Sunday, January 26, 2014

Basic stock investing - Valuation

Last week we discussed how to value a business and how business ownership differs from fixed income instruments such as GICs, savings accounts and investing in debt in general. We concluded that you own a business or a share of a business in order to own the profits on the business’ assets. The value of the business can be determined in terms of a basic price earnings ratio e.g. a P/E = 10 or the inverse which is called earnings yield (net earnings divided by business price). You can also determine the value of a business by calculating the net present value of its projected (net) earnings typically going out 25 years and using a minimum required return on investment or discount rate which often is set at 10%. Earlier posts on Microsoft and Intel provide examples of how to calculate a company’s intrinsic value. BTW I don’t guarantee the correctness of these calculations; I just try to give you a taste of how to estimate intrinsic value.

Using an APOD spreadsheet, you can similarly put a value on a rental property. These valuation methods are strictly based on the income from the assets not about how the MARKET values those assets. This is the big issue where so many investors get confused. Comparing a rental property’s actual value with market value should show you how to buy not only real estate but any form of investments – including stocks. You see, net income for a piece of real estate comes from two sources – appreciation and net operating income (NOI).  Net operating income is the money that remains after all operating expenses such as property tax; utilities; management fees and maintenance have been paid. Just like earnings yield in stocks, we’re dividing NOI by the purchase price or property value to calculate the ‘capitalization rate’ or cap rate for short.
Typically in Calgary, Alberta the cap rate for single rental properties such as a town house or apartment is around 3-4%.  In areas of lower population growth and thus often lower rates of appreciation, the cap rate is typically higher. During the 2008-2010 period in the U.S. you could find properties with cap rates in the 8 to 10% range. It really depends a lot on the location of a property, the local economy and demographics. I am talking about long term average cap rates, because cap rates just like earning yields fluctuate and sometimes can be quite volatile. Once you determine a rental property’s net operating income you divide it by the cap rate to get an idea of its business value.
For example: a rental property in Calgary, where the cap rate typically hovers around 3.5%, has an estimated NOI of $10,000 per year. Then that property’s value should be $10,000 divided by 3.5% = $286,000. Alternatively, you could calculate the projected NOI over the next 25 years to come up with the intrinsic value of a rental property similar as I did for stocks using an investor’s required rate of return on investment (ROI) as discount rate.
Now that you know how much your rental business (property) is worth based on its income you may want to acquire it (for the right price). To buy or sell a piece of real estate you have only one place to go: the local real estate market. Just like in the stock market, pricing in the local real estate market follows often the Don McLean song: ‘The more you pay, the more it is worth.’ The market valuation of any investment depends on the current mood of the market and a combination of fundamentals, personal perceptions, the current economy, hysteria or schizophrenia and whatever else – some markets even respond to sun spot patterns if you believe Harry Dent. It tells you what you can get for a property if sold ‘right now’. It is a bit like you sometimes hear on Dragon’s Den: “Do the deal now or I walk! 1, 2… 3… Gone, I am out”. The current market price is only important if you have to sell or buy RIGHT NOW. Do you have to buy a property at market price well above the business’ intrinsic value?  No! The patient investor can wait until he or she feels the price is right. What is the right price? It is the price which provides you the return on investment that you demand!  If 10% return is your required minimum then that is what you base the intrinsic value on!  So don’t buy at market prices above intrinsic value because your return will be less! That is exactly how guys like Warren Buffett invest they only buy at or below their estimated intrinsic value.
The same for selling an investment. The higher the market price is above intrinsic value, the lower your return on investment will be if from then on forward if you don’t sell and hold on. Of course the higher the market price the higher the risk is ending up with less money when holding on! Thus if the market price would only equal the intrinsic value using a discount rate of 2% that is probably when you want to sell. The market price is then too good to be true and it is time to cash in on the appreciation of the property.
During times of market undervaluation, only those who do not have the financial strength to hold on to a property have no choice but to sell at the price a market offers you. Avoid getting in that position. The only other reason to sell below intrinsic value is when you see another investment with a better return and, hopefully, with similar or less risk. That brings us to the topic of risk which is not only a post by itself but probably justifies reading many books.

Sunday, January 19, 2014

Basic stock investing compared to fixed income

When investing in stocks, people are overwhelmed by ratios and widely diverging views of ‘experts’. But in principle all you do is buying an interest in a business. There are numerous businesses in this world and many are doing very well thank you!
As an owner of a common stock or share, you own part of a business. That typically means, you own part of the business assets but also of the liabilities.  The purpose of the business is to use its assets to sell products or services for a profit and you as one of the business owners get a part of the profits. Profits go up or down all the time but hopefully over time the business grows and with it the profits grow. Liabilities are owed taxes, shareholder loans and debt to third party lenders (creditors). Normally, you as owner would be responsible for those liabilities, e.g. if debt wasn’t paid the lenders can go after you personally. 
However, when you are incorporated the business is considered to be a legal entity or legal person by itself; just like you or me are. No not quite, owning another person is considered slavery and today, in most countries, that is considered illegal. Owning an incorporated business is obviously different in this regards – besides if you own a small incorporated company, you’re likely to work for that company rather than the other way around as would be the case with slavery. Of course, when the company grows overtime, you are likely to hire staff and there may come a time that you no longer have to work for the company but just collect its profits.
You could even own your company together with other partners or sell parts of the company to investors outside your normal sphere of influence with whom you share the profits. If those other investors are not active in the day to day business and if they count in the hundreds or even millions then your company has probably taken the step of 'going public’ and it’s shares of ownership trade on one or more stock markets.
My father owned a sporting goods store, which was a business that was profitable over many years until his retirement. My family lived of my father’s income as an employee of the company and of parts of the profits that were paid out as distributions or dividend. The rest of the profits were reinvested in the business for growth and for expansion like the purchase of a sewing machine to produce tents for camping. My father started out as the sole proprietor but overtime using reinvested profits he grew the company and finally my father incorporated. By the time my father was in a position to expand to multiple stores he was too old and the banks didn’t want to help finance this further expansion. Since me and my siblings were not interested in running the company, my father retired and folded the business.
But whether you own shares in my father’s company or in a publicly traded company, the principle remains the same. Share owners or stock holders own a company to make a profit and use these profits to expand and/or to pay out part of the profits to live off or to invest elsewhere.  Also, profits can be used to buy out partners and divide future profits amongst less owners (each remaining owner thus getting a larger part of the profit pie). In publicly owned companies we call this 'share buybacks'.
How much was my father’s store worth?
Well, like any investment, say like a GIC or a bond, it depends on its yield!  How much money does it make?  If I just put money on a bank account the interest I make is my return (with the expectation of getting also my invested money back in one piece). If I am willing to make a long term commitment of not taking my money out for a year or for several years then my money can be used for mortgages or business loans. This represents a more desirable form of money than that in a savings account and it is also a bit riskier for me to lend that money out over a longer time span. Thus I will be paid a higher interest rate.

Now, when money is lend then the interest rates of the loan typically does not change. However, if I put that same money into a working interest of a company, then instead of a fixed income stream, I’ll get a share of the profits and in theory these profits may grow without limits. Yes it is risky, but with corporate growth my share of the profit grows and so does the value of my share of the company.

Thus the question arises how much is that share worth?  Would you be happy to get the same return as when you put the money in a savings account or GIC? Heck No. Running a business is risky! So you want a higher return. Also, part of your profits are reinvested and you never will see that money in your own wallet unless you sell your share in the company. Thus, yes the value of your company grows but what is in it for you?  That part of the company’s profits paid out to you is called dividends and the ratio of dividends divided by the value of your share of the company is called dividend yield.  If you take the company’s total earnings (i.e. including that portion that is used for reinvestment) then we’re talking about ‘earnings yield’ rather than dividend yield.
 Investors like Warren Buffett compare the earnings yield with that of the interest paid on a 10 year loan to the government which is typically considered one of the safest sources of investment return. Investors, of course, want to have a little bit of a ‘risk premium’ for investing in a company rather than in the government Thus, if a 10 year government loan or bond pays 4% interest then an investor in a company may want to have an earnings yield of at least double that; say 10%.  As a rule of thumb, many investors would like to have an earnings yield of 10% or in other words, they like to get $1 earnings for every 10 dollars invested in a company. That ladies and gentlemen is called the Price (of a share)/Earnings (of a share) or P/E ratio.
Typically, a company is worth 10 times its net earnings. Now, please, tell me: If a company earns $1 per year per share and if you paid for a share a P/E of 10, then what would cause that $10 share to go up in value? Right! For the share price to increase in value the earnings per share will have to increase. So if my profits margin does not change and next year I would sell 10% more in goods, then my profits would increase by 10% as well. Using a P/E of 10, then my company would be worth 10x $1 plus the 10 cents in profit increase = 10 times $1.10 or $11.
Say, I sell a product, say ‘macaroni and cheese’ which everybody eats at least twice a week and absolute no more (when eating too much they get sick of it - ‘macaroni and cheese’ poisoning) then I could only increase my profits if the population grew. In more general terms, I would only sell more if the economy grew, i.e. GDP or Gross Domestic Product. Gross Domestic Product defines the amount of stuff our economy produces per year and typically the profits of our companies cannot increase more than the economy; say 4mto 5% per year.  Thus, if a company’s value equals 10 times its earnings and if those earnings do not grow more than the overall economy then the share price would increase typically by 4 to 5%. 
 If you could forecast how much a company earns over the next 25 years (or its life) and you wanted to earn every year 10% (P/E = 10) then you can calculate what that company’s intrinsic value is. How to calculate intrinsic value was presented in an earlier post – click here
In summary, when investing money into your savings account, in a GIC, or in a loan, you fix your return equal to the interest rate but when you invest in a corporation and buy ownership you share in its profit which has the capacity to increase almost infinitely (or… decrease to a unlimited loss).  That is where the idea of increased return with increased risk comes from. But avid readers of this blog know that not all risk is created equal and neither are companies. Thus, although a P/E of 10 may be a general acceptable number for evaluating a company’s value, in the real world this ratio may vary widely between companies and we will talk about that in future posts

Neil Young Bluster and Godfried Rant

I currently work in the oil industry and so, by Eastern Canadian definition my opinion is suspicious while $70 million dollar worth Californian Neil Young’s opinion is trustworthy because he is such a great Canadian singer.  Oh, he flew a few minutes over an oil sands facility with a photographer and is obviously an unbiased expert. Yeah right!  He may mean well when he spends his time in a burned out basement with the full moon in his eyes. But really, do his over-the-top statements open a discussion on the oil sands?  I had the impression that everyone in this country and in the U.S. has been discussing oil sands nearly as long as I can remember.  The oil sands discussion is nearly as polarized as abortion or global warming, eh… climate change. The latest term ‘climate change’ is truly hilarious. Climate has changed since the dawn of time, or better since the creation of this planet 5 billion years or so ago.
Just because I work in the oil industry does not mean I am a big oil crony without integrity. I do not need to work anymore.  Remember reading my profile?  I am a financial adult, i.e. my income is virtually independent of my employer. But unlike Neil, I do use oil and gas and coal and iron ore and gold ore and potash and meat and many other things in my life.  I even use bank and brokerage accounts and thus I am obviously a crony of big banking. I must be the devil personified because I am a ‘one per center’, oil crony, big bank buddy and…. currently I am voting conservative (barring any real serious alternatives).  How amazing that I don’t fall for aspiring demagogues like Justin T and Thomas M!  And what is the impact of voting for Green Party leader Elizabeth May?
No, I am independent of the oil industry (as far as anyone can be independent of this high impact industry); yes I own a few oil and gas stocks but most of my holdings are in physical real estate, banking, insurance and U.S. stocks.  Then why do I work in the oil industry?  I have been thinking about life and came to the following simple conclusion: When everything is brought down to its essence, the question is what the meaning of the existence of a God is.  The answer is probably something like that God exists because he exists and that the meaning of his existence is exactly the same as ours (maybe not yours but surely mine): we don’t exist to die as the ultimate goal in life! We live to travel towards a goal no matter what that goal is. It is the manner in which we travel towards our end rather than the end itself that counts.  It is not about our place in history – we all, no matter how famous, will fade into nothingness over the eons.  Whether there is a continuing existence after this life is immaterial for us now!  As such, we must aim to travel well along the road of life because if not, we’re wasting the only thing that counts. For me life is a valuable gift and I want do something valuable with it.  Yes, it may be valuable for someone to be always on vacation, but that is not the case for me. I want to be contributing to my life and to that of those around me… possibly have even a positive impact on people beyond my immediate sphere of influence.

That is why I work in the oil industry, to help find energy in a responsible way for me and my fellow creatures on this earth – I would like to include the entire universe and possibly even God but then I know a bit about my limits. I like to find and exploit our oil and gas resources as efficiently and sustainably as possible. We live in a somewhat capitalist system. I do not want that a lot different – the current economic and social systems in Canada combine profit, personal accountability and social responsibility close to optimum.  Yes nothing is perfect and yes there are always successful and less successful people, no matter how you describe success.
I live in Alberta which right now, in my books, is one of the best places on earth to live! We have a beautiful nature – mountains and prairies. Our climate is close to superb: a clear winter and summer and, less nice, messy falls and springs.  No even the fall here is spectacular. We have only 4 million people living in Alberta. For comparison: the Netherlands, another excellent place to live, counts sixteen million people living in an area that fits between Calgary and Edmonton.  I live less than  an hour’s drive from the spectacular Rocky Mountains or the semi-arid plains of Southern Alberta. So why would I and many other Albertans wish to destroy this fantastic country? Just so we can buy another micro-wave oven of 55 inch TV?  You know, for a good retirement life I need only $30,000 or so per year plus a nice place to live.  As such why would I destroy the world around me for just more money?  No life is not about money it is about how we live and how we benefit those around us.


Here is a photo of our spectacular nature just 50 minutes outside Calgary and there is so much more. Neil Young, I appreciate your good intentions but, please, just shut up if the only thing you do is creating divisiveness. Yes, a bunch of teenagers commenting on the Globe & Mail ranting and raving against the world as it is that I can understand. But a winner of the Order of Canada with 75 years-plus life experience, from you I expect a more sophisticated view of life. Neil, goddammit, Grow Up! You were my favorite teenage rock star, I can’t count how often I played ‘After the Gold Rush’ but man you should now be 40 years wiser!

Friday, January 10, 2014

How many Americans will be killed before Obama approves keystone?

Bakken oil is light oil and explosive, that is why every week now we're hearing about exploding trains all over North America. But here is an US president fearing a backfired environmental activist vote and plays as a consequence with American lives.

The U.S.A. is not likely to become energy sufficient, so why not approve Keystone rather than importing oil from South American and Middle Eastern dictatorships? Do you really believe that those dictators are concerned about the environment like Canada is?

Mr. Obama is playing politics on the backs of U.S. citizens and supports the same dictatorships that help terrorism and that threaten the U.S.A. Meanwhile he doesn't mind offending his friendly neighbors in the North. Now that is true statesmanship! People in the U.S. wake up and recognize bad politics when you see it!

Sunday, January 5, 2014

How to protect your profits using collared options

In the previous post on protecting profits we discusses selling call options to force you to take profits rather than getting carried away by greed in the last stage of a bull market. Selling a call option in fact, limits your upside (a bit), because after the underlying share price exceeds the call option’s strike price you as writer of the option are obliged to sell your shares at that strike price; this caps or limits your upside.

Of course, with today’s low discount brokerage commissions it doesn’t take much to repurchase the assigned (and sold) shares for around the same price or, upon a small market pull back repurchase the shares at a slightly lower price. When doing so you once again may write new call options against the repurchased price - often with a slightly higher strike price. As long as the market keeps on going up there is no problem. But the higher the market goes… the closer the crash and the higher the risk of not being able to bail out and likely holding your shares all the way to the next bear market bottom.  For a buy and hold investor with lots of patience, that may not really pose a problem. But it robs you of cash to buy great companies for dirt cheap prices near the upcoming bear market bottom.  That is what this is all about: building cash for the next crash!
The emergency break – the price stop set at 25% below the last market high or your most recent purchase price (whichever is higher) may still protect you and provides still a bail out well off the next bear bottom but that is still  a 25% drop! So if we sell call options forces us to sell near a market peak is there a way to reduce the downside better than a 25% loss from the last peak?
Yes! We can collar our profit by limiting both upside AND downside.  Instead of pocketing the call option premium, we use the premium proceeds to BUY a put option over the same term as the call option; say 3 months. Buying a put option means that we are buying insurance against a precipitous drop in the price of the underlying shares. A put option is the right to sell a share at a certain price (the strike price) over a certain period of time. Say we collected $150 dollars for selling a call option on 100 TD shares. Now we are using the proceeds to BUY put options for those same 100 TD shares. By owning the put option, we have the right to sell the TD shares at the strike price and thus, we can bail out with no or a limited loss at any market price that TD may have fallen to – possibly far below the strike price of the option during the term of the option. Thus our ‘loss’  is only equal to the difference between the share price at market peak and the strike price of the put option with may be a lot less than the 25% price drop of the stop-loss.
Let’s do an example:      
TD shares are trading at $100 in January. We own 200 shares worth $20,000.  We write a call option with a strike price of 2.5% above the $100 expiring on April 19, 2014 and collect a $200 premium.  We have already a stop loss price for 25% below TD’s latest high of $100); i.e. sell trigger at $75.00 per share. But that is still quite a price drop. What if we could sell at $90 dollars? Wouldn’t that be better?  So, we’re using the proceeds of the call options sale to buy insurance in the form of 200 put options with a strike price of $90 that expires also on April 19, 2014. Since a 10% drop in share price is often less likely than a 2.5% share price increase, the premium of the put option is probably somewhat less than that of the call option we sold. Say the premium is $150 and we still pocket $50 profit on the option trade as a result. There are three scenarios that could happen:
Scenario 1: During the next three months share prices of TD go over $102.50 and TD gets ‘called’. Result, you make an additional $2.5 profit above the $100 price in January (200x2.5 = $500) plus you will likely collect a dividend of around $0.68 cents per share or 200x 0.68 = $136.00. Your put options expire worthless and you collect $200 minus $150 = $50 in option trade profit. A nice return for just 3 months!
Scenario 2: During the next three months share prices of TD do not exceed $102.50 and do not fall below $90. You collect $136.00 in dividend and a $50 option profit. Plus you keep the shares for another day of course. Not much gain but certainly no pain!
Scenario 3: The market goes haywire and TD shares fell to $85 dollars.  You exercise your put option right prior to expiry. Collect $136.00 in dividend; collect $50 in option premium profits and sold at $90, losing $10 dollar from the peak of the market at $100. Thus you still made more than if you sold at the $85 share price at the time of the option expiry. If this was only a correction and at $80  the market turns up again, you can repurchase the TD shares for anywhere between $80 and $85 dollars and be better off than before. If the crash continuous all the way to a bear market bottom typically 50% below the bull market peak, then you’re laughing with cash in your hand ready to buy around the bear’s bottom. Mission accomplished!
You have collared both your upside and your downside and it didn’t cost you a penny. This is a great technique in top-heavy markets – but you have to be on top of things so that can react according to the 3 scenarios.
Just some words of caution: option trading is something you have to learn in tiny steps. I have been trading this stuff now for over 5 years and got only more active over the last 3 years or so. My trades are still small – 2 to 4 contracts at a time. So yes, percentage-wise the profits are huge but the impact on my overall portfolio is still small. Also, check out my post: Outlook 2014 and you see that I am far from bearish. In fact, many market guru predictions are cautious and the market itself, except for some outliers such as Facebook or Twitter, is reasonably priced. I think there is still a lot of room for upside – we’re at ‘the beginning of the last inning’. The last inning may last another year or another two years or… it may be tomorrow! Who knows the future?  I do not longer recommend buying large amounts of stocks nor do I recommend to start selling off the portfolio in a panic. Rather, I suggest looking for clouds appearing at the horizon and start preparing for the coming storm whenever that may happen. ‘Be Prepared’ is the Scout’s motto and so should we.