Posts tagged ‘Stocks’
Metrics Mix-Up: Stocks and Real Estate Valuation
When it comes to making money, investors choose from a broad menu of investment categories, ranging all the way from baseball cards and wines to collectible cars and art. Two of the larger and more popular investment categories are stocks and real estate. Unfortunately for those poor souls (such as me) analyzing these two classes of assets, the stock and real estate investor bigwigs have not come together to create an integrated metric system. Much the same way the United States has chosen to go it alone on a proprietary customary unit measurement system with Burma and Liberia – choosing inches and feet over centimeters and meters. On the subject of stock and real estate valuation, investors and industry professionals have been stubbornly defiant in designing unique and cryptic terminology, despite sharing the exact same financial principles.
Who Cares About Real Estate?
Well, apparently everyone. Southern California doesn’t have a monopoly on real estate, but through my practice in Orange County, I find it difficult to not trip over real estate investors on a daily basis. I work in effectively what was “ground zero” of the subprime debacle and the commercial real estate pains continue to ripple through “the OC.”
Ramping up the real estate learning curve reminds me of my high school Spanish class – I understood enough Spanish to work my way through a Taco Bell menu but little else. In order to actually learn Spanish I had to completely immerse myself in the language, even if it meant continually speaking to my classmates in Spanish through my alias (Paco).
Real Estate Foundational Terms
Despite being a relative new resident in the Orange County area, engrossing myself in real estate hasn’t been much of a challenge. Over a brief period, my interactions and conversations taught me my financial degrees and credentials were just as applicable in the realty world as they were in the stock market world. While evaluating real estate valuation techniques, I discovered two new key terms:
1) NOI (Net Operating Income): Unlike stock analysis, which uses “Net Income” as a core driver in determining an asset’s value, real estate relies on NOI. Net operating income is generally derived by calculating income before depreciation and interest expense. In finance, there are many versions of income. I’m sure there are more explanations, but two reasons behind the selection of NOI in real estate valuation over other metrics is due to the following: a) NOI may be used as a proxy for cash flow, which can be integral in many valuation techniques; and b) NOI is “capital structure neutral” if comparing multiple properties. Therefore, NOI allows an investor to compare varying properties on an apples-to-apples basis regardless of whether a property is massively leveraged or debt-free.
2) Cap Rate (Capitalization Rate): This ratio is computed by taking the NOI and dividing it by a property’s initial cost (or value). In stock market language, you can think of a “cap rate” as an inverted P/E (Price – Earnings) ratio – an inverted P/E ratio has also been called the “earnings yield.” Complicating terminology matters is the interchangeable use of income and earnings in the investment world. In the case of the P/E ratio, the denominator generally used is “Net Income.”
A shortcoming to the cap rate ratio, in my view, is the failure to deduct taxes. Although comparability across properties may get muddied, if determining profit availability to investors is the main goal, then I think an adjusted NOI (subtracting taxes) would be a more useful proxy for valuation purposes. Tax benefits associated with REITS (Real Estate Investment Trusts) complicates the metric usage issue further.
The simplistic beauty of marrying NOI and a cap rate is that a crude valuation estimate can be constructed by merely blending these two metrics together. For example, a commercial real estate property generating $500,000 in NOI that applies a 5% cap rate to the property can arrive at a valuation estimate of $10,000,000 ($500,000/.05).
Similarities between Stocks & Real Estate
At the end of the day, the theoretical value of ANY asset can be calculated by taking the projected after-tax cash flows and discounting that stream back into today’s dollars – whether we are talking about a stock, bond, derivative, real estate property, or other asset. Both stock and real estate analysis use readily available income numbers and price ratios to estimate cash flows and valuations. Regrettably, since real estate and equity investors generally play in different leagues, the rules and language are different.
The lingo used for analyzing separate asset classes may be unique, but the math and fundamental examination are the same. The formula for learning real estate is similar to that of Spanish – you need to dive in and immerse yourself into the new language. If you don’t believe me, just ask Paco.
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 YUM or any other security mentioned. 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.
Sports & Investing: Why Strong Earnings Can Hurt Stock Prices
There are many similarities between investing in stocks and handicapping in sports betting. For example, investors (bettors) have opposing views on whether a particular stock (team) will go up or down (win or lose), and determine if the valuation (point spread) is reflective of the proper equilibrium (supply & demand). And just like the stock market, virtually anybody off the street can place a sports bet – assuming one is of legal age and in a legal betting jurisdiction.
Right now investors are poring over data as part of the critical, quarterly earnings ritual. Thus far, roughly 20% of the companies in S&P 500 index have reported their results and 78% of those companies have beaten Wall Street expectations (CNBC). Unfortunately for the bulls, this trend has not been strong enough to push market prices higher in 2010.
So how and why can market prices go down on good news? There are many reasons that short-term price trends can diverge from short-run fundamentals. One major reason for the price-fundamental gap is the following factor: expectations. Just last week, the market had climbed over +70% in a ten month period, before issues surrounding the Massachusetts Senatorial election, President Obama’s banking reform proposals, and Federal Reserve Bank Chairman Ben Bernanke’s re-appointment surfaced. With such a large run-up in the equity markets come loftier expectations for both the economy and individual companies. So when corporate earnings unveiled from companies like Google (GOOG), J.P. Morgan (JPM), and Intel (INTC) outperform relative to forecasts, one explanation for an interim price correction is due to a significant group of investors not being surprised by the robust profit reports. In sports betting lingo, the sports team may have won the game this week, but they did not win by enough points (“cover the spread”).
Some other reasons stock prices move lower on good news:
- Market Direction: Regardless of the underlying trends, if the market is moving lower, in many instances the market dip can overwhelm any positive, stock- specific factors.
- Profit Taking: Many times investors holding a long position will have price targets or levels, if achieved, that will trigger selling whether positive elements are in place or not.
- Interest Rates: Certain valuation techniques (e.g. Discounted Cash Flow and Dividend Discount Model) integrate interest rates into the value calculation. Therefore, a climb in interest rates has the potential of lowering stock prices – even if the dynamics surrounding a particular security are excellent.
- Quality of Earnings: Sometimes producing winning results is not enough (see also Tricks of the Trade article). On occasion, items such as one-time gains, aggressive revenue recognition, and lower than average tax rates assist a company in getting over a profit hurdle. Investors value quality in addition to quantity.
- Outlook: Even if current period results may be strong, on some occasions a company’s outlook regarding future prospects may be worse than expected. A dark or worsening outlook can pressure security prices.
- Politics & Taxes: These factors may prove especially important to the market this year, since this is a mid-term election year. Political and tax policy changes today may have negative impacts on future profits, thereby impacting stock prices.
- Other Exogenous Items: Natural disasters and security attacks are examples of negative shocks that could damage price values, irrespective of fundamentals.
Certainly these previously mentioned issues do not cover the full gamut of explanations for temporary price-fundamental gaps. Moreover, many of these factors could be used in reverse to explain market price increases in the face of weaker than anticipated results.
For those individuals traveling to Las Vegas to place a wager on the NFL Super Bowl, betting on the hot team may not be enough. If expectations are not met and the hot team wins by less than the point spread, don’t be surprised to see a decline in the value of the bet.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and GOOG, but at the time of publishing had no direct positions in JPM and INTC. 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.
Can the Lost Decade Strike Twice?
There is an old saying that lightning does not strike twice in the same place. I firmly believe this principle will apply to stock returns over the next decade. Josh Brown, investor and writer for The Reformed Broker highlighted a chart published by Bloomberg showing the 10-year return for various asset classes. Statisticians and market commentators have been quick to point out that stocks, as measured by various benchmarks, have not only underperformed bonds for the last 10 years, but stock performance has actually also been negative for the trailing decade.
Source: Bloomberg via The Reformed Broker
Will this trend persist during the next decade? Will the lost decade in stocks be repeated again, similar to the deflation death spiral experienced by the Japanese? (Read more regarding Japanese market on IC). With the Fed Funds rate at effectively zero, is it possible bonds can pull off a miracle over the next 10 years? I suppose anything is possible, but I seriously doubt it.
Let’s not forget that the P/E ratio (Price-Earnings) pegged by some to be at about 14-15x’s 2010 expected earnings – nestled comfortably within historical bands. Granted, financials and some other sectors were overheated (e.g. certain Consumer industries), but based on next year’s estimates, some industries are already expected to exceed the peak earnings achieved during 2007 (e.g., Technology).
History on Our Side
Source: Crestmont Research. Dated graph over the last century showing stock returns rarely result in negative returns over a rolling 10 year period.
For the trailing decade using December 20, 2009 as an end point, I arrive at a marginally negative return for the S&P 500 index assuming an average dividend yield of 2.5% for the period. Certainly the negative return would be pronounced by any fees, commissions or taxes related to a 10-year buy-and-hold strategy of the broad market index. This chart gets chopped off in 2005, nonetheless history is on our side, lending support that stock returns have a good chance of improving on the results over the last 10 years.
Equity Risk Premium
The bubbles and scandals that have blanketed corporate America over the last 10 years have made the average investor extremely skeptical. What does this mean for the pricing of risk? Well, if you rewind to the year 2000 when technology exceeded 50% of some indexes, and many investors thought technology was a low risk endeavor, there was virtually no equity risk premium discounted into many stock prices. If you fast forward to today, the reverse is occurring. Investors despise market volatility and arguably demand a much higher risk premium for taking on the instability of stocks. This is the exact environment investors should desire – lots of skepticism and money piled into bonds (See IC article on investor queasiness). As Warren Buffett says, “Be fearful when others are greedy and greedy when others are fearful.” I believe the next 10 years will be a time to be greedy.
The analysis above is obviously very narrow in scope, since we are only discussing domestic stock markets. In my client portfolios I advocate a broadly diversified portfolio across asset classes (including bonds), geographies, and styles. However, in managing bonds across portfolios, I am forced to tactfully include strategies such as inflation protection and shorter duration techniques. With the year-end fast approaching, now is a good time to review your financial goals and asset allocation.
Lightning definitely negatively impacted stocks this decade, but betting for lightning to strike twice this decade could very well turn out to be a losing wager.
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 time of publishing had no direct positions in BRKA. 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.
Equities Up, But Investors Queasy
The market may have recovered partially from its illness over the last two years, but investors are still queasy when it comes to equities. The market is up by more than +60% since the March 2009 lows despite the unemployment rate continuing to tick higher, reaching 10.2% in October. Even though equity markets have rebounded, recovering investors have flocked to the drug store with their prescriptions for bonds. Mark Dodson, CFA, from Hays Advisory published a telling chart that highlights the extreme aversion savers have shown towards stocks.
Source: Hays Advisory LLC (Thomson Reuters Datastream)
Dodson adds:
“Net new fund mutual fund flows favor bonds over stocks dramatically, so much so that flows are on the cusp of breaking into record territory, with the previous record occurring back in the doldrums of the 2002 bear market. Given nothing but the chart (above), we would never in a million years guess that the stock market has rallied 50-60% off the March lows. It looks more like what you would see right in the throes of a nasty stock market decline.”
Checking and savings data from the Federal Reserve Bank of Saint Louis further corroborates the mood of the general public as the nausea of the last two years has yet to wear off. The mountains of cash on the sidelines have the potential of fueling further gains under the right conditions (see also Dry Powder Piled High story).
As Dodson notes in the Hays Advisory note, not everything is doom and gloom when it comes to stocks. For one, insider purchases according to the Emergent Financial Gambill Ratio is the highest since the recent bear market came to a halt. This trend is important, because as Peter Lynch emphasizes, “There are many reasons insiders sell shares but only one reason they buy, they feel the price is going up.”
What’s more, the yield curve is the steepest it has been in the last 25 years. This opposing signal should provide comfort to those blue investors that cried through inverted yield curves (T-Bill yields higher than 10-Year Notes) that preceded the recessions of 2000 and 2008.
Equity investors are still feeling ill, but time will tell if a dose of bond selling and a prescription for “cash-into-stocks” will make the queasy patient feel better?
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: 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.
Siegel Digs in Heels on Stocks
Jeremy Siegel, Wharton University Professor and author of Stocks for the Long Run, is defending his long-term thesis that stocks will outperform bonds over the long-run. Mr. Siegel in his latest Financial Times article vigorously defends his optimistic equity belief despite recent questions regarding the validity and accuracy of his long-term data (see my earlier article).
He acknowledges the -3.15% return of U.S. stock performance over the last decade (the fourth worst period since 1871), so what gives him confidence in stocks now? Let’s take a peek on why Siegel is digging in his heels:
Since 1871, the three worst ten-year returns for stocks have ended in the years 1974, 1920, and 1978. These were followed, respectively, by real, after-inflation stock returns of more than 8 per cent, 13 per cent, and 9 per cent over next ten years. In fact for the 13 ten-year periods of negative returns stocks have suffered since 1871, the next ten years gave investors real returns that averaged over 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all ten years periods, and is twice the return offered by long-term government bonds.
Siegel’s bullish stock stance has also been attacked by Robert Arnott, Chairman of Research Affiliates, when he noted a certain bond strategy bested stocks over the last 40 years. Here’s what Mr. Siegel has to say about stock versus bond performance:
Even with the recent bear market factored in, stocks have always done better than Treasury bonds over every 30-year period since 1871. And over 20-year periods, stocks bested Treasuries in all but about 5 per cent of the cases… In fact, with the recent stock market recovery and bond market decline, stock returns now handily outpace bond returns over the past 30 and 40 years.
If you’re 50, 60, or older, then Siegel’s time horizons may not fit into your plans. Nonetheless, in any game one chooses to play (including the game of money), I, like many, prefer to have the odds stacked in my favor.
In addressing the skeptics, such as Bill Gross who believes the U.S. is entering a “New Normal” phase of sluggish growth, Mr. Siegel notes this commentary even if true does not account for the faster pace of international growth – Siegel goes on to explain that the S&P 500 corporations garner almost 50% of revenues from these faster growing areas outside the U.S.
On the subject of valuation, Mr. Siegel highlights the market is trading at roughly 14x’s 2010 estimates, well below the 18-20x multiples usually associated with low-interest rate periods like these.
In periods of extreme volatility (upwards or downwards), the prevailing beliefs fight reversion to the mean arguments because trend followers believe “this time is different.” Just think of the cab drivers who were buying tech stocks in the late 1990s, or of the neighbor buying rental real estate in 2006. Bill Gross with his “New Normal” doesn’t buy the reversion argument either. Time will tell if we have entered a new challenging era like Mr. Gross sees? Regardless, Professor Siegel will be digging in his heels as he invests in stocks for the long run.
Read the Whole Financial Times Article Written by Professor Siegel
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
Praying for a Better Market with Pope Benedict XVI
As reported on Bloomberg, the pontiff called for a new era of economic justice and for a new global authority to regulate financial institutions. Pope Benedict XVI weighed in on the markets with a 150 page document demanding a retooling of the economic and financial models that got us into this financial crisis.
In a conflicted dilemma, the video clip above ponders the question of whether sinners or saints perform better in the stock market? Unfortunately for church-goers, sin appears to perform better. The indulgent Vice Fund (VICEX) outperformed the virtuous Ave Maria Catholic Values Fund (AVEMX) for the period discussed.
Chomping at the bit to open up that margin account??
I’m not sure if the Pope is going to open a margin account at Scottrade, and start day-trading levered inverse ETFs and options, but perhaps he will be praying for a better market and performance for us honest, trustworthy and faithful investors.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
Building Your Financial Future – Mistakes Made in Investment Planning
Building Your Dream Future Requires a Plan
Building your retirement and financial future can be likened with the challenge of designing and building your dream home. The tools and strategies selected will determine the ultimate cost and outcome of the project.
I constantly get asked by investors, “Wade, is this the bottom – is now the right time to get in the markets?” First of all, if I precisely knew the answer, I would buy my own island and drink coconut-umbrella drinks all day. And secondarily, despite the desire for a simple, get-rich quick answer, the true solution often is more complex (surprise!). If building your financial future is like designing your dream home, then serious questions need to be explored before your wealth building journey begins:
1) Do I have enough money, and if not, how much money do I need to develop my financial future?
2) Can I build it myself, or do I need the help of professionals?
3) Do I have contingency plans in place, should my circumstances change?
4) What tools and supplies do I need to effectively bring my plans to life?
Most investors I run into have no investment plan in place, do not know the costs (fees) of the tools and strategies they are using, and if they are using an advisor (broker) they typically are in the dark with respect to the strategy implemented.
For the “Do-It-Yourselfers”, the largest problem I am witnessing right now is excessive conservatism. Certainly, for those who have already built their financial future, it does not make sense to take on unnecessary risk. However, for most, this is a losing strategy in a world laden with inflation and ever-growing entitlements like Medicare and Social Security. There’s clearly a difference between stuffing money under the mattress (short-term Treasuries, CDs, Money Market, etc.) and prudent conservatism. This is a credo I preach to my clients.
In many cases this conservative stance merely compounds a previous misstep. Many investors undertook excessive risk prior to the current financial crisis – for example piling 100% of investment portfolios into five emerging market commodity stocks.
What these examples prove is that the average investor is too emotional (buys too much near peaks, and capitulates near bottoms), while paying too much in fees. If you don’t believe me, then my conclusions are perfectly encapsulated in John Bogle’s (Vanguard) 1984-2002 study. The analysis shows the average investor dramatically underperforming both the professionally managed mutual fund (approximately by 7% annually) and the passive (“Do Nothing”) strategy by a whopping 10% per year.
Building your financial future, like building your dream home, requires objective and intensive planning. With the proper tools, strategies and advice, you can succeed in building your dream future, which may even include a coconut-umbrella drink.
Religious Pursuit of Stock Knowledge (Top 5 Books)
Feed Your Brain
In this stress-filled society dominated with endless amounts of information, and where the masses chase instant gratification, it is difficult to find the time, energy, and focus to curl up to a good book. But in life, knowledge acquisition requires more than a quick keyboard dance on Google.com, or a fleeting skim of a Wikipedia passage. Mastering a subject requires in-depth, nuanced analysis, and books are ideal vehicles used to achieve this aim.
When it comes to the topic of equity investing, it feels as though there are an infinite number of books scattered on the investment menu. Investing in many ways is like religion – there are so many different styles to choose from, even if many of them strive for the same or similar goals. Therefore, I believe if investors are fine-tuning or shopping for an investment philosophy, it makes sense to explore a cross-section of investment styles/religions.
In my view, successful equity investing integrates a balanced mix of “art” and “science.” Too much emphasis on either aspect can be detrimental to investors’ financial health. Although understanding the science takes time, training and patience, generally a committed student can learn the nuts and bolts of investing by mastering the key financial equations, ratios, and concepts. However, becoming a fluent investment artist requires the adept understanding and prediction of human behavior – no easy task.
Having logged thousands of hours and decades of years, my blood shot eyes and finance-soaked brain came up with a balanced mix of “art” and “science” in what I call my, “Top 5 Stock Book Starter Kit”:
A Random Walk Down Wall Street by Burton Malkiel
A great foundational investment book that tackles the major internal and external factors impacting our complex financial markets.
Beating the Street by Peter Lynch
A “Hall-of-Famer” growth investor, Lynch successfully managed the Fidelity Magellan Fund from 1977 to 1990 and averaged a +29% annual return. This book provides countless pearls of wisdom for both the seasoned pro and the bushy-tailed novice.
The Intelligent Investor by Benjamin Graham
When Warren Buffet pronounces this, “By far the best book on investing ever written,” people should pay attention. Graham is considered by many to be the father of “value” investing.
Reminiscences of a Stock Operator by Edwin Lefevre
This book profiles the life and times of early 20th century trader Jesse Livermore, commonly believed to be the greatest trader of all-time. Livermore provides a view into the “fast money” approach that contrasts the traditional “growth” and “value” investment styles.
Common Stocks and Uncommon Profits by Phil Fisher
A Wall Street legend that explains the key factors of superior stock returns.
There you go…upon completion, you will have officially become a stock guru!
Investing Caffeine 
