Saturday, October 24, 2015

Investment crystal ball: Demographics and Inflation

I just bought another investment book to read – it came highly recommended. It is written by yet another famous investor: Howard Marks. What makes this book unique is that Mr. Marks writes essays about what he thinks are the most important things an investor should be aware of and three(3) other top investors: Seth Klarman, Christopher C. Davis and Paul Johnson annotate their comments. Wow! This is great fun. 
I just opened the first essay and there in the first paragraph something hit home like a missile: a quote from Benjamin Graham! “The art of investment has one characteristic that is not generally appreciated. A credible, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom” I
So, when you aim to build your retirement nest egg, things don’t have to be difficult you can just buy the entire market and get market performance. Buy a bunch of ETFs and you'll do OK. This simplistic strategy is often advocated on this blog. If your aim is to become one of the great investors then things become a lot more difficult – you have to think out-of-the box and be right and… execute right!  Before doing anything else, ask yourself are you happy with ‘normal’ returns of  4 to 6% above the rate of inflation or are you going to be the next Warren Buffett?
“Because investing is at least as much art as it is science, it’s never my goal … to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic”
I for one, do not have to be a great investor. Having a retirement nest egg that is large enough to have the lifestyle I enjoy and help me achieve my goals in life is enough. For that average market returns from a diversified portfolio with a long term outlook is sufficient. However, for me investing is also intriguing and I want to understand it better as it is such an important part of understanding what makes the world go around… and yes that is one of my personal goals.  
I want to do things that are worthwhile – not just for me but also for my sphere of influence. I have my core portfolio of investments and a portfolio where I experiment to learn and test what works better in today's world.
When looking out over today’s investment landscape I see two common themes: Low economic growth and low inflation if not deflation. Now, if you want to define what inflation and economic growth exactly are, then doing a couple of PHD theses may bring you a tiny step closer. But here they are expressed in terms of simple GDP growth and CPI increases  which should do for now. 
We live indeed in a low growth and low inflation world. Harry Dent one of the world’s most read and most popular demographers showed in the 1980s how demographics, in particular baby boomer demographics, correlates very well with stock market performance.  Dent made a basic assumption – the behavior of a generation follows closely the patterns of previous generations.  Thus you are first a toddler, you go to ECS or Kindergarten, next you are off to elementary school,  high school and then university. You leave your parents’ home, shack up and protest against previous generations (in particular your parents). Next you get married, have a career, have kids, become empty nester, retire and die. Just lovely!
As a child you earn no money and you costs your parents a lot of money. Also the state will invest a lot in your education without getting an immediate return. So the idea was that after buying their first home, a lot of baby boomers would not only incur a mortgage but also have a lot of expensive kids while governments incurred a lot of deficits to finance the education of those kids. In other words lots of debt by governments and parents as well as a booming economy with high inflation. Next the baby boomer's kids get older and earn their own money while baby boomers themselves pay down their debts and save for retirement rather than spend. Same for governments, especially if later generations are smaller and have less children.  In that stage deficits fall and so do interest rates while economic growth slows and while inflation falls.  That is basically what has happened happening from 1980 until now. 
Today we live in a period where baby boomers are saving more, borrowing less and buying less real estate; that translates into low economic growth and low inflation.  China seemed to be our savior in terms of economic growth, but guess what; the effects of their one-child-per-family policy created a graying population in China as well.  Japan was a bit ahead of the curve and so it had its lost decade a bit earlier (starting with the 1989 crash?). Europe lies in between Japan and North America demographically - hence the European debt crisis and quantitative easing.
BUT… BUT…  is it all demographics and is there no hope?  Well, Harry Dent’s assumption was that all generations have similar spending patterns over their lives and that is a gross oversimplification if not untrue. We’re forgetting that the world is changing at ever increasing rates.  I am not kidding; progress was minimal and glacially slow [pun intended] during prehistoric time. There were few inventions like fire, wheel, spear etc. During the middle ages people definitely lived in a different world with some progress and things started evolve at a slightly more measurable rate during the industrial revolution. 
So yes, new generations used to live similar lives as their parents did. But in the 20th century, we progressed dramatically and when the baby boomers came in, the mantra was that this was a generation that did everything different than their parents. Now progress is accelerating even more with the advance of computers and the internet. Next industrial internet, 3-D printing, immunology, biotech, etc. We're changing at mind numbing speed.
You may have read on this block that medical science advances our life-expectancy now nearly one year per year. That means we  theoretically have become immortal. Just do the math: my life expectancy is around 84 years but next year it will be 85 years and in 2017 my life expectancy will be 86 years. Now with progress in medicine accelerating what will my life expectancy be in 2020? 93 years or even older? Yes young man, we’re theoretically immortal unless we (better you) are hit by a truck or if you think that quality of life is unimportant (I am talking about becoming a vegetable)! 
Point is that behavior of generations do change. Look at this example on a small macro-economic aspect. The millennium generation is as large if not larger than the baby boomer generation. But with baby boomers reaching retirement the economy has slowed dramatically. So now it is difficult for millenniums to have a secure income (made even worse by changing technology and associated productivity). The effect: the millennium generation experiences a delayed adult hood. They can’t afford to life on their own and stay longer with Mommy and Daddy; they won’t start families right away or buy houses as early as the baby boomers did. Spending behavior of the millennium generation has shifted to later years if it hasn’t changed entirely.
That is why demographic patterns aren’t as predictable as Mr. Dent assumed. The same is true for energy and metals. Everything is changing and this makes our world much less predictable, So my expectation is that Millenniums are likely to form families and buy houses over the coming 5 years and thus economic growth will resume and so stock markets and investment returns will go back to ‘normal’. 
However, it is also forecast that later this century worldwide population growth is likely to slow down or even stagnate. Our workplace will change dramatically. Not everyone will have a traditional job; a basic form of lifestyle may become quite comfortable and affordable  for everyone while our economic system changes dramatically. What if food comes from a replicator and is just an energy conversion? What if robotic labor becomes the norm and persons are not part of the manufacturing process. Instead they pursue their own goals which not necessarily result in increased monetary wealth. I wouldn’t be surprised that economic measures such GDP growth become less meaningful and that measurement of personnel wellness becomes critical.
I foresee a significant change in our capitalistic society coming soon in a neighborhood near you. Here is another ‘tiny change’ coming up right now! Alarm Force and other home security companies may be passé with the rise of Nest thermostats, Camera’s and Smoke Alarms; with Lutron Light switches and garage doors opened from a cell phone. My 1980s house was just converted to a ‘smart home’ for around $1000.00 Good riddance Protectron or ADP.
My feeling is that over the long term technology is likely to cause significant deflation – much more than the cheap labor costs of China ever did. This will be bad for credit markets and retirees living on fixed income. To offset this will be governments that continue printing money and quantitative easing that hollow out our monetary system because our meaningless GDP numbers will falsely indicate continued 'slow' growth. Interest rate policy appears to have become ineffective if not obsolete. Yet, our lifestyle will continue to improve. 
What this all will mean for the economic stability of our society and the nations we currently live in?  I have a feeling that social change may prove to get even more dramatic than technological change. I hope we can avoid internet lynching of people’s reputation but I feel this trend is just the beginning.
Imagine this. Alberta’s latest premier Rachel Notley has been given a majority and 4 year mandate – although more because of disenchantment with the Conservatives than a strong believe in Notley’s NDP. The Royalty Review and New Climate Change policy turn not out to be what the average Albertan really wanted. Next thing, Notley’s gives a speech that is not entirely politically correct – especially when taken out-of-context.  Or worse, Notley is caught on a security camera kicking her cat in the elevator. A YouTube video on the topic goes viral and 4 hours later the internet lynch mob demands resignation of Notley and here NDP cabinet. With her moral credibility destroyed in hours, will her government survive? What would be the effect on our democracy if she perished despite a legal election and the 4 year mandate given to her just a few months earlier? If you think this cannot happen I urge you to think again.
So with this in mind how do you feel about Demographics and inflation?  Is the present still key to the past, as they say in geology?  Is the present key to forecasting the future or are we standing at the dawn of an entirely new world with the rules of economics and investing about to change completely?  Would you still live in a house? Would you still eat?  Would need you need heating and other forms of energy?  I would invest in hard assets – assets that are not depending on the mood swings of central banks and public policy. But I also would look forward with eagerness to a world that continuously changes (in general) for the better.

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.

Saturday, October 3, 2015

A look in the investment crystal ball: Introduction

Although we cannot predict the future, investors should have an idea about where the world is going. It is important to have investment scenarios that range from optimistic to outright doom – these prepare you for what to do when encountering the good, the bad and the …. J. These scenarios often revolve around your core outlook for the world.

Note, I don’t say just Canada because we need a wider view.  Harry S. Dent provided me with a view of demographics.  Jeff Rubin helped me about a view on oil and gas. I also use investment research groups such as Stansberry in the U.S. to develop my views and techniques. There are also Warren Buffett; Jeremy Siegel; David Dreman; Peter Thiel and many others. But in the end, I must have a view of my own, just as you should. Your view continuously changes as does the world. The future is definitely not cast in stone and there are so many aspects to take into account. It is hard to fathom an individual – no matter how bright – who can encompass all.  So we see the world from our personal point of view and we’re biasing our own future vision based on it.

That is what is investing all about:  to ensure we have the funds and means to make our goals in life real. Your goals probably will change – the only thing that is certain in this world is that things change! You may reach one or all of your goals, but then what?  You make new goals!  People say that the rich have never enough – that is not quite correct.  Rich and/or successful people (these are not exactly the same) reach goals and just like anyone else, they will have to find new challenges. Thus, one strives always for bigger and better.  If you stop doing so, your survival muscles atrophy and you may just as well die.  Extremely stated? Maybe but there is a lot of truth in that statement.

These days we see ever more uncertainty and noise, so where do I think we’re going? To answer that, I’ll try to create a series of posts each addressing one or two topics. I hope I won’t ramble too much but please, give me some rope…. J

  1.  What is investing – what am I? Buy and Hold, Diversified; Focused; Trader; Speculator; Accumulator; Seven income streams?
  2. Demographics and inflation
  3. GDP worldwide, debt and Inflation – Hoax, delusion or maybe even irrelevant?
  4. Energy
  5. Immortality
  6. Technology
  7. Star Trek – vision and future reality? What about Robert Heinlein?
From the topics you may gather than I am reading a fair bit. Yes, but in spurts – sometimes fiction and other times non-fiction.  It all helps me form a worldview. Should I include BNN and similar business programs or Home and Garden TV?  I love Netflix these days especially BBC style crime series. They all provide me with pieces of life’s puzzle – some more than others.  In fact, apart from reading and watching good TV series, the successful investor should like travel – it shows you how others live and helps you better understand where they are coming from. By the way, music is important too – it calms you during periods of investment panic and it lets you better appreciate the successes in your life. So investing helps you achieve your life goals but it also sets your lifestyle. Watching commercial TV channels such as CTV, ABS and CBC will quickly become tedious and as a successful investor you’ll be living with your eyes wide open (except for politics and petty local news). You may become a bit too money focused – that is where vacations help.  Anyway, I digress, next post is in the making.