by WWM | Feb 28, 2018 | Compound Returns, Investment Concepts
Before getting into mutual fund concerns, I want to cover a crucial investment concept. One that will help clarify a few of the problems with many investment funds. Namely, the concept of compound returns.
Understanding and properly utilizing the power of compound returns will likely grow your investment portfolio more than any individual investment selection.
Got your attention? Good. Because first we need to look at some calculations to understand compound return.
For the examples below, we will keep it straightforward. We shall assume this is a typical economist’s world with no taxes, no transaction costs, reinvestments at the prevailing rates, etc.
Simple Returns
Most are familiar with simple return. That is the return you receive from an investment in interest, dividends, or capital.
The important thing with simple return is that the money earned on the investment is not re-invested. You receive the interest or dividend and then you promptly spend it celebrating your shrewd investment skills.
For example, you purchase a $1000 bond at face value with a 10% interest rate paid annually. Each year you receive $100 in interest for a simple return of 10% annually. At the end of the 10 years, the bond matures and you are paid back your original $1000. The net return was also $1000 over the 10 years (10 payments of $100 per year).
You might also consider returns in your own life. Anywhere you work involves a return on your efforts.
Let’s say you work in a factory. You are paid for each box assembled and each day you can assemble 20 boxes. You pile them in the corner and your boss counts them Friday evening. Then you are paid $100 per box. Work harder and you might get 25 completed. Take it easy and you get less done. Friday night you should have 100 boxes completed and get paid $1000. The 100 boxes and the $1000 are the simple return for your labour.
Compound Returns
Compound returns are like simple returns, except you do not spend the money you receive from the investment. Instead, you reinvest the receipts at the same rate of return as the original investment.
Say you purchase a bond fund that will yield 10% annually for your $1000. Essentially the same investment as in our example above. However, interest earned on the fund is automatically reinvested in the fund so that your returns compound annually.
At the end of year one, you earn $100. Same as with the simple return. But instead of getting a cheque for $100 and spending it, the interest is automatically reinvested in additional fund units.
So that $100 of earned interest stays and will start to earn interest itself for the remaining 9 years of the investment. And that is the key to the power of compounding.
At the end of year two, your original $1000 will have earned another $100. Plus your year one interest of $100 will have returned an additional $10. This pattern continues over the life of the investment.
Each penny you earn on your investment will itself begin to generate its own future returns. And that future return will also start earning a return.
Now $10 here and there may not seem like much, but over time it really adds up. In fact, in many investment scenarios, the incremental returns from reinvesting previous returns is greater than the simple return.
In this example, at the end of 10 years your investment has earned you $1594. Compare this with the $1000 under the simple return. You did significantly better under the compound return.
Through the compounding in this example, you generated an extra 59% return over the 10 years. Not too bad for something that had no cost to you.
If it been a 20 year bond rather than 10, your cumulative simple return would be $2000. However, the total compound return would be $5727. The return from reinvesting the interest income is greater than the interest on your initial capital.
If we look at the warehouse job again, think of it as a factory from a magical world. On day one, you assemble your 20 boxes. On day two, you assemble another 20, but you notice the boxes from day one have risen up and started assembling more boxes themselves. By day’s end your pile has 20 boxes in it, but the boxes have contributed another 3, for a total of 23. A greater result, yet you did not work any harder.
On day three, you keep working on your 20 boxes. Again, those other boxes are assisting. As there are now 43 boxes to start day three, they generate 6.5 boxes rather than the prior day’s 3.
When your boss does the Friday count you are surprised to find 135 boxes assembled. You only assembled 100, but you ended up with a lot extra. And, as the boxes do not get paid, you get the entire $1350 for yourself.
You head home to enjoy the weekend, realizing that come Monday, the boxes will start producing more boxes each day than you do yourself. In time you can let them do all the work and assist your boss in finding a bigger warehouse for all the assembled boxes.
That is the power of compounding!
Next up, we shall look at Compound Return Investment Lessons.
by WWM | Feb 21, 2018 | Mutual Funds
Today we will explore the advantages of mutual funds as investments.
I believe mutual and exchange traded funds (ETFs) should be the cornerstone of most investors’ portfolios. This is especially true for investors who have have yet to accumulate significant wealth. However, even for those with substantial portfolios, funds are often the wisest investment path.
Why do I think this? What are the advantages of investing in mutual funds?
Investment Options
As we saw in our Mutual Fund Introduction, there are a vast number of funds available for purchase in a multitude of investment styles and asset classes.
Previously, we reviewed various Mutual Fund Categories. You can invest in specific asset classes, such as fixed income or equities. You can also invest in funds that follow specific investment strategies or analytics. If you want funds following value or growth strategies, no problem. You want dividend yield, there are many funds to invest in. Small-cap, biotech funds from Israel? You can find those too. Pretty much everything can be found in a specific fund.
This allows you to easily create any combination of assets within your portfolio. Also, to quickly adjust these combinations as your personal circumstances change.
You may even find funds that allow access to investments that you could not feasibly acquire on your own. Real estate, venture capital, and fine art are examples.
When we discuss asset allocations and portfolio returns, you will see that having ready access to a wide variety of assets is vital to investment success.
Diversification
Diversification is an extremely important feature of funds, especially for smaller investors.
Diversification allows one to reduce overall portfolio risk while maintaining the same level of expected returns. It also allows one to invest in riskier assets that have higher expected returns without increasing the overall portfolio risk.
A very useful tool to incorporate in one’s investment strategy. Probably the most important aspect of successful investing.
For more information on diversification, please refer to three earlier posts: An Introduction to Diversification; Diversification and Asset Correlations; Asset Correlations in Action; A Little More on Diversification.
Due to the number of investments held within a typical mutual fund, there is normally strong diversification already built in. Not always, as we shall discuss later, but usually.
Diversification within a fund will relate to the category of the fund. The diversification may be between: companies in specific sectors (e.g., oil and gas exploration equity funds); entire sectors and industries (e.g., consumer product equity funds); geographical regions (e.g., country specific, international, or global funds); maturity dates (e.g., long term bond funds); asset classes (e.g., balanced or asset allocation funds).
Smaller investors may not be able to diversify on their own through individual assets. This may be due to the lack of overall wealth, an inability to access investments across all asset classes, or the prohibitive cost in trying to diversify with limited funds.
As one’s wealth grows over time, an individual may be able to achieve adequate portfolio diversification on his own. But for any investor, even larger ones, mutual funds can provide excellent diversification on a cost-effective basis.
For example, the RBC O’Shaughnessy All-Canadian Equity Fund provides exposure to a variety of Canadian public companies. As at February 20, 2018, it holds 104 companies in its portfolio. How many investors have the wealth to invest in 104 different companies? Not to mention the time to analyze and track a portfolio of that size.
Cost Effectiveness
Diversification is crucial in investing. But it can be a costly endeavour.
To create a well diversified portfolio requires a significant number of different investments. In diversifying away the nonsystematic risk in equities alone may necessitate holding at least 30 to 40 different stocks. Then factor in fixed income, money market, and other asset classes (e.g., real estate, commodities) and one’s portfolio can become quite large.
This is especially problematic for investors in two cost-related ways.
First, when trying to diversify within and between asset classes, the average small investor tends to spread themselves thin when acquiring investments.
Second, buying marketable securities (stocks, bonds, etc.) involves paying commissions on each trade. The less securities purchased, or the greater the number of trades made, the higher the relative cost of the acquisition.
For example, to invest $6,000 in 30 different stocks, you are only able to invest $200 in each company. That may not allow you to purchase very many shares of any company. In some cases, $200 might not even allow you to acquire one share in some popular companies. Amazon, Google, Tesla (and many others) would be excluded from your investment options as all currently trade above $200 per share.
And even with low online brokerage rates of $10 per trade, you will spend $300 on commissions to buy 30 different companies (as opposed to only $10 had you bought just one stock). You will need to generate a portfolio return of 5% simply to recover the commissions paid. Not an easy endeavour.
By investing through mutual funds, you pool your money with many other investors. This provides an economy of scale to reduce the individual impact of commissions and allows for the purchase of assets of any value. Even Berkshire Hathaway A shares at a February 20, 2018 price of $306,000 per share.
Economies of scale also allow for better pricing on fixed income instruments. As greater amounts of money market instruments are purchased, the offered interest rate is typically higher than for smaller investments.
A third “cost” is the value of your time. Unless you love to spend your spare time analyzing investments (granted, who does not love that), then there is the cost of your time. Even investing in 30 stocks requires a lot of effort to identify potential investments and monitor your holdings. Funds simplify the process and time required.
Ease of Investing
One thing that brokers and mutual funds are great at is making it very easy to invest.
You can invest in funds either through the specific fund itself or via your brokerage account.
Note that some funds may not be available through your broker. Different brokers may offer different funds. Some offer a better selection than others. When choosing a broker, find one that offers a wide selection of funds for purchase.
There are many funds that do not have sales fees (front or back loads) which saves money. Often, brokers waive commissions for the purchase of certain funds that they sell. Or there may be no commissions when shifting money from one fund to another in the same fund family.
Again, when choosing funds or an online broker, consider the transaction costs associated with the fund purchase. Given the number of funds available, you should be able to fulfill your investment objectives entirely with no-load funds.
There are very few reasons why you should pay a sales fee or commission on a mutual fund. Avoid.
Many funds allow relatively small initial investments and even smaller subsequent purchases.
Some funds allow for automatic investments via monthly/quarterly/etc. direct debits from your bank account. These Direct Purchase Plans (DPPs) allow investors to invest without making an effort. It is also a superb way to engage in dollar cost averaging. A concept you should utilize and one we will cover later on.
Some funds offer Dividend Reinvestment Plans (DRIPs). Any distributions made from the fund are automatically reinvested into additional shares of the fund. Except for having to pay tax on distributions you do not physically receive, this is an excellent way to invest and accumulate wealth over time.
Liquidity
Liquidity, or ease of divesting, is another advantage of mutual funds.
Asset liquidity is important when assessing investments. To refresh, please review Liquidity Risk for Investors.
With some exceptions, most open-ended mutual funds are valued daily. These funds normally redeem (i.e., buyback) your shares (or units) each day based on the fund’s closing net asset value. Because the fund itself redeems the shares, open-ended funds are usually extremely liquid.
And by posting net asset values daily, investors have high certainty as to the proceeds they will receive on disposition.
Professional Management
Some believe this to be an advantage. Others actually believe it a negative.
In theory, having a mutual fund professionally managed should be a positive. The investments made are well researched. The portfolio is monitored to ensure proper construction for the style (e.g., a value equity fund has the best possible value stocks). And when it is appropriate to sell securities, they are sold in a timely manner.
In short, you are letting an investment professional make the investing decisions for you.
Assuming you are not a professional yourself, that should mean better investment decisions will be made than if you were left to your own devices. Also, by delegating asset management to a professional, you do not need to spend your precious time, researching and monitoring multiple investments.
In practice, this advantage does not always arise. In delegating the investment decisions to others, you must pay for that privilege in higher management fees. That might be okay if the annual performance of actively managed funds exceeded passive (no professional decision making) funds. But that is not always the case. Nor even usually.
We will look at the active versus passive debate in an upcoming post as it is an important issue.
While these advantages make mutual funds appear the ideal investment, there are some potential drawbacks or issues that must be considered when investing in mutual funds.
We will look at these next time.
by WWM | Feb 14, 2018 | Mutual Funds
We detoured from our review of investment funds to look at a few strategies and analytical ratios often used by investors.
In our Mutual Fund Introduction, we saw that there are an overwhelming number of mutual funds on offer. And that these funds cover the entire spectrum of asset classes and sub-classes.
How can investors possibly make sense of these investments? Truthfully, it is hard.
Today we will look at a few available mutual fund types.
Money Market
Money market instruments are short-term debt instruments (i.e., less than 1 year to maturity). Investments are considered extremely safe due to the nature of the fund investments.
Interest income is paid to investors.
While the returns are not high, they are better than what one would receive from savings accounts. And as the fund aggregates money from many individual investors, it can obtain higher returns on treasury bills and other short-term debt than a small investor could achieve on his own.
Money market funds may be available in foreign currencies. This may create foreign exchange gains or losses as compared with the investor’s domestic currency. In some cases, this can greatly enhance investor returns or possibly create losses.
Always take care when investing in money market funds – or any asset – that are not in your own currency.
Fixed Income Funds
You may also see these termed “bond funds”.
These funds invest in government and corporate debt. Some include preferred shares as well.
Within the fixed income style, there are many sub-categories.
Quality of Issuer
Some funds focus only on high quality debt issuers.
Other funds specialize in high risk issuers in the expectation of receiving higher returns. This latter group of non-investment grade fixed income instruments is known as “high yield” or “junk bonds”.
The quality of the issuer is based on ratings assigned by one of the bond rating agencies. For example, bonds with ratings below BBB by Standards & Poors or Baa by Moody’s are considered non-investment grade bonds.
Terms to Maturity
Some funds concentrate on specific terms to maturity. Perhaps only investing in bonds with maturities between 5 and 10 years. Or maybe only in bonds with over 20 years life remaining.
Or you may see “bond ladders”. These funds spread out maturity dates like rungs of a ladder to smooth interest rate and reinvestment risks.
Regardless of Type
Fixed income funds attempt to generate a steady cash flow of interest (or dividend) income to investors. Although the objective is income, there may be capital gains or losses as well.
As interest rates fall, the market value of existing bonds will increase. This can create a capital gain if the bond is sold prior to maturity. Should interest rates rise, bond prices will fall, causing a capital loss if the bond is sold.
Due to the underlying investments and longer maturity dates, fixed income funds should generate greater interest income than money market funds. However, in times of rising interest rates, money market funds may outperform fixed income funds if the fixed income funds experience capital losses. Something to watch out for when investing in fixed income.
Balanced Funds
Balanced funds try to provide a balance between security, income, and capital appreciation.
The funds invest in a mix of money market, fixed income, and equity instruments to achieve this objective. As a result, the fund generates both dividend and interest income as well as capital gains (or losses).
The asset mixture is defined in the fund’s stated objectives. They do not need to be “balanced” equally.
Combination of asset classes may be fixed (e.g., 5% money market, 35% fixed income, 60% equities) or have a range of maximum and minimum investment levels for each of the three classes (e.g. 0-10% money market, 20-50% fixed income, 40-70% equities).
Investment percentages may further be broken down into asset sub-classes. For example, if 60% is allocated to equities, perhaps 30% is United States, 25% Other International, and 5% Canada.
The fund’s prospectus will lay out the investment strategy and restrictions.
Do not confuse balanced funds with asset allocation funds.
Asset Allocation Funds
Although similar in nature, there is usually greater flexibility in an asset allocation fund. This allows the portfolio manager to take advantage of changes in the business cycle to maximize investments in an asset class.
For example, as the economy heats up, stocks will begin to rise and fixed income assets should fall in value. An asset allocation portfolio manager has the flexibility to shift the bulk of the portfolio assets into equities and out of under-performing asset classes like bonds.
Balanced funds have less or no leeway in altering the asset mix.
Because of the extra work involved by the asset allocation managers, it is normal for asset allocation funds to charge higher fees than similar balanced funds.
Target-Date Funds
Like balanced or asset allocation funds, target-date funds invest in multiple asset classes.
However, target-date funds automatically reset the portfolio asset mix based on the stated investment time horizon.
With a long maturity, investments are skewed towards riskier assets. As the maturity date gets closer, assets shift into less risky investments.
This is much like Life-Cycle funds (also known as “Aged-Based” funds).
We will consider these funds further when we look at investor profiles and strategies.
Equity Funds
The largest class of funds are equity funds. They also have the most sub-categories.
In general, equity funds strive for long-term capital appreciation. Some may also generate income, but that is normally a secondary consideration. The exception being equity income funds that specifically seek dividends.
Equity funds may be aggregated in a variety of ways.
Market Capitalization
They may focus on stocks of companies that have certain levels of market capitalization. Large cap or small cap equity funds are common variations.
Type of Company
They may focus on characteristics and style fits of companies.
For example, value or growth equity funds.
Some funds focus on companies that pay high dividends. Others on companies that pay no dividends.
Geographics
You will also see funds based on the geographic location of the underlying companies. These equity funds may be designated domestic, international, and global.
Domestic equity funds are those that contain stocks listed on stock exchanges in the same country as the investor.
International equity funds are those whose companies are listed on stock exchanges outside the investor’s country of domicile. International funds may also be called “foreign” funds.
Global equity funds may contain shares of companies from anywhere in the world.
For example, consider the Credit Suisse (CH) Swiss Blue Chips Equity Fund UB. It invests mainly in large cap companies located in Switzerland. Nestle, Novartis, Roche, UBS, etc.
As a Swiss investor, this would be domestic fund. To an Canadian investor, it would be an international fund.
In contrast, the Credit Suisse (Lux) Global Value Equity Fund BH CHF invests in a wider range of equities. Its scope includes “undervalued companies which are listed worldwide on regulated and accessible markets.”
Because it has shares of companies from both within and outside Switzerland, it is a global fund to a Swiss investor. And to a Canadian investor as well.
Sector
Within the broader categories, you may see smaller fund compositions, such as by industry or business sector.
For example, Fidelity offers equity funds that cover: Consumer Staples, Consumer Discretionary, Energy, Industrials, Telecommunications, Financial Services, Health Care, Materials, Natural Resources, Precious Metals, Technology, Utilities.
Countries or Regions
Funds also exist that narrow the geographic segments into regions and countries.
T. Rowe Price has a Global Stock fund. But they also provide more geographically focussed equity funds including: Africa & Middle East, Emerging European & Mediterranean, Emerging Markets, European, Japan, Latin America, New Asia.
Or you may even see subsets of subsets. A BRIC fund is a good example. This is an emerging market segment that includes only Brazil, Russia, India, and China. The four largest emerging markets.
Speciality Funds
Speciality funds are those that do not fit into one of the above boxes. Hard to believe, I know.
That said, some people include sector and regional funds as specialty funds.
Real Estate
In this category, you usually find investments in real estate companies or assets.
Some funds invest in operating companies that manage hotels, develop properties, etc.
Precious Metals
You may also see funds that invest in precious metals.
This can be achieved by investing in companies involved in precious metals. Often this includes indirect involvement, such as service companies.
It may also include direct investments in the assets.
For example, Tocqueville Gold (TGLDX) invests about 80% of its capital into shares of mining and related companies. But up to “20% of the fund’s total assets may be invested directly in gold bullion and other precious metals.”
Collectibles
Some funds allow you to invest in other exotic assets such as collectibles.
There are many funds that specialize in tiny market segments, including fine art and vintage wine.
I would caution investors with these unique types of funds. Usually the management fees are extremely high, the ability to liquidate one’s investment may be limited, and the investment time frame required may be substantial.
While collectibles may be useful for diversification, I would not recommend their purchase for most investors.
Environment, Social, and Governance (ESG)
A very popular investment niche over the last decade or so.
These funds invest in specific areas or exclude specific investments from their options in an attempt to be socially responsible or ethical.
For example, the Pax Ellevate Global Women’s Index Fund (PXWIX) employs “a global, index-based investment strategy designed to capture investment returns associated with gender diversity and women’s leadership.”
Or consider The American Trust Allegiance Fund (ATAFX). Its investment strategy seeks positive returns, while “avoiding companies involved in the alcohol, gambling, tobacco and health care industries.”
That is an overview of common fund categories. Over time, I will discuss these in more detail as we look at constructing diversified portfolios.
by WWM | Feb 7, 2018 | Investment Strategies
Growth strategy is another extremely common method for investing in equities. Many mutual funds offer this style.
Some investors view growth investing as the polar opposite of value investing. I would not fully agree with that assessment. There are differences, but there is also common ground between value and growth strategies.
Today we will take a look at growth investing. What it is. How it really compares to value investing.
Followed by things to watch out for when trading in growth stocks.
Growth Companies
Growth companies are those whose future earnings are expected to grow at a higher than average rate as compared to specified benchmarks. The benchmarks may relate to the stock market as a whole. Or to the industry or sector in which the company operates. Sometimes projected versus historic earnings growth of the company itself is factored in.
Companies expected to have strong earnings growth typically pay out little to nothing in dividends to shareholders. These companies reinvest their earnings and cash flow into the company, so as to continue growing the business.
As we saw in value investing, analysts review price-to-earnings (P/E) ratios to assess where a stock might trade. If earnings are rapidly growing, that suggests upward stock price movement, assuming the P/E multiples remain constant.
Growth Strategy
In value investing, investors look for companies with relatively low P/E and price-to-book (P/B) ratios, as well as high dividend yields.
In growth investing, this same fundamental analysis is less important.
Growth stocks may have low price-to-earnings or price-to-book ratios. More typically, the ratios will be relatively high. This reflects the belief that growth stocks will increase their earnings over time, thereby justifying higher multiples. However, high P/E and P/B ratios are more a result, not necessarily an indication, of a growth stock. I would not focus my growth strategy on stocks with high P/E or P/B ratios. Instead, focus on earnings growth projections.
Individuals invest in growth stocks for the capital appreciation, not for dividend income. As a result, dividend yields are not heavily considered. Except to the point that growth investors prefer companies that reinvest earnings into the company, not pay them out to shareholders in dividends. You will find that growth stocks tend to have low to zero dividend yields.
Due to the desire for capital gains over income stream, growth investors have a higher risk appetite than value investors.
Quantitative Analysis
The key is the expected earnings growth, rather than any specific ratios.
In analyzing the numbers, investors look at three areas.
Historic Revenue and Earnings Growth Rates
Revenues drive earnings. Without sales growth, earnings will suffer.
Earnings result from revenues. But they are also impacted by a company’s cost structure.
Revenues may increase, but if a company cannot manage its expenses, then earnings will not increase as expected.
When assessing earnings potential, it is imperative to consider costs, not simply revenues.
Some analysts believe one should look for companies that have experienced a minimum of 10% average annual growth in both revenues and earnings over the previous 3-5 years. Others believe 15% is more appropriate, with a 20% growth rate for the most recent year.
Rather than engage in absolutes, I prefer to compare a company’s metrics against competitors, industry, and the market as a whole.
Perhaps the biotech industry earnings are growing at a rate of 50% per annum. Would I consider any biotech companies growing at 30% as growth stocks? Probably not.
When looking at numbers, always put them in context.
Future Revenues and Earnings Growth Rates
As with any quantitative analysis, the past is interesting, but the future is what counts.
Investors must analyze potential growth rates for revenues and earnings over future periods.
For many companies, professional analysts and the companies themselves provide estimates for future results.
Of course, the future is based on many variables that may or may not come to pass.
And the farther out the time period, the less reliable the estimates.
PEG Ratio
One ratio that growth investors do often use is the price-to-earnings-to-growth (PEG) ratio.
It takes a company’s P/E ratio and divides it by the company’s annual earnings growth rate. The lower the ratio, the potentially more attractive the stock.
Stocks with ratios less than 1.0 are considered undervalued.
Some investors prefer the PEG over the P/E alone as it factors in growth rates, not simply static earnings.
Consider two companies. A has a share price of $100, earnings per share of $2.00 and an expected annual earnings growth rate of 25%. B has a share price of $15, earnings per share of $1.00 and earnings growth of 10%.
With greater earnings and higher growth rate, A might be the better stock.
But if we look at the ratios, we see that A has a P/E of 50 and a PEG of 2. B has a P/E of 15 and a PEG of 1.5.
In comparing P/E ratios between A and B, it is hard to come up with an assessment of value. The lower P/E of B indicates it might have value versus A. But without knowing the industries in which the companies operate (and the industry average P/Es), it is difficult to make any sense of the ratios.
By factoring in the earnings growth rates, comparisons can be made.
With a lower PEG ratio, B appears to be the better investment. A may have higher earnings per share and better expected growth, but it appears to be overpriced relative to B.
Qualitative Analysis
In assessing growth stocks, qualitative analysis is extremely important.
In this sense, growth analysis is very much the same as value investing.
When determining the potential for growth, investors seek companies that they believe will dominate their industry or sector. Companies that will experience revenue and earnings growth that is superior to its competitors or the market.
Companies that dominate tend to have at least one significant competitive advantage.
This may include: patents, new technology, etc. that provides a product or service advantage; superior management that provides the leadership to excel; possessing substantial barriers to entry that prevent competitors from entering the industry, thus creating a monopoly or oligopoly that can be exploited; marketing campaigns that enhance sales; superior production or delivery methods that reduce costs versus competitors.
Microsoft, Dell, Apple, and Google have all been growth stocks. If you look at their developmental years, you can see how they used different competitive advantages to rapidly increase revenues and earnings.
Each of these companies has many reasons for their rapid growth. But if we pull one reason from each, we see some of the above characteristics. With Dell, it was a superior delivery method for personal computers. Apple had a visionary leader in Steve Jobs. Google developed a new method to search the internet. Microsoft rose to dominance with their proprietary operating systems.
I could list many other examples of companies with competitive advantages. I am sure you can think of many as well.
Assessing the futures earnings potential requires more qualitative analysis than quantitative.
Problems with Growth Stock Analysis
Growth strategies are based on investing in stocks with relatively high earnings growth.
But in assessing earnings growth, one must make assumptions concerning multiple variables. As with any estimates of future results, there are many variables that need to come true. If any of the assumptions are incorrect, the resulting earnings projections will be wrong.
Second, the farther out the time horizon, the less reliable any estimates can be.
These are two problems with all quantitative analysis under any investment style. Having to rely on variables and guesstimates that may or may not come true. And the longer the time period, the more risk of errors.
Third, what exactly is relatively high earnings growth differs between investors. As we saw above, some analysts believe 10% growth to be high. Others 15%. And there are no doubt some investors that have higher thresholds.
How you define a high growth rate will frame your investment options.
Fourth, many growth stocks are relatively small companies; small to mid-cap in size. Therefore, public information may be limited, making quantitative analysis more difficult.
As companies grow in size, it becomes harder to maintain above average growth rates.
You can see this in many former growth stocks. Over time, as they grow, earnings growth falls within normal parameter.
While there are differences between value and growth styles, they do have commonalities.
Both rely on quantitative analysis that is based on assumptions that may or may not be accurate. The worse the assumptions, the greater the probability of poor investment selections.
And both styles rely heavily on qualitative assessments. This requires an understanding of the company and the industry in which it operates.
by WWM | Jan 31, 2018 | Investment Analysis
Financial ratios have value to investors and analysts. But there are also limitations to their usefulness.
Why is Dividend Yield Important?
Dividend yield calculations are important to investors in two different areas.
Fixed Income Investing
Some investors seek investments with a steady income flow. They tend to be the more risk averse, fixed income investors.
The dividend yield of a stock allows them to compare the income stream against fixed income alternatives. That may be other companies that issue dividends. Or it may be other asset classes, such as money market or bond investments.
It also lets them review historic and expected dividend payouts to provide some comfort as to future income streams.
Finally, although locking in a (hopefully) fixed income stream, there is also the possibility for capital appreciation should the share price increase. As with bonds, if general interest rates fall, the price of the shares should rise.
For example, consider Prefco. When general interest rates were 4%, the unique circumstances for the company (earnings potential, competitors, industry, risk, etc.) required that they issue their preferred shares at $50, with a fixed dividend of 5%. This equates to an annual payout of $2.50.
If general interest rates decrease to 3%, there will be an impact on the company’s shares. Probably not an identical impact, but some change. Perhaps the appropriate yield for Prefco based on the lower interest rate is 4%.
As it is pays 5% at $50 per share, investors will buy Prefco as a value play. This will drive the share price up, until it hits $62.50. The price reflecting the new appropriate yield of 4% ($2.50 annual cash dividend divided into $62.50 share price).
Investors who bought shares in the original offering will have unrealized capital gains of $12.50 per share or 25%. Nice if you invested solely for the dividend income. Of course, if interest rates rise, investors may experience unrealized losses.
Value Investing
Value investors seeking capital gains also use dividend yield in their quantitative analysis.
The dividends are nice as they provide a hedge should the shares not appreciate. But the main hope for value shareholders is an increase in share price.
Value investors look for companies with relatively high dividend yields. Relative as compared to benchmark yields, including: company’s history, competitor, industry, sector, stock market. Yields would also be compared to interest rates offered on money market instruments and bonds.
The belief is that high dividend yields results in two possible actions.
One, high dividend yield may indicate the share price is undervalued. Over time, the company’s fortunes will improve and the dividend yield will revert to historic lower levels relative to the benchmark employed as the share price increases.
Two, fixed income seekers will identify the high dividend yield stocks as superior investments versus lower yield alternatives. As the fixed income investors increase demand for shares of the high yield company, the share price will rise, bringing capital gains to the value investor.
As the high dividend yield returns to a lower rate, demand slows and the share price finds equilibrium at a reasonable dividend yield. Reasonable being in line with investor demand based on expectations of the company’s future performance, ability to pay dividends, etc.
The Prefco example above illustrates this principle. The same holds true for common stock (and bonds).
Dividend Yield Limitations
The Past is Not the Future
What transpired in the past is no guarantee of future events.
Dividends are only paid if the company has adequate free cash flow to pay shareholders. Company expansion, new debt issues, dealing with lawsuits are all examples of activities that can erode free cash positions.
Just because a company has made payments in the past does not mean that they will continue in the future. This is especially true concerning common shares. Of less concern are preferred shares, but there is still a risk.
Note that companies do not like to slash or cancel dividends if they historically pay them out. Reducing dividends is usually perceived by investors as negative information about a company’s future results.
Investors like dividend consistency. Companies that fluctuate their payouts are less attractive to investors. This necessitates the company having to increase their dividends, when they do pay them, to entice investors to accept a risk of periods with smaller or no dividends.
High Yields Can be a Negative
Companies with high dividend yields are often mature companies with minimal opportunities for continued operational growth. Because of the limited internal investment possibilities, these companies tend to have high dividend payout ratios.
A dividend payout ratio is the amount of dividends paid to shareholders divided by the net earnings of a company. Companies that payout all their earnings in dividends have a 100% payout ratio. Companies that pay no dividends have 0% payout ratios (100% earnings retention ratio).
High payout ratios are good for those seeking dividend income, less so for those who desire capital appreciation.
Consider a low dividend payout company, or one that does not pay any dividends.
Often these companies prefer to reinvest positive cash flow into growing the business. Purchasing new equipment, conducting research and development of new product lines, spending money to market existing products. Expenditures that work to increase revenues and profits. Which, in turn, should drive share price over time.
Investors believe that the return from cash reinvested in the company’s operations is a better investment than receiving a dividend and investing it elsewhere.
As a value investor, you may see limited capital appreciation in a value stock if there are few opportunities for internal growth and the company distributes its retained earnings to shareholders.
High Yield Indicates Value and Junk
As with low Price/Earnings (P/E) or Price/Book (P/B) ratios, high dividend yields may indicate value in a company’s shares.
But it may also indicate that the shares are worth less than previously thought by investors.
An Example of Limitations
On July 1, Junkco traded at $50 per share and had a trailing dividend yield of 4% (so its annual dividend is $2). This yield was considered reasonable as compared to industry and market averages, as well as to prevailing interest rates offered in the bond and money markets.
On July 10, Junkco announced that it lost a key sales contract that provided 85% of its annual revenue. With no replacement sales available, the share price plunged to $20.
Not good for the company, but great for the dividend yield. It rose to 10%. Much higher than benchmark comparisons.
But does this make the company a value play or a good investment?
If Junkco cannot replace the lost 85% of total revenue, earnings and cash flow will suffer. Junkco may survive this much lost revenue in the short term, but over the long run they will need to scale back their operations or face bankruptcy. Without new sources of revenue, Junkco is definitely not a value stock.
The same warning applies to fixed income investors.
If the original 4% yield was considered reasonable, then at 10% Junkco should be very attractive for dividend seekers.
And if Junkco can replace their revenues, it might be a great deal.
But if they cannot, even in the short term, I would expect Junkco to cancel or severely reduce their dividends. If Junkco reduces the dividend from $2 to $0.50, that would lower the dividend yield to 2.5%. Not a good deal versus the old yield of 4%. And if they cancel the dividend due to lack of cash, that would be even worse for fixed income investors.
Final Thoughts
All quantitative analysis – P/E, P/B, and dividend yield – can be a good indicator of a value investment. But they can also lead investors to see poor investments as having value. Never crunch numbers in isolation.
You must also perform qualitative analysis to separate good from bad. To put the numbers into proper context.
Never ignore the soft side of the analysis and only focus on the numbers.
Avoid the free lunches. If something looks too good, there may be a (negative) reason.