Now before you decided to go public or evento sell it at all it’s probably a good idea to 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 businessis to compare it to other similar businesses. Now the stock market is actually a prettyinteresting place to look. Now the stock market is a list of companiesthat have sold shares to the public and you can look in the New York Times or the WallStreet Journal or online, on Yahoo Finance or Google or other sites and look at stockprices for Coke, for MacDonald’s and what those stock prices tell you is what the valueof the company is. And how do you figure out the value of thecompany? Well you look at where the stock price is. You count how many shares are outstanding. The shares outstanding will be listed in variousfilings with the FCC. You multiply the shares outstanding timesthe stock price. That tells you the price you’re paying forthe equity of the company, so if you go back to our example of our little lemonade standwe have 1,500 shares of stock outstanding. We sold them for a dollar initially, one-thirdof them to an investor and the business initially had a value of $1,500. So what is the business worth today? Well one way to look at it; let’s look atother lemonade stand companies. Let’s assume other lemonade stand companieshave sold either in the private market, the public market for a price of 10 times earningsor 10 times profit, so that will give you a sense of value. You could look at the stock market if thereare other examples of a business similar to a lemonade stand company. Perhaps a company that sold soda every monthwould 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 share in yearfive. If we put a 20 multiple on that dollar thebusiness is worth, according to the comparable about $20 per share. We’ve got 1,500 shares outstanding. We multiply 1,500 times 20. Now our business is worth $30,000. So we had a company that started out at 1,500,five years later it’s worth $30,000. That’s actually quite good. Well how do we raise $4,000 if that’s theappropriate value for our business? Well if we sold 200 of our shares, 200 ofour shares that are today now worth $20 a share we could raise the $4,000 that we aretalking about. Now what would that do? What would happen if we sold 200 of our sharesin the market? Well our interest in the business would godown because today we own 66 and 2/3 percent or 2/3 of the company. A third is owned by our private investors. Well if we sold stock in the market, if wesold 200 of the shares that we would own our ownership would go from 67% to 53%, so thegood news there is we’d still have control of the business because in most public companiesowning a majority allows you to control the business going forward, but because the companyis now owned by public shareholders you have to make sure their interests are properlyrepresented, so you have to have a board of directors, a group of individuals who representthe interests of the shareholders who have a duty to make sure that their shareholdersare treated properly and you wouldn’t have the same degree of flexibility you had whenyou were a private company because you have other constituencies that you need to thinkabout. Now the benefit of the IPO is the stock wouldnow be liquid. There would be a market where it would tradein the public markets and then over time if I wanted to sell more stock I could do soor if new investors wanted to come in they could buy stock and our stock would now beliquid. It would make me feel better about this businessin terms of my ability to at some point exit or if a I wanted to raise more money I couldsell stock fairly easily in the market because each day you could look up the price eitheron the web or in the New York Times or otherwise and you could figure out what your businessis worth. Okay, now how does this matter to you? Now the purpose of the example of our lemonadestand is just going to give you a primer on what companies are, what they do, how theyearn profits, what the various reports they provide to investors so investors can figureout what they’re worth and the purpose of this lecture is to give you a sense of someof the things you need to think about when you’re thinking about investing perhapssome of your own money whether you want to invest in a lemonade stand or you want toinvest in a company on the market, so a few basic points to think about. One of the most important is if you’re goingto be a successful investor it makes a lot of sense to start early. Now that’s kind of a hard thing. Today you’re probably a student. You don’t have a lot of spare money. Keys to Successful Investing Well let’s assume at 22 you have a prettygood job. Instead of spending your money on gadgetsor a fancy apartment or not so fancy apartment or going out and drinking a fair amount youput some money aside and you start investing money. Let’s say you could save $10,000 at 22 andyou can earn a 10% return on that money between now and the time you retire. What would you have in 43 years? The answer, if you put aside $10,000, youdon’t save another penny and you invested it in your and you earned 10% on your moneyeach year you’d have $600,000 in year 43 and the reason for that is well in year 1your $10,000 will become 11, in year 2 your $11,000 would grow by 10% and so you wouldbe earning interest not just on your original principle, but you’d earn interest on theinterest you had earned the previous year and that compounding effect allows money togrow in an almost exponential fashion. Now obviously if you earn more than 10% youcan earn even higher returns. Now that’s if you put $10,000 aside at 22you’d have $600,000 in 43 years. That’s pretty good. What is you had to wait until you were 32when you earn the same 10% per annum? The problem there is by year 33 you’d onlyhave $232,000. Maybe that is not enough to retire, so thekey thing here is if you’re going to be an investor one of the most valuable assetsyou have today as someone who is 18 or 19 years-old is your youth. You want to start early so that your moneycan grow over time. Now what if you could earn 15%? I'll give a you better sense of how powerfulcompounding is because remember at 10% for 43 years you’d have $600,000. That’s pretty good, but if you earned 15%you’d have over 4 million. Now you’re in a pretty good position andso obviously making smart decisions about where you put your money has a huge differencein what you’re retirement assets are. Now obviously if could put aside more than$10,000, if you could put aside $10,000 each year then you’re wealth would be quite enormous. Now just for fun if you were one of the world’sgreat investors, Warren Buffet being a good example, if you could earn 20% per year for43 years you’d have 25 million dollars. Again the original $10,000 investment wouldincrease about 2,500 times over that period of time just by earning a 20% return. Albert Einstein said the most powerful forcein the universe is compound interest, so the key is start early, earn an attractive returnand avoid losing money and you’re going to have a very nice retirement. Okay, now let’s talk about the risk of losingmoney. Now let’s assume that in order to try toget a 20% return you took a lot of risk and it turns out that every 12 years you losthalf your money because you just made—you hit a bad patch in the market or you madedumb decisions. Well your 25 million dollars at 20% wouldnow only be worth a million eight in 43 years, so a key success factor here is not just shootingfor the fences, trying to get the highest return. It’s avoiding significant loses over theperiod. Okay, so as Warren Buffet says rule numberone in investing is never lose money and rule number two is never forget rule number one,so if you can avoid loses and earn an attractive return over time you’re going to have alot of money if you can stick at it for a long period of time. So how do you be a successful investor? Now I'm assuming that you’re not going togo into the business of investing. I'm assuming that you’re going to be a doctoror 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 I would give my sister, my grandmother on what she should do if shewere in the same position. I think that’s probably the right way tothink about it. So number one, how do you avoid losing money? What are the good places to invest? My first piece of advice is despite the storyabout the lemonade stand I’d avoid investing in lemonade stands. I’d avoid investing in startup businesseswhere the prospects are not very well known because again you don’t need to make 100%a year to have a fortune. You just need to invest at an attractive return10, 15 percent over a long period of time. Your money grows very significantly. So how do you avoid the riskiest investments? My advice would be to invest in public securities,invest in listed companies, companies that trade on the stock market. Why, because those businesses tend to be moreestablished. They have to meet certain hurdles before theygo public. The stocks are liquid, so you can change yourmind if you want to sell. If you invest in a private lemonade standit’s hard to find someone to take you out of that investment unless that business becomesfabulously profitable. So that’s piece of advice number one, investin public companies. Number two, you want to invest in businessesthat you can understand. What I mean by that is there are lots of businessesthat you come in that you deal with in the course of your day in your personal life,whether it’s a retail store that you know because you like shopping there or it’sa product, your iPad that you think is a great product, but you have to understand how thecompany makes money. If the business is just too complicated, youdon’t understand how they make money, even if they’ve had a great track record I wouldavoid it and a lot of people thought Enron was an incredible business because it appearedto 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 wantto invest at a reasonable price. It could be a fabulous business that is donevery well over a long period of time, but if you pay too much for it you’re not goingto earn a very good return investing in that company. The last bit is that you want to invest ina business that you could theoretically own forever. If the stock market were to close for 10 yearsyou wouldn’t be unhappy. What do I mean by that? Again if you’re going to compound your moneyat a 10 or 15 percent return over a 43 year period of time you really want a businessthat 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 meetthat standard. Maybe a good example is Coca Cola. 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 andto retail establishments and they make a profit every time they serve a Coca Cola. People drank a lot of Coca Cola for a verylong period of time. The world’s population is growing. They sell it in almost every country in theworld and each year people drink a little bit more Coca Cola, so it’s a pretty easybusiness to understand and it’s also a business that I think is unlikely to be competed awayas a result of technology or some other new product. It’s been around long enough. People have grown used to the taste. Parents give it to their children and youcan expect it will be around a long period of time. I think that’s one good example. Another good example might be MacDonald’s. You may 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 open up these little—build these littleboxes. They rent them to the franchisees. They charge them royalties in exchange forthe name and they sell hamburgers and French fries and you know what? People have to eat. It’s relatively low cost food. The quality is pretty good and they continueto grow every year. So I think the consistent message here istry to find a business that you can understand that’s not particularly complicated thathas a successful long term track record that makes an attractive profit and can grow overtime. So what are the key things to look for ina business as I say that lasts forever? Well you want a business that sells a productor a service that people need and that is somewhat unique and they have a loyalty tothis particular brand or product and that people are willing to pay a premium for that. Another good example might be a candy business. While people are going to buy generic versionsof 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 product to be unique. You don’t want it to be a commodity thateveryone else can sell because when you sell a commodity anyone can sell it and they cansell it at a better price and it’s very hard to make a profit doing that. If you’re investing for the long term youwant to invest in businesses that have very little debt. In our little example before we talked aboutour lemonade stand. There is $250 worth of debt. That didn’t put too much pressure on thelemonade stand company, but if it had been $1,000 and we hit a rough patch the businesscould have gone out of business for failure to pay its debts. The shareholders could have been wiped out. So if you can find a company that can earnattractive profits, that doesn’t have a lot of debt or they generate vastly more profitsthan they need to pay the interest on their debt that is a safe place to put your moneyover a long period of time. You want businesses that have what peoplecall barriers to entry. You want a business where it’s hard forsomeone tomorrow to set up a new company to compete with you and put you out of business. I mean going back to the Coca Cola example. Coca Cola has such a strong market presence. People have come to expect when they go toa restaurant they can ask for a Coke and get a Coke. It’s very hard for someone else to breakin. 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 someone tocome 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 realloyalty and they won’t switch and it doesn’t—even if someone offers the same, similar productfor 20% less they still want the branded, high quality product. You also want businesses that are not particularlysensitive to outside factors, so-called extrinsic factors that you can’t control. So if a business will be affected dramaticallyif the price of a particular commodity goes up or if interest rates move up and down orif currency prices change. You want a company that is fairly immune towhat is going on in the world and I'll use my Coca Cola example. I mean if you think about Coca Cola it’sa product that has been around probably 120 years. Over that period of time there have been multipleworld wars. There has been all kinds of you know, developmentof nuclear weapons, all kinds of unfortunate events and tragedies and so on and so forth,but each year the company pretty much makes a little bit more money than they made beforeand they’re going to be around and you can be confident based on the history that thisis a business that is going to be around almost regardless of whether interest rates are at14%, whether the US dollar is not worth very much or the price of gold is up or down. Those are the kind of companies you want toinvest in, in the long term, businesses that are extremely immune to the events that aregoing on in the world. Another criteria, if you think back to ourlemonade stand company, as we grew we had to buy more and more lemonade stands. Now those lemonade stands only cost $300 each,but imagine a business where every time you grew you had to build a new factory to producemore and more product and those factories were really expensive. Well that company might generate a lot ofcash from the business, but in order to grow you’re going to have to just reinvest moreand more cash into the business. The best businesses are the ones where theydon’t require a lot of capital to be reinvested in the company. They generate lots of cash that you can useto 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 capital intensity business. Maybe the best way to think about a low capitalintensity business is to think about a high capital intensity business. If you think about the auto industry beforeyou produce your first car you have to build a huge factory. You’ve got buy a lot of machine tools. You have to make an enormous investment beforeyou can send your first car out the door and those machine tools wear out over time andas you make more and more cars you have to invest more and more in the factories, soit’s a business that historically has not been very attractive for the owners of thebusiness. If you looked at the price of General Motors’stock 50 years ago it actually hasn’t changed meaningfully even up until the last severalyears before it went bankrupt. If you ignored the most recent period up throughthe bankruptcy of GM very few people made money investing in GM over a 40 or 50 yearperiod of time and the reason for that is that GM constantly had to reinvest every dollarthat they generated to build better and better factories so they can be competitive. If you compare that to Coca Cola while CocaCola there are bottling companies around the world a lot of those bottling companies aren’teven owned by Coca Cola. What they’re really doing is they’re sellinga formula and in exchange for that formula they get a royalty on every dollar that isspent on Coca Cola. Those are the better businesses. Another good example might be American Express. If you think about the American Express cardwhen you take your American Express card and you buy something American Express card getsa few percent of every dollar that you spend. So you put up the capital and they get a severalpercentage point return on that. They get 3% of so of what you spent. So businesses where you own a royalty on otherpeople’s capital are the best businesses in the world to invest in. I guess the last point I would make is thatif you’re going to invest in public companies it’s probably safest to invest in businessesthat are not controlled. A controlled company is kind of like our lemonadestand business that we took public. The problem with a controlled company unlessthe controlling shareholder is someone you completely trust, unless there is someonethat has a great track record for taking care of so-called minority investors, the non-controllingshareholders it can be a risk of proposition to invest in that business because you’reat the whim of the controlling shareholder and even if the controlling shareholder todayis someone that you feel comfortable with there is no assurance that in the future theymight 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 simplyhave a profitable business and a business that has done well. You have to make sure that the managementand the people that control the business think about you as an owner and are going to protectyour interests. So these are some of the key criteria to thinkabout. The Psychology of Investing and Mutual Funds Now when are you ready to start investingmoney? My guess is you’re a student. You probably have student loans. Perhaps you even have some credit card debt. You’re going to graduate. You’re going to get a job. So you don’t want to jump right in and whileyou have a lot of debt outstanding start investing in the stock market. The stock market is a place to invest whenyou’ve got a good—you have money you can put away that you won’t need for 5 years,maybe 10 years. So if you’re paying relatively high interestrates on your credit cards you definitely want to pay off your credit cards first beforeyou think about investing in the stock market. You student loans are probably lower costthan your credit cards, but again here my best advice would be if your student loansare costing you six or seven percent well if you pay them off it’s as if you earneda guaranteed six or seven percent return and you’re just better off getting rid of yourcredit card debt and even your student loan debt before you commit a lot of material amountof money to the stock market. So what do you do with your money while you’rewaiting to invest? The answer is you pay down your debt and youwant to have—even once you’ve paid off your credit card debts, perhaps you paid downyour student loans, you want to have enough money in the bank so that even if you wereto lose your job tomorrow you’ve got a good 6 months, maybe even 12 months of money setaside. So these are some pretty high standards andobviously therefore these make it harder to start investing earlier, but the safest courseof action in order to be a successful investor is be as—have as little debt as possible. Be comfortable having some money in the bank,so if you lose your job tomorrow you can live until to find your next opportunity and onceyou’ve achieved those goals then put aside money that you don’t need to touch. If you can do that then you can be a successfulinvestor. 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 reasonableprice. You want to buy a business that is going toexist forever, that has barriers to entry, where it’s going to be difficult for peopleto compete with you, but all those things are important, but even—and a lot of investorsfollow those principles. The problem is that when they put them intopractice and there is a panic in the world and the stock market is heading down everyday and they’re watching the value of their IRA or their investment account decline thenatural tendency is sort of to do the opposite of what makes sense. Generally it makes sense to be a buyer wheneveryone else is selling and probably be a seller when everyone else is buying, but justhuman tendencies, the tendency of the natural lemming-like tendency when everyone else isselling you want to be doing the same thing encourages you as an investor to make mistakes,so a lot of people sold into the crash of ’87 when in fact they should have been abuyer in that kind of environment. So that’s why I talked before a little bitabout why it’s very important to be comfortable. You want to be financially comfortable. If you have student loans you want to havea manageable amount of debt. You probably don’t want to be paying any—youdon’t want to have any revolving credit card debt outstanding. You want to have some money in the bank becauseif you’re comfortable then the money that you’re risking in the stock market is notgoing to affect your lifestyle in the short term. As long as you don’t need that money tomorrowyou can afford to deal with the fluctuations of the stock market and the fluctuations,depending on who you are can have a big impact on you. People tend to feel rich when the stocks aregoing up. They tend to feel poor when the stocks aregoing down and the reality is the stock market in the short term is what Ben Graham or evenWarren Buffet called a voting machine. Really stock prices reflect what people thinkin the very short term. If affects the supply and demand for investors,buying and selling stocks in the short term. Over the long term however, stocks tend toreflect the 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 beable to avoid some natural human tendencies to follow the herd. When the stock market is going down everyday you’re natural tendency is to want to sell. When the stock market is actually going upevery day your natural tendency is to want to buy, so in bubbles you probably shouldbe a seller. In busts you should probably be a buyer andyou have to have that kind of a discipline. You have to have a stomach to withstand thevolatility of the stock markets. The key way to have a stomach to withstandthe volatility of 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 thestock market in the short term is what we call a voting machine. It really represents the whims of people inthe short term. Stock prices are affected by many things,by events going on in the world that really have nothing to do with the value of certaincompanies that you’re investing in, so you’ve got to just accept the fact that what youown can go down meaningfully in value after you buy it. That doesn’t necessarily mean you’ve madean investment mistake. It’s just the nature of the volatility ofthe stock market. How do you get comfortable? Well the way you get comfortable with thevolatility is 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 of the business. You make sure it’s a business that you understand. You make sure the price you’re paying isreasonable relative to the earnings of the company and we talked before a little bitabout earnings and how to look at a value of a business by putting a multiple on earnings. A more sophisticated way to think about abusiness is to—the value of anything is actually the amount of cash you can take outof it over a very long period of time and people do build models to predict how muchcash a business will generate over a long period. That is probably something a little bit morecomplicated than we’re going to get into for the purpose of this lecture, but maybeanother way to think about it would be helpful. So when you by a bond and you get an interestrate, so today the 10 year Treasury pays about 3%. You’re earning 3% on your investment. When you buy a stock that’s trading at amultiple of its profits or a so-called PE ratio or a price to earnings ratio let’ssay of 10 times it’s very similar to a bond. In fact, if you flip over the PE ratio, youput the E on top, what the business is earning and you put the price that you’re payingfor the stock on the bottom it’s what the earnings are per share over the price youget what’s called an earnings yield and you can compare that earnings yield to forexample the 10 year Treasury, so a company trading at a 10 PE is actually trading ata 10% earning yield, so you can actually think about stocks or buying equity in a businessas very similar to buying an interest in a bond. The difference is in the bond you know whatthe coupon is going to be. You know that 3% interest rate every yearfor the next 10 years. With stock you don’t know what the couponis going to be. The coupon in the stock is how much profitit earns 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 hopefully the long term trend is up andso the way I think about the decision between buying a bond or buying a stock is I wantto make sure that the earnings yield, that earnings per share over the price I'm payingfor the stock is higher than what I could get owning a Treasury and that earnings yieldis something that’s going to grow over a long period of time. Now if you had a business that was growingat a very, very high rate very often—or growing its profits at a very high rate, veryoften people are prepared to pay a pretty high multiple of those profits. Why, because they expect that earnings yieldto grow, so if you had a business you might even pay—it might be cheap some day to buya business at 30 times its profits or a 3% or a 3.3% earnings yield if you think that3.3% is going to grow at a high rate and eventually get meaningfully higher to a 5, a 6, a 7,a 8 or 10 percent rate. Those kinds of investments are much riskier. The higher the multiple generally the higherthe 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 recommendingthe MacDonald’s and the Coca Cola’s of the world are to find businesses that whereyou’re going in yield your earnings yield is high enough that you don’t need to beright about a very high rate of growth into the future in order to earn attractive rateof return. Okay, so the few key success factors for beingan investor in the stock market are one, do the homework yourself. Make sure you understand the companies thatyou’re investing in. Two, invest money that you won’t need formany years and three, limit the amount of—don’t borrow money certainly to invest in the stockmarket and limit that amount of leverage, if any, that you have as an investor. Okay, so after this brief 40 minute lectureI wouldn’t just jump in immediately and start investing in the stock market. You have some work to do. There is some books you can read and we’regoing to 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 booksas opposed to reading books and the experience associated with starting small and investingin the stock market. Let’s say this is just not for you. I don’t want to invest, buy individual stocks. It just seems too risky. I don’t have the time to do my own research. What are your alternatives? Well you alternatives are to outsource yourinvesting to others. You can hire a money manager or you can hirea group of money managers and there are a couple of different alternatives for a startupinvestor. The most common alternative is mutual fundcompanies. So what is a mutual fund? A mutual fund is I guess technically it’sa corporation, but where you buy stock in this corporation and the manager selects aportfolio of stocks. So what they do is they pool together capital,money from a large group of investors. So say they raise a billion dollars and theytake that money and they invest in a diversified collection of securities. Now the benefit of this approach is that witha tiny amount of money, even less than $1,000 you can buy into a diversified portfolio managedby a professional manager who is compensated to do a good job for you investing in themarket. So mutual funds are a good potential areafor investment. The problem is there are probably 7, 8,000,maybe 10,000 different mutual funds and some are fantastic and some are not particularlygood, so you need to do research to find a good mutual fund manager in the same way thatyou need to find individual stocks, so it’s not just the easy thing of just invest inmutual funds. So here are a few key success factors in identifyinga mutual fund or a money manager of any kind to select. Number one, you want someone who has an investmentstrategy that makes sense to you; you understand what they do and how they do it. They’re not appealing to your insecurityby using complicated words and expressions that you don’t understand. If they can’t explain to you in two minuteswhat they do and how they do it and why it makes sense then it’s a strategy you shouldn’tinvest in. Number two and this is not necessarily inthis order. This probably should be number one, is youwant someone with a reputation for integrity. Again if you’re starting out you probablywant to invest in some of—a mutual fund that is sponsored by some of the larger mutualfund complexes as opposed to a tiny little mutual fund that is privately—by a mutualfund company that you’ve never heard of. There is some benefit in the larger institutionsthat have—you can be more confident that they’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 valueinvesting has a very long term track record and there are other kinds of investing includingtechnical investing where people are betting on stocks based on price movements, but Ihighly recommend against those kind of approaches. So you want someone making investments wherethey’re buying companies based on their belief that the prospects of the businesswill be good and that the price paid relative to what the business is worth represents asignificant discount. You want to invest with someone that a longterm track record and I would say 5 years is the absolute minimum and ideally you wantsomeone who has 10, 15, 20 years of experience investing in the markets because there isa lot that you can learn being a long term investor in the market. You want someone who has a consistent approach,where they haven’t changed what they do materially year by year, that they have astated strategy that they’ve kept to thick and thin that has enabled them to earn anattractive return over their lifetime as an investor and I always say in some way mostimportantly you want someone who is investing the substantial majority of their own moneyalongside yours. Obviously it shouldn’t be that they’reinvesting your money. This is what they do for you, but for theirmoney they do something meaningfully different. You want someone whose interests are alignedwith yours. If it’s a mutual fund you want them to havea lot of money in their own mutual fund. If it’s a hedge fund, which is a privatelysold fund for investors who have higher net worth you want a manager who is investingalongside you as well. I have a strong aversion to strategies thatrequire the use of leverage, so in the same way you want to invest in companies that usevery little debt you want to invest in investment strategies that you very little leverage. If you can avoid leverage and invest in highquality businesses or invest with high quality managers it’s hard to lose a lot of moneyversus the use of leverage. Lots of money can be lost. Now in the same way when you’re buildinga portfolio of stocks where you don’t want to put all of your eggs in one basket andyou want a reasonable degree of diversification and the more sophisticated, the more workyou do, the higher the quality the business is you invest in the more concentrated yourportfolio can be, but I would say for an individual investor you want to own at least 10 and probably15 and as many as 20 different securities. Many people would consider that to be a relativelyhighly concentrated portfolio. In our view you want to own the best 10 or15 businesses you can find and if you invest in low leverage, high quality companies that’sa comfortable degree of diversification. If you invest with money managers you probablydon’t want to put all your eggs in one basket there either and here you probably want tohave two or three different, perhaps four different alternative, mutual funds or moneymanagers, so again there you have some degree of diversification in your holdings. Finance in Our Lives So we spent the hour. We started with a little lemonade stand companyand the purpose of that was to give you some of the basics on how to think about a business,where the profits comes from, what revenues are, what expenses are, what a balance sheetis, what an income statement is, how to think about what a business is worth, how to thinkabout what the difference between what a good business is versus a bad business, how debtoffered is generally higher, actually lower risk, but lower return, how equity investorsor investors who buy the stock or the ownership of a business have the potential to earn moreor lose more and we use that background as a way to think about- We use that as the—just as the basics toget someone of the vocabulary to think about investing and we talked about investing inthe stock market. We talked about ways to think about how toselect investments, how to deal with some of the psychological issues of investing. We covered a fair amount of ground in a relativelyshort period of time. Now I entitled the lecture Everything youNeed to Know about Finance and Investing in Less Than an Hour. Well it really isn’t everything you needto know. It’s really just an introduction and hopefullyI didn’t mislead you, induce you to watch this for an hour, but there is a lot morethat can be learned and there is wonderful books that can teach you on the topic, soI think what is interesting about investing whether you choose this as a fulltime careeror not if you’re going to be successful in your career you’re going to make somemoney and how you invest that money is going to make a big difference in the quality oflife that you have and perhaps that your children have or the kind of house you’re able tobuy or the retirement that you’re going to be able to enjoy and we talked about thedifference between a 10% return and a 15 and a 20% return over a very long lifetime andwhat impact that has in terms of how much wealth you create over the period, so investingis going to be important to you whether you like it or not and learning more about investingis going to have a big impact on your quality of life if money is something that you needin order to meet some of your goals. So I recommend this as an area worthy of explorationand the more you learn about investing the more—these same concepts while they’reuseful in deciding how to invest your portfolio they’re also useful to you in thinking aboutdecisions like buying a home, making decisions in your line of work, if you’re a lawyerwhether to hire additional people, these kinds of calculations and thought processes arehelpful and they’re helpful in life and I recommend that you learn more. So take a look at the reading list and goodluck.