Understanding the Power of Compounding
Compounding in Action
The investment rate assumes a return net of taxes and fees.
The effect of inflation on the purchasing power of the FV can be offset by increasing your annual contributions by a like percentage. As your income increases, so too should your investment contributions.
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The Future Value of investing $1,000 per annum, when compounded by the annual rate of 6% for the number of years are as shown below:
Rate 6%
Years... FV
10 years 13,181
20 years 36,786
30 years 70,058
40 years 154,762
50 years 290,336
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 7,360
20 years 11,470
30 years 13,765
40 years 15,046
50 years 15,762
A lump sum of $7360 invested for 10 years at 6 percent will produce the same FV ($13,181) as $1000 a year for 10 years.
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The Future Value of investing $1,000 per annum, when compounded by the annual rate of 8% for the number of years are as shown below:
Rate 8%
Years... FV
10 years 14,487
20 years 45,762
30 years 113,283
40 years 259,057
50 years 573,770
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 6,710
20 years 9,818
30 years 11,258
40 years 11,925
50 years 12,233
A lump sum of $6,710 invested for 10 years at 8 percent will produce the same FV ($14,487) as $1000 a year for 10 years.
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The Future Value of investing $1,000 per annum, when compounded by the annual rate of 10% for the number of years are as shown below:
Rate 10%
Years... FV
10 years 15,937
20 years 57,275
30 years 164,494
40 years 442,593
50 years 1,163,909
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 6,145
20 years 8,514
30 years 9,427
40 years 9,779
50 years 9.915
A lump sum of $6,145 invested for 10 years at 10 percent will produce the same FV ($15,937) as $1000 a year for 10 years.
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The Future Value of investing $1,000 per annum, when compounded by the annual rate of 12% for the number of years are as shown below:
Rate 12%
Years... FV
10 years 17,549
20 years 72,052
30 years 241,333
40 years 767,091
50 years 2,400,018
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 5,650
20 years 7,469
30 years 8,055
40 years 8,244
50 years 8,304
A lump sum of $5,650 invested for 10 years at 15 percent will produce the same FV ($17,549) as $1000 a year for 10 years.
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The Future Value of investing $1,000 per annum, when compounded by the annual rate of 15% for the number of years are as shown below:
Rate 15%
Years... FV
10 years 20,304
20 years 102,444
30 years 434,745
40 years 1,779,090
50 years 7,217,716
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 5,019
20 years 6,259
30 years 6,566
40 years 6,642
50 years 6,661
A lump sum of $5,019 invested for 10 years at 15 percent will produce the same FV ($20,304) as $1000 a year for 10 years.
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Note:
It is not so much the increase in FV over the early 10-year periods of the savings plan, but the increase over the final 10-year period that yields the big bucks.
For instance, if we reference the compounding at 10 percent, FV increased by $41,338 between years 10 and 20, while the increase between years 40 and 50 was $721,316.
Thereafter, if you start your investment plan at age 30 rather than 20, the $1,000 a year you spent before that rather than invested will have cost you $721,316.
The greatest deterrent to an investment plan is not so much the fortitude to put aside a small percentage of income, but the willpower not to steal from the fund until your regular employment income ceases. Anyone can become rich if they start an investment plan early in life.
Of course, the more you love your work, the longer you will be employed and the more savings you will accumulate. If you find the thought of working until you are 70 abhorrent, then the thought of working at 30 or 40 years of age will be even less attractive; in which case, investing is probably irrelevant because you’re going to have a miserable or unfulfilled life anyway. People who hate working are more likely to become welfare dependent.
Lump sum investing
A lump sum of $7,360 invested for 10 years at 6 percent will produce the same FV ($13,181) as $1,000 a year for 10 years.
A lump sum of $9,779 invested for 40 years at 10 percent will produce the same FV ($442,593) as $1,000 a year for 40 years.
If the same lump sum were invested 10 years earlier – that is, allowed to compound for 50 years, rather than 40 – the nest egg will be boosted by a further $705,372 to $1,147,965.
Have you ever thought about putting something aside for your kids that they can’t touch for 50 years?
Sentiment and moral gratification usually centre on diminishing their incentive to achieve their own sense of self-satisfaction by helping them when they get married or want to buy a house.
If they are like 98 percent of people, the time they really need financial help is after they have lived the good life and have limited savings and no career income.
Material assets are not so important when you have the greatest asset of all: youth.
Related readings:
Oriental Holdings Bhd: The Buy-Hold Advantage
http://www.horizon.my/2008/11/oriental-holdings-bhd-the-buy-hold-advantage/
Oriental Holdings Berhad - What if You had Bought and Held? I happened to be reading the Annual Report of Oriental Holdings Berhad (ORIENT) the other day and came across a statement by Chairman Dato Loh Cheng Yean:
“A holding of 1,000 stocks in Oriental when it was listed in 1964 would translate into 40,255 Oriental stocks worth RM263,670, based on the share price of RM6.55 at the end of 2007. In addition the stocks would have earned a total gross dividend of RM137,660. The gross dividends received and the appreciation in value is equivalent to a remarkable average rate of return of 14.60% for each of the 44 years.”
This sounds pretty good… see once again we’re talking 40 years. I find Oriental Holdings to be quite “remarkable” because it is such a diverse collection of different businesses which include auto assembly, auto parts manufacturing, oil palm, hotels, property etc. But 85% of its RM498 million Operating Profit is from auto and oil palm.
The Story of Anne Scheiber
http://www.horizon.my/2008/11/the-story-of-anne-scheiber/
Maxwell recounts the story of Anne Scheiber, an elderly and thrifty lady who lived in New York and worked for the Inland Revenue Service. When Scheiber retired at age fifty-one, she was only making $3,150 a year. She was treated poorly by her employer and was never promoted. Yet when Anne Scheiber died in 1995 at the age of 101, it was discovered that she left an estate to Yeshiva University worth US$22 million!
How did a public service worker with minimal salary accumulate such a staggering wealth?
Comments by: banking88 on November 25th, 2008 12:13 pm
yes, the key is to invest for the long-term…your wealth would multiply with componding returns…now it’s a good time to enter the market using the dollar cost averaging method…
Thursday 27 November 2008
To Upgrade the Quality of Your Portfolio
To upgrade the quality of your portfolio
For those who already hold a portfolio of stocks that may have been selected without reference to value, a culling approach to upgrade the quality of your portfolio by replacing overpriced stocks with those offering better value, would be suggested.
Although it is probable that you hold some stocks that should be sold immediately, in making that determination you must be sure of what you are doing and not act with undue haste.
Solicit advice and input from others you respect, but keep your own counsel and do not be influenced by those whose knowledge is unlikely to be superior to your own.
Let’s also consider some basic selling issues:
Tax
Let’s say you buy a stock for $5 and it rises to $15 when its value is $11. If you sell it for $15 and the $10 profit was subject to 40 percent tax, you would be left with $11. If you consider that $11 would be a good price at which to buy the stock, there is not much point in selling at the same net price.
Management
Great businesses with sound corporate management are quite rare. If you are invested in such a company, selling and attempting to find a replacement with similar management qualities is likely to be difficult. Buffett says he is wary of the risk in switching allegiance to people less well known to him.
Fear of not being able to buy back at a better price.
For those who already hold a portfolio of stocks that may have been selected without reference to value, a culling approach to upgrade the quality of your portfolio by replacing overpriced stocks with those offering better value, would be suggested.
Although it is probable that you hold some stocks that should be sold immediately, in making that determination you must be sure of what you are doing and not act with undue haste.
Solicit advice and input from others you respect, but keep your own counsel and do not be influenced by those whose knowledge is unlikely to be superior to your own.
Let’s also consider some basic selling issues:
Tax
Let’s say you buy a stock for $5 and it rises to $15 when its value is $11. If you sell it for $15 and the $10 profit was subject to 40 percent tax, you would be left with $11. If you consider that $11 would be a good price at which to buy the stock, there is not much point in selling at the same net price.
Management
Great businesses with sound corporate management are quite rare. If you are invested in such a company, selling and attempting to find a replacement with similar management qualities is likely to be difficult. Buffett says he is wary of the risk in switching allegiance to people less well known to him.
Fear of not being able to buy back at a better price.
Think Availability of Opportunities
Think Availability of Opportunities; Not Diversification or Acting Contrary to the Market
Portfolio Diversification
Towards the end of a bull market, when selling presents more opportunities than buying, the cash and interest-bearing securities will be quite high. In the tail-end of a bear market, when opportunities are more plentiful, the cash and interest-bearing securities might be close to zero.
The amount of cash and interest-bearing securities you carry will depend on several factors, not the least important of which is your comfort level with the price volatility of equities.
Think of the Availability of Opportunities
Conventional wisdom tells us a portfolio should be spread over a diversified range of industries on the premise that a downturn in one sector of the economy will only affect a portion of your portfolio. A contrarian would argue that you should only buy into an industry that is suffering a downturn because prices will be cheap.
However, think not in terms of diversification or acting contrary to the market, but of the availability of opportunities.
Remember Mae West’s words: “Too much of a good thing can be wonderful”. Mae, however, was a woman of experience with the ability to know a good thing. Lacking that same experience, or the necessary time to acquire it, it’s easier to recognize and avoid what is not a good thing.
This approach will not guarantee that every selection will be wonderful. It may even eliminate a few stocks that may have turned out to be wonderful, but in eliminating most of what is likely to be a lot less than wonderful, it should deliver above-average results.
Portfolio Diversification
There can be no hard and fast rules about diversifying. However, a portfolio should contain a certain amount of cash and interest-bearing securities. These should be weighted towards
- higher yielding secure preference shares that have no downside price risk on conversion and
- property trusts or REITS that have low profit and price volatility.
Towards the end of a bull market, when selling presents more opportunities than buying, the cash and interest-bearing securities will be quite high. In the tail-end of a bear market, when opportunities are more plentiful, the cash and interest-bearing securities might be close to zero.
The amount of cash and interest-bearing securities you carry will depend on several factors, not the least important of which is your comfort level with the price volatility of equities.
Think of the Availability of Opportunities
Conventional wisdom tells us a portfolio should be spread over a diversified range of industries on the premise that a downturn in one sector of the economy will only affect a portion of your portfolio. A contrarian would argue that you should only buy into an industry that is suffering a downturn because prices will be cheap.
However, think not in terms of diversification or acting contrary to the market, but of the availability of opportunities.
Remember Mae West’s words: “Too much of a good thing can be wonderful”. Mae, however, was a woman of experience with the ability to know a good thing. Lacking that same experience, or the necessary time to acquire it, it’s easier to recognize and avoid what is not a good thing.
This approach will not guarantee that every selection will be wonderful. It may even eliminate a few stocks that may have turned out to be wonderful, but in eliminating most of what is likely to be a lot less than wonderful, it should deliver above-average results.
How many stocks should you hold?
How many stocks should you hold?
The proprietor or manager of a business is likely to have only one investment, his or her business – nothing wrong with that.
Most equity funds hold many stocks – nothing wrong with that either. In recognizing its limitations, management is minimizing the impact of mistakes. The last thing you want if someone who doesn’t know what he or she is doing investing your money in a handful of stocks.
As an individual investor, having a few hundred dollars in each of very many stocks is obviously not economical in terms of brokerage fees, administration and time devoted to following each stock. Availability of worthwhile opportunities, aversion to risk, size of portfolio and level of expertise all contribute to the number of stocks you should hold.
If you know what you are doing and have the time to do research, as a rough guide, the maximum stocks to be held should be the lesser of 15 or the square root (to the nearest whole number) of the collective market prices of the portfolio divided by 1000. So a portfolio priced at $9000 would contain 3 stocks. (Square root of 9000/1000 = square root of 9 = 3)
For example:
Value of portfolio…. Maximum Number of stocks
$4000……..2
$9000……..3
$16,000…….4
$25,000…….5
$36,000…….6
$49,000…....7
$64,000…....8
$81,000…....9
$100,000…..10
$121,000…..11
$144,000…..12
$169,000…..13
$196,000…..14
$225,000+…..15 (Maximum)
The proprietor or manager of a business is likely to have only one investment, his or her business – nothing wrong with that.
Most equity funds hold many stocks – nothing wrong with that either. In recognizing its limitations, management is minimizing the impact of mistakes. The last thing you want if someone who doesn’t know what he or she is doing investing your money in a handful of stocks.
As an individual investor, having a few hundred dollars in each of very many stocks is obviously not economical in terms of brokerage fees, administration and time devoted to following each stock. Availability of worthwhile opportunities, aversion to risk, size of portfolio and level of expertise all contribute to the number of stocks you should hold.
If you know what you are doing and have the time to do research, as a rough guide, the maximum stocks to be held should be the lesser of 15 or the square root (to the nearest whole number) of the collective market prices of the portfolio divided by 1000. So a portfolio priced at $9000 would contain 3 stocks. (Square root of 9000/1000 = square root of 9 = 3)
For example:
Value of portfolio…. Maximum Number of stocks
$4000……..2
$9000……..3
$16,000…….4
$25,000…….5
$36,000…….6
$49,000…....7
$64,000…....8
$81,000…....9
$100,000…..10
$121,000…..11
$144,000…..12
$169,000…..13
$196,000…..14
$225,000+…..15 (Maximum)
Wednesday 26 November 2008
Dollar cost averaging investor
By investing equal amounts of cash each year, fewer stocks will be acquired when prices are higher and more when prices are lower. It is therefore an ideal way of investing for those with a regular savings plan.
In disaster years when the market was down, the price value of the investor's holding bottomed, but it was the additional units bought in these disaster years when prices were low that enabled a positive overall return. A particular year that was considered to be a great year for the stock market, was also the worst year for our dollar cost averaging investor.
By investing a portion of annual income once a year in good businesses, young investors need not care what happens to the price. Rather than cause for gloom, market crashes are a reason for celebration.
In disaster years when the market was down, the price value of the investor's holding bottomed, but it was the additional units bought in these disaster years when prices were low that enabled a positive overall return. A particular year that was considered to be a great year for the stock market, was also the worst year for our dollar cost averaging investor.
By investing a portion of annual income once a year in good businesses, young investors need not care what happens to the price. Rather than cause for gloom, market crashes are a reason for celebration.
Slow consistent accumulation through the power of compounding
Investing is not about making a quick kill, but slow and consistent accumulation through the power of compounding.
Sometimes, exceptional results will occur through the catch-up process of buying underpriced stocks or excessive market pricing, but unless you really know what you are doing, never gamble on chasing quick returns by being enticed to buy on margin.
Most individuals trading in highly leveraged futures are eventually wiped out by their lack of staying power when exceptional price volatility extinguishes their small percentage of equity. Losing a bet in which you can be 100 percent right with your choice but 1 percent wrong with the timing doesn't seem very good odds. Making money is nice, but peace of mind is much more valuable.
Sometimes, exceptional results will occur through the catch-up process of buying underpriced stocks or excessive market pricing, but unless you really know what you are doing, never gamble on chasing quick returns by being enticed to buy on margin.
Most individuals trading in highly leveraged futures are eventually wiped out by their lack of staying power when exceptional price volatility extinguishes their small percentage of equity. Losing a bet in which you can be 100 percent right with your choice but 1 percent wrong with the timing doesn't seem very good odds. Making money is nice, but peace of mind is much more valuable.
Best companies to invest in
Positive attributes to look for
So long as ROE is not overly leveraged by too much interest-bearing debt, the best companies in which to invest have a high ROE and a proven ability to reinvest a good proportion of profits without negatively affecting their ROE.
A company with a high ROE that distributes all, or close to all, profits is telling you that while it's a good business, it lacks the opportunity to grow. For instance, the sole local newspaper might be highly profitable by virtue of its monopoly, but opportunities to start a new paper or to buy an existing paper at a favourable price are likely to be rare. Profit growth is therefore limited to circulation growth. Such companies have the investment characteristics of an interest-bearing security - yield, but little or no growth - and must be valued accordingly.
Businesses that have historically long-term high ROEs with a high reinvestment rate have a sustainable competitive advantage that is difficult to duplicate. They have established brand-name products or services, patent rights, an established market niche or an innovative business model.
Although businesses with these qualities will not be selling at bargain prices, we can afford to pay a premium for a great business and still achieve a high return in the long term. The club of great businesses is not a closed shop, so watch out for new additions among smaller, less recognized companies that display these attributes.
So long as ROE is not overly leveraged by too much interest-bearing debt, the best companies in which to invest have a high ROE and a proven ability to reinvest a good proportion of profits without negatively affecting their ROE.
A company with a high ROE that distributes all, or close to all, profits is telling you that while it's a good business, it lacks the opportunity to grow. For instance, the sole local newspaper might be highly profitable by virtue of its monopoly, but opportunities to start a new paper or to buy an existing paper at a favourable price are likely to be rare. Profit growth is therefore limited to circulation growth. Such companies have the investment characteristics of an interest-bearing security - yield, but little or no growth - and must be valued accordingly.
Businesses that have historically long-term high ROEs with a high reinvestment rate have a sustainable competitive advantage that is difficult to duplicate. They have established brand-name products or services, patent rights, an established market niche or an innovative business model.
Although businesses with these qualities will not be selling at bargain prices, we can afford to pay a premium for a great business and still achieve a high return in the long term. The club of great businesses is not a closed shop, so watch out for new additions among smaller, less recognized companies that display these attributes.
Tuesday 25 November 2008
Ben Graham Checklist for Finding Undervalued Stocks
In addition to identifying and quantifying important value components, Graham left us with an assortment of general stock selection rules. He created a number of checklists at different times in his career to serve different investment objectives and portfolio strategies. The checklists review different aspects of a company's financial strength, intrinsic value, and the realtionship with price.
Here is a
Ben Graham Checklist for Finding Undervalued Stocks
Criterias
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.
If a stock meets 7 of the 10 criteria, it is probably a good value, according to Graham.
If you're income oriented, Graham recommended paying special attention to items 1 through 7.
If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.
If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.
Again, these checklists are a guideline and example, not a cookbook recipe you should follow precisely. They are a way of thinking and an example of how you may construct your own value investing system.
The criteria mentioned above are probably more focussed on dividends and safety than even today's value investors choose to be. But today's value investing practice owes an immense debt to this type of financial and investment analysis.
Spreadsheet for finding Undervalue Stocks
http://spreadsheets.google.com/pub?key=tZGNWHLD2d2nTgCcxSKyoCA&output=html
Reference: 20.11.2008 - KLSE MARKET PE
Here is a
Ben Graham Checklist for Finding Undervalued Stocks
Criterias
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.
If a stock meets 7 of the 10 criteria, it is probably a good value, according to Graham.
If you're income oriented, Graham recommended paying special attention to items 1 through 7.
If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.
If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.
Again, these checklists are a guideline and example, not a cookbook recipe you should follow precisely. They are a way of thinking and an example of how you may construct your own value investing system.
The criteria mentioned above are probably more focussed on dividends and safety than even today's value investors choose to be. But today's value investing practice owes an immense debt to this type of financial and investment analysis.
Spreadsheet for finding Undervalue Stocks
http://spreadsheets.google.com/pub?key=tZGNWHLD2d2nTgCcxSKyoCA&output=html
Reference: 20.11.2008 - KLSE MARKET PE
Impact of Interest Rates on Stock Prices
Impact of Interest Rates on Stock Prices
Warren Buffett highlighted the impact of interest rates on the Dow in a speech he gave on the stock market in July 1999. To demonstrate the correlation between interest rates and stock prices, with the exception of the inflation figures, he provided the data below which depicts two 17-year periods, between 1964 and 1981, and 1981 to 1998.
31st December
Gain in GNP over each 17 year period (%)
1964 – 1981…..373
1981 – 1998…..177
DJIA
1964—874
1981-- 875
1998--9181
Interest on long term government bonds (%)
1964-- 4.20
1981-- 13.65
1998-- 5.09
Increase in consumer price index over each 17 year period (%)
1964 – 1981…..201
1981 – 1998……74
Note:
The inflationary effect on asset values together with retained profits and new capital issues would have significantly increased the book values of the companies comprising the Dow during the first period 1964 – 1981. Yet, in spite of the huge increase in GNP, the 1964 index figure was basically the same 17 years later. Prices had been subdued by a more than threefold increase in interest rates.
In the second 17-year period from 1981 to 1998, in spite of GNP growth and inflation being less than 50 percent of the first period, the Dow increased by 949 percent. The driving factor was declining interest rates that diverted money out of interest-bearing securities into equities.
Interest rates increase at times of high inflation partly to offset the diminishing value of money and the government’s desire to curb demand in what is seen to be, as measured by GNP, a fast-growing economy. Conversely, when inflation subsided in the second 17-year period, interest rates declined.
Warren Buffett highlighted the impact of interest rates on the Dow in a speech he gave on the stock market in July 1999. To demonstrate the correlation between interest rates and stock prices, with the exception of the inflation figures, he provided the data below which depicts two 17-year periods, between 1964 and 1981, and 1981 to 1998.
31st December
Gain in GNP over each 17 year period (%)
1964 – 1981…..373
1981 – 1998…..177
DJIA
1964—874
1981-- 875
1998--9181
Interest on long term government bonds (%)
1964-- 4.20
1981-- 13.65
1998-- 5.09
Increase in consumer price index over each 17 year period (%)
1964 – 1981…..201
1981 – 1998……74
Note:
The inflationary effect on asset values together with retained profits and new capital issues would have significantly increased the book values of the companies comprising the Dow during the first period 1964 – 1981. Yet, in spite of the huge increase in GNP, the 1964 index figure was basically the same 17 years later. Prices had been subdued by a more than threefold increase in interest rates.
In the second 17-year period from 1981 to 1998, in spite of GNP growth and inflation being less than 50 percent of the first period, the Dow increased by 949 percent. The driving factor was declining interest rates that diverted money out of interest-bearing securities into equities.
Interest rates increase at times of high inflation partly to offset the diminishing value of money and the government’s desire to curb demand in what is seen to be, as measured by GNP, a fast-growing economy. Conversely, when inflation subsided in the second 17-year period, interest rates declined.
Economic Impact of Interest Rates and the Japanese Economy
Economic Impact of Interest Rates
There is a tendency to forget that for every borrower there is a lender and that interest rates work both ways. Less interest paid by borrowers means less interest received by lenders. When interest rates rise or fall, total disposable income doesn’t change; it simply redistributes.
Effect of rising interest rates on consumers
1. Consumer demand declines because the forced reduction in consumption by the greater number of borrowers is greater than the increased consumption of the lesser number of lenders.
2. Reduced demand is said to dampen inflationary impact of rising prices.
3. Budget-strapped families are forced to work extra hours or family member to seek part-time work.
4. The subsequent increase in availability of labour reduces pressure on wage demands.
Effect of interest rates rise on highly leveraged businesses
1. Profitability of highly leveraged businesses is reduced by their high cost of debt. Main impact on profitability is felt by exporters.
2. More foreign capital inflows are attracted by the higher interest rates which increases the exchange rate, consequently reducing the value of exports in the domestic currency.
3. Lower export output means reduced demand for labour and consequent further restraint on wage increases.
4. Higher exchange rate also means that the lower cost of imports will reduce prices
5. Reduced labour demand in industries competing with imported goods stabilizes costs by again increasing the availability of labour.
Effect of falling interest rates
1. Debtors are rewarded and more inclined to be financially irresponsible.
2. Those who have been prudent in accumulating savings in interest-bearing securities are penalized and less inclined to be prudent in the future. (Given the impact of a 40 percent tax rate and 3 percent inflation on an interest rate of 5 percent, the zero return (5 percent x 60 percent – 3 percent) provides zero incentive for prudence.)
3. Although serving short-term political objectives and rescuing overleveraged debtors, the longer-term effects of artificially low interest rates have proven to be undesirable.
Low Interest rates and The Japanese Economy
Any doubt about the effectiveness of low interest rates to stimulate the real economy should have been dispelled by the well-publicised Japanese experience. In spite of having interest rates close to zero and the government running a huge annual deficit, thus leaving more disposable income in the hands of the consumers, Japan has suffered a lingering recession since 1990.
The Nikkei 225 index’s loss of one-third of its value in the past 20 years can only be attributed to the low profitability of Japan’s corporations. Even with the leverage of close to zero interest rates, the ROE of Japan’s large nonfinancial firms fell from 8.2 percent in 1988 to an average of 3.1 percent between 1992 and 1999. It has since recovered to roughly 10 percent in 2007, but still lags a long way behind higher-interest-rate countries.
The real determinant of economic viability, ROFE (Returns on Funds Employed), would obviously be considerably lower than the quoted ROEs. When debt servicing is of no concern, inefficiencies creep into the business and the economic viability of capex becomes less important.
The prices of those wonderful products we buy from Japan are subsidized by shareholders of Japanese corporations. Little wonder that Buffett, when asked about investing in Japan in 2007, wryly commented that the profitability of Japanese companies was too low for Berkshire’s liking.
Although Japanese corporate profitability is improving, by Western standards most of its major corporations have not been economically viable in the past, and if required to pay equitable rates of interest, would be in serious financial difficulty.
The high Nikkei index PE ratio in 2007 of 18 (price-to-book value of 1.9) on average ROEs of 10 percent is influenced by the meager average dividend yield of 1.1 percent still being better than leaving money in the bank.
With so little incentive to invest and debt so cheap, it is not surprising that in 2005 Japan was the world’s largest consumer of luxury goods, accounting for 41 percent. Rather than working in favour of Japanese investors, low interest rates over the past 20 years have decimated their funds. Although low domestic rates persist, demand for Japanese stocks will remain high and they will therefore continue to be grossly overpriced.
The reason Japan keeps rates so low is to encourage an outflow of capital to dampen the yen exchange rate to help its exporters. In other words, domestic employment is the prime motivation. If Japan’s trade surplus were repatriated, rather than being left abroad, the US dollar would crumble and the yen appreciate to a level that would make life even tougher, perhaps impossible, for many Japanese exporters.
Here is a simple question to see whether you have been following the argument.
Given a Nikkei index figure of 16,500 and the abovementioned ROE (10 percent) and price to book value (1.9), what would the Nikkei index need to be to achieve a 10 percent return from an index fund that replicated it? Answer: 8684
When ROE and RR (Rate of Return) are equal, value is equal to book value. Therefore, 16,500 / 1.9 (price to book value) = 8684.
These are the sorts of things to consider when thinking about investing in international funds.
Related article: 20.11.2008 - KLSE MARKET PE
There is a tendency to forget that for every borrower there is a lender and that interest rates work both ways. Less interest paid by borrowers means less interest received by lenders. When interest rates rise or fall, total disposable income doesn’t change; it simply redistributes.
Effect of rising interest rates on consumers
1. Consumer demand declines because the forced reduction in consumption by the greater number of borrowers is greater than the increased consumption of the lesser number of lenders.
2. Reduced demand is said to dampen inflationary impact of rising prices.
3. Budget-strapped families are forced to work extra hours or family member to seek part-time work.
4. The subsequent increase in availability of labour reduces pressure on wage demands.
Effect of interest rates rise on highly leveraged businesses
1. Profitability of highly leveraged businesses is reduced by their high cost of debt. Main impact on profitability is felt by exporters.
2. More foreign capital inflows are attracted by the higher interest rates which increases the exchange rate, consequently reducing the value of exports in the domestic currency.
3. Lower export output means reduced demand for labour and consequent further restraint on wage increases.
4. Higher exchange rate also means that the lower cost of imports will reduce prices
5. Reduced labour demand in industries competing with imported goods stabilizes costs by again increasing the availability of labour.
Effect of falling interest rates
1. Debtors are rewarded and more inclined to be financially irresponsible.
2. Those who have been prudent in accumulating savings in interest-bearing securities are penalized and less inclined to be prudent in the future. (Given the impact of a 40 percent tax rate and 3 percent inflation on an interest rate of 5 percent, the zero return (5 percent x 60 percent – 3 percent) provides zero incentive for prudence.)
3. Although serving short-term political objectives and rescuing overleveraged debtors, the longer-term effects of artificially low interest rates have proven to be undesirable.
Low Interest rates and The Japanese Economy
Any doubt about the effectiveness of low interest rates to stimulate the real economy should have been dispelled by the well-publicised Japanese experience. In spite of having interest rates close to zero and the government running a huge annual deficit, thus leaving more disposable income in the hands of the consumers, Japan has suffered a lingering recession since 1990.
The Nikkei 225 index’s loss of one-third of its value in the past 20 years can only be attributed to the low profitability of Japan’s corporations. Even with the leverage of close to zero interest rates, the ROE of Japan’s large nonfinancial firms fell from 8.2 percent in 1988 to an average of 3.1 percent between 1992 and 1999. It has since recovered to roughly 10 percent in 2007, but still lags a long way behind higher-interest-rate countries.
The real determinant of economic viability, ROFE (Returns on Funds Employed), would obviously be considerably lower than the quoted ROEs. When debt servicing is of no concern, inefficiencies creep into the business and the economic viability of capex becomes less important.
The prices of those wonderful products we buy from Japan are subsidized by shareholders of Japanese corporations. Little wonder that Buffett, when asked about investing in Japan in 2007, wryly commented that the profitability of Japanese companies was too low for Berkshire’s liking.
Although Japanese corporate profitability is improving, by Western standards most of its major corporations have not been economically viable in the past, and if required to pay equitable rates of interest, would be in serious financial difficulty.
The high Nikkei index PE ratio in 2007 of 18 (price-to-book value of 1.9) on average ROEs of 10 percent is influenced by the meager average dividend yield of 1.1 percent still being better than leaving money in the bank.
With so little incentive to invest and debt so cheap, it is not surprising that in 2005 Japan was the world’s largest consumer of luxury goods, accounting for 41 percent. Rather than working in favour of Japanese investors, low interest rates over the past 20 years have decimated their funds. Although low domestic rates persist, demand for Japanese stocks will remain high and they will therefore continue to be grossly overpriced.
The reason Japan keeps rates so low is to encourage an outflow of capital to dampen the yen exchange rate to help its exporters. In other words, domestic employment is the prime motivation. If Japan’s trade surplus were repatriated, rather than being left abroad, the US dollar would crumble and the yen appreciate to a level that would make life even tougher, perhaps impossible, for many Japanese exporters.
Here is a simple question to see whether you have been following the argument.
Given a Nikkei index figure of 16,500 and the abovementioned ROE (10 percent) and price to book value (1.9), what would the Nikkei index need to be to achieve a 10 percent return from an index fund that replicated it? Answer: 8684
When ROE and RR (Rate of Return) are equal, value is equal to book value. Therefore, 16,500 / 1.9 (price to book value) = 8684.
These are the sorts of things to consider when thinking about investing in international funds.
Related article: 20.11.2008 - KLSE MARKET PE
Berkshire Hathaway's Stock Price
Compound Annual Growth Rate from 1990 to 1996 approximately: 26%
Compound Annual Growth Rate from 1996 to 2000 approximately: 18%
Compound Annual Growth Rate from 2001 to 2005 approximately
(still positive CAGR but well below Buffett's goal of 15%): 4%
Compound Annual Growth Rate from 2006 to Mid 2008 approximately: 31%
Berkshire Hathaway played a serious game of catchup during this short time frame.
Compound Annual Growth Rate from 1990 to Mid 2008 approximately: 17%
Berkshire Hathaway has exceeded the goal of 15% CAGR over a 17.5 year period.
Berkshire Hathaway has exceeded the goal of 15% CAGR over a 17.5 year period.
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Of course there are some companies that exceeded 100% CAGR on their stock price during the 1990's.
It is interesting to note that RedHat (ticker: RHT) had more than a 14000% CAGR from August 11, 1999 until December 9, 1999 when the share price went from $54.50 to $286.25.
Of course it also had a very bad CAGR of -89% from December 9, 1999 until September 18, 2001.
During this time the stock had a 2 for 1 stock split on January 10, 2000. On a split adjusted basis, the stock went from $143.12 to $3.02 per share.
Educational experience with an outcome other than expected
During bull markets owning stocks and calls on underpriced stocks should increase the value of the portfolio.
Bear markets should benefit positions in your portfolio that are either short overpriced companies or own puts on the overpriced stock.
Income may be generated by selling covered calls or credit spreads during a neutral market.
Please note that I have made extensive use of the words "should" and "may". Please do not invest any money that you can not afford to lose. Everyone has a different tolerance for risk. It is important that you do your own homework and take responsibility for any decisions that you make.
When investing, it doesn't take very long to have an educational experience with an outcome other than expected.
http://hyperdiversification.com/default.aspx
Bear markets should benefit positions in your portfolio that are either short overpriced companies or own puts on the overpriced stock.
Income may be generated by selling covered calls or credit spreads during a neutral market.
Please note that I have made extensive use of the words "should" and "may". Please do not invest any money that you can not afford to lose. Everyone has a different tolerance for risk. It is important that you do your own homework and take responsibility for any decisions that you make.
When investing, it doesn't take very long to have an educational experience with an outcome other than expected.
http://hyperdiversification.com/default.aspx
In Warren Buffet's 1992 letter to the share holders he discussed the following:
- During 1992, their Book Value had increased by 20.3%
- Between 1964 and 1992 book value per share (BVPS) had increased from $19 to $7745 resulting in a CAGR of 23.6%.
- Used book value for intrinsic value.
- CAGR goal 15%
- The number of outstanding shares has changed very little between 1964 and 1992 (1,137,778 vs. 1,152,547 respectively)
- Requiring a significant Margin of Safety (MOS) when purchasing stock in another company as a cornerstone of Berkshire Hathaway's success
My mom bought her first new car back in 1965. It was a Ford Falcon. She really liked the car. I wonder how much higher her networth would be if she would have bought a used car and invested the difference in Berkshire Hathaway. ;) Of course BH is the exception and not the norm. :))
http://hyperdiversification.com/cagr_main.aspx
Learn from:
Our focus is to protect and accumulate wealth for our clients. To do that, we are guided by one core principal. DON'T LOSE MONEY. It seems simple, but is by far one of the most challenging endeavors an investor can undertake.
In order to achieve the goal of capital preservation, the Strategy must protect previously earned gains while allowing an investor to profit from a market rebound after a substantial market decline. In other words, the Strategy wants to profit from bull markets and protect the portfolio in bear markets. http://www.swaninvesting.com/home
High-net-worth Investors & Listed Options
Portfolio Management Strategies for Affluent Investors, Family Offices, and Trust Companies http://www.swaninvesting.com/HighNetWorthInvestors.pdf
Monday 24 November 2008
What do all Berkshire Hathaway companies have in common?
What do all Berkshire Hathaway companies have in common?
They are profitable, safe and solid.
They are easy to understand with simple business models.
They produce plenty of cash flow to reinvest.
They are unique businesses with strong market positions and franchises.
They have solid, trustworthy management.
They were bought at reasonable prices.
We ordinary value investors can't assemble this kind of portfolio, but we can learn from what makes Berkshire Hathaway and its master tick.
Ref: Berkshire Hathaway's SEC filing
http://www.hoovers.com/free/co/secdoc.xhtml?ID=10206&ipage=6253178
They are profitable, safe and solid.
They are easy to understand with simple business models.
They produce plenty of cash flow to reinvest.
They are unique businesses with strong market positions and franchises.
They have solid, trustworthy management.
They were bought at reasonable prices.
We ordinary value investors can't assemble this kind of portfolio, but we can learn from what makes Berkshire Hathaway and its master tick.
Ref: Berkshire Hathaway's SEC filing
http://www.hoovers.com/free/co/secdoc.xhtml?ID=10206&ipage=6253178
Berkshire Hathaway's Acquisition Criteria: Telling it like it is
Take a look at the following set of "acquisition criteria," straight from the 2006 Berkshire Hathaway Annual report. Straight, clear, to the point - and never before have we seen anything like this - including the commentary - in a shareholder report.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units).
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations).
3. Businesses earning good returns on equity while employing little or no debt.
4. Management in place (we can't supply it).
5. Simple businesses (if there's lots of technology, we won't understand it).
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminary, about a transaction when price is unknown).
The larger the company, the greater will be our interest. We would like to make an acquisition in the $5-20 billion range. We are not interested, however, in receiving suggestions about purchases we may make in the general stock market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don't participate in auctions.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units).
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations).
3. Businesses earning good returns on equity while employing little or no debt.
4. Management in place (we can't supply it).
5. Simple businesses (if there's lots of technology, we won't understand it).
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminary, about a transaction when price is unknown).
The larger the company, the greater will be our interest. We would like to make an acquisition in the $5-20 billion range. We are not interested, however, in receiving suggestions about purchases we may make in the general stock market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don't participate in auctions.
It is not about diversification
Why diversify your portfolio? Is this the key to investing success?
Diversification provides safety in numbers and avoids the eggs-in-one basket syndrome, so it protects the value of a portfolio.
But the masters of value investing have shown that diversification only serves to dilute returns. If you're doing the value investing thing right, you are picking the right companies at the right price, so there's no need to provide this extra insurance. In fact, over-diversification only serves to dilute returns.
However, perhaps diversification isn't a bad idea until you prove yourself a good value investor. Diversification may suggest 'conservative' style, but diversification per se is not a value investing technique.
Diversification provides safety in numbers and avoids the eggs-in-one basket syndrome, so it protects the value of a portfolio.
But the masters of value investing have shown that diversification only serves to dilute returns. If you're doing the value investing thing right, you are picking the right companies at the right price, so there's no need to provide this extra insurance. In fact, over-diversification only serves to dilute returns.
However, perhaps diversification isn't a bad idea until you prove yourself a good value investor. Diversification may suggest 'conservative' style, but diversification per se is not a value investing technique.
Margin of Safety in Value Investing
The idea of buying a company at a bargain price is to achieve a margin of safety. This is important to provide a buffer if business events don't turn out exactly as predicted (and they won't).
- The value investing style calls for building in margins of safety by buying at a reasonable price.
- The style also suggests finding margins of safety within the business itself, for instance, so-called "moats" or competitive advantages that differentiate the business from its competitors.
- Also, a large cash hoard or the absence of debt offers a financial margin of safety.
Sunday 23 November 2008
Choosing a Discount Assumption
Choosing a discount assumption
In theory, the discount rate should be your own personal cost of capital for this kind of investment. If you have a million dollars and can invest it with no risk in a Treasury bond at 6 percent, your cost of capital is the risk-free 6 percent you would forgo by not investing in the bond. So the implied cost of your dollars made available to invest in Business XYZ starts at 6 percent. Financial types refer to this opportunity cost as the risk-free cost of capital.
But implicitly, Company XYZ common stock is riskier than the bond investment. Sales, earnings, and myriad other intrinsic things can change, as can markets and the market perception of XYZ’s worth. So an equity premium is added to the risk-free cost of capital rate. In effect, the total cost of capital is your required compensation, or hurdle, for the opportunity you’ve lost by not buying the bond, plus the assumption of risk by investing in XYZ.
Much has gone into identifying appropriate risk premiums and the like. Modern portfolio theory and its reliance on beta – a measure of relative stock price volatility – doesn’t really do much for most value investors. (Remember: Price doesn’t determine value.)
The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar. The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.
As you build and run models, you’ll see firsthand how the discount rate affects the resulting intrinsic value. Here are a few points to remember:
In theory, the discount rate should be your own personal cost of capital for this kind of investment. If you have a million dollars and can invest it with no risk in a Treasury bond at 6 percent, your cost of capital is the risk-free 6 percent you would forgo by not investing in the bond. So the implied cost of your dollars made available to invest in Business XYZ starts at 6 percent. Financial types refer to this opportunity cost as the risk-free cost of capital.
But implicitly, Company XYZ common stock is riskier than the bond investment. Sales, earnings, and myriad other intrinsic things can change, as can markets and the market perception of XYZ’s worth. So an equity premium is added to the risk-free cost of capital rate. In effect, the total cost of capital is your required compensation, or hurdle, for the opportunity you’ve lost by not buying the bond, plus the assumption of risk by investing in XYZ.
Much has gone into identifying appropriate risk premiums and the like. Modern portfolio theory and its reliance on beta – a measure of relative stock price volatility – doesn’t really do much for most value investors. (Remember: Price doesn’t determine value.)
The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar. The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.
As you build and run models, you’ll see firsthand how the discount rate affects the resulting intrinsic value. Here are a few points to remember:
- The higher the discount rate, the lower the intrinsic value – and vice versa.
- The second-stage discount rate should always be higher than the first stage. Risk increases the farther out you go.
- If you choose an aggressive growth rate, it makes sense also to choose a higher discount rate. Risk of failure is higher with high growth rates.
- If the discount rate exceeds the growth rate, intrinsic value will be low and implode more quickly the larger the gap. Aggressive growth assumptions with low discount rates yield very high intrinsic values.
If you’re worried about earnings and earnings growth consistency and want to factor it in somehow, but don’t want to do a deep statistical analysis on a zillion numbers, Value Line does one for you. At the bottom right corner of the Value Line Investment Survey sheet is a figure called “Earnings Predictability” if the Survey covers the company you’re evaluating.
It’s really a statistical predictability score normalised to 100 (100 is best, 0 is worst). A score of 80 and higher indicates relative safety; below 80 means that you may want to attenuate growth rates or bump up the discount rate to account for uncertainty.
Here again is the set of growth and discount assumptions used for an example. Consistency is important, but growth rates will vary for each company, and discount rates may change also with differing risk assessments.
First-stage growth 10%
Second-stage growth 5%
First-stage discount rate 12%
Second-stage discount rate 15%
Intrinsic Value Model
Intrinsic value is driven by current and especially future earnings. Projecting future growth in these earnings is vital to determining intrinsic value.
First-stage growth
Near-term growth is by nature easier to model, and as a result of the discounting process, they contribute more towards the final result anyway. So intrinsic value models are set up to specifically value a first stage in detail, year-by-year. Typically, the first stage is 10 years, although in some analyses it may be more or less.
More often than not, the first stage is assumed to have a higher growth rate and a lower discount rate than the second stage.
Second-stage growth
The second stage covers the more nebulous period of business life beyond the first stage. Second-stage returns are harder to project accurately, so intrinsic value models use one of two assumptions to estimate what’s known as continuing value:
- Indefinite life: The indefinite life model assumes ongoing returns and uses a mathematical formula to project returns over an indefinite period and assign a value to those returns.
- Acquisition: Want a convenient way to bypass mathematical approximations? Assume that someone will come along and buy your business after the first stage at a reasonable valuation. Returns include all future payouts, including lump sums, so this method works too, so long as resale value is projected reasonably.
Summary.
Each stage of a business life has a growth rate and discount rate applicable to that stage. One growth rate and one discount rate is applied to the first stage, and another growth and discount rate to the second. Then, you calculate net future earnings by first compounding growth over the first stage and then discounting that value back to the present. A generalised formula, either indefinite life or acquisition-based, is applied to the second stage. The value attributed to the second stage is called continuing value.
**Appraising the Value of a Business
Appraising the Value of a Business
Investment is most intelligent when it is most business-like.
( Benjamin Graham)
Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you would look for the following:
1. Income: Profits and strong positive operating cash flows exceeding capital requirements are good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
2. Income Growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
3. Productive Capital Investment: If a company is able to invest additional capital productively – at a greater return than it would get by putting it in the bank – that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
4. Rising Productivity and Falling Expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
5. Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
6. Steady or Rising Asset Values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
7. Favourable Intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.
Investment is most intelligent when it is most business-like.
( Benjamin Graham)
Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you would look for the following:
1. Income: Profits and strong positive operating cash flows exceeding capital requirements are good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
2. Income Growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
3. Productive Capital Investment: If a company is able to invest additional capital productively – at a greater return than it would get by putting it in the bank – that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
4. Rising Productivity and Falling Expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
5. Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
6. Steady or Rising Asset Values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
7. Favourable Intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.
**A Seven-Step Process for investing in New Assets
Advice for investment accumulators
By Christopher M. Flanagan, J.D.
Published January 1998
React to this article in the Discussion Forum.
Frequently, people make investment decisions based not so much on what they know or what their experiences have been but, rather, on how they acquire assets. In other words, how investors build their portfolios often is driven by how they acquire their investable cash. For example, one might be a partner in a medical or law firm and receive a partnership distribution. Or, perhaps he or she is a corporate executive who receives a yearly bonus. In either case, assets are received in stages or "chunks," and the individual must now determine an investment route for these new assets. The result of this piecemeal approach now is a collection or accumulation of investments. It is a difficult process if you have a goal of being consistent with an overall plan.
A Flawed Investment Process
After receiving that Christmas bonus, or perhaps liquidating part of a business, the accumulator’s investment process typically takes the following path. First, current market trends are considered, e.g., "Blue chip stocks seem to be doing well," or "There are global opportunities, but market volatility is a concern." Ideas are then checked with a knowledgeable person whom the investor respects (stockbroker or relative). Next, the investor reviews his or her current portfolio and considers whether to add to existing investments, e.g., "I might want to add money to my common stock fund." Finally, the money is invested. The process appears logical to the accumulator, but it is flawed in that it typically takes into account only "this year’s" money and not all of the investor’s assets. The result is a collection of investments, rather than a portfolio with a comprehensive strategy.
A Seven-Step Process
While everyone’s situation is unique and financial needs can be met and addressed in a multitude of ways, the process for identifying what those needs are revolves around the same fundamental issues. At the risk of oversimplification, applying the following seven-step process would enable the accumulator to make smarter investment decisions for the long-term and not just for the moment.
Establish an investment goal. Establishing investment goals amounts basically to writing down, in language someone else would understand, one’s personal investment goals. It can be in very general terms, such as "I want to have enough money for a comfortable retirement," or "I want to make sure I can put three children through college," or perhaps, "I never want to run out of money." That’s pretty plain language, but it certainly does the job of identifying an individual’s financial ambitions and concerns.
Determine the ability to tolerate investment risk. Understanding how much risk someone can tolerate is a very personal thing, but one rule of thumb can help an individual know when they’ve exceeded that comfortable level. Again, it is a basic guideline, but one should "never own any investment that will cause you to lose even five minutes’ sleep at night." Investors frequently ignore this guideline in an "up" market.
Calculate the annual return objective: what kind of performance do you need to get from your investments. The next step is to calculate the average annual return the investor needs or wants, and there are a couple of ways to do this. Begin by looking back at the personal investment goals. As an example, let’s use the goal of a college education for three children. If an individual needs $100,000 a year in today’s dollars—and knowing how much he or she has today and how much will be put aside going forward—you can go through the mathematical calculations of figuring out exactly what annual return on the money is needed to reach the goal. The individual can then get a sense for whether his or her expectations are realistic and whether he or she is setting enough aside to invest for future use. Another method is to take a look at the historical performance data, not over a one-year period, but over a ten-, thirty-, and fifty-year period. Studying long-term performance results will help to keep in line the investor’s expectations for future returns.
Select asset allocation among types of investment vehicles. The next step is determining the asset allocation that best meets investment objectives. Arguably, this is the most critical step and one where individuals could benefit from some professional advice. Asset allocation, the buzz words in financial services today, is how assets are apportioned among various asset classes (stocks, bonds, etc.). The goal is to achieve the highest return at a risk level the investor is comfortable with. Achieving the highest return for any given level of risk is an efficient portfolio mix. Generally speaking, we know that between 65 percent and 85 percent of a portfolio’s performance will be dictated by the structure of the portfolio—the mix of asset classes—rather than the specific individual investments that are held within it. Consequently, it is more important to figure out what portion of a portfolio should be in stocks, etc., rather than which stocks to select. Here is where someone might call on expert assistance. Chart first how much risk exists in the current portfolio (it is often more than expected). Next, determine if it is possible to increase potential returns without increasing your risk and identify the ideal mix of investment types, (stocks, bonds, etc.) necessary to accomplish this.
Choose specific investments. Based on the investment types identified, it is now time to choose the specific investments that are most appropriate. This is where most of the investment "clutter" happens: comparing which stocks did better than others, which funds outperformed benchmarks, etc. And it is here that one needs to have a well-diversified portfolio. Once again, though, while investment selection undeniably impacts the overall performance of a portfolio, it is more important that those investment selections are diversified within the investment types that best support the investor’s long-term investment strategy.
Monitor portfolio performance quarterly. While it isn’t necessary to get mired in every single week’s or month’s worth of statements, it is important to review results on a quarterly basis. Take a hard look at the percentage returns on the entire portfolio during the past quarter. How do those results compare to the annual percentage return objective and to the long-term goal? Were performance expectations met, and were they realistic? Does the investment strategy need to be adjusted?
Revisit steps 1-5 annually. Once a year, walk through the above steps for making smarter decisions. Revisit (perhaps revise) investment goals, as they can and should change over time. With the current appetite for risk in mind, calculate the annual percentage return objectives. Accurately select the asset allocation that will help to meet those goals, and the result will be a successfully structured portfolio.
Ironically, "investment accumulators" usually don’t appreciate how successful they truly are. Because they didn’t inherit their money or win a lottery, but rather just worked for it a little at a time over the years, they don’t think of themselves as "wealthy" or even financially successful. Consequently, they may not be giving their investment portfolio the respect it deserves.
Christopher M. Flanagan, J.D., is a regional manager for Mellon Private Asset Management, a service mark of Mellon Bank Corporation and its subsidiaries.
http://www.physiciansnews.com/finance/198.html
By Christopher M. Flanagan, J.D.
Published January 1998
React to this article in the Discussion Forum.
Frequently, people make investment decisions based not so much on what they know or what their experiences have been but, rather, on how they acquire assets. In other words, how investors build their portfolios often is driven by how they acquire their investable cash. For example, one might be a partner in a medical or law firm and receive a partnership distribution. Or, perhaps he or she is a corporate executive who receives a yearly bonus. In either case, assets are received in stages or "chunks," and the individual must now determine an investment route for these new assets. The result of this piecemeal approach now is a collection or accumulation of investments. It is a difficult process if you have a goal of being consistent with an overall plan.
A Flawed Investment Process
After receiving that Christmas bonus, or perhaps liquidating part of a business, the accumulator’s investment process typically takes the following path. First, current market trends are considered, e.g., "Blue chip stocks seem to be doing well," or "There are global opportunities, but market volatility is a concern." Ideas are then checked with a knowledgeable person whom the investor respects (stockbroker or relative). Next, the investor reviews his or her current portfolio and considers whether to add to existing investments, e.g., "I might want to add money to my common stock fund." Finally, the money is invested. The process appears logical to the accumulator, but it is flawed in that it typically takes into account only "this year’s" money and not all of the investor’s assets. The result is a collection of investments, rather than a portfolio with a comprehensive strategy.
A Seven-Step Process
While everyone’s situation is unique and financial needs can be met and addressed in a multitude of ways, the process for identifying what those needs are revolves around the same fundamental issues. At the risk of oversimplification, applying the following seven-step process would enable the accumulator to make smarter investment decisions for the long-term and not just for the moment.
Establish an investment goal. Establishing investment goals amounts basically to writing down, in language someone else would understand, one’s personal investment goals. It can be in very general terms, such as "I want to have enough money for a comfortable retirement," or "I want to make sure I can put three children through college," or perhaps, "I never want to run out of money." That’s pretty plain language, but it certainly does the job of identifying an individual’s financial ambitions and concerns.
Determine the ability to tolerate investment risk. Understanding how much risk someone can tolerate is a very personal thing, but one rule of thumb can help an individual know when they’ve exceeded that comfortable level. Again, it is a basic guideline, but one should "never own any investment that will cause you to lose even five minutes’ sleep at night." Investors frequently ignore this guideline in an "up" market.
Calculate the annual return objective: what kind of performance do you need to get from your investments. The next step is to calculate the average annual return the investor needs or wants, and there are a couple of ways to do this. Begin by looking back at the personal investment goals. As an example, let’s use the goal of a college education for three children. If an individual needs $100,000 a year in today’s dollars—and knowing how much he or she has today and how much will be put aside going forward—you can go through the mathematical calculations of figuring out exactly what annual return on the money is needed to reach the goal. The individual can then get a sense for whether his or her expectations are realistic and whether he or she is setting enough aside to invest for future use. Another method is to take a look at the historical performance data, not over a one-year period, but over a ten-, thirty-, and fifty-year period. Studying long-term performance results will help to keep in line the investor’s expectations for future returns.
Select asset allocation among types of investment vehicles. The next step is determining the asset allocation that best meets investment objectives. Arguably, this is the most critical step and one where individuals could benefit from some professional advice. Asset allocation, the buzz words in financial services today, is how assets are apportioned among various asset classes (stocks, bonds, etc.). The goal is to achieve the highest return at a risk level the investor is comfortable with. Achieving the highest return for any given level of risk is an efficient portfolio mix. Generally speaking, we know that between 65 percent and 85 percent of a portfolio’s performance will be dictated by the structure of the portfolio—the mix of asset classes—rather than the specific individual investments that are held within it. Consequently, it is more important to figure out what portion of a portfolio should be in stocks, etc., rather than which stocks to select. Here is where someone might call on expert assistance. Chart first how much risk exists in the current portfolio (it is often more than expected). Next, determine if it is possible to increase potential returns without increasing your risk and identify the ideal mix of investment types, (stocks, bonds, etc.) necessary to accomplish this.
Choose specific investments. Based on the investment types identified, it is now time to choose the specific investments that are most appropriate. This is where most of the investment "clutter" happens: comparing which stocks did better than others, which funds outperformed benchmarks, etc. And it is here that one needs to have a well-diversified portfolio. Once again, though, while investment selection undeniably impacts the overall performance of a portfolio, it is more important that those investment selections are diversified within the investment types that best support the investor’s long-term investment strategy.
Monitor portfolio performance quarterly. While it isn’t necessary to get mired in every single week’s or month’s worth of statements, it is important to review results on a quarterly basis. Take a hard look at the percentage returns on the entire portfolio during the past quarter. How do those results compare to the annual percentage return objective and to the long-term goal? Were performance expectations met, and were they realistic? Does the investment strategy need to be adjusted?
Revisit steps 1-5 annually. Once a year, walk through the above steps for making smarter decisions. Revisit (perhaps revise) investment goals, as they can and should change over time. With the current appetite for risk in mind, calculate the annual percentage return objectives. Accurately select the asset allocation that will help to meet those goals, and the result will be a successfully structured portfolio.
Ironically, "investment accumulators" usually don’t appreciate how successful they truly are. Because they didn’t inherit their money or win a lottery, but rather just worked for it a little at a time over the years, they don’t think of themselves as "wealthy" or even financially successful. Consequently, they may not be giving their investment portfolio the respect it deserves.
Christopher M. Flanagan, J.D., is a regional manager for Mellon Private Asset Management, a service mark of Mellon Bank Corporation and its subsidiaries.
http://www.physiciansnews.com/finance/198.html
Saturday 22 November 2008
Is now the time to bail out?
Is now the time to bail out?
A volatile market isn't necessarily a bad market. But selling when stocks are down is usually a bad idea.
By the Mole, Money Magazine's undercover financial planner
October 29, 2008: 5:47 AM ET
NEW YORK (Money) -- Question: I know market timing is a loser's game. However, I do think there is abundant evidence that the next 12-18 months are going to be very difficult for equities. Do you see any merit in trimming some equity holdings, parking the proceeds in short-term bonds or cash, and committing to immediately dollar-cost averaging back into the market on a monthly fixed schedule?
The Mole's Answer: Your question is a very sophisticated way of asking whether you should bail from the market right now. While I don't know your total situation, I can tell you that selling after equities are down by 40% is usually a bad thing.
First of all, I wholeheartedly agree with your statement that market timing is a loser's game. Many studies have shown the systematically bad job that individual investors do of timing the market.
We are constantly testing the market winds. When conditions are favorable, we increase our exposure. When conditions become so far from favorable that they're in another zip code, such as what we're currently experiencing, we decrease our exposure.
Unfortunately, we tend to do both of these things after the fact. Truth be told, we all want stock returns during bull markets and money market returns in bear markets. But as much as we may want them, no one really knows exactly how to get them, since we can't predict when bear markets and bull markets are beginning or ending.
Second, when you state that the next 12-18 months are likely to be "difficult" for equities, I'm not sure I agree with you. If by "difficult," you mean volatile, then you are probably right.
The last few weeks in the stock market has set all sorts of records for volatility. Emotions are running wild and there is a likelihood that this volatility will not end anytime soon.
But I would not agree that this translates into a bad period for the stock market. Primarily because the stock market is a better buy today than it was last year. In fact, I can quantify it by saying it's a 40% better value.
Which begs the question, why wasn't I getting as many inquiries about selling last year when the market was hitting new highs?
But that's a rhetorical question - the answer is that we humans have a tendency to predict the future based on the recent past.
This "recency bias," as it's known in the financial planning world, has us thinking inside the box of current events. If the market is thriving, as it was between 2003 and 2007, then we believe it will always be thriving. And in times like these when the sustained market dive is giving us all nose bleeds, we believe we'll never pull out of it.
Onto your question of whether you should sell now with a commitment to buy back in with periodic purchases, also known as dollar-cost averaging. As sophisticated and well thought out as this sounds, it still means selling your equities after they are down by 40%, and still equals market timing.
A better time to consider selling would have been last year after equities had more than doubled.
I can't tell you how the stock market will perform over the next 12 -18 months. No one can. It may very well turn out to be the right thing to do but the odds are very much against you.
Studies actually quantify that we pay an average penalty of 1.5% annually for timing the stock market and chasing the hot performers. Many of us come up with all sorts of rationale for doing what we're doing, but it ultimately just results in outsmarting ourselves.
The fact that you say you will commit to buying back periodically is a bit confusing. I'm glad you realize the market doesn't signal to us that we have hit bottom and that now is the time to buy, but it also hasn't sent you a signal that now is the time to sell.
Systematic rebalancing would have had you selling some of your stocks between 2002 and 2007, as they were skyrocketing. Now is probably when you should be buying.
My advice: Find an asset allocation that is right for you and stick to it. Try to rebalance in times like these, which actually means buying more stocks. Remember that investing during a rough economy can be the right thing to do. If someone tells you that you can have the upside of the market without the risk, don't believe them.
The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail him at http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/mailto:themole@moneymail.com. Send feedback to Money Magazine
Find this article at: http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/index.htm
A volatile market isn't necessarily a bad market. But selling when stocks are down is usually a bad idea.
By the Mole, Money Magazine's undercover financial planner
October 29, 2008: 5:47 AM ET
NEW YORK (Money) -- Question: I know market timing is a loser's game. However, I do think there is abundant evidence that the next 12-18 months are going to be very difficult for equities. Do you see any merit in trimming some equity holdings, parking the proceeds in short-term bonds or cash, and committing to immediately dollar-cost averaging back into the market on a monthly fixed schedule?
The Mole's Answer: Your question is a very sophisticated way of asking whether you should bail from the market right now. While I don't know your total situation, I can tell you that selling after equities are down by 40% is usually a bad thing.
First of all, I wholeheartedly agree with your statement that market timing is a loser's game. Many studies have shown the systematically bad job that individual investors do of timing the market.
We are constantly testing the market winds. When conditions are favorable, we increase our exposure. When conditions become so far from favorable that they're in another zip code, such as what we're currently experiencing, we decrease our exposure.
Unfortunately, we tend to do both of these things after the fact. Truth be told, we all want stock returns during bull markets and money market returns in bear markets. But as much as we may want them, no one really knows exactly how to get them, since we can't predict when bear markets and bull markets are beginning or ending.
Second, when you state that the next 12-18 months are likely to be "difficult" for equities, I'm not sure I agree with you. If by "difficult," you mean volatile, then you are probably right.
The last few weeks in the stock market has set all sorts of records for volatility. Emotions are running wild and there is a likelihood that this volatility will not end anytime soon.
But I would not agree that this translates into a bad period for the stock market. Primarily because the stock market is a better buy today than it was last year. In fact, I can quantify it by saying it's a 40% better value.
Which begs the question, why wasn't I getting as many inquiries about selling last year when the market was hitting new highs?
But that's a rhetorical question - the answer is that we humans have a tendency to predict the future based on the recent past.
This "recency bias," as it's known in the financial planning world, has us thinking inside the box of current events. If the market is thriving, as it was between 2003 and 2007, then we believe it will always be thriving. And in times like these when the sustained market dive is giving us all nose bleeds, we believe we'll never pull out of it.
Onto your question of whether you should sell now with a commitment to buy back in with periodic purchases, also known as dollar-cost averaging. As sophisticated and well thought out as this sounds, it still means selling your equities after they are down by 40%, and still equals market timing.
A better time to consider selling would have been last year after equities had more than doubled.
I can't tell you how the stock market will perform over the next 12 -18 months. No one can. It may very well turn out to be the right thing to do but the odds are very much against you.
Studies actually quantify that we pay an average penalty of 1.5% annually for timing the stock market and chasing the hot performers. Many of us come up with all sorts of rationale for doing what we're doing, but it ultimately just results in outsmarting ourselves.
The fact that you say you will commit to buying back periodically is a bit confusing. I'm glad you realize the market doesn't signal to us that we have hit bottom and that now is the time to buy, but it also hasn't sent you a signal that now is the time to sell.
Systematic rebalancing would have had you selling some of your stocks between 2002 and 2007, as they were skyrocketing. Now is probably when you should be buying.
My advice: Find an asset allocation that is right for you and stick to it. Try to rebalance in times like these, which actually means buying more stocks. Remember that investing during a rough economy can be the right thing to do. If someone tells you that you can have the upside of the market without the risk, don't believe them.
The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail him at http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/mailto:themole@moneymail.com. Send feedback to Money Magazine
Find this article at: http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/index.htm
Friday 21 November 2008
Focus on Return on Equity
The Key to Finding Stocks that Will Make You Rich? Focus on Return on Equity
By Joshua Kennon, About.com
Countless successful investors, businessmen, and financiers have emphatically stated, and proven through their own career, over long periods of time, the performance of a stock most closely correlates with the return earned on shareholders’ equity.
As one well known investor put it, even if you buy a business at a huge discount, if you hold the stock for five, ten years or more, it’s going to be highly unlikely that you will be able to earn more than the ROE generated by the underlying enterprise.
Likewise, even a more reasonable price or a slightly higher price-to-earnings ratio for a better business that earns, say sixteen or seventeen percent on capital, you’re going to have very, very good results over a twenty or thirty year period.
An excellent example is Johnson & Johnson. According to the company’s most recent annual report, “In 2006, we logged our 74th year of sales increases, our 23rd consecutive year of earnings increases adjusted for special charges and our 44th consecutive year of dividend increases. This is a record matched by very few, if any, companies in history.” The firm is diversified throughout the medical supplies, pharmaceutical, and consumer product fields. These include household names such as Tylenol, Band-Aid, Stayfree, Carefree, K-Y, Splenda, Neutrogena, Benadryl, Sudafed, Listerine, Visine, Lubriderm, and Neosporin, not to mention the eponymous baby care products such as powder, lotion, and oil. Compared to the S&P 500, the stock currently trades at a lower p/e ratio, a lower price to cash flow ratio, a lower price to book ratio, and boasts a higher cash dividend yield, all while earning a much higher return on assets and return on equity than the average publicly traded company!
Investing is a game of weighing odds and reducing risk. Can you guarantee that you will beat the market? No. You can, however, increase the chances of that happening by focusing on companies that have comparable profiles – established histories, management with huge financial interest in the company, a history of executing well, discipline in returning excess capital to shareholders through cash dividends and share repurchases, as well as a focused pipeline of opportunities for future growth. These are the stocks that have better chances of compounding uninterrupted, meaning less of your money goes to commissions, market maker spread, capital gains taxes, and other frictional expenses. That small advantage can lead to enormous gains in your net worth; only 3% more each year, over an investing lifetime (say, fifty-years), is triple the wealth!
The biggest challenge is the fact that very few firms are actually able to maintain high returns on equity over substantial stretches of time because of the breathtaking ruthlessness of capitalism. Of course, as consumers, we all benefit from this in the form of a higher standard of living through lower costs, but for owners, it can mean volatility and financial setback. That’s why you must settle inside of yourself the question of exactly how large a company’s competitive “moat” is, factoring that into your valuation. Do you think someone will be able to unseat Coca-Cola as the dominant soft drink company in the world? How about Microsoft? The latter would certainly seem more vulnerable than the former, but both are much better off than a marginal steel company trying to eek out a profit in a commodity-like business with little or no pricing power and few, if any, barriers of entry.
http://beginnersinvest.about.com/od/investstrategiesstyles/a/aa110107a_roe.htm
By Joshua Kennon, About.com
Countless successful investors, businessmen, and financiers have emphatically stated, and proven through their own career, over long periods of time, the performance of a stock most closely correlates with the return earned on shareholders’ equity.
As one well known investor put it, even if you buy a business at a huge discount, if you hold the stock for five, ten years or more, it’s going to be highly unlikely that you will be able to earn more than the ROE generated by the underlying enterprise.
Likewise, even a more reasonable price or a slightly higher price-to-earnings ratio for a better business that earns, say sixteen or seventeen percent on capital, you’re going to have very, very good results over a twenty or thirty year period.
An excellent example is Johnson & Johnson. According to the company’s most recent annual report, “In 2006, we logged our 74th year of sales increases, our 23rd consecutive year of earnings increases adjusted for special charges and our 44th consecutive year of dividend increases. This is a record matched by very few, if any, companies in history.” The firm is diversified throughout the medical supplies, pharmaceutical, and consumer product fields. These include household names such as Tylenol, Band-Aid, Stayfree, Carefree, K-Y, Splenda, Neutrogena, Benadryl, Sudafed, Listerine, Visine, Lubriderm, and Neosporin, not to mention the eponymous baby care products such as powder, lotion, and oil. Compared to the S&P 500, the stock currently trades at a lower p/e ratio, a lower price to cash flow ratio, a lower price to book ratio, and boasts a higher cash dividend yield, all while earning a much higher return on assets and return on equity than the average publicly traded company!
Investing is a game of weighing odds and reducing risk. Can you guarantee that you will beat the market? No. You can, however, increase the chances of that happening by focusing on companies that have comparable profiles – established histories, management with huge financial interest in the company, a history of executing well, discipline in returning excess capital to shareholders through cash dividends and share repurchases, as well as a focused pipeline of opportunities for future growth. These are the stocks that have better chances of compounding uninterrupted, meaning less of your money goes to commissions, market maker spread, capital gains taxes, and other frictional expenses. That small advantage can lead to enormous gains in your net worth; only 3% more each year, over an investing lifetime (say, fifty-years), is triple the wealth!
The biggest challenge is the fact that very few firms are actually able to maintain high returns on equity over substantial stretches of time because of the breathtaking ruthlessness of capitalism. Of course, as consumers, we all benefit from this in the form of a higher standard of living through lower costs, but for owners, it can mean volatility and financial setback. That’s why you must settle inside of yourself the question of exactly how large a company’s competitive “moat” is, factoring that into your valuation. Do you think someone will be able to unseat Coca-Cola as the dominant soft drink company in the world? How about Microsoft? The latter would certainly seem more vulnerable than the former, but both are much better off than a marginal steel company trying to eek out a profit in a commodity-like business with little or no pricing power and few, if any, barriers of entry.
http://beginnersinvest.about.com/od/investstrategiesstyles/a/aa110107a_roe.htm
Four Investment Objectives Define Strategy
Four Investment Objectives Define Strategy
By Ken Little, About.com
In broad terms, four main investment objectives cover how you accomplish most financial goals.
These investment objectives are important because certain products and strategies work for one objective, but may produce poor results for another objective.
It is quite likely you will use several of these investment objectives simultaneously to accomplish different objectives without any conflict.
Let’s examine these objectives and see how they differ.
Capital Appreciation
Capital appreciation is concerned with long-term growth. This strategy is most familiar in retirement plans where investments work for many years inside a qualified plan.
However, investing for capital appreciation is not limited to qualified retirement accounts. If this is your objective, you are planning to hold the stocks for many years.
You are content to let them grow within your portfolio, reinvesting dividends to purchase more shares. A typical strategy employs making regular purchases.
You are not very concerned with day-to-day fluctuations, but keep a close eye on the fundamentals of the company for changes that could affect long-term growth.
Current Income
If your objective is current income, you are most likely interested in stocks that pay a consistent and high dividend. You may also include some top-quality real estate investment trusts (REITs) and highly-rated bonds.
All of these products produce current income on a regular basis.
Many people who pursue a strategy of current income are retired and use the income for living expenses. Other people take advantage of a lump sum of capital to create an income stream that never touches the principal, yet provides cash for certain current needs (college, for example).
Capital Preservation
Capital preservation is a strategy you often associate with elderly people who want to make sure they don’t outlive their money.
Retired on nearly retired people often use this strategy to hold on the detention has.
For this investor, safety is extremely important – even to the extent of giving up return for security.
The logic for this safety is clear. If they lose their money through foolish investment and are retired, it is unlike they will get a chance to replace it.
Investors who use capital preservation tend to invest in bank CDs, U.S. Treasury issues, savings accounts.
Speculation
The speculator is not a true investor, but a trader who enjoys jumping into and out of stocks as if they were bad shoes.
Speculators or traders are interested in quick profits and used advanced trading techniques like shorting stocks, trading on the margin, options and other special equipment.
They have no love for the companies they trade and, in fact may not know much about them at all other than the stock is volatile and ripe for a quick profit.
Speculators keep their eyes open for a quick profit situation and hope to trade in and out without much thought about the underlying companies.
Many people try speculating in the stock market with the misguided goal of getting rich. It doesn’t work that way.
If you want to try your hand, make sure you are using money you can afford to lose. It’s easy to get addicted, so make sure you understand the real possibilities of losing your investment.
Conclusion
Your investment style should match you financial objectives. If it doesn’t, you should see professional help in dealing with investment choices that match you financial objectives.
http://stocks.about.com/od/investingstrategies/a/021906technque.htm
By Ken Little, About.com
In broad terms, four main investment objectives cover how you accomplish most financial goals.
These investment objectives are important because certain products and strategies work for one objective, but may produce poor results for another objective.
It is quite likely you will use several of these investment objectives simultaneously to accomplish different objectives without any conflict.
Let’s examine these objectives and see how they differ.
Capital Appreciation
Capital appreciation is concerned with long-term growth. This strategy is most familiar in retirement plans where investments work for many years inside a qualified plan.
However, investing for capital appreciation is not limited to qualified retirement accounts. If this is your objective, you are planning to hold the stocks for many years.
You are content to let them grow within your portfolio, reinvesting dividends to purchase more shares. A typical strategy employs making regular purchases.
You are not very concerned with day-to-day fluctuations, but keep a close eye on the fundamentals of the company for changes that could affect long-term growth.
Current Income
If your objective is current income, you are most likely interested in stocks that pay a consistent and high dividend. You may also include some top-quality real estate investment trusts (REITs) and highly-rated bonds.
All of these products produce current income on a regular basis.
Many people who pursue a strategy of current income are retired and use the income for living expenses. Other people take advantage of a lump sum of capital to create an income stream that never touches the principal, yet provides cash for certain current needs (college, for example).
Capital Preservation
Capital preservation is a strategy you often associate with elderly people who want to make sure they don’t outlive their money.
Retired on nearly retired people often use this strategy to hold on the detention has.
For this investor, safety is extremely important – even to the extent of giving up return for security.
The logic for this safety is clear. If they lose their money through foolish investment and are retired, it is unlike they will get a chance to replace it.
Investors who use capital preservation tend to invest in bank CDs, U.S. Treasury issues, savings accounts.
Speculation
The speculator is not a true investor, but a trader who enjoys jumping into and out of stocks as if they were bad shoes.
Speculators or traders are interested in quick profits and used advanced trading techniques like shorting stocks, trading on the margin, options and other special equipment.
They have no love for the companies they trade and, in fact may not know much about them at all other than the stock is volatile and ripe for a quick profit.
Speculators keep their eyes open for a quick profit situation and hope to trade in and out without much thought about the underlying companies.
Many people try speculating in the stock market with the misguided goal of getting rich. It doesn’t work that way.
If you want to try your hand, make sure you are using money you can afford to lose. It’s easy to get addicted, so make sure you understand the real possibilities of losing your investment.
Conclusion
Your investment style should match you financial objectives. If it doesn’t, you should see professional help in dealing with investment choices that match you financial objectives.
http://stocks.about.com/od/investingstrategies/a/021906technque.htm
Preparing Your Portfolio Is the Most Important Action You Can Take
The One Factor Stock Investors Can Control
Preparing Your Portfolio Is the Most Important Action You Can Take
By Ken Little, About.com
When the stock market is running very hot or very cold, it is on everyone’s mind and few conversations last very long before turning to the latest numbers.
Whether it is the dot.com boom of the 1990s or the credit crisis of 2007, when the market is erratic and volatile, people are engaged.
The factors that lead to a boom-bust cycle in the market are important. Investment professionals and regulators spend a great deal of time trying to understand what happens in the market during these periods.
Individual investors have little influence on the market. While it is important to understand what happens and why, that is not the most important consideration for individual investors.
Stock Investors Important Influence
The most important influence on how your portfolio performs is how well you have prepared it. Preparation is the only factor you can influence.
Preparation means adopting a reasonable allocation between stocks, bonds and cash. It also means diversifying you holdings by industry sector, company size and growth and value stocks.
Most investors should consider a bond allocation equal to their age. For example, a 45 year-old investor should have 55 percent in stocks and 45 percent in bonds.
You can’t know with any assurance which turns the market will take - even industry professionals don’t know.
However, if you have five or more years before you need to convert holdings to cash, the odds are good that your portfolio will do as well as possible if you maintain a reasonable allocation.
There are no guarantees in investing. You assume that over the long-term your holdings will grow, however an assumption, even one based on historical truths, is not a guarantee.
Establishing an Allocation
Establishing an allocation and maintaining it is a challenging exercise. Here’s why:
Assume your allocation was 60 percent stocks and 40 percent bonds. If stocks are shooting up, the temptation is to put more money into the hot side of your allocation - ride the gains up.
What this often means is investors pay inflated prices. When the boom collapses as they all do, investors are either stuck with stock worth much less than they paid or they bail out with a loss.
The rational way to approach a rapidly expanding market is to watch your allocation and when it becomes out of balance, sell off stocks and add to bonds. This may let you take profits, but you may miss out on some future gains.
In a rapidly dropping market, investors should consider buying stocks to maintain balance. You may be able to buy stocks at depressed prices, which increases the odds of significant gains when the market returns.
Many investors would find their losses were lower and their gains higher if they would maintain a reasonable allocation regardless of what the market does.
If you can take a long-term approach, you could look at your holdings once a year (or maybe once a quarter in very volatile markets) and make adjustments.
The remainder of the time avoid the temptation to buy during a boom or sell during a bust.
http://stocks.about.com/od/investingstrategies/a/102608portfolio.htm
Preparing Your Portfolio Is the Most Important Action You Can Take
By Ken Little, About.com
When the stock market is running very hot or very cold, it is on everyone’s mind and few conversations last very long before turning to the latest numbers.
Whether it is the dot.com boom of the 1990s or the credit crisis of 2007, when the market is erratic and volatile, people are engaged.
The factors that lead to a boom-bust cycle in the market are important. Investment professionals and regulators spend a great deal of time trying to understand what happens in the market during these periods.
Individual investors have little influence on the market. While it is important to understand what happens and why, that is not the most important consideration for individual investors.
Stock Investors Important Influence
The most important influence on how your portfolio performs is how well you have prepared it. Preparation is the only factor you can influence.
Preparation means adopting a reasonable allocation between stocks, bonds and cash. It also means diversifying you holdings by industry sector, company size and growth and value stocks.
Most investors should consider a bond allocation equal to their age. For example, a 45 year-old investor should have 55 percent in stocks and 45 percent in bonds.
You can’t know with any assurance which turns the market will take - even industry professionals don’t know.
However, if you have five or more years before you need to convert holdings to cash, the odds are good that your portfolio will do as well as possible if you maintain a reasonable allocation.
There are no guarantees in investing. You assume that over the long-term your holdings will grow, however an assumption, even one based on historical truths, is not a guarantee.
Establishing an Allocation
Establishing an allocation and maintaining it is a challenging exercise. Here’s why:
Assume your allocation was 60 percent stocks and 40 percent bonds. If stocks are shooting up, the temptation is to put more money into the hot side of your allocation - ride the gains up.
What this often means is investors pay inflated prices. When the boom collapses as they all do, investors are either stuck with stock worth much less than they paid or they bail out with a loss.
The rational way to approach a rapidly expanding market is to watch your allocation and when it becomes out of balance, sell off stocks and add to bonds. This may let you take profits, but you may miss out on some future gains.
In a rapidly dropping market, investors should consider buying stocks to maintain balance. You may be able to buy stocks at depressed prices, which increases the odds of significant gains when the market returns.
Many investors would find their losses were lower and their gains higher if they would maintain a reasonable allocation regardless of what the market does.
If you can take a long-term approach, you could look at your holdings once a year (or maybe once a quarter in very volatile markets) and make adjustments.
The remainder of the time avoid the temptation to buy during a boom or sell during a bust.
http://stocks.about.com/od/investingstrategies/a/102608portfolio.htm
A Look at Growth, Income and Value Investing
Investing Philosophies - Part One
A Look at Growth, Income, and Value Investing
By Ken Little, About.com
Developing an investing philosophy may seem like an academic exercise, however over time, it will help shape your thinking about the types of stocks that work for your portfolio.
This first of a two-part series looks at the three main investing philosophies:
Growth
Value
Income
Most investors fall into one or a combination of these investing philosophies.
Growth Investors
As the name implies, growth investors look for the rising stars. They are interested in companies that have high potential for earning growth. High earning growth invariable leads to high stock prices – at least in theory. Growth investors are willing to bet on young companies that show promise of becoming leaders in their industry.
The technology stocks, especially during the late 1990s, were the perfect example of growth stocks. Many of these young companies started with an idea and nothing more and now are large successful companies.
Of course, a great many more of those same technology companies started out with an idea and nothing more and ended up where they started. Which is to say that growth investing carries the risk that some of your investments are going to fail. As much as Americans like success stories, there are more failures than successes when it comes to market leadership.
Value Investors
Value investors look for the stocks that the market has overlooked. Value doesn’t mean cheap as in low per share price, but under priced relative to the value of the company.
These are stocks the market has passed over while chasing some other industry sector or more glamorous investments. The value investor looks for stocks with a low price/earnings ratio meaning the market is not willing to pay much in the way of a premium for the stock.
Of course, the value investor needs to make sure there in nothing wrong with the company that would warrant a low stock price other than neglect or market inattention. Assuming the company is solid, the value investor’s strategy is to buy and hold the stock, anticipating the future time when the market will recognize the company’s worth and bid the stock up to its true value.
Income Investors
Income investing is the most straight-forward of all philosophies and the most conservative. Income is the motivation and investors target companies paying high and consistent dividends.
People near or in retirement are fond of this strategy for obvious reasons. The companies that qualify for the income investor tend to be large and well-established. There is always some risk involved in investing in stocks, however this remains the most conservative of the investing philosophies.
If the stock price increases, that’s icing on the cake for the income investor who would probably trade some capital appreciation for a higher dividend.
Conclusion
These three investing philosophies take in a large number of investors, however it is not required that you fall purely in one camp or another. As a practical matter, you will likely modify your investing philosophy as your life circumstances change.
http://stocks.about.com/od/investingphilisophies/a/Investphilone.htm
A Look at Growth, Income, and Value Investing
By Ken Little, About.com
Developing an investing philosophy may seem like an academic exercise, however over time, it will help shape your thinking about the types of stocks that work for your portfolio.
This first of a two-part series looks at the three main investing philosophies:
Growth
Value
Income
Most investors fall into one or a combination of these investing philosophies.
Growth Investors
As the name implies, growth investors look for the rising stars. They are interested in companies that have high potential for earning growth. High earning growth invariable leads to high stock prices – at least in theory. Growth investors are willing to bet on young companies that show promise of becoming leaders in their industry.
The technology stocks, especially during the late 1990s, were the perfect example of growth stocks. Many of these young companies started with an idea and nothing more and now are large successful companies.
Of course, a great many more of those same technology companies started out with an idea and nothing more and ended up where they started. Which is to say that growth investing carries the risk that some of your investments are going to fail. As much as Americans like success stories, there are more failures than successes when it comes to market leadership.
Value Investors
Value investors look for the stocks that the market has overlooked. Value doesn’t mean cheap as in low per share price, but under priced relative to the value of the company.
These are stocks the market has passed over while chasing some other industry sector or more glamorous investments. The value investor looks for stocks with a low price/earnings ratio meaning the market is not willing to pay much in the way of a premium for the stock.
Of course, the value investor needs to make sure there in nothing wrong with the company that would warrant a low stock price other than neglect or market inattention. Assuming the company is solid, the value investor’s strategy is to buy and hold the stock, anticipating the future time when the market will recognize the company’s worth and bid the stock up to its true value.
Income Investors
Income investing is the most straight-forward of all philosophies and the most conservative. Income is the motivation and investors target companies paying high and consistent dividends.
People near or in retirement are fond of this strategy for obvious reasons. The companies that qualify for the income investor tend to be large and well-established. There is always some risk involved in investing in stocks, however this remains the most conservative of the investing philosophies.
If the stock price increases, that’s icing on the cake for the income investor who would probably trade some capital appreciation for a higher dividend.
Conclusion
These three investing philosophies take in a large number of investors, however it is not required that you fall purely in one camp or another. As a practical matter, you will likely modify your investing philosophy as your life circumstances change.
http://stocks.about.com/od/investingphilisophies/a/Investphilone.htm
Three Main Influences on Stock Prices
Three Main Influences on Stock Prices
By Ken Little, About.com
There are three main areas of influence that move a stock’s price up or down. If you understand these influences, it will help you decide whether the price movement is a buy, sell or sit tight signal.
Fundamentals
Clearly, the most direct influence on a stock’s price is a change in the economic fundamentals of the business.
If revenues and profits are on a steep upward trend with no indication of leveling off, you can expect to see the stock price rise as investors bid up this attractive company.
On the other hand, if the profit picture is flat or, worse, declining with no change in sight, look for investors to abandon the stock and the price to fall.
These are simple examples of changes in fundamentals. Other, more complex and subtle changes can occur that may not dramatically affect the stock price immediately (increased debt, a poor acquisition and so on can also trigger price changes).
The point is that changes in the underlying business have a direct impact on the stock’s price. Smart investors spot the subtle changes before they become price-movers and take the appropriate action.
Sector Changes
Changes in the stock’s sector can have positive or negative affects on price too. Some sectors or industries are cyclical in nature and you should know that would affect price.
However, when whole sectors catch of fire (think dot.com stocks) or burn up (think dot.com stocks, again), even those companies that have solid fundamentals are pulled along with the rest of the sector.
You may hold a stock that is a victim of “guilt by association” when an industry falls out of favor. Likewise, stocks can see prices artificially inflated if they find themselves in the right industry at the right time.
Market Swings
The market goes up and the market goes down. That’s about all you can say with certainty concerning the stock market.
As the market moves up and down, your stock may move with or against it. Most large-cap stocks will follow the market to some degree, but smaller companies may not get the same push every time.
In general, a strong market move either up or down will carry more stocks with it than not, so your stock may be up or down for no other reason than the market was up or down.
Conclusion
How do you use this information?
A change in fundamentals may be an opportunity to buy more shares of a growing company or it may signal the time to sell if the changes are for the worse.
A change in the sector is usually temporary so most long-term investors will ride out dips due to these factors. However, if something drastically changes in the stock’s industry due to regulation or a new technology, for example, you may want to reevaluate your position. Is the company capable of adapting or do you own a dinosaur?
Market swings that move your stock’s price can be opportunities to buy additional shares (assuming all the company’s fundamentals still checkout). If the rising market pushes up your stock’s price, it may be time to take a profit on part of your holdings and wait for the price to come back down to earth to reinvest.
http://stocks.about.com/od/evaluatingstocks/a/0317threefact.htm
By Ken Little, About.com
There are three main areas of influence that move a stock’s price up or down. If you understand these influences, it will help you decide whether the price movement is a buy, sell or sit tight signal.
Fundamentals
Clearly, the most direct influence on a stock’s price is a change in the economic fundamentals of the business.
If revenues and profits are on a steep upward trend with no indication of leveling off, you can expect to see the stock price rise as investors bid up this attractive company.
On the other hand, if the profit picture is flat or, worse, declining with no change in sight, look for investors to abandon the stock and the price to fall.
These are simple examples of changes in fundamentals. Other, more complex and subtle changes can occur that may not dramatically affect the stock price immediately (increased debt, a poor acquisition and so on can also trigger price changes).
The point is that changes in the underlying business have a direct impact on the stock’s price. Smart investors spot the subtle changes before they become price-movers and take the appropriate action.
Sector Changes
Changes in the stock’s sector can have positive or negative affects on price too. Some sectors or industries are cyclical in nature and you should know that would affect price.
However, when whole sectors catch of fire (think dot.com stocks) or burn up (think dot.com stocks, again), even those companies that have solid fundamentals are pulled along with the rest of the sector.
You may hold a stock that is a victim of “guilt by association” when an industry falls out of favor. Likewise, stocks can see prices artificially inflated if they find themselves in the right industry at the right time.
Market Swings
The market goes up and the market goes down. That’s about all you can say with certainty concerning the stock market.
As the market moves up and down, your stock may move with or against it. Most large-cap stocks will follow the market to some degree, but smaller companies may not get the same push every time.
In general, a strong market move either up or down will carry more stocks with it than not, so your stock may be up or down for no other reason than the market was up or down.
Conclusion
How do you use this information?
A change in fundamentals may be an opportunity to buy more shares of a growing company or it may signal the time to sell if the changes are for the worse.
A change in the sector is usually temporary so most long-term investors will ride out dips due to these factors. However, if something drastically changes in the stock’s industry due to regulation or a new technology, for example, you may want to reevaluate your position. Is the company capable of adapting or do you own a dinosaur?
Market swings that move your stock’s price can be opportunities to buy additional shares (assuming all the company’s fundamentals still checkout). If the rising market pushes up your stock’s price, it may be time to take a profit on part of your holdings and wait for the price to come back down to earth to reinvest.
http://stocks.about.com/od/evaluatingstocks/a/0317threefact.htm
Thursday 20 November 2008
The Myth of EPS Growth
The myth of EPS growth
Impact of Retained earnings on EPS
When EPS growth is entirely due to profits from retained earnings, the increased EPS percentage measures the impact of ROE on those retained earnings.
For instance,
Half of profit is retained: If ROE is 20 percent, half the profit is retained and ROE in the following year remains steady at 20 percent, EPS will increase by 10 percent.
All profit is retained: If all profit is retained and reinvested at 20 percent, EPS will increase by 20 per cent.
All profit is distributed: If all profit were distributed, irrespective of ROE, EPS growth would be zero.
Impact of borrowings (debt) on EPS
Increasing borrowings (debt) on EPS: However, even if all profits were distributed as dividends and the business increased its borrowings, EPS would increase. So an increase in EPS might simply signify an increase in debt.
Decreasing borrowings (debt) on EPS: Conversely, if borrowings were reduced and ROFE exceeded the cost of debt, EPS would decline.
Impact of new capital issues on EPS
When equity per share increases by virtue of new capital issues that exceed the current equity per share, EPS can increase when the business performance (ROE) declines.
So the positive news of an increase in EPS might disguise the fact that value has declined by virtue of diminished profitability.
Because management seems to be as equally ignorant of this factor as the market, focusing on EPS growth can make bad capital-allocation (acquisitions) decisions appear beneficial.
When new shares are issued at a price that exceeds the book value of equity per share, the EPS of a company with a modest business performance can increase quite dramatically.
For instance, a company with a ROE of 10 per cent, $500 million equity and 100 million shares on issue will have an EPS of $0.50 on its equity of $5.00 per share. Given a P/E ratio of 15, the $5.00 equity per share will be priced at $7.50 ($0.50 x 15).
New shares are issued at a price > the book value of equity per share: If the company issues a further 100 million shares at its market price of $7.50, raising $750 million, the 200 million shares on issue will have an equity of $1.25 billion or $6.25 per share.
If the modest ROE of 10 percent is maintained on the increased capital, EPS will grow by 25 percent. That is: equity $1.25 billion / 10% = $125 million / 200 million shares = EPS of 62.5c.
If the P/E ratio of 15 is maintained, the shares will now be priced at 62.5c x 15 = $9.36.
New shareholders whose generosity increased the original shareholders’ equity by 25 per cent to $6.25 a share, having paid $7.50 for stock now priced at $9.36, will be under the impression they made a sound investment decision.
When a company regularly issues shares at prices that exceed the current equity per share, the false impressions of EPS growth will give support and impetus to its share price.
New shares are issued at a price = the book value of equity per share: If the new shares had been issued with the $5.00 equity per share, a price that is closer to the value, EPS would have remained unchanged and EPS growth would be zero.
Does this mean that the lack of EPS growth diminishes the value of the business? Of course not, it is still the same business.
New shares issued at a price > the book value of equity per share, but the ROE declines: When new capital issues are made at prices that exceed the equity per share, EPS will not necessarily decline when the business performance declines. If ROE declined to 8 percent in the example given, EPS will be unchanged: equity $6.25 x ROE 8 percent = EPS 50c.
Conclusion:
The coloured bar charts of profit, dividends and EPS growth in an annual report, although correctly stated, can give an entirely misleading impression. The ever-increasing height of the EPS, profit and dividend columns in the bar chart have nothing whatsoever to do with the business performance.
Because both management and market participants fail to recognise the importance of ROE and ROFE, you are unlikely to ever see them depicted by way of a bar chart in the annual report, or for that matter in an analyst’s research. If you do, take a good look at the company because the CEO is likely to be one of that rare breed who truly understands the impact of capital-allocation decisions.
Using Charlie Munger’s terminology, such a CEO can be likened to a two-legged man competing with one-legged men in an arse-kicking contest. Much better for management, so the thinking goes, to treat shareholders like fools by depicting graphs that move in continuous upward direction.
So what does EPS growth tell us? Essentially nothing, and it should therefore, be disregarded as another misleading indicator that leads to erratic pricing.
Impact of Retained earnings on EPS
When EPS growth is entirely due to profits from retained earnings, the increased EPS percentage measures the impact of ROE on those retained earnings.
For instance,
Half of profit is retained: If ROE is 20 percent, half the profit is retained and ROE in the following year remains steady at 20 percent, EPS will increase by 10 percent.
All profit is retained: If all profit is retained and reinvested at 20 percent, EPS will increase by 20 per cent.
All profit is distributed: If all profit were distributed, irrespective of ROE, EPS growth would be zero.
Impact of borrowings (debt) on EPS
Increasing borrowings (debt) on EPS: However, even if all profits were distributed as dividends and the business increased its borrowings, EPS would increase. So an increase in EPS might simply signify an increase in debt.
Decreasing borrowings (debt) on EPS: Conversely, if borrowings were reduced and ROFE exceeded the cost of debt, EPS would decline.
Impact of new capital issues on EPS
When equity per share increases by virtue of new capital issues that exceed the current equity per share, EPS can increase when the business performance (ROE) declines.
So the positive news of an increase in EPS might disguise the fact that value has declined by virtue of diminished profitability.
Because management seems to be as equally ignorant of this factor as the market, focusing on EPS growth can make bad capital-allocation (acquisitions) decisions appear beneficial.
When new shares are issued at a price that exceeds the book value of equity per share, the EPS of a company with a modest business performance can increase quite dramatically.
For instance, a company with a ROE of 10 per cent, $500 million equity and 100 million shares on issue will have an EPS of $0.50 on its equity of $5.00 per share. Given a P/E ratio of 15, the $5.00 equity per share will be priced at $7.50 ($0.50 x 15).
New shares are issued at a price > the book value of equity per share: If the company issues a further 100 million shares at its market price of $7.50, raising $750 million, the 200 million shares on issue will have an equity of $1.25 billion or $6.25 per share.
If the modest ROE of 10 percent is maintained on the increased capital, EPS will grow by 25 percent. That is: equity $1.25 billion / 10% = $125 million / 200 million shares = EPS of 62.5c.
If the P/E ratio of 15 is maintained, the shares will now be priced at 62.5c x 15 = $9.36.
New shareholders whose generosity increased the original shareholders’ equity by 25 per cent to $6.25 a share, having paid $7.50 for stock now priced at $9.36, will be under the impression they made a sound investment decision.
When a company regularly issues shares at prices that exceed the current equity per share, the false impressions of EPS growth will give support and impetus to its share price.
New shares are issued at a price = the book value of equity per share: If the new shares had been issued with the $5.00 equity per share, a price that is closer to the value, EPS would have remained unchanged and EPS growth would be zero.
Does this mean that the lack of EPS growth diminishes the value of the business? Of course not, it is still the same business.
New shares issued at a price > the book value of equity per share, but the ROE declines: When new capital issues are made at prices that exceed the equity per share, EPS will not necessarily decline when the business performance declines. If ROE declined to 8 percent in the example given, EPS will be unchanged: equity $6.25 x ROE 8 percent = EPS 50c.
Conclusion:
The coloured bar charts of profit, dividends and EPS growth in an annual report, although correctly stated, can give an entirely misleading impression. The ever-increasing height of the EPS, profit and dividend columns in the bar chart have nothing whatsoever to do with the business performance.
Because both management and market participants fail to recognise the importance of ROE and ROFE, you are unlikely to ever see them depicted by way of a bar chart in the annual report, or for that matter in an analyst’s research. If you do, take a good look at the company because the CEO is likely to be one of that rare breed who truly understands the impact of capital-allocation decisions.
Using Charlie Munger’s terminology, such a CEO can be likened to a two-legged man competing with one-legged men in an arse-kicking contest. Much better for management, so the thinking goes, to treat shareholders like fools by depicting graphs that move in continuous upward direction.
So what does EPS growth tell us? Essentially nothing, and it should therefore, be disregarded as another misleading indicator that leads to erratic pricing.
Growth
There is a huge difference between the business that grows and requires lots of capital to do so and the business that grows and doesn’t require capital. (Warren Buffett, 1994 Berkshire AGM)
Growth
When a company is said to be “growing its business” or simply “growing”, it means that the business is using its retained profits or new capital to expand its existing business or to acquire other ready-made businesses.
Organic growth: Growth is said to be organic when a company is using retained profits and debt to expand its existing operations.
The ability to increase market share or penetrate new markets without compromising profit margins indicates a healthy demand for the company’s products or services. Such businesses therefore normally make good long-term investments.
Growth by acquiring other businesses: Companies with limited potential to expand organically might grow externally by acquiring other businesses using existing resources or new capital.
If profitability or ROFE (return on funds employed) from a new acquisition is less than the ROFE in the existing business, the decline in overall profitability will reduce the per-share value.
Because capital-allocation decisions are the Achilles heel of most businesses, companies on the acquisition trail should be treated with caution.
Acquisitions that come at a price that is hard for seller to refuse, while increasing profit in absolute terms, frequently lead to diminished profitability and therefore loss of per-share value.
Growth
When a company is said to be “growing its business” or simply “growing”, it means that the business is using its retained profits or new capital to expand its existing business or to acquire other ready-made businesses.
Organic growth: Growth is said to be organic when a company is using retained profits and debt to expand its existing operations.
The ability to increase market share or penetrate new markets without compromising profit margins indicates a healthy demand for the company’s products or services. Such businesses therefore normally make good long-term investments.
Growth by acquiring other businesses: Companies with limited potential to expand organically might grow externally by acquiring other businesses using existing resources or new capital.
If profitability or ROFE (return on funds employed) from a new acquisition is less than the ROFE in the existing business, the decline in overall profitability will reduce the per-share value.
Because capital-allocation decisions are the Achilles heel of most businesses, companies on the acquisition trail should be treated with caution.
Acquisitions that come at a price that is hard for seller to refuse, while increasing profit in absolute terms, frequently lead to diminished profitability and therefore loss of per-share value.
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