Saturday, October 10, 2015

Investment crystal ball: What is investing?

Investing is to ensure we have the funds and means to make our goals in life real. It is that simple. It is about generating cash flow. Cash flow reinvestment should help protect us against inflation that may reduce, over time,  our existing cash flow to zero purchasing power. Cash flow enables us to live our lifestyle and help us realize our goals in life.
We can generate cash flow through a job, through working as a self-employed or as an employee.  This type of cash flow will only last as long as we have the ability to sell our sweaty labor in an economic attractive fashion. This ability is likely to diminish with time as we either lose our motivation to work or as we lose our physical (or mental) ability to perform the job.  The main, and hopefully durable, way to generate cash flow is to own assets that throw off cash such as rental property, stocks, fixed income.
Investing is about acquiring assets that generate cash flow. The art is to buy those assets as cheap as possible while the assets produce maximum cash flow. The cash flow is typically generated in two ways: 
  1.  The asset appreciates (capital gains) and its subsequently sold or
  2.  The asset produces a continuous income stream. 
 Appreciation can be achieved by purchasing assets below asset value and then selling them  for a higher price. Generally, if an asset is productive and throws of ever increasing amounts of profits  then the value of the asset increases as well. But other factors may also result in appreciation.
Selling an asset purely because it has increased in value regardless of the reason it has done so , is often considered trading or speculation. There are many ways to make money from investment quality assets but I consider investing strictly as the process of purchasing assets for the purpose of generating cash flow.  This cash flow hopefully increases over time to keep up with inflation or more.

How does an asset increase its cash flow?  Well, with real estate, cash flow is thrown off in the form of rental income (minus operating expenses). The cash flow can be used to reinvest in the property itself (paying off the mortgage or renovating), or for buying another property, either will lead to higher rental income and more valuable assets. A property with increasing rental income often experiences property value appreciation. Both appreciation and rental increases are often a function of population growth; economic growth and inflation. 

Typically inflation increases the value of the property and leverage translates that in equity growth at a rate exceeding the inflation rate.  The beauty of real estate is that with time the mortgage value in terms of purchasing power goes to zero because of inflation, while simultaneously the cash flow portion used to make the mortgage payments reduces the principal ultimately to zero as well. Overtime, with your mortgage value decreasing, your return on equity will grow at slower and slower rates until it equals the annual appreciation of the property plus the cap rate. This results in maximum cash flow. With high leverage (e.g. loan-to-value = 80%) your total return can be 15% or in some examples infinite (nothing down) but net cash flow is nearly zero. So real estate can deliver very high rates of return  and little cash flow or modest returns with high net cash flow - take your pick.
When dealing with stocks, leverage plays a role as well. One should never forget the corporate debt a company has. Unlike the real estate investor, the amount of leverage (and often the level of risk) is beyond control of the shareholder/investor. Debt levels are determined by the company’s management and it can greatly increase or decrease a company’s net earnings. High earnings are not only a function of operating profits (often expressed as EBITDA) but they are also a function of the financial structure of a company, in particular of its debt.  Companies throw off earnings that can be used for re-investment, acquisitions, stock-buy-backs and dividends.

Dividends paid by a company is the cash flow for the investor and it can make up to 40% of the profits on a long time stock investment. Dividends compound overtime as a result of inflation and real profit growth. Appreciation of companies are due to capital efficiency (improving the bottom line by management actions); market share growth and inflation. With growing income the company grows in size (often to an optimum size where after many companies decline and ultimately disappear).

Corporate earnings growth results in share price appreciation.  Thus it is important to know how much a company earns as a proportion of its book value (return on equity) and as a proportion of its market value (price/earnings ratio or the inverse: earnings yield).  Earnings yield, the earnings expressed  as a percentage of its market value (the total value of its outstanding shares at current market price) is comparable with the bank rate or the yield on 5 or 10 year government bond. Earnings yield is typically higher because corporate earnings are often more volatile than interest earned on government bonds (yield).
Earnings yield, government bond rates, cap rate plus rate of appreciation are ways of comparing the performance of various investment classes. Due to all kinds of investment risk, it is important to have a portfolio of diversifying investment asset classes and profitability can be expressed as weight averaged return of all the investment classes together.  Thus when comparing your returns from a certain asset class one should compare it with like assets. For example compare the return on Canadian stocks with those of the entire Canadian stock market (TSX 300) and don’t forget to exclude your cash holdings as they are an entirely different asset class than stocks!

You may have heard the statement that every millionaire has at least 7 streams of income. Well that is the real basis of a diversified investment portfolio. For example: Stream 1 can be your daily job; Stream 2 can be your company or a royalty income; Stream 3 can be Real Estate; Stream 4 can be Fixed Income; Stream 5 is possibly dividends from a Stock Portfolio; Stream 6 may be proceeds from options trading and Stream 7 can be appreciation of gold or art or collector items such as antique cars. Within those streams you can diversify as well and when dealing with stock portfolios and fixed income this is especially worthwhile.
So we’re buying assets that throw off cash flow, we’re not traders or speculators. Are you buying a house every week and sell it 30 days later? Are you working with a different employer every week and does your business fluctuate billions of dollars in value every day or two?  No of course not. Investors should buy assets for the long term and often benefit more the longer they hold those assets. Asset appreciation is of secondary importance - it will take care of itself. It is an asset's ability to throw off secure cash flow to live from and to reinvest that is our primary goal.

The long term value of an asset is determined by the amount of cash flow it throws of and its growth in ownership equity (both a function of earnings growth).  There often is a great difference between the value of your asset and what the market pays you for that asset. That is, why the price you pay for your assets is very important – that is why you want to buy good assets when nobody else sees their value while you buy them cheap.  On the other hand, there is a trade-off between waiting for the cheap price but missing out on cash flow and paying a bit more for the asset but collecting a long stream of cash flow starting immediately. Although you bought the asset not at rock bottom prices a good income stream may make the asset more profitable than one bought at rock bottom prices after a long wait. 

One should always evaluate what a good price is considering current conditions because it may allow you to collect significant cash flow which can be a big part of your profit. That is where the term GARP comes in: buying Good Assets at Reasonable Price. The art is to determine what a reasonable price is!  An important part of valuation is how fast a company grows and consequently how fast its earnings grow. The GARP acronym is a bit bastardized in the above text. It really means  Growth At a Reasonable Price.  Whatever interpretation you prefer, the key is to buy assets at a reasonable price during every stage of a market – as always there are many ways to skin a cat, more important is that you know why you skin a cat!
The bulk of my portfolio is based on the criteria described above and the longer I invest, the more I strive to own capital efficient investments that throw of reliable growing cash flow over the long term. However, I also use a small portion of my portfolio to increase that income. He who owns assets has options (different ways of making money). And… this includes option trading (pun intended).  Option trading is a whole topic on its own and forms an important ingredient for profiting both in bull and bear market. You should only trade options of companies you wish to own or better in assets you wish to own. After all you could sell an option to someone who wants to buy your house for a certain price (strike price) somewhere within the next 6 months (term of option). Options are an important tool for risk management – one that I am just starting to learn. It also is a topic beyond the current post topic and we’ll revisit it in the future.
So why is it important to have a crystal ball as an investor ? It is to help define what long term assets are likely to meet your current and future needs. It is not to forecast short term market fluctuations, because not many 'investors', in spite of their claims, can do that consistently right. But a long term vision for both the world we live in AND your goals in life will help determine where you’re putting your money.

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