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.

Currency Risk Inherent in Commodities Investing (for foreigners)

Since I’ve been advocating buying oil over the last few days I figured it was a good time to explain a point of larger scale finance that can affect a lot of people internationally if they start buying oil.

As you start to grow your wealth you’re going to increasingly become exposed to the global financial environment spending money in different countries and currencies, selling to different counties and currencies, dealing with different political and tax systems, different regulations, and so on.  What you’ll often find is what seems like a good business model in one market can be fatal in another.  The world is full of examples of big successful companies that entered a new market only to leave later after experiencing failure.

For our purposes the risk we’re going to focus on is currency risk.  If for example you’re an Australian business purchasing services from US providers the last couple months have been rough for you as the Australian dollar hit a 5 year low.  The same principle applies to investing, in this case investing in oil.  The US dollar is relatively strong at the moment and the price of oil is relatively low.  If the US dollar were to fall you’d see the price of oil rise relatively to international currencies while remaining the same price in real global terms.  In other words, the price of oil could go up by 10% and you could end up with zero profit in your local currency if those gains were either as a result of a drop in the US dollar or offset by gains in your local currency.

This is especially important for those investing from countries where their local currency is highly commodity, and in particular oil dependent such as Canada.  Canada’s dollar is trading quite low compared to the US dollar at the moment and oil is trading low as well.  The danger for Canadians is if the price of oil increases the value of the Canadian dollar is also likely to increase at least somewhat and this will, at least to some extent, undermine returns.

Of course in theory the opposite could happen if you were in an economy where your currency would fluctuate inversely to the price of oil and you could compound your returns.  (No currency will be entirely in line with the movement of any particular commodity but certain currencies at least tend to be more commodity dependent based on the make-up of their economy).

The basic lesson is to watch global factors especially as you begin to operate more and more globally.  It can help you to plan for risks such as fluctuations in foreign currencies and costs.  It also represents a tremendous opportunity as volatility opens the door for advantages in importing and exporting.  For example, prices are typically set between given markets based on relatively long term trends.  Books are a good example of this, visit Canada and you’ll see a price in USD and another in CAD.  These are physically printed on the books and aren’t likely to change quickly.  On the other hand the currencies could change quite quickly.  What you can keep in mind then is if say the Canadian dollar has fallen a fair bit in a short period of time, take advantage of it by buying goods from Canada where it’s an option in the period immediately after the fall prior to prices being corrected for the changes in currency value.  If on the other hand the Canadian dollar has risen a fair bit in a short period of time take advantage of using Canadian dollars to purchase abroad rather than locally because the prices will be lower on a relative basis for the same items.  In the early 2000s I took advantage of this disparity purchasing computer parts when purchasing across the border offered significant cost advantages.  Of course it only makes sense at a certain scale and convenience but it’s a valuable lesson to learn.

The Fallacy of Timing Markets – Lessons in Investing Psychology & Strategy

In determining how I wanted to invest in oil today I stumbled upon an article asking if now was a good time to buy oil.  It discussed the classic buy low sell high dynamic and how oil does indeed look low.  Perhaps it was journalistic ass covering or investment advisor ignorance but the article went on the make some comments frequent among investors that cost far more returns than they create.

The two objections raised were “we don’t know how low it will go” and “we don’t know how long it will stay down”.

On the surface these pieces “wisdom” seem logical.  It’s actually a fact, we don’t know how low oil will go (though we can make reasonable guesses about how low it won’t go based on production costs, etc. for example it will almost certainly not fall much below $40/barrel if it even gets there) or how long it will stay down (we can make educated guesses here though we can only project based on a partial rebound not a full recovery if one ever comes).  So what’s the danger?  They expose a fundamental error in investing lore.

The psychological tendency is if something is worth $80 and it drops to $50 where you buy it, but it continues down to $45 before it recovers you will tend to think “look I missed out on that $5 extra I could have earned”.  And “if only I’d waited a little longer I could have caught it at $45 instead of $50”.  The reality is it doesn’t much matter because you made a solid return in a fairly short period of time.  More importantly, what this thinking will do to you more often than not is paralyze you from taking the action that would have earned you the return.  In other words at $45 you’ll tend to think “what if I buy now and it falls to $40?”  Then if it goes back up to $50 you might be busy waiting for it to go back to $45 while it rises back to $80.

Only fools try to time the market, it is simply too difficult.  Yes, there are technical traders who can do a pretty good job in short little bursts but that’s not what we’re talking about here.  What we’re talking about here is speculation based on longer term decisions.

If you want to consistently gain solid returns the way to do it is to discipline yourself around rules and principles.  In this case the rule is “when something falls to the point where it’s a great deal with a significant margin of safety buy it”.  We’re assuming of course that you’ve followed the other principles such as understanding what you’re buying, understanding why it’s a good buy and so on.  At this point if you’ve done it well it doesn’t much matter what happens next in the short term.  If it falls more great, buy more if you’re able.  If the fundamentals change so it’s no longer a good buy then get out.  Otherwise hold until your margin of safety has expired and act accordingly.

In the case of oil I know oil is a good price and yes it might fall in the coming weeks slightly (but not significantly).  If it does and I have new additional available cash I’ll buy more.  If it doesn’t then at least I took advantage of a good price and will watch to cash in accordingly.

What about the timing factor though?  Again, this is a question of margin of safety.  I’m projecting that oil will probably recover fairly reasonably within 6 months or so (this is also in line with some of the Saudi projections) but I don’t expect it to.  My initial margin of safety is to say “it will go up at least temporarily within the next 12 months”.  I know this has some cushion and yet the returns will still be very strong if this proves to be the case.  As a fall back I’m willing to wait 18-24 months at which point it won’t have been a stellar return but still quite reasonable (15% simple return based on a 24 month hold time).  Because of the factors involved I know this is unlikely, it will probably be much sooner and I’m very much ok with it if that does happen.

What if it doesn’t recover or doesn’t recover in the foreseeable future?  It is of course possible that I’ve made a mistake, that prices will fall further and stay low for the next few years.  I consider this unlikely but possible.  If this is the case where’s my margin of safety?  In this case the margin of safety comes from having a solid idea of the basement price it could reasonably reach (somewhere around $40/barrel), which is determined by global market demand, incentives, current state of the economy and most importantly the combination of these and production costs.  Based on these factors its extremely likely that it would fall below those levels especially for a sustained period and fairly unlikely that it will fall substantially below the current levels for any extended period of time.  In other words the worst case scenario is my investment is relatively safe with virtually no chance of more than a 10% loss, which is better than I can say for most stocks.

Why Oil Now?

I recently advocated buying oil as it hit $50/barrel and explained why.  There’s a broader context worth understanding though around why I’m so intensely bullish on oil right now.

As mentioned previously in the long run productive assets (mainly real estate and businesses) will outperform commodities and so commodities aren’t a good investment so much as a trade.  To make money on commodities you need to capitalize on the volatility rather than holding them and you need to understand how to do so.  Even when commodities are low though I hesitate to employ those strategies because the wait time, which is always uncertain, can dramatically undermine returns relative to simply holding productive assets giving off cashflow.

What’s different today?

You’ve got to do something with your money and you’re looking for opportunities.  Aside from my own businesses I’m looking for returns primarily in three places:

  • Private loans
  • Real estate
  • Stocks

We could toss bonds in there on a rare occasion but generally I tend away from bonds for my own strategy.  In the last couple years this blend has served me well.  The problem is to do well in any of these (my personal target is in excess of 20%/yr.) requires locating deals that don’t come around often.  In private loans I’ve managed to generate 7%/quarter in each of the last two years but these were limited short term opportunities based on long relationships I had with businesses in need of short term financing they couldn’t obtain elsewhere.  Real estate is based on understanding the markets, shopping around extensively, and managing the properties well.  Stocks are based on short term inefficiencies in the prices of stable long term companies.  The challenge recently is I’m having a hard time locating any of those opportunities.  Last year in stocks I did fairly well on BP and Toyota but of the stocks I follow and understand there simply aren’t any solid opportunities with great margin of safety, the whole market is in my view fairly overpriced.

When it comes to real estate the markets I follow and know well are in one of two conditions:

  1. Overpriced – for example the markets flooded with Chinese money don’t have realistic pricing I can understand
  2. Uncertain – for example markets dependent on oil at the moment could soften considerably as job markets stagnate

This means there’s an absence of great opportunities as the other fall backs such as bonds and private loans aren’t looking particularly great either.

Under these conditions I’m looking at oil as by far the biggest, surest market opportunity I’m aware of and understand.  I’m betting on around a 30% return in 12 months or less with a reasonable margin of safety and willingness to hold on longer if necessary.  At the moment I simply don’t see any other comparable opportunities where I might etch out a solid 20+%.

Time to Buy Oil? A Lesson in Trading

Anyone who knows me and my investment strategies well will know I’m not fond of commodities, in fact I’m notoriously against buying gold.  The rationale is simple, a productive asset (one where the base value is maintained but it also grows or puts out cashflow) such as a company or piece of land will by nature perform better over the long term all else being equal than a commodity will since the commodity by nature doesn’t grow.  In other words while you might invest in assets such as land and companies the strategy with commodities is to trade them and I tend not to take a trading strategy.

This being said there are exceptions and oil today is one such exception.  I’m buying oil and strongly recommending those I know to do the same.  That doesn’t mean you should run out and do it, everyone’s situation varies but it means I expect oil to produce strong returns in the near future.

What’s the big deal with oil?

Most commodity markets are fairly efficient based on the natural dynamics of supply and demand, much more so than companies or even real estate because they are much less complex, there is less to know.  Whereas in a company there could be poor management, or competition, or a million other factors aside from market conditions that affect the value of the company in the case of a commodity it’s really only the market conditions (supply and demand, whether artificial or not) that matter.

So what’s the key when it comes to commodities?  Same principle as normal, buy low, sell high.  The question is how do you know when it’s low or high?  In the case of stocks and real estate I recommend judging based on the income generated or income they are likely to generate in the future.  When it comes to commodities there is no income potential so you’re essentially betting that the supply will decrease relative to the demand.  The problem I have with gold is supply and demand are completely artificial based purely on market speculation than on real consumptive forces.  Commodities such as oil are different, they are based mostly on real consumptive forces no one really plans on buying barrels of oil to store in a vault as a store of value hedging against the decrease in commodities, etc.

These principles established we have another principle, which is critically important in both investing and trading.  Something might appear to be low but more often than not the market is right, so to beat the market on a consistent basis you need to know something the market doesn’t.  In other words you might look at a company whose stock falls and say “oh it used to trade at $100/share now it’s down to $50/share, that’s a good deal because it’s half price!”  But really the reason the market has decreased its value is because the projected outlook and profitability of the company has decreased so what looks like a stock on for half price is really a fairly priced stock based on the current market conditions so unless you have a reason to believe this is short lived that is better than what the market sees you’ll probably not do well buying that stock.

Same concept is true for a commodity like oil.  Let’s say some revolutionary new alternative energy source was released tomorrow (a bit like what happened to Uranium when cold fusion was first announced), you’d likely see the price of oil drop dramatically because the implication is the demand for oil will decrease as it will be replaced by this superior energy source.  (In practice implementation time of the new energy source, etc. might mean it would have little effect so this example is strictly for illustration purposes).  In other words when the price of oil fell it wouldn’t be a good buy because the market has changed and the price is not likely to ever recover as it’s been fundamentally changed by this new technology.

To consistently make good money then you need to see an opportunity where the value of the commodity or investment has fallen to below what it should be worth under normal market conditions and understand how and why it will correct in fairly short order.  This is where the uncertainty of the 2009 stock market crash comes in.  Companies like GE might have been on sale for 50% off but they weren’t necessarily clear purchase opportunities for most people because no one knew how deep the recession would go or how long it would last, the current prices might have been new fair prices for the foreseeable future.  It turns out with hindsight that this was a great purchase opportunity but it was a lot harder to see in the moment.

How does this apply to oil?  Since the summer oil has fallen from around $100/barrel to less than $50/barrel, a dramatic decline.  On the surface this is potentially a “buy low” opportunity, but let’s look deeper.  We evaluate as follows:

First, we need to understand why it has fallen dramatically so we can understand that this isn’t a fundamental change in the value of oil.  We can evaluate this through the answers to a series of questions.

  1. “Was $100/barrel a relatively fair market price?” In other words dropping from very high to much lower isn’t necessarily a sign of the asset being a good deal today, it might have simply been overpriced before.  This was a fallacy many made when they pointed to houses in 2009 worth half what they’d been selling for previously, the houses weren’t worth what they’d sold for at the peak, they were selling for inflated prices due to the market conditions and the real value was considerably lower.
  2. “What has changed in the market and what’s a new fair value based on the current conditions?” Using the real estate example maybe previously a property was in a good neighborhood but since then it’s become violent and gang infested with a lot of drug use, etc. so it’s no longer as desirable.  If this is the case it might still be a good deal but based on a new valuation so the question is what’s a fair valuation now based on present and projected market conditions?
  3. “Why has the value dropped lower than it should have based on the current or changing market conditions?” Markets over reaction and they under react the important thing to understand if you’re going to predict changes is why so you can apply logic to whether they’ll correct or not.

Before moving on we’ll answer these questions for oil.  Was $100/barrel a fair market price?  At the time, loosely yes maybe slightly lower, but oil stayed relatively stagnant for quite a long period of time.  It’s an environment where the fundamental drivers haven’t and aren’t changing very much.  Production levels typically don’t adjust by more than a few % per year and nor does demand.  Furthermore the market is fairly efficient with global distribution and exchange meaning opportunities for pockets of inefficiency in buying or selling are rare and typically quite isolated leaving little room for long term exploitation (production is a whole other matter but that’s not what we’re referring to here).  We can also look at production costs, which throughout much of the world have become fairly high in the $60-$70/barrel levels (it varies based on what reports you read and it depends on where but the likes of US shale development, Canadian tar sands development, Russian development, etc. hovers in this range with a margin of safety).  These production costs give a sort of guidance around what levels are fair in the market as well since it determines what levels justify added production.  Production costs are substantially lower in places such as the Middle East, but the market overall gets averaged.  In other words yes given the current and expected demand as well as production somewhere in the $90/barrel range it was trading at was quite fair for those market conditions.

What’s changed then and what’s a fair new value?  Here beyond just the immediate factor, which is OPEC specifically the Saudi policy regarding oil production/reserves and their pricing targets let’s look at the big picture.  In the last few years changing US oil policy and improved technology have resulted in massive increases in US oil production, which has decreased the US demand for crude.  Additionally, the global market has in general been fairly slow, China’s economy is slowing in its growth, etc.  Finally, additional technological efficiencies and developments both on the energy production side in the form of alternate energy sources and on the consumption side efficiencies in how we use energy such as more fuel efficient cars, etc. have helped to limit demand relative to supply.  In this environment the case for sustained moderate prices can easily be made.

The specifics of this situation in terms of what triggered the dramatic change in oil prices is OPEC decided to introduce a price target substantially lower than the then normal price level and to achieve this by flooding the global market with additional reserves driving down the prices.  Based on this new factor one might expect that somewhere around a $70/barrel price is more reasonable in today’s market conditions.

Why has it corrected so far below these levels then?  There are two key factors, the first logical the second emotional.  On the one hand there’s a temporary increase in the amount of oil available on the market relative to the demand (demand hasn’t changed much) as OPEC and specifically Saudi releases reserves onto the market but existing more expensive sources remain.  On the other hand as prices are falling fairly rapidly and dramatically the drama is triggering an emotional market response whereby there is more selling and less buying than normal as players wait for the market to settle and see where prices fall.

Now that we’ve answered the first questions the final question becomes:

“Why is this a short term inefficiency that will be corrected fairly quickly?”

To answer this we can look at numerous data points:

  1. As prices fall intrinsically this will lead to increases in demand because the costs of consumption will decrease. You can probably already observe this at the pumps of gas stations as it becomes more affordable to drive people are more willing to drive and to drive more.  This effect will take place across the globe and the system increasing the demand, which has the effect of increasing prices.
  2. As prices fall the high cost producers will decrease production thereby reducing the supply in the market (companies that have a $70/barrel production cost aren’t going to continue to produce if the price of oil is $50/barrel). Reducing the supply in the market will have the added effect of increasing prices.
  3. Supply is artificially high due to opening reserves and as these short term reserves are depleted prices will return to more normal levels.
  4. It’s not in the best interest of anyone including the Saudis or OPEC to have prices at levels as low as we are seeing right now. At say $70/barrel it can make sense because they can make up for decreases in price with increases in market share as the higher cost producers are forced out of the market at least temporarily.  But at say $50/barrel the economics aren’t favorable to any of those nations, which gives them an incentive to limit supply in order to drive the prices up to a more reasonable level.
  5. We can determine norms by comparing various phases in the market over the last 10 years. The last time prices were down at these levels was in a very recessionary economy post 2008.  Even as the economy sat in a fairly uncertain state prices were around $60/barrel.  Today the economy and global demand are much greater than back then, factors which don’t justify prices as low as $50/barrel and below.
  6. Anytime an asset gets cheap investors step in and start regulating the demand forces and trigger the start of a turn around.

At $60/barrel oil wasn’t a great buy because there wasn’t a strong margin of safety.  At $50/barrel or lower it is a great buy because the margin of safety is significant.  I’m expecting to see a 30% increase to at least $65/barrel sometime in the next 12 months if not sooner and making purchase decisions accordingly.  When oil reaches that level I’ll plan on selling because beyond that point, though it might rise much higher there is an element of uncertainty and no real margin of safety unless of course something changes dramatically in the market between now and then.  If it were a productive asset I might be willing to hold at that point based on the productivity of the asset but as a commodity it’s a trade, get in and get out, cashing in on the volatility.

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.

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Risk the Mother of All Bad Deals

Our second principle at Richucation is rich people love great deals, they love to be able to buy things for less than those things are worth.  There are many factors in this process such as knowing your true costs (a good friend once remarked it’s worth it to pay $200 for a shirt you like because the real cost isn’t the shirt, it’s your time to find one that’s perfect for you and you’ll spend more money in time trying to find a better deal or find another you love for a great price than you will save), knowing the accurate value of what you’re buying, etc. but ultimately we return to this as a foundational principle and our first lesson to new students.  Rarely accounted for though is the cost of risk and how risk undermines good deals.

Mark Cuban, the billionaire owner of the Dallas Mavericks, once remarked on his blog that the score comes not from what you extract from any single deal but what you end up with overall.  Put another way it doesn’t matter how an athlete performs in a single game, it is their average over time, the aggregate results.  Most successful companies lose money on various transactions throughout the year but in the aggregate those transactions are covered off by the profitable ones.  The key is knowing those numbers to ensure the winners more than cover the losers and then improving the statistics.

Nowhere is this more true or the dangers more insidious than when considering risk.

Risk is not a particularly popular word with entrepreneurs, by nature entrepreneurs tend to be optimistic, they also tend to as a group overlook failures and focus on successes and psychologically this approach has merit.  In terms of creating success you’ve got to look at the failures and the failure rates.

Let’s start by defining risk.  In this case risk is the probability of failure and its related cost.  It is most insidious because you don’t see it in the short term, it only shows up in the long term so you can have what appear to be great successes that ultimately turn out to be great failures.

Consider the example of the exempt market investment products industry.  Walk into in local investment office and ask them about their available products and they’ll tell you all about the MICs, the real estate development LPs, and many more.  They’ll frequently pitch returns ranging from 8% to 25% per year.  Consider yourself warned, Warren Buffett averages 20%/yr. over a long period, if you think these guys can get you a 25%/yr. return in the aggregate (meaning not by getting lucky during a small cross section of the cycle but when averaged across the whole cycle and repeated cycles) you’re probably deceiving yourself.  Are 25+% returns possible?  Yes, definitely, especially in small deals in limited timeframes by very skillful experts.  Buffett has actually remarked that he could get 50% on $1 million because the dynamics are different.  However, keep in mind that in order to return you 25% the company really needs to be earning probably 35% – 40% because they have to pay all their expenses plus etch out a profit.  Let me be clear, no one truly offers consistent long term returns of 25+%.  The only people who get that are people who are managing their own money often in their own business and other factors weigh in, you should probably be running from promises such as those.  But what about the lower end, a 10% return.  This is very respectable and certainly attainable so you can accept those numbers right?  Not really.  Those in the exempt market industry are fond of harping against the mainstream investment industry pushing mutual funds and GICs.  They talk of beating the market through the exempt market but the truth isn’t nearly so glamorous because the general market accounts for risk in its figures the exempt market does not.

When your mutual fund advisor tells you about the 5%/yr. returns a particular fund has averaged over the last 20 years that’s after accounting for all the ups and downs of those decades.  It might have been 15% one year and -15% another year but after all was said and done they managed to scrape together a 5%/yr. return.  When your exempt market dealer tells you about the 8%/yr. you’ll be getting that’s not an aggregate of results, that’s a promise made without security.  In other words there probably are some that will pay 8%/yr. just like a couple stocks in that bundle within the mutual fund will actually earn a 15%/yr. return.  The problem is people, including investment advisors and portfolio managers, are notoriously bad at picking those companies so to protect you from the risk they buy dozens and work the averages.  You can do the same thing within the exempt market but you’ve got to realize that’s how you’ll see your real returns and it won’t be pretty.  Of those 8%/yr. companies you might actually have a couple that lose all your money, a couple where you lose 20% of your money, a couple might actually pay 5%/yr. and a couple might even pay the full 8%/yr.  The problem is for you to pick, for your investment advisor to pick, for you to be able to bank on it is extremely unlikely.  Thus, you have to when you’re making your investments look at the probability of failure and account for those probabilities.

A simple example, if you’ve got a 20% projected rate of return with a 20% chance of complete loss (btw the chances of complete loss in the exempt market are very high, there’s rarely any cases where investors recoup only a portion of their money, they tend to get returns or lose it all) then what’s your real rate of return?  The real rate of return in the aggregate is actually 0%, meaning if you invest several times these will average out to a 0% rate of return.  You might get lucky and hit a winner without a loser; then again you might get unlucky and hit some losers without any winners (they tend to clump together because they tend to be based on the current stage of the market cycle).  Bottom line you need to be able to do the numbers and make decisions based on the probabilities not based on the projections or promises of advisors and sales people.

The same principle applies in business since all business is an investment.  A real example, I had a company where we’d run promotions with heavy advertising and at the end of the promotion period we’d calculate how we did when accounting for all the advertising expenses, cost of goods sold, wages, commissions, merchant processing, etc.  We’d look at the numbers, see we were pulling in a healthy profit and act accordingly run regular promotions to get the volume high enough to surpass breakeven.    At first, all looked good but there was a critical error in the calculations…the defect rate.  Not that often, but often enough we’d have a defective product that would need to be replaced.  When I’d become involved in the company I’d added warranty upsells so that helped to cover some of the cost and at first blush we’d figured it was no big deal because our margins were so strong, about 75% gross margins we had plenty of room to replace a few defective products and the high level of customer service we offered was good for business.

What was the problem?  First, we didn’t know the defect rates or account for them conservatively in our numbers so we’d walk away from a weekend seeing a $12 000 profit and in the short term that was true, in the long term it was not.  It got worse though, when we looked at the costs we were thinking in terms of a 25% cost, if we say had a 25% defect rate at a 25% cost we just needed to add an additional 6.25% to each product sold to account for these losses.  But what of the real costs?  We needed to pay staff to take the phone calls, to handle customer RMA requests.  We needed to pay for return shipping of the defective unit as well as shipping to the client of the replacement unit often times those shipping costs could exceed our cost on the product to begin with.  Even all those might have been tolerable but in many cases we were selling through a third party and we were hit with refunds.  Now in the case of refunds we needed to refund their full money, but we’d still incurred the shipping costs, we still incurred the staff costs to handle it all, and we now had an opened or defective unit we couldn’t easily resell.  In such cases it was a pure loss that needed to be accounted for.

The bottom line is these sorts of considerations exist in any business and you need to count the aggregate, the long term and the large numbers, not any one instance or sale and you need to turn that into a profit or the business model isn’t sustainable and scalable.

For assistance with figuring this out and developing strategies to mitigate this risk or any other business, investing, and wealth building questions please contact us by clicking “Ask a Business Question” in the lower right corner of the screen and we’ll be happy to assist you.

What the 2013 Bitcoin market can teach us about investing

In 2013 bitcoins have gone from a virtually unknown currency to a multi-billion dollar rage.  What started as an interesting social experiment has become shrouded in fears of crime and money laundering, then lauded by those desiring confidentiality and freedom from government issued currency inflation, to widespread speculation and back.  The price of bitcoins, an anonymous electronic currency has jumped from just a few dollars to over $1000 dollars at one point in the year and invited all kinds of speculation about its future.

A few months ago after the notorious website The Silk Road, which served as an internet marketplace for drugs and other illegal contraband was taken down by the FBI the price of bitcoins dropped from $200 each to around $100 each and I happened into a conversation with the friend who’d first told me about bitcoins.  At the time we asked the question of where they were headed?  Bitcoins are a pure commodity having no intrinsic value only the value afforded by supply and demand.  At the time The Silk Road was shut down it was estimated the site was responsible for half of all bitcoin transactions and thus the future of the currency in terms of the widespread demand was in question.  During the conversation I exercised my usual caution with respect to the currency, “how do you gauge the real demand and consequently the real value?”

It turned out far from The Silk Road’s demise weakening the demand, the publicity around the site due to the related news stories actually spiked demand and over only a short period the price rose to over $800 per bitcoin.  It’s easy at moments such as this to look back and say “I should have anticipated that, I should have invested, I could have earned a healthy 700% profit in only a matter of weeks”, but stocks and commodities always fluctuate and anticipating the whims of the market from day to day is next to impossible.

Shortly thereafter, as the price topped $1000/bitcoin I was contacted by clients of a company where I serve as an advisor asking whether they should invest given the rapidly rising prices.  I gave three important responses that essentially boiled down to “I don’t recommend it”, which also formed the position of the firm:

  1. Bitcoin demand is sure to increase in the future as it becomes a more mainstream currency because the market for anonymity and confidentiality isn’t going anywhere if anything it is growing and it happens to be very affordable for merchants as well given there are minimal transaction costs so long as the currency is stable and merchants are likely able to charge a premium for accepting the currency

 

  1. The basic rule of investing is “buy low, sell high”, when the price has just spiked by numerous multiples in a matter of months is NOT a good indication of it being priced “low”, you want to buy when things fall, not when they rise, this one simple piece of advice would likely help many to do far better in investing and is exactly the opposite of “following the herd”

 

  1. The only way to consistently “buy low and sell high” is to understand what you’re buying and the market for it.  The question is “how do you value bitcoins?” It’s purely based on supply and demand, but what is the real demand for it and how do you know?  What will happen in any rapidly soaring commodity is at some point you’ll get speculators jumping on board so is the demand driven by speculation or practical use?  If you can’t tell then you’re taking an enormous risk by purchasing.

I don’t recommend anything I don’t understand or anything that doesn’t have a very high consistency of success, which of course you can’t know if you don’t understand it.  The thing is this and it’s also what I mentioned to the clients.  I’m not saying you might not make money off it, you might, the problem is how do you know where you are in the cycle?  You don’t, so it’s pure speculation, pure risk, sometimes you win, sometimes you lose, but you’re betting against market efficiency in cases like this and more often than not markets are relatively efficient so over the average you’ll lose.  It turned out bitcoins have gone through rapid price changes dropping down to, at the time of this writing just over $500 per bitcoin.  Imagine being someone who had purchased at $1000 thinking the price would go to $1200 or $2000, or being someone who recommended they buy.  True, the price may well rise to those levels, as I mentioned the long term useful demand for bitcoins is undoubtedly strong, but how long will that take and when it happens what is the efficient price for bitcoins?  If you can’t answer that question you shouldn’t be investing.

Always beware of speculation, of jumping on a trend, the surest bet is to bet counter cyclically based on strong knowledge of your field, buy when prices have fallen, sell when they have risen, don’t be tempted to believe “the price has just gone up a lot but it will probably go up a lot more”, it might, but solid investing is about mitigating risk and that’s a sure way to increase risk.

If you have questions on the subject or any other business, investing or wealth building topic please contact us and we’ll do our best to assist you where we can.

How to Ensure You Don’t Lose Money Part 4 (due diligence)

One of the best insights to ensure you don’t lose money is especially visible if you watch how Bill Gates behaves and thinks.  He’s interesting because he rarely gives much public advice so in order to extract his evident wisdom on business and investing you need to pay attention not to what he’s talking about but how he’s thinking about what he’s talking about and reaching his conclusions.  Here we derive an insight without which the others aren’t important:

Get good quality data

Most people make investment decisions based on the information supplied to them by the investment sales person, someone being paid by the company to sell you the investment.  Just ask yourself how unbiased is that information source?  Even worse both investment advisors and investment sales people are rarely very knowledgeable about or skillful at investing and generally ignorant of this fact.  Try quizzing them on some of the investing fundamentals shared here to get an idea of where gaps in their knowledge lie, do they understand cycles, what causes them and how to read them?  Do they understand what phase you are at in the cycle and what sort of investing behavior should take place as a result?  Do they have a meaningful understanding of risk?  Do they have significant risk mitigation strategy in place for a given investment?  If not you should walk away.

Sadly many unskillful investment sales people sell to and misadvise their friends and family

Where else do people look for investment advice?  Often they’ll pick up tips from their friends or family, individuals who likewise probably understand little about how investing works, how markets work, etc.  One of the best ways to dig into their knowledge is to determine how much they know about and are putting into place legitimate risk mitigation strategies, strategies to protect against the downside.  Most people are naïve about this thinking only of the upside or being pessimistic about the prospects as opposed to taking a coolly rational view (investing is rational) that neither gets excited nor discouraged and instead carefully lays out all the things that could go wrong, evaluates whether measures are in place to protect against these things and also evaluates based on solid third party verified data where the upsides will come from.  Don’t trust those directly involved, make sure every shred of data is high quality.

Disregard anything you are told about projected rates of return they are merely fantasy

Until returns are realized they mean nothing and once they’ve been realized that’s the end of it.  Too many investment brochures are built around headlines advertising some rate of return like 8% or 15% and those might be accurate or they might not, but the key is what’s the data behind the investment and how will it result in those returns?

This is perhaps the most painful part of investing, doing extensive research and verification to understand what you’re investing in and ensuring the data is real and accurate.  You’ll inevitably pay attention to data points that don’t matter early on “noise”, and miss points that are critical, that’s why you need mastery in investing like anything else.  But no matter how solid your models are, no matter how much you understand the market, the investment, the risk, etc. if the data you’re basing those assumptions on is wrong it can ruin everything.

Bottom line make a habit of always seeking out very high quality data and lots of it with respect to any investment you’re going to make, it will help protect you from the wrong decisions over and over again.

I once had a client we were consulting for who was going to loan $150k on some property for a development.  He was told he’d be given security on his money in the form of one of the lots, which was worth that much.  We got involved and asked the developer about the security they assured us it had a solid value based on comparables within the market.  “Perfect”, we replied, “just send us over those comparables and data, we should be able to get this taken care of right away and authorize the transfer”.  Suddenly their story changed “well it’s very difficult to get comparables for this kind of property…”  It turned out when we did independent research that the property in the environment where it would need to be sold to repay the loan was worth about $15k one tenth of the stated $150k.  A simple set of questions and extra bit of investigation that probably saved $150k.  Good use of time?  Much better than the ROI he would have gotten off that loan that’s for sure.

Get great quality data for all your business and investing decisions!

If you’ve got investing questions you’d like to discuss or like us to cover please click “Ask a Business Question” in the lower right corner of the screen to send it to us, looking forward to hearing from you.

Understanding Security

I once learned a very hard lesson, which I’ll never forget.  I was introduced to a group selling some investments “backed” by hard assets, land, and insurance policies.  The argument was worst case scenario the investment is backed by land so you can’t really lose all your money, nothing could be further from the truth.  It taught me the important lesson of what really constitutes security.

If you’re exposed to investments, particularly exempt market investments much you’ll probably hear the term “security” or “secured”, you’ll probably also hear the statement that you aren’t allowed to call almost any investment “guaranteed”.  Basically, the only investments that can be classified as guaranteed are government bonds, which are guaranteed by the government, and GICs, which are backed up to $100 000 (life insurance is essentially the same though backed by a different organization).  For the most part these investments are about as solid as you’re going to get, the problem is you pay a price for that solid backing by getting next to nothing in the form of returns.  (As an aside it is still possibly given a large enough scale systemic failure for government bonds and GICs to fail, but such a failure would need to be so large and so significant as to make your bonds or GICs the least of your concerns and not really worth considering for most of us).

If you want to get even half decent returns you need to step away from the field of guaranteed returns and take on a little more risk, this is where the subject of security comes in.

Security is what backs your investment if something goes wrong

To understand security probably the easiest way is to look at how a bank lends money to you when buying houses.  What happens if you don’t pay?  They get to take your house through a foreclosure process and resell it to recoup some or all of their money.  In other words the mortgage is their security.  Other examples might include a physical asset.  Say you are going to lend someone money to buy a vehicle, you can buy the vehicle so you own it, then they make payments to you with the agreement that you’ll sign the vehicle over to them when they have made all the payments.  In this example if anything goes wrong you own the vehicle.

Security doesn’t protect you from losing all your money but it limits your losses

  So when someone comes to sell you a land development project through a limited partnership (LP) do you have security?  Probably not.  Here’s the important distinction, in most investments you don’t truly have security what you’ve got are shares or units of an investment, the company or partnership might have security but that’s not security you have directly so in effect you’ve got nothing.

The only real types of security are: Titles, Mortgages, Insurance, and cashflow

When push comes to shove you need to recognize what real security is and isn’t, your money may depend on it and really there are only 4, ideally 3, types of security that matter:

  1. Titles – this is when you actually own the physical property (vehicles, computers, property, equipment, etc.) involved without any encumbrance (meaning someone else like a bank doesn’t have any kind of mortgage or security agreement against it). Obviously, some of these are better than others, for example cars tend to depreciate, property tends to appreciate, computers are easy to steal away in the night, vehicles are less so because they have to be registered.  Actually owning the physical property involved is real security and you shouldn’t be afraid to ask for ownership to secure your investment.

 

  1. Mortgages – a mortgage shouldn’t be confused with a lien or caveat, you also need to pay attention to the difference between 1st, 2nd, and 3rd mortgages, banks will almost always limit themselves to 1st mortgages and there’s a reason for that, 2nd mortgages will give you the right to purchase and protect your money if you can afford it if the 1st mortgage holder forecloses but ultimately if you’re in anything but the first position and things go bad you could lose all your money. A 1st mortgage is a very real type of security that does a lot to protect you provided the valuation on the property is appropriately large.

 

  1. Insurance – Some investments are actually insured such as seg funds, in point of fact a lot of types of investments can be insured but very few are. You need to look carefully at the insurance and whose insuring it because insurance companies don’t like to pay out and some “insurance” out there is downright fraudulent in order to sell investments but if you can get it good insurance is a very real kind of security.

 

  1. Profitable Cashflow – this isn’t really a form of security in the same way the others are but it does help to mitigate risk, if you’re investing in something where there is cashflow such as a well-established business then that income helps to protect you from complete loss, of course this assumes you actually get some of that cashflow, which you might not, which is why owners of Worldcom and Nortel were able to lose everything in spite of cashflow.

 

Lots of investment advisors (who are typically no more than salesmen and often don’t understand security themselves) will try to tell you there is security when there isn’t, will tell you there no risk or less risk than there is (often they can’t tell themselves) in order to sell the investment to you.  Note, just because there is risk, or just because it’s possible to lose all your money doesn’t intrinsically mean you shouldn’t invest, after all early investors in Google or Facebook could have lost everything but instead they became billionaires.

If you’ve got investing questions you’d like to discuss or like us to cover please click “Ask a Business Question” in the lower right corner of the screen to send it to us, looking forward to hearing from you.