Saturday, April 30, 2011

It is tax filing time - dealing with frustration

Today is April 30 and I have to file my taxes, or at least pay the taxes I owe. My accountant already filed them. This is the ultimate form of procrastination, rather than writing a cheque and mailing it, I prefer to bore you with my blog and make another posting.

You think investors don't procrastinate? You think that one is always chipper and happy counting dividends, collecting rents, buying below market and selling with big profits? Think again!

Well, I prefer sitting here behind my wireless Microsoft keyboard with coffee (my 4th cup this morning) rather than running to Rona to buy some shiny baseboards to finish off the new laminate floor in one of my trashed rental apartment units.

Do you really think that I get excited about laying laminate floors and screwing in smoke detectors at night? To meet prospective tenants at the most inhumane hours in a tough rental market trying to get my latest vacancy filled?

Heck no, I prefer sitting here in my office looking out over my back yard were spring is slowly returning and drink loads of java. Tonight we're going to the theatre – don't you think 3-D is superior especially when combined with a personal touch?

But alas that is the life of an investor. It is boring and tedious. Nothing is as frustrating as buying RIM and seeing it trade 10% lower the next day or holding on to Microsoft for ages just to see its price drop based on a 30% increase in earnings. If you try to invest based on daily stock market fluctuations or even on a yearly performance you either become utterly frustrated or you are becoming a day-trader. Both are sure ways of losing money. Some investments work out and some don't and it is always the losers that frustrate your days and the winners that you take for granted.

If you want excitement go to Las Vegas or get shot in Mexico on the beach. But if you want to make money, you will have to bear the daily drudgery of long term investing. You procrastinate, enjoy your back yard combined with java and count your future (hoped for) profits.

Quiz: How many times did the author mention the bean drink and his back yard?
Answer: If you really re-read this post to count it, consider a career as bean counter. Oops I guess I am somewhat frustrated. Sorry, sorry, I didn't mean to offend anyone. J

Thursday, April 28, 2011

We are still worrying! - Good

Microsoft's profits are up 31%. RIM is trading at a P/E of 8.6 - lower than BCE or the Canadian banks. Yet these stocks tank and 'experts' are worrying the loss of market share to competitors such as Apple and Google. Strange, you would think that Apple's stock would tank with the release of RIM's playbook.

I bought one, a Playbook that is. It is a lot less clumsy than an I-pad. Lack of applications? There are 521 business aps; 687 entertainment aps, finance aps: 307, and games 1361. Do I need to go on? News: 637. My computer nerd of a son tells me that it is a lot easier to program apps for Playbook than I-Pad. Well the stock market doesn't care!

RIM, Cisco and Microsoft are considered as good as dead no matter how many new products, profits and cash they have on the balance sheet. Canadian oil companies are treated the same way. CNRL is $ 7 dollars below its 52 week high with oil trading at $112 per barrel. Cenovus just got a licking. The Power Corp stocks are also in purgatory.

Have you seen Rogers lately? Hmmm compare that to Tim Horton's, Canadian banks such as TD that trade at 15.1 x earnings, or real estate stocks such as Boardwalk and RioCan.

Every day you're opening the newspaper and you read that rising corporate profits are the norm. Your cpmpany misses earnings by 1 penny and your stock is like the dodo! Economic data is pointing to a continuing recovery with sales going up. But everyone is worrying about competition, the dismal economic outlook which usually turns out better than expected, etc., etc. The only stocks that do well are the ones that are 'in fashion' but you go a tiny distance of the beaten track and there are depressed stocks galore!

If it is not about the slow recovery or about the high level of competition, we can also worry about the liberal/NDP coalition which will vote down a new Conservative Government as soon as it is installed. As if the Conservatives with a near majority number of seats wouldn't close down a coalition government as soon as Gilles Duceppe goes out for a leak! We could also worry about the European debt crises while corporate cash coffers grow and grow. Oh, the market is going to hell in a hand basket!

Well, one thing is for sure. Although the Dow is outperforming the TSX, nobody is euphoric and believes that tomorrow the market will up another 15%. Instead, we worry and worry and expect the worst. Good, then we don't overpay and we don't get overconfident and there is likely still a lot of upside and less chance of a real crash! With many companies paying dividend yields higher than 10yr government bonds there is little reason for a crash! And… after a while, today's chicken littles will miss out on said dividends and modest appreciation. That is until the day they realize that they have missed the boat. Then in a panic they'll start buying at ever sillier valuations.

That is the time we'll sell. For now keep your chin up, enjoy the dividends and look forward to the days that the chickens pay silly prices for your stock holdings. Remember my guess - TSX peaks around 18,000.

Tuesday, April 19, 2011

Valuing Real Estate

Buying a residence or recreational property is usually an emotion driven purchase. A new residence is often chosen not based on economics but based on one's lifestyle choice. You may fall in love with the garage that also has a state-of-the-art workbench. Or the color of the wall paper is soooo pretty! This is the house you want to spend the rest of your life with – or at least the next 5 years. Oh ye unfaithful!

Emotional appeal is the reason that homebuyers pay too much for real estate when judged on the income potential of the place. Realtors typically do a Comparative Market Analysis (CMA), i.e. they compare what similar residences have sold for in the last 30 to 60 days in a particular neighbourhood. This has nothing to do with the economic value of a property and everything with the latest real estate market craze!

Appraisers do a similar evaluation, but they also may value a property based on its economic life and its replacement value. For an investor though, the 'income approach' is required. It typically values a property far less than a CMA and consequently many apartment buildings are selling significantly below replacement costs. There are different names for an income based evaluation. One name you may come across is the Annual Property Operating Data form or APOD. REIN, the Real Estate Investor Network led by Don Campbell calls it "Property Cash Flow Analysis". The evaluation of an investment is typically done following a two step screening process.

First properties are quickly screened for being in the 'Cash Flow Zone'. Does it create roughly enough cash flow so that the investor does not have to subsidize the rental operation? To measure the cash flow zone is nothing more than estimating the Gross Rent/Price Ratio. Typically if the gross annual rent is less than 8% of the property's purchase price it is not economic and the property is dropped as a potential investment.
Say a two-bedroom apartment brings in $1000 per month in rent. Then its annual gross rent is 12 x $1000 = $12000. Thus, as a first screen, the purchase price may not exceed $12,000/0.08 = $150,000. To find such a property in Calgary is, even in today's depressed real estate market, very hard. But that is the screen the property has to meet.

To find such a property the investor may have to review numerous listings on MLS or have his/her Realtor search for such properties. Realtors typically make much easier sales and better commissions when selling residential properties to home buyers. Many do not even understand the economic requirements of the investor. Neither do many have the patience to deal with investors. So you will have to be quite careful as to which Realtor is right for you. Don't just use your cousin or your sister's boyfriend's buddy!

After going through a hundred or so listings, you may find a property that makes it through your screen. Now you're ready to dig a bit deeper. It is time for your APOD. Some Realtors provide investors an APOD, but never forget that these guys and gals want to sell you the property! They often don't act in your best interest but rather in the seller's best interest. So treat such 'Realtor' adjusted APODS with a big shovel of salt!

Below is an example of an APOD spreadsheet. As REIN's Ray Reuter points out, the danger of spreadsheets is that it is so easy to do 'what if' evaluations. You tend to fill in overly optimistic numbers to justify a purchase price that is too high. There is here some serious judgment involved and you have to make sure that you don't put on a pair of rosy glasses because you're so anxious to buy.

 Here is the revenue portion of our APOD example. One two-bedroom apartment in NW Calgary build in the early 1980's typically rents for just over $1000 per month. If you're lucky (rose glasses?) you may rent the parking spot separately for an extra $35 per month or $420 per year. The total Gross Rent would be $12,840 per year minus vacancies. A 5% vacancy rate is pretty optimistic for the first year that you own a rental property, but over the long haul, once you become an experienced landlord it may be realistic. So that would mean that your Effective Rental Income is $12198.00 per year. Wow! A lot of dough! Really?

O yeah, there are expenses! Duuh!! In our example, we're dealing with a condominium complex so all external maintenance including that of the common areas is paid for from the condo fees. Also included in those fees is sometimes part of the utilities. In our case, water, sewer and heating are included in the monthly condo fees of $265. Not bad eh? Oops - $3,180 bucksos per year! Next are property taxes, $1069 per year! Landlord Insurance (building insurance is taken care off by the condo corporation and your tenants are responsible for tenant insurance) - $240 per year. Assuming no tenants trash the place, you probably still need around $300 per year for maintenance inside the unit (plumber, carpet cleaning, paint job, etc.) Oh, and your time or that of a property manager! In Calgary, I often forget about this because then I cannot find any property that makes the grade. Yet you really should take for this around 7% of gross rent or $852 per year. BTW land lording is hard work.

OK that is quite profitable, right? Since the tenant pays for phone, electricity and cable, our operating expenses are 'only' $4,789 and we're making $7409 per year! Eh… not so fast… what about financing? Typically we put 20 to 30% down on a property and the rest is financed through a mortgage. That way we get leverage. Say annual property appreciation of 4% (not counting 2008). So a $100,000 property increases $4000 grant per year in value. With 20% down, that would mean you make $4000 on a $20,000 investment or 20% ROI per year. Not bad eh? Plus rental profits! Yeah if all goes well!

So we need to pay financing expenses from our operating income of $7409. What kind of a mortgage can we get for that and still keep some pocket change? BTW, you better use that 'pocket change' to save for the occasionally trashed unit. A renovation can cost you easily between $7000 and $20,000. Where does that money come from? Well, this is typically not included in our APOD calculations but it is a real expense! Tenant screening is critical – we're in a business of nickel and diming as you may start to realize by now.

We have now reached the 3rd part of the APOD. If you 'paid yourself ' $853 per year for the time you spend on getting renters, collecting rent, calling plumbers, etc. your net operating income would be $6555.14 rather than aforementioned $7409. Your choice!

So suppose you end up paying $200,000 for a property that does not require any renovations and that is, what we call, rent ready. Add to that legal fees – say $1000 - and you put 30% down (my preferred down payment). Then a mortgage of $140,000 is required. With an interest rate of 3.59% (be realistic in your expectations some mortgages are more expensive than others) and 35 years amortization, your payment is $583.76 per month or $7005.18 per year. Ouch! Where are my profits? Yeah, you have to pay every year, if all goes according to plan $450 out of your own pocket! You're subsidizing your tenants and if things don't go according to plan… you are a lot more out of pocket!

The good news is that not all your mortgage payments go to interest. Part goes to paying off your debt – in our example you pay off close to $2049.76 annually. Thus overall you are making money on the rental operation. Now with one property you may not mind to pay out of pocket $450 per year. After all you're paying off the mortgage and accordingly you're making really around $1500 per year – or… only $120 per month.

Ahhh! Don't forget the annual appreciation (if it happens) of 4% in our example. That is greatly enhanced by the mortgage. In terms of profit over our $60,000 down payment you'd be making $9599.58 or 16%. But… with risk and a lot of hard work!

So would you want to pay $250,000 for this rental property? Your ROI would drop to 14% and you'd pay close to $2201 per year out of your own pocket – i.e. you're subsidizing the tenant. How many investments can you handle this way? 5? 10? Or none? REIN says that $250,000 is too much and $200,000 is marginal. A purchase price of $150,000 would provide you a ROI of 19% and every month $100 or so in your pocket (net cash flow).

How many 2 bedrooms do you see listed for $150,000? But that is what you have to pay if you truly want to make money on this property. Rental properties can be profitable but it is a lot of hard work. Are you a potential land lord?

Saturday, April 16, 2011

Sell in May and go away?

Are you kidding me! Who can sell off all their stock in May? Not me who claims to be a long term investor. In fact, if all of you sell your shares in May the prices will undoubtedly fall significantly and I might be interested in buying. Duuuh!

Yet, it seems we have price patterns or better trading patterns that seem to repeat overtime. Are they real or are these just random price paths that look like patterns but aren't? It doesn't matter. What does matter are fundamentals and whether potential investments are priced right.

With oil prices at their upper trading ranges and oil company shares reacting volatilely to even small movements in this commodity's pricing it is time to be more careful. Maybe not in Cushing, but Brent oil prices have reached the danger zone where it may adversely influence economic growth. Going against that are recent opinions that claim that countries such as Saudi Arabia have overstated their reserves and production capacity for years. According to those opinions, Saudi Arabia is barely capable of exporting 10 million barrels per day let be the 12 million barrels capacity that they claim.

So if our current production rates are maxed out, barring new technologies which likely will be immediately denounced by the shrill shouts of environmental activists, (thank you for driving up the oil price even further), what near future oil prices are in store for us? Jeff Rubin thinks $225 per barrel may not be beyond imagination. Surely our world would then become a lot smaller and a new economic way of life could result. If you think that is far out, then maybe you missed the last quarter when China had its first trade deficit in decades!

Add to this the economic results of the earth quakes in Japan, the Middle East rebellions, the indecisive leadership of NATO and Obama's weak leadership regarding Libya. Mix in a record U.S. debt, a nasty debt crisis in Europe and one could really see the world and our stock market through some very black glasses.

So the risk is high for something to really go wrong. Simultaneously, economic indicators in North America look quite decent if not decisively upbeat. A world full of contradictions! So ask yourself, what is the upside for the market over this summer? Weigh this against the downside.

My conclusion is that we'll better cool it for a while. I do not see the stock bargains from a year or even from half a year ago and the upside is limited for oil but also for the economy overall. BRIC countries, in particular China, experience inflation. Several of these countries try to cool their economic growth by making lending more difficult. Not necessarily by raising interest rates but rather by increasing requirements of banks before they can lend to industry and consumers. We are in a 'wait and see' pattern until at least this fall. Then it may be time to re-evaluate. This may not be exciting but then if we want excitement, we can always go to Las Vegas. As far as investing is concerned, boring is good as long as we collect our dividends.

Wednesday, April 6, 2011

Valuing a Stock II

Just buying stocks at low valuations in terms of P/E, CF/P, P/BV or dividend yield was David Dreman's way of buying stock at the right price. The Canadian Share Owner Association has developed a very solid method for buying stocks at the right price as well. Their website is:

The association has long advocated a systematic way of valuing stocks. Their long time track record based on this method speaks for itself. The Share Owner Association has created an extensive database of 'cleaned up' quarterly and annual corporate financial data to ensure that one compares apples with apples and not with oranges. Annual subscription to access the data or get it send to you quarterly on CD is around $250, there is also a membership fee of $90 or so per year. The membership fees entitle you to access on-line webinars that discuss specific case histories of companies based on the association's methodology, subscription to an on-line brokerage magazine and participation in a small investor brokerage service. The latter is a great starting point for small or novice investors. You can open an investment account with just a few hundred dollars and practice for the big world. Commissions are quite reasonable.

Without becoming a member, you can learn the details of the Share Owner Association for free on their website. If this way of investing makes sense to you, then become a member or try to use it on your own. The association's method is based on traditional value investment and fundamental methods. It considers predictable, easily to extrapolate earnings an hallmark for a great company. A picture is worth a thousand words, so here is the final screen of the association's software that helps you interpret the database data for companies you may be interested in (Fig 1.). We'll be using Microsoft as an example – no particular reason other than that I just like this company. But even if the company is great and profitable, can we buy the shares at the right price?

The Blue line depicts revenue over the last 10 years since 2000. You can see that Microsoft's revenue has grown steadily in spite of the wild gyrations of its share price. The green line shows that not only revenue has grown at nearly 11.3% per year but also the company's profits have grown. Not only that, the earnings have not been diluted but excessive new share issues. The green line represents not just profits but the profits earned per share. In 2000 Microsoft earned $0.85 and in 2011 it earned $2.10. Profit grew at 11.8% per year, so its profit margin/share increases every year as well (earnings growth 11.8% versus revenue growth of 11.3%). This is partially the result of extensive share buy-back programs.
Microsoft increases its earnings and revenue as steady as a train without breaks running down a slope. It seems unstoppable. On top of that dividends are paid to shareholders. In 2003, Microsoft started to pay dividends of $0.08 per share while today its dividend has grown to $0.52, that is a dividend yield of 2.5 per cent! GICs anyone? In 2005 it had so much cash on hand; the company paid a special dividend of $3.32 per share. Right now, Microsoft holds again a lot of cash – nearly $48 billion. With 8.5 billion shares that is around $5.5 per share in cash. You may say that at its current share price of $25 dollars, you buy $5.5 cash and $19.5 assets or you earn $2.10 with $19.5 dollars in assets, i.e. a P/E of 19.5/2.1 = 9.3. Now that is cheap! Compare that to Google!

On the graph, below the green line, you see blue boxes representing the price range that the stock traded at. You can see that although earnings have steadily increased, the stock price hasn't. In other words, the stock has become cheaper and cheaper. Just like there seem to be a lot of people who don't like Stephen Harper, there are a lot of people who just don't like Microsoft. It is purely emotional. One day those people will wake up and recognize what a terrific company Microsoft is and then they want to buy, buy and buy. Driving up the stock like crazy! Who are they buying it from? Well, you and me of course (if they pay enough)!

In the meantime, we will be collecting ever increasing dividends and if lucky, from time to time we collect a special dividend as well. Based on the range of P/Es that Microsoft has traded at in the past, the association's software (called Stock Study Guide) shows that prices could go up as high as $110 per share in about five years and based on extrapolated earnings that may climb as high as $3.66 per share (P/E of around 30 (as Microsoft traded at in 2004).

Will we ever reach those earnings and prices? Who knows, no one knows the future, but if the past is any guide, it sure seems possible considering its solid profit growth and revenue growth over the past 10 years.
Both Dreman's method and that of the Canadian Share Owner Association illustrate how you can value stocks and how to determine when the price is right. No market hysteria or emotions – just plain the facts ma 'me!

Saturday, April 2, 2011

Valuing a stock

I have mentioned 'buying shares at the right price' on many occasions on this blog. Benjamin Graham which was Warren Buffett's mentor and author of the stock market classic: "The Intelligent Investor", often used parameters such as P/E and Book value to determine whether a stock was undervalued or not. Reading the 'Intelligent Investor' is a must for every value investor. Although written in the fifties, it is still available in the investment section of many Chapters stores and other bookstores.

Dreman also defines stocks based on these variables, but rather than determining the value of a particular stock he compares it to other stocks in the stock market or in the same stock market sector. His thesis is that stocks are valued efficiently in the market except those that are hot and those that are in the dog house. Hot stocks are overvalued and tend to underperform the market. Stocks in the dog house are undervalued and ignored by investors and analysts alike – nobody expects anything from those stocks but bad news. Stocks that are in-between basically perform like the overall market.

According to David Dreman's research, stocks in the dog house systematically outperform the stock market. Not every one of them, but as a group they do. Some may go completely broke, but a basket comprising several stocks or all stocks in that group will typically outperform the market.

Analysts, like many experts in their field, tend to be poor forecasters; they may forecast human behaviour, the economy or the performance of companies like stock analysts do. The more data is accessible by an expert the more confident experts tend to be and ironically, the less reliable their estimates. It is not only overconfidence to leads usually to overly optimistic forecasts; the errors are also caused by limitations of the human brain. In particular, humans are linear thinkers, we are good in extrapolating the effects of one variable; but we are very poor 'configural' thinkers, i.e. figuring out the effects of many variables combined. When predicting a company's annual profit and sales performance, analysts have to take into account macro-economic factors such as the rate of inflation, consumer confidence and micro-economic data such as demand and supply data for the multiple products a company may produce, availability of raw materials, etcetera and etcetera. The integration of all these variables requires 'configural' thinking' and us humans are not very good at that. Unfortunately, analysts are human too and thus their forecasts are often off… by a wide margin!

Dreman quotes research of earnings forecast errors by analysts between 1973 and 1996 for over 1500 companies that traded on the American stock exchanges. Remember how stock prices literally collapse when earnings are 3 or 5% below analyst consensus? You would think those guys are pretty good if such small deviations caused such large changes in stock valuations. Well think again, the research showed that the average analyst makes an error of 44% in his/her earnings forecast and the median error was… 42%. Wow!

Dreman splits the stock market into quintiles or fifths: the top quintile or 20% of companies that are most expensive, the middle 60% and the bottom quintile. He determines the quitiles for each of the four standard measures of value:
  1. the ratio of earnings per share divided by the price per share is the price earnings ratio. It was also one of the most frequently used variables by Benjamin Graham to determine how expensive a stock is.
  2. the  the share price/cash flow per share ratio for each company in his extensive database of U.S. public companies.
  3. The net asset value of a company is the third measurement to determine how expensive a company is. This is expressed as the book value (assets minus debt) per share which Dreman divides by the share's price to determine a company's bookvalue over price ratio.
  4. Finally he used the dividend yield of each stock in his database
Dreman found that the bottom quintile as determined by these ratios often outperformed the market, but the results became even more striking when Dreman took earnings surprises into account. He found that a negative earnings surprise with the lower quintile companies did do little to the stock price – these were poor stocks to start out with. What else could one expect? The middle quintiles underperformed the markets by 5% in the following year and the top quintile – the hot stocks – underperformed the average market by a whopping 8.9%.! "What would be the effect of a positive earnings surprise?" you might ask.

Glad you did. Dreman's used the Compustat database containing data from 1500 publicly traded U.S. companies from 1973 until 1996. Every year he determined the top quintile, the bottom quintile and the middle quintiles for each measurement type (P/E P/CSF/ BV/P, Dividend yield). A positive earnings surprise for the top quintile was what investors expected, so a year after the surprise their stock price was only 1.5% better than that of the overall market. The middle quintile companies with a positive earnings surprise outperformed the market by 3 percentage points and the lowest quintile outperformed the market by an amazing 8.1%! Those gains were not made right away, most gains were made in the three quarters following the quarter during which the surprise was announced. So plenty of time for investors to react!

According to David Dreman, hot stocks consistently underperform. The middle quintiles are performing as the average market does. The contrarian investor who invests in the bottom quintile companies with positive earnings surprises consistently does better than the average market… by 8.1%. Since exact fundamental analysis is so difficult to achieve, Dreman does not feel that traditional value investors fare as well as in the days of Benjamin Graham.

Warren Buffett is one of the few that seems to be able to predict future corporate performance correctly or better correctly enough to spot value investments a la Benjamin Graham (with some adjustments). But for most of us earthlings, buying bottom quintile companies with positive earnings surprises may prove a successful way of investing as well.

In our next posting we will show you another method of valuing stocks.