Accumulating wealth for retirement is a basic goal of every investor. For many people, the vast majority of their retirement wealth is contained in a tax deferred or tax free investment vehicle. In fact, it is not at all uncommon to run across a couple with 80 to 90% of their entire networth in either 401(k)s, IRAs, Roth IRAs, or some combination of the three. Furthermore, many of these diligent savers go to great lengths to ensure that they maximize their tax-deferred contributions and invest those assets as prudently as possible to maximize wealth in retirement. Why then do so many investors fail to fill out even a few of the most basic estate planning documents to ensure that their nest eggs are used as intended in life, and make it intact to their loved ones upon the investor's death?
One quick example of the latter instance (passing assets along to the next generation) should suffice to show the importance of making sure you do the paperwork. The beneficiary form is easily the single most important estate planning document when dealing with IRAs and Roth IRAs. The beneficiary form controls who will get the investment portfolio and how long they will be able to keep it. What a shame if your loved ones don't get assets intended for them or can't take full advantage of the tax deferred feature of an IRA, or tax free feature of a Roth. Yet it happens all of the time because people fail to fill out a simple beneficiary form, instead relying on their will to take care of the distribution of assets after their death. Here's the problem though!
An individual who inherits an IRA without being named on the beneficiary form will not be considered a designated beneficiary, and that makes a HUGE difference. (An estate has no life expectancy and is never a designated beneficiary even when it is named as the default beneficiary, which is common in plan documents) Inherited IRAs and Roth IRAs must be emptied within 5 years of the death of the owner if the owner dies before the Required Beginning Distribution (RBD) date (always the case in a Roth since there is no RBD). Think about what that little oversight - not filling out a beneficiary form - just cost your heir! Rather than being able to allow assets to continue to grow tax-deferred for decades longer, your heir will be forced to empty the IRA - AND PAY INCOME TAX - no later than 31 December of the fifth year following your death. It's even worse when dealing with a Roth IRA since assets in a Roth can be held tax free and allowed to compound for decades as the beneficiary stretches out tax-free distributions over their lifetime, making for a considerably larger ultimate transfer of wealth between generations.
Failure to fill out a simple beneficiary form for your IRA or Roth IRA is just one example of an estate planning oversight that can cost your family dearly. Take a few minutes to review your beneficiary forms to make sure it doesn't happen to you. And then take some time to review your other estate planning documents as well....
Tuesday, March 30, 2010
Tuesday, March 23, 2010
High Risk Market STILL
The S&P 500 is overvalued by about 25%, but you wouldn't necessarily know it if you listened to the mass financial media. Fair value for the S&P 500 is around 900, based on how the market has been valued historically using 10-year trailing earnings as a measure. Again, you might be lulled into thinking the market is undervalued if you spend too much time listening to CNBC (Heehaw), or reading the likes of Barron's or the Wall Street Journal. Likewise, many of the brokerage firms are busy talking to clients and telling them now is the time to buy, buy, buy!
The only problem with that self-serving assessment is that it probably isn't true. Again, the S&P 500 is about 25% overvalued if history means anything at all. One of the best long-term measures of stock market valuation is the Price-to-Earnings (P/E) ratio, based on trailing 10-year average earnings (commonly known as Shiller's P/E). The current Shiller's P/E is about 20, well above the long run average of 15x - 16x, putting the current market in the top quartile in terms of EXPENSIVE. But why should you care if you are a long-term investor? Isn't it conventional wisdom to buy and hold your investments rather than "time" the market? And doesn't the Efficient Market Hypothesis tell us that no one can outperform the market by timing the market anyway? (since the market is always "correctly" priced given the known information), and therefore everyone should always be invested all of the time if they have a long-term time horizon?
In fact, you should care, because likely three year investing returns change drastically when buying into an expensive market - and your typical friendly neighborhood stockbroker (a.k.a. fee-based advisor) won't necessarily tell you that since they operate under the convenient assumption that stock market returns are unpredictable and, "oh what the heck, let's just always stay invested". Reality is somewhat different from that party line, however, and can lead to LOOONNGGG periods of time needed to recoup market losses for those investors who stay aggressively invested during high risk markets.
First the return assumptions typically used by advisors...
The standard return assumptions based on 125 years of data are: a normally distributed set of returns for a 3-year holding period averaging 9.5%, including dividends; a 15% probability of investors losing money over the 3-year period, a slight possibility of tripling their money and a slight possibility of losing around 80% over three years. The standard return assumptions in fact are merely past history projected into the future. But what if those return assumptions are wrong? What if the actual returns for a 3-year holding period where only 7% annually on average with a 28% probability of losing money during the 3-year holding period? Would you be quite so eager to own stocks then?
Probably not. And, as it turns out, the current Shiller P/E of 20 does create a return distribution in line with the second scenario. Shiller P/Es of 19.2 or higher produce return results averaging a mere 7% per annualized 3-year holding period with a likelihood of losses 28% of the time, according to Keith C. Goddard, CFA (Goddard used Professor Shiller's work on stock market price-to-earnings as his base data). Would individual investors make the same allocation decisions if they knew they had a 28% probability of losing money over a 3-year period rather than only a 15% probability of losing money? Again, probably not, if our experience with investors is representative.
Now, throw in the fact that the broad money supply is still in contraction (real M3 contracting is a 100% accurate indicator of recession 6 months down the road) and the already expensive market becomes an exceedingly dangerous one. Investors should plan accordingly....
(Biechele Royce Advisors will continue to buy good companies at great prices when we can find them, but continues to currently see very little of interest, which also indicates an expensive market.)
The only problem with that self-serving assessment is that it probably isn't true. Again, the S&P 500 is about 25% overvalued if history means anything at all. One of the best long-term measures of stock market valuation is the Price-to-Earnings (P/E) ratio, based on trailing 10-year average earnings (commonly known as Shiller's P/E). The current Shiller's P/E is about 20, well above the long run average of 15x - 16x, putting the current market in the top quartile in terms of EXPENSIVE. But why should you care if you are a long-term investor? Isn't it conventional wisdom to buy and hold your investments rather than "time" the market? And doesn't the Efficient Market Hypothesis tell us that no one can outperform the market by timing the market anyway? (since the market is always "correctly" priced given the known information), and therefore everyone should always be invested all of the time if they have a long-term time horizon?
In fact, you should care, because likely three year investing returns change drastically when buying into an expensive market - and your typical friendly neighborhood stockbroker (a.k.a. fee-based advisor) won't necessarily tell you that since they operate under the convenient assumption that stock market returns are unpredictable and, "oh what the heck, let's just always stay invested". Reality is somewhat different from that party line, however, and can lead to LOOONNGGG periods of time needed to recoup market losses for those investors who stay aggressively invested during high risk markets.
First the return assumptions typically used by advisors...
The standard return assumptions based on 125 years of data are: a normally distributed set of returns for a 3-year holding period averaging 9.5%, including dividends; a 15% probability of investors losing money over the 3-year period, a slight possibility of tripling their money and a slight possibility of losing around 80% over three years. The standard return assumptions in fact are merely past history projected into the future. But what if those return assumptions are wrong? What if the actual returns for a 3-year holding period where only 7% annually on average with a 28% probability of losing money during the 3-year holding period? Would you be quite so eager to own stocks then?
Probably not. And, as it turns out, the current Shiller P/E of 20 does create a return distribution in line with the second scenario. Shiller P/Es of 19.2 or higher produce return results averaging a mere 7% per annualized 3-year holding period with a likelihood of losses 28% of the time, according to Keith C. Goddard, CFA (Goddard used Professor Shiller's work on stock market price-to-earnings as his base data). Would individual investors make the same allocation decisions if they knew they had a 28% probability of losing money over a 3-year period rather than only a 15% probability of losing money? Again, probably not, if our experience with investors is representative.
Now, throw in the fact that the broad money supply is still in contraction (real M3 contracting is a 100% accurate indicator of recession 6 months down the road) and the already expensive market becomes an exceedingly dangerous one. Investors should plan accordingly....
(Biechele Royce Advisors will continue to buy good companies at great prices when we can find them, but continues to currently see very little of interest, which also indicates an expensive market.)
Friday, March 12, 2010
Roth IRA Conversions
"Roth conversions can trigger unintended tax traps and financial problems that are not being addressed in the mounds of 2010 Roth conversion information that currently dominates the media, " Ed Slott wrote recently in his newsletter, "Ed Slott's IRA Advisor."
Biechele Royce Advisors is fielding an increasing number of inquiries from clients and the public regarding Roth conversions. Roth conversions are a hot topic because the income cap for conversions was removed permanently starting in 2010 and the IRS is allowing investors to defer taxes on converted IRAs in 2010 only, until 2011 and 2012 (You can choose to pay 100% of the taxes owed in 2010 or pay tax on half the converted amount in 2011 and on the other half in 2012). A quick review of the main differences between a Roth and a regular IRA might help frame the conversion discussion.
IRAs are funded with pre-tax dollars, reducing an investor's tax bill in the year of the contribution. IRA investments grow tax deferred, but an investor is required to pay income tax on all distributions, which are allowed without penalty when the investor turns 59 1/2 years-old. Required minimum distributions (RMD) kick in once the investor turns 70 1/2. The Roth IRA is funded with after-tax dollars, which means no reduction in your current tax bill. However, you will never pay tax again on your Roth investments and there are no required distributions, making the Roth a very attractive option for anyone who meets the income requirements.
Investors have had an option to convert from an IRA to a Roth for years, but only if they made less than $100,000 annually. All investors are eligible to convert staring in 2010 however, and many investors are weighing the pros and cons as a result. Unfortunately, there is no simple answer to the conversion question and each situation must be reviewed individually. There are, however, a couple of basics to keep in mind when deciding whether a conversion makes sense. Roth conversions are most appealing to clients who have significant IRAs and wouldn't touch them if it weren't for the required minimum distributions (RMD). Roth IRAs are a much better estate planning vehicle since investors aren't required to take RMDs and can therefore leave more assets in a tax free investment vehicle for future generations. And unlike an IRA, which requires beneficiaries to pay income tax on inherited IRAs when taking distributions, Roth IRA distributions are tax free! As well, conversions are attractive to those investors who would owe very little additional income tax on conversion. Future expected income tax rates figure promonently into your calculations here. Income taxes are expected to rise sharply in coming years, which means many of us might be in a higher income tax bracket in retirement, making a conversion now more appealing. On the other hand, you may have less income in retirement, putting you into a lower tax bracket. One last piece of advice on conversion: it is almost never a good idea to pay the taxes generated from a conversion from the IRA since you want as much of your money to grow tax free as possible. Consequently, conversion becomes much less attractive if you don't have money set aside to pay the taxes. The bottom line on the conversion question? Consult with a trained investment professional (CFA) or a CPA for guidance.
Now that you've decided to convert, making sure to avoid the numerous tax traps and pitfalls takes some planning.
First, investors who choose to split the tax bill must understand that it is highly unlikely that the tax bill will be the same in 2011 and 2012. The total tax bill will depend on various factors including tax rates (which could well go higher) and overall income. Also, beware paying the conversion tax with IRA money if you are under 59 1/2 - you will unwittingly trigger the 10 percent penalty. You will also trigger the 10% penalty if you withdraw converted money within 5 years of conversion if you are under 59 1/2. Simple IRAs have a two-year holding period and can not be converted sooner; the IRS will treat it as a taxable distribution! Non-spouse beneficiaries can't convert an inherited IRA but can convert an inherited plan. Don't roll the inherited plan into an IRA and then try to convert or you will have a problem. As well, rolling a plan mid-year into an IRA after converting your IRA to a Roth will lead to a bigger tax bill than anticipated given how the pro rata rule is calculated (only applies if you have basis in your 401(k). Also, for those of you who are already taking required minimum distributions (RMD), you can't roll your entire IRA into a Roth without first taking the required distribution - you will owe taxes one last time! Oh, and for those of you hoping your child will qualify for tuition assistance... remember that tuition assistance is based on income not retirement assets. Converting your IRA to a Roth may disqualify your child from receiving assistance!
There are a number of other tax traps and gotchas that you must carefully consider before making your conversion. Please consult a knowledgeable investment professional before converting willynilly and inadvertently triggering unnecessary taxes and penalties. Qualified professionals include CPAs, CFAs, and CFPs.
Biechele Royce Advisors is fielding an increasing number of inquiries from clients and the public regarding Roth conversions. Roth conversions are a hot topic because the income cap for conversions was removed permanently starting in 2010 and the IRS is allowing investors to defer taxes on converted IRAs in 2010 only, until 2011 and 2012 (You can choose to pay 100% of the taxes owed in 2010 or pay tax on half the converted amount in 2011 and on the other half in 2012). A quick review of the main differences between a Roth and a regular IRA might help frame the conversion discussion.
IRAs are funded with pre-tax dollars, reducing an investor's tax bill in the year of the contribution. IRA investments grow tax deferred, but an investor is required to pay income tax on all distributions, which are allowed without penalty when the investor turns 59 1/2 years-old. Required minimum distributions (RMD) kick in once the investor turns 70 1/2. The Roth IRA is funded with after-tax dollars, which means no reduction in your current tax bill. However, you will never pay tax again on your Roth investments and there are no required distributions, making the Roth a very attractive option for anyone who meets the income requirements.
Investors have had an option to convert from an IRA to a Roth for years, but only if they made less than $100,000 annually. All investors are eligible to convert staring in 2010 however, and many investors are weighing the pros and cons as a result. Unfortunately, there is no simple answer to the conversion question and each situation must be reviewed individually. There are, however, a couple of basics to keep in mind when deciding whether a conversion makes sense. Roth conversions are most appealing to clients who have significant IRAs and wouldn't touch them if it weren't for the required minimum distributions (RMD). Roth IRAs are a much better estate planning vehicle since investors aren't required to take RMDs and can therefore leave more assets in a tax free investment vehicle for future generations. And unlike an IRA, which requires beneficiaries to pay income tax on inherited IRAs when taking distributions, Roth IRA distributions are tax free! As well, conversions are attractive to those investors who would owe very little additional income tax on conversion. Future expected income tax rates figure promonently into your calculations here. Income taxes are expected to rise sharply in coming years, which means many of us might be in a higher income tax bracket in retirement, making a conversion now more appealing. On the other hand, you may have less income in retirement, putting you into a lower tax bracket. One last piece of advice on conversion: it is almost never a good idea to pay the taxes generated from a conversion from the IRA since you want as much of your money to grow tax free as possible. Consequently, conversion becomes much less attractive if you don't have money set aside to pay the taxes. The bottom line on the conversion question? Consult with a trained investment professional (CFA) or a CPA for guidance.
Now that you've decided to convert, making sure to avoid the numerous tax traps and pitfalls takes some planning.
First, investors who choose to split the tax bill must understand that it is highly unlikely that the tax bill will be the same in 2011 and 2012. The total tax bill will depend on various factors including tax rates (which could well go higher) and overall income. Also, beware paying the conversion tax with IRA money if you are under 59 1/2 - you will unwittingly trigger the 10 percent penalty. You will also trigger the 10% penalty if you withdraw converted money within 5 years of conversion if you are under 59 1/2. Simple IRAs have a two-year holding period and can not be converted sooner; the IRS will treat it as a taxable distribution! Non-spouse beneficiaries can't convert an inherited IRA but can convert an inherited plan. Don't roll the inherited plan into an IRA and then try to convert or you will have a problem. As well, rolling a plan mid-year into an IRA after converting your IRA to a Roth will lead to a bigger tax bill than anticipated given how the pro rata rule is calculated (only applies if you have basis in your 401(k). Also, for those of you who are already taking required minimum distributions (RMD), you can't roll your entire IRA into a Roth without first taking the required distribution - you will owe taxes one last time! Oh, and for those of you hoping your child will qualify for tuition assistance... remember that tuition assistance is based on income not retirement assets. Converting your IRA to a Roth may disqualify your child from receiving assistance!
There are a number of other tax traps and gotchas that you must carefully consider before making your conversion. Please consult a knowledgeable investment professional before converting willynilly and inadvertently triggering unnecessary taxes and penalties. Qualified professionals include CPAs, CFAs, and CFPs.
Friday, March 5, 2010
A Market of Stocks - The Art of Stockpicking
(Excerpt from my October 2008 "From The Bleachers" Newsletter)
Perhaps this is a good time to shift to the topic indicated by the title up above, before readers decide we’re just a bit off the mark with it. Our fervent hope is to both entertain and educate our readers on the art of stock picking for – as the title declares – it is a market of stocks not a stock market in which we invest. To be fair, we are contrarian by nature, and a bit old fashion to boot. We recognize that index funds exist, that exchange traded funds are available with which to place your bets on red, black, or even green, but we prefer to build a portfolio the old fashion way, one well researched stock at a time. We hesitate to declare that we’re looking for an undervalued business in which to invest since we will almost assuredly be (mis)labeled as a value investor. So we will avoid the claim. Rather, we simply recognize that a share of stock means a share of ownership in a corporation which entitles the stock holder to a share of the profits, should there be any.
Now oddly enough, we have found over the years that companies that make increasing amounts of money are deemed more valuable (eventually) to investors than those who don’t, and the stock price of said company invariably rises over time as a result of the increasing stream of cash finding its way into the shareholders’ pocket, a truly wonderful outcome for those of us who enjoy turning a profit with our investing. It is our belief that we are buying ownership in a business that guides our search. Not for us the pursuit of a stock, simply because it is rising – that game belongs to the many speculators who invest with a six to twelve month time horizon. Speculators they are because they invariably buy a stock in the hope that it will trade higher in the coming quarters, allowing them to sell at a tidy profit and move on to the next piece of paper. The many mutual fund managers, institutional asset managers, and individuals who choose to rent a stock (and we are now fairly describing upward of 90% of the investors out there) are not interested in the value of the underlying business. They care only whether the stock price will rise in the short run, and turn to such devices as earnings revisions, upside surprises, relative strength indicators and insider buying to divine the short term future of a company’s stock price. We, on the other hand, care very much what price we pay for a company. Just as we choose not to overpay for a car, house, vacation, or that big flat panel TV that makes Peyton Manning’s flapping and stomping prior to the snap looking even more like a blue heron dancing in the shallows (Of course we are fans, season ticket holders as a matter of fact).
Don’t misunderstand however. We have owned all manner of stocks in our 20 years of investing. Technology stocks, drug companies (back when big pharma was considered a growth industry), the King of Beers, and the royalty of soda pop (Coke) have all found their way into our portfolios. We will buy anything in any industry if the price is right, and we are very patient in waiting for that happy event to occur. For instance, Coke was the poster child of expensive back in the late 1990’s, peaking in the vicinity of 55 times earnings if we remember correctly. We even used it as a marvelous example of a great company that was no longer a great investment. But we didn’t hesitate to pay some 20 times earnings in 2005, with the stock in the low 40s, nor did we hesitate to sell it some two years later in the high 50s when the price-to-earnings multiple no longer matched the company’s growth prospects. A market of stocks, not a stock market, and stocks as certificates of ownership in an ongoing business – two of the guiding principles of our investment philosophy.
INTC $14.28
Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.
In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.
In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams often choose to buy back shares with excess cash. We think it unfortunate, because managers tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.
Yet another way to do the math without the distortion of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.
A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.
The company is currently the world’s largest semiconductor chip maker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.
For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).
Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.
Perhaps this is a good time to shift to the topic indicated by the title up above, before readers decide we’re just a bit off the mark with it. Our fervent hope is to both entertain and educate our readers on the art of stock picking for – as the title declares – it is a market of stocks not a stock market in which we invest. To be fair, we are contrarian by nature, and a bit old fashion to boot. We recognize that index funds exist, that exchange traded funds are available with which to place your bets on red, black, or even green, but we prefer to build a portfolio the old fashion way, one well researched stock at a time. We hesitate to declare that we’re looking for an undervalued business in which to invest since we will almost assuredly be (mis)labeled as a value investor. So we will avoid the claim. Rather, we simply recognize that a share of stock means a share of ownership in a corporation which entitles the stock holder to a share of the profits, should there be any.
Now oddly enough, we have found over the years that companies that make increasing amounts of money are deemed more valuable (eventually) to investors than those who don’t, and the stock price of said company invariably rises over time as a result of the increasing stream of cash finding its way into the shareholders’ pocket, a truly wonderful outcome for those of us who enjoy turning a profit with our investing. It is our belief that we are buying ownership in a business that guides our search. Not for us the pursuit of a stock, simply because it is rising – that game belongs to the many speculators who invest with a six to twelve month time horizon. Speculators they are because they invariably buy a stock in the hope that it will trade higher in the coming quarters, allowing them to sell at a tidy profit and move on to the next piece of paper. The many mutual fund managers, institutional asset managers, and individuals who choose to rent a stock (and we are now fairly describing upward of 90% of the investors out there) are not interested in the value of the underlying business. They care only whether the stock price will rise in the short run, and turn to such devices as earnings revisions, upside surprises, relative strength indicators and insider buying to divine the short term future of a company’s stock price. We, on the other hand, care very much what price we pay for a company. Just as we choose not to overpay for a car, house, vacation, or that big flat panel TV that makes Peyton Manning’s flapping and stomping prior to the snap looking even more like a blue heron dancing in the shallows (Of course we are fans, season ticket holders as a matter of fact).
Don’t misunderstand however. We have owned all manner of stocks in our 20 years of investing. Technology stocks, drug companies (back when big pharma was considered a growth industry), the King of Beers, and the royalty of soda pop (Coke) have all found their way into our portfolios. We will buy anything in any industry if the price is right, and we are very patient in waiting for that happy event to occur. For instance, Coke was the poster child of expensive back in the late 1990’s, peaking in the vicinity of 55 times earnings if we remember correctly. We even used it as a marvelous example of a great company that was no longer a great investment. But we didn’t hesitate to pay some 20 times earnings in 2005, with the stock in the low 40s, nor did we hesitate to sell it some two years later in the high 50s when the price-to-earnings multiple no longer matched the company’s growth prospects. A market of stocks, not a stock market, and stocks as certificates of ownership in an ongoing business – two of the guiding principles of our investment philosophy.
INTC $14.28
Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.
In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.
In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams often choose to buy back shares with excess cash. We think it unfortunate, because managers tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.
Yet another way to do the math without the distortion of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.
A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.
The company is currently the world’s largest semiconductor chip maker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.
For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).
Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.
Monday, March 1, 2010
Stock Picking
"So is there a reasonable expectation that a reasonably intelligent consumer can pick stocks?" was the question put to me by a friend. "That would be a challenge to blog on without it sounding like a sales pitch," he went on to write.
Indeed it will be, but I LIKE a challenge! Before I answer the question however, I need to tell you a little bit about myself so that you will better understand my world view...
The CFA Institute awards the Chartered Financial Analyst (CFA) designation to individuals who complete a three-year post MBA graduate program in finance, economics, accounting, statistics, and investing, and who have worked in the industry for at least three years. CFAs are trained as institutional investors and are hired by mutual fund companies, banks, insurance companies, and pension plans, among others, to invest assets on their behalf. My own background includes a 12-year run as a hedge fund manager ($55 million in assets and a tout in 2001 by Barrons as a top fund manager). As well, I've spent over 15 years dealing with individual investors and have learned quite a bit that the CFA textbooks don't teach an aspiring candidate. With all of that out on the table... here's my answer to stock picking for the masses.
Absolutely it is reasonable to expect that a reasonably intelligent consumer can (successfully) pick stocks! In fact, I could teach a person with average intelligence how to outperform the stock market by a wide margin over multi-year periods of time in just a few hours of instruction. Intellectually it just isn't that hard! Wanna beat the U.S. stock market over five-year periods? Piece of cake! Simply focus on companies with solid balance sheets, free cash flow, and which are trading in the bottom quintile of all stocks based on price to sales and/or price to book. You will outperform magnificently over 5 and 10 year periods. Now you won't necessarily outperform over one or two year periods. And you might not outperform after adjusting for volatility. But you will outperform in the metric that counts most - total return!
Okay, if it is so easy then why doesn't everyone simply eschew mutual funds and build their own portfolio of stocks? Because it takes patience and discipline, and a willingness to go against the crowd. John Maynard Keynes' edict that, "it is better for reputation to fail conventionally, than to succeed unconventionally." is spot on. It is well known in professional money management circles that losing money with the crowd is not a career risk, while losing money alone most certainly is! Individual investors share the same behavioral traits as the professionals. They would rather be wrong together than risk being embarassed alone.
Buying beaten down, out-of-favor stocks takes a level of courage and contrarianism that is uncommon to say the least. I have always found it amazing that more people don't focus on buying cheap assets, which can lead to highly profitable outcomes. Instead they are filled with the gambling lust, determined to find that needle in a haystack that might become Microsoft, or Google, or Cisco. The pot of gold at the end of the rainbow leads them to speculate, for instance, in small biotech companies, instead of buying historically profitable companies when they are demonstrably cheap. And speculating is exactly what most investors are doing these days. The average holding period for a stock on the New York stock exchange has fallen to 6 months, down from 6 years 40 years ago. Now, for those of you who would like to actually invest in good companies at great prices, here's all you need to do...
Buy companies with little or no debt. The current ratio should be 1.5x or better and long term debt should not exceed equity. Buy companies with low fixed costs and profitable histories, and which throw off plenty of free cash (what's left over after all the bills are paid, including salaries). Buy companies trading close to book value with a return on equity close to 15%, and buy them when they are trading cheaply based on their own history and relative to the stock market. Read the last few annual reports and the most recent 10K and 10Q to make sure that no long term negative changes to fundamentals have occurred. Finally, don't expect to make money in these stocks over night; it might be a few years before they kick up their heels and take you to the promised land of outperformance. Do all of those things and the academic data overwhelmingly points toward a serious case of studly performance in your future. About the only thing that could ruin it for you is faint heartedness, since you will be going against the crowd, forced to justify your choices to your friends who will sneeringly tell you what a fool you are to bet on boring stuff while they are getting ready to strike it rich in Nanobiotechno Industries Incorporated! Ignore them for they are the fools chasing a pipe dream and you are the true investor buying companies on the cheap!
Indeed it will be, but I LIKE a challenge! Before I answer the question however, I need to tell you a little bit about myself so that you will better understand my world view...
The CFA Institute awards the Chartered Financial Analyst (CFA) designation to individuals who complete a three-year post MBA graduate program in finance, economics, accounting, statistics, and investing, and who have worked in the industry for at least three years. CFAs are trained as institutional investors and are hired by mutual fund companies, banks, insurance companies, and pension plans, among others, to invest assets on their behalf. My own background includes a 12-year run as a hedge fund manager ($55 million in assets and a tout in 2001 by Barrons as a top fund manager). As well, I've spent over 15 years dealing with individual investors and have learned quite a bit that the CFA textbooks don't teach an aspiring candidate. With all of that out on the table... here's my answer to stock picking for the masses.
Absolutely it is reasonable to expect that a reasonably intelligent consumer can (successfully) pick stocks! In fact, I could teach a person with average intelligence how to outperform the stock market by a wide margin over multi-year periods of time in just a few hours of instruction. Intellectually it just isn't that hard! Wanna beat the U.S. stock market over five-year periods? Piece of cake! Simply focus on companies with solid balance sheets, free cash flow, and which are trading in the bottom quintile of all stocks based on price to sales and/or price to book. You will outperform magnificently over 5 and 10 year periods. Now you won't necessarily outperform over one or two year periods. And you might not outperform after adjusting for volatility. But you will outperform in the metric that counts most - total return!
Okay, if it is so easy then why doesn't everyone simply eschew mutual funds and build their own portfolio of stocks? Because it takes patience and discipline, and a willingness to go against the crowd. John Maynard Keynes' edict that, "it is better for reputation to fail conventionally, than to succeed unconventionally." is spot on. It is well known in professional money management circles that losing money with the crowd is not a career risk, while losing money alone most certainly is! Individual investors share the same behavioral traits as the professionals. They would rather be wrong together than risk being embarassed alone.
Buying beaten down, out-of-favor stocks takes a level of courage and contrarianism that is uncommon to say the least. I have always found it amazing that more people don't focus on buying cheap assets, which can lead to highly profitable outcomes. Instead they are filled with the gambling lust, determined to find that needle in a haystack that might become Microsoft, or Google, or Cisco. The pot of gold at the end of the rainbow leads them to speculate, for instance, in small biotech companies, instead of buying historically profitable companies when they are demonstrably cheap. And speculating is exactly what most investors are doing these days. The average holding period for a stock on the New York stock exchange has fallen to 6 months, down from 6 years 40 years ago. Now, for those of you who would like to actually invest in good companies at great prices, here's all you need to do...
Buy companies with little or no debt. The current ratio should be 1.5x or better and long term debt should not exceed equity. Buy companies with low fixed costs and profitable histories, and which throw off plenty of free cash (what's left over after all the bills are paid, including salaries). Buy companies trading close to book value with a return on equity close to 15%, and buy them when they are trading cheaply based on their own history and relative to the stock market. Read the last few annual reports and the most recent 10K and 10Q to make sure that no long term negative changes to fundamentals have occurred. Finally, don't expect to make money in these stocks over night; it might be a few years before they kick up their heels and take you to the promised land of outperformance. Do all of those things and the academic data overwhelmingly points toward a serious case of studly performance in your future. About the only thing that could ruin it for you is faint heartedness, since you will be going against the crowd, forced to justify your choices to your friends who will sneeringly tell you what a fool you are to bet on boring stuff while they are getting ready to strike it rich in Nanobiotechno Industries Incorporated! Ignore them for they are the fools chasing a pipe dream and you are the true investor buying companies on the cheap!
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