Posts filed under ‘Education’
What Happens in Vegas, Stays on Wall Street
What happens in Vegas, stays in Vegas, unless it’s a habit of betting, in which case that habit will follow you back to Wall Street. Just as there are a million ways to make or lose money by investing or speculating in the market, the same principles apply to sports betting as well. Anybody who has been to Las Vegas and gone to the sportsbook knows how incredibly and insanely accurate the oddsmakers are – I speak from immature experience having traveled there for a healthy number of investment conferences and vacations. The oddsmakers are so accurate; you could say they are almost “efficient” at what they do.
But like the market, in the sports world too, efficiency has a tendency to breakdown occasionally and form bubbles. This dynamic leaves both a huge threat of substantial losses and a potential for windfall gains. Where there are bubbles forming, you are bound to find a large number of excited individuals jumping on a bandwagon. Now, let’s take a look at how the worlds of Wall Street and wagers collide and see if any lessons can be learned.
Jumping on the Stock Bandwagon
band·wag·on [band-wag-uhn]: a party, cause, movement, etc., that by its mass appeal or strength readily attracts many followers.
Photo source: Freshpics.blogspot.com
Everybody loves a winner and no one more so than a fresh fan jumping on the bandwagon. Living in Southern California, the bandwagon is presently fully-loaded with proclaimed Los Angeles Laker fans and USC fans, although the Trojan wagon is currently undergoing repair. It’s easy to identify bandwagoners in sports – just find the face painter, guy with a rainbow afro, Boston native sporting a Kobe Bryant jersey, or the fanatic betting on the team favored by three touchdowns. In the game of stocks, identifying the fickle but passionate followers is a little more subtle. Bandwagon status is not measured by the extent of point spreads (predicted scoring differential between two opponents), but rather by level of P/E ratios (Price-Earnings ratio) or other valuation metric of choice.
While it is clear sports bandwagoners root for the “favorites,” in the realm of investing this translates into piling onto the “growth or momentum” stocks (see Momentum Investing article) – I hate generalizing terms but that’s what we bloggers do. Value investors, on the other hand, root for (buy) the “underdogs.”
To illustrate my point, let’s take a look at a few past bandwagon momentum stocks:
- JDS Uniphase Corp. (JDSU): In 2000 we saw these bandwagoners valuing investor favorites like JDS Uniphase at a whopping $99 billion – meaning investors were willingly paying over 100x’s revenues and 600 x’s trailing earnings to own the stock. At the time, JDSU was a “New Economy” stock that was going to revolutionize the proliferation of bandwidth around the globe with their proprietary optical laser components. For those of you keeping score at home, today JDSU’s stock is valued at approximately $2 billion ($9.97), or -98% less than the market value in March 2000 (split-adjusted peak share price of $1,227.38 per share). If it wasn’t for a 1-for-8 reverse stock split in 2006, then a share of JDSU would fetch you $1.25 today, or less than the amount needed to cover an out of network ATM penalty fee.
- Crocs Inc. (CROX): Crox is another one of my favorite bandwagon stocks, because this loud plastic eyesore footwear was clearly a fad that couldn’t sustain its growth once popularity waned, despite my wife being a bandwagon-ee. Like other fad product-related stocks, the company could no longer maintain its growth once they completed stuffing the channel and their customers cried uncle from choking on inventory. Making matters worse for CROX, knockoff versions were offered for a fraction of the cost at local grocery stores and mall kiosks. After about 20 months post its IPO (Initial Public Offering), the music stopped and within 13 months the stock cratered from a $75 per share peak to $0.79 in 2008. The stock never traded at the absurd dot-com levels, but the lofty 37x P/E in 2007 quickly turned negative after close to $200 million in losses were realized in 2008 and 2009. The stock has since rebounded to $12 and change, and maybe their new Crocs high-heel line of $99.00 shoes (see here) will propel the stock higher…cough, cough.
Point Spread, Point Spread, Point Spread
In sports betting the three most important factors in making a winning bet are point spread, point spread, and point spread. Unlike the March Madness college basketball pool in which you may have participated, in the real world the participant needs to do more than just pick the winning teams – the participant must determine by how much a team will win by. Let’s take a gander at a few actual examples.
- Florida Gators vs. Charleston Southern Buccaneers (9/5/09): Without knowing a lot about the powerhouse squad from South Carolina, 99% of respondents, when asked before the game who would win, would select Florida – a consistently dominant national-powerhouse program. The question gets a little trickier when asked the question: “Will the Florida Gators win by more than 63 points?” That’s exactly the point spread sports bettors faced when deciding whether or not to place the bet – somewhat analogous to the question whether JDSU was a prudent investment at 600x’s earnings? Needless to say, although the Buccs kept it close in the first half, and only trailed by 42-3 at halftime, the Gators still managed to squeak by with a 62-3 victory. Worth noting, the 59 point margin of victory resulted in a losing wager for anyone picking the Gators.
- USC Trojans vs. Stanford Cardinal (10/6/2007): Ranked as the presumptive #1 team of the country pre-season, and entering the game with a 35-0 home-game winning streak, USC was a whopping 41 point favorite over Stanford. On the flip side, the Cardinal came into the game fresh off of a 1-11 losing season the prior year, and in the previous year the Cardinal lost to the Trojans 42-0. Stanford ended up winning the 2007 match-up by a score of 24-23, not only pulling off one of the greatest upsets of all-time, but also spoiling USC’s chances of winning the national championship.
Read more about the greatest upsets of all-time.
Beyond the Point Spread
As you can surmise from our discussion, the same point spread standards apply to investing, but when discussing stocks the spread is measured by various valuation metrics based on earnings, cash flows, book value, EBITDA, sales, and other fundamental growth factors.
Of course, in Las Vegas and on Wall Street not everyone follows traditional fundamental analysis. Some gamblers and speculators will transact solely based on less conventional methods, for example quantitative models, technical analysis and trend review (read Technical Analysis: Astrology or Lob Wedge). For example in sports, handicappers may only wager on teams with five-game winning streaks and winning home records. Whereas on Wall Street, speculators may only trade stocks with positive earnings surprises or “head-and-shoulder” patterns. Hot technicians come and go, but very few real investors survive the long haul without using fundamental analysis and valuation as key components of their winning strategies.
As I have argued, there are many ways to make (and lose) money on Wall Street or in Las Vegas, and consistently jumping on the bandwagon is a sure way to lose. For the successful minority whose performance has endured the test of time, a common thread connecting the two disciplines is the ability to determine and profit from a prudently calculated point spread/valuation. History teaches us that the same effective handicapping skills happening in Las Vegas are the same abilities needed to stay on Wall Street and win.
Wade W. Slome, CFA, CFP®
P.S. See how a pro handicapper conquered Las Vegas and placed sportsbooks on the run.
Plan. Invest. Prosper.
*DISCLOSURE: The undergraduate alma mater of Sidoxia Capital Management’s (SCM) President happens to be UCLA, so although I believe any reference to rival school USC is not provided with any malicious agenda, nonetheless there may exist an inherent conflict of interest. SCM and some of its clients own certain exchange traded funds, but at the time of publishing, SCM had no direct position in JDSU, CROX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Investment Credentials: The Letter Shell Game
Photo Source: Imetco.com
In most professional industries – whether you are talking about a doctor, lawyer, dentist, accountant, or other respected field – a comprehensive and rigorous multi-year schooling and examination process is required to gain entrance into the club. Unfortunately for those working with professionals (I use the term loosely) in the investment and insurance fields, all that most advisors need to do is have a pulse and spend a few hours or days studying for an exam. Our structurally flawed and loosely cobbled together financial regulatory system is like a shell game that is constantly moving and hiding different conflicts of interest.
Left in the wake of the financial crisis, the public has been left picking up the pieces from the rating agency conflicts, Madoff scandal, Lehman Brothers bankruptcy, AIG collapse, Goldman Sachs hearings, golden parachute bonuses, billions in fees, commissions, and investor losses. Rather than watch the backs of investors, the system has favored financial institutions and penalized investors with fees, commissions, transactions costs, fine print, and layers of conflicts of interests. Andy Warhol described the amassing of fees like the prices of art – under both circumstances you collect “anything you can get away with.” So unless investors do their own thorough homework, there’s a good chance they will end up with a failing grade.
One of the major deception components is the creation of many worthless, pathetic lettered credentials that in many cases are worth less than the paper or business cards they are written on. Now, I’m sure some of these multi-letter credentials are worth more than others, but as a practicing professional in the industry for more than 15 years, it feels like I come across some new three letter designation every week. I know I am not alone with my sentiments, because respected professionals and colleagues I work with chuckle at many of these lettered credentials, and like me, have no clue what they stand for. When receiving a new business card with some of these strange letters, I often don’t know if I should cover my mouth while I burst out laughing, or if I’m supposed to be genuinely impressed?
Perhaps for hardworking parents, like a Joe and Mary Smith, it may mean something, but unless a multi-year curriculum (for example, the CFA Chartered Financial Analyst or CFP® – Certified Financial Planning programs) is put behind the alphabet of letters on a business card, please do not be offended if I yawn. Investors deserve better and fairer representation from someone managing their life savings, much like they get from a MD performing a surgery, a JD protecting a proprietor’s business, a CPA shielding a tax return from the IRS, or a DDS performing a root canal.
While it may sound like I am demonizing the broker/salesmen/advisors that are swimming around in the investment waters looking for commission opportunities (see Financial Sharks article), I understand some of them have genuine intentions and do not purposely misrepresent their credentials. As a matter of fact, many of the brokerage firms that hire these individuals require them to add funny letters to their business card for marketing purposes.
Here is a list of finance-related credentials other than the aforementioned:
- AAMS (Accredited Asset Management Specialist)
- AFC (Accredited Financial Counselor)
- AWMA (Accredited Wealth Management Advisor)
- CAIA (Chartered Alternative Investment Analyst)
- CASL (Chartered Advisor for Senior Living)
- CCFC (Certified Cash Flow Consultant)
- CFS (Certified Fund Specialist)
- CIMA (Certified Investment Management Analyst)
- CIMC (Certified Investment Management Consultant)
- CMA (Certified Management Accountant)
- CMFC (Chartered Mutual Fund Counselor)
- CMT (Chartered Market Technician)
- ChFC (Chartered Financial Consultant)
- CCFC (Certified Cash Flow Consultant)
- CDFA (Certified Divorce Financial Analyst)
- CEBS (Certified Employee Benefit Specialist)
- CDP (Certified Divorce Planner)
- CLTC (Certified in Long Term Care)
- CLU (Chartered Life Underwriter)
- CPCU (Chartered Property Casualty Underwriter)
- CRPC (Chartered Retirement Planning Counselor)
- CTFA (Certified Trust and Financial Adviser)
- FRM (Financial Risk Manager)
- MSFS (Master of Science in Financial Services)
- PFS (Personal Financial Specialist – awarded by the American Institute of Certified Public Accountants (AICPA))
- QPFC (Qualified Plan Financial Consultant)
- REBC (Registered Employee Benefits Consultant)
- RFC (Registered Financial Consultant)
When it comes to these and other industry credentials I am open to being enlightened on the relative merits…I’m all ears. And even if you trust the CFP® and CFA designations as the gold standards in the investing field, holding those credentials alone are not sufficient to make someone a good adviser. However, until I gain a better understanding of the dozens of other confusing credentials, I will continue to scratch my head and wonder which ones are worth more than the others, and which ones are not worth squat.
Healing the Wounds
It will take a long time for the financial industry to gain back the trust of investors, but it will require a multi-prong effort from regulators, financial industry executives, and investors themselves (who need to do better homework). If we want to more specifically dissect the professional service industry, then why not form one certification for each segment –not dozens.
What’s more, rather than pulling the wool over the public’s eyes with meaningless titles and credentials, let’s establish a fiduciary duty and designation that is demanded of all investment professionals. Moreover, let’s make the filtering process more rigorous in weeding out the dead-weight before handing the precious keys over to a professional. Unless changes are made, the corrupt system will remain structurally flawed, ripe with conflicts of interest, and aggressive salesmen calling themselves professionals –even if meaningless credentials are flaunted around to garner fees and commissions from the unsuspecting public.
Not everyone in the industry is a crook, but make sure you follow the ball very closely, so you do not lose in the investment shell game.
Read the Partial List of Financial Service Credentials on the CFP® Website
Wade W. Slome, CFA, CFP® <— Don’t worry if you are not impressed by these letters…my wife and friends are not either!
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in Lehman/Barclays, GS, or AIG (but do own derivative position in subsidiary) or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
“De-Risking” – It’s All Greek to Me
Source: Photobucket
In the classic comedy Animal House John Belushi (who played the character Bluto) gave new meaning to the Greek toga party (who cares if the Romans actually invented the garment?). Belushi also added some flare to Sam Cooke’s timeless song, Wonderful World:
“Don’t know much about history
Don’t know much biology
Don’t know much about the science book
Don’t know much about the French I took.”
Another line should have been added: “Don’t know much about Wall Street jargon.”
“Derisking” – New Wall Street Word Du Jour
Wading through and keeping up with the ever expanding dictionary of Wall Street lingo and acronyms can be a difficult task – much like deciphering the Greek writings of Plato, the famous ancient philosopher.
A recent term repeated constantly by CNBC commentators and hedge fund managers at the annual SALT (SkyBridge Alternatives) conference in Las Vegas, Nevada deserves some more attention…“derisking.” Elegant, simple, chic, and yes, pure B.S. Why not use “mis-risking,” “un-risking,” “dis-risking?” I suppose when charging people 2 and 20 (a 2% management fee plus 20% of profits above a hurdle), one must try to make the most prosaic terms and expressions sound mysterious and dazzling.
Asking one hedge fund manager after another, CNBC commentator David Faber continually asked managers at the May conference what investing strategies were being employed. Faber asked Marc Lasry, CEO and Co-Founder of Avenue Capital Group, the following:
“I have spoken to number of other large hedge fund managers this morning. Derisking, that’s what they are all talking about Marc. So, given that, are you derisking at all?”
Translation: “The market is going down, so are you following all the other lemmings and becoming more conservative because of the panicked-induced headlines we’re shoveling 24/7?”
Glenn Dubin, Co-Founder and CEO of Highbridge Capital Management, a hedge fund company owned by JP Morgan (JPM) got in the “derisking” mood too: “At this point…we are seeing massive de-risking.”
At the time of the SALT conference, European economic concerns were top of mind for all the fast-money traders, as fears of a credit contagion spreading from Greece to larger countries like Italy and Spain felt more palpable to many. Some nine weeks later, the European bank stress tests have been completed, some overseas economic indicators have come in better than anticipated (i.e., U.K. GDP, German business confidence, exports), and some European markets are up about +10% from the “derisking” phase. So, I wonder what those same hedge funds and traders are doing now?
Perhaps they are “rerisking?” I just made that one up out of thin air, but if I hear “rerisking” on CNBC or see it in the Wall Street Journal, I demand a credit in the Merriam-Webster dictionary, or a citation in Wikipedia at a minimum.
The “derisking” wave did not stop at the SALT conference, but remains alive and well today. In fact, a conference has been created in its honor: The 3rd Annual De-Risking Strategies Summit for Pension Funds, Foundations, and Endowments on October 25 – 27, 2010 in New York.
Obviously, this is just one of many terms, acronyms, and euphemisms that the Wall Street machine is constantly churning out. If “derisking” doesn’t float your boat, then why not try on a “swaption” and “straddle” or “contango” and “crawling peg?”
If the never-ending list of Wall Street jargon is weighing you down and a financial professional is speaking Greek to you with confusing financial terminology, then do yourself a favor and slap that person into silence. More often than not, these financial concepts can be explained to a fifth grader (or Bluto). Unfortunately, a convoluted combination of jargon and acronyms is often used in an attempt to impress the listener. The result is usually confusion and a blank stare.
If you are frustrated with learning the language of Wall Street, you are not alone. I recommend you “derisk” your education by adding Greek 101 to your coursework. If you are going to be confused, you might as well do it with a gyro and some Ouzo in hand.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in JPM or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Dividends: From Sapling to Abundant Fruit Tree
Dividends are like fruit and an investment in stock is much like purchasing a sapling. When purchasing a stock (sapling) the goal is two-fold: 1) Buy a sapling (tree) that is expected to bear a lot of fruit; and 2) Pay a cheap or fair price. If the right saplings are purchased at the right prices, then investors can enjoy a steady diet of fruit that has the potential of producing more fruit each year. Fruit can come in the form of future profits, but as we will see, the sweetness of a profitable company also paying dividends can prove much more fruitful over the long-term.
Investing in growth equities at reasonable prices seems like a pretty intelligent strategy, but of late the vast majority of fresh investor capital has been piling into bonds. This is not a flawed plan for retirees (and certain wealthy individuals) and should be a staple in all investment portfolios, to a degree (some of my client portfolios contain more than 80%+ in fixed income-like securities), but for many investors this overly narrow bond focus can lead to suboptimal outcomes. Right now, I like to think of bonds like a reliable bag of dried fruit, selling for a costly price. However, unlike stocks, bonds do not have the potential of raising periodic payments like a sapling with strong growth prospects. “Double-dippers” who are expecting the economy to spiral into a tailspin, along with nervous snakebit equity investors, prefer the reliability of the bagged dry fruit (bonds)… no matter how high the price.
How Sweet is the Fruit? How Does a +2,300% Yield Sound?
Not only do equities offer the potential of capital appreciation, but they also present the prospect of dividend hikes in the future – important characteristics, especially in inflationary environments. Bonds, on the other hand, offer static fixed payments (no hope of interest rate hikes) with declining purchasing power during periods of escalating general prices.
Given the possibility of a “double-dip” recession, one would expect corporate executives to be guarding their cash with extreme stinginess. On the contrary, so far in 2010, companies have shown their confidence in the recovery by increasing or initiating dividends at a +55% higher clip versus the same period last year. Underpinning these announcements, beyond a belief in an economic recovery, are large piles of cash growing on the balance sheets of nonfinancial companies. According to Standard & Poor’s (S&P), cash hit a record $837 billion at the end of March, up from $665 billion last year.
The S&P 500 dividend yield at 2.06% may not sound overwhelmingly high, but with CDs and money markets paying next to nothing, the Federal Funds rate at effectively 0%, and the 10-Year Treasury Note yielding an uninspiring 3.11%, the S&P yield looks a little more respectable in that light.
If the stock market yield doesn’t enthuse you, how does a +2,300% yield sound to you? That’s roughly what a $.05 (split adjusted) purchase of Wal-Mart (WMT) stock in 1972 would be earning you today based on the current $1.21 dividend per share paid today. That return alone is mind-blowing, but this analysis doesn’t even account for the near 1,000-fold increase in the stock price over the similar timeframe. That’s what happens if you can find a company that increases its dividend for 37 consecutive years.
Procter & Gamble (PG) is another example. After PG increased its dividend for 54 consecutive years, from a split-adjusted $.01 per share in 1970 to a $1.93 payout today, original shareholders are earning an approximate 245% yield on their initial investment (excluding again the massive capital appreciation over 40 years). There’s a reason investment greats like Warren Buffett have invested in great dividend franchises like WMT, PG, KO, BUD, WFC, and AXP.
Bad Apples do Exist
Dividend payment is not guaranteed by any means, as evidenced by the dividend cuts by financial institutions during the 2008-2009 crisis (e.g., BAC, WFC, C) or the discontinuation of BP PLC’s (BP) dividend after the Gulf of Mexico oil spill disaster. Bonds are not immune either. Although bonds are perceived as “safe” investments, the interest and principal payment streams are not fully insured – just ask bondholders of bankrupt companies like Lehman Brothers, Visteon, Tribune, or the countless other companies that have defaulted on their debt promises.
This is where doing your homework by analyzing a company’s competitive positioning, financial wherewithal, and corporate management team can lead you to those companies that have a durable competitive advantage with a corporate culture of returning excess capital to shareholders (see Investing Caffeine’s “Education” section). Certainly finding a WMT and/or PG that will increase dividends consistently for decades is no easy chore, but there are dozens of budding possibilities that S&P has identified as “Dividend Aristocrats” – companies with a multi-year track record of increasing dividends. And although there is uncertainty revolving around dividend taxation going into 2011, I believe it is fair to assume dividend payment treatment will be more favorable than bond income.
Apple Allocation
Growth companies that reinvest profits into new value-expanding projects and/or hoard cash on the balance sheet may make sense conceptually, but dividend paying cultures instill a self-disciplining credo that can better ensure proper capital stewardship by corporate boards. All too often excess capital is treated as funny money, only to be flushed away by overpaying for some high-profile acquisition, or meaningless share buybacks that merely offset generous equity grants to employees.
So, when looking at new and existing investments, consider the importance of dividend payments and dividend growth potential. Investing in an attractively priced sapling with appealing growth prospects can lead to incredibly fruitful returns.
Read the Whole WSJ Article on Dividends
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct positions in BAC, WFC, C, BP, PG, KO, BUD, WFC, AXP, Lehman Brothers, Visteon, Tribune, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Forecasting Recipe: Trend Analysis & Sustainability
Forecasting financial performance of a company requires a fairly simple recipe: one part trend analysis and one part determining sustainability. On the surface, forecasting sounds pretty easy. While discovering certain financial trends can be straightforward, the ability to ascertain the durability of a trend can become endlessly complex.
Before you become Nostradamus and spreadsheet your way to the Wall Street Hall of Fame, an accurate forecaster must first build a firm understanding of a company and the underlying industry. Unfortunately for the predictor, not all companies and industries are created equally. Evaluating the profit dynamics of Cheesecake Factory Inc. (CAKE), an upscale casual chain of restaurants, is quite different from deciphering the financials of 3SBio (SSRX), a Chinese biotech company focused on recombinant products. Regardless of the thorniness of the company or industry, before you can truly look out into the future, the investor should learn the language of the company. For example, learning the importance of “comparable store sales” and “sales per square foot” for CAKE may be just as important as learning about the “Phase III FDA trial endpoint” and “pipeline” for SSRX.
Because you could spend a lifetime following just one company – for instance General Electric Co. (GE) or Microsoft Corp. (MSFT) – and never make an investment, you would probably be better served by applying a framework that allows you to research and analyze multiple industries and companies. There are various tools, whether you consider Harvard professor Michael Porter’s Five Forces or SWOT analysis (Strengths Weaknesses Opportunities Threats), and each provides a template or process to use when tearing apart specific companies and industries.
Nuts & Bolts of Forecasting
Before you can identify a trend, you first need to gather the data. For all companies I examine, I first compile a quarterly and annual income statement, balance sheet, and cash flow statement – those that have followed me know the extreme importance I place on the cash flows of a business. In general a good start is to create common size financial statements for the income statement and balance sheet. Basically, this exercise creates an income statement and balance sheet in percentage terms – usually expressed as a percentage of net sales (income statement) and as a percentage of total assets (balance sheet). Earnings forecasts are often used as a logical starting point for driving the shape of future results across the financials, but further insight can be gleaned by comparing year-over-year (this year vs. last) and sequential (this quarter vs. last quarter) growth rates for key figures.
These common statements will then serve as the foundation of identifying the trends, and force the forecaster to seek answers to random questions like these?
- Why is depreciation expense going down even though the company is expanding retail stores?
- Gross margins increased for seven consecutive quarters for a total of 250 basis points (2.5%), however in the recent quarter margins declined by 175 basis points…why?
- Long-term debt increased by $200 million in the current quarter, but if the company just issued $325 million in equity last quarter, then why do they need new capital?
Many of these types of questions may have logical explanations, but by getting answers the analyst will be in a position to better understand the business issues affecting financial performance and to better forecast future economic values.
Forecasting Your Way to Wrongness
A lot can go wrong with forecasting, principally in the assumptions used for the forecast. As the character Felix Unger from the Odd Couple stated, “You should never “assume.” You see, when you “assume,” you make an “ass”… out of “you”… and “me.”” Often assumptions do not consider the inclusion of important economic shocks or unexpected factors, such as recessions, currency fluctuations, management turnover, lawsuits, accounting changes, new products, restructurings, acquisitions, divestitures, flash crashes, Greek debt downgrades, regulatory reform…yada…yada…yada (you get the idea). To get a better sense for a range of outcomes, sensitivity analysis can be employed to determine a “base case” outcome in conjunction with a rosier “upside case” and more conservative “downside case.” Worth noting is the impact debt levels can have on the variance of outcomes – I think Bear Stearns and Lehman Brothers would concur with this point.
Pinpointing variable financial figures is quite difficult. Different companies and industries inherently have more or less predictable attributes. Predicting when the sun will rise and set is quite a bit more predictable than predicting what Intel Corp’s (INTC) gross margins will be on a quarterly basis. As mentioned earlier, layering on debt can increase the volatility of earnings forecasts as well.
Forecasting is essential in the investment world, but even if you were the best forecaster in the world, investors cannot disregard the importance of valuation skills. The art of valuation is just as important, if not more important than being right on your financial scenarios.
All in all, the recipe of forecasting sounds simple if you look at the basic ingredients of trend and sustainability analysis. However, before the ultimate forecast comes out of the oven, this straightforward recipe requires a lot of preparation, whether it is slicing and dicing cash flow figures, whipping up some margin trends, or measuring up sales growth. Any way you cut it, systematically following a recipe of trend and sustainability analysis is a non-negotiable requirement if you want to heat up superior financial results.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in GE, MSFT, CAKE, SSRX, INTC, JPM/Bear Stearns, Lehman Brothers, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Ray Allen, the VIX, and the Rule of 16
Photo Source: Babble.com
Ray Allen gets paid a lot of money for running into people and bouncing an orange ball around a wooden floor, but even his game can appreciate the importance volatility can play in a high stakes game. First, Allen set an NBA Final’s basketball record of eight three-pointers made (including seven in a row) in Game 2, and then followed up in the next game with an astonishingly dismal “O” for thirteen performance – the second worst shooting performance during a Final’s game in 32 years. The emotional rollercoaster ride for the Celtics fans resembles a volatility chart of the VIX (Volatility Index) in recent weeks.
Chart Source: Yahoo! Finance
In the last 40 trading days the VIX has moved more than +/- 5% on 30 different trading sessions (75% of the time), including seventeen +/- 10% trading days. The +32% spike in the VIX on the day of the “Flash Crash” (May 6, 2010) would have even generated a smirk on the face of Ray Allen, not to mention the face changing impact of the other three +/- 30% move days that occurred within a month of the Flash Crash trading debacle. Even though the VIX has settled down from a short-term peak last month (48.20 on May 21st) to a lower level (28.79), the fear gauge still stands at almost double the rate of the multi-year low just a few months ago (15.23 on April 12th).
The VIX and the Rule of 16
No, this VIX is not the same as the Vicks vapor rub medication placed on your chest to relieve cough symptoms, rather this VIX indicator calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days. Put simply, when fear is high, the price of insurance catapults upwards as measured by the VIX – just like we saw when the VIX spiked above 80 during the 2008 financial crisis and above 40 during the more fresh Greek debt disaster. I’m not in the position to bust out some differential calculus to explain the nuances of a complex VIX formula, but what I can do is regurgitate a helpful formula relating to the VIX, called the Rule of 16. What the Rule of 16 allows laymans to do is understand the relationship between the VIX and daily volatility.
This is how Jeff Luby of Green Faucet describes the Rule of 16:
• VIX of 16 – 1/3 of the time the SPX will have a daily change of at least 1%
• VIX of 32 – 1/3 of the time the SPX will have a daily change of at least 2%
• VIX of 48 – 1/3 of the time the SPX will have a daily change of at least 3%
To put these VIX numbers in perspective, industry citations put the long-term VIX average around a level of 20. With a VIX hovering around 30 now, we are approaching the 2nd bucket of expectations (2%+ moves in the market 1/3 of the time). The price moves don’t correlate directly with the Dow Jones Industrial Average index, but I think about the current VIX levels equating to about a +/- 200 point move in the Dow one or two times per week…uggh.
Generally, I would prefer lower volatility, but I continually remind myself volatility is not necessarily a bad thing – volatility creates opportunities. I’m not sure if I can apply the Rule of 16 to Ray Allen’s scoring output, however based on last night’s 5-10 shooting performance, perhaps volatility in the market and Ray Allen’s shooting game will begin to normalize toward historical ranges.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including S&P 500-like positions), but at the time of publishing SCM had no direct positions in SPX, VIX-related securities, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
The Annuity Trap
Like the infamous Roach Motel, annuities allow investors to check-in while making it very difficult to check out. In many instances, getting out of annuities can be cost prohibitive (fees, charges, commissions, expenses, etc.), even if escaping these fee-laden products is in the investors’ best financial interest.
In an article dated April 13th, 2010, Jay Peroni warned others by outlining a typical annuity fee structure as follows:
- Mortality and Expense Charge 1.50%
- Sub Account Management Fees 1.00%
- Unreported trading costs 0.78%
- Annual Administrative Expenses 0.15%
TOTAL ANNUAL EXPENSES 3.43%
What aren’t included in these numbers above are the surrender charges, which effectively can lock you into the annuity if you are averse to paying hefty surrender charges. Normally, the surrender charges vary from up to a 10% charge for large withdrawals in year one, decreasing to something like 1% in year 10. Worth noting, steep sales commissions can be layered on top of the previous charges or mysteriously embedded in the fee structure categories above.
The Big Sell
Driving the push for these 3%+ annual fees are lucrative financial institutions hiring aggressive salespeople. Typically annuities are sold under the guise of safe tax shelter investments. What the broker won’t tell you is that only a fraction (“exclusion ratio”) of the annuity payments is shielded from taxes, and the rest of the payments are taxed at the higher, unfavorable ordinary income tax rate (relative to qualified dividends and capital gains from other securities). Much of the time, many of the salespeople, who call themselves “financial advisors,” know little about these complex annuity products (see Financial Sharks article). What these brokers do understand are the big, fat commissions they stand to collect upon fleecing unsuspecting investors.
Scores of these so-called advisors are actually “registered representatives” who do not carry a fiduciary duty (meaning they are NOT required to make investment decisions in the best interest of their clients). Certainly, there are some situations where annuities might be appropriate, but from my experience there are very few cases where the egregious charges and expenses outweigh the benefits. I believe the vast majority of brokers/registered reps/salespeople are more concerned about padding their wallets than building and protecting client portfolios.
The Alternatives
If safety and tax advantages are features you are looking for then I encourage you to look at more efficient options such as the following:
- 401k Defined Contribution Retirement Plan (or other “Qualified Plan”): Allows you to achieve tax deferral often with free money given to you in the form of a match to your contributions.
- IRA (Individual Retirement Account): Whether you consider a traditional or Roth IRA, there are tax deferral advantages with lower fees.
- Low Turnover, High Dividend Portfolios: Using a tax efficient management strategy with better tax treatment of income is another approach that I firmly believe will outperform most annuities.
- Tax-Exempt Muni Bonds or Corporates: The tax-exempt status of municipal bonds affords investors a tax advantaged status. The after-tax yield on corporate bonds can be compared to the returns promised on annuities (AFTER all fees, charges, and commissions). Holding individual bonds until maturity can help avoid interest rate risk.
- Ladder Zero Coupon Bonds: If safe fixed payments are what you are looking for, then staggered purchases of zero coupon bonds can be purchased as well.
These are only a few options that could and should be considered when reviewing your personal objectives and circumstances. With regard to the insurance component of an annuity contract, there are more cost effective ways of paying for insurance – most notably, term insurance.
At the end of the day, no matter the financial product, it is important you understand the underlying fees charged on any strategy, along with how the person selling you stuff is compensated. If you don’t do your homework on these extremely complex products (many not regulated by the NASD or SEC), then you may find yourself checking into the annuity hotel, but unable to check out.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Stocks…Bonds on Steroids
With all the spooky headlines in the news today, it’s no wonder everyone is piling into bonds. The Investment Company Institute (ICI), which tracks mutual fund data, showed -88% of the $14 billion in weekly outflows came from equity funds relative to bonds and hybrid securities. With the masses flocking to bonds, it’s no wonder yields are hovering near multi-decade historical lows. Stocks on the other hand are the Rodney Dangerfield (see Doug Kass’s Triple Lindy attempt) of the investment world – they get “no respect.” By flipping stock metrics upside down, we will explore how hated stocks can become the beloved on steroids, if viewed in the proper context.
Davis on Debt Discomfort
Chris Davis, head of the $65 billion in assets at the Davis Funds, believes like I do that navigating the “bubblicious” bond market will be a treacherous task in the coming years. Davis directly states, “The only real bubble in the world is bonds. When you look out over a 10-year period, people are going to get killed.” In the short-run, inflation is not a real worry, but it if you consider the exploding deficits coupled with the exceedingly low interest rates, bond investors are faced with a potential recipe for disaster. Propping up the value of the dollar due to sovereign debt concerns in Greece (and greater Europe) has contributed to lower Treasury rates too. There’s only one direction for interest rates to go, and that’s up. Since the direction of bond prices moves the opposite way of interest rates, mean reversion does not bode well for long-term bond holders.
Earnings Yield: The Winning Formula
Average investors are freaked out about the equity markets and are unknowingly underestimating the risk of bonds. Investors would be in a better frame of mind if they listened to Chris Davis. In comparing stocks and bonds, Davis says, “If people got their statement and looked at the dividend yield and earnings yield, they might do things differently right now. But you have to be able to numb yourself to changes in stock prices, and most people can’t do that.” Humans are emotional creatures and can find this a difficult chore.
What us finance nerds learn through instruction is that a price of a bond can be derived by discounting future interest payments and principle back to today. The same concept applies for dividend paying stocks – the value of a stock can be determined by discounting future dividends back to today.
A favorite metric for stock jocks is the P/E (Price-Earnings) ratio, but what many investors fail to realize is that if this common ratio is flipped over (E/P) then one can arrive at an earnings yield, which is directly comparable to dividend yields (annual dividend per share/price per share) and bond yields (annual interest/bond price).
Earnings are the fuel for future dividends, and dividend yields are a way of comparing stocks with the fixed income yields of bonds. Unlike virtually all bonds, stocks have the ability to increase dividends (the payout) over time – an extremely attractive aspect of stocks. For example, Procter & Gamble (PG) has increased its dividend for 54 consecutive years and Wal-Mart (WMT) 37 years – that assertion cannot be made for bonds.
As stock prices drop, the dividend yields rise – the bond dynamics have been developing in reverse (prices up, yields down). With S&P 500 earnings catapulting upwards +84% in Q1 and the index trading at a very reasonable 13x’s 2010 operating earnings estimates, stocks should be able to outmuscle bonds in the medium to long-term (with or without steroids). There certainly is a spot for bonds in a portfolio, and there are ways to manage interest rate sensitivity (duration), but bonds will have difficulty flexing their biceps in the coming quarters.
Read the full article on Chris Davis’s bond and earnings yield comments
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct positions in PG, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Avoiding Automobile and Portfolio Crashes
Personal opinions of oneself don’t always mirror reality. Self perceptions relating to both driving and investing can be inflated. For example, the National Highway Traffic Safety Administration (NHTSA) reports that 95% of crashes are caused by human error, but 75% of drivers say they are better drivers than most.
Contributing factors to crashes include: 1) Distractions; 2) Alcohol; 3) Unsafe behavior (i.e., speeding); 4) Time of day (fatality rate is 3x higher at night); 5) Lack of safety belt; 6) Weather; and 7) Time of week (weekends are worst crash days).
A spokesman for the Insurance Institute for Highway Safety is quick to point out that driving behind the wheel is the riskiest activity most people engage in on a daily basis – more than 40,000 driving related fatalities occur each year. Careful common sense helps while driving, but driving sober at 4 a.m. (very few drivers on the road) on a weekday with your seatbelt on won’t hurt either.
Avoiding a Portfolio Crash
Another dangerous activity frequently undertaken by Americans is investing, despite people’s inflated beliefs of their money management capabilities. Investing, however, does not have to be harmful if proper precautions are taken.
Here is some of the hazardous behaviors that should be avoided by those maneuvering an investment portfolio:
1) Trading Too Much: Excessive trading leads to undue commissions, transaction costs, bid-ask spread, impact costs. Many of these costs are opaque or invisible and won’t necessarily be evident right away. But like a leaky boat, direct and indirect trading costs have the potential of sinking your portfolio.
2) Worrying about the Economy Too Much: The country experiences about two recessions a decade, nonetheless our economy continues to grow. If macroeconomics still worry you, then look abroad for even healthier growth – considerable international exposure should aid the long-term success of your portfolio and assist you in sleeping better at night.
3) Emotionally Reacting – Not Objectively Planning: News is bad, so sell. News is good, so buy. This type of conduct is a recipe for portfolio disaster. Better to do as Warren Buffett says, “Be fearful when others are greedy, and be greedy when others are fearful.” The long-term fundamental prospects for any investment are much more important than the daily headlines that get the emotional juices flowing.
4) Hostage to Short-term Time Horizon: Rather than worry about the next 10 days, you should be focused on the next 10 years. The further out you can set your time horizon, the better off you will be. Patience is a virtue.
5) Incongruent Portfolio with Risk: Many retirees got caught flat-footed in the midst of the global financial crisis of 2008-09 with investment portfolios heavy in equities and real estate. Diversified portfolios including fixed-income, commodities, international exposure, cash, and alternative investments should be optimized to meet your specific objectives, constraints, risk tolerance, and time horizon.
6) Timing the Market: Attempting to time the market can be hazardous to your investment health (see Market Timing article). If you really want to make money, then avoid the masses – the grass is greener and the eating better away from the herd.
Driving and investing can both be dangerous activities that command responsible behavior. Do yourself a favor and protect yourself and your portfolio from crashing by taking the appropriate precautions and avoiding the common hazardous mistakes.
Read Full Forbes Article on Driving Dangers
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
EBITDA: Sniffing Out the Truth
Financial analysts are constantly seeking the Holy Grail when it comes to financial metrics, and to some financial number crunchers EBITDA (Earnings Before Interest Taxes Depreciation and Amortization – pronounced “eebit-dah”) fits the bill. On the flip side, Warren Buffett’s right hand man Charlie Munger advises investors to replace EBITDA with the words “bullsh*t earnings” every time you encounter this earnings metric. We’ll explore the good, bad, and ugly attributes of this somewhat controversial financial metric.
The Genesis of EBITDA
The origin of the EBITDA measure can be traced back many years, and rose in popularity during the technology boom of the 1990s. “New Economy” companies were producing very little income, so investment bankers became creative in how they defined profits. Under the guise of comparability, a company with debt (Company X) that was paying interest expense could not be compared on an operational profit basis with a closely related company that operated with NO debt (Company Z). In other words, two identical companies could be selling the same number of widgets at the same prices and have the same cost structure and operating income, but the company with debt on their balance sheet would have a different (lower) net income. The investment banker and company X’s answer to this apparent conundrum was to simply compare the operating earnings or EBIT (Earnings Before Interest and Taxes) of each company (X and Z), rather than the disparate net incomes.
The Advantages of EBITDA
Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:
- Operational Comparability: As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice.
- Cash Flow Proxy: Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
- Debt Coverage Ratios: In many lender contracts certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.
The Disadvantages of EBITDA
While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.
- Overstates Income: To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTER all expenses, including interest expense, depreciation expense, and income tax expense.
- Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
- Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).
Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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