Monday, February 17, 2014

Real Estate in Calgary: Boring but quite profitable

I haven’t written a lot about real estate lately. Well the stuff is just boring…. but quite profitable.

 With Calgary’s GDP growth forecasted to be just shy of 4% and with population growth in 2013 at 18,000 and next year's growth forecasted to be around 15,000 what can one wish more? Oh, the unemployment rate is 4.5% or so.

These numbers and the above graphs are courtesy of CREB’s 2014 "Calgary Thriving on Growth" regional housing forecast. GDP growth and net migration are major drivers for future housing sales, rental rates and property prices. The forecast is a bit concerned that with the global economy improving, Calgary may not be that attractive any longer for new-comers. CREB (Calgary Real Estate Board) is also a bit concerned that apartments and townhouses may do better than single family dwellings in the near future as single family dwellings are a bit less affordable. They expect apartment prices to rise around 5.8%. WHAT? WOW! (that is me)

So you want to make a whopping 10% in the stock market next year? Hmmm Let’s do some math. Take the 2013 median apartment price at $250,000; property taxes are around $1200; landlord insurance $230 per year; condo fees around $325 per month or $4200 per year. Hmmm repairs? Only inside the unit (the condo corporation takes care of the rest): $500. Rents are: $1400 with vacancy rates 1.2% Yahoo! 

Based on those numbers. Net Operating Income (NOI) per year is $10,768 or a capitalization rate of 10,768/250,000 = 4.3%.  Add to that the annual appreciation forecasted by CREB of 5.8% and your total return on investment is 10.1%. These returns were calculated with the same spreadsheet as shown below using a Loan-to-value ration = 0 (no debt). 

Now, if you paid down 50% of the purchase price and borrowed the remainder using a 25 year, 5 year term mortgage at an 3.25% interest rate, then the spreadsheet below would calculate a return on your down payment (investment) after financing costs of 16.9%. Now with returns like that, who does need a stock market or for that matter a 5 year GIC that returns you barely 2% per year?

Sunday, February 16, 2014

Taking windfall profits– having your trigger finger on the sell button.

When buying an investment you need to determine beforehand how to exit it. This will help you to develop a selling discipline that will protect you from excessive losses and thus improve your overall portfolio performance.

Exit strategies are:
       1.       Set a target sell price: e.g. 30% above the stock’s current intrinsic value

2.       Sell call options when the overall market becomes too hot (euphoric stage of a bull market) – this forces you to sell while cashing in option premiums (see earlier posts)

3.       Use option collars (combine strategy 2 with buying put options using  the proceeds of the sold call options). This limits your upside and but protects your downside in peaking market bubbles (see earlier posts)

4.       Use stop losses

But what about selling to take a windfall profit?  This is the counter strategy of stop loss selling.
For a stock to become so expensive that it trades 30% above the prevailing intrinsic value may take years if not eternity. For a stock to rise 15 to 20% in a year is not uncommon. For a stock to rise 30% in a month is exceptional and should cause alarm bells to go off. What triggers such alarm bells? Simple, just like you set a trailing stop loss price you have to set a 'take-profits-alarm' price. Let me give you an example:

Source: GlobeinvestorGold

Last year I listened to a pod cast by a trusted investment advisory company (yes, I do listen to others – though not too often J). The advisory recommended to buy Sears below $45 dollars because its real estate holdings were worth much more than its debt and the advisory estimated a net asset value of over $70 per share combined with having a brilliant CEO (Eddie Lampert).  I bought in August  2013 for $43. 
The chart above showed you what happened next. Sears took off with a vengeance and within a couple of months it peaked around $65. This was a lot of profit in a very short time. I made close to 44% in under 3 months or 175% annualized. There was no clear reason for such an explosion in the stock price and thus the alarm bells went off. I watched the stock for a few more days and sold because the profit was just too good to let it slip. I used the ‘take-profit-alarm’ set at 30% above the purchase price ($43+30%= $56) which was triggered in less than a month. Starting at $56 I checked on the stock at least twice-per-day and let it run until the first sign of trouble. The stock price kept on jumping higher and higher and then around $65 I knew this price was too good to be true and sold. Right after I sold the stock it went even higher; all the way to $70 and I regretted briefly my sale. Then in December the stock crashed first to $42 and then all the way down to $30.
One other thing, when I bought my position in August following the recommendation of the advisory service, I just bought a small position – 100 shares – enough to motivate me to monitor the stock and to hopefully build a larger position if the advisory’s recommendation worked out. With the violent uptick in price, I knew something was not normal – I did not risk any further money because I didn’t understand why the stock moved up so fast and I just let the stock ride. It was a thrill ride with only little money (proportionally to the overall portfolio) at risk. I didn’t buy more because I didn’t really know why the stock took off. I hope that you will also stumble across a little windfall like my Sears experience and that you will not get dragged along by emotion and let greed tempt you to buy more. It is fine to put a little bit of money at risk and let it ride. But if there is no obvious reason for a dramatic price increase in a stock you own then have your trigger finger on the sell button.

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!