Wednesday, August 13, 2008

The Myth of Investor Understanding, Part Two

Yesterday I rambled on about stock prices (meaningless) the earnings multiple (useful). Now it’s time to add additional variables to the mix -- terms you will run across in the financial press and certainly in this blog.

But before we go over the vocab test, however, we have another questions to consider. Steven Covey, (The Seven Effects of Highly Habitual People), admonished his readers to always begin with the end in mind. That means we need a goal.

"Hey! Numbnuts! It’s investing. The goal is to make money."

Right. But how?

You can seek companies that are rapidly increasing their earnings. This is called growth investing. People buy shares of growing companies under the notion that their prices will rise when their earnings increase. Growth investors are going to look at the income statement for ever-increasing revenue -- the “top line” in industry parlance -- and profit, or “the bottom line.” The basic tenet here is the greater fool theory.

You might want to make money by generating cash. Growth investors make money through capital gains -- they buy an asset and resell it for a higher price and keep the difference. Income investors are searching for dividends. These are cash payments companies make to shareholders. Companies that pay dividends are generally done with large-scale growth, so instead of deploying their cash on new plants or research or whatever, they just give it to shareholders. Income investors are primarily looking for one thing: Stability. They want companies with a long history of steady earnings, good management of expenses, marginally higher bottom-line results and big cash payouts in the form of dividends. Income investors like the rule of 72.

The third method of equity investing is the value school. Practicioners of this art subject companies to a ruthless fundamental inspection of their assets, debt, earnings and business model. These investors are looking for companies that are undervalued, either because of difficulty or unrealized potential yet unseen by the broader market. How do you tell if you are hanging out with value investors? The shrimp are very large and the scotch is very old. Value investors hold the efficient market theory dear.

Which is right for you? Your 401(k) probably should be allocated among all three strategies, which, happily, correspond to mutual funds your plan offers. (Your retirement portfolio also should include an allocation to bonds that increases as with your age.) But your discretionary investing style should be whatever you’re most comfortable with. If you like The Next Big Thing, go with growth -- you’ll understand it. If you like cash, there’s absolutely nothing wrong with a fat, double-digit dividend yield. And if you actually enjoy looking at earnings releases and poring over balance sheets -- and like it when the market suddenly discovers that you;ve been right all along -- then you might want to have a go at some value plays.

Now, look, I know this stuff is a little on the dry side. But the potential for reward here is remarkable, and a little math won’t kill you. I have a journalism degree, for Pete’s sake, and I can do it. I promise it’s not difficult.

Take the crash course.

Assets. These are things the company owns that have value. They are found on the balance sheet, which is a snapshot of a company’s finances at a given point in time. “Current” assets can be converted into cash in a year.

Liabilities are debt. "Current" here indicates debts that need to be paid in a year. Assets minus liabilities is shareholder equity. Equity is the piece of the company the shareholders actually own free and clear -- it is what you would have left if you liquidated the assets and paid the debts. The equation is usually written as ASSETS = LIABILITIES + EQUITY.

This gives us several financial elements to work with:

Book value is shareholder equity divided by the number of shares outstanding. Most companies trade at a multiple to book. When share prices are extremely depressed, however, it’s possible to buy a company for less than the “tanglible” value of the shares. GM is such a case. If you bought all of GM, liquated al its assets and paid all of it’s bills, you would still have more money than all of those shares cost to buy. This is actually a pretty rare financial phenomenon.

The other measure we can introduce here is the return on equity, which is calculated by dividing the total net earnings by shareholder equity. Think of this like you would the interest on a bank account: It’s a very rough way to measure what the dollars you put in are earning.

The trick here is to remember what increasing debt or increasing expenses can do to equity and thus to ROE. Borrowing a ton of money will reduce equity and perhaps deceptively increase ROE. As a rule, ROE is best evaluated over time.

Dividend yield is the amount of cash that’s paid to you relative to your investment. Right now, aggregate dividend yields are high because stock prices are low -- they always move in opposite directions. If you buy a stock for $10 a share that offers a 12% dividend, you effectively lock in that dividend. If the price goes up and the dividend, thus, goes down, your rate of return stays the same as the day you bought it -- assuming the dividend remains constant. Most companies are loathe to cut dividends -- that’s a not-so-subtle sign the company is in trouble. Still, it happens all the time. Dividends are dangerous for new investors: You should never buy a stock just for the dividend. Why? Because the board of directors is always just one vote away from ending the dividend on common stock.

Many screeners will also let you search for companies by their rate of growth, either in revenue or earnings, as well as by the change in their share price over a certain period. The other criteria you will see screeners employ is profit margin, which can either be “operating profit” -- also known as EBIDTA (earnings before interest, depreciation, taxes and amortization) or “net profit” -- the bottom line.

Start by choosing a a strategy:

Growth investors might look for small-cap and midcap companies with earnings multiples higher than 25.

Income investors should look for midcap or large-cap stocks with PEs below 15 and dividend yields of greater than 7%.

Value investors should look for any size company trading at a low PE, low price-to-book, positive earnings growth (or the near-term prospect of it) a robust net margin (+/- 15%) and a longterm ROE uptrend.

Then, make a list of potential investments by using a stock screener (here, here or here) to seek companies with the appropriate criteria. When you have fewer than 20 names, you’ve got a reasonable screen. From there, you can decide how detailed your analysis of each company should be. And the lesson you might well learn is that you'd rather leave this sort of stuff to a good adviser -- a real brass umlauted mensch -- or whether you simply want to go with a certain style of investing and choose a good low-fee fund that employs it.

Friday: Why “I don’t have enough money to invest” is a copout.

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