Sunday, June 24, 2012

Viable Stock Market Investment – Part III


Does it matter to a company how it gets capital to increase profit? Does it matter whether it has to pay interest or a fixed dividend as would be the case with preferred shares?  Not really.

The difference is more important to the lenders and preferred share owners. Whether the company pays interest on money invested out of operating profit (profit before interest, taxes, depreciation and amortization = EBITDA) or out of net income (profit after debt financing, taxes, depreciation and amortization) does not really matter does it?

A lender though gets paid interest before the common and preferred share owners are paid. In case of dissolution of the corporation, first the lenders (in order of seniority), then the preferred share owners and finally the share owners are paid out from the sales proceeds of a company’s assets. Thus lenders have a better chance to recoup their investment capital than preferred share owners. Last in line are the shareholders; but for taking those risks the shareholder’s upside is greater than that of the other capital providers; that of the preferred share holder is somewhat less and typically fixed; and the lenders get an even lower fixed return.
All three groups are capital providers and in today’s corporate world it is management and the board of directors that steer and control the plublic company. In theory the shareowners control the company, but what is ownership without real control?  Only over the last number of years with the rise in shareholder activism, shareholders could, under special conditions, take some decisive action as shown for example at CP Rail. However, this is more the exception than the rule.

Still, since shareholders own the corporate earnings (after preferred share dividends), the shareholder should understand the corporation’s potential to make money. How else is the shareholder to choose which company to own?

So let’s look at a company’s capital structure. The question to ask is: “If I as an owner could borrow money at 3% and earn with that money 9%, why would I not use ‘leverage’?”  To answer that, we have to look again at the example company’s income statement and balance sheet. First shown below is the income statement assuming 50% debt and 50% shareholder equity:
Figure 1 Income statement of 50% levered company

Shoot!  It looks nearly the same as that of a company without leverage. Operating Profit, just like with the APOD is not affected by financing costs! But we do, in addition to taxes, now also have to pay the interest before counting the chickens, eh… Net Income. Oh, this is cute! See, we FIRST deduct the interest from our Operating Profit and then the company pays tax over the remainder. Instead of paying $2 million in taxes the levered corporation pays ‘only’ $1.7 million. The government pays part of the interest!

So in fact we don’t pay 3% interest but 3% minus 0.3% = 2.7% interest to earn 9% income. And there is more! At first sight, our net income is down from $18 million  to $15.3 million to be divided amongst 10 million shares or down from $1.80 for the debt free corporation to $1.53 per share for the levered corp. Sounds not good unless you know how much was invested per share, i.e. the book value per share. For that we need the balance sheet.
 Figure 2. Balance Sheet of company with 50% debt

This balance sheet is different from the company without debt (compare with Figure 3). At the start of the year total assets were $200 million for both companies. However, the debt free company had $200 million shareholder equity or a book value of $20 per share while the levered company has only $100 million shareholder equity (the rest is debt) or a book value of only $10 per share. So, the investors in the debt free corporation paid $20 per share to earn $1.86 or a 9% return on equity compared to paying $10 per share to earn $1.53 or a 15.3% return on equity in the levered corporation. Who did better? Right, the investors who paid $10.00.
Figure 3. Balance sheet of corporation without debt.

OMG accounting is so difficult! One needs at least to know some high school math to understand this. J  BUT, there always is a ‘but’! And there is where the risk lies!
Well there are many buts. Let’s start with the most obvious ones. Say inflation picks up its ugly head and thus interest rates rise. Say inflation rises from 2 to 5%. So production costs went up by 5%. But also a new competitor entered the market and this prevents our levered company from increasing prices. Oh, and then interest rates have to increase as well from 3% to 6%. How does our profit picture look now? 

Well the Profit Margin dropped in both companies (debt free and 50% levered) from 10% to 4.8%. Painful! Net income dropped from $18 million to $9 million in the debt free company and from $15.3 to $3.6 million in the levered company. Percentage wise that is a net income reduction of 50% and 76% respectively!  If both companies were trading first at a P/E of 12, now investors would likely not willing to pay more than a P/E of 9 or maybe even less. The stock price in the debt free company would then be: 9 x 0.9 or $8.10 down from $21.60 and that of the levered company would be 9 x 0.36 = $3.24 down from $18.36. Those are price drops of 63% for the debt free and 82% for the levered company.

So you can see that with debt, the investment risk has dramatically risen. You, the investor, do not control the debt level of your company. It is management that does. This is a significant difference with real estate where you set your debt level. The only control the investor has is to investigate the company’s debt level prior to purchasing its stock. There are two other very important points to make.

As a founding investor, the money that you pay for a share goes entirely to share equity. Thus you paid $20 for $20 book value in the debt free company and $10.00 per share for $10 net assets in the levered company. But the stock market investor pays for earnings, i.e. the share price is set by the price/earnings multiple (the P/E ratio). Now if you were one of the lucky investors who put up the founding capital in the debt free corporation rather than that you bought the stock at the Initial Public Offering or in the stock market, what would you do when you went public and sold part or all of your company to stock market investors?

Well first you would sell the company at a time of maximum profit margins in order to get the highest price, i.e. the highest P/E ratio. Say that your ‘growth company’ at the time of IPO sells for a P/E of 13 then what would you do right before the offering?  Right, get leverage and not by a conservative amount; but as much as you likely could get away with. After all, it is the new investors who will have to pay the interest!  So rather than selling your company at 13x 1.86 or $24.18 for a measly profit of $4.18 you would take out 50% of the equity or even more and replace it with a loan. Now you have recovered $10.00 per share and your selling the company for 13 x $1.53 (net income per share after interest) = $19.89 and you made at total profit of $29.89 - $20 = $9.89 per share (more than double the profit without the debt).  Your return would be not $4.18/20 = 21% (in one year) but $9.90/$20 = 50%. Wow!!
Who pays for that? The IPO investor and on top of that the IPO investor takes on the liability to pay back the loan! Now who is getting here the short end of the stick? Add to that the commissions for the investment bankers and lawyers who administered the deal and you can easily understand why you don’t want to buy an IPO! Ever! Never has the term: ‘Caveat emptor’ or ‘Buyer beware’ been so applicable!

There is though a golden side to this story. North American Blue Chips are right now flush with cash!  Do I have to say more?  See you at the next post?

Saturday, June 23, 2012

Viable Stock Market Investment - Part I


Let’s look at stock market investments as buying part of a company. A concept used by some of the best investors in the world. If you buy a part of a company, then you are not in for the short haul. However, buying part of a public company contrary to buying a private company puts you on the sidelines as far as directing company operations and financing  is concerned– that is done by corporate management and your phantom representative, the ‘board of directors’.

I say ‘phantom’ because does the board really represent you?  You have a symbolic vote at the AGM as to who is on that board and many directors are often not even significant shareholders. Do they represent you or are they buddies of management?

Still, as ‘owner’ of a portion of a public company, it is important to understand its numbers. Financial statements are not the ‘end all’ of corporations. Good corporations are also characterized by a dominant market position within their segments as determined by branding, product or service quality and consistency. Add to that the skills and reputation of its management and board of directors, and… also of its entire staff.

Truly, management and the board are only setting overall corporate direction; they are the leadership that, often through example, set the corporate culture. But it is ultimately the quality of their staff that leads to the execution of corporate direction. If management is out of touch with its staff and sets unrealistic targets and promotes corruption and dishonesty within the company the staff will respond in a negative way and the company will likely go do the drain.

So it is not only the numbers that make or break a company, it is the entire synergy of good finances, good management and good staff that creates or maintains good branding, good quality products and/or services with excellent market position that separate an excellent company from one that is poor or mediocre. Some of this can be found in the numbers; that is the easiest spot to start to evaluate a company and its potential as a stock market investment.

What we are looking for is a combination of healthy leverage, growth revenue, profits, and future potential. We’re looking at how these numbers are translated into investor cash flow, i.e. dividends, and appreciation. The dividend is the bird in the hand; appreciation is the flock in the bush - the speculative part of the investment. Both combined result hopefully in a desirable return on investment.

The cash flow (dividends) we need to live from; to reinvest and to avoid forced sales. Those same down turns not only are times we, investors, must survive; we also need them to buy excellent companies at a good price.  The latter is not critical but it is desirable; even an investment bought at the peak of a market will throw off profits when held for the long term. Although the ROI may be somewhat lower than if bought at the bottom of a market, its returns are not disastrously lower as we discussed in earlier posts on several occasions.

Are you ready for the numbers?  Not quite yet. Many companies have been started with excellent boards and managers and with talented staff and good finances. Yet many failed – companies need the wind in their back, especially in the early years. The wind or the environment in which these companies grow that is the economy - the macro-picture.

There needs to be a market for a company's products, the market could be a new market for an innovative product that has, in the near future, limitless growth or it could be a mature market that grows not more than GDP. There are two forms of GDP: there is nominal and there is real GDP. The real GDP is nominal GDP corrected for inflation.  When working with leverage, inflation can prove very beneficial and thus we should look at both types of GDP. Also, inflation and interest rates are linked.

So we’re assuming a product producing company (in fact services are products too), whose owners have invested a certain amount of equity in the company, i.e. shareholder equity. We call this equity sometimes ‘book value’ or ‘net asset value’. When the equity is brought into the company by shareholders, the company’s book value is divided by the number of shares and expressed as the book value per share. 

This is different from the share price, which is the price offered in the stock market. The share price is, as we have seen in other posts, a kind of unpredictable thing based not only on corporate fundamentals but by many other factors including market and investor psychology at the time. Book value is the equity per share that is actually invested in the company it is used to buy company assets and fund its operations.
In our simplified company financials, we will run four cases as shown in the tables below. Also shown below are the inflation rate, Interest rate, real GDP and nominal GDP values that impact the company. Finally displayed are the number of shares and the share equity underlying each share. Multiplying the equity per share with the number of outstanding shares results in the company’s total shareholder equity at the time the company was founded (year 1).

If company shares are traded, the share price varies dependent on what investors pay for them in the stock market. If, for example, the shares traded at a certain point in time at $18.50 then the company’s corresponding market cap(ital) would be 10 million shares times $18.50 or $185 million dollars. Obviously, our example company is not Apple, which has currently a market cap of $542 Billion or just over half a trillion dollars while Microsoft is ‘only’ a quarter of a trillionJ.
Click inage to magnify

Viable Stock Market Investment – Part II

Case I shows numbers of a corporation with an unlimited product market that can grow regardless of the economy. We used to call such companies ‘recession proof’; they are often companies with new innovative products that people want no matter what the economy does.  When Apple’s iPods came out everyone wanted one and Apple just couldn’t produce enough of them to keep up with demand.  For several years, iPod sales grew enormously.

In our example company we also assume that no matter how much is produced, the production costs don’t change. For simplicity, we do not consider the effects of ‘economy of scale’. Neither do we consider the effects of competitors and supply that exceeds market demand on product pricing. The profit margin is constant (10%).
Finally, we assume that the company is not borrowing any money. Its working capital is restricted to equity brought in by the investors, i.e. $20 per share. We’re looking at 3 years of data; in real life, most investors look at 5 years or even 10 years of data.

Just like with the real estate’s APOD we’re starting with the income and operating profits. Below is the Income Statement:

With the sale of 10,000,000 shares at $20 each the company acquired $200,000,000 in capital which was used to produce $200,000,000 in merchandise and to sell it with a profit margin of 10% for total revenue or sales proceeds of $220,000,000 including $20,000,000 (twenty million) operating profit.  This is akin to the Net Operating Income from a rental property.
Since no money was borrowed, all profits go to the shareholders after corporate taxes which are set at a flat rate of 10% or 0.1 x $20,000,000 = $2,000,000. Thus on an after tax basis shareholders made $18,000,000 profits in year 1. Wow, I didn’t know that accounting was that complex!

Well, the balance sheet is even easier. It is shown below.

The Balance Sheet basically shows the companies’ financial structure. It shows where the capital came from, how much it is at a specific date (e.g. at the company’s fiscal year end) and who owns the capital, shareholders, lenders, the government (taxes), unpaid suppliers, etc.
Our corporate structure is simple; there are no loans and the taxes were paid from this year’s profits and nothing is owed to the government. The only contributors to capital are the shareholders. At the beginning of year1, the shareholders put in $20 per share of $200,000,000 overall and they made an after tax profit of $18,000,000.  What is being done with these profits?

Well, the operating profit could be paid out as dividends; in fact all $18,000,000 could be paid to the investors as dividends. Since the corporation already paid corporate taxes, the government will tax you less on the dividends than on other income such as salary or interest income. That is the reason for dividend tax credits on your tax credits. If you had invested in a foreign company then the Canadian Government did not collect taxes on your company’s income and then why should it pay you a dividend tax credit? In that case, those dividends are between you and the foreign country’s tax man!

Did you see the profit margin on your investment? $18,000,000 divided by $200,000,000 million? That is close to 9%! Wow, that is a lot better than you’d make on a GIC today! So what are you going to do with your share of the profits? Invest it in a GIC at 2% per year?  Wouldn’t it be better to re-invest it in the company and make 9%?

How would you reinvest? Buy more stock in the stock market?  What if the company was not publicly traded? You couldn’t buy stock no matter what you paid? If you bought in the stock market you would have to pay stockbroker commissions and you have to pay the current stock market price which could be a lot more that $20! So your 9% profit would go down to 7% or even less!

You might wish that management never paid out the dividend and just kept it with the company!  Then your initial investment would grow at a compound rate of 9%. You would make 9% on your initial twenty dollars and also on this year’s profit!  What?  What was it that management said?  “Can do! We want to grow the company; we need money to expand and we don’t want to pay money to raise new capital. Just let us keep your money and we make next year another 9% after tax for you!”

“Peleaaaase!”, you may want to shout out. ”Yes I don’t want dividends. Just grow the company!”  Thus the company ‘retains’ your earnings and now your shareholder’s equity is not $20 per share or $200,000,000 for the entire company but also includes the $18,000,000 in retained earnings. The equity per share or the book value per share is now $20 plus $18,000,000 dividend by the 10,000,000 outstanding shares or $21.80! Total Shareholder Equity at year end is $218,000,000. 
Would you sell your share now for $20 per share in the stock market? No Way! You’d want at least $21.80 and since there is no other investment that would compound at 9% per year, you would probably want more!
So we’re keeping the money in the company and use it to produce even more in year2 and yet more in year3. Lo and behold, each year we’re earning 9% on our money and each year our earnings increase and so does the share’s book value. 

So what could the market be doing during those 3 years?  If interest rates and inflation stay unchanged, other investors would love to own part of your company. They would want it even if it earned only 7% per share rather than 9%.  If you sold your shares at the end of year2 for its book value of $21.80, the buyer would earn in year2 $1.96 per share. He would have an forward earnings yield of 1.96/21.80 = 9% or a forward price/earnings ratio of 21.80/1.96 = 1/9%= 11 .1

If the buyer used this year’s earnings of $1.80 the earnings yield would be $1.8/21.80= 8% or a P/E of 12.1 So the lower the earnings yield, the higher the P/E and if a buyer was willing to buy your share for an earnings yield of 7% or P/E of 14 it would bring you not $21.80 but $1.80x14= $25.71. Would you sell for a $5.71 capital gain on a $20.00 investment?
If you could invest your $25.71 elsewhere for a 9% compound rate, I think you would sell in a jiffy. Heck, you would sell if you only could earn 7% because you’re not sure whether the company can keep on growing every year at 9%. That is what should go through your mind when you consider both company financials and market valuations! 

Some investors may be willing to pay even a higher P/E if they thought that the company could keep on generating 9% on its equity for several more years. These investors may think: "Heck, the economy looks good, everyone is happy. There is virtual no risk to buy this company."

Or… investors don’t believe that 9% growth is sustainable. Because who can afford buying more and more product when the Europeans are about to go bankrupt, and China’s economy is growing only 7% per year and Obama is president in the U.S. and if the world is coming to an end? These guys would not even pay a P/E of 8! Your $20 share sells only for $14.40 in the stock market. Ouch you are in a bear market! Oh we’re all going broke! Two months later, or 6 months later, for some mysterious reason, everyone is happy again and then your company is selling for a P/E of 13. Earnings were better than the analysts expected.

No matter all the speculation in the market, your company is likely to keep on producing and made $1.96 in year 2 and another $2.14 after tax in year 3. If you sold finally in year 3 to someone willing to pay a P/E of 13, you made 13x$2.14= $28.00 or a profit of $8.00 while your company earned $5.90 over the same period. Hmmm…. The combination of real earnings and market psychology can be quite profitable but is this investing or emotional dithering?

I'll tell you. Your company ownership is an investment. Trying to sell it in the market for a profit by taking advantage of the emotional dithering of others is smart. Getting affected by the market emotions is a sure recipe for losing your investment cool and losing money.

The other thing we're learning from all these numbers is that if the profitability of a company doesn’t change then no matter how much it grows, return on equity will not change either. In order to increase earnings per share, the production costs have to come down or the company should increase its product's price (if the market allows it). Or… the company could have another capital structure by using other forms of capital such as preferred shares and borrowed money.
If you can borrow investment money at an interest rate of 3% to earn 9% would that not be sweet? We'll investigate in a later post.

Sunday, June 17, 2012

The Greeks made me at least a $1000

I always tell you about long term investing and not to worry about the day-to-day media noise.  So why was I clinging to my Windows Phone this weekend? Well… I had a short term trade and it hinged a bit on the outcome of the Greek elections.

You must be aware of my dabbling in the option markets to generate extra cash. I wrote a whole series of posts on the topic. So what made me so dependent on my, by now loved and trusted Windows Phone? Well, I wanted to sell JNJ first thing on Monday morning for $65.90 U.S. This would likely go through if the more conservative parties in support of the EU bail-out won while the markets would likely crater if the more radical left won the election. Not that this matters in the large scheme of things. I know Johnson and Johnson is a great company and its stock price will sooner or later go back over $65.00 and I would make some money anyway.

It all began some time ago, April 03 when the stock market was in a blissful rally. JNJ was approaching $66 per share and I wanted to make some quick cash by selling a put option. Using my earlier mentioned ‘Option Tracker’ spreadsheet, I calculated that there was no chance for the stock to fall below $65.00 for the foreseeable future and thus I sold 4 put contracts with a strike price of $65 to expire on May 18. Proceeds after commission were $245.00.

That is easy money provided the share price of JNJ wouldn’t fall below $65 prior to May 18. To remind readers: when you buy an option you pay for the right to do something while when you sell an option you take on the obligation to do something. In my case, I took on the obligation to buy 400 shares of JNJ for $65.00 if the share price fell below $65  prior to May 18. Well, that was not likely to happen I thought; hence the ‘easy money’.

Then the European Debt crisis stuck up its ugly head again and we got a correction. The Greeks had an election the results of which did not let them construct a government. New elections had to be held on June 17th and hopefully the pro-Euro forces would win or else… Armageddon, the End of the World,…. Blah, blah, blah.

JNJ dropped in May to $63 and my options were exercised and 400 JNJ shares were assigned to my account for $26,043.00 (including commission). There was no cash in the account, so the money was borrowed. Oh… my G… , I don’t want to increase my debt at this point in time. But… he… JNJ is a good stock, the crisis will pass and JNJ will go back over $65.00 maybe even higher; then I sell.

Next thing that happened was that I received $207.4 in dividends. Then the market in its wisdom started to turn around and JNJ shot back up like a rocket. Friday it closed at $65.90 and I wanted to cash in. Oops, the Greek elections – are they in or are they out? My Windows Phone just reported they’re in.

So on Monday morning, there will be an enormous rally until the moment that somebody feels that the news is not good after all. But then it will be too late for the sucker who bought my JNJ stock. My total profit: $245 put option premium plus $207.40 dividends plus $350.01 sales proceeds minus $90 interest = $712.01 on an investment of zero. That is an infinite ROI.

In the worst case, I might have had to hold on to JNJ which I would have been happy to do because buying it for $65 minus the option premium of 61 cents or $64.39 would have not been bad either. In the meantime, my whole stock portfolio may shoot up Monday morning and that makes me for a few seconds think that the Greeks earned me a thousand dollars plus over the weekend. Zeus be thanked.

When are stocks most likely to go up?

Momentum investors says: “When they are already going up.” Value investors say: “After the crash, when you can buy a company at a discount of its net asset value.” Growth investors say, “When you buy a company whose earnings grow fast.”  They are all right of course,  but there is always a ‘but’ with these approaches and in the ‘but’s lies the risk.

So when do we incur the highest risk?  When the economy is hot; then we then pay almost any price for earnings and earnings growth. When we pay a premium for the company’s net assets and when prices seem to go up forever. So why were you buying stocks in the hot 2007 stock market when risks were highest?
When do we incur the lowest risk?  When everyone is afraid, when stocks are on sale; when momentum has changed from downward to pointing up; when earnings are recovering; when we no longer run the risk of ‘catching a falling knife’.

Is that today’s market? So why are you not buying? Why are you hording cash on the sidelines? I tell you why! You’re afraid of losing you hard saved and hard earned investment loonies, especially after 2008-2009. You’re scared by the headlines; but headlines are to sell newspapers. The real news you will have to eke out from articles which are more often emphasizing the bad than the good. You will have to look for reasons why things are going to get better amongst herds of doom & gloomers, amongst herds of fear mongers and chickenlittles.
Today, we’re climbing a real ‘Wall of Worry’ and it is not easy to put your money out there. But then, things could indeed turn worse again. If investors hate one thing rather than losing money slowly over time than it is to lose money overnight! The answer of how to deal with this is two-fold:

1.       You need to know that you buy truly a valuable, viable investment

2.       If things don’t work out, you should not lose all your investment marbles. In other words, don’t put all your eggs in one basket - diversify.

We’ve discussed how to recognize a viable investment in real estate and we will do the same for stockmarket investments. But first let’s look at point 2 – diversification.
There are many ways to diversify including the classic portfolio rebalancing strategy. But in its simplest form, diversification is to not put all your money in a single investment strategy. Put some in real estate; put some in value stocks; put some in Hi-Tech. Trade a bit in options, buy bonds, and so on and on; or as the old Romans used to say: "et cetera!"

Of course, at the top of the line should be the need to have sufficient cash for you to live through a down turn without have to ration your food and lifestyle beyond what you may consider ‘common sense’. Investment money, in theory, should be money you can afford to lose. Now between you and me, I do not want to lose any money whether I can afford it or not. However, the idea is that you should be able to continue living the way you want even if you lost the money.
This is an important concept. Many things in life show you that if you hold on to it too tightly, you will likely strangle and lose it.  You should allow your children enough freedom so that they will be with you until the day you die or, when you’re an undauntable optimist, forever. That is also true for your financial children - your investments. You should be willing to lose some investment money with the expectation of getting better overall returns.
That is the idea, behind: ‘Nibble, Nibble, Nibble'. You buy the investment that is down, but only in small amounts , not more than you can ‘afford’ to lose and no more than a small portion of your total portfolio.
Recognizing a ‘viable stock market investment’ is not easy. In fact, I have created spreadsheet analogues to the APOD. Now we’re calling them 'financial statements' and just like the APOD there are revenues, expenses, operating income and the costs of financings that lead to net income and cash flow. I am using very simple financials and some macro-economic parameters to come up with easy to understand scenarios from which one can make conclusions that blew my socks off.
If you understand these simplified financials, you will understand why you don’t want to participate in initial public stock offerings or IPOs; you will understand how to increase the value of a company and develop criteria that help you identify the more promising and viable stock market investments.
 In the end, as stated in earlier posts, it is about generating cash flow that allows you to live, to re-invest and to sit out the downturns. So if you just stick with that, you’ll do fine over the long term. Over the short term, it are the market emotions that determine your returns – it is not much better than a casino. Over the long term it is humanity's drive for improved well-being that makes investing worthwhile. This is statistically shown in earlier published data on this blog (Some Ken Fisher vitamins for long term investors  ). Here is a reminder:
(Click on image to magnify)

Saturday, June 16, 2012

A Viable Investment

By now, regular readers should already have a good idea about what I mean when talking about a viable investment. But let me spell it out in general terms. Then we will discuss what a viable real estate investment should entail. In one of the following posts we’ll do the same for a stock market investment.
A viable investment should throw off sufficient cash flow so that it makes a significant contribution to the overall portfolio and provides funds for future investment, my costs of living (in the lifestyle that I consider desirable) and so that it provides sufficient cash reserves preventing a forced sale during down turns. 
Let me elaborate on ‘forced sales’. Investing is like the rest of life – mostly it proceeds uneventful and hopefully along the lines that one desires. That is basically what I call ‘being happy’. Most people don’t realize when they’re happy because they think that ‘being happy’ means to be on a never-ending high. That is impossible, something can be thrilling and euphoric for the first time, possible even up to the 10th time, but after the hundredth time experiencing something you will consider the event normal. That is why we often don’t realize that we already are leading a happy live. Also, you need from time to time a challenge to not only appreciate what you have but also to do something meaningful with your live. Most people are happiest when they are in the process of achieving something worthwhile and you cannot do something worthwhile if it does not pose a challenge. Maybe review your own life and your own current challenges and see whether you are not already happy but just don’t realize it.

Forced sales, are like the flue. You may live an uneventful healthy life. Then suddenly you get the flue. In a matter of hours you can feel like you're dying and some of the less healthy amongst us actually do. The same with investing, you mosey happily along, then you get hit by the financial flue and are forced to sell because you are not financially strong. In no time you're fighting for your investor survival.

Money and wealth do not make you healthy nor does it make you happy. What it does is providing you with a multitude of opportunities to pursue and maintain your happiness. In the end, the goal is to lead a rich, satisfying meaningful and a happy life. Money, education, family and friends are the wealth that provides you the means to lead such a life. I can tell you, luckily not first-hand though, that you cannot take your earthly asset with you into the hereafter! So why pursue more than your need to buy groceries? By now you know the answer: because wealth provides you with a multitude of ways to pursue a rich, fulfilling and happy life.  At REIN they call that your personal Belize!
Oh… so sorry, master; I digressed from the topic: a viable real estate investment. Maybe it takes more than one post to get the story out, but then my regular readers know that my thoughts do wander off from time to time to the more important things in life. Worse, sometimes they just wander. Oh… I digress now twice in one paragraph!

The answer to determine whether you have a viable real estate investment is to become a member of REIN… I mean, the answer lies in the numbers and REIN will teach you that much better than I can in a tiny blog. But since blog readers are always in a hurry, let’s use an APOD for now. APOD stands for Annual Property Operating Data and you may have already seen it on this blog in various forms. Let’s use one of my favorite real estate investments as an example: the two bedroom apartment in a condominium complex in Calgary.

Typical monthly rent is currently $1050 per month, thus the annual gross rental income is 12 x $1050 = $12,600. After subtracting ‘Vacancy and Bad Debt’, which currently are in Calgary as low as 3%, the remainder is called Effective Rent, which in our example amounts to $12,571.20 per year.
Out of this money you have to pay the operating costs. This is where the nickel and diming begins! You have to ask yourself what kind of a landlord you want to be. Personally, my goal is to provide a comfortable home for a reasonable rent to my friends the tenants. The tenants are my friends, because they pay for all my costs in return for my down payment and for me helping to keep their place in good shape. They will not only pay for the operating costs, they also pay off my mortgage and even put some cash in my pocket every month. To top it off, I can keep all the appreciation of the property during the years I own it. Finally, my friends the tenants index their contributions with inflation and if there is a lot of demand for rentals they pay me even a bit extra so that I get similar rents as the other greedy landlords around me charge. They do all that out of the goodness of their tenants hearts and I don’t want to pee them off. Because when my tenant friends get annoyed, they can cause a lot of damage instead of benefits to my $200,000 plus property. How eager are you to let your teenage son drive in your new Lamborghini? Same with my tenant friends, I have to feel really good about them to hand them over the keys to my rental dive!

It is all in the friendly numbers. Below is the APOD’s Effective Rent portion. One more thing to note; you have to be precise in what you actually rent out. You may rent out the apartment to your tenant friends but does that include the parking spot(s)? In today’s cities, people may want to rent your parking spot separately especially when you are near an LRT station. So, a parking spot requires due diligence upon purchase and you may rent it sometimes out in addition to your apartment!
(click on the image to magnify)

I guess this is a good point for a break. See you at the next post.

A Viable Investment – Part II

(click on the image to magnify)

The APOD’s screenshot above shows operating expenses total $5,647.98.  This includes, condofees which in turn include part of the utilities. The remainder of the utilities (e.g. phone or internet) I let the tenants pay. Then there is landlord insurance, maintenance, i.e. small repairs, and of course my time (management fees).

Subtracting these Operating Expenses from the Effective Rent gives us the Net Operating Income (NOI). One way to valuate rental real estate is to compare your Cap rate (NOI/Property Value) with that for similar properties in your investment area. In NW Calgary the Cap Rate is typically 3 to 3.5%.  Thus based on the example’s NOI of $12,571.20 minus $5.647.98 equals $6.923.22 and the property would be worth NOI/cap rate = $9323.22/0.035 = $197,806.17

We bought it for $200,000 so that sounds O.K. In other areas, however, the cap rate may be higher; say 5% and then the property would be worth only $138,464.  The reasons that the cap rate varies so widely can be numerous and it is up to the investor to decide what is important to him/her. In Calgary, annual appreciation is typically higher than elsewhere in the country so that may explain why an investor is prepared to miss out on some cash flow - he’ll make up in capital gains. At other times the cap rate is entirely based on market emotions and again it is up to investor to decide whether to buy, sell or walk.

But what is essential is whether the investor can hold on to a property until he/she chooses to sell rather than that it is a forced sale. When you’re forced to sell, especially at a market bottom then you are no longer in control and your investment is no longer viable. Hence you need an investment that not only has a positive net operating income but also is one that after financing costs throws of meaning full amounts of cash.

When an investor owns the property clear title, i.e. there is no mortgage then the entire net operating income goes to the investor. His return equals the cap rate which is NOI/Property Price (akin to the P/E ratio for stocks or better Earnings yield which is the inverse: Earnings/Investment price x 100%). In our example the capitalization rate equals $6,923.22/$200,000 = 3.5%. If a property appreciates by 5% annually, the investor’s total return is 8.5% per year - but in this post we focus on the cash flow returns.

Now, many real estate investors use leverage, i.e. a mortgage. If the cap rate exceeds the interest rate, the investor earns 3.5% on $200,000 but if $100,000 of that is borrowed using a mortgage at an interest rate of 3%, then the investor’s capital lay-out is only $100,000 and he makes 3.5% plus 3.5% minus the interest rate charged for the mortgage (3%) on the remaining $100,000. Instead of yielding $6,923.22 on $200,000 or 3.5%, the investment yields $6,923 minus $3,000 (interest on $100,000) = $3,923.22 on an investment of $100,000 or 3.92%!  Aahhh the power of leverage!

However, not only does the investor pay interest, he also has to pay back a bit of the mortgage principal every month. Typically in the first year of a 25 year mortgage the investor pays back about $2,734 of the initial $100,000 principal. Thus the total monthly mortgage payment is $473 which has to be paid out of the monthly cash flow of $6,923.22/12 = $576.93. Thus every month the investor puts $103.69 in his pocket. Not too bad plus he pays off 223.17 per month in principal. 

But what if the rental market tanks and he has to pay for rental incentives or collects only $700 per month in rent rather than $1050? Oops, his cash flow has gone negative, i.e. he has to PAY out of his own pocket $212.05 – part of which goes to paying down the mortgage, but still it is cash out of pocket. If there is no other income, the investor will be forced to sell the property! Subsidizing a property for $212.05 per month is often no big deal, but what if you had 10 such properties? You would need to come up with $2,120 each month! Ouch, you may need a job on the side to do so.

But if rents fall, guess what, the property value falls and new investors want a better cap rate; say the cap rate rises during high vacancy times from 3.5% to 5%?  Oh then the property, as you recall would be worth $186,464.32. Eh…. Noooo! That would be so if your NOI didn’t fall but with rents falling to $700 now the NOI has fallen to $5,534 and when valued at a cap rate of 5% the property would be worth to an investor only: $62,687 Oops!  There was that $100,000 mortgage and it did barely decline over the year but… your initial $100,000 equity has dropped now to barely $-37,312 that is NEGATIVE $37K!  Yep you lost $137,000!
Now if you had the opportunity to wait out this bad stretch in the market then you probably would recover most if not more than the initial $100,000 down payment but your 1 year mortgage term is over and the bank does not feel that you have enough equity in the place. They don’t want to renew and want their $100,000 back by the end of the month! Ouch, Oh…. Booh, booh!

Now, 50plus percentage drops in real estate value happen rarely, except in the U.S. J  Would it be likely for the rent to drop within the first year of your purchase from $1050 to $700? Not likely. But you better know whether you want to have that kind of leverage. Can you survive such a financial flue or would you be forced into an untimely sale. Do you have the financial strength to sit out such a blood bath?  In 1982, after the NEP and recession, Alberta real estate values in some condo complexes did indeed drop up to 50%! Many home owners were in trouble and handed the keys of their homes back to the bank. 

You have a viable investment, if your cash flow remains positive under those circumstances. Of course you can be more aggressive as an investor but the risk that you fail and end up with a forced sale or foreclosure will increase exponentially with your leverage.

The beauty of real estate is that you are the CEO of your own real estate company, you can determine at what level of leverage you feel safe; in other words, at what level your investment is still viable. When investing in stocks, you give that power away as happened to investors in Yellow Pages; in fact there even management lost control in the end and lenders determined where the cash flow went; Yellow Pages may never recover. In spite of its initial solid character and great dividends Yellow Pages was not a viable investment. Using leverage in real estate can also cause you to lose control; just ask a certain Peter Pocklington or the Reichmann family!

There is another profit center than cash flow that is greatly enhanced by leverage and that is the appreciation of your property. Something that is even more speculative. Thus, in real estate there is truly a risk-reward equation which can make you rich or put you in the poor house.

Saturday, June 9, 2012

Worrywarts


There are even books titled ‘Worrywarts’: The Worrywart’s Companion; The Worrywart’s Prayer Book; Intergalactic Worrywarts (I kid you not) and my favorite: the Purple Sluggy Worrywarts!   A search on Amazon revealed that they are currently selling 37 books with ‘Worrywart’ titles.
I know you may worry that if ‘Worrying’ is so prevalent in the world then why are there not 2000 titles for sale or even more. Maybe you worry that only 37 titles suggests that the world is not worrying enough. So I did search for all ‘worry’ and ‘worried’ titles which added 1783 and 292 titles respectively to the total. Now we’re comfortably over 2000 titles that worry one way or another. Hehe,… that is one thing less to worry about!

Then I had this brilliant idea and did a Bing search for ‘worried investors’ and it found over 25million postings. Unfortunately, Google didn’t do as well in 0.23 seconds it found only 18 million items. Now you may understand why I prefer Microsoft (Bing) over Google! And Apple… pffff do they even own a search engine?
Every day investors seem to react to yet another worry. Since 2008 we have dealt with: Lehman’s, Maddox, the Financial Crisis, the Subprime crisis, the low oil price, the Shipping index, low liquidity, the U.S. Real Estate collapse, European debt crises (installments 1 through 10), Peak oil, Global Warming, Kyoto scrapped, Oil sands pollution, Keystone, Structured Debt Vehicles, Rising unemployment, falling GDP, Japan’s Earth Quake, Iran’s fascist Nuclear Threat; North Korea’s Communist Nuclear Threat, the Arab Spring…. and another couple of hundred causes of the never happening ‘end of the world’.

Every time that the 'world ends', the markets reacts with volatility. The volatility is used by hedge funds with limited success and great self-delusion to 'profit' and by banks and their ‘rogue’ employees for rampant speculation. Retail investors are scared ‘sh.tless’ and avoid the stock markets like the plague while they park their money in Guaranteed Investment Loss Certificates and other low risk money losing investments. The markets live by fear and breathes fear for close to 10 years now. The scariest fear is of course the prospect of yet another 'Bubble' - we're seeing bubbles everywhere!

 Since March 2009 though, we literally have been climbing a wall of worry. Just look at the charts of the Dow and S&P500. Commodities, in case you have forgotten, usually do best when the economy is firing on all cylinders late in the business cycle, thus the TSX has been lagging since 2008. Amongst all the worries, you may have forgotten that Canadian Real Estate overall has done quite well in Vancouver and Toronto; thank you very much! In Alberta it was tougher! But then Alberta's real estate profits during the early part of the decade were outright spectacular and over the long term investments do tend to revert to their average!

So if you didn’t panic and if you didn't sell your stocks you would probably have broken even regardless of all the turmoil. You might even have made a bit of money if you focussed on cash flow rather than appreciation over the last 5 years. Of course, now that everything seems depressing and we’re living in this 'perpetual gloom', you may be tempted to walk away from all this investment misery!

In reality your internal psychological warfare is the main reason that investing is not easy! You have to learn to differentiate between what works (over the long term) and what will not survive, rather than worrying about the daily moves of the markets. Think long term because over time  investment performance will return to the long term average.

When the markets move all up in unison and euphoria, even the most rotten investors make money. But it is during these though times, when we’re climbing the wall of worry, that the good investors create the foundation(s) of their future wealth.