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The Worst Question Financial Advisors Ask You

I recently read an article about “what should I do with my extra cash?”

The basic premise here is cash loses value over time so you want to minimize how much cash you’re holding keeping only enough liquidity around to deal with your needs and provide a buffer so you’re not forced to sell investments when they are down.  With this in mind the question makes perfect sense.  Unfortunately, the answer reflected the common nonsense you often hear from financial planners.

Let’s start with the basics.  FINANCIAL PLANNERS ARE NOT INVESTMENT EXPERTS!

What?  You ask isn’t that the point?  Maybe it’s supposed to be but in practice virtually none of them do better than the market investing their own money in fact most do worse.  In other words they aren’t necessarily great sources of information.  Worse, they are USUALLY incentivized by getting commissions based on the products they sell you, hardly an impartial source of information.  This isn’t always true of course there are financial fiduciaries who can be very good but they are the rarity and still aren’t necessarily skilled investors.

That’s a buyer beware.

Now back to the main subject here, which is a question I hear from financial advisors and planners all the time “how much risk are you willing to take on?”  AWFUL!

Why is this question so bad?

Well, we’ve talked before on numerous occasions both in our training and blog posts as well as books, etc. about how risk is defined and how it isn’t defined in a meaningful way.  Technically, the answer to the question should always be “I want the best risk weighted return”.  Here’s an example, it is NEVER sound financial advice to tell someone to buy lottery tickets.  I don’t care what their tolerance for risk is it’s bad advice but that’s what the question implies.  In other words the question comes from a place that is uneducated, which is a good reflection of the investment knowledge of most financial advisors.

Good financial advice should maximize the risk weighted returns for clients, always period there is really no other value or purpose of a financial advisor if they aren’t helping you to get a better return on a risk weighted basis then they aren’t doing their job well after all why would you pay them if not for this?

So let’s talk about what the real question should be when you get into the conversation.  “What is the time horizon in which you’ll need this money and consequently how much volatility is safe?”  In other words if you buy something with a fair bit of volatility there’s a risk you’ll be forced to sell when it is down.  That is the ONLY risk that should be considered in this part of the equation the so called “risk appetite” because all the other risk should be balanced against returns so on a risk weighted basis you’re getting ahead.

Why are other questions about risk nonsensical to ask a client?  Because it implies that there is somehow a correlation between risk and return.  In other words to get higher return you have to take on more risk.  The problem is that’s false.  You might…maybe, have to take on more volatility.  You’ll definitely have to take on greater exposure to the underlying asset but that’s not the same as risk.  Remember the way we define risk that is actually meaningful to people?

“What is the chance of loss and severity of loss?”  That’s risk the way it matters.  In this sense as we’ve noted in other articles increased volatility can actually decrease returns so decreasing risk by that definition actually increases returns.  Likewise for choice of asset class and price of asset class.

Financial advisors should be helping you to simultaenously decrease risk while increasing returns.  To do this they need to consider your financial needs over the next little while and they should educate you about potential investment performance and how to cope with potential events psychologically.  But on no planet should they be guiding you into higher risk weighted investments that’s just bad financial advice.

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Invest in Apple now?

At the end of last week based on their worst earnings report in years Apple’s stock tumbled drastically.  Carl Icahn the legendary activist investor announced he’s sold his shares.  There’s concerns about Apple’s ability to grow given the slowdown in China.  But is it cheaper than it should be?  For the first time in over a decade it’s trading for less than a 10 P/E.

Our second rule of investing is to buy something that’s going to increase in value…this is primarily examined by considering a productive asset and at the moment in spite of drops Apple is certainly a productive cash making machine.  But does it have durability?

Our third rule is to buy for less than it’s worth but what is a fair valuation?  For the last several years buying Apply for below a 10 P/E would have been a dream but now?

Let’s consider the fundamentals – when you’re buying a stock you’re not buying it for today you’re buying for the anticipation of what it’s going to provide in the future.  So the question isn’t whether Apple is doing well now (really based on today it’s better value than say most of the banks) but moving forward.

How do we determine whether sales are likely to continue?  We need to look at what are they selling and who are the customers.

The big reason for the drop in sales was due to drops in iPhone sales, which have traditionally been a cash cow.  Are people going to stop buying iPhones?  No.  Could the upgrade cycle decrease?  Absolutely, the value of upgrading is decreasing.  Could the market slow?  Absolutely, it has, which is the issue here.  What about competition?  Yes, Apple’s market share could erode as well.

What about other products?  iPad sales have been declining.  iPods have largely died out.  Apple Watch hasn’t created a meaningful share of their business and it’s questionable whether it will.  Apple TV and similar products make a very small % of their overall sales.  Macs are a relatively declining market or at least not growing.  This leaves the services, iTunes, Apps, Apple Pay, etc. as well as the possibility of new product lines (TV, car, etc.).  Here there’s a reasonable chance for growth, enough to offset losses in other areas?  Perhaps.  There’s also the possibility of reinvesting additional profits, which are substantial, to increase overall revenues and profits.

Based on the strong brand, distribution, relatively established market, etc. major disruption to Apple’s core businesses seem unlikely there will be minor changes of course but nothing too substantial.  The services business is where the greatest potential for growth lies and it is substantial likely doubling or more over the next few years.  This combined with reinvestment are likely to produce modest returns or at least stability over the mid term (short term you’ll likely see an additional decline as reflected by the higher forward P/E ratio).

This means at the current P/E ratio the investment is likely fairly stable over a mid to long term but what about above market returns?

Above market returns on a predictable basis come from one of two things:

  1. Higher than normal growth
  2. Lower price than the value of the company

Higher than normal growth in the case of Apple is nearly impossible.  How come?  Because the incredible market cap means even if they had a huge win in say the car industry the size of the industry and the win relative to their market cap isn’t sufficient to substantially move the needle.  It might result in 10-20% growth but over a few years, which is not impressive.  Apple is not a so called 10 bagger at this stage.

In other words if Apple isn’t under priced you’re probably better off investing in the general market or a diversified holding with greater protection against uncertainty than merely buying Apple.

Is it undervalued?

In this market we typically are basing valuations on a 5% interest rate to provide a margin of safety in other words a fair multiple on a risk free investment would be 20 times…Apple is currently trading for below 10 times, which means the risk premium is decent, probably better than buying bonds.  But is this a fair price or a great price?

At present the projections are earnings will drop over the coming year, which if earnings continued to fall would make the valuation fair to slightly high. but what about looking forward?

The key is to attempt to determine the forward value, which one would expect to include a modest growth rate based on reinvestment of earnings, operational efficiencies and growing product lines/markets.  Unfortunately, most of Apple’s markets in the aggregate aren’t likely to grow substantially, many will likely decrease (services will be the main growth area as well as additional product lines).  The good news is there’s substantial capital available for reinvestment, which can reasonably be invested at a 5% compounded rate of return.

What’s the problem with these figures?  Based on a 10x valuation one would expect a 10% annual rate of return but if the compounding rate is less than 10% this rate of return will over time diminish meaning an 8 times multiple is likely more fair over the very  long term.

What does this mean for us?  Apple’s stock is likely fair to slightly low based on the present value but not low based on the future value.  In other words the likelihood you’ll see substantial appreciation in the stock price within the near to mid term is quite low.

Conclusion – while Apple is likely a fairly safe bet in that it’s unlikely to experience substantial downside it is unlikely to experience substantial upside either and consequently probably not a market beating investment.

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Is the stock market going to crash?

will the stock market crash?

I read an article yesterday in a publication that was forwarded to me showing a variety of indicators suggesting the stock market is going to have a major drop in the near future.  This particular publication is constantly putting out articles like this and I provided the following reply.

I’m not a big fan of this kind of thing for several reasons:

 

  1. Lots of groups – like FIR – make their money off constant gloom and doom stories, take a look back over the articles you’ve sent from them for the last few years and it’s a steady stream of warnings about how things are going to collapse (remember our conversation last summer about them saying the big correction was coming in September, we saw that drop in August, which was a great buying opportunity and then recovered pretty quickly and in spite of some little ups and downs has remained relatively flat).  This makes sense because fear sells, but it’s not an accurate world view as measured by what’s really been going on
  2. It makes the fatal mistake of believing the past equals the future but as we know history is not destiny a lot of things are different today from how they were decades ago so the real question isn’t what happened in the past but what are the drivers that will create change right?  If the drivers have changed then we can’t expect the same outcome.  This is arguably why 2008-2009 wasn’t as bad as 1929, because we had a banking system in place with an ability to jump in and prevent things from falling as far as they did back then

 

None of this is to say they are mistaken, they might not be but let’s look at the fundamental drivers and be rational about it.  Here’s where I’m a big fan of Buffett who has frankly far outperformed all of these guys for decades so based on results he might be worth listening to.  Or Ray Dalio who fits the same mould.  Ed Bogle is a pretty good one as well.

 

Let’s start with the basics.  What causes the market to go up?  Money going into it.  Literally, no rise can happen within the market without more money going into it so for it to rise the money has to come from somewhere.  Over the last few years that money has primarily come from quantitative easing, which has now stopped (Dalio believes they’ll have no choice but to initiate QE4 at some time in the not too distant future so we’ll see if that happens).  In a sense they poured trillions of dollars into the system by swapping government bonds for bank reserves on bank balance sheets and this had the effect of driving up the market a lot more than it would have without those initiatives.

 

Now that this has stopped the money can only come from a few places:

 

  1. Government deficit spending – this is the only way the base money supply grows and might happen to a small extent but doesn’t look probable at levels that would make a big difference measured against the scale of the economy
  2. Foreign investment – the question is “from where”?  China?  Not likely, not with the state of the economy over there.  Europe?  Same boat.  Really any amount of foreign investment large enough to substantially move the needle seems pretty slim
  3. Private debt – the credit markets could expand substantially, which is what happened leading up to 2008 but what would drive that?  Normally, you need rising asset prices (not very likely), falling interest rates (virtually impossible), easing lending rules (pretty unlikely), rising household income (not likely to be enough)
  4. Share buy backs – this could happen to some extent but probably not enough to move the meter substantially

 

Bottom line the forecast of pretty much everyone significant that I know of is the market isn’t going to grow much in the next 10 years.  Whether you want to take that timeline or shrink it down a bunch to say 3-5 years I don’t see any drivers baring another round of QE and a significant one that would push the market as a whole up substantially.

 

Let’s look at the opposite is the market likely to drop substantially?  Again the inverse is true here what causes the market to drop?  When money gets pulled out of the market.  Typically, when there’s a rapid collapse it comes from two things:

 

  1. Debt bubbles bursting because people can’t afford to service the debt they’ve taken on – this is what has been happening in China where people are buying on margin rather than with cash and is also what happened with the housing market in 2008.  The problem is there isn’t a major debt bubble in the US markets right now, I just read a report that household net worth is the highest it has been since the 1980s.  If interest rates rose substantially that could create problems but is that very likely?  You’d need to see substantial increases in inflation for this to happen and even then the Fed will be monitoring it closely.  I’d imagine as the price of oil recovers, which it will probably do over the next year or two you’ll see an upward tick in inflation and there’s a reasonable chance of small interest rate hikes but not ones substantial enough to force a lot of defaults especially since most of the debt is amortized long term
  2. Fear – this is what happened in August and again at the start of 2016 people panicked and sold based on what was happening in other parts of the world, this could well happen but if it’s not backed by real fundamentals represents a buying opportunity because it will turn around as it did in both of those cases.  To quote Ben Graham in the short term the market is a popularity measuring machine in the long run it is a weight measuring machine (meaning it measures profits).  I think it’s stupid to speculate on what public sentiment will or will not be it could go in any number of directions but it’s impossible to say in advance.

 

Those are rapid drops but there could also be a gradual decline, which might come from a couple major sources:

 

  1. Decreasing corporate earnings – earnings definitely slowed at the start of the year due to weakening demand in markets such as China.  You could have definite ebs and flows here, at the moment general market P/E ratios are high but not extremely high, they are still within the bounds of reason so I’m not worried about a major correction but also wouldn’t advise buying general indexes.  Realistically, corporate earnings aren’t likely to drop much but they might not continue to rise as much
  2. Slowly rising interest rates – essentially, this means less margin and a more from money away from equities and indo bonds.  This would be a very slow process and wouldn’t likely push the market down so much as keep it flat
  3. People selling for other reasons – for example you’ll sell stocks to buy a home.  This is the biggest concern because as Robert Kiyosaki pointed out 2016 is the first year baby boomers are starting to retire and will begin selling their portfolios to pay for their living and this is going to continue for 15 years.  “Demographics are destiny”.  This will be fairly gradual but will also be substantial and I don’t see enough new money coming in to counteract it

 

If we look at those drivers what does this all tell us?

 

We probably aren’t looking at a massive sustained crash, it’s possible but pretty unlikely in the near future, a lot of things would need to go wrong at the same time.  On the other hand there’s VERY SMALL chance of any major market gains so most of the returns are likely to be in the form of dividends.

 

This brings us full circle to the Buffett insights.  Buffett says don’t pay attention to all that macro economic stuff.  Instead look at a company that’s producing solid earnings for a decent price and is going to continue producing solid earnings.  Buy that company knowing so long as it continues to produce more and more cash you’re going to be good no matter whether the market goes up or down or sideways because ultimately company cash becomes shareholder cash.

 

In this market I think if you want decent returns you need to focus on individual companies at specific times rather than the market as a whole because the market as a whole is pretty likely to look a lot like Japan for the last 2 decades.

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When the “Sell if it Drops 10%” Rule is Stupid

Should I sell when the stock drops?

If you spend much time studying stocks and investing you’ll eventually run into this risk management rule some people swear by “if a stock you’re holding drops by 10% no matter what else is the case, sell!”

We’ve covered the subject of risk at length but to summarize some key points:

  • Risk consists of two parts the probability of loss and the severity in the event of loss
  • Most traders don’t employ strategies that reduce the probability of loss and think only about reducing the severity of loss – this of course is stupid because if you’ve got a losing % even if you lose 2% at a time you’ll eventually bleed yourself dry, which is why we don’t buy lottery tickets
  • Most traders employ a severity of loss protection that includes two key points: never risk more than say 2% of your portfolio on a given trade, employ stop losses to ensure you can’t lose more than a certain amount
  • Most retail investors use diversification and asset allocation to minimize their risk

Generally, you’ll notice we advocate two positions when it comes to investing:

  1. Average Investors – For those who don’t want to spend time mastering investing stick with dollar cost averaging a strong diversification and asset allocation mix, hold long term and forget about it
  1. Sophisticated Investors – For those who want to learn to master investing the more diversified you are the less likely you are to beat the market so focus on highly concentrated well researched investments following the investment rules we teach

You’ll notice neither of these philosophies involve employing the 10% loss and sell rule.  Why not?

The basis of the rule is preventing loss but the underlying assumption of it is you don’t know when you invest that what you’re investing in is fundamentally solid and we patently disagree with this approach.  We don’t believe you should invest if you don’t know with a high degree of certainty what you’re investing in is fundamentally solid and we advocate a lot of learning and diligence to ensure this.

Selling if it drops 10% makes sense for people who are trading based purely on technical or even based on speculative investment analysis for example people who invest in uncertain growth stocks.  The reason is because it takes a disproportionate gain to make up for a loss for example a 50% drop requires a 100% rise to recover while a 90% drop requires a 1000% rise to recover.  The theory is a 1000% gain is highly unlikely.

Value investing suggests quite the opposite premise that if the asset’s value is solid then the lower it is the better investment it is because the upside is greater and chance it is undervalued is greater.  In other words the chance of a gain isn’t based on how much the asset needs to increase in price in percentage terms but rather what the underlying intrinsic value is.  If the intrinsic value is 1000% higher than the current price then given time it will eventually go there and you’ll earn a significant return.

In other words if you’re confident of a durable underlying value in the asset you’ve purchased the lower an asset drops in price the more interested you should be in buying and if the value is intrinsic then you’d be crazy to sell based on a 10% decline because it’s got an ever greater chance of increasing.

There is a caveat to all of this.  We certainly make mistakes from time to time so instead of selling when a stock you’re holding drops 10% you should re-examine the company to ensure your underlying assumptions are accurate and the intrinsic value is indeed what you estimated it to be.  If you discover you were in error either the value isn’t what you thought or the underlying asset isn’t durable and is decreasing in value with not guarantee of coming back then you should sell but selling should be based on fundamentals of the underlying company not a decrease in price.

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Which is the better investment? IBM vs BNS Jan 2016 Part 2

Scotiabank BNS

Continued from part 1

So how come I’m saying IBM is likely to outperform BNS midterm?  Again, understanding the second part of the analysis that it’s a business not a stock.  It happens at the moment this is reflected in each company’s return on equity ROE but this isn’t always the case (BNS ROE 14.05%, IBM ROE 103.55%) but the PEG ratios would have you believe differently since the IBM PEG is 1.21 while the BNS PEG is a more attractive 1.02).

Mid term the value of a stock is much more a function of the ability to compound growth than it is to produce simple returns.  For more details, see our article on compounding vs simple growth.  In simple returns BNS and IBM are very comparable around 9.2 P/E means expected annual simple return of 10.87% (slightly higher than the market average of the S&P long term including dividends).  If you simply held the stock and each year those earnings continued then you’d expect over the long term to receive those profits (this is again a crude analogy because of course the profits won’t all be distributed at least in the short run).

But we aren’t concerned with simple annual returns, we’re concerned with compound annual returns, which means what can the company do to take that 10.87% and grow it further?  If you bought a bond that paid you 10% return and reinvested the profits then year 2 you’d make 11% on your original investment, then 12.1% and so on by year 6 it would actually be 15%/yr return on your initial investment.  So 15%/yr on your initial investment after 5 years is what we consider a 10% compound rate of return whereas with a simple return after 5 years you’d still be earning only 10%/yr.  When investing in stocks this is a function of how much the company is able to grow.

How you’ll be able to determine the company earnings or earning potential is based on applying the formula for profit.

Let’s look at BNS and IBM and compare how much they’re able to grow.

BNS is a huge Canadian bank in a saturated highly competitive market with very few large players.  It’s also a very well established market meaning it’s very unlikely Scotia bank will gain or lose substantial market share.  Further, the Canadian market isn’t likely to grow much (you’d expect it to grow in proportion to demographics so as the population rises you’d expect the company’s sales to grow accordingly but this won’t be a large amount perhaps a couple percent per year (latest data puts the Canadian population growth rate at 1.2%/yr)).  The market size on a per person basis should grow slightly due to inflation so you’d expect to include those figures about another 2%/yr.  You’d also expect over the long haul for a well managed company to find ways to increase operational efficiencies driving down costs slightly and thereby increasing margins though some of these will probably be eaten up by competition but again these will be minor perhaps a 2%/yr. gain unless something dramatic happens.

If you’re counting we’ve so far got a collective growth of 5.2%/yr. (this would be the rate of compounding in theory).  There are three other possible sources of growth:

  • They could grow into other markets – BNS is the most international of the Canadian banks with particular strength in Latin America and those markets are definitely higher potential growth markets than Canada so this presents some upside opportunity for BNS

 

  • They could offer new products or services to the existing market – the problem is what might these be? They are already in the business of deposit taking/transactional banking, loans, credit cards, processing, brokerage accounts, investments, investment banking, insurance, etc.  What else is there really?  Growth opportunities here are minimal

 

  • They could reinvest the profits by purchasing other companies and thereby increasing their cashflow or simply putting the money to work in the market – this is likely and will probably produce a couple % growth

In other words because of reinvestment and growth into other markets we’d expect probably another 2-4%/yr growth ball parking the annual rate of growth at somewhere around 8% perhaps a little more and perhaps a little less without factoring in the effects of the business cycle, which means this should hold true over a fairly long but not necessarily short term.

So you’ve got a rate of return of 10.87% but that rate of return is greater than the rate of growth so we’d expect it to drop slightly on a compounded annual basis over time.  This is especially true because they are paying out almost half of the return in the form of dividends and therefore unable to compound it.  Barring some major acquisitions, which are possible but also fairly unlikely these numbers won’t likely diverge dramatically in the long term.

Let’s compare this to IBM.  IBM is already ahead because there’s a 1% difference in dividend rates (somewhat of an indication they have more of an ability to reinvest their capital than BNS does or why not return the money to shareholders?).  What’s IBM’s market environment?

Again, theoretically, we’d expect them to grow with inflation, find ways to increase the productivity within the business (probably more so than BNS due to the nature of the business and because margins should scale better in a more IP oriented company), and grow with the population.  The difference is in IBM’s case that it is in several markets that are growing quite dramatically or at least have considerable growth potential.

For example, the cloud computing market is growing at a rate of 33%/yr. with IBM being one of the major players meaning if IBM simply maintains their market share we would expect that portion of their business to grow at 33% per year!  There’s no way BNS can come close to matching that.  Other markets are growing as well for example the server market grew by 6-17% depending on whose numbers you look at.  In other words in IBM maintains their market share they’ll grow at a rate far exceeding BNS…but will they and will they grow their market share in any of those key segments?

In certain sectors their market share is growing such as cloud and their a company that’s uniquely positioned with their services supporting their other key business areas meaning in certain sectors it’s hard to compete with them for all but a few players.  The risk to IBM is they could fall behind in fact they have slipped with decreasing revenues largely driving the decline in their stock price but fortunately not at the expense of their P/E ratio in fact quite the opposite it’s become increasingly attractive.

Without going into substantially detailed analysis about how IBM makes money, the direction of the market, etc. it’s difficult to compare how they’ll fare vs competitors in the market many of which markets are emerging and various players such as Microsoft, Amazon, and Oracle have unique offerings and differing approaches to the market.  But there is one big indicator the average person can use.  Warren Buffett owns and continues to load up on IBM shares.  Why is this important?

Buffett is exceptionally good at predicting the long term growth of a company and he doesn’t buy companies he doesn’t have a very strong reason to believe will beat the market in the long term.  This alone is a good indication for IBM combined with the growing market yet very stable business model.  It’s a riskier investment in the long term than BNS but given all the above factors it wouldn’t be surprising to see around 15%/yr. compounded returns in the mid term.  This isn’t something you can tell simply by looking at the financial statements, you need the understand the business and the business environment.

Suffice to say if BNS compounds at a rate of 8%-9%/yr. and IBM compounds at a rate of 15%/yr. then over 5 years IBM is a substantially more attractive buy than BNS even though within the next 6-24 months BNS is almost certainly the better buy.

 

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Which is the Better Investment? BNS vs TAC Jan 2016

TAC-transalta

We previously examined IBM vs BNS to consider the difference in short vs mid term strategy and the impact of compounding.

Now we’ll look at two other somewhat similar companies, at least similar by certain metrics.  BNS and TAC.

Let’s start with how they’re similar.  Both at 5 year lows.  Both relatively stable predictable businesses.  Both with low P/E ratios.  Both paying relatively high dividends.  Both profitable.

Here we get into some substantial differences and the purpose of this article is to contrast some misnomers that might seem good on the surface but on a risk weighted basis are likely to get you into trouble.

TAC has a P/E of 6.74 while BNS is 9.25.  TAC pays a dividend of 17.30% while BNS pays a dividend of 5.23%.  TAC has a P/B of 0.51 while BNS has a P/B of 1.32.  By all of these measures TAC looks to be the better buy but is it the case?  Let’s dig deeper.

First, I always believe in ignoring dividends when investing, they are a bonus not the focus of investing they risk swaying you to buy an inferior company.  This being said there’s a big warning sign with the TAC dividends…the dividend exceeds the earnings.  Meaning it is physically impossible for the company to sustain these dividend levels long term.  Either earnings have to increase or the dividends have to decrease, probably quite substantially, there’s simply no way around it (I’d expect to see the dividend rate cut in half sometime in the near future).  In other words the dividends advantage isn’t one you can rely on looking forward any substantial time period.

What about the P/E ratio though surely this is better?  Yes, if the P/E ratio reflected the likely ongoing earnings of the company the company would be radically under valued.  The problem is this is the trailing P/E ratio the forward P/E is 16.89 while the BNS forward P/E is 5.83.  In other words while BNS is expected to substantially increase profits during the next 12 months TAC is expected to see profits decrease by more than 50% in the next 12 months.  I happen to believe for a variety of reasons that TAC will eventually recover based on understanding their business (assuming it isn’t purchased) but these numbers make the outlook in the short term (anywhere from 6-24 months) pretty mild.

Further, while TAC has low margins and profits with high debt (debt interest is currently wiping out roughly half of the operating income) BNS has massive profits, substantial cash reserves, and strong margins.  In other words BNS is a much safer bet than TAC, which is definitely struggling.  When the stock price is struggling but the company is not as in the case of BNS at the moment, you’ve got a fantastic buying opportunity.

But what about the price to book ratio?  Aren’t you paying more for BNS than it’s worth and far less for TAC than it’s worth?  The TAC price to book is definitely very favorable and worth considering closely (I’ve previously expressed that TAC is likely a good mid term investment).  First, as I’ve discussed on many occasions book value isn’t necessarily a good estimate of the value of a company since it fails to account for substantial intangible assets.  That’s being said it is relatively accurate for a company like TAC (less so for a company like BNS).

The fact is one of two things will have to happen.  Either the book value will need to decrease whether from losses or depreciation or the company’s stock will over time need to rise to properly reflect the true book value.  This is true for TAC but not for BNS, which isn’t under valued measured by the book value.

What’s the concern?  The near to mid term profitability of TAC is questionable and recently adopted new regulations mean the company is going to be phasing out some existing power plants, thereby potentially reducing their asset to liabilities ratio in the long term.  In other words the extent in a reasonable period of time to which the stock is likely to recover based on the book value is somewhat questionable.

The real question for TAC is will the lower profit levels sustain themselves as a new, lower normal, will profits continue to fall, or will earnings rise?  The company is an optimal target for a buy out and announced in mid 2015 that a buyout offer was being considered.  Would this be favorable for investors?  It would almost certainly see an immediate jump in the share price but whether this was profitable would depend at what price point you entered and at what price point the offer was made.

All round BNS is an extremely safe and solid bet whereas TAC is much less certain in the short term though likely will beat the market in the mid term.

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Which is the Better Investment? IBM vs BNS Jan 2016

IBM

This week I examined two companies from different contexts in considering investment opportunities (for those who follow in the last week the Dow dropped about 1000 points and presented a lot of great buying opportunities) these were Scotia Bank (ticker symbol BNS) and IBM.  Since there’s a very valuable lesson here it seemed like a good idea to share the analysis.

On the surface according to my typical methodology BNS and IBM seem very comparable.  Both are at 5 year lows.  Both pay relatively high dividends (about 5% for BNS and 4% for IBM depending on which day you bought).  Both have P/E ratios of slightly over 9 (IBM slightly lower than BNS but not meaningfully so).  Both are low by comparable industry standards.  Both are large well established companies.  Both have forward P/E ratios lower than their existing P/E ratio suggesting profits will increase in the next 12 months.

In spite of these factors the two are quite different as investments (both fairly attractive, but quite different).  If you were going to choose which to invest in, which would be the better choice?

There are two key lessons here:

  1. Your time horizon/investment strategy will determine in part what investment is best for you
  2. When you’re investing you are buying companies not stocks

Let’s start with this point about investment strategy and time horizon.

Warren Buffett passes up opportunities every day where stocks go up in relatively short order why?  There are lots of reasons but he has a particular investment philosophy, which is based on long term not short or even mid term results.  This is because he aims to buy a company and reap the rewards resulting in less ongoing work.  This allows him to own a much larger portfolio of companies because he doesn’t have to keep such a close eye on them as if he was investing short or mid term.

Let’s ask the flip side of question if Warren Buffett is turning it down does it mean it’s a bad investment?  Not at all, it might be a great investment for someone who is applying a different strategy or maybe has a different timeframe.  People make money every day investing with a different strategy from Buffett and they consistently beat the market.  There are multiple ways to invest successfully.  You’ve got to decide what’s best for you.

How does this apply to the BNS vs IBM analysis?

According to my analysis BNS is likely to do better than IBM short term.  This is based on two things primarily.  The first is the forward P/E ratio of the company, which is generally pretty accurate for large predictable well established companies like banks especially Canadian banks is MUCH lower than the current P/E ratio and the difference between current and forward is much greater for BNS than IBM.  If BNS earnings rise as predicted it’s highly unlikely the stock will remain down.

Further, because the P/E ratio is lower one would expect a higher midterm return than the P/E ratio of IBM (this is somewhat of a crude analysis but gives a reasonable outlook).  Loosely speaking it works like this.  If you take 100 and divide by the P/E ratio then assuming the earnings remain consistent you should expect over the midterm to earn a simple return that as a rate of return because the profits are ultimately the money of the shareholders (loosely the book value of the company should be growing by that much each year and this can’t continue to grow for long without the value of the stock continuing to grow at a comparable rate).  This of course assumes the P/E ratio is an accurate reflection of the earnings of the company, which it isn’t perfect something like Buffett’s concept of owner’s earnings tends to be more accurate but for the sake of simplicity this will do for preliminary analysis.

I should mention when we’re talking about short term I’m generally referring to a period ranging from a few months to a couple years and when I say midterm I’m referring to a period of typically around 2-5 years with anything more especially in 10-year range being long term (anything much beyond the 15 year range I’d consider extremely long term and is much more difficult to predict).  Long term will typically mean going through at least one business cycle, while mid term will generally involve merely a phase of the business cycle and short term is based more on the buying and selling cycle of a company.  Knowing this allows different insights into probable price behavior.

The second reason I believe BNS is a more probable bet in the short term is because of the nature of the businesses, which is a major Canadian bank is very consistent, the valuation shouldn’t fluctuate much and nor will earnings or the market.  We’re in a rare situation where two factors are simultaneously affecting BNS causing the stock to take more of a tumble than it probably deserves.  IBM is somewhat different because it’s in markets that are rapidly changing hence there’s more opportunity for a company to come into or fall out of favor with the market, which is what’s happening to IBM at the moment in spite of most of the company’s fundamentals not changing.

Understanding this plays into the second point we discussed, which is you’re buying a company not a stock.  If you don’t understand the company, you’re likely to miss a lot in the stock and make many errors long term.  I can make those predictions with some measure of accuracy because I’m not simply looking at the stocks themselves, I’m looking at the companies and the markets they are in.  If you’re ignoring these factors you’re likely to run into a lot of problems.

Continued on part 2

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Today is a Day Watch Lists Pay Off! Buying Opportunities!

For those who don’t follow the markets this morning following an 8.5% drop in the Shanghai stock market the Dow dropped the fastest it has ever fallen in history, over a 1000 point loss before recovering down 588 at the close of the day.

For those who follow my commentaries on the market you’ll know as the Dow rose to 18 000 points I considered it quite expensive and risky as well as found it difficult to find deals (oil at the start of the year when it dropped below $50/barrel and then rose to $60/barrel in fairly short order was the one major exception, which is now much lower and again represents a fairly strong though somewhat less certain buying opportunity).  Over the last couple months the market has gradually come down and a few stocks have started looking more attractive.  Unfortunately, they’ve lacked a margin of safety so I’ve been sitting waiting and watching today those opportunities finally popped up.

 

Going through the Watchlist

There’s a big lesson here.  If you didn’t have a watch list and suddenly had to start looking for great buying opportunities you’re in trouble because that research takes time.  I have a set of stocks I follow and advise everyone else to do so as well.  I know these are solid companies, I know approximately what they are worth, how they perform, etc.  What this means is now when the market shifts dramatically I can act quickly.

 

“Aren’t you worried about it going lower?”

A friend asked me this question earlier today.  The answer is “no”.  But rather than just saying so let’s figure out why.

Is there are good chance the stocks will drop lower?  Definitely!  In fact I’d probably say it’s around a 60% chance they’ll go lower.  Then why am I not worried?

There are only a few reasons to worry about the price dropping lower:

  1. You’ve got a scarcity mindset where you are worried you’ll miss out on that extra bit of return
  2. You’re worried it will continue dropping and you’ll lose money
  3. You’re worried about how the time horizon will be affected by the drop and the losses that could ensure

Let’s explore these in reverse order.

Worry about the time horizon

This is a fair concern, the time horizon matters for one of two reasons.

First, you can’t afford to hold long term – say because you’re trading options with time decay, or you’re buying with leverage, or you’ll have a relatively short term need for the money (maybe to pay for a new house or a car or post secondary education or retirement, etc.)  With respect to leverage and options that isn’t my game so it’s a non-issue, hence not worried but yes those would be legitimate concerns for those who were trading options or using leverage.  The issue of needing the money within a short to mid term time horizon again, it’s a very valid concern.  If say the shares drop an additional 10% and you’re forced to sell before they record you could be forced to crystalize this loss.  If you follow the Richucation wealth building strategies you won’t be in this position because part of the strategy involves building a reserve fund, getting out of debt, and building a solid base of assets to draw on before engaging in investments like these.  Hence again, not worried.

Second because you’re concerned the longer time horizon will mean a lower relative rate of return and consequently you’ll have an opportunity cost associated with the investment (ie. there are or will likely be better opportunities).  This is likewise is a fair concern there might be an opportunity cost.  My philosophy in this is much like picking tops and bottoms, I can’t do it, it’s too much hit or miss so instead I’m looking for a good deal and then don’t experience scarcity about it.  I benchmark a risk weighted return and so long as it meets my target standards I’ll go for it I believe worrying about what is “best” will just lead to emotions, which undermines good investing.  So once again, no worries.

Worry about a continual drop and ultimately losing money

There will be one of two ways you’ll lose money.  Either you can’t afford to wait for the stock to recover or it won’t recover.  We’ve already addressed the issues about being able to afford waiting but here are some additional details.

In general the stock will recover to within a margin of safety of the fair market value for a very stable company in relatively short order (usually within 6-24 months so I need to be willing and able to hold that long and for the reasonable projected returns based on the differential between the fair market value net of margin of safety and the current share price).  The exception to this is going to be where the earnings of the company drop meaning the fair market value drops (please consult my books and other posts on the subject).  In other words the danger this time horizon will be extended out much further arises from the possibility of a significant drop in profits for a protracted period of time.  In other words as part of my assessment and due diligence I have to consider carefully what the likely outlook for the profits of the company are.  I’ll do this by examining the business model, profit trends, examine the forward looking P/E, possibly examine the company’s return on equity (ROE), the competitive environment, management (especially management changes), and environment the company finds itself in.  For example does it have debt and is it likely to need to incur more debt?  Are there commodities on which the prices are based that will affect either costs or revenues?  For example, if I was looking at an oil stock and oil was at $100/barrel (especially at an all time high or historic high compared to the recent past (last couple years) then I’d be concerned there might be a drop in oil prices, which could result in a decrease in earnings, which could sustain a longer term dip in the value of the company and consequently a stock recovery.  This is all part of due diligence, understanding what you’re investing in and being able to assess why the stock is down in order to determine if this is likely part of a long term negative earnings trend.

For example, the stock of car manufacturers Nissan, Mitsubishi, and Toyota are currently down in some cases with very attractive P/E ratios.  Why?  Largely based on the slowdown in the Chinese economy, which sparks fears of less demand for cars and consequently lower P/E ratios, this is reflected to some extent in much higher forward P/E ratios for the respective companies than current P/E ratio.  This is genuinely a troubling forward looking trend and could signal a long term drop in earnings.  Likely, those companies will survive and remain profitable but won’t be valued as high as they were over the last several years.  On the other hand we could look at AFLAC or CIBC.  The former is a US insurance company providing supplementary insurance to individuals and groups in the US and Japan.  Insurance is a pretty predictable business where it is highly unlikely to see massive swings in either revenues or expenses.  The exposure the company has to China is minimal.  In other words it is highly unlikely earnings will fall much if at all in fact they are likely to rise slightly (as reflected by their forward looking P/E) if only due to reinvesting earnings to say nothing of the market growing, great efficiencies due to technology, etc.  They won’t grow a lot but they are likely to grow some, which means their fair market value is likely to rise and the stock isn’t likely to remain very low very long.  CIBC is in a similar situation.  It is a Canadian bank, highly regulated with little exposure to China in a very predictable industry in a market where there’s essentially an oligopoly and major market changes are unlikely.  It is highly likely they’ll see minor earnings increases, nothing dramatic but also not a drop, meaning the fair market value of the company will remain relatively stable and if the stock is under-priced (which with a P/E below 10 it certainly is (I’d expect a P/E of between 11 and 12 for a Canadian bank) it should recover within a reasonable time frame.

This ties into the second concern, which is the price of the stock won’t recover that the company will fall to zero or be bought up at very low levels putting the shareholders into an uncertain situation since who does the acquiring is unknown etc.  This is the reason for using a model where we choose stable companies where the dangers of the company vanishing within a short to mid time frame are close to zero.

Because these are the types of companies I’m looking at I’m not worried.

Scarcity on missing that extra bit of return

Here we get to the heart of the concern of “what if it drops more?”  There’s a belief the company is solid and undervalued, it’s going to recover it’s just a question of when and how much…but what if we buy today for $10/share and we could have bought tomorrow for $9/share.

This is bad thinking.  This is greedy thinking.

It might drop further, you could average your way in by buying some today and if it drops buying more tomorrow and so on.  It might drop tomorrow but then again it might rise tomorrow.  Without a close examination of technicals and being on top of it it’s impossible to say and I don’t try to guess.  I don’t try to make more than anyone else off a given investment I aim to make consistently great risk weighted returns.

I know great buying opportunities come up relatively infrequently and if you want to take advantage of them you need to be ready and jump on them when they show up.

Warren Buffett has a story he tells about this kind of situation.  He ranks it as his worst call ever.  He didn’t buy Wal-mart shares thinking they would drop a bit more so held off.  He said he figures that decision has cost him about $5 billion.

Yes, the stock might drop more and if you’ve got relatively good data that this will be the case go ahead and wait or inch your way in rather than buying all at once.  That isn’t my philosophy unless I’ve got a lot of options that are all fantastic and relatively great.  In that case I’ll diversify and in those situations I can afford to slide in more gradually.  But as a general rule I’ve found decisiveness when a great deal comes up is important and I don’t worry about whether I could have gotten a slightly higher rate of return.  To me the most important thing the thing that lets me sleep well at night is knowing I got a solid risk weighted rate of return and aim for consistency believing the consistency will pay off more than attempts to squeeze out that last little bit.

So to conclude that’s how come I’m not worried about the stocks dropping lower.

If you’re interested in more details, have questions, would like assistance please contact us by clicking “Ask a business question” in the lower right corner of the screen, we’re here to help.  Also check out other blog posts and our books offering detailed information on these and other wealth building topics.

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Following up June 20, 2014 Stocking Investing Examples

Back in June 2014 we gave an example of evaluating 4 stocks using the Richucation method of considering stock valuations and investing.  We’re always very upfront that we aren’t giving a recommendation or a statement whether the stock will make money or not but rather using it to demonstrate the principles behind how to value stocks.  The reality is anyone can get lucky and we never know what the market will do.  The intention is to improve the probabilities of a profitable investment.

That being said you can imagine the pressure that comes from publishing an opinion on a given stock, will it go up?  Will it go down?  Will we look good?  Will we look bad?  However, looking back and seeing how accurate we were is a great way to create mastery and learn to refine our craft so with that in mind today we’re going to revisit those 4 stocks to see how they’ve fared since we evaluated them back in June 2014 and whether they would have likely been a profitable investment.

At the time I stated I wouldn’t be buying them and gave an explanation of why not, why I didn’t consider them a low risk investment.  The four stocks were CREE, HIBB, LL, and UNFI.  Below are charts of each of those stocks from the date of the last publication to the present, approximately 1 year:

CREE Stock

CREE Stock performance June 20, 2014 – May 22, 2015

HIBB Stock

HIBB Stock performance June 20, 2014 – May 22, 2015

LL Stock

LL Stock performance June 20, 2014 – May 22, 2015

UNFI Stock

UNFI Stock performance June 20, 2014 – May 22, 2015

As you can see compared to June 20, 2014 just after the recommendation to buy was made based on a supposed condition of being oversold on the part of the Wall Street Journal and Seeking Alpha reports three of the four stocks have been down the entire time, in fact quite substantially.  Only one has risen at all from that date’s stock price namely UNFI.  The first two had very minor initial upward movement then collapsed down below the original price and never recovered.  The third was 100% down.

Now, you could argue you’d have a stop loss in place to limit your downside (hopefully that would be the case) but is that realistic?  For a lot of people no.  More importantly you’d still have lost money you’d simply have minimized your losses.

You could argue the upside of the one stock that did well would have made up for the losses in the other three if a reasonable stop loss would have controlled the risk on those other three.  Here’s the problem with that:

  1. How would you have known when to sell vs. whether to hold? Just an arbitrary stop loss preventing more than say a 5% loss would be impractical because what if it was just a temporary drop in the stock value that’s going to recover?

 

  1. How do you know when to sell from a rise standpoint? UNFI rose dramatically by over 30%, a great return if that was the investment and the returns were crystalized but then it dropped to around the same starting point.  How would you have known when to sell?

 

  1. You’ve got 75% of your portfolio in this example going down so you need to make three times the return in the remaining 25% just to break even!

 

Very technically oriented traders might have been able to read technical indicators in near real time and cashed in on the volatility but we’re not interested in trading stocks since that’s a replacement for a job or business.  We want something less intense with higher probability, we want an investment according to predictable rules.  In this case the rules told us not to invest that it wasn’t a safe bet, in 75% of the cases these proved to be accurate, in the remaining 25% it depended on when you bought and sold.

But here’s what’s so useful about investing based on solid fundamental economics as we advocate.

  1. You know when to hold or double down – you won’t always be right but in the vast majority of circumstances as the stock drops if the numbers are improving you know to continue holding and in most cases (again it’s probability) it will pay off, in fact the lower it goes the better deal (more profitable) it becomes

 

  1. You know when to sell – you may miss out on some upside in this respect, which is where being able to evaluate the value of dividends and opportunity cost elsewhere comes in but you’ll be able to cash in on low risk returns

 

The methodology we employ isn’t based on buying and holding forever nor is it based on being greedy or scared.  It is based on cashing in on a few market inefficiencies each year that collectively add up to a great return while minimizing the chance and severity of loss as much as possible.

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Stock Investing Examples June 20, 2014

Today I watched a presentation on why four particular stocks are supposed to be a good investment (http://seekingalpha.com/instablog/400846-marty-chilberg/3004373-barrons-4-oversold-stocks-to-buy) and having just sold some other holdings and looking for new ones it seemed worthwhile to check out.  The stocks in question were CREE, LL, HIBB, and UNFI.  All four have fallen substantially in the last year and received two upgrades from Wall Street analysts, in fact that they are the only four on the S&P 1500 to be in this position.  After reviewing them all I won’t be purchasing any of them at this point.  Why not?

Being down is a solid starting point for looking at whether to buy a stock after all the rule is “buy low, sell high” and they definitely aren’t high by historic standards in fact they are down DRAMATICALLY!  But what’s our key strategy here at Richucation?  It’s to capitalize on volatility by buying undervalued stocks and then crystalizing those gains when they return to their proper values.  The key question here is risk.

Risk in our minds is the chance and severity of loss and we bet pretty highly against risk meaning we believe strongly that by decreasing our real risk we increase our returns.  We avoid risk primarily in three ways:

  1. Buying stocks that are undervalued compared with their norm and industry norm
  2. Buying stocks that are undervalued in the real returns they provided as measured by P/E
  3. Buying stocks whose profits are likely to remain stable or grow

The four stocks listed above currently meet the first standard, which is why they were worth investigating.  The second standard is where we typically depart most sharply from traditional investment methodologies.

Ultimately the only REAL returns in the stock market are derived from profits produced by the underlying companies; everything else is just a shell game of money trading hands between speculators.  Hence the real bet when investing in a company is either based on its current profits or the belief that there will be future profits.  We take the view that betting on a possible future rather than a present reality is risky because the future is very uncertain.  We want to minimize uncertainty as a means of increasing yield.  Hence we only invest in profitable companies.

When we find a profitable company the question is what’s it worth based on its profitability?  This is a market question in other words “compared to what?”  The benchmark here always needs to be the lowest risk alternatively available so generally long term whole life insurance yields and government bond yields.  After all it doesn’t make any sense to take on additional risk unless the returns will surpass what we can get with a minimum of risk in a highly rated government bond.  If bonds are paying 12% then I need a lot higher than that in returns measured by P/E than if bonds are paying 2%.  In theory, a 2% bond yield is equivalent to a P/E ratio of 50, while a 10% bond yield is equal to a P/E ratio of 10.  In other words since the bond rates are way down right now we’d expect to invest in stocks with comparatively higher P/E ratios than we would have in say 1980.

On this basis of bond rates alone you might say the stocks above are good after all they all have less than a 50 times P/E but there are two additional factors to consider.  First, the market is comparative to other available investments in other words if the rest of the market is at a 10 times P/E (it’s not even close) then 40 times P/E would be very high.  The more important consideration though is when measuring stock prices against bond rates you need to factor in a margin of safety since the risk of most stocks is substantially higher than the risk in bonds.  At present the US treasury bond site lists the composite rate at 1.94% but this is exceptionally low by historic standards and even by global standards when we consider what savings accounts in very stable countries such as Australia are paying as a result we wouldn’t want to operate on a comparative basis of less than 5% (around what you see as the long term historic yield of a dividend participating whole life policy) or a P/E ratio of 20.  By this standard all four stocks of the stocks in question except HIBB fail to meet the test.  In other words by our standards they are definitely not undervalued when value is measured by profit yield and consequently we’d consider them risky.  Keep in mind this is typical for high growth stocks and plenty of people make money on such stocks but our approach is to categorize most such purchases as speculation rather than solid investment.  We aim to make our stock purchases with very little to no risk.

Think about this logically if a company has say a P/E ratio of 40 (CREE is at 48.38) you’re talking about the profits of the company generating a 2.5% return…that’s very poor something I’d never accept in say a real estate investment, which is very solid.  In theory this means those who purchase it are betting on very high growth but even if it doubled its profitability achieving a 20 times P/E ratio it would still be at only 5% return, still not exciting so for it to be really attractive it would need to at least quadruple its profitability, which in most cases is pretty unlikely and not a very safe bet.  Of course growth oriented investors don’t look at it this way but then that also explains why they typically don’t beat the general market.

HIBB is sitting at a P/E of 19.31, not low by the standards we like to invest in but also tolerable given current bond rates.  This brings us to the last question is profitability likely to grow or at least remain steady.  In other words investing at present is banking on a 5% return, which based on our risk weighting isn’t especially undervalued.  The remaining risk then is that it might go decrease in profitability, which might occur for four primary reasons:

  1. The market decreases
  2. Their market share decreases (competition)
  3. Their operational efficiency (margins) decrease (management risk)

This is where knowing the company comes in.  For example, if Visa were priced at this level we’d argue the market isn’t likely to decrease (payment by credit card is increasing globally) nor is Visa’s market share likely to decrease (they are very well entrenched with no significant competitors) so the main risk is to their operational efficiency/margins (for example EU pressure on interchange rates could decrease their profitability).  We’d deem this a fairly minimal risk and seriously consider buying Visa at this P/E ratio if all other factors checked out because we know it’s a solid business that’s not likely to go anywhere.  Hibbett Sports (HIBB) isn’t like Visa though facing much more real competition and profoundly different management risks and so by my reckoning doesn’t have a sufficient margin of safety to justify the risk.

Bottom line we’re always making investments looking for the absolute minimum of risk purchasing stocks that have an extremely high likelihood of increasing based on the fundamental drivers, which are profitability, the long term strength of the company, and the traditional valuation of the company and industry.