Saturday, July 27, 2013

Part 2. Stop Loss – Are you ready to take the emotions out of your stock selling? Play hearts!

In between this post and the previous one, I stopped to play a couple of rounds of hearts. I am grim because I lost more rounds then I won! It was better for me to stop playing than trying to force my luck and risking my objectivity in the game play. Sometimes, you keep on playing, often without pleasure or interest in the hope that the odds of the game will favour you. Typically when that happens you have become half an automaton and you’d likely play the newly obtained hand poorly without even recognizing the favorable card distribution… how investment-like!

‘Stop-losses’ are much alike to deciding to take a break from the game rather than waiting for better odds. Tomorrow when you play again, even with the same hands you may do better because you’re rested and more focussed on the game. The stop-loss strategy is just like one of the play strategies you’d teach yourself for a playing a particular game. Before your market position turns for the worst, you'd take a breather. If you lose more than 15, 20 or 25% from the stock’s recent price peak or from your recent purchase then sell it no matter what and take a break. Go back to the drawing board!  
Heck! With current low discount brokerage commissions, in theory, right after executing the stop loss,  you could be back in the market for under 10 bucks. But is it wise to go back into the market just after a stop loss is triggered? That could be one of your other game strategies! Once a stop loss is triggered you must wait at least 3 months before repurchasing the stock. And/or you don’t get back in ,until the stock price is trading once again above its 50-day- moving average. Whatever your fancy; but stick with it!

Part 1. Stop Loss – Are you ready to take the emotions out of your stock selling? Play hearts!

Investing is a continuous process of learning, experimentation and self-assessment. I used to play as a student card games, I played evenings away with my parents and friends typically hearts or gin rummy. Whenever I come home after work feeling too tired to do anything, I often turn on the computer and play hearts. You’d think that by now, I’d play the game to perfection but still I win only 50% of the time. There is the chance element, but there is also the ongoing process of still improving my game play. One of the toughest things in the game is to count the cards every time you play a round; it takes effort and concentration and a memory that doesn’t mix up the count with counts from the 10 previous games. Even then, you cannot take into account the randomness of card distributions and the logical or illogical decisions of the computer or people you play with. What about your own condition, do you feel too tired to think? Are you in a mood of consistent logic or are you in a ‘who cares' mood. Are you willing to take a risk that night or are you playing it conservatively?
Investing is a lot more complex than playing hearts, but in many ways it is also has a lot in common with playing games like hearts. It is in my opinion not surprising that a guy like Warren Buffett is so hooked on playing bridge that he bought his first computer to play bridge. I don’t have the patience to play bridge; I am more a ‘hearts’ guy and maybe that is why Warren is doing so much better than me as an investor. The same discipline that is required to play bridge is also making him such a logical investor. Whenever you hear Warren talk about investing it is about numbers; odds and selecting high quality companies with predictable earnings but even more, I sometimes think, with an honest and dedicated management. All decision skills required in the bridge game.
It is true, that your investment personality comes out when you play cards or play golf. I am not a great golf player; I am not even an average golf player but from what I have seen on the odd occasion playing it is that it is a great way to learn about your own investment habits and behavior. Next time you have a chance, asses your sense of risk tolerance and the manner of your decision making on the golf course. If you an el-cheapo like me, maybe play hearts instead.

Thursday, July 25, 2013

This bull market has still a lot of steam

You may have the impression that the world stock markets would do a lot better if only China’s economy resumed its leadership. But in my opinion, nothing is further from the truth. First of all let’s look at those incredible GDP numbers that China posts at regular time intervals. Any western economy would kill for such growth, but if the Chinese economy really grows at 7 or 7.5% per year then why is China’s demand for commodities so far down the drain? Why are we even in a commodity bear market? If their GDP grows so much then their demand for natural resources should still grow at an impressive rate especially when combined with the economic growth of other emerging markets.

Then we hear that this month’s PMI (Purchasing Manager Index) in China fell below 50% suggesting a shrinking manufacturing sector. How do you do that while the economy is supposedly growing at a torrid 7.5% or so? There are also the Chinese banking and/or shadow banking crises. So, the Chinese ‘Wunder’ may not be so wonderful after all!
Really, ask yourself, why is Chinese output dropping? Why is, as its GDP numbers suggest, China’s economy drastically slowing? The answer, my friend, is not blowing in the wind! The answer lies in falling exports – or better lower imports from China by the Developed World! You see, in spite of all the Chinese hubris about the U.S. dollar not being a reserve currency anymore, China desperately needs those U.S. Dollars or better it needs the U.S. and European consumer to buy its products. China will apply every trick in the book to sell their products as cheap as they can using not only low labour costs but also all kinds of hidden subsidies to export to the West while creating all kinds of barriers for the Chinese people to buy from the West. Because if we, the West, don’t buy the Chinese ‘Wunder’ is over! If we don’t put massive investment dollars into China to build ever more factories, the Chinese public has no longer the money to speculate on their overvalued real estate markets.
So, Chinese growth of GDP is not a leading indicator of how the world and the world stock markets are going to do; rather it is a lagging indicator. First the Western economies of Europe and the U.S. will have to turn around and then the Chinese will follow. Not only the Chinese economy but most of the other emerging economies as well depend on the return of the Western Consumer. Even if these emerging economies will start to pick up steam again, it is far from certain that the Chinese stocks will benefit as well. In the past during times of high economic growth, Western investors in Chinese and other emerging markets only made moderate returns in highly volatile stock markets – so don’t count on highly profitable Chinese stock market results showing up in your portfolio anytime soon.
China being dependant on the Western world rather than the other way around is not such an amazing fact. Combining the U.S. and European economies, we’re talking about 34 trillion dollar of annual GDP compared to China’s 7 to 8 trillion dollars depending on whose statistics you believe.
European stock markets have been going up over the last year or so, recovering slowly from the 2008 financial crisis and the 2011-2012 European debt crisis. The U.S. has done better and its stock markets have been recovering from the lows of 2009 to new all-time highs. The recoveries in both super economies have been slow and somewhat steady. Now finally, we see more small investors – “Mom & Pop investors” - returning to the stock markets; they are slowly overcoming their fear of stock market volatility.

Stock markets are often leading indicators for improving economic conditions. Thus I foresee continued economic improvement for at least another six months. Combined with the QE (Quantitative Easing) and ECB Bond-Buy-Back safety-nets nearly guaranteeing at least some economic growth, I foresee that European and U.S. economies will not encounter a serious recession for at least another 2 years.  Since stock markets are still cheap on a Price/Earnings basis – especially considering today’s continuing low interest rate environment, stock markets should stay in bull market territory at least until 2015 if not longer. The bull market will last until investors turn irrationally bullish once again, the precursor of Mr. Market’s inevitable revenge in the form of the sudden on-set of a bear market.
Will it be more difficult to find stock market bargains from now on? You bet and I recommend taking from time to time some profits off the table; thus building up cash reserves for the next big crash. Don’t be afraid to let your profits run though; but also consider the use of ‘stop losses’ to ensure that you don’t give back all those hard earned profits in a sudden market crash.
For now, this is my most likely scenario: the U.S. in particular will benefit from the energy revolution resulting in cheap to affordable energy prices that will form the basis for a new manufacturing and high-tech boom in North America. A recovery in Europe will go hand in hand with that in the U.S. The European recovery will be less vigorous because of resistance to adapting the new drilling and production technologies that led to the U.S. Energy Revolution. Europe is much denser populated than North America thus the chance of experiencing a massive drilling and fracking operation (if permitted) under your house would be more likely in Europe than here in North America - hence the opposition. However, If you don’t believe that Europe has a magnificent competitive manufacturing sector capable of recovering significantly then count the number of BMWs and Mercedes on Alberta’s roads!  
With the improving European and U.S. economies, demand for resources will go up, in particular natural gas and to a lesser degree oil (whose prices are already approaching the economic limit) and you’ll see Canadian stocks slowly exiting the current commodity bear market. With increased Western consumer confidence, Chinese exports and thus its economy will improve in turn. Maybe levels of 10%+ GDP growth will be increasingly more difficult to achieve considering the current large size of China’s economy. However 8 to 9% GDP growth is definitely in the cards. That in turn will put Canadian and Australian commodity dominated stock markets back on fire. A booming Canadian stock market will also be the signal that we’re rapidly approaching the next economic cliff and stock market crash. Something that may not happen until 2016. If this scenario plays out, you may look back in 2016 and realize that we have been experiencing history’s longest lasting bull market!
This is not to say that between now and 2016 there won’t be scary moments and nasty corrections. Stock markets and economies don’t tend to go up in a straight line; more likely they will zigzag. So, focus on only investing in good value and sell your poor businesses. Avoid speculation and remember that over the long run, moderate dividend payers that consistently grow their dividends are often the best market performers – no matter what the interest-rate chickens may hysterically shout in the newspapers.

Over the near future, I suggest to invest in U.S. broad market indexes and in European markets, in particular those of Northern Europe (Germany, England, and Holland). Investing in Southern Europe is probably more risky but also potentially more profitable. Don’t forget to invest a portion of your investment funds here at home: banks, insurance, telecom are most promising. Later in the cycle ad more resource companies such as fertilizer and oil/gas producers – possibly even some miners (but that is getting pretty risky in my books).
Over the coming years interest rates are likely to return to more normal levels; we probably will even see inflation returning. It may be worthwhile in the later years of this extended business cycle to again buy some fixed income investments but that is still a long time out. For now, if you do invest in fixed income don’t lock in for more than a year or two and be prepared to share your meager profits with the tax-man.

Friday, July 5, 2013

“Boohoo-yahoo!” says the market.

2008 – 2010 and even the summers of 2011 and 2012 were traumatic times for many investors. As such, the skittishness and risk aversion in the market is easy to understand. But is this market response due to realistic expectations or due to the much acclaimed ‘recency effect’? An effect resulting from the still fresh memories of those traumatic events and forgetting about the long-term behaviour of stocks and investments in general. And yes, 2008 was one of the more severe bear markets in the last hundred years, but the stock market did not drop that much more from its peak than say in 1980-1982; the first major bear market in my adult life. That one is still a deep scar in my personal memory and 2008-2010 for me does not feel as bad.

Now that interest rates finally start to return to a more normal level compared to inflation, the markets panic instead of rejoice. Yes, corporate profits, at first sight may be somewhat suffering because of the slightly higher costs of money.
But let us put this in perspective. With interest rates rising from say 1% to 2.5% (something that would be a lot worse than we’re really experiencing), $100 borrowed would have interest payments going from $ 1 to $2.5. Now if the enterprise value of a company is around $1000 and it has an operating (EBITDA)/enterprise value  ratio of 10x or it earns 10% on its assets, then how would those earnings be affected?  Say the company has an loan to value ratio of 40% then it would have debt equal to 0.4 x $1000 = $400 and that would mean its interest payments have risen from $4 (4 x $1 interest per $100 borrowed) to $10. If operating earnings at $4 interest payments were $100 then Net Earnings (not counting taxes and depreciation) would be $100 - 4 = $96 and at the new higher interest rate those Net Earnings would be $100 – $10) = $90. That represents a drop of 6.3% in Net Earnings and thus its stock value should fall a maximum of 6.3%.
BUT interest rates are increasing because the economy is improving and thus so should the company’s revenues!   Even if those revenues only increased by 4%, because of economies of scale operating profits would likely increase to 5 or 6%.  For example, if the company’s manufacturing plant usage in the 1%-interest-rate economy was 80% then that extra 4% in sales in the 2.5%-interest-rate economy results in increased plant usage. (A plant which runs at certain fixed costs produces now more products at the same fixed costs; that should result in cheaper production costs and thus a higher profit margin.)
Thus operating earnings of $100 should increase to $106 and when you deduct from that the interest payment increase of $10 - $4 =$6, earnings basically stay the same at $100.  In real life, in the U.S., junk bond yields have increased dramatically (J) from 5.8 to 6.3% if I recall correctly, that is not even close to the more than doubled rates in our example.
Now ask yourself whether the recent interest increases in the real market justify say BCE losing 15% of its share price? Of course not, what we have seen lately is nothing more than the hysterical, schizophrenic market in 'over-reaction' mode. With a better economy not only do interest rates rise, but sales are also rising thus improving the profit margins for many companies.
Why do the interest rates rise? Well when sales increase, everybody wants to borrow money to expand and thus the demand for more loans and thus… higher interest rates. That brings us to the second part of this posting.
What’s this kafuffle about inflation?  Well, as one may inspect in real life, everything is relative. You see there are  at least two different ways of measuring inflation. There is inflation due to increased cost of living. This is expressed in the Consumer Price Index or CPI. The CPI has shown very little movement in terms of cost-of-living. Then there are many others, often the gold-bugs, who state that inflation is the ‘speed of money’ or the 'velocity' at which money is circulating through our economy. I am quoting here:

Economists have a term for how quickly money cycles through the economy. They call it “velocity,” and it’s defined as the average frequency with which a unit of money is spent in a specific period of time. As spending increases, or the money supply tightens, velocity increases, and vice versa. In practice, velocity is often calculated as the Gross Domestic Product (GDP) divided by the money supply.

In simple terms, higher values [inflation] reflect a relatively more free-spending society, with each dollar cycling through the economy more quickly. Lower values, on the other hand, indicate a relatively stingier society, in which each dollar circulates through the economy more slowly.

Thus when the central banks buy back bonds and paying for it by printing money, it created ample money supply in the economy; much more than consumers and companies required for loans. The result was artificially low interest rates.

The central banks printed so much money that despite the fact that banks were scared and they started to lend money. The abundance of cheap money available to banks lending it out at higher rates to their most credit worthy clients was too good an opportunity to make big profits and finally the banks caved in and started to lend out money again  at super profits after being paralyzed during the financial crises.

The result was an increase in the speed of money circulating in the economy. The banks started to use these enormous profits to rebuild their balance sheets. Eventuality the affordability of housing ( low prices combined with low mortgage interest rates) resulted in investors and other real estate owners tempted by high profits to return to the U.S. housing market.

In the meantime the speed of money has kept increasing and with that the risk that asset prices and the cost of living will go up. So, the speed-of-money can be considered to represent ‘inflation’. Hence the two schools:  one (especially gold-bugs) stating that inflation is reflected by the speed of money; the other school (including the central banks and government) that inflation is reflected by the CPI.

Gold Bugs love high inflation because they feel that gold is an inflation hedge and thus a high speed of money means higher gold prices. But in this contest of different inflation schools, the central banks appear to win; the idea that inflation, as represented by the CPI, is still far off. The market in general seems to agree with the central banks (for now) – the result is a crash in gold and silver prices.

But as usual, that same market is schizoid. Thus, it also feels that the speed of money has increased by so much that the demand for debt has increased; so much so that it justifies skyrocketing interest rates. Even worse, as shown above, now that same market has concluded that as a result of the rise of interest rates, corporate profits are about to crash and along with it stock prices. “Boohoo-yahoo!” says the market.

So for us ‘cool guys’ we try to get a ‘realistic picture’ as to the current state of affairs. Yes, we’re experiencing an overdone market correction in a mid- stage bull market. A time, during which we can still ‘buy-on-dips’ - provided we see very good value. Also, if you have already made some excellent profits (for example on AutoCanada Inc. - ACQ-T in our Lower PE-Moderate Dividend Portfolio) it may be time to cash some of those profits. A very attractive way to do that is by selling call options as I will describe in a later post. We also should consider moving gradually into fixed income. More about that in yet another later post.