Is inflation as bad as advertised?

The major business news networks have continued to push that inflation is here and inflation is going to run wild. They use the rising commodity prices and the rising oil prices as proof that inflation is present in the economy right now. Ben Bernanke, chairman of the federal reserve has constantly said that inflation expectations are well anchored. Inflation expectation is a very accurate depiction of what real inflation would be. So who is right? And where do we go to find the correct answer. One place I believe we should start when discussing inflation is the spread on the TIPS bonds and Nominal Treasury Bond Yields.

Before we can analyze the spread we have to know what each bond consist of. Nominal Bonds yields consist of two components, real interest rates and inflation compensation. On the other hand we have the Treasury Inflation Protected (TIPS) bonds, whose coupon and principal rise and falls with changes in the CPI (standard measure of inflation in an economy). So the yield on TIPS bonds include only the real interest rate.

So when we take the difference in these bon

ds we are left with what is known as inflation compensation or break even inflation rate. Inflation compensation has two components one is expected inflation and the other is inflation risk premium. Since it is hard to measure inflation risk premium we assume this to be constant and table over time and we say that changes in breakeven inflation captures changes in inflation expectations.

So what does the data show:

If we focus just on the green line which is the difference between Nominal yields and tips yields, we can see the other than the sharp decline during the recession. The spreads show that inflation expectations have steadily been between 2 and 3%.

With the second round of Quantitative Easing, which has done an excellent job of putting the economy on good footing, set to end in June. It we be left up to the federal reserve to gauge inflation and determine if raising of interest rates is justified.

Value Investor Toolkit- P/E ratio

How many times have you been watching CNBC or any other business news show and heard them talk about the Price to Earning Ratio? The price to earning ratio, P/E ratio for short is a valuation of a company's current share price compared to per share earnings. It is calculated as

P/E = Price per share/ earning per share

A high P/E ratio generally means higher forecast earnings growth and low P/E ration means lower forecast earning growth. Investors can use P/E ratio as a way to compare companies within the same industry. Different industry have different average P/E ratio.

You will commonly hear the word price multiple when talking about P/E ratio. That is because P/E ratio show how much an investor is willing to pay for each dollar of earning. Example a P/E ratio of 15 would mean that investors are willing to pay $15 for each dollar of earnings.

P/E ratio can be used as a beginning tool for an investor when deciding on which company to invest in but it should by no means be the only only tool used.

Legend of Investing- Benjamin Graham

Benjamin Graham, the father of value investing and of security analysis. He is the teacher of great investors such as Warren Buffet, Walter Schloss and Irving Kahn. He was a great teacher and great intellectual mind in investing, and he was also a practitioner. His returns have been documented at about 17% per year between the years of 1929 and 1956.

Graham was monumental in moving investing from random speculation to one that relied on evidence. He was one of the first to utilize P/E ratio, debt ratios, book value, current assets etc.

Graham along with his colleague David Dodd produced a text book known as Security Analysis, which it a must have classic for those who believe in value investing. He also authored Intelligent Investing, which Warren Buffet calls "by far the best book on investing ever written".

Legend of Investing- Warren Buffett

Warren Buffett, known as the Oracle of Omaha is hands down one of the greatest investors in history. He was an student of Benjamin Graham, co-author of Security Analysis and the only one to recieve an A in Ben Graham class. Buffett is chairman of Berkshire Hathaway, the former textile mill that Buffet has transformed into a massive conglomerate holding company with subsidiaries ranging from See's Candy to Burlington Norther Santa Fe Railroad. He has managed to average 21% returns in book value from 1965 to 2006.

Investment Philosophy

Buffett earlier philosophy was to look for "cigar butts", that means those down and out investments. He has since transformed into what he terms "focus investing". He seeks to acquire great companies selling below intrisic value and hold them for long periods. He only invest in business he understands, which led him to stay away from the tech bubble and subsequent downfall. He also insist on having a margin of safety.

Investor of the week--Seth Klarman

Seth Klarman is a value investor and portfolio manager at Baupost Group, a $7 billion investment partnership founded by him in 1983. Since its inception, Klarman has managed to guide the portfolio to gains of 20% annually. Klarman is the author of "Margin of Safety" a investing classic that now sells on Amazon in upwards of $900.

Investment Philosophy

Seth Klarman invests in everything from value stocks in the traditional sense to distressed debt, and liquadations. With that said, Klarman has no problem doing nothing on occasions as evidenced by his large cash holding during 2005 and 2006 and when investment opportunities are few. He also returned 5% of cash to his clients for lack of investment opportunities.

Value Investor of the Week- Edward Lampert

Edward Lampert is the founder of ESL Investment, Inc and the Chairman of Sears Holding. Lampert started ESL at the ripe age of 25 and since its inception he has managed to produce returns averaging 29%.

His investment style is very similar to the great investor Warren Buffett. He looks for established businesses with strong cash flow. He also looks for companies that have the ability to produce cash of the long haul. Unlike Mr. Buffett, he does not look at a companies management team because he believes he can influence management and implement changes. Lampert, has experience in the investing in retail.

Mr. Lampert has been compared to Mr. Buffett on numerous occasions and with a track record of successful value investing he will undoubtedly continue to be compared to Buffett in the future.

Value Investor of the Week- Mohnish Pabrai

Mohnish Pabrai is the managing director of Pabrai Investment Funds. He adheres strictly to the principals of Warren Buffett, even structuring his funds like the Early Buffett partnerships. He began his fund with $ 1 million and now has assets of under mangagement of roughly $400 million. He delivered cumulative returns of over 90% vs a -27% return from the S&P index from Oct. 2000 to 2008.

His strategy is simple he looks for undervalued companies typically in smaller companies with market capitalizations of $500 million. He runs a concentrated fund consisting of 10 to 20 holdings. He is mentioned as a new school Warren Buffett. All this from a guy who was a successful entrepreneur, having run a successful computer and it consulting firm before selling it to become a excellent value investor.

For those more interested in learning about his methods you should check out the Dhando Investor: The low-risk value method to high returns.

Stock Pick of the Week: Microsoft

For those of us that use a computer, for business or personal use, this company needs no introduction. Microsoft (Nasdaq: MSFT), generates earnings through the development, manufacturing, licensing, and supporting a wide range of computer software products, such as its wildly successful Windows operating system and Microsoft Office. Microsoft also designs and sales the gaming system Xbox 360 and its accessories. It currently operates in 5 business divisions: Windows, Server and Tools, Online Services, Business, and Entertainment and Devices.

Strengths

Management

Although not considered to be the visionary like his predecessor Bill Gates, Steve Ballmer, who has been with Microsoft since 1980, and his staff have done an masterful job of consistently growing revenue, operating income, and net income in recent years. Management has also been able to have a strong return on equity of roughly 42% all while facing tough economic conditions and ever increasing competition from the likes of Google and Apple.

On top of the steady growth and high return on equity, Microsoft has also repurchased $170 Million in stock and are authorized to continue a $40 million buyback until 2013.

Products

Along with strong management, you have to look at Microsoft's product line. The Kinect, the motion game sensor for Xbox 360, sold 8 million units in 60 days. Demand will surely continue to be steady for Kinect as those who missed out at on the product during Christmas rush begin to get them in the upcoming months. Alongside the Kinect, Microsoft Office 2010 became the fastest selling version of Office in history and helped the the Business division revenue grow 24% year over year.

Windows has also recently released the windows phone 7 operating system in 30 countries through 60 operators and 9 different devices.

Weakness

The main weakness for Microsoft is the competition they face. This competition from Google, Apple and other software developers will effect the ability of Microsoft to provide future returns on equity as high as seen in previous years and also will slowdown growth prospects and profit margins.

Opportunities

The move toward cloud computing represents a major opportunity for Microsoft. The move has already begun with the development of Windows Azure and firms such as Pixar animations have shown possible uses of the platform. With the vast amount of cash reserves and a strong research and development department, Microsoft will be able to enter the area and quickly gain market share.

Threats

There will continue to be threats from Google and Apple in many areas in which Microsoft operates such as online search, cellular handeset operating system.

Valuation

Using Discounted Cash Flows with a 14 % growth rate (average of past 10 years) in the next 5 years, Microsoft has a fair value of $36.01 which is a 22% margin of safety from Wed. closing price of 27.94.

Investment Analysis

While not the superior growth machine it once was, Microsoft is still a company with solid growth, and strong and shareholder friendly management. With $41 billion in cash and cash equivalent it can still be seen as the 800 puond gorilla in the software space.