Before you can conquer the markets and lie back to count your millions, you must have a clear picture of where your finances stand right now. Once you've taken that crucial first step toward your eventual wealth, you'll be ready to set your goals, analyze your style, and put together a real plan — one that will get you exactly where you want to go. The path to wealth comes with countless setbacks, many roadblocks, and dozens of disappointments. A solid plan will help you get through those impediments.
Tuesday, 7 February 2012
Planning for Success
Before you can conquer the markets and lie back to count your millions, you must have a clear picture of where your finances stand right now. Once you've taken that crucial first step toward your eventual wealth, you'll be ready to set your goals, analyze your style, and put together a real plan — one that will get you exactly where you want to go. The path to wealth comes with countless setbacks, many roadblocks, and dozens of disappointments. A solid plan will help you get through those impediments.
Top 10 Things to Do Before You Invest
Top 10 Things to Do Before You Invest
by Michele Cagan, CPA
1. Pay off every penny of credit card debt. You'll earn sky-high (18 to 22 percent!) returns just by paying your credit card balance in full rather than making the minimum monthly interest-laden payments.
2. Build yourself an emergency fund. Start a separate bank account for this purpose alone. It should have enough money to cover at least three to six months of living expenses.
3. Set up and follow a household budget. Keep track of where your money comes from and (even more important) where it's going.
4. Set clear financial goals. Whether you want to save for a new car this year or retirement twenty years from now, you need to know why you're investing.
5. Determine your time frame. How long your money will be working for you plays a key role in designing the best portfolio.
6. Know your risk tolerance. Investing can bring about as many downs as ups, and you have to know just how much uncertainty you can comfortably stand.
7. Figure out your asset allocation mix. Before you start investing, know what proportion of your portfolio will be dedicated to each asset class (like stocks, bonds, and cash, for example).
8. Improve your understanding of the markets. That includes learning about the big picture, such as the global political and economic forces that drive the markets and affect asset prices.
9. Set up your brokerage account. Whether you decide to start out with a financial advisor or take a more do-it-yourself approach, you'll need to have an open brokerage account before you can make your first trade.
10. Analyze every investment before you buy it. Buy only investments that you have researched and fully understand; never risk your money on an unknown.
http://www.netplaces.com/investing/planning-for-success/top-ten-things-to-do-before-you-invest-1.htm
by Michele Cagan, CPA
1. Pay off every penny of credit card debt. You'll earn sky-high (18 to 22 percent!) returns just by paying your credit card balance in full rather than making the minimum monthly interest-laden payments.
2. Build yourself an emergency fund. Start a separate bank account for this purpose alone. It should have enough money to cover at least three to six months of living expenses.
3. Set up and follow a household budget. Keep track of where your money comes from and (even more important) where it's going.
4. Set clear financial goals. Whether you want to save for a new car this year or retirement twenty years from now, you need to know why you're investing.
5. Determine your time frame. How long your money will be working for you plays a key role in designing the best portfolio.
6. Know your risk tolerance. Investing can bring about as many downs as ups, and you have to know just how much uncertainty you can comfortably stand.
7. Figure out your asset allocation mix. Before you start investing, know what proportion of your portfolio will be dedicated to each asset class (like stocks, bonds, and cash, for example).
8. Improve your understanding of the markets. That includes learning about the big picture, such as the global political and economic forces that drive the markets and affect asset prices.
9. Set up your brokerage account. Whether you decide to start out with a financial advisor or take a more do-it-yourself approach, you'll need to have an open brokerage account before you can make your first trade.
10. Analyze every investment before you buy it. Buy only investments that you have researched and fully understand; never risk your money on an unknown.
http://www.netplaces.com/investing/planning-for-success/top-ten-things-to-do-before-you-invest-1.htm
Learn Accounting
Accounting Sections
- Accounting Is More Than Numbers
- The Basic Accounts
- Keeping Track of Transactions
- Setting Up a System
- The Accounting Equation
- Recording Your Revenues
- The Inventory-Cost Connection
- Standard Operating Expenses
- Managing the Payroll
- Always Know Your Cash
- Handling Customer Credit
- Controlling Purchase Costs
- The End of Period Cleanup
- Preparing Financial Statements
- Different Entities Mean Different Equity
- The Income Tax Impact
- The Best Use of Your Financial Statements
- More Ways Accounting Helps Your Business
- Unique Issues for Specific Businesses
- Retirement Plans
- Common Small-Business Tax Snafus
- Accounting Glossary
- Small-Business Resources on the Internet
Monday, 6 February 2012
Graham's Valuation Formula
Investing is a multidimensional activity.
To cope with this complexity, investors have resorted to increasingly powerful computers that purport to capture the inter-relatedness of many variables. But this approach tends to lose the most valuable input of all: human intuition.
A far better solution for the investment process would be to "freeze" some variables so that analyses could focus on a reasonable number of factors.
Benjamin Graham's valuation formula provided all stock market investors with a critically important tool that freezes one of the key variables of the investment process to simplify the purchase decision. By using Graham's formula, investors are freed to consider other important factors when evaluating a public company.
GRAHAM'S SIMPLE FORMULA
To calculate intrinsic value, multiply the earnings growth rate by 2 and add 8.5 to the total, then multiply that by the current earnings per share.
[8.5 + (2 x growth) ] x EPS = Intrinsic Value per share
1. A no-growth company. The company would have a P/E ratio of 8.5 (and an earnings yield of 12%), which is a fairly typical P/E for a mature company.
2. An average-growing company. Most analysts use a P/E range of 15 to 20 times earnings for the S&P 500. This would translate into the average growth stock in the S&P 500 growing between the ranges of 3.25% to 5.75% (mean 4.5%).
3. A faster-growing company. A faster-growing stock growing at 10% will have a P/E ratio of 28.5. This is fairly typical for the faster-growing companies in the S&P 500.
Two flaws in the valuation models. All valuation models have flaws.
1. Models such as Graham's value a company based solely on its earnings. This leaves out the possible positive effects of non-operating assets or negative effects of non-operating liabilities.. That's why investors need to look beyond earnings and examine company balance sheets prior to purchase to look for non-operating assets and liabilities.
2. A second flaw has to do with the potential competition from high interest rates. Should the P/E ratio of stocks be immune to high interest rates? Of course not. Graham himself addressed this issue when he suggested that P/E ratios should be adjusted downward if long-term interest rates on AAA corporate bonds
exceeded 4.4%. The revised Graham formula factors in the current yield to maturity on AAA corporate bonds in the calculation of a company's intrinsic value:
REVISED GRAHAM FORMULA
Intrinsic value per share = EPS x (8.5 + 2g) x 4.4 / y
where,
g = growth rate
y = yield on AAA corporate bonds
If the yields on AAA corporate bonds were to remain at 4.4%, then the original Graham model would remain intact.
If the yields on AAA corporate bonds increased to 6.6%, the P/E ratios would be reduced by 1/3 (4.4/6.6 = 2/3).
If the yields on AAA corporate bonds increased to 8.8%, the P/E ratios would be cut by 1/2. Thus, the future value of all companies would be reduced by 50%, all things being equal.
For those who want to use Graham's amended model, some caution is warranted. The model requires that the user forecast interest rates well into the future. For an investor to rely on recent interest rates as an input to the model could be misleading.
To cope with this complexity, investors have resorted to increasingly powerful computers that purport to capture the inter-relatedness of many variables. But this approach tends to lose the most valuable input of all: human intuition.
A far better solution for the investment process would be to "freeze" some variables so that analyses could focus on a reasonable number of factors.
Benjamin Graham's valuation formula provided all stock market investors with a critically important tool that freezes one of the key variables of the investment process to simplify the purchase decision. By using Graham's formula, investors are freed to consider other important factors when evaluating a public company.
GRAHAM'S SIMPLE FORMULA
To calculate intrinsic value, multiply the earnings growth rate by 2 and add 8.5 to the total, then multiply that by the current earnings per share.
[8.5 + (2 x growth) ] x EPS = Intrinsic Value per share
1. A no-growth company. The company would have a P/E ratio of 8.5 (and an earnings yield of 12%), which is a fairly typical P/E for a mature company.
2. An average-growing company. Most analysts use a P/E range of 15 to 20 times earnings for the S&P 500. This would translate into the average growth stock in the S&P 500 growing between the ranges of 3.25% to 5.75% (mean 4.5%).
3. A faster-growing company. A faster-growing stock growing at 10% will have a P/E ratio of 28.5. This is fairly typical for the faster-growing companies in the S&P 500.
Two flaws in the valuation models. All valuation models have flaws.
1. Models such as Graham's value a company based solely on its earnings. This leaves out the possible positive effects of non-operating assets or negative effects of non-operating liabilities.. That's why investors need to look beyond earnings and examine company balance sheets prior to purchase to look for non-operating assets and liabilities.
2. A second flaw has to do with the potential competition from high interest rates. Should the P/E ratio of stocks be immune to high interest rates? Of course not. Graham himself addressed this issue when he suggested that P/E ratios should be adjusted downward if long-term interest rates on AAA corporate bonds
exceeded 4.4%. The revised Graham formula factors in the current yield to maturity on AAA corporate bonds in the calculation of a company's intrinsic value:
REVISED GRAHAM FORMULA
Intrinsic value per share = EPS x (8.5 + 2g) x 4.4 / y
where,
g = growth rate
y = yield on AAA corporate bonds
If the yields on AAA corporate bonds were to remain at 4.4%, then the original Graham model would remain intact.
If the yields on AAA corporate bonds increased to 6.6%, the P/E ratios would be reduced by 1/3 (4.4/6.6 = 2/3).
If the yields on AAA corporate bonds increased to 8.8%, the P/E ratios would be cut by 1/2. Thus, the future value of all companies would be reduced by 50%, all things being equal.
For those who want to use Graham's amended model, some caution is warranted. The model requires that the user forecast interest rates well into the future. For an investor to rely on recent interest rates as an input to the model could be misleading.
The Intrinsic Value Formula of Benjamin Graham
Intrinsic Value = E (2r + 8.5 ) x 4.4 / Y
E = Earnings
r = Expected Earnings Growth rate
Y = Current yield on AAA corporate bonds.
8.5 = Graham believed this to be the correct P/E multiple for a company with no growth.
Therefore, Intrinsic Value will rise proportionately to
E = Earnings
r = Expected Earnings Growth rate
Y = Current yield on AAA corporate bonds.
8.5 = Graham believed this to be the correct P/E multiple for a company with no growth.
Therefore, Intrinsic Value will rise proportionately to
- rising earnings,
- rising earnings growth rate and
- falling yields of AAA corporate bonds.
P/E ratios have risen in recent years, perhaps making 15 to 20 a more appropriate number for a company with no growth, but a conservative investor will continue to use a low multiplier.
Before accepting this formula too enthusiastically, you might reflect on Warren Buffett's response when asked about it. "I never use formulas like that. I never thought Ben was at his best when he worked with formulas either," he said with a chuckle.
Corporate Taxes
Back in the 1940s Graham suggested that to ensure that management is honest about earnings, corporations should make income tax statements available to investors upon request.
Corporate taxes have become progressively complex over the years, and only the most dedicated investors - and ones with a lot of time to kill - would care to pore over corporate tax statements.
Fortunately, many corporations now include summary tax information in their annual reports to shareholders.
Many investor information services also supply simplified income tax information in their stock reports.
Reporting of earnings on an after-tax basis is standard practice and to most people, the "real bottom line" is the profits after tax.
Comment:
When the company reported an effective tax rate that is lower than the normal, you may wish to know the reasons for this. Perhaps, the company has a tax write-off or tax credit that year.
- If the company paid taxes on income, then it is genuine income.
- If the company didn't, there must be a logical reason, such as a tax write-off or the use of some type of tax credit.
Corporate taxes have become progressively complex over the years, and only the most dedicated investors - and ones with a lot of time to kill - would care to pore over corporate tax statements.
Fortunately, many corporations now include summary tax information in their annual reports to shareholders.
Many investor information services also supply simplified income tax information in their stock reports.
Reporting of earnings on an after-tax basis is standard practice and to most people, the "real bottom line" is the profits after tax.
Comment:
When the company reported an effective tax rate that is lower than the normal, you may wish to know the reasons for this. Perhaps, the company has a tax write-off or tax credit that year.
One simple criterion to base stock purchases - FOCUS ON EARNINGS
Toward the end of his life, Benjamin Graham spent many hours looking for one simple criterion on which to base stock purchases. His focus turned to EARNINGS.
"My research indicates that the best results come from simple earnings criterions."
His multiple criteria for selecting investment-quality stocks have remained the most reliable. What makes an "investment-quality stock"?
Also read:
Ben Graham's checklist for finding undervalued stocks
https://docs.google.com/spreadsheet/ccc?key=0AuRRzs61sKqRdFpHTldITEQyZDJuVGdDY3hTS3lvQ0E&hl=en#gid=0
"My research indicates that the best results come from simple earnings criterions."
His multiple criteria for selecting investment-quality stocks have remained the most reliable. What makes an "investment-quality stock"?
- Financial condition is conservative and working capital position is strong. (Check the Balance Sheet).
- Earnings are reasonably stable, allowing for business conditions that fluctuate over a 10-year period. (Check the Income Statement).
- Average earnings bear a satisfactory ratio to market price. (Check the Valuation).
As investors become more familiar with these guidelines, they follow them easily and automatically, or so it seems.
Buffett and his partner, Charlie Munger, say they don't sweat over formal rules or procedures when trying to determine if a stock has growth potential.
For those of us with less talent and experience than Buffett and Munger, however, it is acceptable to work out a portfolio plan and run a checklist tally of a stock's pluses and minuses.
REMEMBER:
REMEMBER:
- Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
- The companies with the best investment potential are consistently profitable.
- The P/E ratio should be low compared with those of other companies in the same industry.
- The P/E ratio establishes the upper share price limit on intrinsic value.
- Earnings and other estimates should err on the side of understatement. That, in itself, makes for a margin of safety.
Also read:
Ben Graham's checklist for finding undervalued stocks
https://docs.google.com/spreadsheet/ccc?key=0AuRRzs61sKqRdFpHTldITEQyZDJuVGdDY3hTS3lvQ0E&hl=en#gid=0
Be careful with companies in formation - Wait For Earnings
Without Earnings, Nothing To Measure
Graham was suspicious of 'hot' or fast-growth stocks because their promise relies on the prediction of ever-increasing future earnings with little historical evidence that the company can consistently produce ever-rising future earnings.
He warned the growth stock investor to seek two things:
Peter Lynch warns investors to be especially careful with companies in formation. "Wait for earnings," he cautions.
Graham was suspicious of 'hot' or fast-growth stocks because their promise relies on the prediction of ever-increasing future earnings with little historical evidence that the company can consistently produce ever-rising future earnings.
He warned the growth stock investor to seek two things:
- Assurance that growth will continue
- Assurance that the investor isn't paying too high a price for future growth.
Peter Lynch warns investors to be especially careful with companies in formation. "Wait for earnings," he cautions.
- Though Lynch has done very well with some initial public offerings in particular (he was an original investor in Federal Express, "I'd say three out of four have been long-term disappointments."
Venture capital operations
Many high-tech, bio-tech or other emerging technology companies operate more like venture capital operations.
Venture capitalists demand guarantees of high returns because the risk is high that earnings will be slow in arriving, or will never materialize at all.
The venture capitalist is betting on a technology and the talent to put that technology into use.
Venture capital investment is best practiced by those who know a particular industry extremely well.
Knowing and Setting the Upper Limits of Share Price
The P/E also can be used to establish a cap on intrinsic value.
While asset values set the lowest level for estimating intrinsic value, the P/E can serve as an upper limit.
The P/E ratio establishes the maximum amount an investor should pay for earnings.
It is not wrong to pay more, Graham and Dodd noted; it is that doing so enters the realm of speculation.
While asset values set the lowest level for estimating intrinsic value, the P/E can serve as an upper limit.
The P/E ratio establishes the maximum amount an investor should pay for earnings.
- If the investor decides that the appropriate P/E ratio for a stock is 10, the share price paid should be no more than 10 times most recent yearly earnings.
It is not wrong to pay more, Graham and Dodd noted; it is that doing so enters the realm of speculation.
- Since young, rapidly expanding companies generally trade at a P/E ratio of 20 to 25 or above, Graham usually avoided them, which was one reason he never invested in some new start up stocks, though he used and was impressed by their products early in his career.
A Subnormal P/E
When a stock is selling at a P/E significantly lower than that of its competitors, an investor will want to know why?
A low P/E does not necessarily mean higher risk, though the company should be studied with that possibility in mind.
On the other hand, if a stock is cheap in terms of its multiple for a troubling reason (or permanent deterioration of business fundamentals), such as pending depletion of oil or mineral reserves or a patent expiration, the value investor may want to shop elsewhere.
Comment:
Often the low P/E is appropriate for the stock as it is perceived to have poor potential for growth or its earnings are poor, volatile and less stable.
A low P/E does not necessarily mean higher risk, though the company should be studied with that possibility in mind.
- The low P/E stock may be selected anyway if, for example, it is a cyclical stock at a low in its cycle. Cyclical stocks - automobile manufacturers are the most notorious among them - periodically develop fire-sale P/E ratios.
- Other out-of-favour stocks also can drop to surprisingly low P/Es.
On the other hand, if a stock is cheap in terms of its multiple for a troubling reason (or permanent deterioration of business fundamentals), such as pending depletion of oil or mineral reserves or a patent expiration, the value investor may want to shop elsewhere.
Comment:
Often the low P/E is appropriate for the stock as it is perceived to have poor potential for growth or its earnings are poor, volatile and less stable.
A Pricey P/E
High Pricey P/E
A company may be selling at an exceptionally high P/E because it is considered to have remarkably good prospects for growth.
No matter how high the quality of the car you are looking at, there is a price at which it is no longer worth buying. No matter how junky a car is, there is a price at which it is a bargain. Stocks are no different.
Some stocks with high multiples work out, but investors who consistently buy high multiple stocks are likely to lose money in the long run.
Often the highest multiples are present in a bull market which increases the risk.
Graham and Dodd observed, " It is a truism to say that the more impressive the record and the more promising the prospects of stability and growth, the more liberally the per-share earnings should be valued, subject always to our principle that a multiplier higher than 20 (i.e., 'earning basis' of less than 5%) will carry the issue out of the investment range."
It is not wrong to pay more, Graham and Dodd noted; it is simply that doing so enters the realm of speculation.
A company may be selling at an exceptionally high P/E because it is considered to have remarkably good prospects for growth.
No matter how high the quality of the car you are looking at, there is a price at which it is no longer worth buying. No matter how junky a car is, there is a price at which it is a bargain. Stocks are no different.
Some stocks with high multiples work out, but investors who consistently buy high multiple stocks are likely to lose money in the long run.
Often the highest multiples are present in a bull market which increases the risk.
Graham and Dodd observed, " It is a truism to say that the more impressive the record and the more promising the prospects of stability and growth, the more liberally the per-share earnings should be valued, subject always to our principle that a multiplier higher than 20 (i.e., 'earning basis' of less than 5%) will carry the issue out of the investment range."
It is not wrong to pay more, Graham and Dodd noted; it is simply that doing so enters the realm of speculation.
Super High-Growth Portfolio - Pushing the Limit to achieve Maximum Portfolio Growth
There are investors who can and should invest the time and effort to create a supper high-growth portfolio.
Although it will require greater effort in selection and maintenance, a high-performance portfolio can be achieved while abiding by the commandments of value.
Any appearance of higher risk must be well understood and accounted for in the share price.
Pushing the limit, say Graham and Dodd, is a game for the strong-minded and daring individual.
According to Graham, a growth stock should double its per share earnings in 10 years - that is, increase earnings at a compound annual rate of over 7.1%. To do so, a growth stock's sales should be continually higher than sales in the early years.
The investor who can successfully identify such "growth companies" when their shares are available at reasonable prices is certain to do superlatively well with his capital.
Although it will require greater effort in selection and maintenance, a high-performance portfolio can be achieved while abiding by the commandments of value.
Any appearance of higher risk must be well understood and accounted for in the share price.
Pushing the limit, say Graham and Dodd, is a game for the strong-minded and daring individual.
According to Graham, a growth stock should double its per share earnings in 10 years - that is, increase earnings at a compound annual rate of over 7.1%. To do so, a growth stock's sales should be continually higher than sales in the early years.
The investor who can successfully identify such "growth companies" when their shares are available at reasonable prices is certain to do superlatively well with his capital.
Have an opinion on future growth - How can the company increase its earnings?
It is only rational to have an opinion on future growth. Otherwise, how could you ever choose a stock?
When forming that opinion, back up quantitative information with qualitative factors.
For example, ask what management is doing to make a positive impact on earnings.
According to Peter Lynch, there are 5 basic ways a company can increase earnings:
When management is enacting growth-promoting activities, earnings may be temporarily flat. They often soon take a giant step up.
Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.
So what's there to worry about in good earnings? Exceptionally high earnings often attract rough competitors.
The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.
Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.
When forming that opinion, back up quantitative information with qualitative factors.
For example, ask what management is doing to make a positive impact on earnings.
According to Peter Lynch, there are 5 basic ways a company can increase earnings:
- reduce costs;
- raise prices;
- expand into new markets;
- sell more of its products to the old markets; or
- revitalize, close or otherwise dispose of a losing operation.
When management is enacting growth-promoting activities, earnings may be temporarily flat. They often soon take a giant step up.
Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.
So what's there to worry about in good earnings? Exceptionally high earnings often attract rough competitors.
The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.
Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.
Sunday, 5 February 2012
Charlie Munger - Projections do more harm than good
Reading Tea Leaves
" I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections but we care very much about, and look very deeply, at track records. If a company has a lousy track record but a very bright future, we will miss the opportunity," explained Warren Buffett.
Charlie Munger, added that in his opinion projections do more harm than good. "They are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious. They remind me of Mark Twain's saying, 'A mine is a hole in the ground owned by a liar.' Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself."
Here is how Graham and Dodd looked at projections. "While a trend shown in the past is a fact, a 'future trend' is only an assumption. The past, or even careful projections, can be seen as only a 'rough index' to the future."
More than five decades have passed since those words were said, and Buffett still agrees.
" I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections but we care very much about, and look very deeply, at track records. If a company has a lousy track record but a very bright future, we will miss the opportunity," explained Warren Buffett.
Charlie Munger, added that in his opinion projections do more harm than good. "They are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious. They remind me of Mark Twain's saying, 'A mine is a hole in the ground owned by a liar.' Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself."
Here is how Graham and Dodd looked at projections. "While a trend shown in the past is a fact, a 'future trend' is only an assumption. The past, or even careful projections, can be seen as only a 'rough index' to the future."
More than five decades have passed since those words were said, and Buffett still agrees.
How Value Investor identifies Earnings, Sales and Future Growth
The real goal of the value investor is to identify companies with solid financial base that are growing at a faster rate (in terms of sales and earnings) than both their competitors and the economy in general.
All things being equal, share price is likely to increase in value at about the same rate that sales grow.
For dominant companies in major industries, an investor will want a sales growth rate of 5 to 7 percent.
Within a portfolio, look for an overall sales growth rate of at least 10% annually.
Earnings need not rise every year. Almost all industries operate in cycles, and any company can suffer a temporary setback.
But investors should be wary
All things being equal, share price is likely to increase in value at about the same rate that sales grow.
For dominant companies in major industries, an investor will want a sales growth rate of 5 to 7 percent.
Within a portfolio, look for an overall sales growth rate of at least 10% annually.
Earnings need not rise every year. Almost all industries operate in cycles, and any company can suffer a temporary setback.
But investors should be wary
- when a company's earnings and sales are erratic without explanation or
- when sales and earnings are slowly sinking and the company is not taking corrective action.
Dilution of Earnings
When considering a company's earnings per share history, make certain the numbers are adjusted for changes in capitalization; that is, work from fully diluted numbers.
Be sure that all shares that have been authorized for issuance by the board of directors are added into the number of shares outstanding. Newly issued shares, split shares, and shelf registration (shares sitting in the company's vault but not yet issued) must be put in the pot.
This admonition applies not only to the most current earnings but to any earnings from the past that are used for comparison. The easiest way to make the adjustment when new shares are authorized is to work backward. Compute earlier earnings as if the new shares, rights, warrants, privileges, options, and so on already have been exercised. Corresponding changes should be made to book value and current asset value per share.
Fortunately, most companies include adjustments for shareholders in their financial statements, reporting figures on a fully diluted basis. But sometimes not. This is why shareholders must be wide awake when comparing earnings from one year to another, always work from fully diluted earnings.
Be sure that all shares that have been authorized for issuance by the board of directors are added into the number of shares outstanding. Newly issued shares, split shares, and shelf registration (shares sitting in the company's vault but not yet issued) must be put in the pot.
This admonition applies not only to the most current earnings but to any earnings from the past that are used for comparison. The easiest way to make the adjustment when new shares are authorized is to work backward. Compute earlier earnings as if the new shares, rights, warrants, privileges, options, and so on already have been exercised. Corresponding changes should be made to book value and current asset value per share.
Fortunately, most companies include adjustments for shareholders in their financial statements, reporting figures on a fully diluted basis. But sometimes not. This is why shareholders must be wide awake when comparing earnings from one year to another, always work from fully diluted earnings.
Retained Earnings are central to the process of investment growth
A company adds up its income, subtracts its expenses, and pays any dividends due; what is left becomes retained earnings. These are undistributed profits.
Undistributed profits or retained earnings are central to the process of investment growth.
The net worth of the company builds up through the reinvestment of undistributed earnings.
Corporate raiders in particular love to find a company with a lot of cash reserves accumulated from retained earnings.
There is a legitimate dispute over how much retained earnings are adequate, and at what level a company should let loose of some cash and distribute it to shareholders.
Overall, retained earnings like the payment of dividends, deliver a powerful message: the company generates more cash than it needs for the operation of the business.
These earnings, over and above total expenses and taxes, drive the share price higher.
Undistributed profits or retained earnings are central to the process of investment growth.
The net worth of the company builds up through the reinvestment of undistributed earnings.
Corporate raiders in particular love to find a company with a lot of cash reserves accumulated from retained earnings.
There is a legitimate dispute over how much retained earnings are adequate, and at what level a company should let loose of some cash and distribute it to shareholders.
Overall, retained earnings like the payment of dividends, deliver a powerful message: the company generates more cash than it needs for the operation of the business.
That's exactly what a good investment should do.
These earnings, over and above total expenses and taxes, drive the share price higher.
Common stocks have one important investment characteristic and one important speculative characteristic.
- Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings.
- The speculative feature is no mystery. It is the tendency toward excessive and irrational price fluctuations as investors (in Graham's words) "give way to hope, fear, and greed."
Inherent Permanence of Earning Power - The Income that Keeps Coming In
If past earnings are to have any meaning to investors, there must be an inherent permanence to the earning power.
Earnings may be cyclical, or even inconsistent, and still have some permanence.
Benjamin Graham considered a company to have stable earnings when:
Earnings may be cyclical, or even inconsistent, and still have some permanence.
- Many automobile companies have notoriously cyclical results; yet they have managed to keep up an ongoing business over many years.
Benjamin Graham considered a company to have stable earnings when:
- earnings doubled in the most recent 10 years, and,
- earnings declined by no more than 5% no more than twice in the past 10 years.
Another approach to measuring stability is to compare one period of earnings with an earlier period.
- Stability is assessed by the trend of per-share earnings over a ten-year period, compared to the average of the most recent three years.
- No decline represents 100% stability.
- 5.22 (1984); 6.25; 6.31;.5.90; 5.08; 1.36; 0.30; -2.7, 1.38, 6.77; and 10.1 (1994)
- 10-year average = $4.95
- 3-year average = $6.08
- 1994 book value = $46.65 per share
- 1995 trading range = $38.25 to $58.13 per share
Income Statement in Perspective
When problems exist in an income statement, they tend to distort earnings only in a single year, or over a short period of time.
To even out these short-term distortions, use average share price, annual earnings, and other numbers over a span of 7 to 10 years.
"Averaging" establishes typical numbers for the company. The longer the time included in the average, the better.
To even out these short-term distortions, use average share price, annual earnings, and other numbers over a span of 7 to 10 years.
"Averaging" establishes typical numbers for the company. The longer the time included in the average, the better.
Flash Profits: One-time event that impacts earnings
Any one-time event that impacts earnings, such as a gain from the sale of an asset or a one-time loss resulting from a catastrophic event or the write-off of a potential debt, should be lifted out of the earnings figures and set to one side.
These occurrences should be recognized for what they are and judged accordingly. They are in no way indicative of the outlook for future earnings.
A one-time sale of assets tends to make overall corporate profits look better in the year it occurs. Yet the sale decreases the total assets of the company. There is no real gain.
In an established, well-managed company, daily operations finance themselves with cyclical shortfalls covered by short-term borrowing, so never should a one-time gain be used to cover ordinary expenses.
There is no real gain from the one-time sale of assets unless the money is used for one of the following:
These occurrences should be recognized for what they are and judged accordingly. They are in no way indicative of the outlook for future earnings.
A one-time sale of assets tends to make overall corporate profits look better in the year it occurs. Yet the sale decreases the total assets of the company. There is no real gain.
In an established, well-managed company, daily operations finance themselves with cyclical shortfalls covered by short-term borrowing, so never should a one-time gain be used to cover ordinary expenses.
There is no real gain from the one-time sale of assets unless the money is used for one of the following:
- Restore the asset base
- Reduce debt
- Contribute substantially to future earnings.
Taking a Hit - Accounting Write Off or Write Down
Corporate accountants write off or write down items under several sets of circumstances.
Excessive write-offs in one year can, in some circumstances, lead to greater than normal profits in the next. It is an old management trick to take all write-offs or write-down during a period when earnings aren't looking so good anyway.
Yet done frankly and for the right reasons, write-downs may lead to real and long-lasting improvement in earnings.
For alert investors, losses or gains that result from a single episode can be a boon.
- They may write a debt off the books that they are convinced will never be collected.
- They may mark down the value of an asset that is no longer worth what it once was.
Excessive write-offs in one year can, in some circumstances, lead to greater than normal profits in the next. It is an old management trick to take all write-offs or write-down during a period when earnings aren't looking so good anyway.
- The company decides to load all the bad news into one accounting period rather than several fairly bad ones, but the contrast between the bad quarter or year and the subsequent good one appears dramatic.
- This jump in earnings thrills the investing public (the company did lousy last year, but look how it's come around!) But again, the better earnings may turn out to be a brief aberration. The following year the company's earnings fall back into the old ways.
Yet done frankly and for the right reasons, write-downs may lead to real and long-lasting improvement in earnings.
- They make a difference when the company is saying: "This was a problem; we've faced up to it. The adjustment will allow the income statement to accurately reflect the condition of our company in the years ahead."
For alert investors, losses or gains that result from a single episode can be a boon.
- If other investors overreact to the news in either a positive or negative way, it may create a chance to buy or sell at an advantageous price.
Divine Dividends
Dividends represent nothing more than the investor's share of earnings that will be received immediately (rather than through reinvestment and future growth of the stock).
Dividends are one of the quickest and healthiest ways that earnings can make their way into shareholders' pockets.
Graham argued that intelligent investors would rather have dividends in their pockets (even if investors use them to buy more of the same stock) than risk waiting for possible future growth. Furthermore, he insisted, it is management's responsibility to pay dividends.
For long-term investors who follow a "buy and hold" strategy, dividends are the only way to collect on investment gains.
In addition to representing money in the bank, dividends are, to many investors, a reliable indicator of future growth.
Values are determined roughly by earnings available for dividends. This relation among earnings, dividends and values survives.
A long history of dividend payments and regular dividend increases also indicates a substantial company with limited risk.
Additionally, a rise in the dividend is tangible confirmation of the confidence of management in good times ahead. A cut in the dividend is a red flag indicating trouble on the track.
Not all corporate income need be paid in dividends. Depending on the industry and how much capital is required to keep the business growing, the appropriate payout may be as much as 80% or as little as 50% of net earnings.
When studying the dividend payout of a company, calculate both average earnings and average dividends over a 10-year period. From those two averages you can determine the average payout.
Earnings fluctuate, but dividends tend to remain stable or, in the best companies, to rise gradually.
One way of determining if a stock is overvalued or undervalued is to compare its dividend yield with that of similar companies.
Dividends are one of the quickest and healthiest ways that earnings can make their way into shareholders' pockets.
Graham argued that intelligent investors would rather have dividends in their pockets (even if investors use them to buy more of the same stock) than risk waiting for possible future growth. Furthermore, he insisted, it is management's responsibility to pay dividends.
For long-term investors who follow a "buy and hold" strategy, dividends are the only way to collect on investment gains.
In addition to representing money in the bank, dividends are, to many investors, a reliable indicator of future growth.
Values are determined roughly by earnings available for dividends. This relation among earnings, dividends and values survives.
A long history of dividend payments and regular dividend increases also indicates a substantial company with limited risk.
Additionally, a rise in the dividend is tangible confirmation of the confidence of management in good times ahead. A cut in the dividend is a red flag indicating trouble on the track.
Not all corporate income need be paid in dividends. Depending on the industry and how much capital is required to keep the business growing, the appropriate payout may be as much as 80% or as little as 50% of net earnings.
When studying the dividend payout of a company, calculate both average earnings and average dividends over a 10-year period. From those two averages you can determine the average payout.
Earnings fluctuate, but dividends tend to remain stable or, in the best companies, to rise gradually.
One way of determining if a stock is overvalued or undervalued is to compare its dividend yield with that of similar companies.
- Safety, growth, and other factors being equal, the stock with the highest dividend and the lowest share price is the best bargain.
- As a further check of value, investors should compare the stock's dividend yield with that of the whole stock market dividend yield.
Rationale for Withholding Dividends
If a company isn't paying dividends it should, like Berkshire Hathaway, be doing something profitable with its earnings.
It is acceptable to withhold dividends for the following reasons:
- To strengthen the company's working capital
- To increase productive capacity
- To reduce debt.
Dividends in Jeopardy
Dividends may be put in jeopardy in two ways:
- When a company's earnings per share is less than its dividend per share
- When debt is excessive.
A company with substantial earnings rarely becomes insolvent because of bank loans. But when a company is under pressure, lenders may require a suspension of dividends as a form of financial discipline.
Companies amassing huge cash reserves should use these intelligently
Companies with large cash reserves can use these for the direct benefit of their shareholders by giving dividends or can deploy these to grow their businesses in the future.
Benjamin Graham was critical of amassing huge cash reserves within a business unless the company had a genuine future use for the funds.
A certain calculable amount of reserves are necessary to:
The purpose of business is to earn profits for its owners. Owners are entitled to access to profits.
If earnings are retained, Graham persisted in his argument, they had better be used intelligently.
Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons. It is easier to keep the cash on hand to bail management out of bad times or bad decisions. Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income. Consequently, other investors get no income.
Probably the greatest retainer of earnings of all time is Berkshire Hathaway, which keeps and reinvests all its earnings. Berkshire's 23% return on shareholder equity is almost double that of American industry, and Buffett says he will continue to hoard earnings so as long as a dollar of retained earnings translates to no less than a dollar of increased shareholder value. In his case, investors are inclined to let him have his way.
Comment:
It is not uncommon to encounter a company with huge cash reserves in their businesses earning only fixed deposit interest rates for many years. Shareholders should play their active role as business owners through raising the relevant questions to the management in the annual general meeting, to use these cash reserves intelligently.
In recent years, strong cash reserves have provoked takeover bids from corporate raiders. Are they liberators of cash for shareholders or are they destroyers of business, interested only in their own personal enrichment? These raiders often planned to use cash reserves to help finance their purchase, a tactic that often sucks the strength from a company. The management may defend the cash reserve was needed for various reasons, for example, the company needed the cash to cover the next down cycle of the manufacturing business. Corporate raiders love to find and are attracted to a company with huge cash reserves.
Benjamin Graham was critical of amassing huge cash reserves within a business unless the company had a genuine future use for the funds.
A certain calculable amount of reserves are necessary to:
- finance growth,
- guard against bad luck or down cycles,
- cover the settlement of a lawsuit, or
- eventually replace some important asset.
The purpose of business is to earn profits for its owners. Owners are entitled to access to profits.
If earnings are retained, Graham persisted in his argument, they had better be used intelligently.
Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons. It is easier to keep the cash on hand to bail management out of bad times or bad decisions. Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income. Consequently, other investors get no income.
Probably the greatest retainer of earnings of all time is Berkshire Hathaway, which keeps and reinvests all its earnings. Berkshire's 23% return on shareholder equity is almost double that of American industry, and Buffett says he will continue to hoard earnings so as long as a dollar of retained earnings translates to no less than a dollar of increased shareholder value. In his case, investors are inclined to let him have his way.
Comment:
It is not uncommon to encounter a company with huge cash reserves in their businesses earning only fixed deposit interest rates for many years. Shareholders should play their active role as business owners through raising the relevant questions to the management in the annual general meeting, to use these cash reserves intelligently.
In recent years, strong cash reserves have provoked takeover bids from corporate raiders. Are they liberators of cash for shareholders or are they destroyers of business, interested only in their own personal enrichment? These raiders often planned to use cash reserves to help finance their purchase, a tactic that often sucks the strength from a company. The management may defend the cash reserve was needed for various reasons, for example, the company needed the cash to cover the next down cycle of the manufacturing business. Corporate raiders love to find and are attracted to a company with huge cash reserves.
Market Timing - If you absolutely must play the horses
Though Benjamin Graham in no way recommend trying it, he did say that there is a way to combine market timing and value investing principles.
However, Graham noted, the method makes heavy demands on human fortitude, and it can keep an investor out of long stretches of a booming market*. It sounds simple. Yet for those who realize how difficult it is to follow, this strategy can diminish the risk of trading on market movements.
Here is the way it works:
1. Select a diversified list of common stocks (for example, buying undervalued stocks).
2. Determine a normal value for each stock (choose the PE ratio that seems appropriate).
3. Buy the stocks when shares can be bought at a substantial discount - say, two-thirds of what the investor has established as normal value. As an alternative to buying at one target price, the investor can start buying as the stock declines, beginning at 80 percent of normal value.
4. *Sell the stocks when the price has risen substantially above normal value - say 20 percent to 50 percent higher.
The investor thus would buy in a market decline and sell in a rising market.
Comment:
*When you buy wonderful companies at fair prices, you often do not need to sell. You may consider selling some or all when the stock prices are obviously very overvalued. In these situations, the upside gains are limited and the downside losses are high. These will impair the total returns of your portfolio. However, even in such overvalued situations, you should only consider selling when the prices have risen very substantially above their normal values, for example, >> 50% over their normal values. Also, remember to reinvest the money back into other wonderful companies at fair prices that offer a higher reward/risk ratio and that promise returns commensurate with your investment objective.
However, Graham noted, the method makes heavy demands on human fortitude, and it can keep an investor out of long stretches of a booming market*. It sounds simple. Yet for those who realize how difficult it is to follow, this strategy can diminish the risk of trading on market movements.
Here is the way it works:
1. Select a diversified list of common stocks (for example, buying undervalued stocks).
2. Determine a normal value for each stock (choose the PE ratio that seems appropriate).
3. Buy the stocks when shares can be bought at a substantial discount - say, two-thirds of what the investor has established as normal value. As an alternative to buying at one target price, the investor can start buying as the stock declines, beginning at 80 percent of normal value.
4. *Sell the stocks when the price has risen substantially above normal value - say 20 percent to 50 percent higher.
The investor thus would buy in a market decline and sell in a rising market.
Comment:
*When you buy wonderful companies at fair prices, you often do not need to sell. You may consider selling some or all when the stock prices are obviously very overvalued. In these situations, the upside gains are limited and the downside losses are high. These will impair the total returns of your portfolio. However, even in such overvalued situations, you should only consider selling when the prices have risen very substantially above their normal values, for example, >> 50% over their normal values. Also, remember to reinvest the money back into other wonderful companies at fair prices that offer a higher reward/risk ratio and that promise returns commensurate with your investment objective.
Buying Time
When the market hits its low, true value investors feel that harvest time has arrived.
"The most beneficial time to be a value investor is when the market is falling," says institutional manager Seth Klarman. There are plenty of companies ripe for the picking.
In the summer of 1973, when the stock market had plunged 20 percent in value in less than 2 months, Warren Buffett told a friend, "You know, some days I get up and I want to tap dance."
Unfortunately, this is the time when investors are feeling most beat up by the markets. Fear and negative thinking prevail, and anyone who has faced down a bear knows how paralyzing fear can be. This, at the depths of a bear market, is the time to buy as many stocks as are affordable.
Value bargains aren't found in strong market. A good rule is to examine stock markets that have reacted adversely for a year or so.
Undervalued stocks quite often lie dormant for months - many months - on end. The only way to anticipate and catch the surge is to identify the undervalued situation, then take a position, and wait.
Benjamin Graham: "Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience."
"The most beneficial time to be a value investor is when the market is falling," says institutional manager Seth Klarman. There are plenty of companies ripe for the picking.
In the summer of 1973, when the stock market had plunged 20 percent in value in less than 2 months, Warren Buffett told a friend, "You know, some days I get up and I want to tap dance."
Unfortunately, this is the time when investors are feeling most beat up by the markets. Fear and negative thinking prevail, and anyone who has faced down a bear knows how paralyzing fear can be. This, at the depths of a bear market, is the time to buy as many stocks as are affordable.
Value bargains aren't found in strong market. A good rule is to examine stock markets that have reacted adversely for a year or so.
Undervalued stocks quite often lie dormant for months - many months - on end. The only way to anticipate and catch the surge is to identify the undervalued situation, then take a position, and wait.
Benjamin Graham: "Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience."
Signs at the Bottom
The bottom - or near enough the bottom - of a market cycle theoretically should be easier to call than the top or near top.
The evidence is found in the corporate balance sheets, income statements, P/E ratios, dividend yields, and other quantitative measures. It is likewise reflected in low ratios for the market as a whole. The quantitative factors speak for themselves.
The dividend yield on the Dow Jones Industrial Average, for example, usually cycles between a high yield of 6 percent at the market's bottom and a low yield of 3 percent at the top. The Dow's average dividend yield sometimes stretches beyond these boundaries, but historically this is a trustworthy parameter of undervalue and overvalue.
The evidence is found in the corporate balance sheets, income statements, P/E ratios, dividend yields, and other quantitative measures. It is likewise reflected in low ratios for the market as a whole. The quantitative factors speak for themselves.
The dividend yield on the Dow Jones Industrial Average, for example, usually cycles between a high yield of 6 percent at the market's bottom and a low yield of 3 percent at the top. The Dow's average dividend yield sometimes stretches beyond these boundaries, but historically this is a trustworthy parameter of undervalue and overvalue.
Patience - a fundamental investment discipline to have a lot of.
There is only one strategy that works for value investors when the market is high - PATIENCE.
The investor can do one of two things, both of which requires steady nerves:
1. Sell all stocks in a portfolio, take profits, and wait for the market to decline.
2. Stick with those stocks in the portfolio that have long-term potential.
But come the correction, be it sudden or slow, the well-chosen value stocks have a better chance of holding their price.
As for the hot stocks, when they take a hard hit the investor is cornered. If the stock is sold, the loss becomes permanent. The lost money cannot grow. If the investor hangs on to the deflated stock, the long trail back to the original purchase price will deeply erode the overall returns.
Comments:
When you buy wonderful companies at fair or bargain prices, you can often hold these forever. The earnings power of these companies ensure that your returns will be positive over the long term. You often do not need to sell, even if these companies are slightly overvalued as their intrinsic values in the future will probably be higher than the present prices. When the share prices of these wonderful companies go down in tandem with the market corrections or bear markets, you often have the chance to buy more at lower prices. The only action you should avoid is to buy these wonderful companies when they are trading at obviously overvalued high prices. A wonderful company can be a bad investment when you buy it at a high price.
The investor can do one of two things, both of which requires steady nerves:
1. Sell all stocks in a portfolio, take profits, and wait for the market to decline.
- At that time, many good values will present themselves.
- This may sound easy, but it pains many investors to sell a stock when its price is still rising.
2. Stick with those stocks in the portfolio that have long-term potential.
- Sell only those that are clearly overvalued, and once more wait for the market to decline.
- At this time, value stocks may be appreciating at slow pace compared with the frisky growth stocks, but not always.
But come the correction, be it sudden or slow, the well-chosen value stocks have a better chance of holding their price.
As for the hot stocks, when they take a hard hit the investor is cornered. If the stock is sold, the loss becomes permanent. The lost money cannot grow. If the investor hangs on to the deflated stock, the long trail back to the original purchase price will deeply erode the overall returns.
Comments:
When you buy wonderful companies at fair or bargain prices, you can often hold these forever. The earnings power of these companies ensure that your returns will be positive over the long term. You often do not need to sell, even if these companies are slightly overvalued as their intrinsic values in the future will probably be higher than the present prices. When the share prices of these wonderful companies go down in tandem with the market corrections or bear markets, you often have the chance to buy more at lower prices. The only action you should avoid is to buy these wonderful companies when they are trading at obviously overvalued high prices. A wonderful company can be a bad investment when you buy it at a high price.
Saturday, 4 February 2012
Will the great interest rate gamble pay off?
Will the great interest rate gamble pay off?
By flooding the system with 'free’ money, the central banks could be storing up trouble.
By flooding the system with 'free’ money, the central banks could be storing up trouble.
8:50PM GMT 02 Feb 2012
Bravo, Mario Draghi, the European Central Bank’s new president. Everyone assumed that this mild-mannered Italian would be so determined to prove himself to his Bundesbank masters that he’d be even more German than the Germans in pursuit of the principles of sound money. The profligate Italian of caricature would become the hair-shirted German, lashed to the mast of the Bundesbank’s anti-inflationary tradition.
In practice, he’s proved anything but. Since arriving at the ECB, Draghi’s engineered a sort of Club Med putsch, sidelining the German hawks and embarking on the kind of unconventional monetary activism that for several years now has been the hallmark of the US Federal Reserve and Bank of England. He’s been bold, and he’s been decisive.
And it appears to have worked. In promising unlimited funding to Europe’s stricken banks, he’s very likely saved the Continent from the Lehman’s moment for which it was undoubtedly heading. Both Spain and Italy have also found it easier to fund themselves in financial markets, and spreads have narrowed. Banks have been encouraged to borrow cheaply from the ECB to buy higher-yielding government bonds – the “Sarkozy carry trade” – which in turn has allowed countries to finance themselves less expensively.
By the time this month’s auction is over, the ECB will have doled out nearly one and a half trillion euros of “free” money to help keep the banking system alive, with much more to come over the months ahead.
Nobody is under any illusions. These actions have not succeeded in vanquishing the crisis. Underlying structural issues remain unresolved, and it is most unlikely that the starvation diet to which much of the eurozone periphery has been condemned will result in robust recovery. But Mr Draghi has at least prevented the patient from dying on the slab. Two cheers for that.
Even so, you have to wonder where all this “financial repression” – the artificial depression of interest rates – is going to lead. Since the crisis began, the world’s major central banks have engaged in a degree of intervention in financial markets quite without precedent in the modern age, if ever. In seeking salvation from the banking maelstrom, interest rates have been cut close to zero, and long-term bond yields suppressed to historic lows.
In Britain, the Bank of England has already bought up more than a third of the conventional gilts market, or rather more than a quarter of the entire national debt. Since quantitative easing began, the Bank has hoovered up gilts to the value of more than a half of those issued by the Debt Management Office, greatly easing its task in financing the deficit.
Nor is this the limit of the UK’s financial repression. Banks have been required by regulators greatly to increase their liquidity buffers, creating another big source of demand for UK gilts. It’s the same in the US and Europe.
These sovereign debt holdings have created new threats. Given the inflated size of the buffers, it would require only a quite small rise in interest rates – one or two percentage points – to create additional solvency problems for the banks, as we saw with the Franco-Belgian bank Dexia, which had to seek a bail-out after its eurozone sovereign debt turned toxic. Yet it is the rapid expansion of central bank balance sheets which is beginning to cause greater concern.
There are a number of justifications for this expansion. One is that by printing money, the central bank counters the contraction in credit being caused by private and banking sector deleveraging. By so doing, the monetary authority keeps the deflationary bogey at bay.
But it also allows governments to issue debt at lower interest rates, reducing servicing costs and eroding the real value of the debt. Economists have described it as a form of stealth taxation, or debasement.
It’s not an ideal way of proceeding, and it’s deeply unfair on savers, who through negative real interest rates are obliged in effect to subsidise both the Government and other debtors. It is, however, generally considered less painful than the alternative of even greater fiscal austerity.
For the moment, it’s hard to argue that such actions are inflationary. Today’s relatively elevated levels of UK inflation are not directly caused by money-printing, but by devaluation and the spike in energy prices. The problem is not too much money, but not enough. Yet intuitively, one knows that some way down the line, such practices will have inflationary consequences which, once out of the box, will be extremely hard for central banks to put back in again.
Only last week, the US Federal Reserve committed itself to keeping interest rates close to zero for another three years. By the time we get there, the US will have had seven years of essentially “free” money. Nobody knows what the long-term consequences of such financial repression might be. As I say, it’s never been tried before. But we do know from the way unduly loose monetary policy helped stoke the credit bubble in the first place that the potential for things to go very badly wrong is high. Central banks frequently seem to do more harm than good.
In the US, credit conditions already seem to be easing. Recent evidence points to sustainable growth of some 2 to 3 per cent. As the economy normalises, so must interest rates. The fear must be that we’ve grown so used to and reliant on ultra-low rates that the economy won’t be able to tolerate anything else. The dangers are all too obvious.
http://www.telegraph.co.uk/finance/financialcrisis/9057320/Will-the-great-interest-rate-gamble-pay-off.html
http://www.telegraph.co.uk/finance/financialcrisis/9057320/Will-the-great-interest-rate-gamble-pay-off.html
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