Saturday, July 28, 2012

What is the investment’s value?

On Wednesday July 19, 2012, Apple was worth $ 567 billion. This Thursday it was worth nearly  $ 40 billion less or $ 530 billion. So, what is it really worth?

That question is difficult to answer, but it is hard to justify that a company loses $40 billion of its value in less than a week. Not that Apple lost money. To the contrary it earned $35 billion dollar in the last quarter or nearly 18% more than in the same quarter a year ago.  Its profit margin went up to 42.8% from 41.7%! To top it off, Apple announced its first ever quarterly dividend of $2.65 per share something hardly anyone bothered to mention!  Is it a growth company trading at a super high unsustainably high P/E? Hardly, with $41 per share in annual net earnings it traded at 15x earnings and at its current price it is trading at a P/E of 14
No, the reason for its fall was a drop in sales revenue!  Not a real drop, it only sold fewer products than ‘The Street’, whomever that may be, expected!  And really, the sales were less than expected because many buyers are waiting for the release of new product, in particular iPhone vs 5 in the next quarter.  Wow, so much bad news J No wonder the world is coming to an end. 

In 2007, a nice condo in Whistler, BC was sold for close to $ 1 million and last summer it sold for $725K. What is it really worth? 
What happened?  Did we enter a new ice-age?  Did the place get flooded? Did it burn down? Nothing of the sort! We went through the U.S. real estate collapse and through the U.S. financial crisis and today we're going through the European crises.  Nothing changed with the property – in fact, they just added a beautiful, state of the art gas-stove and complimentary range-hood. 
In terms of assets both Apple and the Whistler property have increased in value.

However, potential buyers have disappeared nobody has the guts or the money to buy Apple nor the Whistler condo. Both have retained their functionality (earning money and providing a nice lifestyle) but nearly like flipping a switch you can now buy these assets for a lot less than just a short time earlier.
If the buyers disappear or if nobody wants to sell then prices are affected. I am not talking about the value of the asset but about whether it is available for sale or whether there is a buyer. Supply and demand.  Is the Whistler Property truly worth $275,000 less than a few years earlier?  No, but in the recent past there was one owner out of many, who was in financial trouble and needed cash badly enough that he/she was willing to sell it for any price while there were only a few buyers who were willing to take the property off the buyer’s hands and only if they got an exceptional good deal.  There were hundreds if not many more owners who were not willing to sell for that price. But we often seem to think that it is only the last sale that sets the value of an asset.  Ludicrous!  I have no other word for it – just ludicrous.
We have in real estate a number of ways of appraising the value of a property. In fact there are three distinct methods:
  1. based on the sale price of several other properties of comparable quality in the same area.
  2. based on the replacement or building costs of the property.
  3. based on the income (or better) the net operating profits it generates.
Guess what, each method results often in different values. So which one is the real value?
The market is exactly that – a place of trading. We buy and sell assets in the market and a price is negotiated based on the motivations of buyer and seller. If you ever went to a flea market and traded you know how one buys in a market. It depends on how badly you want a certain gadget and how badly the seller wants to get rid of it.  Often, you can buy a similar gadget in a normal retail store nearby, but you would have to pay a lot more. So, is the price you paid for your gadget in the flea market the real value or is ithe price you have to pay in the store its real value?
Alternatively, we could estimate how much it costs to make such a gadget and set that as its value. So then the price is dependent on the costs of labour, the raw materials that go into making the gadget, taxes, patent  or license fees or the product development costs, etc. But if nobody wants the gadget, is then its sale price based on production costs reflective of its true value?
We could look at value based on how much income an investment generates, but is that income, net operating income? Or is it net or free cash flow or is it that part of an investment’s free cash flow that is paid out as dividends?  Many sophisticated investors use the amount of free cash flow that an operation throws off over its expected life discounted over time (i,e, net present value of a cash flow stream). But, who determines the real life span of an investment and who determines what discount rate is appropriate?
Wherever we turn, there is always a judgement call required of the investor and there never is a real objective value. So value is volatile and the only way we can set it is by determining how an investment fits in our overall portfolio and the goals we have set for that portfolio in order to realize our dreams in life, our personal Belize as REIN calls it.  There is no objective value for an investment; value depends on the owner of the asset.

Say, I've got a condo that cash flows every month (after all expenses other than financing) $1100. In Calgary, a typical rental property has a cap rate of 3 to 4%. If we set a cap rate at 6%, then this property is worth 12 x $1100  annual NOI = $13,200/cap rate = $13,200/0.06 = $220,000.  The last time one of those units was on the market it sold for $180,000 so would you sell it for that price?  Would you sell it for $220,000?  Heck no, were would I find another property that cash flows 6% in Calgary?  For me, the property is worth $13,200/0.035 (the average cash flow) $440,000 but at that asking price I won't likely find a buyer. So I keep it.

The same with stocks, many Dow stocks trade at barely 10x earnings, the dividend yields are 3 to 4%. The market pays not enough to sell it and replace it with another investment of the same potential.  If I put the same money in a 'risk free one year GIC' I would get a 1% interest rate. Even if the stock appreciates 2 or 3% per year, I would have a hard time to find another investment of this quality for the same price. So, I won't sell. How much is it worth to me? $1 invested in a GIC pays me $0.01 per year. That same dollar invested in the Dow makes me 3.5+2.5= 6% or 0.06 cts per dollar. If the stocks perform taccording o their historic average performance of 14% over the long term, I'll make even more. Long term, what is the risk?  As long as I don't sell in a panic at the bottom of a bear market there is virtually no risk. So how much is it worth to me?  I won't sell until I get at least double; yet in today's market there are no buyers willing to pay that price! Thus I'll hold on.

Focus on asset acquisition not on building ‘net worth’. Focus on assets that generate potential cash flow (because even the best property or the best asset can be poorly managed) and focus on the questionwhether the asset will bring you closer to achieving your aspirations in life. Wealth is not about how much money you have, but about how many assets you own that help realize the life you want.

Sunday, July 22, 2012

A Portfolio of Viable Investments

Over the past month or so, we discussed what a viable investment constitutes and how to recognize one. So how does one translate that into a portfolio?  If you go to a financial planner, he will ask how long you plan to live or otherwise assign you a life expectancy based on actuarial statistics.  Isn’t that fun: “Oh Bill, you are a non-smoking white male of 35 years old, thus you are expected to live until the ripe age of 83 years. Oh Nancy, you are a 40 year old female who doesn’t smoke, eats organic foods and exercises 3 times per week; you are probably dead by the age of 86 and your husband will likely croak at 56 because he is fat and boozes too much." J

The financial planner continues:"So let’s see: if we assume that there is no inheritance for the kids then at an average ROI of 5.3421%  and your current level of savings and continued savings of $333.21 per month until the age of 60 years, thereafter in retirement you will be able to spend $431.76 per month until the day you’re scheduled to die. If you live longer, too bad because you’ve no money left and have to eat out of other people’s garbage bins." Do you notice a certain flaw in this form of financial planning apart from the unpleasant prospect of eating out of garbage bins if you outstay your financial welcome on this earth?
Everyone who once believed the demographic studies predicting a 1930’s style of depression on November 23 in 2012 because baby boomers would stop spending should know the futility of predicting the future. If you didn’t fall for that form of clairvoyance, then what about those rock solid stock market predictions or the prediction that nobody needs a computer with more than 32K RAM?  Let me make a prediction about the future that is probably much closer to the truth: Nobody knows what tomorrow will bring!
So, maybe we’re all dead on November 29, 2013 or maybe we all reach immortality provided for a minor monthly fee by Wasser Life Insurance Ltd. Really, we don’t know what tomorrow brings and thus we should plan our retirement as if we will live forever. You know there is something very tempting in such a scenario: From age 0 until 3 we’re home with Mommy and Daddy; then between 4 and 6 we’re spending a great time with the daycare ladies; next we’re spending 6 years at elementary school before graduating to high school.  At age 18 we’re car driving adults – if you can believe that – by age 30 were moving out of our parents place and live off our girlfriend(s) whom we dump upon completing university followed by marrying a hot chick with a great career in engineering. After a strenuous professional career of 10 years, we’re retiring at age 55 to never have to work again unless we really, really want to and when our busy holiday schedule allows us. From 55 until age 120 we’re leading a truly financially independent live and then we’re getting a much deserved upgrade that allows us to live another 500 years at which point we’re so bored with live and we’re so rich because of the financial ideas from a long forgotten blog titled “Canadian Diversified Investor” that after one last party we commit euthanasia surrounded by our smiling favorite offspring which counts by that time in the hundreds.
So we need a retirement plan that is aimed at living nearly forever. Hmmm… So we need inflation indexed income from inflation protected assets not something that runs out of funds after a mere 30 years and preferably something that did not force us to work for much longer than 10 or 20 years. So, using roughly the average Canadian household income as guideline, we need an inflation indexed income of $30,000 per year supplemented by another $20,000 to $30,000 in Canada Pension and old age security (whatever that will be called 500 years from now).  In the past, I showed you two ways of designing a portfolio:
1.       A diversified Asset Portfolio   (July 2010)

2.       A diversified Cash Flow portfolio  (Nov 2011)
Either portfolio will deliver cash flow and capital appreciation but one is focussed on assets while the other is set up to create a series of income streams. In this post we will use the Asset Portfolio because it is a bit more specific in what asset types you can select. From our earlier discussion you know we’re focussing on assets that produce cash flow from rents, dividends and to a much lesser degree interest.

You may want to consider one other asset that is not included in the portfolio but is extremely valuable and capable of throwing off impressive amounts of cash flow every single month of the year.  That asset is you and your job.  Your labor translated into a salary is one of the most profilic ways of generating cash flow – even at age 80 you could take a job at Wal-Mart.  So what is the value of a $40,000 per year job these days?  It depends on your discount rate which may range from 1 to 10% and thus your own asset value ranges from $400,000 to $40,000 respectively.

According to my estimates to generate inflation indexed income of around $40,000 you will need a portfolio of around $1.5 million in assets which comprises a net worth of $1.3 million plus $200,000 in mortgages. The portfolio asset mix is: 38% stocks, 9% fixed income, 47%  actively (by you) and passively (by someone else) managed real estate and 6% cash. The details are shown below. The stock portfolio is also subdivided into active and passive managed. Passive managed stock investments are ETFs and Mutual Funds (I prefer the ETFs), the active portion are stocks selected by yourself based on criteria outlined in this blog before.  Depending on your personal taste and risk, it is not too drastic to change the proportion of active versus inactive stocks.  When dealing with real estate, I would want to keep control and manage most assets myself (possibly with help of a rental manager).
Click to magnify
One minor thing when planning your retirement and building up your assets accordingly.   You MUST live BELOW YOUR MEANS!!!!

Saturday, July 21, 2012

Dow Jones Spiders

About a year ago, I recommended to buy a Dow Jones ETF (SPDR Dow Jones Industrial Average ETF) which contains some of the world's largest and best corporations. Over the past 10 years this ETF returned 5.83% per year, over the past 5 years it returned 1.86%. Over the past 12 months it returned, according to my calculations close to 10%.

Even better, dividend yields have grown from 2.13% to 2.44%. In other words, dividends have increased faster than appreciation which on its own was already quite decent.

I repeat my recommendation to invest in the U.S. because over the next decade it will explode. There is pent-up housing demand; it is one of the youngest and fastest growing populations in the developed world; it has innovation and vigor; it has oodles of cheap energy and is no longer dependent on petro-dictatorships. Yes, it has a high debt load but my guess is that it will be outgrowing today's bad ratios at a pretty impressive clip - with or without Obama.

NIMBY and Environmental action groups are destructive when carried into the extreme

A decade ago, I remember that the worst and ‘eviliest’ industry one could imagine were the banks who robbed everyone blind. Then there were the evil forestry companies and now, it seems, it is the oil industry – pipeline companies to be more precise.
Especially during bad economic times when one or two industries standing out in success, the public likes to vent their frustration on those industries. Strangely enough, we seem to want to destroy those matters that actually may help us to lead a better live. Maybe it is our frustration of being so dependent on these industries that make us vent our anger on them. Take the pipeline battle.
Really, it is essential for us (and I mean the entirety of Canada) to be able to export our oil and gas to the east and to international markets other than the big guy in the south. Imagine, if George Bush was still in power how we would shout if the public realized that the low oil prices forced on Canada’s oil industry subsidized the U.S. wars in Iraq and Afghanistan in addition to the rest of the U.S. economy. Because that is what is happening right now – we are subsidizing the U.S. economy BIG time.
Remember the revulsion of Western Canada with Pierre Trudeau because he wanted to force lower oil prices on western oil to subsidize the east?  Alberta felt that it was an abused colony of eastern Canada. And every election that was decided even before the polling booths in the West closed added insult to injury. Now, we have a similar situation with our southern brothers; even worse we cannot vote for their president but we have to take the price they offer for our natural gas and our oil because there is nowhere else we can sell it. Yes Canada is an energy and resources powerhouse but our resources are land locked and our hands are tied by the U.S. and other foreign interests who are more than happy to stoke our environmental action and NIMBY (not-in-my-back-yard) groups to stop us from exporting the stuff elsewhere.
To some degree the current attention the pipeline industry and oil industry receive these days is good. It forces the industry and regulators to improve their standards and reduce accidents. The same happened a number of years ago to the forestry industry which was forced to improve their practices. Our pipelines are in some places old and don’t meet today’s standards. In past decades when things were more cavalier, obsolete pipelines were shut-in while still full of oil; the consequences we experienced earlier this year. Yes, somebody needs a kick in the A… and work on improving industry practices. But this is more an industry that says: “Well it worked for the last 30 years so why would I change” rather than one of malice as many of its antagonists make it out to be. It is easy to call someone ‘the Keystone Corps’ from the sidelines – besides it makes great politics and helps to keep those dumb Canadians away from the world markets!  It is not for nothing that the U.S. does so well with low oil prices. Look how it did in the last 20 years of the 20th century when it won the cold war and became the world's only superpower.
But… when they cut off their own nose to spite the opposition then the NIMBYs and environmental activitists have gone too far. Those same people move around using the oil and gas they complain about so loudly. In winter they use the gas and maybe even oil (how quaint and wasteful) to heat their meeting halls, power their lights and their LCD PowerPoint presentations not to speak of their homes. What is the source of B.C.’s economic prosperity and personal welfare? Where does the money for their social services come from? How do the people that live in B.C.s interior make their money if not from forestry, mining and energy? Yes, I bet the native people would love to return to living from the land; to return to times when their population was a fraction of the size that it is today.
Most provinces in the east are now receiving job orders from the west. Ironically, their own auto industry requires gasoline and power to function and they need the federal royalties and other taxes from the resource industries to fund their life style.  Whether they want to acknowledge it or not; we need to have these viable industries. If you hate Alberta and you don’t think energy is important for Canada, then ask the B.C. government which is cowering under the wrath of the foreign funded activists in a province where the bulk of the revenue comes from resources. Especially if you do not wish to include the land transfer taxes from Asian funded transactions that makes Vancouver’s real estate unaffordable for the average Vancouverite. Then ask the Saskatchewan government where their reinvigorated economic growth is coming from; ask Newfoundlanders what the source is of their newly found wealth?
Quebec is in my mind the province that is most skilled at cutting of its own nose to spite those that it resents. Look at their language laws; look at their self-imposed handicaps and their proportionally shrinking population. They will protect and protest themselves into oblivion. The latest fiasco is their moratorium on the gas industry. I admire Quebec’s culture and it is truly a ‘Belle Provence’; it also has the same faults as its French cousins: its self-righteousness and its cultural arrogance.
So, is there anyone whom I haven’t upset yet? Ladies and Gentlemen, life is about balance and I fear that the current focus of the NIMBYs and Environment Activism is out of balance. Just like we were a few years ago out of balance on ‘Global Warming’, Canada's Human Rights tribunals, plain old ‘Communism’ and before that on “Capitalism’ and on…  Something that may be quite beneficial but that in overdose becomes fatal.
Right now, the oversensitivity regarding our pipelines, and the oil industry in general, as displayed by the NIMBY's and the environmental activists is threatening Canada's chance of continued prosperity. No duck can die, no fish can be found deformed by simple decay, and no barrel of oil can be spilled without hysterical screams of indignation, sincere and false, coming out of the mouthpieces of these groups which in turn are amplified by our sensationalizing media. We are rapidly approaching the point where NIMBY and environmental action groups are becoming a force of destruction rather than preservation.

Artificially low interest rates not the way out of our current malaise

The U.S. Central bank follows a policy of artificial low interest rates and the Bank of Canada follows. In Europe, the large sovereign debts of many countries have come home to roost and the U.S. is not far behind.  Is 7% interest rates the magic limit for Italian and Spanish debt?  Who knows and who cares.  While both U.S. governments and European governments scale back their hiring, corporations are flush with cash but afraid of using it.  In the meantime banks and insurance companies see their profits stagnate due to either too low a profit margin on loans or over-anxious lending practices that make only the very rich credit worthy.
Is this the way out or is this the way to prolong today’s economic malaise?  Let’s look at baby boomers – the Canadian baby boomers. They are reaching retirement age, but how much is needed to retire?  The average Canadian household spends around $50.000 per year; 3% of households have a net worth over $ 1 million with the average household net worth set at $370K or so. Where is most of that net worth invested? It is tied up in our homes.
Think about it. Only the top 3% of households owns a million and most of that is in real estate. So how much are the liquid funds that generate retirement income? The average Canadian house is worth around $350K; millionaires have probably houses in the $500,000 to $700,000 range.  So how much retirement income is their non-real estate assets generating at 1% percent per year interest rates? Yep, around $3,000 to $4,000. The stock market hasn’t been very good for most Canadians over the last ten years – many are barely breaking even. Is that freedom 55 at $3000 to $4000 per year?  Oh, and then one has to pay taxes and one has to re-invest to keep up with inflation.  So how many baby boomers can live of $1,000 per year? Once our 'affluent' babyboomer is sixty five, or better sixty seven, add to that a 'generous' Canadian pension.  For that flamboyant lifestyle the baby boomer needs a $1million net worth or more. And that is for only 3% of the babyboomers what about all the others?
Really, the low interest rate policies of the central banks are costing baby boomers dearly. No wonder they have to work longer.  Yes, it is also social interaction and a longer healthier live that has baby boomers abandon their early retirement dreams. But above all it is plain economic necessity. Finally the kids are out of the house and now the golden earnings years where many people start to save more seriously for retirement are here. But guess what, trying to cling on to these supposedly easy savings is a lot tougher than many expected. You’re doing well if you’ve broken even since 2008.
 The baby boomers keep on working longer and thus there is no big job vacuum for younger generations to fill up. On the contrary the youngsters have to compete against the much more experienced baby boomers. They have to compete with their Mom and Dad for jobs. No wonder, youth unemployment is fairly high in Canada and sky-high in some European countries. On top of it, in its infinite wisdom governments are implementing austerity measures reducing the number of jobs even further and companies do hire but as little as possible because no one seems to know what tomorrow brings and everyone is risk averse to the extreme.
The need for a diversified portfolio has never been higher. I don’t mean a diversified stock portfolio but rather a portfolio of all kinds of investments that have one thing in common:  they create positive cash flow. Whether it is from mortgage investment companies paying yields of 6 to 8%; from real estate rental income yielding between 3 - 6% or dividends yields of 3% or more on large conservatively run companies such as Canadian Banks, real estate companies such as Brookfield; conglomerates such as Power Corp, BCE, TELUS, Rogers, GE, Kraft, JNJ. And last but not least our Low PE and moderate dividend portfolio. A 1% GIC won’t do unless it is cashable and available at a moment’s notice. 
You will need the patience of Job and overtime this mess will be sorted out. 1% won’t do. You’ll need an overall portfolio cash flow of 3% plus appreciation (however slow) protecting you over the long run from inflation. More austerity leads to even fewer jobs and the prolonged low interest rates won’t stimulate the economy such as demonstrated by all those companies that have more cash than they’ll need.  So, urge your private sector leaders; your politicians and your central banks of stopping these low interest rate games because it impoverishes everyone. Artificial low interest rates should be raised to above the current inflation rate and with the historical profit margin added. That means in my books an interest rate of 3 to 4%. Still low but not artificially low. At least then, some of Canada’s baby boomer can afford to retire and in turn allow more youngsters to enter the work place.

Sunday, July 15, 2012

Viable Stock Market Investments – Conclusions

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

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

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

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

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

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

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

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

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

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

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

Regarding share valuation

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

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

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

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

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

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

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

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

Friday, July 13, 2012

Viable Stock Market Investments – Part VI

We have looked at the financial statements of corporations with unlimited growth potential. We learned that their growth rate is dependent and limited by their return on equity unless they use leverage (or issue shares). We have looked at an example of a company with nearly unlimited growth potential Microsoft. First we thought that there was virtually no debt financing, but then we realized that deferred taxes, accounts payable and potential legal liabilities also are forms of leverage but at an interest rate that is virtually zero. It is not only the debt equity ratio that should be considered; one also has to look at the ratio of liabilities (excluding shareholder equity)/shareholder equity

We have gotten insight into the IPO deals that are offered to investors and learned that the initial (founding) investors make out like bandits along with the investment bankers that administer the IPOs. We also learned that there is a significant difference in valuing an investment based on book value and based on earnings. This is why founding investors do so well and today, we’ll focus on whether there is a lesson for our own investment strategies (other than avoiding IPOs).
Now, we’re looking at companies that have mature growth prospects, companies that don’t have revenue grow faster than nominal GDP. We often pay attention to real GDP growth, i.e. economic growth adjusted for inflation. But really the economic output is also affected by inflation as it drives revenue up when product prices increase and it also drives up the cost of production, hence nominal GDP growth is also very important.
We assume that in spite of being in a mature market the competition is not strong enough that companies cannot increase their product prices at the same rate as inflation. Also, we ignore the impact of economy-of-scale and that unit production costs are optimum and cannot be lowered.

We’re starting with the unlevered or debt free company:
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Figure 1. Debt Free Income Statement
Basically we’re noting that if return on equity doesn’t change (figure 2) then net earnings grow at the same rate as revenue growth - in this case at the same growth rate as nominal GDP or 5%. To keep up with demand, each year part of the net income has to be invested to expand product at a compound rate of 5%. Note a compound rate of 5% equals an annual rate of 5.1%

The remainder of net income is paid to the investors as dividend. So let’s look at the balance sheet and at the Per Share Numbers and Ratios in figure 2.
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Figure 2 Debt Free Balance Sheet and Per Share Numbers and Ratios.
Each year, we retain enough net income to expand production by 5% and return the remainder to the investor as a dividend. This results in a payout ratio (Dividends/Net Income) of 44%. The retained earnings are each year added to shareholder equity. Note that in our spreadsheets we’re adding the retained earnings to shareholder equity at the beginning of each year while in many real financial statements, retained earnings are calculated on a cumulative basis.

Since there is no debt, the companies total asset value is shareholder equity. As stated in our initial posts of this series, there are 10 million outstanding shares, thus in year 1, the net earnings per shares are 18 million divided by 10 million or $1.80 per share as shown under the ‘Per Share Numbers and Ratios’. Since net income growths at a compound rate of 5% and a non-compounded rate of 5.1% so do the earnings per share provided that no new shares are issued or no shares are bought back.
The dividends paid out in Year 1 are 80 cents per share and based on the book value per share that is a yield (dividend/share price) of 4%. Return on equity doesn’t change because the profit margin doesn’t change and neither does tax rates and interest rates.

During year 1, the company went public and did an initial public share offering (IPO). Here is the thing all investors should pay attention to! Initial investors or founding investors paid book value for their shares. In other words, they paid for the assets of the company. But the stock market investors often pay for the company’s earnings. How much profit do these assets make for me?  Stock market investors ask how much they earn on each dollar invested not how much they pay for the company’s assets.
Thus, the new stock is often priced at the same rate as shares of competing companies. In our example, companies in the same industry as our company are valued by the stock market at PEs ranging from 11 to 13. As our company enters the market, the issuers of the IPO (founding investors and their investment bankers) want to sell at the highest possible price; the stock market investors want a new ‘fast growing’ profitable company at an attractive price. So, they agree to price the IPO at 12x earnings or 12 x $1.80 = $21.60.  The founding members paid $20 for each share, so their profit is $1.60 for the year or 8%. They also made sure they collect the year’s dividend before going public and thus collected another 80 cents. That is a dividend yield of 4% based on their $20 investment. Yet, in later years, the dividend yield is based on the stock market share price and if the shares keep trading at 12x earnings, the dividend yield for the IPO buyers is 3.9%
Thus for the founding shareholders, return on their shares including dividends is 12% (8%+4%) in year one, while in later years, the return is only 8.9% Now what do you think that leverage would do to this scenario?
At the start of year 1, the founding shareholders went to the credit market and obtained debt equal to 50% of their total assets. Thus, shareholder equity was $100 million and debt was $100 million creating the same $200 million asset value as the debt free company has. With the same profit margin, they also had an operating profit of $20 million from which they paid taxes and interest on the debt. Since the interest was paid to create the business, it is part of the costs of doing business and thus it is tax deductible.
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Figure 3. Income Statement of levered company
Hence, income before taxes is operating income minus interest or $17 million resulting in taxes of $1.7 million rather than $2 million for the debt free company. Effectively, the levered company does not pay $3 million but only $2.7 million for its credit.

Still, Net Income of $15.3 million is less than the $18 million for the debt free company and so is net income per share: $1.53 versus $1.80. Dividends however are higher because to grow by 5%, only half the expansion costs are paid from net income, the rest is borrowed! The shares pay $1.03 instead of $0.80 in dividend. The payout ratio is a lot higher: 67% instead of 44% of net income is paid out to investors.

With the company going public in year 1, the founding investors receive a dividend yield of 10.3% on their initial investment of $10 per share versus 4% for the founding investors of debt free company which made 80 cents on $20 invested.  Also, the return on their equity (earnings/equity) has increased dramatically from 9% to a whopping 15.3%. But that is nothing compared to the profits they make when going to the stock market.
Remember: the stock market pays for earnings, the founding investors paid for assets! At 12x earnings the stock of the levered company sells for 12 x $1.53 or $18.36 slightly less than the debt free company. But the profit is $8.36 on $10 invested or 83.6% rather than 8%! If you add the dividend yield the founding investors made in year 1 93.9% or $ 9.39 per share!
Also, the stock market investors make out better than those in the debt free company because their ROIs in the following years are 10.9% versus 8.9%. But… that is only true when things go as planned. The public shareholders in the levered company incur a lot higher risk than those in the debt free company as shown in an earlier post of this series.
Not only that. What if the shareowners of the now public debt free company decide to take on 50% debt? Where would the profits go? Yes, they would go through the roof for the stock market investors would bought the IPO because those shareholders bought a company at a price much closer to book value than the ones in the levered company.
Benjamin Graham, the mentor of Warren Buffett and the father of value investing, wanted only to buy companies at book value, or even better, at a 10% discount of book value just to be safe! To do so, you have to buy during market down turns, when there is ‘blood in the street’ and when investors are in a panic selling at ridiculous low P/Es and often at low price to book values.
Our accounting system is not perfect. There is room for number fudging and also, it is basically geared towards manufacturing companies. How would you reflect the rising value of real estate in a company?  How would you reflect the asset value increase in an oil company that has added new oil and gas reserves or whose reserves value has changed along with changing oil and gas prices. How do you reflect the value of patents and other intellectual property owned by companies such as Apple and Microsoft?
We’ll talk about that a bit more in our concluding post(s) on this topic.
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Figure 4 Balance Sheet and Per Share Numbers and Ratios of levered company

Saturday, July 7, 2012

Viable Stock Market Investments – Part V

Profits are the revenues of a company minus the costs of its products which are sometimes called operating expenses. These profits are similar to the net operating income from a rental property. Those who read my earlier posts about viable real estate investments must see the next step coming: “How is all this financed?” What is the financial structure of this investment?

In real estate, the rental property is paid for by the down payment (investor equity) and the mortgage. In the corporation, this is in fact exactly the same. The company’s assets that enable it to operate (produce and sell its products or services) are financed also out of shareholder equity and corporate debt. Corporate debts are typically loans that are virtually never repaid. This is similar to government bonds. 
The corporation usually pays interest but rarely pays back the principal or loan amount; the face value of the bond. In this it differs from classic real estate where the debt service payments comprise both interest and repayment of some of the outstanding debt or mortgage principal.
So, you may have figured out by now that just like with real estate, Net Operating Income or Operating Profit or Funds from operations, don’t encompass the entire income statement. We have to pay interest on debt and strangely enough, we also have to pay taxes!  And finally, one of the tools that is so often abused in corporate finance and contrary to most real estate, our machinery and equipment is used up – it gets worn out or becomes obsolete. This is what we call ‘depreciation’ or when it involves paying off a major multi-year expense it may be called ‘amortization’.
Thus the Operating Profit is sometimes called “Earnings before Interest, Taxes, Depreciation and Amortization’ which is then abbreviated to EBITDA. Basically, depreciation is nothing more than a ‘savings account’ where part of the profits are ‘put aside’ to replace machinery that gets worn out and that needs to be replaced somewhere in the future. Amortization is a bit similar, but relates to building and land expenses that really don’t get ‘worn out’ but whose purchase price is not paid out of the operating profits at once but bit by bit over many years – Amortized is the official term.
I said that corporate debt, like government debt, is rarely repaid. The reason is that ‘leverage’ increases the earnings per share as discussed in our previous posts. Thus, a corporate bond often has an expiry date at which time the lenders or creditors have to be repaid. Repayment is often done by taking out another corporate loan or ‘bond’ at the time of expiry of the older bond and the proceeds are used to pay back the older bond. “The debt is rolled over” in other words, the debt will never repaid. Bonds and other forms of debt (e.g. bank loans) that expire within the current operating year are called current liabilities. Current liabilities are also invoices that haven’t been paid yet; ‘accounts payable’ which are basically short term loans provided by the corporation’s suppliers. Also, there may be deferred taxes owed to the government that are due and they also form part of the ‘current liabilities’.
Offsetting the current liabilities are current assets. Current assets (or working capital) are readily available for operations (e.g. to pay salaries, rent, etc.), they include cash and short term investments (e.g. money market funds),accounts receivable (bills to be collected within the current year), pre-paid expenses and goodies that are in inventory and that are to be sold within the operating year. So current assets are offset by current liabilities and the difference is called ‘Net working capital’. Net working capital is an indicator as to how liquid or capable a company is to fund current operations and expiring debt.
Working capital and the fixed assets such as machinery and buildings are making up the corporation’s operating capital which is in turn funded by shareholder equity, corporate debt and other liabilities. Enough said; time for Microsoft!
In 2011, Microsoft has no debts that require significant interest payments. It has to pay taxes though. There is no equipment or significant depreciation or amortization. All its research and product development is paid out of sales revenue and considered part of the production costs. Now talk about being profitable!
There are other companies that have very little assets, Engineering Procurement Companies (EPCs) like SNC-Lavalin. They can rent their offices and hire and fire their assets - engineering and support staff - with little notice. Of course, staff can leave the company as well and start working for a competitor or the EPC’s clients on short notice. SNC’s real assets are its client base and the project contracts. So what are you buying when you invest in SNC or Fluor or Bantrel?  Recognize some risk?
Microsoft has ‘only’ $12 billion in long term debt.  But it also owes another $11 billion in deferred taxes (read interest free loan from the government) and other liabilities such as moneys reserved for legal liabilities in ongoing court cases as well as patents and licenses that have to be paid for; etc.  If you add this all up then in 2011 Microsoft had $51 billion in liabilities (both current as well as long term) and $57 billion in shareholder equity. Total assets (operating capital) were $51 plus $57 billion or $108 billion.
So let’s now first complete the income statement:
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In 2011, EBITDA or operating profits were $28 billion; it paid no interest but owed $5 billion income taxes. Thus its NET INCOME, the profits owned by its shareholders, was $23 billion! That is $23 billion buckaroos to be divided amongst 8.4 billion shares or $2.75 per share. The company’s shares trade currently for $30 per share or a price earnings ratio of 9.37

What do shareholders do with their net earnings? Well, here lies the problem: Shareholders own but do not control the profits. That is done by management and the board. They determine how much of the profits are paid out to shareholders as dividends, how much is paid for share-repurchasing and how much is used for re-investment in corporate growth.
Now the question arises from those that read my postings about how debt increases corporate net earnings and earnings per share: how much leverage does Microsoft use? You could say $11.9 billion or you could say 11.9 billion plus $39.7 billion in interest free other liabilities, i.e. $51 billion.

But really, did you forget about Microsoft’s current assets? What about its cash and short term investments to be precise? Some is needed to pay for daily expenses but all $53 billion? Are you kidding? Basically, Microsoft has so much cash that most of it is just laying around ‘doing nothing’. All this cash is waiting for what? Paying off Microsoft’s interest free liabilities? Why? Maybe Microsoft should pay of its low interest $11.9 billion in debt? It could be done in one fell swoop and its net operating earnings would not suffer and its profit margin would still be an incredible 40%. Or…
Fifty-two billion buckeroos owned by 8.5 billion shares or $6.26 per share could be paid out tomorrow as a special dividend. That would be on top of its normal dividend of $5.3 billion and another $8.2 billion paid out as share buybacks out of net income!
So really, when you own a Microsoft share of $30 you could tomorrow receive $6.26 cash if Bill Gates and Steve Balmer say so (because you have no control). Your real Microsoft share price is: $30-6.26= $23.74 and with that you earned $2.75 in 2011 and possible 10 to 15% more next year! Microsoft’s real P/E is 8.6 which is unheard of so cheap! You pay a P/E of 11 for the typical Canadian Bank one of the most solid and stale investments in the world!  In 2001 investors were willing to buy Microsoft for a P/E of 60!
Oh BTW, those 2001 investors did not receive a dividend of $0.64 per share and per year nor did the company buy back its shares at a rate of 2.6% per year. The $14.6 billion of 2009 net earnings had to be shared by 8.9 billion shares or $1.62 per share. Since then Microsoft has bought back nearly 500 million shares. If that same profit was divided by Microsoft’s current 8.4 billion outstanding shares each share earned: $1.72 instead of $1.62. Buying back shares is a different way of paying shareholders that is tax free!  In fact, although net earnings overall have increased by 29.4% per year, earnings per share have increased an even more impressive $33.8% PER YEAR!
In the meantime the current black mood in the markets doesn’t recognize the stellar performance of this company. To be honest, the stellar performance of Apple is barely recognized either.  It is not that companies don’t perform in the current economy. Rather it is the investor who can’t recognize true value when it is dangled right in front of his nose! A nose that is plugged with the soot of the European Crisis and the ‘slow growth’ of the North American economy!
Many of the multinational companies offer incredible rewards for investors willing to buy them in today’s stock market. They will be doubly rewarded when corporations once again use leverage to fund their operations. Yes, of course leverage will come back, it will be used appropriately by current managers and boards or it will be done for them by new management as nearly happened a couple of years ago at BCE. Boy; did that company wake up! Or as happened a few months back at sleepy CP Rail!  That is capitalism for you! If current management does not use its resources in a prudent but efficient manner a new management will come in appointed by the shareholders or by a corporate raider who merges with or takes over the company. Yes as individual shareholders we don’t have control but if a corporation does not perform to its full potential the market will somehow force it. In requiem Blackberry?
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Viable Stock Market Investments – Part IV

Let’s look at a real life but simplified example: Microsoft. This is not a recommendation to buy or sell Microsoft. This is just an example and neither do I warrant that the data used is correct. In fact, Microsoft’s financials are way too complex to down load from a website such as Globe Investor or Yahoo.  The data contains contradictions or is incomplete and I adjusted numbers to fit in our example.
We’re looking at this data as if we are the business owner rather than the traditional ‘make-a-quick-buck’ stock market investor who moves in and out of the stock at the first whiff of good or bad news.  In the end, we all want to invest our money to make more money; the ultimate goal being the ability to have your money work for you rather than you working for money.
In fact, we’re not that different from the business owner, who also wants to have his money work for him rather than the other way around. The difference is, you sit in your arm chair or are employed elsewhere (passive investor) and the business owner works for his company (active investor). In fact, each investor in rental properties is a business owner as well. The real estate investor runs everyday her rental company; she maintains the property or have a rental manager do this for her (I am using ‘her’ although I do know that there are male investors as wellJ), she sets the rental rates based on the market, she arranges for financing, manages cash flow, etc., etc.
But in the end, both the passive investor and the active business owner investor, both draw a salary, cash flow (dividends) and have appreciating and growing assets. The active investor controls the business; the passive investor does not. Apart from control, there is no real difference and thus we should know and understand how our business makes money and how much. We also should expect like any business owner to hold on through good and bad times. If we think the business model has changed and results become unpredictable, we should consider selling. If the business is no longer viable sell it or its assets and use the proceeds to invest elsewhere. 
There is another investor out there, the trader. The trader doesn’t care about the underlying business. He cares only about buying an investment product and selling it at a profit. Sometimes he loses money and at other times he wins. Investors such as me do all three: I do active investing (I own rental real estate and a real corporation), I do passive investing – I am a small silent partner in a ‘Mortgage Investment Corporation’ or MIC, I am a silent partner in a joint real estate venture and I own shares in public companies. I also trade on occasion – sometimes, a minor bit in stock arbitrage and in options.  Whatever I do, I have to keep in mind what kind of investment I do. Is this deal a trade, an active or a passive investment? Many investors don’t know what type of investor they are or what kind of deals they are doing – this is where many lose their shirt.
Warren Buffett does everything as well, but he is best known for investing in stock of public companies. He is a passive investor in those cases but still often sits on the board of directors of his investments and he looks at their financial statements. His buddy, William Gates used to be an active investor with Microsoft but now he has moved on to the Bill and Melinda Foundation and leaves the work in the hands of his university friend Steve Ballmer. If you are an owner of Microsoft shares then you’re buddies with both Steve and Bill. If they understand where Microsoft’s money comes from shouldn’t you as well?
Every company provides a service or product that it makes at a certain cost (expenses) and sells at a profit  (Operating Income) for a certain price (revenue). Microsoft sold $70 billion of goodies in 2011. Two years earlier, in 2009 it sold $58 billion. On average it sold each year 10% more. With Windows 8, the windows phone and the Surface tablets coming that revenue growth is likely to accelerateeven further.
It cost $42 billion and $39 billion to make those goodies in 2011 and 2009 respectively. In other words, Microsoft sold 10% more per year for goods that cost it 4.2% more per year to produce. Guess what, their operating profit increased from $20 billion to $ 28 or it increased by 21% per year. Microsoft’s profit margin (profit divided by the costs to produce) increased from 34% to 40% - not did Microsoft sell more, they also produced each goodie at a lower price!
Now that is a good looking business wouldn’t you say?  Not something you learned from the newspaper headlines, he?  No, from the headlines you would think that Microsoft is passé!  
If we used the new profits to reinvest, we could create next year 40% more goods. We could sell for a profit margin of 40% or better if we could lower our production costs per unit. That is if market demand also grows by at least 40%!

A lot of products are sold at a much higher profit margin when they just come out and after that competition will force the profit margin down. If Microsoft had never developed newer and better versions of Windows, Office or Xbox games, its customers would have switched to Linux, Apple Macintosh, Sony, Playstation, Firefox, Google Chrome, Android, etc, etc. Its profit margin would have dropped to the point that nobody makes a profit.
That is what happened with cell and smartphone producers. Everyone is making them in a brutally competitive market where only Samsung and Apple are currently profitable! Look what happened to PC makers – last year even HP wanted to stop making desktops and they gave up on tablets within months after launching it!  Microsoft’s profit margin is currently 40% and it is climbing! Apple’s is 23%
In other words, Microsoft’s profit margin could allow it to grow its production by 40% while Apple could only grow by 23%. Of course a company can borrow more money or issue more shares to build more facilities. But that falls under financing and the balance sheet; we will talk more about that later. It must be clear by now, that in today’s competitive high-tech market both Apple and Microsoft are formidable competitors – both with a good chance to exist still a hundred of years from now similar to companies such as CocaCola, IBM, Johnson and Johnson, GE, Ford, GM and RCA.  Oops!  RCA the television maker did bite the dust and GM and Ford were nearly bankrupt in 2008. That is the world of competition! Even after being in business for a hundred years you are not safe. Neither was the world dominance of the U.S. China, Russia, the British Empire, the Ottoman Empire or Rome and Greece. Greece? Italy?  Well, you get my drift.
He Godfried, did you learn all that from a financial statement?  Wow man!  But I digress. In fact, we did not learn this from the financial statements; we learned it from looking at the INCOME Statement only. The numbers are shown below. As I said:’high school math’. You’d think that the news media could do that wouldn’t you?
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See you next post! Then we’ll discuss Microsoft’s Balance Sheet. We don’t want you to get a headache.
We? The royal ‘I’? Godfried it’s all going to your head!