Sunday, July 15, 2012

Viable Stock Market Investments – Conclusions


Well we’ve reached that point of our posting series on viable stock market investments where conclusions are due. You may have noticed that while we posted the series that we barely commented on the stock market, the collapse of this commodity or the sensational rise of that company. Yet, our portfolio hasn’t gone down the drain, rather it kept on bringing in dividends, rents and interest, possibly some return of capital or capital gains and/or losses.  Our portfolio muddled along and that is the difference between investing and trading – we’re buying and holding.
As retail investors, those suckers whom are victims to the service fees, commissions and numerous surcharges of the financial industry , we are usually not in a position to trade. We would lose out against the enormous sophistication of that same financial industry whose ultimate goal is to fleece us and the competition as much as possible. Trading is a zero sum game or worse – one party wins and the other loses. Running a business or being an investor is entirely different; here is room for win-win. If this wasn’t the case then why build a better world?  Why would you want to invest in your own or someone else’s business? 
Investors such as me run businesses and we invest in other people’s businesses. I am employed on staff at an energy company, or I work as a consultant through my company Eucalyptus Consulting. I am in the real estate rental business and I invest in other people’s mortgage operations and real estate join ventures. Lastly, but not least, I invest in stocks and bonds. This is how I have built up a portfolio of multiple income streams as advocated by authors such as Robert Allen. Investing is about knowing the science of investing; about knowing the history of investing; about the behavior of investor psychology and market psychology and… about the channels and tools available to us for acquiring investments –i.e. the financial industry which is not necessarily our friend.
Even Warren Buffett is not your friend; he makes his money from your investments, from your insurance premiums, even from selling goodies to his shareholders at Berkshire Hathaway’s hugely popular AGM. I bet, no I know, that there are times that Warren’s interest don’t jive with yours and then whom is he going to give the benefit of the doubt?
In Law, Medicine and even in real estate, your professionals and agents have a fiduciary duty to act first in your best interest. Now you also know that if something is required to be written down in law then the opposite has happened and probably is happening. Strangely enough, no such regulations exist for the financial industry which is allowed to put its interest ahead of yours. Not only that, that same industry is vigorously fighting  against having their fiduciary duties enshrined in law.  Hmm….
So we are investors, not traders, and thus we own our investments for the long haul and these investments are businesses that we either run ourselves, are run by friends or partners, or we invest in publicly traded companies or debt. Sometimes one investment does better than another; sometimes one investment is doing not as bad as the others. That is why we diversify and really, in spite of ‘all the math’, diversification is not more complex than that. So basically, we’re owners or part owners of a number of businesses that have good, bad and normal times.  Only when the business model is broken do we adjust it or eliminate the business.  A broken business model is not a personal failure – nothing is a personal failure. As a minimum something is a valuable lesson. And as Donald Trump says: “It is not personal; it is business”. 
So how do we learn about a business or investment? We do it through many ways; but one of the most important tools for understanding how a business makes money; to understand what the ‘business model’ is about and whether it works are the financial statements. I showed you examples of companies with unlimited growth and with growth equal to nominal GDP; I showed how leverage impacts earnings of these companies and how in the end it impacts investor return. It is relatively easy to read the spreadsheets and see whether you agree with my observations.  But there are many more observations that can be made that were not immediately relevant to my story but may be relevant to you or for a particular investment. I barely scraped the surface.  So I encourage all of you to set up your own spreadsheets and play with them. After all, the best way of learning something is actually doing it.
Below is a list of the observations that stood out most for me:
Regarding Corporate Profitability and Net Earnings

1.       Operating Profit is determined by the profit margin which is affected by changes in product price and operating efficiency (e.g. economics of scale).

2.       Operating Profit is the principal driver of a company. (if you think that this is basic then remember the dot.com crash)

3.       Net Income is affected by Operating Profit, the corporate financial structure and the tax regime

4.       Return on Equity determines the growth rate of a company. No matter how high demand, unless you raise capital you cannot grow more than your company makes in profit.

5.       A company with growth limited by falling demand or by demand that is restricted by nominal GDP growth has excess profits not needed for reinvestment that should be returned to the owners as dividend.

6.       If you raise your capital by issuing shares (equity) you will not increase your return on equity

7.       If you raise capital by borrowing you will increase your return on equity

8.      When borrowing money the corporation gets an additional tax deduction which effectively reduces its borrowing costs

9.      A company may increase leverage by delaying payment to suppliers (Accounts Payable); deferred taxes; incurring other liabilities that are not immediately payable.  This leverage is often on an interest free or reduced interest rate basis.

10.   Depreciation and Amortization can be used to distorted net earnings; so are other factors such as level of inventory and pre-paid or discounted sales.

Regarding share valuation

1.       Leverage reduces the equity invested per share and affects earnings per share and return on equity.

2.       Leverage increases dividends available for distribution and results in a much higher payout ratio.

3.       Stock market investors ask how much they earn on each dollar invested not how much they pay for the company’s assets

4.       Optimized leverage and rosy corporate numbers sold by the founding owners and investment bankers is what makes an IPO a losing game for most stock market investors

5.       Buying a stock close to book value, enables the shareholders to push for increased leverage and achieve better profitability – it also reduces risk resulting from leverage.

6.      Benjamin Graham, the father of value investing, did buy stocks for book value first and for earnings second.

7.       Many stock market investors invest for earnings per dollar (often amplified by leverage) and incur much more risk than the traditional value investor.

This list is a lot to chew on and shows how important it is for you to examine the financial statements of individual companies you invest in. It also illustrates how little control a stock market investor has and that with so many factors determining a corporate success, it may be better ‘to buy the entire stockmarket’, i.e. buy stock market index ETFs. Buying such a portfolio may, especially for smaller investors, lower brokerage fees, lower the administrative complexities of running a portfolio and it may spread out the risk of buying a poorly managed company (i.e. diversification).
This brings us back to our initial question as to what a viable stock market investment is. As investors we have to ‘live’ of our investments. We want to control what happens to our profits as much as possible. We need to be able to avoid forced sales, we need to be able to service portfolio debt, we need to make additional investments at attractive prices and we need to make our monthly payments for the corporate jet and that yacht in the CaribbeanJ.
So a viable stock market investment should provide cash flow. Yes, you may cash-in some capital appreciation from to time to time when we rebalance our portfolio or when a stock became too overvalued or when a corporation has to be sold because its business model no longer works. But our blood, our fuel of investor life is cash flow. Cash flow from employment, from our business (es), from interest and from dividends. We must have dividends and if we’re so happy with a company that we want to buy more than we use that dividend to re-invest in it. But that decision is ours not that of management.
When we buy a stock we want to buy a well-run company with a great business model. A Coca-Cola, Microsoft, a Canadian bank. Not a gold company in Timbuktu or a lama start-up in Nepal.  We’re not gamblers. Yes, there is room for here and there a smaller sized but respectable company but then we invest in them as a group. A separate portfolio such as our Low P/E and moderate dividend portfolio with 10 companies and we still check for reasonable debt and consistent growth.
That a stock of a company is viable does not mean that it will not go down from time to time. But as long as its business model stays on track, we’ll hold on to it collecting dividends and then after 5 to 10 years there may come a time that our company stock is so wildly popular that others will offer a price that is too good to refuse. Then you say: “Well if you want it so badly, I’ll sell it to you”. Because you know that other cheaper opportunities will come along.
Ideally, I would build a portfolio with U.S. stock market index ETFs that pay a dividend and Canadian stock market index ETFs that pay a dividend.  I also would buy some short term Canadian Government and Canadian corporate bond ETFs. Next, to tweak this highly diversified portfolio, I would select my star performing public companies, i.e. the dividend payers I mentioned before.  My investment money is not for a gambling casino. Yes, there will be times the portfolio does worse than other times, but overall it will provide me with investment growth and ultimately the financial freedom to live the way I like best.
Some may ask why not a European ETF or an BRIC Market ETF?  My answer, yes I would consider adding a German or Dutch ETF now that Europe is so depressed. I also would consider companies such as Diageo and Telefonica. But only in small amounts.  I think that the Canadian and U.S. market have already build-in a lot of exposure to the BRIC countries and the North American markets are protected with a much better regulatory system than that of the BRIC countries.  But just like with Canada’s natural gas producers, I would only nibble.

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