Saturday, October 31, 2009
It's Not a Game of Chance!
This is the second half of my intro to Fundamental Analysis. When you buy a stock, you do not need to hope and pray once that buy order has been filled. It is NOT like when you play roulette and the ball has been spun. This is because you know you have bought a stock that will likely go up! I will talk about a few tools that will help you identify whether a company is undervalued or not.
Ken Fisher pioneered the use of the Price-to-Sales ratio (P/S ratio) in the 1980s. One of the disadvantages about using the P/E (profit-to-earnings) ratio is that it doesn't really work if the company is not making any profit! Sometimes, you may find a company with very good prospects but is not currently making any money. How do you judge if this company is worth buying? The price-to-sales (P/S ratio) can help you.
The concept behind this ratio is simple. A company has a certain amount of sales or revenue and also costs associated with running the company, etc. For a good company, a portion of that sales will become profits. For really good companies, that percentage can be as high as 50% or 60%. What that means is for every dollar that its customers pay, 50% of that money is pure profit.
This helps us very much. Let's say a company has sales of $10 per share. The price of the stock is $15. It's not making any profit currently, but what if it starts cutting costs and starts making money at 50% margin? That means that it has $5 earnings per share ($10 sales × 50%). The P/E ratio becomes 3 ($15 divided by $5). And we know that for a healthy company, a P/E ratio of 3 is a dream come true for us investors! So, we definitely want to by this company!
So, what was the P/S ratio for that company we just talked about? It was $15 / $10, or 1.5. Of course, an operating margin of 50% is not easy to achieve. You will need to do some research on the particular industry you're looking at. If the profit margins for most of the companies in that industry is 20-30%, you may want to use 20% for your analysis.
Some people recommend that a P/S ratio of 1.0. I would definitely not go blindly and start buying any stocks that have a P/S ratio of less than 1.0. The company may be in huge debt and could go bankrupt at any moment! So, please do your homework!
A ratio that has been used for many, many years is the price-to-book ratio. It is a very well known ratio in value investing circles. The theory is very simple as well. A company owns many assets such as buildings, machinery, computers, product, etc. If it were to be liquidated, all of these assets can be sold for a value. This is the "book value". Sometimes, a stock may be traded at value that is lower than the book value. It's almost like someone coming up to you to sell you a $1 bill for $0.50! It's a little irrational, but it does happen!
So, a P/B ratio of less than 1 will start to get us excited. A caveat is that the book value may be inflated. It is a matter of accounting and goes beyond my knowledge. My advice is the same as always: be prudent and dig a little deeper. What seems too good to be true may be just that!
Get Out of Debt!
A company may have great P/E and P/S numbers, but it may also have a huge amount of debt. You have to wary of these companies. As we all know, with debt also comes interests. Debt is not necessarily bad in itself. Most companies borrow money so it is able to expand or to carry inventory, etc. However, if debt is too high, then you may want to avoid buying the stock of that particular company. You want the debt to be small enough that the company can pay back the debt in a few years. Simply compare the amount of debt to the earnings or free cash flow of the company. That will give you an idea of whether a good deal is really that good!
It's All So Complicated
You know what? You are right! Fundamental analysis is not easy and is still very much an art than a science. Most books will tell you exactly what I have told you...a whole bunch of ratios and no real way to evaluate if the business is fundamentally sound. Also, they will not give you a real quantitative way of determining under what price we should buy a company.
There's no need to fret! Take a look at one of my older posts: Rule #1 - The Book That Energized Me. It talks about a book that gives a very, very simple and quantitative way of determining whether a company is undervalued or not. I will likely write another post that is more in depth to discuss the actual calculations that the author, Phil Town, teaches. Stay tuned!
Sunday, October 25, 2009
Fresco at the Vatican, by Michelangelo, depicting the personifications of Fortitude, Prudence, and Temperance
In Catholic teaching, there are 2 major categories of virtues: human virtues and theological virtues. Theological virtues (i.e. faith, hope, and charity) are the basis of all other virtues and they relate to God. The human virtues, virtues that help us do good, are divided into 4 Cardinal Virtues: prudence, justice, fortitude, and temperance. Today, we will look specifically at the virtue of prudence.
Prudence, as defined by the Catechism of the Catholic Church (CCC 1806), "is the virtue that disposes practical reason to discern our true good in every circumstance and to choose the right means of achieving it...it guides the other virtues by setting rule and measure." Simply speaking, prudence helps us choose good and how to attain it with care. It is a virtue that proves to be invaluable to every investor.
When not using prudence in investing, it becomes what I call, "reckless investing". I have done some of that myself. It was the year 2000...I was 22 years old and had a beautiful image of the world (I still do, but in a different way). I have heard about people buying and holding stocks and making a small fortune over time.
I was hired as an engineering intern at Celestica, Inc. (Ticker: CLS). The dot-com days were coming to an end, but I had no idea. It seemed like everyone was doing very well in their stocks, because as we all knew, the internet will revolutionize the way we do everything! And the high-tech companies that were involved with manufacturing the infrastructure were bound to benefit. So, I bought into this thinking and invested my savings into the likes of Celestica, Nortel (ticket:NT...but they're in bankruptcy protection now, so you won't find much), AMD (ticker: AMD) and Nvidia (ticker: NVDA).
At that time, I had no idea what fundamental analysis was. Heck, I didn't even know what technical analysis was. I simply just bought stocks that had names attached to "tech". The most that I did was look at the stock's chart and extrapolated into the future to see how much money I would make. What happened after that, you are all fully aware. I made a couple of thousand of dollars at first, but soon saw much of my investment vaporize into thin air. This is the perfect example of "reckless investing".
Why was it reckless? Let me illustrate with an analogy. One sunny Sunday afternoon, you walk into a flea market. You want to buy something, but you don't know what. Soon, you see a crowd gathering around a booth, swarming to buy a gadget you have never seen before. You have no idea what the gadget does, but it does look kind of fancy with some spinning fins and a long cord. Most of the people around you don't know what it was either, but they all know it was a good buy since everyone else was buying it. So, you whip out a fresh $20 bill and hand it to the seller. As you walk home with the gadget, you admire at how shiny it is. Once you get home, you show it to your wife. She takes a look and says, "Hey, that's the USB fan they were selling on TV for $3.99 including shipping!"
That story sounds a little unbelievable, but that is exactly what investors were doing in the late 90s and early 2000s. They bought into companies, which they had not a clue what they were about, but most of all, they had no idea what they were worth. This is a result of lack of prudence on the part of investors. To be prudent is to know what a stock is worth and buy at a price below that.
Fundamental Analysis attempts to find the value of each stock. It's like buying bread at the supermarket. Even if everyone was buying a loaf of bread at $200 per loaf, you wouldn't pay $200 (unless there was a widespread famine), because you know a loaf of bread is only worth $3. Therefore, fundamental analysis seeks to find the intrinsic value of a stock.
Before we begin, let's look at a misconception of how stocks work. Stocks are traded in a stock exchange (e.g. New York Stock Exchange), where you, me, Warren Buffet, or the bum down the street may have access to (as long as we each have an account with a broker). The price of a stock at any given moment is simply the last price at which it was bought/sold. There is absolutely NO fixed relationship between a company's assets, earnings, or future prospects with how much a share of its stock is sold for. It is entirely determined by the price people are willing to buy/sell the stock for. However, having said that, people who buy/sell stocks are somewhat rational (at least most of the time), and will look at the company's well-being to determine what price is right.
There are instances where euphoria or depression hits the entire stock market. You can find evidence of the former in the late 90s where companies were bid up to prices hundreds of times above their earnings. The latter occurs in more recent memory in March of 2009, when the S&P 500 hit 666 points, more than 55% off its peak. The stocks were either traded at prices way above or way below what they were worth. So, our quest is to find out what the stocks are worth, buy at prices way lower than their worth, and sell at prices way higher.
Instead of looking at public companies, let's look at a small business to simplify things. Say your brother-in-law comes to you one day and proposes a business deal. He wants you to chip in to buy a local coffee shop. "Hmm," you think to yourself, "How do I know I'm not buying a sinking ship?" You then ask him to show you some numbers.
The current owner is asking for $500K for the coffee shop. For the past 5 years, business has grown from making profits of $40K/year to $75K/year. You have to admit, as well, that their coffee is pretty darn good. Ok, you say to yourself, if we invest $500K to buy this coffee shop, how long is the payback period? Assuming the profits continue to hover around $75K/year, it would take you a bit more than 6 years to recoup your initial investment. After that, it's all free money! You decide that it's a good deal and go ahead with your brother-in-law's proposition.
What we just looked at is the Price-to-Earnings ratio or P/E ratio as it is more commonly known. We essentially divide the price of a company by the profits it makes in the last year. How does that work for a stock? It's pretty much the same. When you research into a stock, you will readily find the earnings per share (EPS) published. That number is calculated simply by dividing the money the company makes in the last 12 months by the number of outstanding shares. You can then calculate the P/E ratio by simply dividing the share price by the EPS.
So you now know what the P/E ratio is, but how do you use it? It's simple. If the P/E ratio of a company is 1, it means in one year, the company made the same amount of money as it is currently valued. It is an excellent deal for a stable company, because you know the money will keep rolling in and you will have recouped your money in one year. There's very little risk in this investment.
If you find a company with a P/E ratio of 100, it would take 100 years for you to recoup your initial investment if earnings were to be kept consistent. That would not be a good deal!
The S&P 500 have averaged a P/E of between 12-18 in the past 50 years. For a company with steady earnings, you can expect the P/E to be around 10. For a growth company, the P/E can be 15 - 40. Many companies in the dot-com days had P/Es of greater than 100! As you can see, its not an exaggeration when I call my investing, reckless investing!
To Be Continued...
The P/E ratio only paints a small part of a bigger picture. If you find a company with a P/E of less than 5, it doesn't necessarily mean you have found a gem. The company may be in decline and its competition is about to wipe it out. Conversely, if you find a company with a P/E of greater than 100, it does not necessarily mean that it is overvalued. It may have been losing money in previous quarters, but the business is turning around. Earnings barely broke even, and therefore, the P/E ratio is inflated. Or, maybe the company is in growth mode and its earnings are on a straight trajectory to the moon. We need to look at many other factors to determine the value of a company.
In the second part of this post, I will go into more depth the different tools an investor can use to estimate a company's value.
Friday, October 16, 2009
This post is strictly a display of the engineer coming out of me. As a mechanical engineer, I'm fairly familiar with how statistics are used to estimate something. It's called statistical sampling. I'm sure you've heard of it before, but you may not have realized. It comes up every few years in a democratic state...how? Well, it's all in the polls. When an election comes up, polls are taken and each candidate or party is assigned a percentage of the votes predicted. For example, you will hear that the polls predict Candidate A will win the election, with the poll being right 19 times out of 20.
A Brief Lesson on Statistics
It all sounds a little unintelligible...how is it done? Well, as you might have guessed, the polls don't actually go to every single house in the riding and ask every eligible voter who he/she is going to vote for. The poll goes around and takes a random sampling of voters, say 1000 of them. Out of the 1000 voters, their opinions will give a picture of how the election will turn out to be. Assuming a normal distribution (bell curve), the poll will use what are called confidence intervals. In our case, it would be 95% confidence intervals, hence 19 times out of 20. Basically, the poll gives say Candidate A 45% of the vote. The 95% confidence interval can be42% -47%. Because it was only a sample of 1000 voters, the actual vote could vary between 42% - 47%. And we are 95% confident that this interval captures the right percentage.
So, why am I bringing this up? How does this apply to Q3 earnings season? Remember, you heard it here first. I'm using statistical sampling to predict how the entire Q3 earnings season will turn out. Using Yahoo Finance (http://biz.yahoo.com/z/extreme.html), I'm able to see which companies have beat, met, or missed earnings.
From Oct 5 - Oct 14, 37 companies beat earnings and 10 missed. The proportion is 78.7% beat earnings. This is a small sample of the companies that have reported, but we can estimate what the 95% confidence intervals are for the entire season. The confidence intervals can be calculated with the following equation:
For those who want to learn what the heck this is, you can visit wikipedia at http://en.wikipedia.org/wiki/Binomial_proportion_confidence_interval. Anyway, the intervals turn out to be from 67.0% - 90.4%. What this means is that we can be 95% confident that by the time Q3 earnings is done and over with, 67-90% of the companies will have beat their earnings estimates. So, up to 9 out of 10 companies could beat earnings this season! This is HUGE! Even if the final outcome is on the low side, two thirds of the companies will have beat earnings. This translates to an awesome earnings season to me! With this estimate, I'm quite willing to keep my money in the market!
We can continue to monitor and improve our estimates as new data comes out. By 12:30 pm on Oct 15, 93 companies have beat and 20 have missed. The proportion is now 82.3%, which is right inside our initial prediction. With the larger sample size, our new updated intervals are 75.3% - 89.3%. So, we're definitely on a good track to a good earnings season.
There are some caveats. The market is ever changing and so are earnings estimates. Market analysts are free to change their estimates as they continue to observe the earnings that are coming out. So, their estimates may drift up or down depending on how other companies are doing, which means this method is not totally accurate!
As well, our sampling may not be randomized enough...So, be careful when using this method. Having said that, I am still predicting a good earnings season, which would logically result in a good market!
Saturday, October 3, 2009
"Wealth quickly gotten dwindles away, but amassed little by little, it grows." - Proverbs 13:11
Wisdom of the Proverbs
The wisdom of the Scriptures is really amazing. It is full of timeless truths, and this verse from the Proverbs about wealth is no different. You can imagine two people with very different circumstances. The first won a million dollars in a lottery and the other, over his entire working career, amassed a savings of a million dollars. What kind of mentality would the former have when he cashes that million dollar cheque? Maybe, "I'm going to treat myself to a nice vacation, buy a sports car, spread a bit of the wealth to my close friends, etc." There is absolutely nothing wrong with any of the above, but the frame of mind is to spend, and to spend quickly. At the end of the first year, he may have spent a good 20-30% of his fortune. On the other hand, the latter understands the hard work it took to save up that one million dollars. He is not going to spend a good chunk of it in one setting.
The Proverbs is not commenting on the morality of the speed of obtaining wealth, but it is simply stating a fact. When money is obtained in a short timespan, chances of it being spent quickly is higher. On the other hand, if it is saved over a long period of time, it will grow. It speaks more about human nature than anything. Saving requires discipline and once obtained, it stays with you for the rest of your life.
Catholic Retirement...Well, Really, It's Just Smart Retirement!
So, how do we apply this proverb to our investments? What is the way of Catholic retirement? In my spare time, I have built a spreadsheet that plans out my retirement. It is like one of those retirement calculators that you can find on bank websites, except better! :) Please download it if you'd like. You'll need to enable macros in Excel for this to work, but don't worry, no viruses here! Let's go through it line by line.
First, what do the colours mean? Yellow denotes an entry box. If the cell is not yellow, you don't need to touch it. Some of the colours I put in there just highlights certain things.
1. Right at the top, we have our biggest enemy: inflation! One of the main reasons why we cannot afford not to invest is because if our money is stagnant, the value of it actually decreases over time. Everyone can recall how something used to be so much cheaper when they were kids! The historical inflation rate in North America for the past few decades is somewhere between 2 to 3%. I've put in a default 2.5%.
2. The second entry box is the growth rate of our investment. This is the average growth you are expecting to see in your investment per year. For reference, a CD (certificate of deposit [or GIC - guaranteed investment certificate in Canada]) usually returns about 2-3%, because it typically matches inflation quite closely. Therefore, CDs usually give an illusion of increasing the value of your money, when in fact, it is remaining constant, at best (due to the canceling effects of inflation). Depending on which years you take an average, the S&P 500 index will return anywhere between 8-12%. I don't believe that is good enough. My goal is to get 20-30% returns consistently year-after-year. You will soon see how much difference a few percent make!
3. The third entry box is how much money you intend to add to your retirement investment each year while you are still working. 10-20% of your before-tax income would be a good start.
4. The fourth entry box is how much money you already have in your investment.
5. The fifth entry box is your estate value (in today's dollars), or how much money you want to leave your family/friends/charity of choice.
6. The sixth entry box is your current age.
7. The seventh entry box is your final age, or how long you're expecting to live. To be safe, I have put 85 so we ensure the chances of you running out of money is low.
8. The eighth entry box is the fun part. It's how many more years you want to work before you retire...Go ahead, have some fun...put in 5 and see what your investment needs to do for you to achieve that goal...freedom 35...not impossible to achieve!
9. Now we have our first non-entry box. The "age of retirement" box just shows how old you will be at your retirement.
10. The next box is the "years of retirement". It shows how long your retirement will last.
11. Here, this box shows how much your investment is worth at retirement. Whatever numbers you have chosen, it does look pretty big, doesn't it? That is the power of compounding, my friend. Your money will work harder and better than you will ever work for yourself! And that is the reason why you're reading this blog!
12. The 12th box shows your estate value in the "future" dollars. The value of the money is the same, but the magnitude of the number is larger due to inflation.
13. After retirement, some people choose to move their investments into safer vehicles (e.g. bonds). I do not necessarily agree with that strategy, but it is understandable. So, how much do you expect your investment to return (after inflation)? For simplicity sake, if you expect it to be 10%, just minus the inflation rate from 10%. So, if you are using 2.5% as your inflation, enter 7.5%.
14. If your retirement investment is in some tax-deferred plan (such as 401(k) or IRA [RRSP in Canada]), you will get taxed as you withdraw money. If it's not in a tax-deferred plan, you probably still have to pay taxes on capital gains. Enter in the tax rate at which you expect to be taxed.
15. This box shows you how much money you will withdraw from your retirement funds during the first year of your retirement.
16. This box shows how much actually gets into your hands after Uncle Sam takes his cut.
17. Finally, this is the inflation adjusted amount, or in other words, what the value is in today's dollars. If you intend to be spending $40000 per year in your retirement, you would want this number to be $40000.
Now that you have entered in all your info, click on that "Optimize for Retirement" button at the bottom. You will need to have macros enabled for this button to work. Otherwise, it'll just do nothing. What this button does is it find out how much money you can withdraw per month based on the data you have provided.
I will confess now: this spreadsheet is not entirely flawless. Many things change over the course of your lifetime, including inflation rates, tax rates, etc., etc. This sheet only provides you a constant value for these things. If you want to be on the safe side, enter a larger number for inflation and taxes. Having said that, this sheet will probably suffice in showing what actions you need to take in order to achieve your retirement goal.
Now, Let's Have Some Fun!
So now that you have become familiar with the spreadsheet, let's play around with some numbers to see what our retirement is going to look like.
The Young Father
So, let's take someone similar to myself, in his 30s with a young family and some savings. For our numbers, let's use...
Contribution per year: $5000
Present investment value: $20000
Estate value: $0
Final age: 85
Current age: 30
Remaining work years: 30
I've left out the investment growth value so we can play around with that.
Investment growth rate: 3% --- Value at Retirement: $293,559
Investment growth rate: 9% --- Value at Retirement: $1,008,230
Investment growth rate: 15% --- Value at Retirement: $3,824,020
Investment growth rate: 20% --- Value at Retirement: $11,838,816
Whoa! What a difference! I did not select these numbers randomly. 3% is a typical return for a CD (or GIC). 9% is an average return for the S&P 500. 15% is considered a very good long-term return for any fund. 20% is what I believe a smart individual investor can achieve the long-term.
As one can see, the investment value grows exponentially as your growth rate increases. If the young father has a return of 9%, he will have $1 million when he retires. If, on the other hand, his return is 20%, he will have almost $12 million! That's a 12-fold increase in value for a 2-fold increase in growth rate! So, here we have it. Don't settle for less! You want to increase your growth rate as much as possible!
The Early Bird
Now that we have established the importance of growth rate, let's look at our time horizon. For our numbers, let's use...
Growth rate: 15%
Contribution per year: $5000
Present investment value: $0
Estate value: $0
Final age: 85
Let's change up the age and number of working years and assume that we work until 60 years old. This represents how early we start our retirement savings.
Current age: 20, Remaining work years: 40 --- Value at Retirement: $10,229,769
Current age: 30, Remaining work years: 30 --- Value at Retirement: $2,499,785
Current age: 40, Remaining work years: 20 --- Value at Retirement: $589,051
Current age: 50, Remaining work years: 10 --- Value at Retirement: $116,746
The Early Bird, starting at age 20, saves up $10 million dollars for his retirement, while the late starter, at age 50, is only able to save $116K. The late starter is going to have a really tough retirement living on government pensions! Again, for compounding to work its magic, it needs time! The difference of 10 years can prove to be life-changing! If you can afford to work a few more years, your retirement can be a lot more enjoyable!
The Super Saver
Let's see how the contribution amount affects the final value your retirement funds.
Growth rate: 15%
Present investment value: $0
Estate value: $0
Current age: 30
Final age: 85
Remaining work years: 30
Contribution per year: $1000 --- Value at Retirement: $499,957
Contribution per year: $3000 --- Value at Retirement: $1,499,871
Contribution per year: $5000 --- Value at Retirement: $2,499,785
Contribution per year: $10000 --- Value at Retirement: $4,999,569
There's sometimes a slight misconception amongst investors that the more one contributes to one's retirement funds, the better. That is true, but to a lesser effect than the previous two factors. The value of retirement grows linearly with the contribution amount. $1000/year contribution yields a final value of $500K, while a $10000/year contribution yields a $5 million final value. So, yes, it is true that it is better to contribute more, but its effects are less pronounced than if you spent some more time increasing your returns by 1 or 2%, or if you start your retirement savings a year or two earlier.
The conclusion is threefold:
1. Increase your returns!
2. Start early (or work a little longer)
3. Increase your contribution (but don't put too much emphasis on this).
Since this is a blog about investing, we will focus on conclusion #1 in future posts. It's actually not that difficult...don't get fooled by the myths perpetuated by the investment industry. The individual investor has many advantages over fund managers and yes, even Warren Buffet. We'll explore these a little later on!
Labels: Retirement Planning