Sunday, 30 June 2013

Intrinsic Value using Discounted Cash Flows

The most common method of arriving at the intrinsic value of a stock is using the discounted cash flows (DCF) method.

DCF models are used to price a number of different assets.

The model that most stock analysts use is the DCF method.

Understanding the reasoning behind using this process.

The DCF method for valuing stocks rests on the principle of a stock is worth the sum of its future discounted cash flows.

The DCF model uses projections and estimates to arrive at a fair market value for the stock.

This is the method preferred by most stock analysts.

DCF is the favoured method of most stock investors.

The weakness of DCF model.

The weakness of the DCF model is you (and me).

The model only works if you have realistic estimates to include on future cash flows, estimated future revenues, how much risk is involved, industry analysis, and so on.

The outcome is only as good as the data you enter.

The outcomes will be tainted by the estimates you enter.

It is possible to find estimates for many of the variables on the internet; however, it is not always possible to verify how the author arrived at these conclusions.

Among industry professionals there are often wide differences in estimates and risk factors.

The strengths of the DCF model.

The model produces actionable numbers if the inputs are from professional analysts who study the market and study the stock you are researching.

The intrinsic value is still subjective because of the estimates, and other professional analysts may see the company differently.

However, your best bet for finding a reliable estimate of a stock's intrinsic value is from an expert.

[If a commentator is touting a stock, he or she should disclose if they have any financial interest in the stock or stand to gain if the price rises.]

Friday, 28 June 2013

The higher the risk, the higher the potential return, and the LESS LIKELY it will achieve the higher return


The rule of thumb is "the higher the risk, the higher the potential return," but you need to consider an addition to the rule so that it states the relationship more clearly:  the higher the risk, the higher the potential return, and the less likely it will achieve the higher return.

Buying a stock that is risky doesn't mean you will lose money and it doesn't mean it will achieve a 25% gain in one year.  However, both outcomes are possible.

How do you know what the risk is and how do you determine what the potential reward (stock price gain) should be?

There are times when you should use other products besides stocks. When to avoid stocks?

Investing in stocks is not always the best answer for a financial goal.  There are times when you should use other products beside stocks.

Investing in stocks to meet short-term goals is usually not a good idea.  Do not use stocks for any goal that is fewer than five years from completion.  Any financial goal you need to achieve in fewer than five years is exposed to a risk that the stock market will swing to the downside just when you need the money.  The best plans can be sabotaged by a volatile stock market over the short term.

As you approach retirement, you will want to dial back your exposure to stocks and move into safer alternatives.

Wednesday, 26 June 2013

Done well, value investing is a successful, safe way to invest.

Be prudent and don't take the market at face value

Done well, value investing is a successful, safe way to invest. The logic of the approach - buying an asset for less than its underlying value - is irrefutable.
Here are five of the best mistakes prevalent in investing.
    • Focusing only on the numbers One of the most common investing mistakes is to concentrate only on a stock's financial data. The big four banks, for example, all carry forecast dividend yields of about 6 per cent, and price-earnings ratios of about 14-15. Based on numbers, they're closely matched. When you consider the risks entailed in ANZ's Asian expansion and National Australia Bank's aggressive push for market share, however, the numbers suddenly don't seem to tell the whole story. These qualitative factors are why we favour Commonwealth Bank and Westpac over ANZ and NAB.
    • Mistaking permanent declines for temporary ones When businesses hit rough patches, it can be a great time to buy. We've had positive recommendations on Aristocrat Leisure over the past few years for this reason. While a poor product line-up and the strong Aussie dollar were all hurting Aristocrat in the short term, we expected this business to perform well in the long run. If profits stayed permanently depressed, we'd have overpaid for Aristocrat. However, things are slowly turning around.
    • Buying low-quality businesses Unfortunately, high-quality businesses are seldom cheap. Value investors therefore often end up with portfolios full of cheap but low-quality stocks, entailing greater risk. It's better to fill your portfolio with high-quality businesses, especially if you're patient and buy opportunistically.
    • Neglecting economic considerations ''If you spend more than 13 minutes analysing economic and market forecasts, you've wasted 10 minutes.'' Ever since uttering that sentence, fund manager Peter Lynch gave value investors a free pass to ignore the economy. Or so they thought. You can't completely ignore the economy, but the success of your investments should never rely on specific, short-term forecasts. An investment in Rio Tinto, for example, hinges largely on the continued strength of China's economy. That's an economic forecast we're not willing to gamble on at current prices. An appreciation of cycles should underpin your stock purchases and disposals.
    • Ignoring the market A healthy scepticism of the market's wisdom is vital. When you're right, the rewards can be enormous. The market wrote down RHG Group from $0.95 to $0.05 before Intelligent Investor Share Advisor's positive recommendations were vindicated. But when you're wrong, it can be bad. Backing ourselves explains why we were too late in pulling the pin on Timbercorp. Share-price movements should never influence your analysis. But they can offer a timely prompt to reconsider your thinking. When you're going against the grain, make sure you know why you disagree with the market.
      This article contains general investment advice only (under AFSL 282288).
      Nathan Bell is the research director at Intelligent Investor Share Advisor. Money readers can get a free trial and a special end of financial year offer

      Tuesday, 25 June 2013

      Soaring bond yields across the world threaten trillion of dollars in losses for investors and a fresh financial crisis.

      The Swiss-based institution said losses on US Treasury securities alone will reach $1 trillion if average yields rise by 300 basis points, with even greater damage in a string of other countries. The loss could range from 15pc to 35pc of GDP in France, Italy, Japan, and the UK. “Such a big upward move can happen relatively fast,” said the BIS in its annual report, citing the 1994 bond crash.
      “Someone must ultimately hold the interest rate risk. As foreign and domestic banks would be among those experiencing the losses, interest rate increases pose risks to the stability of the financial system if not executed with great care.”
      The warning comes after US Federal Reserve set off the most dramatic spike in US borrowing costs for over a decade last week with talk of early exit from quantitative easing (QE), sending tremors through the global system.
      The yield on 10-year Treasuries has jumped 80 basis points since the Fed began to talk tough two months ago, closing at 2.51pc on Friday.
      The side-effect has been a run on emerging markets, a reversal of hot-money inflows into China, and fresh debt jitters in Portugal, Spain, and Italy. Nomura said the US yield spike threatens to “expose the cracks in Europe once again” and short-circuit the US housing recovery.
      The BIS, the lair of central bankers, said authorities must press ahead with monetary tightening regardless of bond worries, warning that QE and zero rates are already doing more harm than good. The longer they go on, the greater the dangers.
      “Central banks cannot do more without compounding the risks they have already created,” it said in what amounts to an full assault on the credibility of ultra-stimulus policies.
      Describing monetary policy as “very accommodative globally” , it warned that the “cost-benefit balance is inexorably becoming less and less favourable.”
      The BIS appeared call for combined monetary and fiscal tightening, prompting angry warnings from economists around the world that this risks a second leg of the crisis and perhaps a slide into depression.
      “It is a resurgence of extreme 1930s liquidationism. If applied this would do grave damage to the world economy,” he said.
      Marcus Nunes from the Fundação Getúlio Vargas in São Paulo said the report “reeks of Austrianism”, referring to the hard-line view of the Austrian School that debt busts lead to `creative destruction’ and should be allowed to run their course.
      Prof Nunes fears a repeat of 1937 when premature tightening aborted recovery from the depression. “What is implicitly proposed is a degree of fiscal and monetary contraction that would make 1937 feel like a ‘walk in the park on a sunny day’.
      The BIS said monetary stimulus has created a host of problems, including “aggressive risk-taking”, “the build-up of financial imbalances”, and further “misallocation of capital”.
      It said the central bank mantra of doing “whatever it takes” to boost growth has outlived its usefulness, and has left the Fed, the Bank of England, and others, stuck with $10 trillion in bonds. “Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances,” it said.
      The emergencies policies have bought time for governments to put their budgets in order and tackle the deeper crisis of falling productivity, but this has been squandered. The BIS said leaders have put off the reforms needed to clear out dead wood and unleash fresh energy. Productivity growth in the rich states has dropped from 1.8pc between 1980-2000, to 1.3pc from 2001-2007, to just 0.7pc from 2010-2012. It has turned negative in Britain and Italy.
      “Extending monetary stimulus is taking the pressure off those who need to act. In the end, only a forceful programme of repair and reform will return economies to strong and sustainable real growth,” it said.
      Piling on the pressure, the BIS said to call for draconian fiscal tightening to avert a future debt crisis across the big industrial economies, with Britain needing to slash its `primary budget’ by up to 13pc of GDP to meet ageing costs.
      “Public debt in most advanced economies has reached unprecedented levels in peacetime. Even worse, official debt statistics understate the true scale of fiscal problems. The belief that governments do not face a solvency constraint is a dangerous illusion. Bond investors can and do punish governments hard and fast.”
      “Governments must redouble their efforts to ensure that their fiscal trajectories are sustainable. Growth will simply not be high enough on its own. Postponing the pain carries the risk of forcing consolidation under stress – which is the current situation in a number of countries in southern Europe.”
      The call for double-barrelled fiscal and monetary contraction is remarkable, challenging the widely-held view that easy money is crucial to smooth the way for budget cuts and deep reform.
      The BIS is in stark conflict with the International Monetary Fund and most Anglo-Saxon, French, and many Asian economists, as well as the team of premier Shinzo Abe in Japan. What is emerging is a bitter dispute over the thrust of global economic policy at a crucial moment.
      Critics say the BIS is discrediting monetary remedies before it is clear whether the West is safely out of the woods. It may now be much harder to push through fresh QE if it turns out that the Fed has jumped the gun with talk of early bond tapering.
      Scott Sumner from Bentley University said the BIS is wrong to argue that delaying exit from QE and zero rates is itself dangerous. The historical record from the US in 1937, Japan in 2000, and other cases, is that acting too soon can lead to a serious economic relapse. When the US did delay in 1951, the damage was minor and easily contained.
      Prof Sumner warned that Europe risks following Japan into a deflationary slump if it takes the advice of the BIS and persists with its current contraction policies.

      How low can the Aussie dollar go?

      There are five key influences on the Australian dollar and each offers a clue as to how low the dollar might fall.
      It’s now almost 30 years since the float of the Australian dollar and rarely has it been stronger than in the past few years.
      Only now are investors, surprised at the rapidity of the recent drop, waking up to this fact. The economy is starting to feel it too, with Ford closing down local operations, local tourism struggling as Australians head overseas and now Holden giving an ultimatum to staff: accept pay cuts or risk losing your job.

      Many people explain away this strength with the phrase ‘‘commodities boom’’, but it’s more complex than that.
      There are five key influences on the Australian dollar and each in its own way offers a clue as to how low the dollar might fall.

      1. Interest rates
      If you can borrow at 0.25 per cent in Europe, the US or Japan and can invest it in Australian bonds, assets or bank accounts paying 3-4 per cent, plus capital gains, why wouldn’t you?

      National Australia Bank recently estimated that the upward pressure on the local currency as a result of the US Federal Reserve’s zero interest rate and their quantitative easing program could be worth as much as 20 cents in the Aussie.
      And of course, those global investors could look at the Reserve Bank and feel pretty safe that if it were to reduce rates, it would do so cautiously and gradually.

      For the last few years, Australia has been a giant post box for international hot money. Right now, that reputation is under pressure.

      2. Global and Australian growth
      In addition to relatively high rates, global investors flocked to Australia after 2009 due to the resilience of the Australian economy, assisted by local and Chinese stimulus.

      We didn’t have a housing crash and we didn’t follow the US and UK economies into deep recession, which is why we became a safe harbour.

      3. The US dollar
      The US dollar is the most under-appreciated driver of the Aussie dollar.

      Traders and investors talk about growth, interest rates, the mining boom, the budget position and household debt, but on the other side of the AUD/USD currency pair the same questions are asked of the US as an input into the Aussie.
      The perceived value of the US dollar is an important factor in the relative price of the Aussie and, after a long period of weakness, it’s likely to grow in strength.

      4. Investor sentiment
      When we see a convergence of major drivers like this, investor sentiment itself becomes a fourth driver. Here, we enter the currency expectations market.

      Since 2009 large speculators – hedge funds and the like – have been supporters of the Aussie dollar for all but a brief period of market instability in the middle of last year when the euro teetered.

      Generally, global speculators have been supporters of the Australian dollar since the global financial crisis. That is now on the verge of a reversal.

      5. Technicals
      The Aussie has had strong technical chart since the GFC: every new move led to a new high and every dip was followed by a rebound. Even as volatility reached extreme levels in the past few years, the chart for the Aussie remained indomitable. Its safe-harbour status was never breached in a technical sense. That encouraged speculators and investors to buy the dips whenever global trouble loomed.

      That’s how we got to where we are. To see where we might go, let’s examine these five key drivers from the other angle.
      Australian interest rates are falling much further than most forecasters anticipated. The main cause is that Chinese growth is slowing faster than many expected (although not us), pushing down the key export prices that drove Australia’s commodity boom. As a result, mining projects have been cancelled en masse. Yet the boom ran long enough for mining companies to believe it would last.

      Even with the cancelled projects, lots of new supply is on the way, just as China slows. This will drive commodity prices down further still.

      The likelihood is that Chinese and Australian growth, and Australian interest rates, will fall further. So although the carry trade into the dollar is still positive, with declining yields and an increased risk of capital loss, it now faces more headwinds.

      To make matters more difficult for the Aussie, the US housing market is recovering. Although fiscal challenges loom and monetary policy is still very loose, markets are beginning to price in stabilisation to the former and a tightening in the latter.

      In the passing beauty parade of foreign exchange, the US dollar is being viewed as the least ugly. As the US dollar index rises it is hitting a variety of asset classes, including gold and the Aussie dollar.

      Sentiment among hedge funds and speculative traders – see recent comments by George Soros and Stanley Druckenmiller – has turned against our currency.

      As recently as April this year, the Aussie was trading above $US1.05 before the recent fall took it to around $US0.92. That’s a fall of about 12 per cent.

      So, how low can it go?
      NAB recently suggested the $A could fall to 87 US cents by December 2014. But let’s remember that for all the extreme recent calls about the crash in the Aussie and the impending doom facing it, the reality is that it is simply back at the bottom of what might be considered a wide 10-15 cent range it has been in since breaking up through 94 US cents in mid-2010.

      This sell-off is not all that shocking and the forecasters of doom forget this.

      A fall below 94 cents would signal a different and lower scenario. Our assessment is that this is likely, especially if the economy weakens due to the withdrawal of mining investment, assuming consumption doesn’t fill the gap.

      That may necessitate rate cuts to 2 per cent or just below.

      Despite the recent highs, the Aussie dollar’s average remains steadfastly around 75 US cents. It may not revert to the mean but after 22 years without a recession, you wouldn’t want to bet on it.

      What might happen if Australia did have a recession?
      The answer was offered during the GFC low when global investors believed that was about to happen. Back then it fell to $US0.5960. There’s your answer.

      To protect your portfolio against that possibility, and to hedge against falling interest rates, Intelligent Investor Share Advisor has recommended allocating a portion of your portfolio to overseas markets. Each of its model portfolios has an allocation to businesses that stand to benefit from a falling Aussie dollar.

      This article contains general investment advice only (under AFSL 282288).
      By Greg McKenna and David Llewellyn-Smith of MacroBusiness, in conjunction with Intelligent Investor Share Advisor,

      Read more:

      The Shanghai Composite Index dived 5.2 per cent as volumes spiked to the highest. 15 CSI300 components plunged by the maximum-allowed 10 per cent.

      China shares suffered their worst daily loss in almost four years on Monday, taking Hong Kong markets lower, with financials hammered on fears that the central bank would keep money tight and economic growth could slow sharply.
      Despite money market rates easing for a second-straight session on Monday, mainland investors remained jittery about monetary conditions and braced for disappointment when the People's Bank of China conducts a scheduled open market operation on Tuesday.

      The CSI300 of the top Shanghai and Shenzhen listings plunged 6.2 per cent. The Shanghai Composite Index dived 5.2 per cent as volumes spiked to the highest in about a month. Monday's losses were their worst since August 31, 2009.
      The Hang Seng Index slid 2.2 per cent to 19,814 points, closing below the 20,000-point mark for the first time since September 11. The China Enterprises Index of the leading Chinese listings in Hong Kong tumbled 3.2 per cent to its lowest since October 2011.

      At $US10 billion, Hong Kong turnover was off Friday's three-month high, but was still some 20 per cent more than its average in the last 20 sessions. Short selling accounted for 13.6 per cent of total turnover, versus the 8 per cent historical average.

      Late Monday morning, share-losses accelerated in rising volumes after the Chinese central bank described liquidity in the country's financial system as "reasonable", repeating what was said in a Sunday commentary in the official Xinhua news agency.

      The commentary also said the latest spike in money market rates was a result of market distortions caused by widespread speculative trading and shadow financing. The central bank, in its quarterly report on Sunday, pledged to "fine tune" existing "prudent" monetary policy.

      "I think the market is expecting 'fine-tuning' to mean a tightening of liquidity moving forward, especially after the way official media talked about shadow financing over the weekend," said Cao Xuefeng, Chengdu-based head of research at Huaxi Securities.

      "People are quite jittery ahead of the first of two (PBOC) open-market operations for the week on Tuesday. In this market environment, it's tough to call a bottom, fears could spread about funding for companies," Cao added.

      The weakness in the mainland markets also extended to the property and other growth-sensitive sectors. A Xinhua report that 30.9 billion yuan of shares could become tradeable further weighed on markets, a move that may potentially compete for already tight liquidity.

      Among CSI300 component stocks, only four finished the day with gains. Poly Real Estate and Southwest Securities were among 15 CSI300 components that plunged by the maximum-allowed 10 per cent.

      Warren Buffett-backed Chinese automaker BYD plunged 11 per cent in Hong Kong after CLSA analysts repeated their sell call. They see its share price down 80 per cent from Monday's close, believing its new F3 sedan has been launched too late.

      Banks hammered
      Monday's plunge came despite the overnight repo rate, a key measure of funding costs in China's interbank market, falling by more than two percentage points to 6.64 per cent on a weighted-average basis, its lowest since last Tuesday. It had peaked near 12 per cent last Thursday.

      Among the biggest losers were smaller banks seen as more reliant on short-term interbank funding. The Shanghai financial sub-index skidded 7.3 per cent in its worst day since November 2008, during the financial crisis that started that year.

      Shanghai-listed China Minsheng Bank and Industrial Bank, along with Shenzhen-listed Ping An Bank all plunged by 10 per cent. Minsheng's Hong Kong listing skidded 8 per cent in its worst day since October 2011.

      Minsheng shares, some of the most popular in both markets earlier this year, are now down 40 percent from a peak in January. They are down 19.4 per cent on the year, compared to the 22 per cent slide for the H-share index.

      Among the "Big Four" Chinese banks listed in Hong Kong, Agricultural Bank of China (AgBank) and Industrial Bank of China (ICBC) had the biggest percentage losses, 2.9 and 3 per cent, respectively.


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