"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.
Friday, March 12, 2010
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!
Thursday, February 18, 2010
High Risk Market
The S&P 500 fell almost 10% from its January 19th high to its February low. We wrote about the overbought market in our 2010 forecast and the likelihood of a 20% plus pullback sometime in 2010; the question is, has the expected decline already begun or is the market working off its overbought state by trading sideways for a few months (markets can correct in time instead of price, chopping sideways until earnings catch up with price). There is no question that the up trend from the March 2009 low is broken. Furthermore, with the 20-day moving average now below both the 50 and 100-day moving average, additional market weakness is a distinct possibility. Add in half a dozen distribution days (down days on heavy volume) since the January 19 high, and the case builds that the rally is on wobbly legs and will need to regain momentum in fairly short order if further profit taking is to be avoided (many institutional investors rely on charts to trigger buy and sell decisions, which is why charts are useful in the first place - circular reasoning I know, but very much a reality in the casino that passes for today's stock market). Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline.
As well, it is easy to build a fundamental case for further declines in the market. The S&P 500 is still about 20% over valued using $60 for earnings and 15x for a trailing multiple. (The S&P 500 has traded on average at 14 to 15x trailing reported earnings historically). Also, reported economic growth is mostly smoke and mirrors at the moment. The reported 5.7% Q4 GDP growth is likely to give way to Q2 and Q3 2010 growth in the 1% to 2% range, given the weak final demand components of the Q4 number. As you will recall, Q4 GDP got a huge assist from inventories declining at a slower rate, adding an estimated 4.4% to the final number. History indicates that subsequent quarters show punk growth when over half of GDP growth is coming from inventories.
In fact, there have been 9 quarters since 1970 in which GDP grew by at least 3 percent and at least half of the growth was due to inventories. While inventory spikes make for big growth numbers (average growth in the 9 quarters was 6.6%), average growth in the subsequent quarter averaged only 0.9% and only 1.6% in the second quarter following the blowout number. Weak growth numbers in the next few quarters will likely make current earnings forecasts overly optimistic, which will, in turn, pressure the stock market (It is possible that Q1 will come in fairly strong if the inventory swing hasn't quite played out).
One last indicator that the market is due for a further decline, or at least a relatively long period of sideways chop - the "we-can't-find-many-good-companies-at-great-prices" indicator is flashing at us. As many of you know by now, we do not do market timing. Rather, we look at risk levels in the market as context for our bottoms up, one-company-at-a-time, portfolio construction. It is currently taking us quite a bit longer to put new money to work in our client portfolios because we are just not finding that many good companies at great prices at the moment. Our price discipline held us in good stead in 2000-2001 and again in 2007-2008; we would expect it to prove beneficial once again in 2010. Meanwhile, we recommend continuing to treat the market as high risk, and plan accordingly...
As well, it is easy to build a fundamental case for further declines in the market. The S&P 500 is still about 20% over valued using $60 for earnings and 15x for a trailing multiple. (The S&P 500 has traded on average at 14 to 15x trailing reported earnings historically). Also, reported economic growth is mostly smoke and mirrors at the moment. The reported 5.7% Q4 GDP growth is likely to give way to Q2 and Q3 2010 growth in the 1% to 2% range, given the weak final demand components of the Q4 number. As you will recall, Q4 GDP got a huge assist from inventories declining at a slower rate, adding an estimated 4.4% to the final number. History indicates that subsequent quarters show punk growth when over half of GDP growth is coming from inventories.
In fact, there have been 9 quarters since 1970 in which GDP grew by at least 3 percent and at least half of the growth was due to inventories. While inventory spikes make for big growth numbers (average growth in the 9 quarters was 6.6%), average growth in the subsequent quarter averaged only 0.9% and only 1.6% in the second quarter following the blowout number. Weak growth numbers in the next few quarters will likely make current earnings forecasts overly optimistic, which will, in turn, pressure the stock market (It is possible that Q1 will come in fairly strong if the inventory swing hasn't quite played out).
One last indicator that the market is due for a further decline, or at least a relatively long period of sideways chop - the "we-can't-find-many-good-companies-at-great-prices" indicator is flashing at us. As many of you know by now, we do not do market timing. Rather, we look at risk levels in the market as context for our bottoms up, one-company-at-a-time, portfolio construction. It is currently taking us quite a bit longer to put new money to work in our client portfolios because we are just not finding that many good companies at great prices at the moment. Our price discipline held us in good stead in 2000-2001 and again in 2007-2008; we would expect it to prove beneficial once again in 2010. Meanwhile, we recommend continuing to treat the market as high risk, and plan accordingly...
Wednesday, February 10, 2010
Bogus GDP Report Revision
We wrote recently about the bogus Q4 GDP number which was reported initially at 5.7% last month. We believe the final number will come in somewhere between 2.0% and 3.0% when all is said and done - although we won't likely see that admission from our clever government bean counters for a year or so. Meanwhile, it looks as if there could actually be an upward revision in the GDP number as the December inventory number was likely flat, while the BEA assumed a sharp inventory liquidation in December. It is possible that the GDP number might temporarily be revised as high as 6.7% for Q4 2009, leading people to assume that a strong economic recovery is in place. Given that over 4% of the Q4 number would be due to a decline in the rate of decline of inventory liquidation and that personal income took a bigger hit than previously thought (based on Friday's downward revision in payrolls and hours worked) we are unable to get on board with the idea that the U.S. economy is powering strongly ahead. Rather, given continued weak end demand, we see an economy poised to decelerate back into recession sometime in 2010 - likely in the third quarter. Our confidence in that forecast is only increased by the continued and increasing contraction in real M3 (the broadest measure of money supply). As previously mentioned, contraction in real M3 is historically a 100% predictor of economic contraction in the following two to three quarters. We think it unlikely that it will be different this time.
And, of course, a renewal of the recession means a continuing rise in unemployment and decline in home prices among other (bad) things. A double dip recession is also unlikely to be a positive for the U.S. stock market....
And, of course, a renewal of the recession means a continuing rise in unemployment and decline in home prices among other (bad) things. A double dip recession is also unlikely to be a positive for the U.S. stock market....
Monday, February 8, 2010
Diversification Revisited
Proper diversification is one of the single most important tools for any investor. Properly diversified investment portfolios are the best means of protecting and growing wealth. There are two main levels of diversification, at the asset level, and at the individual security level. Most people ought to own both stocks and bonds, as well as real estate, commodities, and cash. As well, folks ought to own some international stocks and bonds since a good portion of the world economy is outside the U.S. and investors can miss out on quite a few attractive investment opportunities by limiting themselves primarily to home country investments. (Home bias is a well known investor mistake that leads investors to put too much of their money in domestic assets and not enough elsewhere). And well-diversified portfolios should also have diversification within asset classes. Too much exposure to any one company, through its stock or bonds, is an unnecessary risk that is unjustified in most cases. A couple of real life examples can help investors to understand how risky it can be to invest too much in one single asset class or one security.
The first example is a case in which an individual sold his business and retired. His fee-based advisor (stockbroker) built a portfolio consisting of $2 million in stock mutual funds and $400k in private real estate investment trusts. The $2 million in stock mutual funds consisted of a large cap growth fund, large cap value fund, small cap fund, and an international fund (a pretty common allocation for the many sales guys passing themselves off as qualified investment advisors). Of course, all of the funds were front loaded and paid the sales guy a hefty 5.75% commission along with a 0.30% yearly trailing commission, and of course our poor investor was also paying 0.60% annually to the mutual fund to actually do the investing. The $400k in private REITs was split into two investments with the same company, with basically the same commercial real estate exposure in both.
So what kind of diversification did our poor investor get for all those commissions paid? Very little is the answer. The three U.S. stock mutual funds all performed equally badly during the 2007-2009 bear market and the international fund did even worse. The illiquid private REITS can't really be valued since our investor can't get out of those particular roach motels at the moment - the REITs are husbanding their capital and have suspended redemptions for the time being. The bottom line is our retired investor is busily looking to unretire now that his portfolio has dropped from $2.4 million to $1.2 million. Oh, and in case you are wondering why the sales guy put our investor in illiquid private rather than liquid public REITS the answer is.... BIGGER COMMISSIONS!
Our second case study highlights both types of unwarranted concentration. The fee-based advisor had put an older couple 100% in bonds (at the older couple's request), using both mutual funds and individual bonds. Additionally, the advisor had placed the majority of the money allocated to individual bonds in GE Capital bonds and California muni bonds. In fact, the GE capital bonds alone made up approximately 50% of the entire portfolio. Yikes!
There are a few observations worth making here. First, commission based advisors must sell something in order to make money. Like any good salesman they will keep trying until they find something their customer likes. Don't want mutual fund A? How about mutual fund B? Don't really want to own stocks? No problem, I'll sell you bonds (and take a juicy slice of the mark up). The moral of this story is that commission based advisors often sell what's easiest to sell rather than providing actual investment advice to the client (and risk losing the sale). There is no way a couple in their mid-60s with a 25 to 30 year planning horizon should be allowed to put 100% of their money in bonds - unless they have so much wealth that purchasing power risk (inflation) isn't going to bite them in the budget in the out years. And after Enron, WorldCom, Bear Stearns, Lehman Brothers, AIG, GM, Fannie Mae, and Freddie Mac, do I even need to talk about the incredible risk assumed by having some 50% of your bond portfolio in just one company? The fact is that our couple did dodge a bullet as the Federal Government did have to (quietly) bail out GE last year when the commercial paper market seized up.
Building properly diversified, low-cost, portfolios that will both preserve and grow an investor's wealth is a critical step in planning for retirement. Appropriate portfolios are not static in nature as they must change as an investor's needs change. Unfortunately, most financial advisors are paid to sell products and do not actually make their money from giving advice or investing on a client's behalf. Consequently, their motivation to sell frequently gets in the way of sound investment advice. It is no coincidence that both of our poorly constructed portfolios were put together by fee-based advisors. The fact is that it is a huge conflict of interest, which investors would be well advised to take into consideration when dealing with "the sales guy".
The first example is a case in which an individual sold his business and retired. His fee-based advisor (stockbroker) built a portfolio consisting of $2 million in stock mutual funds and $400k in private real estate investment trusts. The $2 million in stock mutual funds consisted of a large cap growth fund, large cap value fund, small cap fund, and an international fund (a pretty common allocation for the many sales guys passing themselves off as qualified investment advisors). Of course, all of the funds were front loaded and paid the sales guy a hefty 5.75% commission along with a 0.30% yearly trailing commission, and of course our poor investor was also paying 0.60% annually to the mutual fund to actually do the investing. The $400k in private REITs was split into two investments with the same company, with basically the same commercial real estate exposure in both.
So what kind of diversification did our poor investor get for all those commissions paid? Very little is the answer. The three U.S. stock mutual funds all performed equally badly during the 2007-2009 bear market and the international fund did even worse. The illiquid private REITS can't really be valued since our investor can't get out of those particular roach motels at the moment - the REITs are husbanding their capital and have suspended redemptions for the time being. The bottom line is our retired investor is busily looking to unretire now that his portfolio has dropped from $2.4 million to $1.2 million. Oh, and in case you are wondering why the sales guy put our investor in illiquid private rather than liquid public REITS the answer is.... BIGGER COMMISSIONS!
Our second case study highlights both types of unwarranted concentration. The fee-based advisor had put an older couple 100% in bonds (at the older couple's request), using both mutual funds and individual bonds. Additionally, the advisor had placed the majority of the money allocated to individual bonds in GE Capital bonds and California muni bonds. In fact, the GE capital bonds alone made up approximately 50% of the entire portfolio. Yikes!
There are a few observations worth making here. First, commission based advisors must sell something in order to make money. Like any good salesman they will keep trying until they find something their customer likes. Don't want mutual fund A? How about mutual fund B? Don't really want to own stocks? No problem, I'll sell you bonds (and take a juicy slice of the mark up). The moral of this story is that commission based advisors often sell what's easiest to sell rather than providing actual investment advice to the client (and risk losing the sale). There is no way a couple in their mid-60s with a 25 to 30 year planning horizon should be allowed to put 100% of their money in bonds - unless they have so much wealth that purchasing power risk (inflation) isn't going to bite them in the budget in the out years. And after Enron, WorldCom, Bear Stearns, Lehman Brothers, AIG, GM, Fannie Mae, and Freddie Mac, do I even need to talk about the incredible risk assumed by having some 50% of your bond portfolio in just one company? The fact is that our couple did dodge a bullet as the Federal Government did have to (quietly) bail out GE last year when the commercial paper market seized up.
Building properly diversified, low-cost, portfolios that will both preserve and grow an investor's wealth is a critical step in planning for retirement. Appropriate portfolios are not static in nature as they must change as an investor's needs change. Unfortunately, most financial advisors are paid to sell products and do not actually make their money from giving advice or investing on a client's behalf. Consequently, their motivation to sell frequently gets in the way of sound investment advice. It is no coincidence that both of our poorly constructed portfolios were put together by fee-based advisors. The fact is that it is a huge conflict of interest, which investors would be well advised to take into consideration when dealing with "the sales guy".
Monday, February 1, 2010
The Bogus Q4 GDP Number!
Whoopee! The economy is in a strong recovery and all is well with the world. The huge stock market advance of last year is justified after all and it's clear sailing from here on out! Or is it?
The short answer is that we aren't buying what the numbers are selling. Q4 GDP was reported at 5.7% but that number is much less than meets the eye. Inventory build accounted for about 3.7% of that growth and will likely reverse in subsequent quarters given the weak consumption component (the consumer spending growth rate actually declined in the quarter from 2.3% in Q3 to 1.7% in Q4). Approximately 90% of the preliminary GDP number is composed of guesstimates since most of the inputs aren't finalized yet; the government has had a tendency to report overly optimistic initial numbers and then revise down those initial estimates in later quarters... when people aren't paying as much attention. One likely source of a coming downward revision is the trade deficit, which worsened in October and November (December hasn't been reported yet), but, nevertheless, is credited with adding 0.5% to the GDP number in Q4. Other problems with the GDP number were falling imports and declining aggregate private hours worked, which contracted at a 0.5% annual rate. Neither number indicates any kind of strong recovery taking place. All in all, we think the GDP data point toward a slow growth to no growth economy in coming quarters and quite likely an outright resumption of the recession sometime in 2010.
Further evidence that we are heading back into recession in the next few quarters lies with the money supply data. Money supply growth is currently negative as M2 and M3 continue to contract. We have never had an outright contraction in M3 (the broadest measure of money supply) without an accompanying recession! The bottom line for the public is to take the currently reported economic numbers with a HUGE grain of salt, and to act appropriately in positioning their investment portfolios.
The short answer is that we aren't buying what the numbers are selling. Q4 GDP was reported at 5.7% but that number is much less than meets the eye. Inventory build accounted for about 3.7% of that growth and will likely reverse in subsequent quarters given the weak consumption component (the consumer spending growth rate actually declined in the quarter from 2.3% in Q3 to 1.7% in Q4). Approximately 90% of the preliminary GDP number is composed of guesstimates since most of the inputs aren't finalized yet; the government has had a tendency to report overly optimistic initial numbers and then revise down those initial estimates in later quarters... when people aren't paying as much attention. One likely source of a coming downward revision is the trade deficit, which worsened in October and November (December hasn't been reported yet), but, nevertheless, is credited with adding 0.5% to the GDP number in Q4. Other problems with the GDP number were falling imports and declining aggregate private hours worked, which contracted at a 0.5% annual rate. Neither number indicates any kind of strong recovery taking place. All in all, we think the GDP data point toward a slow growth to no growth economy in coming quarters and quite likely an outright resumption of the recession sometime in 2010.
Further evidence that we are heading back into recession in the next few quarters lies with the money supply data. Money supply growth is currently negative as M2 and M3 continue to contract. We have never had an outright contraction in M3 (the broadest measure of money supply) without an accompanying recession! The bottom line for the public is to take the currently reported economic numbers with a HUGE grain of salt, and to act appropriately in positioning their investment portfolios.
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