Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate.
While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors.
There are periods when the investors become bullish and their investment horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares.
On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavourable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares regiter decline as fear and uncertainty pervade the market.
The market tends to move in cycles. As John Train says:
"You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later."
The cycles are caused by mass psychology. As John Train explains:
"The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic."
One would expect large scale participation of institutions to dampen the price fluctuations in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of ths kind has happened.
On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.
Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality than the general investing public and have succumbed in equal measure to the temptation to speculate.
As John Maynard Keynes had argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals supposedly possessing better judgment and knowledge compete in the market place.
Why? According to Keynes, even these peope are concerned with speculation (the activity of forecasting the psychology of the market) and not enterprise (the activity of forecasting the prospective yield of assets over their whole life).
Tuesday, 2 September 2008
Interest Rate Risk
The changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up, the market price of existing fixed income securities falls, and vice versa.
This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security.
For example, a debenture that has a face value of MR 100 and a fixed rate of 12% will sell at a discount if the interest rate moves up from, say, 1% to 14%.
While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly.
The changes in the relative yields of debentures and equity shares influence equity prices.
This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security.
For example, a debenture that has a face value of MR 100 and a fixed rate of 12% will sell at a discount if the interest rate moves up from, say, 1% to 14%.
While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly.
The changes in the relative yields of debentures and equity shares influence equity prices.
Business risk
As a holder of corporate securities (equity shares or debentures), you are exposed to the risk of poor business performance.
This may be caused by a variety of factors like
Often, of course, the principal factor may be inept and incompetent management.
The poor business performance definitely affects the interest of equity shareholders, who have a residual claim on the income and wealth of the firm.
It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In such a case, debenture holders face the prospect of default risk.
This may be caused by a variety of factors like
- heightened competition,
- emergence of new technologies,
- development of substitute products,
- shifts in consumer preferences,
- inadequate supply of essential inputs,
- changes in government policies and so on.
Often, of course, the principal factor may be inept and incompetent management.
The poor business performance definitely affects the interest of equity shareholders, who have a residual claim on the income and wealth of the firm.
It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In such a case, debenture holders face the prospect of default risk.
Risk
You cannot talk about investment returns without talking about risk because investment decisions invariably involve a trade-off between the two.
Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.
More specifically, most investors are concerned about the actual outcome being less than the expected outcome.
The wider the range of possible outcomes, the greater the risk.
Sources of Risk
Risk emanates from several sources. The three major ones are:
Types of Risk
Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows:
Total risk = Unique risk + Market risk
http://myinvestingnotes.blogspot.com/2008/09/types-of-risk-total-risk-unique-risk.html
Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.
More specifically, most investors are concerned about the actual outcome being less than the expected outcome.
The wider the range of possible outcomes, the greater the risk.
Sources of Risk
Risk emanates from several sources. The three major ones are:
1. business risk,
http://myinvestingnotes.blogspot.com/2008/09/business-risk.html
2. interest rate risk, and
http://myinvestingnotes.blogspot.com/2008/09/interest-rate-risk.html
3. market risk.
http://myinvestingnotes.blogspot.com/2008/09/market-risk.html
Types of Risk
Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows:
Total risk = Unique risk + Market risk
http://myinvestingnotes.blogspot.com/2008/09/types-of-risk-total-risk-unique-risk.html
Return
Return is the primary motivating force that drives nvestment. It represents the reward for undertaking investment. Since the game of investing is about returns (after allowing for risk), measurement of realised (historical) returns is necessary to assess how well the investment manager has done. In addition, historical returns are often used as an important input in estimating future (prospective) returns.
The Components of Return
The return of an investment consists of two components.
Current Return: The first component that often comes to mind when one is thinking about return is the periodic cash flow (income), such as dividend or interest, generated by the investment. Current return is measured as the periodic income in relation to the beginnin price of the investment.
Capital Return: The second component of return is reflected in the price change called the capital return - it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return predominates.
Thus, the total return for any security (or for that matter any asset) is defined as:
Total Return = Current Return + Capital Return
The current return can be zero or positive, whereas the capital return can be negaive, zero, or positive.
The Components of Return
The return of an investment consists of two components.
Current Return: The first component that often comes to mind when one is thinking about return is the periodic cash flow (income), such as dividend or interest, generated by the investment. Current return is measured as the periodic income in relation to the beginnin price of the investment.
Capital Return: The second component of return is reflected in the price change called the capital return - it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return predominates.
Thus, the total return for any security (or for that matter any asset) is defined as:
Total Return = Current Return + Capital Return
The current return can be zero or positive, whereas the capital return can be negaive, zero, or positive.
Risk and Return - Two Sides of the Investment Coin
Investment decisions are influenced by various motives.
Some people invest in a business to acquire control and enjoy the prestige associated with it.
Some people invest in expensive yatchs and famous villas to display their wealth.
Most investors, however, are largely guided by the pecuniary motive of earning a return on their investment.
For earning returns investors have to almost invariably bear some risk.
In general, risk and return go hand in hand.
While investors like returns they abhor risk.
Investment decisions, therefore, involve a tradeoff between risk and return.
Since risk and return are central to investment decisions, we must understand what risk and return are and how they should be measured.
Monday, 1 September 2008
Estimation of Intrinsic Value
The procedure commonly employed by investment analysts to estimate the intrinsic vlaue of a share consists of the following steps:
1. Estimate the expected earnings per share
http://myinvestingnotes.blogspot.com/2008/09/estimating-expected-eps-cash-flow-per.html
2. Establish a PE ratio
http://myinvestingnotes.blogspot.com/2008/09/establishing-pe-ratio.html
3. Develop a value anchor and a value range
http://myinvestingnotes.blogspot.com/2008/09/determine-value-anchor-and-value-range.html
1. Estimate the expected earnings per share
http://myinvestingnotes.blogspot.com/2008/09/estimating-expected-eps-cash-flow-per.html
2. Establish a PE ratio
http://myinvestingnotes.blogspot.com/2008/09/establishing-pe-ratio.html
3. Develop a value anchor and a value range
http://myinvestingnotes.blogspot.com/2008/09/determine-value-anchor-and-value-range.html
Determine a Value Anchor and a Value Range
1. Determine a Value Anchor
The value anchor is obtained as follows:
= Projected EPS x Appropriate PE ratio
In our illustration, the projected EPS is 5.00 and the appropriate PE multiple is 6.87. Hence the valu anchor is 34.35. However, as valuation is inherently an uncertain and imprecise exercise, it would be naive to put great faith in a single point intrinsic value estimate. Practical wisdom calls for defining an intrinsic value range around the single point estimate.
2. Determine a Value Range
For example, in the above illustration, where an intrinsic value estimate of 34.35 has been arrived at, it may be more sensible to talk of an intrinsic value range of say 30 to 38. When you define a range like this, you are essentially saying that a "there may be a bias and error in my estimate. In view of this, feel that the value range is 30 to 38." Given this value range, your decision rule may be as follows:
Market Price*** (Decision)
< 30***********(Buy)
30 to 28********(Hold)
>38************(Sell)
The value anchor is obtained as follows:
= Projected EPS x Appropriate PE ratio
In our illustration, the projected EPS is 5.00 and the appropriate PE multiple is 6.87. Hence the valu anchor is 34.35. However, as valuation is inherently an uncertain and imprecise exercise, it would be naive to put great faith in a single point intrinsic value estimate. Practical wisdom calls for defining an intrinsic value range around the single point estimate.
2. Determine a Value Range
For example, in the above illustration, where an intrinsic value estimate of 34.35 has been arrived at, it may be more sensible to talk of an intrinsic value range of say 30 to 38. When you define a range like this, you are essentially saying that a "there may be a bias and error in my estimate. In view of this, feel that the value range is 30 to 38." Given this value range, your decision rule may be as follows:
Market Price*** (Decision)
< 30***********(Buy)
30 to 28********(Hold)
>38************(Sell)
Estimating the Expected EPS & Cash Flow per Share
1. Estimating the Expected EPS
Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.
As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:
20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
202***216
Operating expenses
74***81***Increase by 9.5%
Depreciation
30***34
S&GA expenses
44***47
Operating profit
128***135
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
130***137
Interest
25***24***Decrease by 4%
Profit before tax
105***113
Tax
35***38***Increase by 8.57%
Profit after tax
70***75
Number of equity shares
15 m *** 15 m
EPS
4.67***5.00
Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.
As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.
It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.
2. Estimating the Cash Flow per Share
In addition to the EPS, the cash flow per share which is defined as:
= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares
is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).
Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.
As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:
20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
202***216
Operating expenses
74***81***Increase by 9.5%
Depreciation
30***34
S&GA expenses
44***47
Operating profit
128***135
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
130***137
Interest
25***24***Decrease by 4%
Profit before tax
105***113
Tax
35***38***Increase by 8.57%
Profit after tax
70***75
Number of equity shares
15 m *** 15 m
EPS
4.67***5.00
Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.
As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.
It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.
2. Estimating the Cash Flow per Share
In addition to the EPS, the cash flow per share which is defined as:
= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares
is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).
Establishing a PE Ratio
The PE ratio maybe derived from the
Constant Growth Dividend Model.
We derive the PE ratio for a constant growth firm from the constant growth dividend discount model.
PE Ratio
= Dividend payout ratio/ (Required return on equity - Expected growth rate in dividends)
Dividend Payout Ratio: Most companies treat their dividend commitment seriously. Consequently, once dividends are set at a certain level, they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear that a higher level of dividends can be sustained. Thanks to these policies, dividends adjust with a lag to earnings.
If the dividend payout ratio increases the above ratio increases, which has a favourable effect ont he price-earnings multiple. However, an increasein the dividend payout ratio has the effect of lowering the expected growth rate of dividends int he denomination of the above ratio which leads to a decrease in the price-earnings multiple. On the whole, in most cases, these two effects are likely to balance out.
Required Return on Equity: The required return on equity is a function of the risk-free rate of return and a risk premium. According to the capital asset pricing model, a popularly used risk-return model, the rquired return on equity is:
= Risk-free return + (Beta of equity) ( Expected market risk premium)
Expected Growth Rate in Dividends: The third variable influencing the PE ratio is the expected growth rate in dividends. The expected growth rate in dividends is equal to:
= Retention ratio x Return on Equity.
Cross-Section Analysis
You can look at the PE ratios of similar firms in the industry and take a view on what is a reasonable PE ratio for the subject company.
Alternatively, you can conduct cross-section regression analysis wherein the PE ratio is regressed on several fundamental variables. Here is an illustrative specification:
PE ratio
= a1 + a2 Growth rate in earnings + a2 Dividend payout ratio + a3 Variability of earnings + a4 Company size.
Based on the estimated coefficients of such cross-section regression analysis, the PE ratio for the subject firm may be derived.
Historical Analysis.
You can look at the historical PE ratio of the subject company and take a view on what is a reasonable PE ratio, taking into account the changes in the capital market and the evolving competition.
As an illustration, the prospective PE ratio for Horizon Limited for the past three years was
PE Ratio 20x5 9.25, 20x6 6.63, 20x7 6.23
The average PE ratio for Horizon Limited was: (9.25+6.63+6.23)/3 = 7.37
Considering the changing conditions in the capital market and the emerging competition for Horizon Limite you may say that the average PE for the past three years is applicable in the immediate future as well.
The Weighted PE Ratio
We arrived at two PE ratio estimates:
PE ratio based on the constant growth dividend discount model: 6.36
PE ratio based on historical analysis: 7.37
We can combine these two estimates by taking a simple arithmetic average of them - this means that both the estimates are accorded equal weight. Doing so, we get the weighted PE ratio of:
(6.36+7.37)/2 = 6.87
- constant growth dividend model, or
- cross-section analysis, or
- historical analysis.
Constant Growth Dividend Model.
We derive the PE ratio for a constant growth firm from the constant growth dividend discount model.
PE Ratio
= Dividend payout ratio/ (Required return on equity - Expected growth rate in dividends)
Dividend Payout Ratio: Most companies treat their dividend commitment seriously. Consequently, once dividends are set at a certain level, they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear that a higher level of dividends can be sustained. Thanks to these policies, dividends adjust with a lag to earnings.
If the dividend payout ratio increases the above ratio increases, which has a favourable effect ont he price-earnings multiple. However, an increasein the dividend payout ratio has the effect of lowering the expected growth rate of dividends int he denomination of the above ratio which leads to a decrease in the price-earnings multiple. On the whole, in most cases, these two effects are likely to balance out.
Required Return on Equity: The required return on equity is a function of the risk-free rate of return and a risk premium. According to the capital asset pricing model, a popularly used risk-return model, the rquired return on equity is:
= Risk-free return + (Beta of equity) ( Expected market risk premium)
Expected Growth Rate in Dividends: The third variable influencing the PE ratio is the expected growth rate in dividends. The expected growth rate in dividends is equal to:
= Retention ratio x Return on Equity.
Cross-Section Analysis
You can look at the PE ratios of similar firms in the industry and take a view on what is a reasonable PE ratio for the subject company.
Alternatively, you can conduct cross-section regression analysis wherein the PE ratio is regressed on several fundamental variables. Here is an illustrative specification:
PE ratio
= a1 + a2 Growth rate in earnings + a2 Dividend payout ratio + a3 Variability of earnings + a4 Company size.
Based on the estimated coefficients of such cross-section regression analysis, the PE ratio for the subject firm may be derived.
Historical Analysis.
You can look at the historical PE ratio of the subject company and take a view on what is a reasonable PE ratio, taking into account the changes in the capital market and the evolving competition.
As an illustration, the prospective PE ratio for Horizon Limited for the past three years was
PE Ratio 20x5 9.25, 20x6 6.63, 20x7 6.23
The average PE ratio for Horizon Limited was: (9.25+6.63+6.23)/3 = 7.37
Considering the changing conditions in the capital market and the emerging competition for Horizon Limite you may say that the average PE for the past three years is applicable in the immediate future as well.
The Weighted PE Ratio
We arrived at two PE ratio estimates:
PE ratio based on the constant growth dividend discount model: 6.36
PE ratio based on historical analysis: 7.37
We can combine these two estimates by taking a simple arithmetic average of them - this means that both the estimates are accorded equal weight. Doing so, we get the weighted PE ratio of:
(6.36+7.37)/2 = 6.87
Different PE ratios
Estimated EPS is based on a number of assumptions about the behaviour of revenues and costs. The reliability of the EPS forecast hinges critically on how realistic are these assumptions.
The other half of the valuation exercise is concerned with the price-earnings ratio which reflects the price investors are willing to pay per cents of EPS. In essence, it represens the market's summary evaluation of a company's prospects
Note that different PE ratios can be calculated for the same stock at any given point in time:
PE ratio based on last year's reported earnings
PE ratio based on trailing 12 months earnings
PE ratio based on current year's expected earnings
PE ratio based on the following year's expected earnings
An example may be given to illustrate the different PE ratios. The equity stock of ABC Limited is trading on August 1, 20x5 for MR 120 and the following EPS data is available:
EPS for last year (April 1, 20x4 - March 31, 20x5): 8 sen
EPS for trailing 12 months (July1, 20x4 - June 30, 20x5): 8.5 sen
EPS expected for the current year (April 1, 20x5 - March 31, 20x6): 9 sen
EPS expected for the following year (April 1, 20x6 -March 31, 20x7): 10 sen
The different PE ratios are as follows:
PE ratio based o last year's reported earnings: 120/8 = 15.0
PE ratio based on trailing 12 months earnings: 120/8.5 = 14.1
PE ratio based on current year's expected earnings: 120/9.0 = 13.3
PE ratio based on the folowing year's expected earnings: 120/10.0 = 12.0
We will generally use the PE ratio based on current year's expected earnings.
The other half of the valuation exercise is concerned with the price-earnings ratio which reflects the price investors are willing to pay per cents of EPS. In essence, it represens the market's summary evaluation of a company's prospects
Note that different PE ratios can be calculated for the same stock at any given point in time:
PE ratio based on last year's reported earnings
PE ratio based on trailing 12 months earnings
PE ratio based on current year's expected earnings
PE ratio based on the following year's expected earnings
An example may be given to illustrate the different PE ratios. The equity stock of ABC Limited is trading on August 1, 20x5 for MR 120 and the following EPS data is available:
EPS for last year (April 1, 20x4 - March 31, 20x5): 8 sen
EPS for trailing 12 months (July1, 20x4 - June 30, 20x5): 8.5 sen
EPS expected for the current year (April 1, 20x5 - March 31, 20x6): 9 sen
EPS expected for the following year (April 1, 20x6 -March 31, 20x7): 10 sen
The different PE ratios are as follows:
PE ratio based o last year's reported earnings: 120/8 = 15.0
PE ratio based on trailing 12 months earnings: 120/8.5 = 14.1
PE ratio based on current year's expected earnings: 120/9.0 = 13.3
PE ratio based on the folowing year's expected earnings: 120/10.0 = 12.0
We will generally use the PE ratio based on current year's expected earnings.
Peter Lynch's Classification of Companies
There are different ways of classifying shares. Here is Peter Lynch's classification of companies (and by derivation, shares).
Slow growers: Large and ageing companies that are expected to grow slightly faster than the gross national product.
Stalwarts: Giant companies that are faster than slow growers but are not agile climbers.
Fast growers: Small, aggressive new enterprises that grow at 10 to 25% a year.
Cyclicals: Companies whose sales and profit rise and fall in a regular, though not completely predicatable fashion.
Turnarounds: Companies which are steeped in accumuated losses but which show signs of recovery. Turnaround companies have the potential to make up lose ground quickly.
Slow growers: Large and ageing companies that are expected to grow slightly faster than the gross national product.
Stalwarts: Giant companies that are faster than slow growers but are not agile climbers.
Fast growers: Small, aggressive new enterprises that grow at 10 to 25% a year.
Cyclicals: Companies whose sales and profit rise and fall in a regular, though not completely predicatable fashion.
Turnarounds: Companies which are steeped in accumuated losses but which show signs of recovery. Turnaround companies have the potential to make up lose ground quickly.
Stock Market Classification of Equity Shares
Stock market classification of Equity Shares
Blue chip shares: Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.
Growth shares: Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.
Income shares: Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.
Cyclical shares: Shares of companies that have a pronounced cyclicality in their operations.
Defensive shares: Shares of companies that are relatively unaffected by the ups and downs in general business conditions.
Speculative shares: Shares that tend to fluctute wdely because there is a lot of speculative trading in them.
Note that the above classification is only indicative. It should not be regarded as rigid and straightjacketed. Often you can't pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.
Blue chip shares: Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.
Growth shares: Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.
Income shares: Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.
Cyclical shares: Shares of companies that have a pronounced cyclicality in their operations.
Defensive shares: Shares of companies that are relatively unaffected by the ups and downs in general business conditions.
Speculative shares: Shares that tend to fluctute wdely because there is a lot of speculative trading in them.
Note that the above classification is only indicative. It should not be regarded as rigid and straightjacketed. Often you can't pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.
The smart way to get rich
http://articles.moneycentral.msn.com/Investing/StockInvestingTrading/TheSmartWayToGetRich.aspx
The smart way to get rich
To get big rewards, you'll need to take some risks. What's important is knowing -- based on your needs, your time frame and other factors -- just how much danger you can handle.
By Annie Logue, MSN Money
Feel like taking a risk in hopes of hitting the jackpot on a rocket stock?
Before you make the leap, you might want to get a grip on risk.
Risk is great . . . when you make money
Prices go up, prices go down, and you never know which way they're headed next. A lot of folks would say, well, that's risk. But really that's only half the picture. The other half is what you do in response.
"Nothing goes up forever"
After all, there's nothing wrong with risk itself. What's important is how you handle it. To know how to manage the risk-reward equation, you're first going to have to get a grip on what you're playing with -- and how much you can afford to lose.
Graphic: How risky is it?
It's pretty hard to talk about investment risk without falling into a lot of clichés about roller coasters and bungee jumping and being able to sleep at night. That imagery is entertaining but maybe not terribly helpful. Instead, let's start with the basics. We don't want to lose money, right?
"Obviously, negative return is risk," says Lee Schultheis, the CEO and chief investment strategist at AIP Mutual Funds in White Plains, N.Y.
Pros such as Schultheis use some pretty powerful computer-driven tools in their analysis of risk. Here are just a few of the concepts that are important to them:
Standard deviation, much beloved of finance professors, measures how much the results of a process tend to vary. The higher the standard deviation, the more unpredictable the results.
Correlation, used by those managing diversified portfolios, tells you how much two assets move together to reinforce -- or offset -- performance.
Value at risk, often used by hedge funds, measures the likelihood that you will lose all of your money in any time period.
All three are mathematical concepts and require some comfort with statistics to calculate -- but not to understand. Each translates the uncertainties of risk into mathematical estimates of likelihood that offer a good basis for planning.
Math won't help everything
If you have an investment with a high standard deviation, close correlation to other investments or a high value at risk, you're taking on significantly more risk. If more than one of those factors is involved, watch out.
Let's say you're thinking about doubling up an investment in technology stocks. Results in that sector are going to be erratic to begin with. But because the new investment correlates positively with stuff you already own, the risk to you is much greater.
Normally, riskier investments hold the promise of greater returns over the long run. But that may not help you sleep at night.
What are acceptable losses?
Professionals will use concepts like standard deviation and correlation to balance risks in ways that can get pretty complicated. The average investor isn't equipped for that sort of thing. Fortunately, there are approaches that are a lot simpler to manage while still offering an approach that is fundamentally sound.
Edward Gjertsen, a certified financial planner with Mack Investment Securities in Glenview, Ill., encourages his clients to think about risk in a more personal way. He tries to focus their attention on their own fundamental needs.
How safe is your job?
He offers clients what he calls his seven-day cash challenge. Clients are asked to withdraw as much cash as they think they will need for all of their expenses -- coffee, groceries, whatever -- during one week. Then he asks them to report back on when the money runs out.
Very few folks make it through all seven days without a trip to the ATM.
"The ones who do it find it's eye-opening," Gjertsen says.
That's because most of us have a lot of expenses that we don't think about: birthday presents, a manicure before a party, prescription refills and the like.
"Every time somebody swipes a card, somebody's making money somewhere," Gjertsen says. "You don't necessarily realize this money is whipping through your hands."
The cash challenge helps Gjertsen's clients understand where they should draw the line on risk. Most of us do not want to gamble away the money we need to pay basic expenses and buy an occasional birthday present. But if we can take care of our basic needs, plan for college for the kids and fund a reasonable retirement, say, and still have a bit of money left over, that's different. There, maybe a bit of additional risk makes sense.
"Your portfolio should reflect whatever your underlying risk preferences are," says Leo Harmon, a senior director at Fiduciary Management Associates in Chicago.
To handle risk intelligently, you first need to make sure you can afford it. Then make sure it fits well into our overall investment strategy. Diversify. Don't bet the farm on a single sector. And recognize that it's not just how much money you'll need, it's when you'll need it.
For instance: A technology sector that sees a lot of ups and downs may be the worst possible investment for an individual who is planning to retire next year. But for the person with a 10- or 20-year time horizon, the same sector might make a lot of sense.
In the right situation, the addition of some well-managed risk makes sense and should have a positive effect on a portfolio. To profit from additional risk, though, you have to be comfortable enough to ride out the short-term fluctuations. Be prepared for some volatility, and understand that the ups and downs tend to get more extreme as the risks go up.
How competing economies help you
Meanwhile: Bear in mind that all investments carry risks of one sort or another. Just because a security has low volatility doesn't mean that there's no potential for loss. A steady loser is a lot worse than an investment that goes down a lot but then goes up by even more.
"It might not feel bad along the way because it only goes down a little bit at a time," AIP Mutual Funds' Schultheis says of the steady losers. In the end, though, a loss is still a loss.
If you think it through, risk can work in your favor. And you can still sleep at night.
Published April 11, 2008
The smart way to get rich
To get big rewards, you'll need to take some risks. What's important is knowing -- based on your needs, your time frame and other factors -- just how much danger you can handle.
By Annie Logue, MSN Money
Feel like taking a risk in hopes of hitting the jackpot on a rocket stock?
Before you make the leap, you might want to get a grip on risk.
Risk is great . . . when you make money
Prices go up, prices go down, and you never know which way they're headed next. A lot of folks would say, well, that's risk. But really that's only half the picture. The other half is what you do in response.
"Nothing goes up forever"
After all, there's nothing wrong with risk itself. What's important is how you handle it. To know how to manage the risk-reward equation, you're first going to have to get a grip on what you're playing with -- and how much you can afford to lose.
Graphic: How risky is it?
It's pretty hard to talk about investment risk without falling into a lot of clichés about roller coasters and bungee jumping and being able to sleep at night. That imagery is entertaining but maybe not terribly helpful. Instead, let's start with the basics. We don't want to lose money, right?
"Obviously, negative return is risk," says Lee Schultheis, the CEO and chief investment strategist at AIP Mutual Funds in White Plains, N.Y.
Pros such as Schultheis use some pretty powerful computer-driven tools in their analysis of risk. Here are just a few of the concepts that are important to them:
Standard deviation, much beloved of finance professors, measures how much the results of a process tend to vary. The higher the standard deviation, the more unpredictable the results.
Correlation, used by those managing diversified portfolios, tells you how much two assets move together to reinforce -- or offset -- performance.
Value at risk, often used by hedge funds, measures the likelihood that you will lose all of your money in any time period.
All three are mathematical concepts and require some comfort with statistics to calculate -- but not to understand. Each translates the uncertainties of risk into mathematical estimates of likelihood that offer a good basis for planning.
Math won't help everything
If you have an investment with a high standard deviation, close correlation to other investments or a high value at risk, you're taking on significantly more risk. If more than one of those factors is involved, watch out.
Let's say you're thinking about doubling up an investment in technology stocks. Results in that sector are going to be erratic to begin with. But because the new investment correlates positively with stuff you already own, the risk to you is much greater.
Normally, riskier investments hold the promise of greater returns over the long run. But that may not help you sleep at night.
What are acceptable losses?
Professionals will use concepts like standard deviation and correlation to balance risks in ways that can get pretty complicated. The average investor isn't equipped for that sort of thing. Fortunately, there are approaches that are a lot simpler to manage while still offering an approach that is fundamentally sound.
Edward Gjertsen, a certified financial planner with Mack Investment Securities in Glenview, Ill., encourages his clients to think about risk in a more personal way. He tries to focus their attention on their own fundamental needs.
How safe is your job?
He offers clients what he calls his seven-day cash challenge. Clients are asked to withdraw as much cash as they think they will need for all of their expenses -- coffee, groceries, whatever -- during one week. Then he asks them to report back on when the money runs out.
Very few folks make it through all seven days without a trip to the ATM.
"The ones who do it find it's eye-opening," Gjertsen says.
That's because most of us have a lot of expenses that we don't think about: birthday presents, a manicure before a party, prescription refills and the like.
"Every time somebody swipes a card, somebody's making money somewhere," Gjertsen says. "You don't necessarily realize this money is whipping through your hands."
The cash challenge helps Gjertsen's clients understand where they should draw the line on risk. Most of us do not want to gamble away the money we need to pay basic expenses and buy an occasional birthday present. But if we can take care of our basic needs, plan for college for the kids and fund a reasonable retirement, say, and still have a bit of money left over, that's different. There, maybe a bit of additional risk makes sense.
"Your portfolio should reflect whatever your underlying risk preferences are," says Leo Harmon, a senior director at Fiduciary Management Associates in Chicago.
To handle risk intelligently, you first need to make sure you can afford it. Then make sure it fits well into our overall investment strategy. Diversify. Don't bet the farm on a single sector. And recognize that it's not just how much money you'll need, it's when you'll need it.
For instance: A technology sector that sees a lot of ups and downs may be the worst possible investment for an individual who is planning to retire next year. But for the person with a 10- or 20-year time horizon, the same sector might make a lot of sense.
In the right situation, the addition of some well-managed risk makes sense and should have a positive effect on a portfolio. To profit from additional risk, though, you have to be comfortable enough to ride out the short-term fluctuations. Be prepared for some volatility, and understand that the ups and downs tend to get more extreme as the risks go up.
How competing economies help you
Meanwhile: Bear in mind that all investments carry risks of one sort or another. Just because a security has low volatility doesn't mean that there's no potential for loss. A steady loser is a lot worse than an investment that goes down a lot but then goes up by even more.
"It might not feel bad along the way because it only goes down a little bit at a time," AIP Mutual Funds' Schultheis says of the steady losers. In the end, though, a loss is still a loss.
If you think it through, risk can work in your favor. And you can still sleep at night.
Published April 11, 2008
Investing: When to bet the farm
http://articles.moneycentral.msn.com/Investing/StockInvestingTrading/InvestingWhenToBetTheFarm.aspx#pageTopAnchor
Investing: When to bet the farm
Big payoffs often require big risks. Bet wrong, and you could lose everything. Do you have what it takes? And how do you assess whether a dicey investment is worth it?
By Annie Logue, MSN Money
You want a big return? How big a risk do you want to take to get it? Gauging the risks associated with really promising investments, and handling those risks appropriately, can change your life.
"It's never safe to take a risk, by definition," says Carl Luft, an associate professor of finance at DePaul University in Chicago.
Yet successful investors take major risks all the time. They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. How big a payoff might the investment produce? And how likely is success?
Successful investors look hard at the downside as well. What would the price of failure be? And how likely is that?
Just jump in and take a risk
And what about all the outcomes in between?
Luft emphasizes that successful investors tend to have a broad view, taking the downside into account with the upside. They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."
"An expected return is an average," Luft says. "It's the probability of all of the outcomes."
Risk assessment gets pretty sophisticated at risk-oriented hedge funds. These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. But the basics are just common sense.
Russell Lundeberg, the chief investment officer for Barrett Capital Management in Richmond, Va., spends his days researching investments both risky and safe for the wealthy families in the firm's client base. He researches basic business practices as well as the big-picture business opportunity.
"The No. 1 most overlooked aspect of hedge fund due diligence is on the operational side," he says. "The things that can be potential risks and pitfalls are not always easy to spot."
Among the not-so-obvious business risks, Lundberg mentions high employee turnover, sloppy accounting and computers that aren't backed up. A mistake in the office can wipe out an investment's potential return even in the most promising environment, Lundeberg says.
Our own personalities add complexity to high-risk situations.
Bill Gurtin of Gurtin Fixed Income Management in San Diego points out the risks associated with overly emotional reactions.
"What you don't want to happen is for people to get emotional with the market," he says.
The more emotional we get, the more likely it is we will make a mistake, Gurtin explains.
A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.
Graphic: Three ways to analyze a company (Quantitative, Qualitative and Technical Analysis)
Where risk is high, the investor needs to analyze his or her life situation.
Is financial risk really risky?
"There are times in your life when it's appropriate to take different levels of risk," Gurtin says.
Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.
"Let's say you're young, in your mid-20s," Luft says. "If you take a big risk and something goes wrong, you have time to recover." On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.
Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed.
"In investing and in life, you have to look at everything on a risk-and-reward basis," says Manny Weintraub, the president of Integre Advisors, a New York firm that manages equities for long-term growth. "Volatility is not the end of the world."
Risk lesson from the OTB
Weintraub is a good example. He left the investment firm of Neuberger Berman in 2003 to start his own firm. He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.
"Careers are actually the easiest place to take risks, as long as you don't burn your bridges," Weintraub says.
Luft suggests younger investors, particularly, should be ready to gamble with their careers. But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.
Published Aug. 28, 2008
Investing: When to bet the farm
Big payoffs often require big risks. Bet wrong, and you could lose everything. Do you have what it takes? And how do you assess whether a dicey investment is worth it?
By Annie Logue, MSN Money
You want a big return? How big a risk do you want to take to get it? Gauging the risks associated with really promising investments, and handling those risks appropriately, can change your life.
"It's never safe to take a risk, by definition," says Carl Luft, an associate professor of finance at DePaul University in Chicago.
Yet successful investors take major risks all the time. They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. How big a payoff might the investment produce? And how likely is success?
Successful investors look hard at the downside as well. What would the price of failure be? And how likely is that?
Just jump in and take a risk
And what about all the outcomes in between?
Luft emphasizes that successful investors tend to have a broad view, taking the downside into account with the upside. They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."
"An expected return is an average," Luft says. "It's the probability of all of the outcomes."
Risk assessment gets pretty sophisticated at risk-oriented hedge funds. These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. But the basics are just common sense.
Russell Lundeberg, the chief investment officer for Barrett Capital Management in Richmond, Va., spends his days researching investments both risky and safe for the wealthy families in the firm's client base. He researches basic business practices as well as the big-picture business opportunity.
"The No. 1 most overlooked aspect of hedge fund due diligence is on the operational side," he says. "The things that can be potential risks and pitfalls are not always easy to spot."
Among the not-so-obvious business risks, Lundberg mentions high employee turnover, sloppy accounting and computers that aren't backed up. A mistake in the office can wipe out an investment's potential return even in the most promising environment, Lundeberg says.
Our own personalities add complexity to high-risk situations.
Bill Gurtin of Gurtin Fixed Income Management in San Diego points out the risks associated with overly emotional reactions.
"What you don't want to happen is for people to get emotional with the market," he says.
The more emotional we get, the more likely it is we will make a mistake, Gurtin explains.
A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.
Graphic: Three ways to analyze a company (Quantitative, Qualitative and Technical Analysis)
Where risk is high, the investor needs to analyze his or her life situation.
Is financial risk really risky?
"There are times in your life when it's appropriate to take different levels of risk," Gurtin says.
Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.
"Let's say you're young, in your mid-20s," Luft says. "If you take a big risk and something goes wrong, you have time to recover." On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.
Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed.
"In investing and in life, you have to look at everything on a risk-and-reward basis," says Manny Weintraub, the president of Integre Advisors, a New York firm that manages equities for long-term growth. "Volatility is not the end of the world."
Risk lesson from the OTB
Weintraub is a good example. He left the investment firm of Neuberger Berman in 2003 to start his own firm. He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.
"Careers are actually the easiest place to take risks, as long as you don't burn your bridges," Weintraub says.
Luft suggests younger investors, particularly, should be ready to gamble with their careers. But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.
Published Aug. 28, 2008
Thursday, 28 August 2008
Understanding Stock Market Return
Stock market return
= fundamental return + speculative return
= (earnings growth + dividend yield) + (change in PE ratio)
http://turtleinvestor888.blogspot.com/2008/03/is-there-such-thing-call-value_19.html
= fundamental return + speculative return
= (earnings growth + dividend yield) + (change in PE ratio)
http://turtleinvestor888.blogspot.com/2008/03/is-there-such-thing-call-value_19.html
Sunday, 24 August 2008
How to analyze the market? Bank
Because the service that banks provide is so vital to long-term economic growth, the banking indutry is almost certain to grow in line with the world's total output, no matter which sector generates the greatest need for capital. Whether the demand for money comes from an industry such as technology or pharmaceuticals or consumers' incessant demand for housing, banks will benefit.
The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers,profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as noninterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.
Interest income
- Interest expense
__________________
= Net interest income
- Provisions for loan losses
+ Noninterest income
__________________
= Net revenue
The low cost of borrowing - combined with the advantae banks have on the lending side - allows banks to earn attractive returns on their spread.
That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank beter than another? Here are a few examples of wide-moat banks with different strategies:
The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers,profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as noninterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.
Interest income
- Interest expense
__________________
= Net interest income
- Provisions for loan losses
+ Noninterest income
__________________
= Net revenue
The low cost of borrowing - combined with the advantae banks have on the lending side - allows banks to earn attractive returns on their spread.
That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank beter than another? Here are a few examples of wide-moat banks with different strategies:
- Citigroup uses its worldwide geographic reach and deep product bench to increase revenues and diversify its risk exposure, which allows it to perform well in even difficult environments.
- Wells Fargo is an expert at attracting deposits which area key source of lower cost funds, and it has a deeply ingrained sales culture that drives revenues.
- Fifth Third has an aggressive sales culture, a low-risk loan philosophy, and a sharp focus on costs.
It's all about Risk.
Whether a financial institution specializes in making commercial loans or consumer loans, the heart and soul of bnking is centered on one thing: risk management. Banks accept three types of risk:
- credit,
- liquidity, and
- interest rate,
and they get paid to take on this risk. Borrowers and lenders pay banks through interest or fees bcause they are unwilling to manage the risk on ther own, or because banks can do it more cheaply.
But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan losses grow faster than expected.
Saturday, 23 August 2008
How to analyze the market? Business Services
While the companies in our business services sector operate in relative obscurity, the sector deserves more attention. Here, we can find a large number of firms running wonderful, wide-moat businesses - just the kind we like to buy at the right price and hold as long-term investors.
Companies in the business services sector are as varied as the businesses they serve. After all, the group include firms such as Fiserv (financial institution data processing), Waste Management (waste hauling), Omnicom (advertising), and even United Airlines (air transportation). Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at:
Although not all companies within the industry fit perfectly into just one of these categries, it's a useful distinction to make when you're analyzing a potential investment in business services. Despite being such diverse group of businesses, a few major themes impact the majority of business services companies.
Outsourcing Trend
Business-to-business services have grown significantly, increasing as a percentage of GDP from 3.5 percent in 1990 to 5.4 percent in 2001. Fueling the growth has been the popularity of outsourcing - the practice of offloading noncore tasks to third parties.
Many business services providers have essentially created markets for themselves based on this trend. Cintas, for example, has successfully convinced companies tha it's better to pay Cintas to service employees' uniforms than to leave the responsibility to each individual employee or to handle it themselves. Other industries developed to fill needs that would be difficult or impossible for companies to handle internally. It is impractical, for example, for every mom-and-pop retailer to develop its own infrastructur to facilitate its acceptance of credit and debit card payments. Instead, companies such as First Data and National Processing allow retailers to tap into larger systems, the fixed costs of which can be leveraged across many clients.
Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the sucess of their company.
Economic Moats in Business Services.
In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume - especially over fixed-cost networks - companies can lower unit costs and achieve greater profitability.
To capitalize on this, many business services firms have attempted to acquire their way to critical mass and achieve scale economies by consolidating the operations of multiple businesses. For example, data processing firms such as Fiserv, First Data, and ADP have all made acquisitions an important part of their overall strategies.
Size impacts the industry through branding as well. Often,brands play a major role in a business outsourcing purchase decision. Companies amy be hesitant to utsource payroll processing (and the related handling of employee pay and tax funds) to Fly-By-Night Upstart, Inc., but are comfortable entrusting the responsibility to ADP, founded in 1949 and currently the biggest payroll processor. Even in business services, brands count, and it's usually the biggest companies that have the most recognizable brands.
Many industries in business services have significant barriers to entry, making it tough for new players to enter the field. For example, a company that wanted to process credit card transactions for banks and retailers would have to build a processing infrastructure to support its business, including hardware, the software development to manage the data, and a sales network to sign customers. Such a company would have to go through considerable trouble and expense just to try to compete against a company such as First Data, which already handles billions of transactions each year.
Despite the relatively high barriers to entry in th electonic transaction processing industry, their's little protection against competition from other industry participants. For example, in 2001, Concord EFS lost Bank of America's electronic funds transfer switching business to a very aggressive bid from competitor Visa. Thus, although most business services industries have wide moats, companies still need to differentiate themselves further to fend off potentially intense competition from established industry players.
Companies in the business services sector are as varied as the businesses they serve. After all, the group include firms such as Fiserv (financial institution data processing), Waste Management (waste hauling), Omnicom (advertising), and even United Airlines (air transportation). Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at:
- technology-based
- people-based, and
- hard-asset-based subsectors.
Although not all companies within the industry fit perfectly into just one of these categries, it's a useful distinction to make when you're analyzing a potential investment in business services. Despite being such diverse group of businesses, a few major themes impact the majority of business services companies.
Outsourcing Trend
Business-to-business services have grown significantly, increasing as a percentage of GDP from 3.5 percent in 1990 to 5.4 percent in 2001. Fueling the growth has been the popularity of outsourcing - the practice of offloading noncore tasks to third parties.
Many business services providers have essentially created markets for themselves based on this trend. Cintas, for example, has successfully convinced companies tha it's better to pay Cintas to service employees' uniforms than to leave the responsibility to each individual employee or to handle it themselves. Other industries developed to fill needs that would be difficult or impossible for companies to handle internally. It is impractical, for example, for every mom-and-pop retailer to develop its own infrastructur to facilitate its acceptance of credit and debit card payments. Instead, companies such as First Data and National Processing allow retailers to tap into larger systems, the fixed costs of which can be leveraged across many clients.
Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the sucess of their company.
Economic Moats in Business Services.
In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume - especially over fixed-cost networks - companies can lower unit costs and achieve greater profitability.
To capitalize on this, many business services firms have attempted to acquire their way to critical mass and achieve scale economies by consolidating the operations of multiple businesses. For example, data processing firms such as Fiserv, First Data, and ADP have all made acquisitions an important part of their overall strategies.
Size impacts the industry through branding as well. Often,brands play a major role in a business outsourcing purchase decision. Companies amy be hesitant to utsource payroll processing (and the related handling of employee pay and tax funds) to Fly-By-Night Upstart, Inc., but are comfortable entrusting the responsibility to ADP, founded in 1949 and currently the biggest payroll processor. Even in business services, brands count, and it's usually the biggest companies that have the most recognizable brands.
Many industries in business services have significant barriers to entry, making it tough for new players to enter the field. For example, a company that wanted to process credit card transactions for banks and retailers would have to build a processing infrastructure to support its business, including hardware, the software development to manage the data, and a sales network to sign customers. Such a company would have to go through considerable trouble and expense just to try to compete against a company such as First Data, which already handles billions of transactions each year.
Despite the relatively high barriers to entry in th electonic transaction processing industry, their's little protection against competition from other industry participants. For example, in 2001, Concord EFS lost Bank of America's electronic funds transfer switching business to a very aggressive bid from competitor Visa. Thus, although most business services industries have wide moats, companies still need to differentiate themselves further to fend off potentially intense competition from established industry players.
Is the Firm Cyclical?
Firms that go through boom and bust cycles - semiconductor companies and auto manufacturers are good examples - require a bit more care. Although you'd typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they're likely to fall off soon. For cyclical stocks, your best bet is to look at the most recent cyclical peak, make a judgment whether the next peak is likely to be lower or higher than the last one, and calculate a P/E based on the current price relative to what you think earnings per share will be at the next peak.
High-yield stocks more appealing now
22-08-2008: High-yield stocks more appealing now
http://www.theedgedaily.com/cms/content.jsp?id=com.tms.cms.article.Article_e5adafa1-cb73c03a-df294000-75281632#
Stock markets worldwide have been, and will probably continue to be, buffeted by a myriad of uncertainties. Questions such as the health of the US economy and troubled financial markets appear unlikely to be answered anytime soon.
Stock markets worldwide have been, and will probably continue to be, buffeted by a myriad of uncertainties. Questions such as the health of the US economy and troubled financial markets appear unlikely to be answered anytime soon.
Investor confidence is depressed with the limited visibility. The Kuala Lumpur Composite Index has fallen nearly 26% in the year-to-date. Many have sold down their equity holdings and are staying on the sidelines.
Typically, when uncertainties are high, investors lean towards more defensive and stable dividend-paying stocks. And there are a fair number of stocks that pay good dividends, offering yields that exceed bank deposit rates.
Inflationary pressures and demand slowdown will affect company earnings by varying degrees. However, there are still pockets of strength - and some of these companies are paying higher dividends, in line with their earnings growth. Good dividends, in turn, should lend support to their share prices.
CSC Steel has generous dividend policy
Steel companies, for instance, are enjoying robust earnings. CSC Steel Holdings (RM1.36) reported net profit totalling RM73.5 million in the first half of 2008 (1H08), compared with RM79.7 million for the whole of 2007. Sales and earnings are being driven by higher volume and selling prices for its flat steel products, primarily cold rolled coils (CRC).
Outlook for the steel sector remains upbeat for the next one to two years. Despite a slight weakening in prices, few expect a significant correction from prevailing levels - with costlier iron ore, coking coal and energy providing fairly firm floor support.
CSC has a policy to pay out half of annual earnings as dividends. Hence, based on our estimated earnings of 35.2 sen and 37.2 sen per share in 2008-2009, respectively, dividends should rise to about 18-19 sen per share in those two years. That will earn shareholders very attractive gross yields of 13.2%-14%.
CSC's shares are trading at only 3.9 times our estimated earnings in 2008 and well below its latest reported net tangible assets of RM1.94 per share. Such low valuations would limit the stock's downside risks. The stock will trade ex-entitlement for interim dividend of 6.5 sen per share on Aug 27.
Nestle ups dividends in 2008
Consumer companies tend to enjoy more resilient demand and steadier earnings. Hence, they tend to have stable and higher-than-market average dividend payouts. The current downtrend in commodity prices would also bode well for earnings going forward.
Despite rising raw material costs, Nestle's (RM27.25) 1H08 net profit grew nearly 24% year-on-year (y-o-y) to RM176.1 million - on the back of demand increases and stronger exports. The company paid 61.19 sen per share special dividends earlier this year and has proposed another 50 sen per share interim dividends. The entitlement date was fixed for Aug 26. Assuming total dividends of 171.2 sen per share for 2008, shareholders will earn a net yield of 6.3%.
Amway maintains steady dividends
Direct selling company Amway (RM6.85) is also doing pretty well. Net profit was about 24% higher y-o-y in 1H08 at RM42.7 million. The company has been paying dividends very consistently over the years. With minimal capital expenditure required, Amway usually distributes the bulk of earnings back to shareholders.
Dividends are expected to total 61 sen per share in 2008. That translates into gross yield of 8.9%. Its shares are also trading at fairly decent valuations of roughly 12.9 and 12.1 times our estimated earnings of 53 sen and 56.8 sen per share in 2008-2009, respectively.
Note: This report is brought to you by Asia Analytica Sdn Bhd, a licensed investment adviser. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.
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