What's that stock worth?
When you buy a stock, you're buying the future earnings of the company and their effect your wealth. Your future depends on purchasing stocks that grow earnings and increase in value.
If you pay too much for a company's stock, you won't make much money on it.
If your stock pays a dividend, you'll collect that dividend, regardless of the price you pay.
On the other hand, part of the total investment yield is based on what happens to the stock price.
If the company whose stock you purchase pays no dividend, how can you earn anything at all from your investment? Only one way; by appreciation in the stock price. What drives stock prices up? Expectations of future earnings! The company earns money. It takes that money and does something with it. What? hopefully it re-invests in the business, so the next year it earns more money. If so, rising earnings, and rising earnings per share should result in a higher price for the stock.
If the company decides to pay some of it's earnings to it's owners in the form of a dividend, you can do one of three things with that dividend: use it buy something you want, use it to buy more of the company's stock, or use it to buy a position in some other company.
Most folks think that you shouldn't pay more than 15-20x earnings to own a stock. That would be an earnings return (return on invested capital or ROIC) of 5-7%. Some companies make a lot more money than that. If the executives use some of the earnings to grow the company, stock price tends to drift up to keep the price/earnings in a historical range. You have to pay attention to whether the company is issuing a lot of new shares, since that will dilute earnings per share and adversely effect price per share. Some companies use excess earnings. over and above what's needed to grow the business, to purchase shares and retire them. That reduction in shares tends to boost the price per share, thus making the value of your holding higher, as earnings are distributed amongst fewer shares.
Certainly, a company that is generating loads of cash, paying some of it to owners as dividends, using some of it to grow the business, and some of it to buy back shares sounds like an investment you'd like to own. The good news is, there are plenty of such companies out there; you just have to know how to identify them.
There are lots of ways you can start; one would be to use a screening tool. There are many, from value line, Morning-star, investors daily, etc. I like a subscription service called FASTGraphs.
You can read websites that are devoted to investing, develop a screening list and use any number of resources to find the metrics you need to decide if a company is worth your attention.
I got to my roughly 50 issue portfolio by following my nose, subscribing to newsletters and reading Seeking Alpha. Over time I collected enough understanding of valuation to have a rough understanding of how to decide if a company is on a good footing or not. I don't do formal valuation, but I have some understanding of how it works. Others do it and publish it routinely online.
I check my holdings regularly via FASTGraphs to see if the rate of earnings growth is declining, if the dividend growth rate is changing, if the valuation is getting too high.
Dividend growth investors live in the tension between two desires; the first is to have a growing stream of income. The second is to see the portfolio value increase. The problem is, high stock prices mean less accumulated shares when the dividends are reinvested. Low stock prices mean the stock value isn't appreciating. What's an investor to do? Find a company that constantly raises dividends. That allows continue accumulation of meaningful amounts of additional shares, and drives the appreciation of stock value as well. If valuation outstrips dividend growth, then you rotate to another more appropriately valued company. That means you need a reserve team. You need to know some companies that you'd buy if one of your holdings needs replacing for one reason or another. So, you keep a watch list; companies you'd own if you had twice the money.
In order to grow income and grow wealth, you need both dividends as well as appreciation in the value of your holdings. The good news is, there are plenty of companies who have done this in good times and bad. You can find them. They're not hidden. They're right in plain sight. Ditch the adviser. Ditch the fees. Study hard, read a lot. Keep listening until you hear the truth. You'll be able to recognize it. Sound principles are not obscure.
Saturday, May 25, 2013
Saturday, May 4, 2013
The beginnings of my "wisdom" compendeum
I read a lot on Seeking Alpha. I've been doing so for about 3-4 years now. Slowly, it's replacing my interest in investing newsletters. First, it's free and second, I've amassed a portfolio of favorite authors that I can learn from, so the "gurus" don't matter as much anymore.
I'm beginning to have the makings of a book of wisdom in my head. Writing down the outline of that book helps it to grow, so I'll start with a few thoughts that could grow into a real useful guideline.
Chapter One;
You're just starting out in your adult life. You have a job, are earning money, and have a bit left over each month after expenses. What do you intend to do with the extra, after you have purchased enough ice cream and movie tickets to satisfy yourself? Some gray haired associate suggests it's time to think about your future and begin investing for your future security. So off you go, looking for advice to help you on your way. Beware, you are entering a mine-field of swindlers, who exist to strip you of your money.
Don't believe the common wisdom. When you're young, you can't afford to reach out onto the outer branches of the risk-reward curve. Forget about capital gains as a metric of good investing. The idea that you have several "market cycles" in you and can afford to take some risks is a form of swindle that the "professional advisers" pitch as a means to capture your money as they trade your shares for you. The conventional wisdom that says you can't have outsized returns without taking on risk is just plain wrong. The truth is that you don't need either outsized returns OR high risk to meet your goals. What you really need is a means to fulfill Warren Buffet's first rule of investing; "don't lose money". And also, his second rule; "never forget rule number one".
Purchase earning power. Purchase earning power at a bargain when you can, and purchase it at a fair price when there aren't bargains to be found. The most simple metric of this advice is the P/E ratio. However, this isn't enough. Look at earnings history. The best indication of future growth in earnings is a long history of prior growth in earnings. The thoroughbreds with long histories of rising earnings tend to be large-cap multinational companies. Now, there is no free lunch, and one can always find an example that refutes the wisdom. However, toothpaste and toilet paper won't be replaced anytime soon, so trotting out an example like Eastman Kodak as a reason to avoid stalwart steady investments isn't fair. Most products of most companies aren't going to be made obsolete by new technology.
If low-risk is actually a better place to start, then you are starting with more conservative, probably slower growing investments. This is not what the conventional wisdom tells you. However, one of the hardest lessons learned by the amateur investor is making a bet on a company with a great story and a rocket-like trajectory in stock price, is that the price is a bet on future earnings, and if that meteoric growth in earnings doesn't occur, the stock price crashes to earth and your hard-earned money evaporates in the crash. Been there, done that...
So, you think, "I'm doomed to either expose myself to the boom/bust world of the speculative high growth stocks, or be safely and boringly trapped in the slow-growth sector of large-cap stock universe". Not actually...because you haven't yet considered the amazingly powerful opportunity that exists in dividend-growth and the compounding effects of dividend reinvestment. That's a story for another chapter. This chapter is about the counter-intuitive wisdom that you need to assimilate; your first investments should be in places where your money is safe, produces predictable and reliable returns, so you aren't trying to play catch-up later in life with a portfolio full of regrets. Many of those "safe" investments have produced outsized returns through the last 14 years of incredible volatility in the equity markets, so the tortoise has truly beaten the hare and all of it's sycophants who masquerade as advisers.
Next point; the conservative investments you make early will be very powerful engines of wealth accumulation later in life, when your energy is flagging and you're thinking about the endpoint of your labors. If you learned anything in high-school physics, imagine the effects of acceleration when it just goes on and on and on. That's what compounding is about. If you can lock in an inflation-beating compounding engine and let it run over 30-40 years time, it has incredible inertia and momentum that will sustain you in the last 3rd of your life, when you aren't interested in running the race of the workaday world anymore.
What is the inevitable result when you purchase a source of rising earnings? Eventually, if not immediately or constantly, the value of the holding rises (Price per share, silly!). The market is fickle and often ignores rising earnings for quite a while, or sometimes gets a crush on an individual stock and drives price up far in excess of what is appropriate for current or projected earnings for a given stock. This is called over-valuation and it can be used to your advantage if you already own the stock, but it's a trap if you are in the purchasing mode, since paying too much for future earnings means you just won't see the growth in value of your investment if you pay too high a price for control of those future earnings.
One piece of this wisdom is that you should purchase stocks like you purchase a house. You don't purchase a house with the intention of moving in, then selling, moving out, buying and moving in again, selling and moving out very frequently. That's a ticket to bleeding from a thousand cuts. Same for the investment world. You need to purchase for the long haul. Then, short term fluctuations in price are less damaging to your overall investment performance. You don't see your money dribble out of your hands through hundreds of buy/sell transaction costs. Buy something that you won't sell, even if the market chooses to discount the value for significant periods of time. The key is to pay attention to the business performance and ignore the short-term fluctuations in stock price. After all, are you purchasing a piece of the business, or a stock certificate? Well, you're purchasing both, but unlike baseball cards, the stock certificate is merely representative of what you actually own, which is a part-ownership in a business. You buy a business so it can produce returns on your investment over time, like income and appreciation in value.
So, ask yourself, is that micro-cap, dot-com, start-up company more likely to be there in 10 years, or is Coca Cola? What is a "sure thing" for your long term security?
Mature companies that earn lots of cash often already have significant market penetration, so they aren't spending every dime trying to expand further. They have learned the dangers of rapid growth, so they have methodical, incremental growth and reinvestment strategies. However, they sell stuff that earns lots of cash. What do they do with that cash? Some of them hoard huge amounts of it. Others use it to reward the owners (stockholders).
They can do so in two ways; One is to repurchase shares with cash. This reduces the overall share-count and the share price tends to rise. You should be somewhat suspicious of this activity however; first, some companies buy back stock regardless of whether the price is low or high, taking some of YOUR money and spending it in a way that you WOULDN'T, buying stock at too high a price. Also, they buy shares, reissue them as options to executives, so the actual share count doesn't decline and the repurchase is a sneaky way of shoveling more money into the pockets of company insiders, instead of distributing profits to all owners proportionately.
A more transparent way for a company to reward it's owners is with dividends. Many, but not all companies pay out a portion of the profits from the business as dividends. The best of these companies, whose earnings rise year by year, also pay dividends that rise year by year. That is called 'dividend growth'. The rate of dividend growth can be measured. The proportion of earnings payed out as dividends can be calculated. These metrics can be tracked as a means to monitor company performance, just like earnings.
The key value in dividends is what happens when you turn them back into more shares of the same (or different) company. That introduces compounding into your investment performance. You not only benefit if the stock price rises, but you have more shares, each of which allows you to claim a piece of the next distribution of dividends. The practice of purchasing dividend-paying investments in companies that raise dividends reliably, then reinvesting the dividends to produce a rising stream of dividend income, is called Dividend Growth Investing. It's not the only strategy for growing wealth, but it has some very attractive features that make it a sound strategy for many reasons. We'll explore some of those reasons in future chapters. However, just as a taste of what is to come, think of this; you purchase a company that grows earnings by 7% every year. It pays out a fixed portion of earnings as dividends, say 50%. That means the dividend is going to grow by 7% per year. The fact that earnings grow by 7% per year, means that stock price will rise over time, unless the company is rampantly issuing more stock, diluting earnings per share (you have to keep an eye on this). If share count is static, earnings per share are rising 7% per year, so stock price will eventually rise about 7% per year. Are you trapped with a 7% investment yield? No...if you reinvest your dividends, you grow the value of your holdings at about 10.5 % per year, so you're accumulating wealth faster than the company is growing! That's the power of compounding.
More on this later...
There's a whole world of dividend investing resources out there, from subscription based investing newsletters (not free) to a bunch of web-based stuff, some of which is quite useful. Like anything else you have invested in, like your education, if you spend some time and effort, you can become knowledgeable and self-directed and you don't need to pay an "expert" to do it for you. After all, they don't guarantee results and they cost you investment performance due to fees. Trust me, you don't need them. What you need is knowledge, reliable sources of information, and a strategy that keeps you safe. You can acquire all of this without paying an adviser. Some tools are proprietary and you can choose to pay for them if you wish. I choose to subscribe to a few services that provide both intellectual content and screening tools. However, they make up a very small fraction of the investment expense, much less than an adviser or a mutual fund fee. Stroll along with me and I'll show you one way to do it yourself.
I'm beginning to have the makings of a book of wisdom in my head. Writing down the outline of that book helps it to grow, so I'll start with a few thoughts that could grow into a real useful guideline.
Chapter One;
You're just starting out in your adult life. You have a job, are earning money, and have a bit left over each month after expenses. What do you intend to do with the extra, after you have purchased enough ice cream and movie tickets to satisfy yourself? Some gray haired associate suggests it's time to think about your future and begin investing for your future security. So off you go, looking for advice to help you on your way. Beware, you are entering a mine-field of swindlers, who exist to strip you of your money.
Don't believe the common wisdom. When you're young, you can't afford to reach out onto the outer branches of the risk-reward curve. Forget about capital gains as a metric of good investing. The idea that you have several "market cycles" in you and can afford to take some risks is a form of swindle that the "professional advisers" pitch as a means to capture your money as they trade your shares for you. The conventional wisdom that says you can't have outsized returns without taking on risk is just plain wrong. The truth is that you don't need either outsized returns OR high risk to meet your goals. What you really need is a means to fulfill Warren Buffet's first rule of investing; "don't lose money". And also, his second rule; "never forget rule number one".
Purchase earning power. Purchase earning power at a bargain when you can, and purchase it at a fair price when there aren't bargains to be found. The most simple metric of this advice is the P/E ratio. However, this isn't enough. Look at earnings history. The best indication of future growth in earnings is a long history of prior growth in earnings. The thoroughbreds with long histories of rising earnings tend to be large-cap multinational companies. Now, there is no free lunch, and one can always find an example that refutes the wisdom. However, toothpaste and toilet paper won't be replaced anytime soon, so trotting out an example like Eastman Kodak as a reason to avoid stalwart steady investments isn't fair. Most products of most companies aren't going to be made obsolete by new technology.
If low-risk is actually a better place to start, then you are starting with more conservative, probably slower growing investments. This is not what the conventional wisdom tells you. However, one of the hardest lessons learned by the amateur investor is making a bet on a company with a great story and a rocket-like trajectory in stock price, is that the price is a bet on future earnings, and if that meteoric growth in earnings doesn't occur, the stock price crashes to earth and your hard-earned money evaporates in the crash. Been there, done that...
So, you think, "I'm doomed to either expose myself to the boom/bust world of the speculative high growth stocks, or be safely and boringly trapped in the slow-growth sector of large-cap stock universe". Not actually...because you haven't yet considered the amazingly powerful opportunity that exists in dividend-growth and the compounding effects of dividend reinvestment. That's a story for another chapter. This chapter is about the counter-intuitive wisdom that you need to assimilate; your first investments should be in places where your money is safe, produces predictable and reliable returns, so you aren't trying to play catch-up later in life with a portfolio full of regrets. Many of those "safe" investments have produced outsized returns through the last 14 years of incredible volatility in the equity markets, so the tortoise has truly beaten the hare and all of it's sycophants who masquerade as advisers.
Next point; the conservative investments you make early will be very powerful engines of wealth accumulation later in life, when your energy is flagging and you're thinking about the endpoint of your labors. If you learned anything in high-school physics, imagine the effects of acceleration when it just goes on and on and on. That's what compounding is about. If you can lock in an inflation-beating compounding engine and let it run over 30-40 years time, it has incredible inertia and momentum that will sustain you in the last 3rd of your life, when you aren't interested in running the race of the workaday world anymore.
What is the inevitable result when you purchase a source of rising earnings? Eventually, if not immediately or constantly, the value of the holding rises (Price per share, silly!). The market is fickle and often ignores rising earnings for quite a while, or sometimes gets a crush on an individual stock and drives price up far in excess of what is appropriate for current or projected earnings for a given stock. This is called over-valuation and it can be used to your advantage if you already own the stock, but it's a trap if you are in the purchasing mode, since paying too much for future earnings means you just won't see the growth in value of your investment if you pay too high a price for control of those future earnings.
One piece of this wisdom is that you should purchase stocks like you purchase a house. You don't purchase a house with the intention of moving in, then selling, moving out, buying and moving in again, selling and moving out very frequently. That's a ticket to bleeding from a thousand cuts. Same for the investment world. You need to purchase for the long haul. Then, short term fluctuations in price are less damaging to your overall investment performance. You don't see your money dribble out of your hands through hundreds of buy/sell transaction costs. Buy something that you won't sell, even if the market chooses to discount the value for significant periods of time. The key is to pay attention to the business performance and ignore the short-term fluctuations in stock price. After all, are you purchasing a piece of the business, or a stock certificate? Well, you're purchasing both, but unlike baseball cards, the stock certificate is merely representative of what you actually own, which is a part-ownership in a business. You buy a business so it can produce returns on your investment over time, like income and appreciation in value.
So, ask yourself, is that micro-cap, dot-com, start-up company more likely to be there in 10 years, or is Coca Cola? What is a "sure thing" for your long term security?
Mature companies that earn lots of cash often already have significant market penetration, so they aren't spending every dime trying to expand further. They have learned the dangers of rapid growth, so they have methodical, incremental growth and reinvestment strategies. However, they sell stuff that earns lots of cash. What do they do with that cash? Some of them hoard huge amounts of it. Others use it to reward the owners (stockholders).
They can do so in two ways; One is to repurchase shares with cash. This reduces the overall share-count and the share price tends to rise. You should be somewhat suspicious of this activity however; first, some companies buy back stock regardless of whether the price is low or high, taking some of YOUR money and spending it in a way that you WOULDN'T, buying stock at too high a price. Also, they buy shares, reissue them as options to executives, so the actual share count doesn't decline and the repurchase is a sneaky way of shoveling more money into the pockets of company insiders, instead of distributing profits to all owners proportionately.
A more transparent way for a company to reward it's owners is with dividends. Many, but not all companies pay out a portion of the profits from the business as dividends. The best of these companies, whose earnings rise year by year, also pay dividends that rise year by year. That is called 'dividend growth'. The rate of dividend growth can be measured. The proportion of earnings payed out as dividends can be calculated. These metrics can be tracked as a means to monitor company performance, just like earnings.
The key value in dividends is what happens when you turn them back into more shares of the same (or different) company. That introduces compounding into your investment performance. You not only benefit if the stock price rises, but you have more shares, each of which allows you to claim a piece of the next distribution of dividends. The practice of purchasing dividend-paying investments in companies that raise dividends reliably, then reinvesting the dividends to produce a rising stream of dividend income, is called Dividend Growth Investing. It's not the only strategy for growing wealth, but it has some very attractive features that make it a sound strategy for many reasons. We'll explore some of those reasons in future chapters. However, just as a taste of what is to come, think of this; you purchase a company that grows earnings by 7% every year. It pays out a fixed portion of earnings as dividends, say 50%. That means the dividend is going to grow by 7% per year. The fact that earnings grow by 7% per year, means that stock price will rise over time, unless the company is rampantly issuing more stock, diluting earnings per share (you have to keep an eye on this). If share count is static, earnings per share are rising 7% per year, so stock price will eventually rise about 7% per year. Are you trapped with a 7% investment yield? No...if you reinvest your dividends, you grow the value of your holdings at about 10.5 % per year, so you're accumulating wealth faster than the company is growing! That's the power of compounding.
More on this later...
There's a whole world of dividend investing resources out there, from subscription based investing newsletters (not free) to a bunch of web-based stuff, some of which is quite useful. Like anything else you have invested in, like your education, if you spend some time and effort, you can become knowledgeable and self-directed and you don't need to pay an "expert" to do it for you. After all, they don't guarantee results and they cost you investment performance due to fees. Trust me, you don't need them. What you need is knowledge, reliable sources of information, and a strategy that keeps you safe. You can acquire all of this without paying an adviser. Some tools are proprietary and you can choose to pay for them if you wish. I choose to subscribe to a few services that provide both intellectual content and screening tools. However, they make up a very small fraction of the investment expense, much less than an adviser or a mutual fund fee. Stroll along with me and I'll show you one way to do it yourself.
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