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P/E Is The Wrong Measure

September 30, 2011 Leave a comment

Blogging buddy Andrew Hallam wrote a couple of months ago about how he was able to get Berkshire Hathaway shares for free. As he rightly illustrates, when the share prices approaches or falls below the book value of a business (what accountants say it’s worth) it can be a great opportunity. There’s still a possibility that management will waste that value and leave shareholders with nothing but I don’t see BH going that way.

That got me thinking… what Andrew is really saying is that you could buy the shares, receive assets of an equal value, and get the future earnings of the business for free. If you bought the whole company you could sell off the assets for the price you paid, ignoring the value of the future revenue.

Normally when we measure stock valuations we look at the P/E ratio which compares the total price of the shares (including asset values) to the earnings. What does this tell us? You could say that earnings have some relationship to assets which are needed to create them, but that’s likely to vary between different industries. If you buy shares in a $500m company that has $250m in assets and $50m in earnings, you’re really buying $250m in assets and paying another $250m just for the future earnings. But we overlook that with the P/E ratio and just say you’re buying $50m in earnings for $500m today.

On the other side, “value” indexes and strategies are often built on the price-to-book ratio which tells you how much you’re paying for the assets above their regular value. This tells us a bit more since it gets closer to the actual future value of the company, but if different companies need different levels of assets to produce the same earnings that will throw off the ratio. A P/B ratio of 3 in some industries might even be equivalent to 15 in others if they need much less assets!

It would be interesting to look at what you pay for a stock above the book value, and then compare that to the earnings. In other words Price – Book, divided by Earnings (call it ERV for Earnings Valuation). With the example above the company’s ERV ratio would be (500-250)/50 = 5x earnings, compared to a P/E ratio of 10x and P/B of 2x. This puts the assets to one side and measures what you’re really paying for the future income. However I’m not sure if this would be a useful measure at the market index level since there could be a lot of variation between companies and industries. And even though this sets aside the assets, we know that the company couldn’t earn the same revenue without those assets so they do have to be packaged in with the rest of the business.

It may be more useful as a way to see when a certain company is performing better than the rest of their industry by generating similar earnings with less assets. In a way this combines the P/E and P/B ratios into one number. Looking at Andrew’s example at $70/share, Berkshire Hathaway would have an ERV ratio of 1.2x earnings! This shows that 1.2 years after he bought the shares he will get an equal value back from the accumulated earnings and the assets (assuming no changes in asset values or earnings). If the price was twice the book value instead ($128.44), the ERV would be much higher at 13.3x.

If this is useful at all at the market level, it might be to signal when the market has more of a “value” orientation since it compares what shareholders pay above book value to get the earnings, instead of relating the price to the book value and ignoring the earnings.

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Investment Opportunities in Small Businesses?

September 29, 2011 Leave a comment

John Kay’s interesting commentary continues with a recent FT article going into detail on the way banking has shifted from supporting other businesses to supporting itself. Put together with his earlier commentary on the 90s asset bubble where investment markets were twisted to reward entrepreneurs before they did the hard work (just as bank executives are sometimes rewarded for not doing their job now), this paints an interesting picture.

As he claims, large companies generate a lot of cash already to cover their spending and get more from the stock and bond markets without having resort to ordinary bank loans. In other words they would mostly be serviced by investment banks. Smaller businesses (which generate a lot of economic activity because they have more growth potential) can’t raise capital that way so they rely on bank loans, but those loans have dried up in the last few years. Presumably this means that ordinary bank deposits are used more for proprietary trading and the like rather than business loans.

This has interesting results on two levels. As a large-scale policy, it makes sense that we would want to have more lending to the small businesses that generate a lot of economic activity and are being dragged down now. A government response aimed at this might have the impact we need right now in North America.

But this could also have an effect on the individual investor. If small businesses are being held back mostly by a lack of capital because no one is looking at them, private investors might be able to step in and fill the void. In turn they should earn a good return for taking this risk and providing this valuable service. The investors get additional returns, the businesses get the capital to expand, and the the economy turns up a bit.

It might seem that this would be risky because you can’t save the whole economy just by lending to one business. There are some businesses that will only survive if the economy does well, but there are others that can make good returns in the current environment. And if their increasing success and the resulting spending and investment helps support other businesses, it just might start a growth feedback cycle and increase their success.

This opportunity is a bit limited because the average person doesn’t have the knowledge and skills to evaluate the future prospects for a small business, or much capital to risk in a loan to it. It would take some diversification because you can’t bet everything on one business. But for those who have a suitable level of capital and experience (such as a few million earned from their own business) there could be a lot of attractive loans to make. And it’s worth keeping in mind in case any opportunities to get involved in a small way come up.

Not all small businesses deserve more credit – the majority might just be too risky – but it seems that some do need more and would reward investors who have the foresight to get involved. In fact if there’s enough opportunity here it might make sense for investors to create an organization that would gather capital in small amounts, review businesses that need loans to determine their creditworthiness, administer the loans, and spread out the risk. You could call it a Business Association for New Credit.

Index Picking Is The New Stock Picking

September 27, 2011 6 comments

It’s commonly said is that stock picking was easier a long time ago (50, 70, or 100 years ago) but the market is getting more efficient so it’s harder to beat an index by picking individual stocks now. This has led many investors to use index funds these days, and I’m among them. But in investing every success is self-defeating when it goes too far. This could lead to opportunities for investors who are informed and have the right emotional balance.

It seems that markets are moving more and more as a whole, especially in the last 10 years. This comes from a variety of effects. Individual investors will frequently sell their stock funds (which are either index funds or closet index funds) causing the whole market to go down since their funds cover most of the market. Or institutions that have a very broad asset exposure and get into trouble will sell one asset class to rescue another, causing a whole market to drop for reasons that have nothing to do with it. On the other side I’m not sure yet if a rising market would draw in more indexed capital or if people would try picking stocks for even bigger wins (see 1999).

In reality the fundamentals have not changed. A large part of the market is driven by emotion (even professional investment administrators at institutions that pick other professional managers to handle the money have to face the emotions of justifying their job every year). The actual amount of capital that’s driven by rational investors seems pretty small sometimes, although they do have a tendency to make money over time and have more to work with. What’s happened (starting around 40 years ago) is that instead of individual stocks bouncing around wildly on top of peoples’ shifting emotions, this effect is being transferred to markets as a whole.

This has interesting implications for thoughtful investors. If stock picking is dead, is “index picking” the new opportunity? This could include a variety of ways to adjust weightings between different indexes. I keep substantial positions in the indexes that interest me and adjust the allocations slightly when I think there’s an opportunity. Someone who’s more confident might only be invested in 4 of the 10 indexes they’re interested in depending on the current conditions.

Stock picking also may not be dead. With increased index following stocks may move together more often and with more active managers the opportunities may be smaller and shorter. But if a whole market is driven down or pushed up it’s likely that some of the individual companies in it don’t belong in the same boat. I’m not interested in stock picking at this point though because the best picks can be dragged down when the whole market is punished. Using indexes allows me to work at a higher level and have more options for diversification without having to do a lot more research.

What’s really required to “beat the average” is to have a better emotional balance than the average influencer (not the average investor since some investors answer to someone else). For example this might mean making decisions on a 10-year time-frame while everyone else is thinking about the next 3 months. If you can do this there are many ways to apply it.

The math is clear: the average person is not above average and never will be. When it comes to advice that anyone can follow, the average returns from the capital markets are generally fair and we’re lucky to have them available to us. If I have to “settle” for average returns that’s perfectly fine. But if I can put the cold metallic side of my heart to work and earn a slightly higher return I’m willing to experiment with that.

Buying On Dips Not A Good Idea?

September 26, 2011 Leave a comment

Jason Zweig’s recent WSJ article points out that buying more stocks when prices drop may not be a wise strategy if they rose so much before that the prices are still at a high level. In effect the common advice to “buy on dips” may be misguided. The market can and often does drift slowly in one direction until a sharp move gets headlines.

The argument is right. If you can buy before the initial rise that’s better than buying after the small dip that follows. But that depends a lot on the options and knowledge you have at the start. Taking his example based on the last 10 years, you couldn’t take everything you invested over that time and put it in as a lump sum at the start of the decade. Even if you could, you didn’t go into it knowing what stocks would do. And if you keep some capital out of one stock market that doesn’t mean it has to be in cash. It could go to other less correlated markets, to bonds, or to other defensive but productive assets. Even buying gold 10 years ago would have had good results.

As an example, at the start of the year I thought that stock markets might be just a little above fair value and held a small bond allocation to protect against and profit from possible drops. That bond index has returned over 7% since the start of the year while stocks have had a good series of declines which makes me lucky. But that’s just what actually happened. If you asked me then I would have guessed at further gradual increases in stock prices and falling bond prices. In that case if prices rose until now and then had one 5% drop, it wouldn’t make sense to buy more stocks because I could have gotten a better deal by having more in stocks at the start of the year. Without knowing which of those scenarios will happen we have to be prepared for both.

The other side is that buying before the increase doesn’t do you much good unless you can also sell before the market returns to its original level. This won’t happen all the time, but in a period such as the late 90s you could buy early and then have prices go up. But if you just held on and did nothing, they would soon fall back to their original level or below. Whenever there are unsustainable increases I would prefer to do some selling on the way up to actually keep some of the gains.

As the article illustrates, the important thing is not to think that a dip in prices means they are cheap. You need to look at the bigger picture. If the stock market hits a P/E of 25 and then has a 3% drop I’m not going to rush out and buy more because I’m not confident going all out on an investment with an earnings yield of 4%. What I like even more than a nice 5% drop is a headline raising alarm about how much the market has dropped in the last 3 months. Since I don’t watch the market daily all kinds of headlines can be a useful reminder to check where it’s at now.

Stock Dividend Yields Go Above Bonds

September 23, 2011 Leave a comment

I recently updated some key indicators I track for the indexes I use. In the process I noticed that with the fall in bond yields and stock prices recently there are places where you can get a major stock index with a dividend yield greater than the yield on bonds. For example the TSX Composite dividend yield appears to be around 2.75% now while the DEX Universe bond index yield to maturity is around 2.4%.

Not only is there a fairly good gap between bond yields and stock earnings, but you could actually get more cash immediately from holding stocks. Combined with the likely price increases following somewhat below-average stock valuations, this makes quite a difference from the start of the year when bond yields were close to 1% higher and stock earnings yields were about 1.5% lower

The main risk remaining is that the drop in stock prices could be predicting a worsening economic environment where stock earnings fall and dividends might get cut. Then again economic indicators have predicted 9 of the last 6 recessions and stocks are for specific companies, not the whole economy. Other than that one risk it looks like stockholders are collecting a nice risk premium these days.

This has the potential to shift allocations for those who are willing to make short-term adjustments. I’m not making any major moves just yet but this is something to keep in mind, and if valuations keep getting better with falling stock prices I may be looking for any extra cash I can throw into my portfolio.

As pointed out by several researchers, stock dividend yields have largely been below bond yields since the 1960s. In fact some data from Robert Shiller shows that the S&P 500 dividend yield stayed below the US government 10-year bond yield from 1960 to 2009 after generally being higher before that. There are many ways to measure this so what I’m seeing might not be a big reversal.  But what was old may yet be new again. As I wrote recently this is one of the many benefits of market crashes. We may fall into a good market for investors soon!

Less Goals, More Systems

September 19, 2011 Leave a comment

There’s more than enough motivational blogs so I’m not about to turn this into one, but personal finance is closely related to goals so once in a while it helps to review them. I recently came across a great piece by Scott Adams explaining why systems are more useful than goals. I’ve found this to be true myself.

Some financial goals have repeated themselves year after year for lack of a clear way to actually get there. Recently I’ve cut back on all of that and re-focused on doable next steps. Although the goals are lower, they help direct the action needed to get there and once they are reached I can aim for something bigger. The momentum from consistently meeting and exceeding realistic goals is also a psychological tool that’s literally worth a fortune. Although improving your situation by 30% in a year might not sound like a lot when you’re starting from a low point, that can compound every year just like a 30% investment return would.

When it comes to investments I have no goals related to specific portfolio values, just conservative estimates that I can adjust over the next 20 years. The only goals I do set are related to things I fully control such as how much is added to the portfolio. If you’re struggling with something, making yourself “attempt” it like Scott Adams does might be a good tool too.

Currently I don’t see that being necessary since I’m liable to invest (and work out) a little more than I should if left unchecked. But if you can set up automatic transfers to do what you need every month, then you don’t even need a goal – you just need to avoid crashing the system. This is a powerful tool that I use a lot.

Are your goals closer to wishful thinking of practical actions? Do you have clear steps to get there?

Multinational Risks

September 16, 2011 Leave a comment

It’s now becoming commonplace to buy stocks in one country and get exposure to many others due to large multinational companies that are increasing their sales and profits outside their home countries. This is a good thing, although we have to be careful not to assume our investment is exposed only to one country. But are there some risks that come with it?

In recent months we have been reminded of the lack of transparency from popular companies in China, and in recent years we have seen British savers lose money that they put in Iceland’s banks because the laws they were used to didn’t reach that far. Getting accurate information and being protected by ownership and contract laws is something we take for granted but for many people it’s not the way things work.

Although these cases all relate to companies that clearly went too far, it’s also widely known that many large and stable companies are increasingly holding assets outside of developed countries to minimize their taxes. There is certainly some chance that this reduces transparency and increases property risk, and not just for Canadian miners that keep having their assets nationalized in South America. The risks could affect the companies themselves, if managers have greater opportunities for fraud in less-regulated countries, or investors if they just can’t figure out what the company actually has.

It wouldn’t be surprising to see more cases of this coming up in the future. Hopefully it remains isolated so we can reduce the risks by not concentrating our investments in a few companies. But the right opportunities and incentives for taking advantage of corporations could turn it into a much larger risk that affects all investors at some point.

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