Monday, May 31, 2010

If this is not a Wall-of-Worry then what is?

You look at recent headlines and you may think that there is no end to our economic gloom. Greece, Spain, rising interest rates, minority government, big deficits and falling - no crashing or about to crash - stock markets, collapsing oil prices, etc. Wow life is terrible!

Yet the stock market is near a 52 week high, barely 700 points below the 12400 high of the TSX. Yeah a market crash must be unavoidable. Oil is around $75 and seems not capable of falling below $70 for any significant length of time. Then we're learning about record quarterly earnings of the banks, and Toronto and Vancouver real estate prices at top-heavy levels. The deficit is noticable less than expected and B.T.W. the Canadian economy grew a measley 6% (annualized) in the last quarter - biggest rise in 10 years or so.

Surely the world is coming to an end... or let the good times continue. Guess what, I like these 'walls of worry' and the continuing hand-wringing of famous bears whose names I seem not be able to remember and of whom we never heard until the last crash. These are the times to buy stocks and real estate. These buying opportunities won't last, whether it is investing in dividend, positive cashflow or good value in Alberta.

Saturday, May 22, 2010

Emotion isn’t something to fear, but to exploit

Below is one of the better articles by Derek Decloet of the Globe and Mail on Investing. Highly recommended reading indeed.
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Published on Friday, May. 21, 2010 7:53PM EDT Last updated on Friday, May. 21, 2010 7:55PM EDT

In Bangkok this week, anti-government protesters set the stock exchange on fire. In financial centres around the world, investors wished they had done the same.

There is something odd about the way in which a market slide – and that’s what this month has brought, a slide, not a panic – sets off a frenetic search for causes. Many times, these explanations make no sense, or are half-baked guesses, or are (at best) incomplete. Take Thursday’s drop, which sent the U.S. markets tumbling nearly 4 per cent and the TSX down more than 2. It was purportedly set off by “nagging worries that Europe’s debt crisis could spread,” said The New York Times , or by “fears of a disorderly crackdown on banks and financial markets,” according to the Financial Times.

So the problem was either politicians foolishly running huge deficits or politicians passing ill-conceived rules for banks – unless, of course, the real culprit was politicians acting arbitrarily against traders, as Germany’s leaders were accused of doing with a sudden ban on naked short-selling of certain investments, such as credit default swaps tied to government bonds.

Now it’s true that some people would decide to sell stocks for these reasons. It’s also true that a great many investors, particularly individuals, can’t tell you what Portugal’s debt-to-GDP ratio is, haven’t got a clue what a credit default swap is, and believe that “naked” is something you get with your spouse, not with your portfolio. When these people sell their stocks at a moment like this, they often do so for one reason: because stocks are going down.

It’s emotion that’s driving them, not reason. But that’s not something to fear. It’s something to exploit. Doing so is simple, which is not to say it’s easy.

“The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.” So wrote Ben Graham, the intellectual father of value investing, in The Intelligent Investor, the most important book ever written about investing (an endorsement by none other than Warren Buffett, Graham’s former student).

What makes Graham’s volume so valuable is a single insight: The best way to make money in the stock market over the long run is to (mostly) ignore the stock market. He didn’t quite put it those words. But the book’s underlying message is to block out most of what you hear about the S&P 500 doing this and the 200-day moving average doing that and “official corrections” (a 10-per-cent drop in an index, which some major benchmarks, such as the Dow Jones industrial average , hit this week).

You don’t need them. The vast majority of investors don’t even need to know much of anything about the complicated financial instruments at the centre of the credit crisis. Collateralized debt obligations backed by residential mortgage-backed securities, asset-backed commercial paper, credit default swaps – these things may be fascinating, but they’re distractions from an investor’s real job.

Which is what, exactly? To identify a good business, figure out what it’s worth, then wait until someone hits the panic button and will sell it for less than that – at which point you take them up on the offer. Repeat until rich. In volatile times, the market allows you to do this, because – and this is by far the most important thing one can take away from Messrs. Graham and Buffett – stock prices fluctuate far more than real business values do.

If Johnson & Johnson, one of the world’s great businesses, were a private company, would it be worth $15-billion less than it was a month ago? Clearly not. But as a public company, it has shed about that much in market capitalization as Europe’s crisis gained steam. UPS and MasterCard are worth $6-billion less than they were a few weeks ago – have their businesses deteriorated that much, that fast? Is Air Transat, the Montreal airline and tour company, really half as valuable as it was on New Year’s Day? (It’s an airline, admittedly, the toughest industry there is. But this is not some nearly-bankrupt U.S. carrier; it’s a company that has been consistently profitable in the past that is enduring a temporary panic about its future.)

I’m not saying you should buy these stocks. But the formula for good investing in trying times is clear enough: Decide which ones you do want to own, and when the stock exchanges are battered and smouldering, make your move. Credit default swaps and “naked short-selling” don’t have much to do with it.

A comparison of market risk between real estate and stock market investments.

When investing in 1973 in non-leveraged real estate, a $1.00 investment would have appreciated to $17.23 in 2010 based on Calgary’s average single family house price. Was that same dollar invested in the stocks of the Dow Jones, it would have brought in $12.63. This does not include rental income or dividends. Of course there was volatility along the way. If the same comparison was done in 2005, your stocks would have been worth $12.60 and the real estate $9.39.

As often pointed out at REIN, no investment does go up in a straight line. Also, Calgary real estate appreciates faster than many other parts of Canada. In Calgary, real estate appreciates at a compounded rate of about 8% while Canada’s average real estate compounds at 6% or so. Though the rate of appreciation is higher, cap rates in Calgary are lower than Canada’s average. A 1-2% difference in compounded appreciation may not seem significant, but over the same 37 year period, $1 invested in Canadian real estate would have appreciated to only $8.64.

A lot of real estate investors feel real estate is less volatile than stock market investments. But when one compares year end stock market and real estate prices, this is not the case. Check out the graph in the figure below. Stocks trade on a daily basis and with price movements reported nearly instantaneous; while real estate prices are only reported on a monthly bases by local real estate boards. So it may seem that the stock market is more volatile, but as the graph shows, that is not necessarily the case on a year-over-year basis.


Figure 1 - comparison of investment performance as the value invested of $1 in real estate compared with shares in the Dow Jones.

Price volatility is often referred to as risk, because if one is forced to sell in a down market, an investor is likely to sell at a loss. So the real issue is, whether one can hold on to an investment through good and bad times, until the investor chooses to sell the investment at a profit. That is, why buying at the right price but also selling at the right price are so important – both determine in the end how profitable the investment was.

So, if volatility constitutes risk because it may cause a forced sale at a market low, then when using leverage that risk is significantly increased, because a significant amount of the investor’s control regarding when to sell is handed over to the lender. The latter can be demanding repayment of the loan from the investor at any inappropriate time (a down market) and thus forces the investor to sell, possiblye at a loss – a loss that is magnified by the degree of leverage used. The higher the leverage is the higher potential is for loss. To get a better idea about how much higher the risk incurred is, have a look at the figure below, where the value of $1.00 invested without leverage in the real estate market or stock market is compared to a real estate investment levered at a LTV (loan to value ratio) of 80%.

Figure 2- Investment performance of $1 invested  in real estate or shares in the Dow Jones compared with an 80% LTV real estate investment. Note equity in the leveraged investment turned negative in 1985 and a new $1 investment was made after a 7 year period of bankruptcy and credit record repair.

The increased volatility of the leveraged investment is sufficiently extreme that the non-leveraged investments seem to increase smoothly. Also, the equity invested in the 80% LTV investment was wiped out in 1985. It was assumed in this simulation, that the investor went bankrupt and needed the subsequent 7 years to repair his/her credit record and to raise new equity ($1.00) before the investor was able to re-enter the real estate market to make a new 80% LTV investment.

In Figure 3, the same investment comparisons are shown but now in terms of year-over-year investment value change and expressed as a percentage of the amount invested in the year before.

Figure 3- comparison of investment performance of $1 invested in real estate or shares in the Dow Jones with a 80% LTV real estate investment expressed in terms of the percentage of annual change.

My conclusion is that in terms of performance, non-leveraged stock market and real estate investments are comparable in terms of risk and return over the long term. However, their performance is not well correlated because Calgary real estate outperforms the Dow Jones over certain periods while at other times the Dow Jones out performs Calgary real estate. This supports the idea of investment diversification. The use of leverage adds significant real estate investment risk and increases the potential reward (returns). This risk is often mitigated by aiming for positive cash flow obtained from rental or other real estate activities. One must however ask oneself, based on the above result, whether long term stock market investments could not be enhanced in performance as well using leverage, where the risk related to volatility is offset by funds generated from dividend income and better liquidity.

Friday, May 7, 2010

Here is an idea for taking advantage of the recent currency fluctuations.

Even if you have written off the U.S. economy, something that is not wise to do, there are a number of great U.S. companies with a worldwide presence that will likely do better and better over time. Examples include Microsoft, General Electric, Johnson and Johnson.

So you buy them now while they still trade at moderate prices. Let’s for example use Microsoft. This cash generating monster has been shunned by investors for many years and it is so much cheaper than Apple or Google; however successful, you can buy Microsoft still at a modest P/E. If you buy it at the bottom of the current trading range for $27 and just hold it until we’re back to where it was just a few days ago (at $31) you’re bound to make a nice profit.

But now add the currency effect. In times of instability, the Canadian Dollar trades at its lows due to the ‘flight to quality’ as strangely the U.S. dollar is referred to while U.S. debt load keeps piling on. Next thing you know, things were not so bad as all the pundits said. Commodities rise again and everyone runs away from the U.S. dollar , and voila, the Canadian dollar is back at parity and some ‘experts’ predict it may well go as high as $1.05. So why not buy Microsoft with borrowed money?

You buy e.g. 100 shares of Microsoft for around $27.00 U.S. and now you borrow the money from your U.S. margin account, $2700 plus $ 10 buying commission. Now you wait until the $Cdn recovers (say that takes 3 months) or it even shoots up to $1.05 and you pay off your loan which used to be: $2710/0.95 or $2852Cdn. but is now only: $2581 Cdn.

You’ll be paying interest of say 7% per year or $47U.S. for 3 months. After 6 months (or less) all misery is forgotten and Microsoft trades ones again around $31.00. Oops, you also got two dividend payments of 2x100x0.13 = $26 and you sell off the shares. The dollar is down again to 0.95 because this time Iran is making ugly nuclear noises. Your proceeds: $3100 plus $26 minus $10 selling commission and minus 3 months interest ($47) = $3069 U.S. or $3230 Cdn. That is a profit of $649 on Cdn $2581 invested or a return of 25% in 6 months or 50% per year.

There is risk, so don’t overdo it. Microsoft shares could fall after all, or the Canadian dollar does not recover. Also, it means you will have to keep a close eye on both Microsoft and the currencies, but for 50%? Why not! You can play the same game with GE or JNJ or with shares of whatever other great U.S. company you feel comfortable with.

Thursday, May 6, 2010

Don’t worry, be happy and go fishing!

So what is one to do now that the world is coming to an end? What about going fishing?

Well, is your portfolio up to date? Did you sell off your investment mistakes and do you only own well run companies that you bought for a good price? Then what else is there left to do than either to panic or to go fishing?

There is only so much under your control. You cannot control the weather. You cannot control the U.S. dollar, interest rates or the Greek debt crisis. You cannot even control the next investor over, your wife and certainly not your kids. So... go fishing. Because selling in a panic is probably the worst you can do.

What about cash? Cash is king. So you can keep on accumulating cash from rent, dividend, and interest. Maybe this is the time to dump that dead beat investment and add the cash to your stash! In the worst case you can claim the capital loss , reduce your taxes and add it to your many ‘learning experiences’.

If it wasn’t for the Greek Crisis of Investor Confidence the stock market would have been up significantly; North American companies are right now reporting increasingly better earnings. Leverage overall is still declining and American savers still are not spending with the unabashed frenzy of the pre-2007 years. I have no clue as to whether this debt crisis is contagious but ‘Que sera, sera’! I am not the Bank of Canada, the Chancellor of Germany or the Premier of the Netherlands. And even if I was, the Greek citizens are not taking this curtailing of bad economic habits gracefully. So... it is out of my control.

Glaring at the computer monitor and fretting about my losses will not help; other than the end of the world, over the long term things will probably work out. In the mean time, I am accumulating cash, sell a couple of losers to add cash to the stash and when the fog of panic clears, I should be able to identify some attractive investment opportunities that will add to my profits overtime. So are you ready to go fishing?

Storm in a glass of water?

Greece and the EU are on everybody’s mind right now. Greece seems to be the spoiled kid of Europe who never saved, always borrowed from the older ‘kids’ and then doesn’t pay back. The Greek people are angry and demonstrating refusing to cut back their too generous social system. How would you feel if you were a Greek Senior who saw his/her pension payments cut back? How would you feel if you’re a retired GM worker and your pension is about to go down the drain?
Of course you would be angry. Of course you would put city hall on fire or go after whomever else you could possibly blame but yourself. We are the ones that elect our governments - at least when you live in a ‘democracy’ which is by the way a Greek invention. Whom do we elect? The ones who are competent and tell us the way things are? Are you kidding me?

We elect the ones who promise us to do what we want. We of course never want to pay more taxes, we always blame the other political parties for what is wrong with our country; we’re cynical about our leaders and system and call everybody else corrupt. Then we vote for the lowest taxes, we blame the rich and tax them out our country, we want the best social system no money of ours can buy and when all is said and done, it is the darn banks that foreclose on our houses and the damn capitalists who caused the financial crises and we blame everone for all the trouble we caused by our own choices. But it is not our fault. It is the greedy banker, big oil, and corrupt government, the Russians, Rasputin and Santa Clause who are the cause of our problems. Personally, I do not blame anyone other than of course Arnold Schwarzenegger. We all know he is the real cause!

So now that Greece is in trouble, we’re getting scared and point also at Spain and Italy and... the Queen in the U.K. Gosh maybe the whole of Europe will default – them and their juicy social welfare programs! We in North America would never do that! Well... other than universal health care (the system where you get everything for fee while waiting... and waiting) and Canada Pension (which nobody can afford and is like an eternal Ponzi Scheme) and E.I. whose surplus was used by the Liberals to whitewash our deficit. And after having gloated about our wise banking system which for a change did not collapse in 2008, we can look south to the ruins of U.S. real estate and their enormous government debt – God are those Americans dumb!

Reality is, that if we do not learn to manage our personal finances; if we do not learn to rely on our own first rather than expecting a bail out from the nanny state; if we do not think about the consequences of our voting behaviour, we will stay stuck in this world of problems and misery. We end up blaming others for problems we ourselves have created and blaming will not solve our problems. In fact, we are so similar to our immature teenage kids, it is shocking. But aren’t we the grown-ups?