Archive for February, 2021

Roadmap to Investing During Inflation

Thursday, February 18th, 2021

The thing that is top of mind for investors at the moment is inflation.  It seems that on a daily basis, the yield on the 10-year Treasury Note rises as the congress talks about another round of stimulus for the economy.  This talk of stimulus has investors worried that it is more than needed, and that worry is leading to the fear of inflation moving materially above 2%.

We all know that as inflation rises, bond yields rise as well because investors require ever higher yields to compensate for the lost purchasing power of the dollar due to inflation.  This, of consequence, sends the value of the bonds people already own down and they slow losses in their bonds portfolio holdings.

So, inflation up = bonds lose money.  It’s a very standard bit of knowledge that investors possess.

However, inflation’s impact on the stock market is less well understood.  We all believe that when inflation goes up, stock prices come down, and the graph below from Ally Invest confirms that since 1990, or over the last 30 years, at least for the first twelve months we see reduced stock market returns when inflation is reported above 2% compared to when it is reported below 2%.

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So why is this?  Stock market returns may be adversely affected by inflation because those inflationary pressures may threaten future corporate profits.  As investors value stocks for investment purposes, nominal discount rates used to value future corporate profits rise under inflationary pressures, reducing current value of those future profits and thus the value of the stock market.

Our job, then, as investment managers is to position portfolios so that they are defensive against the impact of inflation by including stocks of companies that will benefit from inflation or that have pricing power to raise prices of their goods and services as inflation rises.

What are these companies?  The easy ones to identify are precious metals miners, agriculture related companies, energy companies, real estate, or any other company in a commodity business.  All of these companies act as insurance for your portfolio during times inflation is rising or at a high level.

The more difficult ones to identify are the ones that are not commodity producers.  A rule of thumb for investment managers is that Value Stocks out-perform the market during times of rising or high inflation and Growth Stocks out-perform the market during times of falling or low inflation.  We have seen this over the past several years as growth stocks have outperformed value stocks in the post 2008 stock market crash era.

So why would Value Stocks out-perform?  Value Stocks in general have material amounts of current cash flows and dividends, and many have pricing power for their products and services.  As inflation rises, their current cash flows rise and dividend increases tend to follow as the prices for their output rise with inflation.  As valuations for these companies are calculated, during the initial phase of rising inflation, the cash flows are rising faster than the increase in the rate at which investors discount those cash flows.

Unfortunately, there is level of inflation above which the discount rate rises faster than the companies can increase prices, thereby leading to a slowing of cash flow growth rates.  From the studies I’ve read, as inflation rises to 3% above then current inflation levels, cash flow growth will increase as companies can raise the prices for their goods and services without a material impact on demand.

In fact, the height of the out-performance of Value Stocks over Growth Stocks is when the rate of inflation has risen to between 2% and 3% above then current levels as this is where the price increases have been maximized and demand has not been impeded.  When inflation increases greater than 3% above the then current levels, demand begins to fall along with wider economic conditions.

From the period when inflation rises greater than 3% above then current levels until it tops out is a really bad time for the stock market because all values are discounted at rates greater than companies can increase cash flows.  This is when you have to watch for stock prices to bottom, generally ahead of the ultimate top in inflation, and watch for Growth Stocks to begin to out-perform the market once again.

So here is your roadmap to investing during an inflationary period:  based upon an analysis of the history of inflation and stock prices, when inflation starts to rise the initial 12 months shows pressure on the broader stock market as investors begin to adjust to the new reality.  During this time, Value Stocks begin to out-perform the wider stock market and expand their outperformance as the rate of inflation increase to a level of 3% above current.  Beyond a 3% rise, both Value Stocks and Growth stocks perform poorly until investors being to anticipate a top in inflation, then Growth Stocks begin their period of out-performance as inflation falls.

Please note that this road map imples just buying Apple, Google, Facebook, Amazon, Netflix and Tesla will lead to you outperforming the stock market.  Nor can you rely on your index funds as we are  entering a period where stock picking will be key to the health of your savings and investment.  If you do not want to try your hand at picking stocks that will outperform the market during an inflationary time, use a professional who understands the implications of inflation and proper portfolio management.  If I can help, please let me know.

 

 


 

Step #3 In Detail

Friday, February 12th, 2021

Last week, I posted about Gambling Vs Investing and gave you a step by step guide on how to be an investor.  I’ve had some questions about parts of the process, so I thought it would be a good blog post to discuss some of those steps in more detail.  So, I thought we would start with Step #3 since steps 1 and 2 deal with deciding to buy a stop and choosing one to research.

“Step #3:  examine the macro issues impacting the stock:

·   is the stock market itself in a bull phase or a bear phase;

·   do you believe from a timing standpoint that now is a good time to buy ANY stock;

·   is the industry within which the company operates in a bull or bear phase:

·   are there forces that are acting as catalysts to push the stock price higher or are there headwinds that will exert downward pressure on the stock price (e.g., an example catalyst for an electric vehicle company is the government doing something to cause the price of oil to go higher; an example of a headwind for a retail store is consumers choosing to shop online instead of going to the mall)”

Examine the macro issues impacting the stock provides you a big picture overview.  There is an old investment saying “A rising tide lifts all boats” that applies here – meaning that if the stock market itself is going up, then all of its participant companies have a force pushing their stock prices higher.  However, the opposite also applies as a falling stock market will take prices of good companies down along with bad ones.  What you want to do is determine which way the tide is flowing in order to know if your timing is right to buy from a macro perspective.

How do you do that?

  • You can look at the valuation of the market and see if its overvalued or undervalued
  • You can look at the trends to see if it is trading above or below its moving averages.
  • You can look at breadth to see how many companies are moving along with the price of the market
  • You can look at sentiment so see if investors are euphoric or frightened

Today, lets focus on valuation and figuring out where we are in the macro picture.  A future blog post will look at trends, breadth and sentiment.

I have a number of ratios I calculate and indicators I follow that tell me this, but as in individual investor you have more limited time and access to information than I do as a professional.

So the easiest things you can do are:

  • Look at the P/E Ratio of the S&P 500 Index and see if it is trading below 10 (extreme undervalued) below 15 (undervalued) or over 20 (overvalued)
    • I could go thru the calculation for you, but the Wall Street Journal is nice enough to just tell you what the current P/E ratio is today compare to a year ago, so you get a picture of the trend – a P/E Ratio that is higher today than a year go tells you that the stock market is more expensive today than a year ago so some caution is warranted.
      • https://www.wsj.com/market-data/stocks/peyields
      • From the table below copied from this link, you can see today’s P/E of 43.92 is materially higher than last year’s 26.10
    • Since 43.92 is above 20, this simplistic measurement tells you the market is overvalued.

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  • Apply the Rule of 20 to determine the timing:  the sum of the S&P 500 P/E Ratio based upon estimated earnings for next year + the Projected Rate of Inflation must be less than 20
    • We know that we can get the P/E ratio from the WSJ link above, but they are also kind enough to provide you with the P/E Ratio based upon next year’s estimated earnings, or in this case 22.71.  This is already over the Rule of 20 threshold for overvalued, but roll with me…
    • We also need to know the Projected Rate of Inflation to complete our formula.  Again, our friends at the WSJ provide this data for you
      • https://www.wsj.com/graphics/econsurvey/?mod=nav_top_subsection    Once you navigate to this page, just choose CPI along the left side of the page in the Economic Indicators section
      • From the table below, you are given choices on timeframes for the projection.  I usually use the 6month projection since that is the average number of months overwhich our earnings projection covers.  There is no science here, just use one of them and you will be close enough, but make sure you have a basis for your selection
    • Our Rule of 20 calculation yields 22.71 + 2.8 = 25.51, or a number greater than our threshold of 20

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  • Compare the total value of the US Stock Market to the output of the US economy.  This is Warren Buffet’s favorite indicator for determining if the stock market is overvalued or undervalued from a macro standpoint.  You can do the research to figure out the total value of the stock market and the current reading of GDP (the measure of economic output), but I cheat and go to the gurufocus website and they provide the information for me – you just need to the the “X” at the bottom of the log-in pop-up screen to access it
    • https://www.gurufocus.com/stock-market-valuations.php
    • The chart they provide gives you a visual that is easy to follow – looking at it below you can see that the stock market is significantly overvalued compared to the economy and that they overvaluation has grown wider over since it was last on par in 2009

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They also provide us with this chart that bring the graph relevance:

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Why is valuation at a macro level important?  Because today’s valuation helps determine your future returns.  Again our friends gurufocus provide us a graph that explains this.

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This is a busy graph, but it shows that the mover overvalued the market, the lower the forecast future returns are for the stock market.  This graph shows you that the most significantly overvalued level shown (i.e., the ratio of the value of the stock market to GDP) is 130%, leading to a projected negative 7% forward return.  They do not calculate the forward return when this ratio is at 195% (see the chart above) but the forward return would logically be significantly lower than negative 7%.

However, let me stress this point:  this is not the Bible, its more like government ethics – it is a guideline that is rarely adhered to by the stock market.  There are two factors to remember:  (1) this really only applies if you are a buyer of the broad stock market TODAY; and (2)you can find companies to buy today that will return significant profits for you in the future, even if the broader stock market has a negative return over coming years.

Don’t let this analysis convince you to sell everything you own simply because these guidelines provide an answer that is not pretty.

Do, however, let these calculations tell you that from a macro standpoint, now is not the best time to be a buyer of initial or expanded stock market exposure – there will be a time when the market is more supportive than it is right now of expanding your allocation to stocks.  You can use these tools to help you determine that, or you can hire a professional to do the work for you.  I believe the right answer is to hire a professional that understands this stuff – not all do, some will tell you that the market is set to go higher indefinitely, you can watch them on stock bubble television all day long, but that is not reasonable or logical – and let that professional use the tools in their toolbox to determine when the macro environment says to be a buyer.

Gambling Vs Investing

Friday, February 5th, 2021

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It has been a crazy couple of weeks in the stock market.  If you haven’t watched the investment news for awhile, you missed a wild ride in a few heavily shorted companies.  Gamestop is one of those companies, and in the chart above you can see that its price was in the $11 range for several months then rose to the mid-upper-teens for a period of time before being pushed up to nearly $500 in a short squeeze before backing down to the $50 level.  This is the essence of volatility and one of the things that you see when stock markets are nearing a top – people forget about basic risk management and turn investing into gambling.

If you are wondering how this sort of thing happens, here is a short explanation in bullet point format:

·  Gamestop as a business historically sold video games in cartridge format

·  Most video games are now downloaded directly over the internet, leading to a significant decrease in revenue over time and a subsequent drop in its stock price

·  Gamestop acquired a new major investor that recently sold their own internet driven business for more than a billion dollars who has said he plans to help Gamestop transition to a new internet-based business model

·  Many large hedge funds were short the stock of Gamestock, which is bet against the company in the belief that it would go down even further in price

·  However, small investors were discussing this change on internet discussion boards and as a group decided to try to drive the stock price higher with buying, forcing the hedge funds to cover their shorts by buying stock, starting a process that feeds upon itself:  buying begets more buying

·  Once the ball got rolling, and the stock price started to move, the discussion boards detailed how the small investors could buy calls on Gamestop which ultimately would move the stock higher because the brokers would have to buy the stock of Gamestock as a risk management measure which put more pressure on the hedge funds to buy as the stock price moved up

·  Here is an Article Posted On Reddit re: Gamestop Investing that helped to fuel the fire, and which the hedge funds missed – there  is another Reddit post out there (I can’t find it now to provide you the link) that told people to sell when the stock reached $480…guess what the high was on that chart:  $483

·  A lot of people who bought at the beginning of this frenzy made good money, but it was still a bet that that the Reddit community could drive the stock to a level where the hedge funds would be forced to buy stock to cover their short position

·  However, many more people lost money because they were a buyer at prices above $50 and didn’t sell into the frenzy – and the hedge funds who were forced to buy at $483 or some other price significantly above today’s $62 price have lots hundreds of millions of dollars, putting two major hedge funds on the brink of bankruptcy

·  This frenzy also forced a number of brokers to halt trading in Gamestop shares, causing a number of investors to lose money, either actually or from an opportunity cost standpoint, and the class action lawsuits against them are starting to come forward

Let me make it clear, what the small investors did was not illegal, but it is not investing.

What is investing?  Let me walk you through a process that I use that entails a significant amount of due diligence.  Due diligence is a process used to find the stock of a company that has the opportunity to outperform the rest of the stock market.  If you invest your own money, I hope you are engaging in a similar process – if not, I would be happy to manager your nest egg so that it follow process.

Due diligence involves research into companies to determine whether they would make a good fit as part of an overall portfolio designed to achieve an objective.  I won’t discuss in this post how you design and develop a portfolio nor how to position a portfolio to achieve an objective, but those will make interesting posts for the future.  However let’s take a look at buying one stock so you get a feel for the process.

Step #1:  you determine that you need to buy a stock – there are many reasons for this, like you have some cash to invest or you want to swap a current stock in which you have lost faith into one that you believe will outperform the market.

Step #2:  you decide on a stock you want to research – there are a number of ways to determine your research candidate, like you hear about it on investment television, from a neighbor, or perhaps you are a fan of their products, to name a few.

Step #3:  examine the macro issues impacting the stock:

·   is the stock market itself in a bull phase or a bear phase;

·   do you believe from a timing standpoint that now is a good time to buy ANY stock;

·   is the industry within which the company operates in a bull or bear phase:

·   are there forces that are acting as catalysts to push the stock price higher or are there headwinds that will exert downward pressure on the stock price (e.g., an example catalyst for an electric vehicle company is the government doing something to cause the price of oil to go higher; an example of a headwind for a retail store is consumers choosing to shop online instead of going to the mall)

Once you determine that the overall market is at a place where buying stock makes sense and that the industry for your company is not facing significant headwinds, then we turn to examining the company itself

Step #4:  examine the fundamentals – this involves math, so be prepared to do it or trust the wall street analysts numbers (I don’t trust them since they are predominantly bullish and will sometimes use unconventional methods to justify a future stock price target higher than today’s price)

 ·   you need to determine an intrinsic value for the company’s stock (this is different than a price target that analysts publish) and compare it to today’s stock price since you want to buy the stock near or hopefully below that intrinsic value – this is complicated

·   an intrinsic value involves examining the company’s cash flows an discounting them so you determine what they are worth today

·   if the stock market is in a bull phase, it can be difficult to find a stock trading below its intrinsic value – so you will have to decide it buying above intrinsic value makes sense or whether it would be better to buy it once the price moves closer to intrinsic value

·   you need to determine if the company’s ongoing operations will support a move higher in stock price

·   you need to examine a company’s earnings growth (historic and projected) and its return on equity (historic and projected) to see if they meet you desired levels

·   there are two ways a stock’s price will move higher or lower:  (1) rising or falling earnings; and (2) how much investors value those earnings – a high level of earnings growth and return on equity will help you make sure you are meeting (1) above

·   you need to examine a company’s financial strength to make sure they will be around for the long term and can withstand a recession when it happens

·   debt levels,  cash on hand, owners equity levels, and free cash flow generation are critical

Step #5:  you need to look at a company’s valuation to determine if it is an acceptable time to buy or whether you should wait until the stock price comes down to acceptable valuation multiples – see (2) above

·   price to earnings multiples, prices to sales multiples, price to book multiples, price to earnings growth multiples, price to intrinsic value multiples all need to be examined at a minimum to see if the stock is trading at an acceptable valuation level to buy it

·   studies show that more money is lost in the stock market buying a company that is over-valued than lost based upon buying those with bad fundamentals

Step #6:  you need to look at a chart to see if technically it is time to buy or not

·   a stock chart is just a visual representation of the collective investor view on this company

·   sentiment and momentum play a big part in the short term outlook for a stock’s price

·   buying a stock when it is near the bottom of its short-term trading range can produce significantly higher long-term returns than buying a stock near the top of its short-term trading range

·   this helps you determine what price you want to pay for the stock and what price you will accept paying for the stock if it never gets to the price you want (if your analysis supports buying it at the higher price

Step #7:  buy that bad boy!

·   if everything aligns and you are satisfied you have a company that you want to own with good fundamentals at an acceptable valuation and current stock price, then buy it

Step #8:  determine what price you want to sell the stock

·   set an upper price target for the stocks – this doesn’t need to be a hard sell target, it might be the price where you want to rerun the steps above to make sure owning the stock makes sense (e.g., an example of this is buying a cyclical stock tied to the ups and downs of the economy – you want to buy it when the economy is a catalyst for the stock price to go higher but you want to sell it before a downturn in the economy becomes a headwind; setting a price target will force you to re-examine your reasons for owning the stock and will tell you whether to continue to hold it or whether to sell it – just remember to set a new target price if you continue to hold it)

·   set a price below your purchase price where you draw the line on losses – a common one is 9% so that you avoid any double digit losses on an investment

·   this can be tricky because many times you hit your loss limit and sell the stock only to see it recover and excel to the price target you set – but it is more important that you maintain standard practices because over the long-term you will be more successful than if you are haphazard in your actions

·   sometimes something can happen and a stock will plummet below your loss limit price (it’s just the way the market works and is typically news related relative to some non-public negative information becoming public) – you have to decide whether to cut your losses and sell at this lower price or you determine that this is an over-reaction by the market and it has provided you an opportunity to buy more shares at this cheaper price

Step #8:  document your analysis and your reason for buying the stock and for ultimately selling the stock

·   one of the major benefits of documentation is so that in the future you know why you bought a company and so that if you sell it you have done a significant portion of your due diligence in case you want to buy it back

Investing is not gambling – due diligence ensures that your stock portfolio will not go to zero and that you will have the best chance possible to meet your objectives

·   yes, some non-public information can become public and drive the price of one stock to zero or close to it, but that is why you build a portfolio and diversify that single company risk away

·   you can also have publicly available information drive a stock’s price to zero or close to it, but that is why we have this due diligence process that forces you to periodically review the company you bought and to sell it if something changes or your analysis was wrong (hey, it can happen, it does to professional investment managers all the time for many different reasons:  if your projections of future earnings and returns do not pan out, if investor sentiment changes, if your view of an acceptable valuation level to buy that stock is wrong, or any of countless other things happen)

Over the years, I have developed spread sheets that automate a significant portion of this due diligence process.  They help guide me to determine if what I want to buy will outperform the overall market and they help guide me to determine if I want to sell it.  However, if you are managing your personal portfolio, it is important for you to follow this process or another one that you develop on your own.  Sticking to a process will help keep you out of trouble, will help you achieve your objectives, and will make the weight of these critical decisions a bit lighter.

–Mark