Apr 242017
 

Today we’ll explore a common question I get asked all the time: What is my thought process behind leverage?

The short answer is simple. I want to make high returns without being exposed to high risk. Normally the two go hand-in-hand. But leverage allows me to separate them.

For example, a speculative marijuana stock may grow 20% to 50% a year. But it could just as easily lose half its value. The potential reward is tempting. But the high risk is not worth it.

Instead, I’m looking for a lower return, lower risk investment such as an established pipeline company known for its predictable earnings, dividend growth, large economic moat, and low stock volatility. Using historical data and fundamental analysis I may determine that there is a very high probability this stock will appreciate 4% to 10% a year. I can then apply a leverage multiplier of 5 times on this investment which means my actual expected rate of return is 20% to 50%.

In other words, I do not subject myself to the high risk that is typically associated with juicy returns. But I still get those juicy returns! Awww yeah. 😀

That’s pretty much it. The long answer requires some further explanation. Let’s start with the 3 criteria I look for before I borrow to invest.

 

The 3 fundamental rules of practicing leverage

  1. A 10+ year investment time horizon.
  2. An adequate diversification strategy.
  3. An asymmetric risk-return opportunity.

The first and second rules are straightforward. Billionaire Jeff Bezos recommends we think in 7 year terms to remain competitive. I suggest taking that up to 10 years just to be safe. 🙂 In terms of diversification it can mean more than just having stocks and bonds.

 

Seek Out Asymmetric Returns

Now comes the fun part. Rule number 3. As we all know there is no investment without risk. The third rule is about knowing which investment has a favorable risk to reward ratio. This simply means comparing the odds. For example, let’s say we are asked to roll a normal 6 sided die. If it lands on 1, 2, 3, or 4, we win $10. 🙂 But if it lands on 5 or 6, we lose $10.

So should we play? The answer is a resounding yes every time! 😀 We have a 66.7% chance (4/6) of success. So from a rational perspective this has an asymmetric probability in favor of us winning.

 

Analyzing Probable Returns with a Bell Curve

We can use a normal distribution to help identify favorable investment opportunities. In statistics, a normal (bell curve) distribution outlines all the possibilities with the most likely outcome being in the middle. The standard deviation can be used to measure the variation in a set of data. Let’s see how we can put this bell curve to use when we overlay it on top of a chart that shows how many times the stock market returned a specific amount over any 10 year period between 1916 to 2016. (source)

So over the last century, any 10 year period of investing in the S&P500 index would have returned somewhere between 6% to 11%, 40% of the time, or within 1 standard deviation of a normal distribution curve. Additionally, returns were between 3% to 14%, 72% of the time, within 2 standard deviations from the mean.

This strongly suggests that we have a 95% chance (95/100 possibilities) of making at least 3% annual return from the stock market in any given 10 year period. Pretty neat eh? 😀 Time in the market reduces risk in the market, and creates a huge asymmetric advantage to investors!

But enough theory. Let’s see this at work in a real life example.

 

Banking on Leverage

A couple of years ago I used leverage to buy RBC Royal Bank stocks. Let’s go through my thought process behind this decision.

Large cap, blue-chip dividend stocks are ideal to use leverage on. They don’t come much bluer and larger cap than RBC. It’s the largest company in the country. Plus, there’s a lion in the logo. That’s how you know it’s a top quality company. 😉

I borrowed $4,000 to buy 55 shares of TSE:RY and contributed $0 of my own money. I wrote a full analysis on RBC and explained why I thought it was a good stock to buy at the time. The reason I used leverage was because I didn’t have any cash and the investment fits my 3 rules of leverage.

  • First rule: I planned to keep RY stock for the next 10 years.
  • Second rule: I made sure RY would only be a small part of my total portfolio.
  • Third rule: RY’s P/E ratio, peg ratio, and other fundamental measurements looked appealing in 2015. The stock was expected to grow 8% to 10% a year for the foreseeable future. Historical data showed strong earnings growth and stock appreciation. RY’s dividend would be enough to cover the interest cost of the debt. Thus, this would have a favorable asymmetric risk-to-reward ratio.

My return on this investment so far, net of margin interest cost, is about 37% or $1,500. Not too shabby. 😀 But this shouldn’t be a big surprise. After all, stocks are fundamentally priced based on their earnings. And RBC has an impressive history of consistent earnings growth. Back in 2015, RY was expected to earn $7.35 per share by 2017. Fast forward to today, it appears RY may actually be on track to hit $7.40 EPS this year. We shall see.

This leveraging strategy is also recession resistant. For example, let’s say I did the exact same thing in 2007 at the peak of RY’s market capitalization, (the worst possible time to use leverage) right before the greatest recession of our generation. Yikes! Well despite the unfortunate timing, 10 years later I would still end up with a 70% positive return, net of interest expenses! This is why I am not concerned about future recessions. 😉 I know I can just hang on to RY until the stock market recovers like it always does after a major correction.

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Mar 302017
 

Recent Purchase – Yellow Media Ltd

Although most of my investments are in blue-chip dividend paying companies, it can be fun sometimes to speculate on smaller companies as well. It’s kind of a risky play, but I recently picked up 120 shares of Yellow Media (TSE:Y.) I paid on average $8.14 per share, plus commission.

The stock is trading at 0.61 Price/Book ratio, so its net assets are worth more than the company. The forward P/E ratio of 11.8 is also quite attractive. The phone book industry is dying, but Yellow Media is transitioning into the digital world. The reason I decided to buy now is because the company just hired a new CFO and the stock has started to go up again. 🙂 It has greatly reduced its debt over the past several years. Although its print business is suffering, it plans to organically grow its digital revenue between 5% to 8% a year. Yellow Media already owns a lot of online content and gets tons of internet traffic. 🙂

I first came across Yellow Media when I read Nelson’s post on The Fool last month. He analysis appears to be sound. I believe (Y) has potential to come back from its current lows. But it’s far from a guarantee. The stock currently trades at about $8/share. In 1 year from now, Yellow Media stock will either grow to over $12/share (50% gain) or drop to something like $6/share. I’m investing because the upside potential outweighs the possible downside for me.

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Mar 232017
 

Earlier today I was feeling kinda lonely. 😥 So I decided to buy some shares.
Ah yes. It sure feels good to have a bit of company. 😄 And that company is called Costco.

In this series of blog posts I’ll explain how I determine which stocks to add to my portfolio based on strategic valuation methods. 🙂

How to Value a Stock: The Graham Formula 

Today, we’ll look at one of the most common formulas to determine the intrinsic value of a company; it’s call the Benjamin Graham Formula, named after the famous value investor who taught Warren Buffett. 🙂

The Graham formula looks like the following:

Benjamin Graham Formula

This should give us an idea of how much we should pay to buy a stock. Let’s go over the variables.

V = Intrinsic value, or what the stock should be worth today.
EPS = Trailing twelve months earnings per share.
8.5 = P/E base for a no-growth company.
g = Expected long term earnings growth rate.

 

Is Costco Stock Undervalued or Overvalued?

This formula works best with blue-chip, large cap, value stocks. We will use Costco Wholesale Corporation as an example since I just purchased some recently. 🙂

So to find out the intrinsic value of Costco (NASDAQ:COST) we need to look up the earnings per share (EPS). This information can be found on Google Finance.  We see that it’s $5.41.

Next in the formula, we need the “g” value. We can find this information on the Nasdaq.com website, and see that it’s 10.71%.

 

Finally we can now plug everything into the formula to see the result.

 

So as of today, March 23rd, Costco should be worth around $162 per share according to the Benjamin Graham formula.

But of course the stock is actually trading at $167. This means Costco is currently overvalued because its shares are trading at a premium compared to the fair value we just calculated.

Nevertheless, I still went ahead and purchased 10 shares of Costco this morning. The 3% premium I paid over the intrinsic value isn’t a big deal for me. Plus Costco recently announced an increase of membership fees to $60 per year. Like most other Costco shoppers I have decided to keep renewing my membership with them. But at least now I own 10 Costco shares, which entitles me (as a shareholder) to receive US $54 of after tax profits every year. This amount converted into Canadian dollars is more than enough to cover the expense of my annual Costco membership, haha. 😀

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Feb 202017
 

For buy and hold investors, some like to actively pick and choose individual assets to buy, while others prefer to invest in the entire market. But which is a better investment strategy? Similar to a cronut, the answer is simple, but may not be obvious.

passive vs active

Which Investment Style is Better: Passive or Active?

The Cronut is a pastry that combines together a croissant and a doughnut. It was invented by New York City pastry chef Dominique Ansel and is trademarked. You should try one if you ever visit NYC. 🙂 They cost $5 each. But you can also find cronut knockoffs in Mexico that are much cheaper than the real thing, so you don’t peso much. 😄

Anyway, why is this relevant to investing? Because much like a cronut, the better investing strategy between passive and active, is not one or the other, but both. 😀 By combining individually selected assets, and index funds into one single pot, we can create the ultimate investment portfolio. This takes advantage of low-cost index funds, while adding alpha (excess returns) in certain segments of our portfolio. 😉

So how can we implement this? First, we actively pick and choose specific investments in the areas that we have extensive knowledgeable about. Then use the passive investing method to buy index funds for all other asset classes that we have insufficient knowledge about.

For example, I selected individual farms to buy in 2012/2013 because I knew how to look at soil quality, flood risk, earnings potential, etc. Therefore, I knew how to find undervalued land. Historically speaking higher quality farms appreciate faster than lower quality ones so I made sure to only buy farms above a certain quality. Farmland funds however, invest in all quality land. As a result I have outperformed every farmland or agricultural based ETF I could find on the stock market. So within the context of this asset class, passive investing would not have done me any good.

On the other hand, when I decided to get into the United Kingdom stock market last year, I decided to buy a low-cost stock market ETF. European stocks are beyond my comfort zone. I wasn’t about to perform due diligence on all 250 stocks of the FTSE 250 index. So that’s why I invested in a broad market UK index fund instead which contains those 250 individual stocks. 🙂

This is why self knowledge is very important for investors. We should try to use our strengths and specific knowledge to produce better than average outcomes in certain types of industries or asset classes. Then we can aim for average market returns in all other areas that we do not understand. Overall, this should give us a higher investment return than either a completely passive approach (which will give us average market returns), or a completely active approach (which will most likely result in under-performing the market.)

But in order for this combined investment approach to succeed we have to know the limits of our knowledge and capabilities.

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Feb 062017
 

Index investing is a great way to build long term wealth. It’s simple to implement, convenient, and you are guaranteed to make the same returns as the market, minus any fees. But is it right for everyone?

Taking a closer look at Index Investing

How Indexes Are Managed

There’s a common theory that retail investors shouldn’t try to beat the market since it’s almost impossible to do over time. But I’m not sure this is true. The “index” isn’t the holy grail of stock selection. Some folks from the S&P Index Committee sit in a room and decide which stocks to include in their index based on a set of criteria with arbitrary measurements. It would be preferable if prominent investors such as Ray Dalio or Warren Buffett were on this committee, but they aren’t. Lol.

The S&P/TSX Composite index is made up of 250 stocks, chosen by the committee. It’s intriguing how only 250 stocks are selected out of the possible 1500+ on the entire Canadian stock market. The methodology for selecting stocks to be included in an index contains guidelines for minimum weight in the market, price per share, market cap, and sufficient liquidity requirements. The index is reviewed quarterly and all Index Securities that, in the opinion of the Index Committee, do not meet certain requirements are removed. And for the S&P 500 stock market index in the United States, anywhere from 25 to 50 changes are made every year. It’s basically a handful of people getting paid to actively manage a list of stocks that they believe represents the overall equity market.

The Paradox of Index Investing

From what I’ve heard, the whole idea of index investing is to match the market’s performance using a passive methodology. But if picking individual stocks will underperform the market most of the time, according to the mainstream, then how can index investing work if it’s based on a managed list of stocks that is updated every quarter based on the decisions of some individuals on Wall Street? Why are they more qualified to pick stocks for the index than let’s say, personal finance bloggers? 😀

I don’t think it would be hard for a handful of competent value and dividend investors to get together, create their own list of 250 stocks, and then beat the S&P/TSX Composite index. Last year Nelson from Financial Uproar hosted a stock picking contest for personal finance bloggers. There were 14 participants, including myself. Our average investment return for 2016 was 30%. We beat all the major indexes in both Canada and the U.S. Since an index is meant to represent the average of the stock market, then all we had to do to beat the market was to just be better than average. 😉 Easy peasy.

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