Long-term Stock Market Growth and GDP

A stock market represents the sum total of the public's perception of the business value of the companies trading in that market.

True business value, is the sum total of productive assets and, in particular, what those assets produce in the form of current and future earnings.

As long as companies produce more, it makes sense that their values rise.

And as long as the public perception matches true value, the stock value rises in lockstep.

GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total bookselling business.

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

GDP growth of 3 to 5%
Productivity growth of 1 to 2%
Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year?

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually.

But for a particular stock?

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever?

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen.

Intrinsic Value = (2g+8.5) x EPS

Dissecting Graham's Intrinsic Value Formula


Graham's formula:
V = (2g+8.5) E x 4.4/Y

where,
V= intrinsic value
g= growth rate of earnings
E= current EPS
Y= current interest rate (average rate of high grade corporate bonds)

V = (2g+8.5) x (4.4/Y) x E

V = (Multiple) x E

Therefore the Multiple of E is a multiple of 2 components as illustrated

Multiple = (2g+8.5) x (4.4/Y)

(I) If Y is equal to 4.4
(4.4/Y) = 1
Multiple = (2g + 8.5)


(II) If Y is less than 4.4
(4.4/Y) > 1
Multiple > (2g + 8.5)


(III) If Y is greater than 4.4
(4.4/Y) < 1
Multiple < (2g + 8.5)


As we are presently in a low interest environment, let us assume that Y is equal or less than 4.4. Therefore, the multiple should be equal or more than (2g + 8.5), as in (I) and (II) above.

To be on the conservative side, we can use (2g + 8.5) as the multiple of EPS as a simple quick test to check on the stock's price and true value (intrinsic value).

Simplified Graham's formula:
V = (2g + 8.5) x EPS


EPS can be derived by multiplying [(1/PE) x Price of stock], both are readily available in the local paper.

Reminder: You shouldn't go out and buy or sell stock based on this formula alone, of course, but it's a great "quick" test of a stock's price and true value.

Graham's Intrinsic Value Formula

Graham did create a very useful and easy-to-use intrinsic value formula.

Graham's formula: You take a current earnings, apply a base P/E ratio, add a growth factor if there is a growth, and adjust according to current bond yield. The result is an intrinsic value that the stock can be expected to achieve in the real world if growth targets are met.

Formula: Intrinsic value = E x (2g + 8.5) x 4.4/Y

E = current annual earnings per share
g = annual earnings growth rate. (Graham would have suggested using a conservative number for growth.)
8.5 = base P/E ratio for a stock with no growth
Y = current interest rate, represented as the average rate on high-grade corporate bonds. (Note that lower bond rates make the intrinsic value higher, as future earnings streams are worth more in a lower interest rate environment.)

Take Hewlett Packard as an example. With current earnings (trailing 12 months) of $2.30 per share, a growth rate of 10%, and a corporate bond interest rate of 6%, the intrinsic value is

= $2.30 x [(2 x 10) + 8.5] x (4.4/6)
= $48.07 per share

This value almost exactly matches the price at the time that these calculations were made. That suggests little potential price appreciation in the stock - unless per share earnings growth accelerates or bond yields dip.

Acceleration in the business would increase the earnings growth rate, and share repurchases would increase the earnings per share. Both changes, especially taken together, would stimulate growth in intrinsic value.

You shouldn't go out and buy or sell stock based on this formula alone, of course, but it's a great "quick" test of a stock's price and true value.

Malaysian REITs

Malaysian REITs are:

• KPJ Reit
• Boustead Reit
• Amfirst Reit
• Axis Reit
• Hektar Reit
• Starhill Reit

and

• AHP
• AHP2,
• ARREIT,
• ATRIUM REIT
• QCAPITA REIT
• TWRREIT
• UOAREIT

Financial Year 2008
KPJ Reit
EPS: 7.4c
DPS: 7.7c
NAB/Share: 1.03
D/E Ratio: 0.53
Rental Income to Property Assets: 0.07
Nett Rental Margin: 94.52%
ROE 9.93%

DY range: 9.8% - 7.8%
Price range: 0.83 - 0.93
PE ratio range: 10.5 - 13.2

Financial Year 2008
Boustead Reit
EPS: 11.0
DPS: 10.9c
NAB/Share: 1.26
D/E Ratio: 0.14
Rental Income to Property Assets: 0.08
Nett Rental Margin: 97.77%
ROE 27.13%

DY range: 11.0% - 6.8%
Price range: 0.99 - 1.60
PE ratio range: 9.0 - 14.6

Financial Year 2008
AMFIRST Reit
EPS: 7.3c
DPS: 8.0c
NAB/Share: 1.03
D/E Ratio: 0.89
Rental Income to Property Assets: 0.07
Nett Rental Margin: 70.25%%
ROE 7.07%

DY range: 10.8% - 8.4%
Price range: 0.74 - 0.95
PE ratio range: 10.1 - 13

Financial Year 2008
AXIS Reit
EPS: 15.2c P
DPS: 14.9c
NAB/Share: 1.75
D/E Ratio: 0.07
Rental Income to Property Assets: 0.09
Nett Rental Margin: 84.41%
ROE 14.17%

DY range: 15% - 7.5%
Price range: 1.00 - 2.00
PE ratio range: 6.5 - 13.3

Financial Year 2008
HEXTAR Reit
EPS: 11.3c
DPS: 10.7c
NAB/Share: 1.26
D/E Ratio: 0.75
Rental Income to Property Assets: 0.12
Nett Rental Margin: 62.69%
ROE 15.01%

DY range: 14.7% - 7%
Price range: 0.73 - 1.54
PE ratio range: 6.4 - 13.4

Financial Year 2008
STARHILL Reit
EPS: 6.9c
DPS: 6.9c
NAB/Share: 0.97
D/E Ratio: 0.16
Rental Income to Property Assets: 0.08
Nett Rental Margin: 83.73%
ROE 7.09%

DY range: 9.8% - 7.5%
Price range: 0.70 - 0.93
PE ratio range: 10.2 - 13.4

Also read:
REITs - Selecting REITs

REITs - Selecting REITs

Choosing a good REIT is like choosing any other value investment.

Assets = Real Estate
Debt = Debt
Returns = Rents + other payments received on the portfolio.

An investor must analyze and compare a REIT's:

• management quality,
• real and anticipated returns,
• yields, growth,
• reserves, and
• asset values.

Many of the techniques for common stock can be put to work here.

PE and price to FFO (funds from operations) ratios are examined as they would be for other businesses.

• Compare the PE and price to FFO for the different REITs.
• Relate these PE and price to FFO to their growth rates.

Also important is the price to book, or P/B ratio.

• A REIT trading below its per-share book value is essentially trading at a discount.

Remember also that REITs are not immune to :

• asset quality problems,
• bad management and management decisions,
• declining markets, or
• poor expense management.

Do the due diligence.

Malaysian REITs are:

• KPJ Reit
• Boustead Reit
• Amfirst Reit
• Axis Reit
• Hektar Reit
• Starhill Reit

and

• AHP
• AHP2
• ARREIT
• ATRIUM REIT
• QCAPITA REIT
• TWRREIT
• UOAREIT

REITs - Property Portfolio

REIT investors should check out the property portfolio. This isn't easy, but it's easier than it used to be with online resources, usually provided by the REIT company itself.

Because real estate is not traded regularly, the ability to ascertain values is limited to:

• appraisals,
• replacement values, and,
• for income-producing properties, discounted cash flow analysis.

Appraisals are difficult to find.

Looking at the properties, and their locations, and assessing commonly reported local real estate price trends, occupancy rates, and economic trends, and whether the book value of a property is sustainable, is probably best.

If the REIT you choose is diversified with a number of different types of properties in different geographic regions, you will experience less volatility if an industry or locale experiences hard times.

If you are more concentrated, be sure that the type of property or the geographic area continues to be economically viable into the foreseeable future.

Occupancy rates for past and current years are available for most major and some smaller cities in the US from commercial real estate Web sites, and you may even wish to contact a local real estate professional.

REIT appraisal is difficult, but there is another way: REIT mutual and closed-ended funds, and there are even a few REIT ETFs. Many mutual fund families have funds built around REIT investments. REIT mutual funds are an easy way to get exposure to REITs without spending volumes of time researching the valuations of underlying holdings, vacancy rates, economic vibrancy, and so on. One way to find these funds is to enter "REIT mutual fund" in your search engine.

REITs - Debts and Leverage

Good REIT managers will typically hold debt levels to 35% or less of the total capitalization of the trust.

Some managers have long tenure and have weathered many storms.

The lower the level of debt, the more conservative management tends to be.

Also, look for managers investing their own funds in the REIT.

REITs - what and why

REITS are technically investment trusts that works like closed-ended funds holding real estate instead of stocks or bonds.

REITS pool investor money to allow average individual investors to invest in a portfolio of

• commercial,
• residential, or
• specialized real estate properties.

By buying shares in a REIT, you take proportional ownership in the real estate ventures that the trust owns. And these ventures range beyond traditional properties to health care and retirement facilities; ports and warehouses; even car dealerships, penitentiaries, and high-end hotels.

Certain REIT characteristics make them attractive to the value investor.

• Like closed-ended funds, REITS trade on the exchanges, often at a discount to NAV.
• It is possible to focus on certain types of real estate or certain regions of the country.
• And, typically, they pay healthy yields, often in excess of 5%, while providing some downside protection.

In the US, there are about 190 publicly traded REITs with some $400 billion of assets.

• REITs performed very well during the 2000-2002 market correction, and continued to perform well as real estate prices boomed in the middle of the decade, with a gain of 35% as a group in 2006.
• But as the real estate market soured in 2007, REITs and particularly those in the mortgage business or with highly leveraged portfolios, tended to suffer.

Investors like REITs for:

• their yield,
• their ownership with hard physical assets,
• their stability, and
• for their long-term performance, estimated at over 13% annually during 1975-2005, which is better than most stock investments.

Many investors pick REITs for their negative correlation with stocks - when stocks are doing poorly, REITs are doing well or are holding their own.

Value Investing: Provide a Margin of Safety

The idea of buying a company at a bargain price to achieve a margin of safety, provides 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
• a large cash hoard, or,
• the absence of debt.

These offer a financial margin of safety.

Value Investing: Focus on Intangibles

Today's value investors are as intently focussed on business intangibles, like brand and customer loyalty, as on the "hard" financials.

It is all about looking at what's behind the numbers, and moreover, what will create tangible value in the future.

So a look at the market or markets in which the company operates is important.

Therefore, it is so important to look at:

• products,
• market position,
• brand,
• public perception,
• customers and customer perception,
• supply chain,
• leadership,
• opinions, and
• a host of others factor.

Value investing: It's not about diversification

Is diversification 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 are doing the value investing thing right, you are picking the right companies at the right prices, so there's no need to provide this extra insurance.

In fact, over-diversification only serves to dilute returns.

That said, perhaps diversification isn't a bad idea until you prove yourself a good value investor.

The point is that, somewhat counter to the conservative image, diversification per se is not a value investing technique.

Value investing: No magic formulas

Some people look for a magic formula in investing that guarantees success.

Value investing isn't quite that simple.

There are so many elements and nuances that go into a company's business that you can't know them all, let alone figure out how to weigh them in your model.

So rather than a recipe for success, you will instead have a list of ingredients that should be in every dish. But the art of cooking it up into a suitable vlue invstment is up to you.

Like all othe investing approaches, value investing is both art and science. It is more scientific and methodical than some approaches, but it is by no means completely formulaic.

Value Investing: A Quest for Consistency

Value investors have varying approaches to risk, some willing to accept greater risk for greater rewards.

However, almost all value investors like a degree of consistency in

• returns,
• profitability,
• growth,
• asset value,
• management effectiveness,
• customer base,
• supply chain, and
• most other aspects of the business.

It's the same consistency you would strive for if you bought that espresso cart or hardware store yourself.

Before agreeing to buy that hardware store, you'd probably want to know that the customer base is stable and that income flows are steady or at least predictable. If that's not the case, you would need to have a certain amount of additional capital to absorb the variations. Perhaps, you would need more for more advertising or promotion to bolster the customer base.

In short, there would be an uncetainty in the business, which, from the owner's point of view, translates to risk.

• The presence of risk requires additional capital and causes greater doubt about the success of the investment for you or any other investors in the business.
• As a result, the potential return required to accept this risk, and make you, the investor, look the other way is greater.

The value investor looks for consistency in an attempt to minimise risk and provide a margin of safety for his or her investment.

This is not to say the value investor won't invest in a risky enterprise; it's just to say that the price paid for earnings potential must correctly reflect the risk.

Consistency need not be absolute, but predictable performance is important.

Value Investing: Always do due diligence

This cannot be repeated enough.

The value investor must do the numbers and work to understand the company's value.

Although there are information sources and services that do some of the number crunching, you are not relieved of the duty of looking at, interpreting, and understanding the results.

Diligent value investors review the facts and don't act until they're confident in their understanding of the company, its value, and the relation between value and price.

With great discipline, the value investor does the work, applies sound judgement, and patiently waits for the right price. That is what separates the masters like Buffett from the rest.

Investing is no more than the allocation of capital for use by an enterprise with the idea of achieving a suitable return. He who allocates capital best wins!

Value Investing is a style of investing

Value investing is a style of investing. It is an approach to investing.

As an investor, you will adopt some of the principles of this style of investing, but not all of them.

You will develop a style and system that works for you.

Since blogging, this journey has been an interesting and rewarding discovery.