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.

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.

 

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.

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

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.

Why is business valuation so hard?

There are entire books, courses, consultancies dedicated to valuing businesses.  Yet, in spite of these there is very little credibility to those valuations with it being difficult to assign a fixed value to even large stable companies.  A business is ultimately valued based on the same principles as anything else, based on supply and demand meaning in theory it’s worth what someone is willing to pay for it and so the question often becomes “what’s the normal level someone would be willing to pay for it? And how do you figure that out?”  There are industry norms, small businesses depending on the industry, size, and assets tend to be valued at a 3 times multiple of earnings, a small accounting firm might be 75% of one year profits, sometimes various discount formulas are used.  Large public companies tend to start around 10 times earnings and then vary depending on trends, assets, industry, etc. but these are very arbitrary and generic assessments, the type that are likely to get you into trouble.  What’s the trouble?  Why the inconsistency?

A business is valued essentially from one perspective only, ROI.  In other words when considering what to pay for a business, what the business is worth the question is what will the return be for the investment relative to other opportunities?  Though it’s generally not on the mind of most investors, entrepreneurs, and business owners, the basic comparison to be made is government or equivalent bonds.  In other words government bonds tend to be a very certain, nearly as certain as you’ll get (assuming here we’re talking about AAA bonds) return.  A similar retail comparison would be lending money on an insured mortgage or loan to value first position mortgage where the security is virtually absolute and will cover the potential losses.  Understandably, a business is expected to produce a substantially higher rate of return than such bonds, why?  Because there’s substantially more risk.  In other words the balance being struck is the perceived risk relative to the apparent return, this is where we start to see the difference between the returns offered in a small business vs. a large public company.  In a small company it tends to be less stable and thus uncertain, in a large public company there’s generally an established infrastructure, brand, system, etc. and thus greater consistency in the long term performance, though neither generalization is accurate.  In a sense you might say purchasing at a 3 times multiplier (a theoretical 33% return) vs. say a 3% return on government bonds is a statement that “The risk of the business is 11 times greater than that of the bonds” (it’s not quite that simple but it communicates the general idea).

There’s an added complexity when it comes to a business that isn’t present in most other purchases such as real estate, bonds, or commodities.  The value of anything is contextual, meaning it is worth different amounts to different people in different times and places, however, nowhere is this more profound than with a business.   Think about Microsoft acquiring Skype for $8 billion.  Was it worth it?  Debatable, but how could it possibly be worth it when Skype wasn’t producing any profit?  The answer lies in Microsoft’s ability to use what Skype had (something like 160 million users) to extract more value than Skype could alone.  How?  Being able to sell other Microsoft products to them for a start.  Or the ability to decrease development and marketing costs associated with trying to capture that same market share from Skype.  Or the ability to keep competitors such as Google or Apple out (at the time of the acquisition Apple was driving forward aggressively with Facetime and the only real mobile competitor product was Skype).  This concept of leveraging an asset within the context of another company to be worth far more than it is worth outside that company is the root of most acquisitions that occur at outrageous multipliers (the other is the value of durability in dominating a market space).

On the one hand you have the uncertainty of the business’ future performance, which is often almost complete speculation.  (I was involved in the sales process of one of my companies recently and remarked at how ridiculous the idea of using multipliers as a means of valuation was given the fact that in a business such as this one revenues and profits could easily double or be reduced by half after a change of ownership or management and consequently it was laughable to look at the scenario as though there was some kind of predictable return in the future).  On the other hand you have the context of what it’s worth to the buyer and the market, which can vary wildly.  The combination of these factors make valuing businesses in general to be a virtually impossible feat.

Where then does this leave us?

Warren Buffett offers what is perhaps the most profound insight into business valuation.  Essentially, his position is you can’t accurately value most businesses; there is simply too much uncertainty at least as an outside investor.  Instead, you need to focus on businesses that are like bonds or cashflowing real estate; they have a stable long term outlook.  These he defines as businesses with a “durable competitive advantage”.  Such an advantage is often difficult to quantify and might come in many forms depending on the scale of the company, but it must have some advantage that’s extremely difficult to crack, sufficiently so that the costs don’t make it worth the returns and consequently the business is likely to endure for an extended period of time or perhaps even grow.  If a business is consistent and stable you can assign a valuation to it and those valuations should be directly comparable to the rate of return of bonds.

The other case where business valuations are possible with a certain accuracy is when there’s a current asset whether tangible or intangible that will have an immediate value for the business making the acquisition.  This might be a customer base, it might be technology, or might be infrastructure, a brand, or a team.  In each of these cases a calculation can be made based on how valuable they’ll be to the new owners within a margin of error and make a decision accordingly.

Beware anytime someone comes to you with a fool proof method of business valuation, it can be dangerous but because it is so challenging it is also perhaps the greatest opportunity for market inefficiencies.

To learn more about buying businesses, business valuations, investing, business growth and wealth building follow our articles and information or contact us with any questions you might have to receive personalized answers.

When should you invest?

Warren Buffett was once asked the question of “when should you invest?” to which he replied “when you’ve got money”.  Aside from the comical nature of the comment for which he is famous the statement carries with it a certain wisdom to be expanded upon.  When indeed one might ask?  When during the market cycle, when is the price right, when is the economy optimal?

What was Buffett really trying to say?  Was he saying simply invest haphazardly because you have money?  No, not at all.  Was he saying “rush in”?  No.  Was he saying “listen every moment you aren’t in the market you’re missing out on compounding and the value of your dollars is eroding due to inflation?”  Yes, he was saying that to some extent and that’s a valuable point.  One of the most significant factors financial planners are likely to point out is the value of getting started early that the effects of compounding become more acute with time and consequently getting started early is very valuable.  But there’s something else more useful for us in Buffett’s wisdom.

How many times do people sit watching a stock trying to time the bottom, or find the perfect time to invest?  Very often!  Getting the timing right can be an obsession for many and it can result in their missing plenty of great opportunities.  It is to these people in particular that Buffett’s wisdom is poignant.

Let’s rephrase what Buffett is saying “if you’ve got a great company at a good price it’s always the right time to invest”.  In other words start by looking for great companies, when you find them identify a good price then whether they might go lower or not, invest if you have money.

The problem many are trapped by and the reason this wisdom is so valuable is because timing the market is virtually impossible, no one can really tell how high it will go or how low it will fall, the market will have ups and it will have downs, this is why dollar cost averaging is such a useful process for average people and relied upon by investment advisors because on average the market might go up but that doesn’t mean it will go up any particular day so if you put all your money in one day you might lose, but if you are putting it in every day then on average it will be going up and generally it takes a lot longer to go up than it does to come down so you’ll have more up days than down days.

If you’ve got a great company at a good price perhaps the price will drop further, if that’s the case, buy more as you have money to invest, but if you’ve got a great company at a good price you’re going to make money in the aggregate so do it and get back to making more money to invest.  Get back to doing what you do best and continue to invest as those opportunities exist.  Don’t invest when those opportunities aren’t present but don’t obsess over the perfect timing, it will cause you stress, cause you to miss opportunities, and take up far more time than it’s worth.

Principles need to be simple to execute consistently, that’s exactly what this principle does, it’s not a rule, you can make money without doing it, but as a guiding force it will make your life better and make you more successful.  The time to invest in great opportunities is when you have money to invest in them, there is never a time to invest in poor opportunities, which are determined by either the price (too high) or the venture (anything less than great).  Rather than timing the market spend your time looking for great ventures and determining what constitutes a good price for those ventures.

There is one final piece of wisdom in Buffett’s statement.  You’ll notice he doesn’t say “invest when you have credit”.  Buffett has become the world’s richest man mostly without debt, yes he ran partnerships capitalized by others to increase his leverage and yes he allocated the capital of his companies particularly insurance companies to increase his holdings and consequently his personal returns, but there’s an important distinction when it comes to what he did and what many people did.  In his case there was no holding cost.  Holding costs can kill you and they’ll certainly radically undermine returns.  The first step for practically everyone should be to pay off high interest credit card debt because you won’t consistently get better returns than what the credit card companies are charging you.  What if what you invest in requires you hold out for an extra year longer than you’d expected?  If you were investing with debt that means you’ve got an additional year of costs, now what if you can’t afford to service that debt and have to sell at a loss?  Debt raises your level of risk astronomically so invest when you have money, not when you have credit and your life will be happier and generally, more successful.

Have more questions about wealth building?  We’d love to hear from you, ask away!

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What is Credit?

Credit is used every day often without us even knowing it.  If you’ve got a tab at the bar they have essentially provided you with credit even though it’s very short term credit.  There’s an illusion that only banks can create credit and some conspiracy theorists who decry the unfairness of this system.  Nothing could be further from the truth.

Credit is incredibly important and in other articles we’ll examine how it works to create cycles within the economy.  The question is what is it?

To be clear, we’re not referring to credit scores here.  What we’re referring to is a means of payment.  You pay with either cash or credit, again not referring to credit cards in this case.  So what is it?

In any transaction there is an exchange a good or service for cash or credit.  Let’s consider what happens in a cash transaction (not referring to physical bills here but where there is no debt created).  In a case such as this I pay you money and you give me a good or service.  Look at our balance sheets.  At the start I’ve got an asset and you’ve got cash.  Then when the transaction goes through we swap.

Before the Transaction

 

Me You
Cash Goods

After the Transaction

Me You
Goods Cash

Now let’s see what happens if we change this process and instead of paying with cash.

Before the Transaction

Me You
Assets Liabilities Assets Liabilities
None None Goods None

After the Transaction

Me You
Assets Liabilities Assets Liabilities
Goods Debt (payable) Debt (receivable) None

 

Notice what happened here.  Instead of paying cash debt was created.  What is debt?  Debt is an asset for the person who is going to collect the debt and a liability for the person who has to pay the debt.

In other words, credit is when we create out of thin air an asset on one person’s balance sheet with a corresponding exactly equal liability on the other person’s balance sheet.  When the debt is paid off you’ll go back to the way it was in the cash transaction with just cash on the balance sheet of the person who was paid and no liability on the balance sheet of the person who paid.  What’s important about this?  A lot of people confuse credit for money because it can be used as such but credit, which can be issued to an unlimited extent within the confines of physical resources is not really the same as creating money.  It is treated as money in many cases to exchange goods and services but the difference is there is no net growth in wealth because credit cancels itself out.  What it does is it allows transactions to take place sooner, which can help to increase productivity and activate resources in the economy that would normally just be sitting.

Hopefully that gives you a basic understanding of what credit is and how it works.  There’s a lot more to it of course but we’ll cover those nuances in future posts.

If you’re interested in a deeper understanding of credit or any other business or wealth building issue please contact us and we’d be happy to assist you.

The psychological drivers behind cycles

In any asset class, market or economy there are cycles.  In other cases we attempt to explain a bit about the debt cycles and how they work driven by the expansion and contraction of credit (effectively the rise and fall of the money supply and spending).  For those interested the best explanation is arguably Ray Dalio’s elegant video How the Economic Machine Works available on Youtube.  However, aside from the financial reasons for cycles there are also psychological ones.  The two are very much tied together but the psychological ones amplify the financial ones and show up with much more volatility in many cases driving the financial ones.

Here’s the first premise to understand:

“Capital wants to go to where it is most productive”

What does this mean?  It means money will naturally tend to flow to where there is the highest rate of return.  So in other words if say one place was paying 5%/yr. and another was paying 8% per year over time money would flow away from the 5% rate of return investments and towards the 8% rate of return investments.  It’s more complicated than that of course but in the aggregate this holds true.

Here’s the second premise to understand:

“Markets will naturally equalize over time to a rational value”

This means over time as people buy and sell within a market that which is being bought and sold will tend towards its fair price.  This is why prices for items all over the world are fairly stable and when they aren’t those differences don’t last.  Here’s an example of how this works.  Let’s say you buy a car and pay too much for it.  Say other similar cars are selling for $20 000 and you pay $30 000 for it.  The theoretic value when you bought it will be $30 000, but it will tend towards the $20 000 level because on average people are only willing to pay $20 000 for it.  Why won’t they pay $30 000 for it?  Because they can get something similar for $20 000, so why would they pay $30 000 for it?  In other words each person wants to stretch their dollar as far as they can, get the most they can for each dollar so they won’t overpay for it at least not by much in most situations.

The reverse is also true, say you bought that same car for $10 000.  The price will tend towards $20 000 because if similar cars are selling for $20 000 then why would you sell it for less?  In other words you want to get the most you possibly can for what you’re selling.  Of course the person who buys it from you will feel the same way so even if you sold for somewhat less than it is worth they’ll try to sell for a little bit more.

These opposing forces of the part of the market that is selling wanting to charge as much as possible and the part of the market that is buying wanting to pay as little as possible will drive towards an equilibrium.  You’ll always get little exceptions such as when someone needs something in a hurry and is willing to discount lower or pay more to get it faster but on the whole this concept holds true.

Based on all of this you’d think prices would just sit at a nice equilibrium, which in most markets they do to a large extent but financial markets tend to be a little different, which is because of trends.  A trend for our purposes is when the value of something is changing in a particular direction either positive or negative.  Here’s what happens psychologically.

Person A maybe buys low and sells high getting a pretty good yield.  In other words maybe there’s a pocket of the market that’s a little undervalued so there’s an opportunity to buy for less than it would normally be priced at and sell for maybe slightly over what it’s worth.  This is normal, this is the task of the entrepreneur.  But something happens.  Person B sees that person A just made a good amount of money and decides to do the same.  If this happens enough times and it catches a rising trend this is when something interesting tends to happen.  The rising trend means even as people start to buy closer to the actual value of something they are still able to sell it and make money.  What this does is starts a herd mentality, which is slow at first.  At this point it is still based on ok economics, not great economics like we would advocate but it’s still fine.

Because people are buying more it creates artificial demand that is to say investment demand for whatever is being purchase.  More demand drives prices up, which means those who bought previously are making even more money off their purchase and more people start to see them do so.  The people who see everyone else making money start to figure they want to get in on this after all returns here look great so they go and buy (remember capital flows to where there are the highest returns).  A problem happens at this point though, which is people start paying more for something than it is worth because they are speculating on it going higher and other people are buying from them for even more (reinforcing the notion that it was a good purchase) because they in turn are speculating.  In theory this could go on forever but remember what we said before?

Over time markets will tend back towards rational values.

The reason for this is because as a percentage of a person’s income and net worth as the prices go up it becomes less and less affordable so less and less people can buy, which means there’s less of an opportunity for prices to go up.  This is compounded by the fact that the rational market (real entrepreneurs and investors) stop buying once the market gets too high and that reduces the number of buyers further.

To help understand this let’s consider the example of a house.  Say it’s worth $200k and the trend is upward so over the period of our example it would have grown to a real value of $250k.  But before it gets there someone buys it for $220k and sells for $250k, because all the houses are going up someone else buys for $270k, so another person buys for $300k and another after them for $350k and so on.  Just ask yourself how many people can afford a $200k house?  Quite a few, but how many can afford a $350k house?  A lot less.  So if the number of potential buyers at $350k is half of the number at $200k but the number of houses for sale is the same then someone is losing out.  The period of time it takes to sell the house with fewer buyers goes up, which decreases the rate of return.  This is compounded by prices maybe needing to be slashed.  Suddenly, the market reverses as people who bought too high can’t find buyers at that level (because other people are slashing prices for a similar product so why would someone pay a higher price than necessary).

This is where the cycle gets most aggressive in terms of the speed (you’ll notice markets tend to fall faster than they rise when they are coming down from an especially bad artificial high).  What happens here?  People begin to panic as they see prices falling, they speculated so they worry they won’t be able to sell for what they paid for it so they list their assets but this floods the market, which makes it harder to sell still so people have to slash their prices, which means more people have to slash their prices.  Now those who had bought speculating hoping to make a quick buck they can’t afford to hold it and they owe more on it than it is worth so suddenly they are losing money…a lot of people are losing money.  What does this do?  It reduces the number of available buyers, which puts even more downward pressure on prices so they sink well below the actual values (say down to $150k or $200k instead of the $250k they should be at in a rational market).

So how does it stop this free fall?  First, those who were holding long term, who had bought for low (say around $200k) provide a buffer in the market, a rational level.  Second, investors see how prices have fallen irrationally low and start to buy, which adds buyers to the market and helps to stabilize prices.  Third, those who really needed to dump the products for fear of losing what they put in gradually get weeded out while those who can afford to wait and hold decide not to sell so they don’t lose out.  Fourth, as prices drop there is a larger pool of buyers who can afford to buy, which increases demand and gradually the market begins to turn again to rise towards a more rational level.

What’s the psychology of the market here in summary?

  1. Desire to produce returns on money
  2. Speculation as money seems to be easy
  3. Pulling out by investors as prices become irrational and out of control
  4. Panic as the market turns
  5. Desire to hold for prices to recover
  6. Desire to capitalize on good deals once prices have fallen

If you understand cycles you can do substantially better at investing since a good investor knows what behaviors to take during what phase of the cycle in order to maximize returns.  You’ve got to pay attention to debt cycles as well and those are more predictable but you’ll see psychological cycles more frequently than debt cycles and showing up in smaller markets or assets.  If you’re interested in more information on investing or have questions please feel free to write to us and we’ll get back to you with an answer.

Have questions about market or investment cycles?  Have other business or wealth building questions?  Contact us with your questions and we’ll provide answers.  Click “Ask a Business Question” at the lower right of the screen.

Don’t invest just because it’s cheap

At Richucation we talk a lot about good deals and their importance, you have to buy lower than you sell and one of the best ways to mitigate the risk of loss is to buy for less than something is worth.  These principles are true but we also caution you that you can’t get rich cutting costs, or more appropriately cutting costs doesn’t bring in profits, it’s only good if you’ve got corresponding revenues you can recoup those profits from.  Put plainly you probably know all kinds of people who try to save $20 or $200 per month off their spending but they are making barely more than a subsistence wage anyway.  In other words no matter how much you cut your costs if you’re only ever making $2000/mo. you’ll never become a billionaire.  There’s another way of looking at this in terms of investing.

Let’s say the market for real estate drops, prices going way down to half what they were previously (much as they did during the 2008 housing crash in the US).  It’s tempting to say “wow, I can pick up houses for $5000, surely any house is worth more than $5000”.  The reality is you could purchase houses for $5000 during that time, in fact you could purchase for less in some cases as little as $500, seemingly outrageous deals in places like Detroit.  Banks would hold mortgages and the owners defaulted turning them into foreclosures, but there was too many so the demand for even inexpensive foreclosures evaporated relative to the demand and banks who once felt secure with assets to protect them were suddenly in trouble.  It became so bad that many of the banks went bankrupt and their creditors and sometimes the city took possession of mass numbers of properties that sat without taxes, insurance, or income, worse they were victims of the elements, of vandalism, having squatters was actually a good thing because at least someone was doing a bit to take care of the place.  And in this environment it was possible to purchase property for seemingly unreal prices.

Does this kind of environment create opportunities?

Absolutely, and many people took advantage of it with creative ways to make money like selling the houses to people who’d ruined their credit and couldn’t get a mortgage for a down payment equal to the purchase price of the house, vendor financing it and counting on at least some profit over the coming ten years but little to no money out of pocket during the interim.  This and many other strategies were employed.  But those are the wins.  The fact of the matter is as good as some of those deals might have seemed there was a reason you could buy mass numbers of properties for those prices, because often far from buying at asset you were buying a liability.  Because taxes would become payable, because the eroding population and rental demand might mean leaving the property empty for ages.  Because renovations were required just to make the property livable and these would cost far more than the property itself.

Herein lies another very obvious yet often overlooked investment lesson.  NEVER invest because something is cheap.  ONLY invest because it is going to increase in value.  Yes, if you can buy cheap enough there’s a higher chance you can make a profit on it.  Yes, if you buy cheaper you are minimizing the amount of money you are exposing to risk.  Yes, if you buy cheap there might theoretically be a better chance it will go up, but the bottom line is price is not an indicator of whether something will rise in value or not.

The first investment question is never “is it cheap”, but rather “is it going up in value?”  The way Warren Buffett frames this is to first look for great companies with a durable competitive advantage and only after finding those does he look to make sure they are a good deal (good price).

This one reminder can save you fortunes, start by looking for things that are going up, then maximize them by buying low and protect yourself by buying low.  You’ll end up with far more by taking this approach than by looking for low prices.

If you’ve got questions about how to do this or about any other investment or business issue please contact us by clicking “Ask a Business Question” at the lower right corner of the screen and we’ll be happy to answer you.