Saturday, October 8, 2011

Paper securities not enough for a diversified portfolio

Are you buying a share of a company or do you speculate in stocks? When buying shares in a company you could use technical analysis – the analysis of stock price seasonality and current buy and sell trends as reflected in trading volume and price chart patterns. Technical analysis basically measures the emotional state of the stock market and in today’s market there is very little relation between the actual financial performance of many companies and the price the emotional investing public pays for those company shares.

Technicians are euphoric because their method of stock analysis helps them predict short term share price movements. Many claim that we are in a trading range or in a bear market. No matter which is right, this means we’re in an emotion driven market. If you are a day trader or speculator you might be able to take advantage of the technical trends and make some money after all.

Last night’s episode of BNN’s Market Call featured Don Valioux. Don’s past picks clearly illustrate my point. Don’s picks all got ‘buy’-signals in late June, 2011. Initially the picks did well, but within a month or two the trends changed. Don claims that by monitoring stocks every day and possibly more often, he detected the changes and sold with minor gains. Now in October the average picks were down 10.8%. Ouch! BNN’s Michael Hainsworth exclaimed “Every day? We’ve got daytime jobs, Don!”

What Don Valioux does is speculating on seasonal trends or price and volume trends. The trends may happen but then they also may ‘turn on you’. Many technical analysts are so focused on the squiggles they analyse that they often don’t even know what the companies that underlie the stocks are about. Ron Meisels is the perfect example he seems to have no clue what the company whose shares he buys does.

Investing, in particular buy and hold or value investing, is quite different. As Peter Lynch and the likes of Warren Buffett say you’re buying part of a company or the whole company. You share in its profits (and losses). Part or all of those profits are reinvested in the company, used for acquisitions, share buy backs or dividends.

The notion that you own a company is false, though. Just try to enter the head office and fire the CEO. Most long term investors have no control over the company they ‘own’ other than when they vote on an AGM or on a take-over deal. You’re literary along for the ride – not only the corporation’s financial ride but also the stock market ride. You’re only the passenger on this roller coaster and that is what makes stock market investing so difficult. The best chance to make money is to hold on and sell at market highs while trying to buy said shares when they’re on sale.

If you invest in mutual funds or ETFs matters of control are even worse. You do not even vote at the AGMs of the companies you own. Worse, your mutual fund or ETF manager may do it or not. In previous postings we have shown that over the long haul, investing in stocks provides good returns, but in extreme cases you may have to wait a decade, yes that is 10 years, or longer before you actually realize a good return. This is why dividends are so valuable! They not only constitute nearly 50% of your total profits, they provide you cash flow while you wait for the appreciation.

The 1970s (see earlier posts) was a time where there was very little appreciation but dividends would have pulled you through. Today’s stock market show a lot of similarities with the 70s and with dividend yields 3 to 5 times higher than long term government bonds, stocks are attractive to invest in. Especially Canadian dividend paying stocks are attractive because they qualify for the dividend tax credit.

From a corporate point of view, issuing shares is not much different from issuing bonds. One ‘pays’ out profits and the other pays interest. As long as a corporation has access to capital in one form or another to finance its acquisitions or expand operations and run its operations (working capital), it does not care. If it is cheaper to issue bonds then it will do so; on the other hand if it is cheaper to issue shares it will do that. Only when management and to some degree staff has interests similar to the share owners then they might care about stock prices. Often options are a tool to align management interest with that of the shareholders. But in falling bear markets that alignment gets lost (especially when the options are ‘re-priced’); also when management gets big financial incentives to merge or acquire regardless of the corporation’s financial merits or that of the shareholders, the alignment of interests may get lost. The board of directors in public corporations are in theory comprised of shareholders, but in reality many of those directors are buddies of senior managers. Rules of corporate governance may have improved a bit, but still the deck is stacked in favor of management.

So when investing in stocks, you do have a long term interest in a company and you should not get distracted by daily stock market movements. Yet the lack of control about your company’s performance is a major issue. Hence, a portfolio is not truly diversified if you only invest in paper securities. If you are still working, you should see your current job also as a part of your portfolio. How stable is it? How is your earnings performing? Then there is the possible lay-off (yet another bear market).

For retirees, holding real assets such as real estate, in particular rental properties should be a definite consideration. What other income streams could you add to your portfolio? Royalties, pensions, your own business? If the last 10 years and our extended life expectancy have taught us anything, then it hopefully is that paper securities alone may not be enough to create a diversified portfolio that allows us to live a full live to the age of 100.

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