Tuesday, March 6, 2012

What's Up?

We’ll take a break discussing options and look at the larger investment picture. Overall, markets and economies are improving. Isn’t it amazing when you listen to all the pundits telling you what everyone else also recognizes as taking place? Only they seem always to think that today’s market is tomorrow’s. When we were at the depths of the European crisis, they tell us that everything only gets worse, that the Euro will fall apart and they predict the end of the European Union. As little kids they want change now and don’t appreciate that these matters take time. Now those same pundits have cooled their temper tantrums along with the progress made in Europe including a commitment to more fiscal oversight. Now that the markets are doing better, the pundits tell us that the markets are doing better and are likely to continue doing so, until…. they do worse. So much for pundit forecasts!


 Euro countries shared the same currency but there was no backing by a coordinated economic policy including rules for fiscal behavior. That was the heart of the Euro crisis. Now a bare four months later that is being put in place, but for some kind of reason, the pundits never allowed for the fact that doing so takes time. Today they all ‘forecast’ a European recession and a modestly growing economy. Eh… gentlemen and the occasional lady pundit, please, that may be today’s situation but that is not necessary tomorrow’s. Tomorrow is likely different and if it isn’t then the’ tomorrow’ the pundits predict is already priced into the market because everyone knows what the pundit herd is predicting.


 Why are investors like Warren Buffett so successful? Simple, they don’t invest in the stock market or in the macro-economy; rather they invest in companies – in good companies that they buy at the right price. Companies do not always perform equally well under different market conditions and investors should expect good and poor quarters; however it is the long term performance that counts. Pundits are like horse race commentators trying to seduce you in betting on today’s favorite. As an investor you do not bet on a company’s near term stock performance but instead you buy a portion of a good company that has an earnings stream that looks good well into the future. The expectation is that the company will still be there 5 to 10 years from now and likely with even better profits.
 
I like investing in dividend paying companies, provided they are good companies. These companies should be profitable enough to not only pay the dividends but also to finance their growth at a decent clip for many years to come. Dividends are part of a company’s earnings and if the earnings grow then so will the dividends. In today’s market the emphasis on dividends surpasses the more fundamental need of earnings and earnings growth. Investors have forgotten that dividends are supposed to reflect management’s confidence in future earnings AND corporate growth. But with today’s dividend obsession, many companies have increased their dividends often at the expense of their growth potential. The results are that you buy those companies often with a decent dividend yield but also with a very low earnings yield. Earnings yield is the inverse of the Price-Earnings ratio and can be used to compare the company’s net earnings to interest earned on, say, a 5 to 10 year low risk government bond. Earnings yield is net income divided by stock price while the bond yield is the interest earned by the bond holder divided by the bond price. Earnings go towards dividends and towards re-investment in the company to create more profitable money earning assets.

 Today’s market has forgotten about the relation between dividends and re-investment capital for future earnings growth. Thus, many companies trade at ‘attractive dividend yields’ but at a high share price or high P/E. When the market loses sight of this relation it is at risk of becoming overvalued. That is, in my opinion, the case with many of today’s dividend paying stocks. They are considered to be low risk because of the hefty dividends; but many investors forget that the dividends have to be supported by earnings and that many of these dividend paying stocks are overpriced based on their earnings. So, what many consider ‘risk off ‘stocks comprise instead today’s high risk market segments.

 At the other side of the equation are many ‘growth stocks’, basically stocks that use all or most of their earnings to re-invest into new equipment or capacity that allows the company to grow even more and with a good profit margin. In fact, management of these companies often feels it can provide a better return on investment by reinvesting in the company rather than paying earnings out as dividends with investors deciding to invest them elsewhere.

Sometimes 'not paying dividends' may lead to management arrogance and poor investment choices; but in today’s markets investors want dividends badly and they have written off these ‘growth’ companies resulting in very cheap share valuations in this market segment. Oil companies and several other resource based companies are in this situation. This is even further aggravated by the cyclical nature of many of these companies; that is to say that many require a good healthy economy to ensure good demand for their products and optimum profits. Examples of cyclical companies are travel companies which do terrible during poor economic times but their profits go through the roof during good economic times.

So in today’s market, when we look for value, it is in those cyclical growth companies that you may find the best value. If you have a very long time horizon, 2 to 5 years, you may want to add natural gas producers to this group as well. The combination of very low trading volumes by retail investors in today’s Canadian Stock Market (which is dominated by resources stocks and banks) and investor anxiety regarding recent traumatic events (the U.S. financial collapse followed by the European debt crisis) have caused many investors to sit on the sidelines and has led to plenty of opportunity. There is still ‘a lot of blood and fear in the streets’ and that is when good investors start buying cheap good companies that lay scattered amongst the market debris.


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