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.

Wednesday, May 30, 2012

Investing and Speculating

When you invest for net cash flow the rest is gravy! During inflationary times, stock markets and real estate can appreciate rapidly but during times of low inflation it is the cash flow that makes you into an investor-survivor. Today, when you compare cash flow from stocks (dividends) and from real estate with interest income, the investor salivates but appreciation is next to nothing.

As long term investors, we know that market psychology ranges from outright doom and gloom to exuberant and that is reflected in P/E and cap rates. We know that sooner or later our investments will be fairly valued by the market and it may even become overvalued. But that only matters if you want to sell!

Why would you want to sell? Only if there is a better business to invest in! Because, how else do you generate cash flow to live from and to invest with?  Once you sell your business, you lose your cash flow and you have to find another opportunity to generate that cash flow or increase your cash flow to ever larger amounts.

Just buying for appreciation is plain speculation and if you try to switch from one business to the next to crystallize your short term profits you’re just a trader. Not to mention the capital gains taxes it may trigger! No wonder Warren Buffett claims that he would like to hold on to his investments ‘forever’.  And so he has as in the case with Coca Cola and American Express. But not all investments work out and sometimes you get ‘an offer’ that you just cannot refuse. Then you sell.

You sell when an investment doesn’t perform as well as you expected or when buyers offer such a ridiculous high price that you cannot hope to capture a similar value ever again. Taxes are a consideration – when you sell you have to pay capital gains taxes. In other words, you get an interest free loan from the government until the day you sell!  Even better, if you lose on the investment you don’t have to pay that loan back to the government. Even better-better! If your investment turns sour, the government will give you a capital loss tax credit. Think really careful about the reasons and the impact of your action if you want to sell.
Basically, we’re owners of a business whether it is real estate or stocks or whether you are a private bank lending money to the government or other corporations (bonds). Even better, we’re CEOs of our own investment business – no matter which investment. Your investments differ in how they generate earnings and cash flow and how much you control your investment. Have a look at the two spreadsheets below that show the income statements for a public corporation (stocks) and for a real estate investment. Are they really that different?

Let’s start with the publicly traded company (stock market) of which you own a small slice. That company provides a service or sells a product to create revenue. The provided services or products cost money in the form of operating expenses.  The difference between you revenues and expenses is your NET OPERATING INCOME. These are the profits generated from your invested capital.  In its simplest form, the profits are generated from the company’s assets and thus your profits divided by the value of shareholder equity are your return on equity (ROE).

That ROE may be a modest 4% but like in real estate, we can increase our return on investment if we can find someone to put up money at a much lower rate than the ROE! Let’s say that rather than putting up $100,000 capital we borrow $80,000 (LTV 80%) then instead of making 4% on $100,000 we’re making 4% of $100,000 or $4000 on a $20,000 investment, that is a return of 20%. Eh… not quite because we have to pay interest on the loan say at 3% per year that is 3% on $80,000 or $2400. So our profit is not $4,000 but $1,600 or $1,600/$20,000 = 8%. Not 20%, but an 8% return on $20,000 is a lot better than 4%!
He… that is just like in real estate!  Not quite, because it is the management of your public corporation that decides how much and at what rates the company lends.  Management could even decide not to take out a loan but sell a different type of ownership, ‘preferred shares’ that pay a fixed dividend rate no matter what the profits are of the company.

Management may also decide how much dividend it pays to the owners – well the board of directors which are supposed to represent the owners and management together decide. They often do that by declaring a dividend, that portion of the corporate profits that they feel is not needed for expansion and/or acquisitions (pay-out ratio).
So when you invest in stocks, you share in the profits but you do not control how the company is run, how it is financed and you don’t have a real say in how much of those profits are paid out to you in dividends (your cash flow). You’re mostly on the side lines or in your armchair waiting for your dividend as determined by others.  Even worse, the company may be increasing in value overtime, but you depend on the markets and their ever changing moods to determine how much a buyer is willing to pay for your shares. We call that ‘passive investing’.

Let’s look at the other business. The real estate business. He… isn’t that the same? The property collects rents, i.e. its revenue and then it has expenses such as condo fees, utilities, repairs and management costs to operate. The revenues minus its operating expenses are… Net Operating Income that goes into your pocket and you determine how that income is handled rather than the management of a public corporation. In fact, you determine what expenses are to be incurred and you or a rental manager appointed by you select the tenants and collect the revenue. Yes, you are operating the business or you hire a staff (the management company) to do it for you.
Also, you determine the financing. Maybe you are happy with a Net Operating Income of say $4000 on $100,000 invested! So your return is 4%. But you control that; instead you may decide to use leverage and use a mortgage or a Heloc to take out an $80,000 loan (LTV 80%). Or you take on a JV partner who pays most of the down payment and is the responsible to qualify for and guarantee the mortgage in return for a part of the profits or a fixed return similar to the preferred share holder. This is the big difference between stock market investing and real estate investing. You not corporate management is in control!

When investing in stock, everything is done for you; you have no control and in the end you collect a dividend and a speculative capital gain. When you invest in real estate, you are the CEO of your business and you are the board and possibly the staff! It is you who determines how much you lend or whatever other financing gig you may invent. You control the profits and you decide how much you reinvest and how much profits you keep for living.  Of course, since you do so much for and control so much of your real estate business, you better be rewarded sufficiently for your blood, sweat and tears, i.e. you want a better overall return on your investment than when investing in stocks.  You are the active investor! Get the picture?

Sunday, May 27, 2012

Investing and speculating in stocks

We discussed cash flow and appreciation in Real Estate, but what about the stock market? There are many strategies for picking undervalued stocks, but these are just that ‘strategies’… to figure out which stock is most likely to appreciate. That is nearly as ‘speculative’ as using horse statistics to bet at the races!

Whether you buy real estate or stock, if you only buy for the appreciation that may happen or not, you’re just speculating. The other side of the medal is investing for the dividends, which are a tax advantaged return that often also is inflation. Dividends from solid companies, not only represent cash flow today but such dividends tend to increase over time.

Dividends from stock and net cash flow for real estate are ‘the bird in the hand’ while the appreciation is the ‘many birds in the bush’.  Often, dividends constitute up to 40% of the total stock investment return and for a prudent investor they provide a live line during bad times as well as the means to build up cash for further investment creating a compounding return.

Dividends are that portion of a company’s earnings that its board of directors has chosen to return to the investor while the remainder goes to reinvestment in the company for expansion and/or acquisition. Often those dividend paying companies are perceived as mature companies that have ‘not much growth’ left and whose management does not see further investment opportunities. In reality nothing is further from the truth; research by experts such as James O’Shaughnessy backs this up plenty: companies that pay dividends and that regularly increase their dividend is, over the long term, one of the best performing categories in the stock market.

So, then how should you see your stock market investment?  Does this approach of investing in dividend paying companies provide a less speculative way towards financial independence and does it provide more confidence during a down turn helping the investor not to give in to the emotional urge to sell near the bottom of a bear market?

Well, as others have pointed as well, see investing in publicly traded companies as buying a piece of company ownership! Think about this in terms of the place where you are currently employed or even your place of ‘self-employment’. These companies do have good and bad years in terms of making money or selling their goods or services. There are good and bad quarters, but overall the company makes steady progress and that is reflected in growing revenue and profits.  Yes, a bad quarter may be frustrating but most other employees barely notice it.  Yet, you may work there day in and day out; month in and month out; and sometimes year-in and year out. 
How would you feel about quitting your job every time there is a bad quarter? Probably you would declare yourself nuts; so why would you not have the same attitude when you own that company’s stock?  You don’t sell a perfectly good business just because the stock is down, or because some guy on TV states that he doesn’t like your company.  Next month that same talking head may recommend that you buy its stock!

Again, the stock price is purely a speculative valuation that may incorporate that company’s growth prospects and current financial position; but mostly the market prices the company on how it feels!  The mass psychology of the market is a much stronger factor in evaluating a company’s stock than dividends and earnings or revenue growth. 

So from now on, see a stock investment firstly in terms of the cash flow it provides you and how reliable that income stream is. Then aim for appreciation, which especially in the short term is purely set by market psychology and you may preferred to wait selling your investment when you get the highest price relative to its earnings. But what are you going to do with the proceeds?  Invest in another high price company in a hot market?  In a later post, we’ll be looking at the numbers behind a possible stock acquisition

Investing and Speculating in Real Estate

Real Estate investing in rental properties is relatively simple. The rental investment provides a net operating income (Net Revenue minus Operating Expenses). Now we can calculate the ratio of net operating income over the purchase price also known as cap rate and compare it with that of similar properties in your area. If your cap rate is higher then you have valued your building probably too low. If it is lower than you have overestimated your property value.  

Unlike a traditional home buyer who compares the price of a property to that of similar ones in the area (CMA or comparative market analysis), rental properties should be valued based on the NOI or net operating income they deliver month after month. It is akin to 'yield on a bond'.

Problem is that cap rates vary over time because of numerous factors.  Suppose interest rates are close to zero; would you like to buy a building with a cap rate of 4%?  You would probably answer that question with an enthusiastic: “Yes, you bet!”

Now suppose interest rates are 5%? Would you still be so enthusiastic about that investment with a 4% cap rate?  Do I notice hesitation?  My answer would be “Heck yes! That is likely even better!”
Wouldn’t I want the higher income from an interest bearing investment?  Well, if interest rates are 5%, the economy is probably doing a lot better than when it is 0% and under normal economic conditions real estate typically appreciates 6% per year. Were interest rates at 0% chances are the economy is poor and I will get little appreciation or worse... So, do I want to make 4% when interest rates are zero and do I want to make 10% (4% NOI plus 6% appreciation) when interest rates are 5%? Yes to both. But… those estimations are based on speculation aren’t they?  The valuation of an investment is circumstance driven; sometimes there may be some logic behind it while at other times it is plain emotions that set the price and thus the cap rate.

Now, speculating that under normal economic conditions I will get the 6% annual appreciation may be a low risk bet (based on similar past performance); but it still is a bet.

What if I could make even more money under those circumstances than just 10%? Real estate prices are typically considered less volatile than those of a stock market – I disagree with that assumption but let’s assume for now that that is true. If 6% appreciation were the norm, the value of a $100,000 property would increase by $6,000 per year while it cash flowed at a cap rate of 4% another $4000.
If interest rates are 1% and I took out a loan of $80,000 i.e. a loan to value ratio of 80%, I would pay $800 interest that year which results in a net cash flow of $4000 minus $800 equals $3200. My investment is $100,000 minus $80,000 or $20,000. So my return on cash invested is: 3200/20000= 16%.  Without leverage, the investor puts down the full $100,000 and makes only 4%. Next add the appreciation!

At a 5% interest rate and an LTV of 80% the investor pays $4000 interest per year and his net cash flow is $4000 NOI minus $4000 interest = Null. BUT, the property likely appreciated by $6000 and that translates in a return of 6000/20000 = 30%!
But markets are unpredictable, and instead of going up when interest rates are 5%, the property value could have declined by 2% and at year’s end, the investor did not make net cash flow but also lost $2000 in value or 2000/20000 whch equals a loss of 10%! Ouch Leverage clearly increases risk; it amplifies the upside but also amplifies the downside. The speculative proportion of the investment has clearly increased dramatically. Not only does the risk and speculative element go up with leverage. But you may also end up with a money pit!

When an investor borrows money for real estate it is usually done through a mortgage. The lender not only demands an interest payment, but he also demands repayment of part of the principal until the balance of the loan is zero at the end of the time of ‘amortization’ which typically ranges from 25 to 35 years. If your cash flow is positive after paying for interest, with the added demand of principal repayment the net cash flow may be zero or may even be negative. In other words, the investor has to make up for the negative cash flow out of pocket.  The investor does now no longer control how the cash flow is to be used. Ooops!

When determining how much leverage you want, you should first ask yourself how much cash flow you need.  Also you should ask yourself, if the market falls by 20% or more, will the bank upon renewal of the mortgage want you to add money to your down payment which at that time is zero or less in case of a LTV of 80%. Can you handle that financially or would it be safer to go with an LTV of 70% or even more conservatively an LTV of 60%. That way you may not get a cash call in a falling market and still receive cash flow. You have then the financial strength to wait out the down turn  rather than being forced to sell the property at or near the bottom of a market.
Although stocks in the stock market respond different price wise than real estate and thus diversifies your portfolio, in many ways, similar considerations are valid. We’ll discuss that in the next post.

Monday, May 21, 2012

North America’s upcoming Golden Age

‘Creative Destruction’ is a term coined by Joseph Trumpeter in his 1942 book: Capitalism, Socialism and Democracy”.  I got that 'knowledge' from Bing, Microsoft’s search engine. If you want to see examples of ‘Creative Destruction’ look no further than the High Tech industry.  This weekend, I got the new Windows Phone which runs basically on the new Windows 8 platform.  It is fantastic!  Although still a work in progress. Windows Phone 7.5 as it is referred to integrates the power of a tablet with cloud computing (Windows Live) and a revived Zune. If you hate the antics of iTunes – software written somewhere around Trumpeter’s time, then Zune is an breath of fresh air (that was how many clich├ęs in a few sentences?).
In earlier posts I speculated that Microsoft Windows would cause a paradigm shift by integrating PCs, tablets, phones and any other ‘smart’ appliance or house into a single operating system. Well Window Phone is the harbinger of this shift with the rest of the world eagerly awaiting the release of Windows 8. Microsoft has learned from its predecessors, in particular Blackberry who released its software and gadgets prematurely and the world did not forgive the company for its buggy software. Don’t get me wrong, at the time of its release, Blackberry Playbook was 'best in class' and Steve Jobs was so scared, he lowered himself to trying to ridicule Playbook's smaller 7 inch size.

But iPhone improved the design of the Blackberry, just like Apple improved the design of the MP3 player and created iPod. Microsoft had been sporting an computer pad for many years, but Apple through superior design and marketing scored with iPad. So, when it comes to gadgets, the consumer has no loyalty and recent history is full with past gadget designers that could not keep up such as Kodak, likely Blackberry and possibly Apple who couldn’t compete in the personal computer market and is now again starting a defensive phase losing out against Google’s Android. And now both Apple and Android will succumb to Microsoft’s Windows 8 et al.'s new paradigm.

 Creative destruction takes not only place in the technology arena but also in Energy and this may prove to be at least as important as Technology. Just think about it! After the war, the U.S. controlled most oil and gas supply with the Seven Sisters as its power brokers - affordable and stable energy prices resulted in unparalleled prosperity. Then the Middle East woke up through OPEC and combined with dire prediction from the 'Club of Rome' regarding upcoming energy shortages they formed the heart of the 1970s Oil Shocks. The U.S., mostly an energy consumer at that time, could not handle high energy prices and its power declined culminating in the humiliations in 1979 with Iran's revolution and Jimmy Carter’s disappointing presidency. Then in the 1980s energy prices, especially that of oil fell and the U.S. came back with a vengeance culminating in the High Tech Revolution and Bill Clinton’s budget surpluses. September 11, 2001 heralded the end of that era, not only because of the Dot.Com crash in 2001 but also because of the reality of ‘Peak Oil’. Energy prices shot up to new records and Canada’s golden decade arrived culminating in Canada's Harper Governments and the 2008-2009 financial crisis. Jeff Rubin claimed that $147 per barrel oil was laying at the root of the Financial Crisis and he may have a point although the corrupt, soppy and arrogant bankers of Wall Street and an overactive real estate market surely were also significant contributing factors.

During the financial crisis, in fact as early as 2004, the North American petroleum industry developed two important new technologies: Horizontal drilling and Multi-stage fracturing. Combined these technologies created a paradigm shift in the energy world. First ‘Tight Gas’ and today ‘Tight Oil’ production opens up uncounted BTUs in energy. The energy markets are adjusting, first with a glut in natural gas and a pipeline shortage to handle this abundance of new, affordable energy. The impact of the new technologies is so immense that North America could not export its new found energy abundance to the rest of the world and the price of natural gas collapsed from peaks as high as $12/Mcf to the lows of this spring at just $2.00. Reality is, that to produce natural gas profitably we’ll need prices in the $4 to $7 range and now having experienced a ‘gas glut for nearly five years, we may approach a turning point (see my earlier post Something rotten is happening in the state of Gas and some older posts). BTW, that I started the 'Something rotten' post with a quote from Shakespeare’s character Marcellus was an unintended pun on the Marcellus Shale Gas Play in the Appalachian.

The petroleum industry and the overall economy will need to adjust to these new energy realities. Oil and gas companies need strong, diversified balance sheets to survive the shocks in the oil and gas markets. Companies like Encana and others based their project economics on gas prices much higher than today’s $2.65 and some may not survive. But those that come out of these turbulent energy markets in tact will flourish for many years to come. Those that cannot adjust to the new realities will fall victim to ‘Creative Destruction’.

Investors who look beyond the initial turmoil may see golden opportunities ahead. Stable and predictable energy supplies in North America for years to come. Less dependence on inhumane, oil based dictatorships, a return of manufacturing to North America. With energy cheaper combined with our innovative and entrepreneurial spirit, the growing affluence of BRIC Countries and thus of their middle class, the democratic reforms in the Middle East we will get an economy that does no longer depend on the ‘lowest labour costs’ but rather on optimum production conditions. The latter is more likely a combination of labour costs, education level of the working population or innovation and new technology. This could restore the trade balances of countries and the finances of governments. Yes it will not be a problem free world society, but I foresee a reprieve of the doom and gloom of the first decade of this century.

If we learned something from the last century, I hope that we don’t forget about the importance of a more even world-wide distribution of prosperity! If some parts of the world population fall too far behind in prosperity there will be an 'extremism of hopelessness' – whether that is masked as religion, culture, race or ideology. In the end it is economics and opportunity that really determines our quality of live. And let’s not forget that an abundance of energy does not mean unlimited consumption at the expensive of our beautiful planet with its sensitive ecological balances. We must continue to strive to true ‘sustainability’ and economies based on a stabilized world population. But I see no reason for an attitude of perpetual doom.

The more they pay, the more it's worth

The longer I invest, the more I realize the importance of cash flow from my investments. It really doesn’t matter what I am investing in, stocks; bonds; real estate. Each investment has two profit centers: cash flow and appreciation. Appreciation is realized by markets that set the value of your investment which may have increased or decreased.  But really, we have no control over appreciation, it happens when it happens. You may have companies such as Microsoft or Wal-Mart whose earnings have increased for the last ten years at a steady and often impressive rate; yet a share now is not much more worth than it was 10 years ago.
So appreciation is beyond our control and therefor it is the truly speculative part of any investment. As Don Mclean sings: “The more they pay; the more it is worth”. How much is paid depends not on facts but on market psychology. Oil prices are governed by a combination of supply and demand (something that most of us cannot accurately gauge) and market fears such as the expectations of economic growth; actual production costs; political instability; social trends concerning the desirability fossil fuels  and whatever other objection a buyer can invent and thinks is valid.  In the end it is a question of ‘What THEY want to pay”.
Did you ever put an ad in Kijiji say for a piece of used furniture that you don’t want to throw out on the dump? You get those buyers at the door saying:  “I want your sofa for free and if not, there are many that give away their sofa so why should I pay 25 bucks for yours?”  Or “Eh, that Billy bookcase is damaged, look at the big scratch on its base!  I won’t pay more than $10!” You may say: “eh duuh, it has been used for 20 years! But nobody sees a scratch on the bottom. Look if you buy it new it cost you $100 at Ikea.”

The potential buyer turns around and says: “I pay $10 and not a penny more. Take it or leave it! There are 10 other suckers from which I can buy a used Billy!”  The buyer is probably right, and if you have to haul it to the dump it costs you time and a dump fee of $10. So… you take it. How unfair! But that is the market for you and it is really the same on the stock market and in real estate, art, gold, etc.
Really, if you buy for appreciation, you speculate! You buy with the expectation (no matter how reasonable) that there will be someone around now or five years from now that thinks your ‘investment’ is worth a lot more mula than you paid for it.
The second component of an investment is cash flow – net cash flow. In real estate it is nothing more than rental revenue minus operating costs minus financing costs.  In manufacturing companies it is revenue minus the costs of making and selling products or services minus financing costs. Of course when you invest in the stock market you give up control of how the net cash flow is used. Management decides and you SPECULATE that this translates in future higher earnings and a good market value.

The bottom line is the stocks dividend i.e. what ends up in your pocket! For you, the investor, net cash flow is  your real estate net cash flow or dividends or the interest payment from your bond. So from now on, let’s invest for net cash flow, dividend yield or interest and admit that the rest, in our purist form of reasoning is speculation – valuation of our investment that is really beyond our control. Is there something wrong with speculation? Not really, but let’s call a spade a spade. It will help you make better investment decisions.
So, when planning your portfolio, especially your retirement portfolio it is the cash flow that you count on. The rest will come or… not. This was also the idea that was behind the earlier ‘COI’ (cash on investment) and ‘ROI’ (return on investment) portfolios. It is really a tool for investor survival, because if you can do with just the cash income from your portfolio without having to sell, then you are in control and you will never be forced to sell, especially not during a bear market. You will have the financial strength to sit out the financial storm and even use it when a true buying opportunity comes along.
With this in mind, let’s examine ‘valuing’ an investment in more detail in a later post.

Sunday, May 13, 2012

Alberta Economic Power House

In our post The Coming Real Estate Summer I pointed to the importance of economic growth and population growth for a prosperous real estate market. The Alberta Government released a small pamphlet titled Alberta Economic Quick Facts and it summarizes Alberta’s economic juggernaut brilliantly. Below I’ll show you some important graphs with economic data.

When an economy is prosperous, its people feel secure and that often increases the birth rate and in-migration. The result is population growth and that translates into increased housing demand. Guess what increased housing demand translates in? Yep a prosperous real estate market!

The Quick Facts pamphlet states: “In 2011, Alberta’s population grew by 1.6% - higher than the Canadian growth rate of 1.0%. According to Statistics Canada, this was mainly due to strong growth in the natural increase (births minus deaths), but also in net international and inter-provincial migration.” As of January 2012, Alberta’s population was 3,817,980 with 64.4% living in Calgary and Edmonton.

Alberta’s GDP increased from 3.3% in 2010 to 5.2% in 2011 – not exactly recession territory! Unemployment fell from 6.5% in 2010 to 5.5% in 2011 compared to 7.4% for Canada overall.  In terms of capital projects such as residential construction, infra-structure and oil and gas investments, investments in the province were 81 billion dollars in 2010 and that grew by 9% to 88.7 billion in 2011. That is an investment of $23,461 per Albertan invested compared to $10,758 in Canada.

No wonder our inflation rate is higher than in the rest of the country – 2.4% versus 1.0%. So let’s compare Real GDP which is corrected for inflation and Alberta still is number one by a wide margin (see below).
We’re benefitting from a wealth of natural resources, but that would not amount to much if our government was not pro-business. Venezuela is resource rich but not exactly business friendly and see what that does to that country's prosperity! The U.S. is considered the icon of liberty and market driven economies. So how does Alberta’s corporate taxes compare to that of the U.S.?  Wow, as the graph below shows Alberta has significant lower taxes. Just looking at corporate taxes is maybe simplistic but it goes a long way to tell the story.

You’d think that this government only caters to oil and gas, but that is a misconception. Alberta is definitely on route to a more diversified economy. Look below at how various industries contribute to Alberta’s total GDP and what industries contribute significantly to our manufacturing output. Now here is a notable fact: our industries produced $286.6 billion dollars, now how much profit would that create? Then in the same year, we’re reinvesting $88.7 billion! If this was a corporation we would think it was some very hot high growth business in super expansion mode, but no this is the province of Alberta!

If Canada is currently at the top of economic prosperity for G7 countries, then how does Alberta rank? I think, you’re getting the picture J!

Saturday, May 12, 2012

Something rotten is happening in the state of Gas

“Something rotten is happening in the state of the state of Gas” says Marcellus. “Heaven will direct it” says Horatio. Marcellus: “Nay, let’s follow it.” Well, not quite Shakespeare but have you seen the gas price chart at the top of this blog lately?  We post it for a reason!

Well, it looks like the price has broken out of its downward trend! Check it out below.
Well this may be rotten for consumers, but this is welcome news for gas producers who are sufferering greatly.  Nibble, Nibble, Nibble!

Yesterday is priced into the market but tomorrow is all about making profits

Some months ago, I wrote that real estate is governed by the local economy and the stock market is governed by the national and world economies. Todd Hirsch of the Alberta Treasury Branch (ATB) spoke last week at the REIN workshop. One of the things he said really hit home: Canada’s economy depends heavily on what’s going on in other countries and that much is beyond the control of Canadians and their government. It is influenced by oil and gas prices and prices of other resources; this in turn is governed by the economies of the BRIC countries, the European situation and of course the U.S. In the latter case, we not only depend on the U.S. economy but also on their politics.

We’re price takers and that is directly reflected in our economy. The ‘only’ thing Canada’s government can do is being fiscally responsible. But then what do you expect from a population of barely 33 million people that is only twice the population size of Holland; a country so small it fits between Calgary and Edmonton?
Last year, Alberta’s economy really stood out. Not only was it the fastest growing economy in Canada. It was the fastest growing in North America and it definitely grew a lot faster than Europe. Its GDP growth was a whopping… 5.2%!! We’re on fire and we do not realize it! Albertan’s look around them and think what they see is ‘normal’. It isn’t and that is shown in the stock market which reflects the overall economy which is far from being on fire. Yet, when Albertan’s look around them they think that fast economic growth is normal and they don’t understand why the stocks are down or at least grow at a snail’s pace.
Real estate is driven by the local economy and there we start seeing the effects of being an island of economic bliss in a sea of grey. Apartment rents are clearly on the rise, Alberta’s population is rapidly approaching 4 million and housing starts are dramatically on the increase. Yes, we haven’t experienced Vancouver and Toronto housing prices, but that is because we had an explosive real estate market between 2004 and 2008! REIN’s Don Campbell calls it the ‘Tiger Wood’s years’ and you know that such peak performance can’t keep up; there is a time of pay back that even Tiger himself experienced.
I noticed a significant increase in condominium apartment prices; we’re definitely coming out of the trough. Sales volumes are up 25% compared with a year ago. There are reports of bidding wars between potential home buyers. As mentioned in another earlier post ‘hold on to your seats’ we’re about to take-off.  I mentioned rents; for apartments, rents have risen by nearly 20% in one year. Vacancies are low around 3%. I rented out one of my places within two days – something unheard of a year ago and dreamed of two years ago!
Often Real Estate is considered a lagging indicator – i.e. it trails economic growth by 6 to 18 months. So, considering world economic growth we should be in real estate doldrums. But we’re not driven by the world economy! We’re driven by Alberta’s. That is, in my mind, the real reason for the increasingly strong real estate market.
This is where diversification works. Alberta investors with holdings both in real estate and the overall stock market investments have a fabulously diversified portfolio – that is as long as you aren’t overweight in oil and gas stocks. If the current Alberta growth is so great - the Provincial Government is expecting to be back in fiscal surplus in 2013-2014 - then how do you think Alberta will do with oil & gas pipeline issues resolved and with oil & gas being traded at world market rather than land-locked market prices? Investors are interested in knowing about what will and might be, rather than in knowing what was yesterday. Yesterday is priced into the market but tomorrow is all about making profits.

Saturday, May 5, 2012

Looking behind the curtain

Don Campbell, president of Canada’s Real Estate Investor Network (REIN) always warns people to ‘look behind the curtain’. What he means by that is that you have to be aware as to what motivates the person that tries to sell you an investment or a piece of real estate. One of the most obvious motivations ‘hidden behind the curtain’ is that of the Realtor, or for that matter of any other broker:  in order to make a living the Realtor has to sell.
The more he or she sells the better the financial reward. A Realtor in the ‘Million Dollar’ club who has hauled in a million plus dollars in gross commissions is quite successful, but does he or she provide YOU with the best deal?  Probably not; that Realtor is probably supported by a team including other subordinate Realtors.The chance that you actually sit down with the ‘Millionaires Club’ member is small let alone that you get his/her undivided attention. You still may get a good deal, but an experienced Realtor with a more modest operation may do a lot better for you.

Another example of ‘looking behind the curtain’ is that of newspapers and newspaper reporters. My wife used to be a freelance reporter and still many of her friends and acquaintances hail from that background. These are often nice people, very personable and with a degree in English literature, journalism or political sciences. They usually are observers of society or of business or whatever they from time to time focus on. The last thing they are though is being  a participant in those observed matters.
They are employed by media that attract customers by writing attention grabbing, newspaper selling stories. Headlines are nothing more than billboards drawing you towards reading the story. Once you’re hooked they have made their sale. The story may contain something that has very little connection to the headline and sometimes the headline only highlighted a minor aspect of the story or is outright misleading regarding its true content.

So how much credence should you give an article on investing by a person that never invested or who has not any qualification in the investment industry?  Some of those articles have actually been written by investment professionals but still may constitute not much more than a self-serving piece of prose. Yet many investors fall for these stories and base investment decisions on them.

Really how many of those writers have ever been in Europe other than for a rushed 2-week vacation? So where lies their expertise when writing about the demise of the European Union? Or when they write about the European debt crisis or about their political leadership?  Really, is their opinion that much better than yours? 

Many writers do not even have investments of their own, but whatever headline is created for whatever purpose, these days, headlines and 'news' seem to scare stock market investors in their boots.  Some writers are actual Americans  living in the U.S., but still is their expertise sufficient to declare the end of the U.S. empire and its economy? Is their on paper expressed opinion even sincere or are they trying to build fear that draws in continued readership?

I grew up in Europe;  I went there to school. I still visit Europe every other year or so. I don’t predict the decline of Europe. Neither do I jump on the jump wagon of the exploding populations of emerging economies such as India and China. Yes, it seems these days obvious to predict endless economic bliss in China and to declare Europe or the U.S. dead. In my humble opinion that is greatly premature.

I think that Europe represents the frontier of a new demographic trend. Our world population cannot and will not grow without limitation. In fact, world population stabilization is predicted by many demographers to occur by the midst of this century. So, unbridled population growth is something of the past and so is our reliance on unbounded economic expansion that depends on such population growth. Europe is in the demographic frontline of this new economy that does not require ever-growing consumer demand. The U.S. and Canada are not far behind. And the supply of cheap labour may prove to be a pipe dream that has no future or has a very limited future. Now where do you want to invest? I suggest you start looking behind the curtain!

Friday, May 4, 2012

In the grips of temptation

Canadian Helicopters is the star performer in our Low P/E- Moderate dividend portfolio. Over the last six months it has increased just over 50% in price (see chart below). Splendid – should we give in to the temptation to grab the profits and run? The gains are exceptional in today’s market!  Well it was our intent not to touch the portfolio until year-end and then to rebalance it. But a 50% profit! What to do?
First we should first check out why the stock has done so well. After all, we bought it for a low P/E and a moderate but good dividend yield. Globe Investor tells us that the current dividend yield is still a desirable, although not spectacular 3.1%. Is it expensive based on P/E?

My spreadsheet claims that based on last year’s available earnings of $2.14 it is trading at a P/E of 16.2!  We’re going to the database of the Canadian Share Owner Association and it reports earnings for 2010  at $2.14, while currently Globe Investor reports that 2011 earnings are now $3.84. At $2.14, Share Owner’s software calculates a P/E of 16.2… Expensive! However based on the latest earnings of $3.84 the P/E is only 9.02. Still quite cheap!

It looks like most of the value increase is directly related to a significant jump in earnings and revenue.  According to our on-line search of press releases this was because of an acquisition made by Canadian Helicoptors in New Zealand and because of better operations at home. The stock is still trading at a very modest P/E. Ergo, no reason to sell. We bought the company at a great price last January and we will stay around for the rest of the ride up.