Saturday, August 3, 2013

Diversification and Investment Timing

Most investment literature follow the mantra on the impossibility of timing, whether it is from Peter Lynch of the famous Fidelity Magellan fund and author of the book ‘One up on Wall Street', contrarian investor David Dreman, or Jeremy Siegel author of ‘Stocks For The Long Run’. So why are we still talking about timing our investment acquisitions?  BTW Jeremy Siegel thinks it likely that the Dow will reach 18,000 by 2014 – click the blue link for a video.

Investing is all about buying at the right price and guess what? When you are at the pricing bottom of any investment market the price may not only be right, it may be ridiculously cheap. So there is a timing element build into investing.
Also, when prices are low market risk for a further drop is low while at high valuations market risk for an upcoming crash is high. Ironically, many pundits will shout hysterically to ‘sell, sell, sell! The market will fall even more!’ at times of market bottoms (because that is how they get their much desired media coverage) and they tend ‘en masse’ to cheer, stating ‘This time it is different; we’re living in a new economy; the market will go much higher!’ near market highs.
Warren Buffett consistently states that investors should NOT overpay; he even comments on his own company – Berkshire Hathaway – often telling the public whether its stock is overvalued or not. So Mr. Buffett and many other legendary investors tend not to make major investments when markets are expensive; sometimes they don't buy for a very long time. Often they ‘underperform the markets’ during years of overpricing while you’ll hear the ‘investment gurus of the day’ shout in the media that ‘Good-old Warren is passé!’  You can bet your last dollar that that is not the case but instead that you’re in an overvalued market.
So, how come that these super investors can wait for years until they get an investment at the right price?  Should you wait and put all your cash into a non-interest paying bank account until the next market crash and bottom?  How many years would that take and what are the opportunity costs of such a strategy?
If you only focus on stock market investing, a strategy of dividend reinvestment may outstrip the profits from a strategy of staying out of the market until the price is right. One of the earlier postings on this blog shows you the math.
However, what when you diversify beyond the stock market, i.e. when true diversification comes in?  When you’re investment targets are not just stocks and bonds, but also real estate, gold, etc. Then there are probably enough market segments that typically are reasonably priced or that are at a market bottom. Professional investors refer to those phenomena as the correlation between asset classes.  If one asset class, say gold, is down you may find another (say oil and gas stocks) is also down; these asset classes correlate well. On the other hand, the gold asset class is often up when manufacturing and financial stocks are down. In that case both asset classes are poorly correlated.  The real estate asset class trails the highs and lows of the stock market by about six months. During stock market crashes, interest rates are often lowered by the central banks and bond prices go up.
Thus, when you are truly diversified, chances are that you don’t have to wait for a long time to see one asset class or another trading at reasonable or at outright cheap prices. Of course, you need to have an idea as to what a ‘reasonable valuation’ represents in both stocks and bonds or real estate. Steve Sjuggerud an analyst at Stansberry Research recently suggested a metric that can be used to value all asset classes more or less with the same yard stick. This may work for you as well. The idea is quite simple: determine based on net cash flow, and in case of stocks that includes the amount of stock buyback programs, how fast it takes for your investment to be paid out.  In case of stocks, take the current stock price and divide it by the sum of the dividends paid to the shareholder plus the amount of money used for that year’s stock buyback program. In Real Estate divide the purchase price of the property by its Net Operating Income.
For example Microsoft pays out $0.92 per year on dividends; stock-buy-backs are roughly 2% of all outstanding shares per year – valued 2% of the current share price = $0.60. So Microsoft returns to its shareholders about $1.52 per share per year. At the current share price of around $30 (let’s keep the numbers simple) a shareholders receives his current investment price of $30.00 per share back in $30/$1.52 = 19.4 years.
If you invest in a one-year GIC that pays an interest rate of 2% per year, then it will take 1/0.02 = 50 years to get your investment money back through interest payments.
The typical rental property in Calgary generates net operating income at 3-3.5% of the property value, this is also referred to as the cap rate. That means you have to collect rents for 1/0.03 = 33.3 years or 1/0.035 = 28.75 years to earn back your initial investment price. Shown below is the payout time of these investments in a small table. Now you can choose on a ‘comparing Apples to Apples’ basis which is currently the best investment. Right, in this case Microsoft  provides the best opportunity.

Asset Class
Payout time (years)
Payout time after tax
Microsoft Shares
19.7
19.7 (in TFSA) or 39.4
GIC
50
50 (in TFSA) or 100
Calgary Rental Property
28.6
28.6

If you want to get even more sophisticated in your selection then use the after-tax return. Real Estate rental income can be offset by capital cost allowance or depreciation – this is only a form of tax deferral until the property is sold. However if you don’t sell the property during your lifetime you won’t have to repay those deferred taxes except upon your death. Have you read my thoughts about immortality?  :) 

Dividends are tax advantaged but are tax sheltered in your Tax Free Savings Account (TFSA). Dividends in an RRSP are basically tax deferred and due when you withdraw funds from your plan.  I assumed in the table above a 50% marginal tax rate.
Now if there was a real estate crash in Calgary and prices fell 35%, the cap rate would skyrocket from 3.5% to 5.4% and the pay-out time would decrease from 28.6 to 18.6 years. So would you then buy Microsoft or Real Estate?  I’m sure you’re getting the point. If Microsoft fell from $30 to $25 dollars its payout would fall to 26.45 years. Did you know that Microsoft traded in 2008 as low as $18?
I guess you’re getting the point. Although it may be near impossible to time market highs and lows,  focussing on the valuation of an investment and using metrics such as payout-time can help you buy the best asset(s) at the best ‘time’, i.e. when there’s ‘blood in the Street!’
Here are some more Jeremy Siegel videos (watch out for when the videos were recorded).

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