Thursday, May 31, 2012

Stock market and real estate investing are two peas from the same portfolio pot

Valuing stocks based on its earnings, earnings growth and net asset value is called value investing. The investor hopes to buy a company or part thereof at a discount of net asset value or based on earnings yield (earnings per share divided by share price x 100%) compared to interest rates (where the 5 year or 10 year bond yield is often used as benchmark).
Growth investing is valuing a company based on anticipated earnings and revenue growth; investors may value growth companies therefor much higher than current earnings justify.
Momentum investors are investors who buy  a stock because it has been going up for a while at steady or increasing trading volumes and chances are that the stock will go higher; hopefully much higher.
Then there are investors who invest based on trends observed on stock price and other charts. They specialize in trend pattern recognition. Patterns that may foreshadow future price moves of the stocks. This is often combined with larger stock trends such as Elliot Waves and seasonality whether that is annual, political or historically patterns.
All these investment philosophies are based on past market experiences and the hope that those past experiences repeat. However, this is only a ‘hope’’ a speculation that may not come true. Microsoft traded at very high P/E (price/earnings) ratios (the inverse of earnings yield) during the High Tech boom on the expectation that earnings growth would increase exponentially. With the High Tech Crash in 2001-2003, the stock price collapsed from well over $50 per share to as low as $20 per share. Thereafter the P/E kept on falling in spite of ever increasing earnings. The earnings of Microsoft have increased from $0.68 per share in 2001 to $2.69 in 2011 or an annual earnings growth of 14.2%. Yet it is currently trading at a P/E of 10.60 which is lower than that of many banks and utility companies. It is not that Microsoft’s earnings are erratic; no they increase like clockwork. The stock is not in fashion though. So how long does a value investor have to wait until Microsoft is recognized as the superb business it is?
There are many examples where appreciation as predicted by value investing, momentum investing or technical investing is not realized. Some argue that these strategies are ‘seasonal’ with periods that technical investing outperforms momentum investing and even value investing.  Thus, if one cannot count on logical, predictable, market valuations of stocks and their underlying companies, one has to admit that investing for appreciation is speculative. No matter how much research has been committed to estimate the company’s future value.
The growth of a company’s assets, debt load, sales and profits is much easier to foresee over the long term. But even here analysts can be quite wrong in their expectations, especially quarterly expectations. Yet the investor masses react to missed or exceeded earnings forecasts drastically forgetting that have to look at the company’s long term performance.
The same can be said about real estate, although there valuation trends are slower to evolve as data is often reported monthly or bi-annually rather than every second as is the case with stocks. If we learned anything from the 2008-2012 period then it should be that asset appreciation is unpredictable especially over the short term. Over the long term, we’re seeing different patterns, but even if patterns as identified by extensive research may help anticipate appreciation there is no guarantee whether that appreciation occurs in year 1 or in year 30. Thus we’re speculating when investing for appreciation.
Today’s earnings are a fact and so are the resulting dividends. Thus, as long as we’re buying a viable business based on today’s earnings and dividends, we’re not speculating except maybe about the assumption that under ‘normal operating and economic conditions’ earnings should stay at least at current levels and so should dividends. We can base our real estate investments on similar parameters, in particular on Net Operating Income and Revenue. To base it on the price that adjacent properties sold for regardless of income is speculation because the buyer anticipates appreciation not income which is at best a secondary consideration.
When we invest for cash flow first and appreciation second, we will have the stamina to sit through significant market down turns. Most people who buy real estate do not panic and neither do they sell at the first sign of a down turn. We have to live somewhere and we know over the long term, appreciation to be in the range of 4 to 6% annually. So why do we panic every time the newspapers scare the heck out of us with alarmist and often incorrect stories? Why are we selling during the numerous down days, corrections and bear markets? We do we sell stocks in an instant when confronted with the first sign of bad news while we hold on to our houses nearly forever!
It is really not very surprising that many Canadians consider their house their best investments, while investing in the ‘volatile speculative stock market’ is seen with distrust and anxiety. Really, both are peas from the same portfolio pot. It is the investor attitude and their speculative expectations to become rich overnight that is the real culprit of so much financial pain. Next time you buy a stock or a piece of real estate, buy it for the cash flow it will throw off or save you (e.g. not paying rent). Buy both stocks and real estate as ownership in a viable and profitable asset and not as a casino activity. If you adhere to investing rather than to speculation, I will bet that your net worth will be a lot higher, possibly beyond your expectations, 10 to 15 years from now. Good investing.

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