Saturday, February 1, 2014

Basic Stock investing – reward does often NOT increase with risk!

In the two previous posts we have made the distinction between market or nominal stock value and the intrinsic value of that stock, i.e. the time adjusted value of the company’s future earnings.  Really, you buy a company to own its future profits which can be used for reinvestment, share buyback programs and/or for dividends. Only when you buy or sell your company is the stock market price important to you.

This brings us to perceived risks that are not really there.  Many stock market investors consider the volatility of the stock market share price as risk. That is only true if you have not the financial strength to hold on to your shares in a down market and you are forced to sell at that unfortunate point in time. Many investors and experts use terms like Beta and Alpha and standard deviation.  This is not relevant for our way of investing. Stock market volatility represents true risk for traders, but these guys (and gals) are living in a completely different universe as we do. That isn’t to say that we don’t do short term deals such as buying and selling options but trading is a zero-sum game that more relies on psychology and on the randomness of short term price movements. When trading the purpose of a deal is to sell for a higher price than you bought and usually one party gets the profit and the other gets creamed. That is not our game.
So if price volatility is not an important risk then what is?  Well, have you heard about Yellow Pages, Kodak, and Blackberry?  Our risk is that a previously good business loses its ways and in the extreme goes bankrupt or gets taken over at less than the price you bought it for. This is called business risk. The risk of getting poor management; the risk of product obsolescence; the risk of poor financial structure (too much or too little debt) and rising interest rates than cannot be offset by higher profit margins, etc.
The other major source of risk is failure to sell. We have been talking about buying businesses at a good price, well below their intrinsic value. Such buying opportunities often arise during stock market corrections or during bear markets. We require a minimum return on investment and we use the latter rate to discount the company’s future earnings and estimate it’s intrinsic value. With a rising stock market, the company’s share price will often go higher and higher. If the share price increases along with its profits then the share price often reflects an increasing intrinsic value; it’s Price/Earnings (P/E) ratio doesn’t change. But, especially during bull markets, investors will value those earnings often higher and higher – the P/E ratio or ‘earnings multiple’ rises rather than that earnings increases. Investors pay a higher price for each dollar earned.  That means, investors are happy with an ever smaller return on investment or discount rate and thus estimate a much higher intrinsic business value than you did or do. Look at the table below:
 
The Excel Pivot (or ‘what if’) table shows that depending on the discount rate decrease intrinsic value increases. Thus, if an investor buys at ever higher prices in a bull market, he/she is willing to pay more for the same future earnings than you did when you bought. For most of us, a return on investment of 10% is fine, but when share prices rise in a bull market, new investors are willing to put up with lower and riskier returns. For me, the business owner, I will then have to choose between selling and realizing my gains or holding on to the business and forego the current stock market profits for a decreased return on investment (ROI) going forward.  For example, we buy Intel for $25 dollars per share with the intrinsic value being 71.63 for a potential ROI of 10%.  Next Intel share prices go up to $100. If I sold for that price, I made my 10% annually plus an handsome $75 dollars in capital gains. If I don’t sell, going forward my return on investment should only be 8% unless somebody is willing to pay even more. 
Say Intel goes up in share price to $712 dollars. If I don’t sell, my future earnings will only result in an ROI of 2% with a very high chance that the share price will drop hereafter. So selling at this outrageous price provides me with a $687 capital gain and the chance to reinvest, now or somewhat later down the road again in Intel at a lower price or in another investment opportunity for a much better ROI of say 10%.  Thus, now we have a very unemotional way of determining at what price to sell. Ironically, this is also an excellent way to illustrate that reward does not necessarily rises with risk!  You will get most bang for your buck when you buy good companies when prices are low and everybody is scared – when there is blood in the streets of the financial world and you sell when everybody is euphoric.
Man is a herd animal – our genetic make-up is to feel safe in the crowd. That is true in nature – man as a social herd animal is highly successful. We dominate earth because of our success against other species. But in the investing world we have to be able to ignore our herd mentality and make our own choices regardless of what the herd thinks.  The notion that returns increase with risk is a fallacy that many don’t understand but now this new insight will hopefully provide you with the means of becoming a successful investor with above average returns. Good hunting!

No comments:

Post a Comment