Saturday, March 24, 2018

Get Ready for a stock market Crash!

Fact is that when market prices go higher and outpace earnings it becomes riskier. In the end, a company is valued based on its profits.  I mean its true profits. If those earnings are reported as ‘Net Income’ you include in those earnings the financial manipulations of management often referred to as ‘financial engineering’.  That is why I like to look at the real earnings of a company that it makes from its operations, i.e. EBITDA or earnings before financial engineering.  

Not all financial engineering is bad. We nearly all do it when buying our first residence. Yes, we use a mortgage or debt. In some ways, debt can make home ownership extremely profitable. Say a house, during good times, appreciates in value at a rate of 5% per cent per year. You have bought your residence with 20% down. If your house was bought for $100,000 then after the first year it is worth $105,000 (always more or less because we never really know).  Thus, the profit is $5,000. You bought the house for $20,000 (20% of $100,000). The rest was other people’s money – usually money from a the bank who may have packaged your debt along with that of many others into a structured investment vehicle (SIV, remember 2008) and sold it to investors.  Thus, you financially engineered your home ownership and made $5000 (minus interest paid on the mortgage) on $20,000 or a return of 25% instead of the 5% appreciation. If the house had fallen 5% in value instead, you would have lost close to $5000 including interest payments or 25% as well. The risk of more profits or losses has increased significantly because you used leverage. Today’s homework is for you to figure out if leverage in a house that only appreciates at the rate of inflation can make real money for you.

Say this was not your home but a rental property. After the costs of owning and running the house for a year, you earned also a net operating income of $3000 (typical earnings per $100,000 invested in Calgary real estate). Next, you have to pay out of your EBITDA mortgage interest say $800. Your rental net income is now $2200 plus $5000 in appreciation and your return is $7200 from $20,000 invested or close to 35% per year. You see what your financial engineering achieved?  But… now you have to pay taxes over $2200 net income typically at your marginal tax rate which in Alberta has just increased from 39% to 45% or so (Thanks Mrs. Notley, I hope you are gone by next year). That would put a severe dent in my after-tax profits. So much for all my hard landlord work which is not included as part of the profits. But wait! The land has increased in value, but the house has had a year of wear-and-tear. The government lets me deduct that wear-and-tear from my taxable income so that over time I may have a ‘savings account’ that pays for replacing the worn-out house. That is called depreciation. How much depreciation?  The government sets the rate and you can not use the depreciation in bad years if  you lost money on your rental operation. But in good years, you have a chance to ‘reduce’ the net rental income by subtracting this intangible ‘depreciation’ and thus lower your taxes. Say you value the building (not the land it is build-on) at $50,000 and assumed a 20-year life expectancy for the building (or whatever the government feels is an appropriate life expectancy). Thus, you may deduct $50,000/20 or $2500 depreciation per year. $2200 earned on rent minus $2500 is… Oops minus $300. With depreciation you are not allowed to make a loss, but you may reduce your net rent income to $0 and thus you don’t pay taxes (unless you sell; so it is not a real deduction but more of a deferral of taxes – in the end the government allways gets you). But for now, you don’t have to pay those taxes. See it as an interest free government loan. This is what financial engineering is all about and it is quite ‘interpretative’ and thus it can distort your true profits or better your ‘net earnings’.

Corporations also make a profit on their operations; whatever the corporate business is, chip maker, money lender, car maker. They also manipulate those earnings, just like the mortgage but now referred to as ‘Debt’. They also have depreciation on equipment or when repaying debt: amortization. They also may issue new shares or ‘equity’ in the stock market. Of course, if the profits are to be shared by more shareholders, then the profits per share are decreasing and if the share price does not fall, the price-earnings ratio increases. An increased price-earnings ratio means investors pay more for every dollar earned.  Right now, it is very popular for companies, to borrow money at a very low interest rate and use that money to buy back or reduce the number of outstanding shares.  The result is more leverage and thus a higher return on the share equity AND… the total net earnings are to be divided amongst less share(owner)s. Consequently, earnings per share go up and thus (as many investors think) the value of shares goes up. But the risk also goes up with increased debt.  Accountants are very good at financial engineering and so is management of many companies.  But does the business get truly more profitable?  No, you still make the same net operating profits or EBITDA it is the financial engineering that increased the net earnings.  When stock markets go up in a bull market because investors are willing to pay more for every dollar of net earnings per share and those earnings have been driven up even further by all this financial engineering, the risk of something going wrong increases dramatically.

During downturns, typically your earnings are not only falling because a company sells less, but also, because of all the leverage and interest that has to be paid out of the reduced EBITDA (and interest payments usually are fixed). As a result, the company’s net earnings in overleveraged companies fall like a rock during poor economic times. At the same time, investors don’t want to pay that much for a $1.00 of net earnings any longer and the P/E goes also down. That is what we call a stock market correction’ or worse an outright ‘stock crash’. If this happens with a lot of companies simultaneously we call it a bear market, in particular when the market prices fall 20% or more. When do you want to buy? When the risks are highest, and investors pay very high prices for a dollar of earnings or when the market has crashed, debts have been repaid and the company survived with investors paying next to nothing for each dollar earned? So that is why you want to buy when markets are down, and when stocks are in recovery mode. Problem, it is nearly impossible to time when market tops and bottoms occur. That is why we sell when prices make no longer ‘sense’ and buy when those stocks are ‘cheap’ or ‘reasonably’ priced.  This way we are fully invested when markets go up and appreciate, while we are low in stocks and high in cash when markets go down.  It goes nearly automatic.

Many crashes don’t come unexpected. They are part of investor live. If trends change, like these weeks with the turnaround in interest rate trends, it is good to sell stocks if the ‘story’, the reason you bought the stock changes. This way you sell the profits made on the old trend and get ready for the new trend. Currently, you may ask yourself if those dividend-paying stocks are also growing earnings or whether they are more like a bond and that their dividends and their dividend yield is not likely to change while interest rates go up. If dividends don’t grow, then those shares become less attractive compared to earning ‘safer’ interest. On the other hand, if there is hope for significant earnings growth, then dividends MAY also grow. They may outpace inflation and even keep up with interest rate. When earnings grow but dividends do not increase, then rather than increasing the dividends, management feels that by reinvesting the earnings into the company returns will be better in the future. Hence, don’t only look at the dividend yield but also look for increased earnings yield (which is the inverse of the price-earnings ratio). Increased dividend and/or earnings yield that keeps up with rising interest rates is a reason you may not want to sell a dividend paying stock in a rising interest rate setting. 

The crash is near. Many tech stocks are very expensive; something goes wrong, like Facebooks private data handling and vulnerable stocks may fall like a stone. The higher the market the higher the risk. Nine years into a bull market may mean the crash is near. Expensive stock markets with high prices due to artificially low interest rates are a bubble and we are in it. What does the Fed say: ‘normalizing interest rates’? Can it be said clearer?  Yes, the speculative froth in the market may still go higher but it is time to become very cautious. Get ready for the musical chairs and the moment that the music stops!

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