Apr 152016
 

This is a guest contribution from my friend Ben Reynolds at Sure Dividend.  Sure Dividend uses The 8 Rules of Dividend Investing to find high quality dividend growth stocks trading at fair or better prices.

Successful investing can be simplified into two aspects:

  1. Maximize returns
  2. Minimize risk

Point one could not be more straightforward.  The more money you make from your investments, the better.

Minimizing risk sounds straightforward, but in practice it is much more complex.  This article takes a look at the ‘standard’ risk measures in the stock market – and whether they are truly useful in reducing risk.

Common Stock Market Risk Metrics

The words Beta, standard deviation, and volatility are often used to describe the risk of individual stocks.  These financial metrics are the backbone of stock market risk measurement.

Beta refers to a specific securities’ sensitivity to overall stock market moves. A Beta greater than 1 shows more price sensitivity. If the market declines by 10%, one would expect a stock with a Beta over 1 to decline by more than 10%.  Alternatively, if the market goes up by 10%, a stock with a Beta greater than 1 would see gains of greater than 10%.

Stock price (return series) standard deviation is the most commonly used risk metric. It is calculated as the annualized stock price standard deviation of a given security.  It measures how ‘bouncy’ returns are.  The more big swings there are in the return series, the greater the stock price standard deviation.  Volatility is the same as stock price standard deviation.  It is another word for the same idea.  Volatility and standard deviation are synonymous in investing.

Fun with Numbers

Everything is a nail to a man with a hammer. Similarly, finance professors like to come up with nice tidy formulas for messy real-world problems. Beta and volatility are proxies for risk. The idea is that riskier securities will see their prices move up and down more.  This means that beta and volatility can measure underlying risk in theory. In the real world, this isn’t true.

Here’s a nice thought experiment:  Imagine you have your pick to invest in 2 different businesses at equal prices. One business makes $1,000 a year every year like clockwork.  The other business makes between $1,000 and $5,000 a year every year. Any rational person would pick the second business even though it has more variability (‘risk’ as academics see it) in its returns. In the stock market, the business that makes $1,000 a year would almost certainly have a lower beta and standard deviation than the $1,000 to $5,000 business because its returns are more ‘stable’.

What Risk Really Is

Real risk can’t be quickly calculated with stock price data. Real investing risk comes from a permanent impairment (loss) of your investment. When you are investing in businesses (stocks), you can understand risk far better by qualitatively analyzing the business.

Is Coca-Cola (KO) less risky than a biotech startup?  Most certainly.  Can I say it is 3.2x less risky?  No, because qualitatively I know Coca-Cola’s business model is proven, but I can’t put numbers to exactly how less risky it is than an unproven biotech startup.  You can say it is much less risky, however.

Some people like precision and exact numbers.  I certainly do.  But you can’t always have them.  Sometimes using exact numbers leads to worse results because the numbers don’t mean much.

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Apr 112016
 

The New York stock exchange regularly releases information about how much margin (or debt) investors are using to invest. Based on the latest reports from the NYSE market data, Doug Short who writes for advisorperspectives put together the following graph which conveniently compares the credit balance of investor’s accounts to the S&P 500 over the past two decades. We can clearly see some correlation between the two sets of data.

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The blue dotted line represents the nominal performance of the stock market index since 1995. The set of red and green bars represents the net credit balance inside investors’ accounts. This credit balance is basically the sum of free credit in cash and margin accounts, minus margin debt. Red bars show that investors have negative credit balances (borrowing money to invest,) and green bars mean they have excess cash or credit.

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Mar 282016
 

Is the Stock Market Overvalued?

My opinion is yes. This post will explain how I came to this conclusion. Thanks to reader Bricks for bringing up this topic.

We’ll be looking at the S&P 500 because it’s a popular index and there’s a lot of data available for it. 🙂 This index basically represents a basket of 500 large publicly traded companies in the United States. We can analyze the following 7 metrics to determine how cheap or expensive the market is. And naturally each of these ratios below can be applied to individual stocks as well. 😉

  1. Trailing P/E ratio
  2. Forward P/E ratio
  3. Forward P/S ratio
  4. Price vs Forward Earnings
  5. Shiller P/E Ratio
  6. Operating Margins
  7. EV / EBITDA ratio

Useful Ratios to Value the Stock Market

1) P/E Ratio – The price to earnings ratio, or sometimes known as the trailing P/E ratio or TTM P/E ratio, is a popular measurement to help determine the valuation of stocks. A low P/E ratio signals a cheap valuation. Historically the P/E ratio of stocks in both Canada and the U.S. hover between 10 to 20 most of the time. However, as of today the P/E ratio of the S&P 500 index is about 22, which signals it is overpriced relative to the norm. (image source)

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2) Forward P/E Ratio – Unlike the trailing P/E ratio, the forward P/E ratio uses projected future earnings. Of course nobody knows how much money companies will make in the future, but this metric provides a sentiment of how profitable the market feels about the next few earnings seasons. According to a FactSet report, the forward P/E ratio of the stock market is 16.5, which is above the long-term average of 14.2. So based on this data stocks are currently about 16% more expensive than what they should be.

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3) Forward P/S Ratio – The price to sales ratio compares the total market value to revenue. It usually moves in the same direction as the P/E ratio but can provide a smoother, more accurate depiction of the market’s valuation (see yellow line in chart above.) This ratio is currently over 1.6x for the S&P 500, which suggests the market is overpriced, even compared to 2008 levels.

4) Price Change vs Forward Earnings Change– The price of the stock market is mainly determined by its future profitability. But recently the price has diverged away from future expected earnings which suggests stock prices are too high.

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Notice what happened after the last time price diverged higher from the forward expected EPS in 2006 and 2007. 🙁

According to John Butters, senior earnings analyst at FactSet, for the first quarter of 2016 it appears 92 companies have issued negative EPS (earnings per share) guidance and only 26 companies have issued positive EPS guidance. This depicts a rather bearish outlook. However, stock prices have not come down nearly enough to reflect these estimates. 😕

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Jan 212016
 

Netflix

I like to maintain an active lifestyle. So in 2014 I invited the popular online streaming service, Netflix, into my home because I wanted to do a marathon. 😆 After all, watching TV burns 70 calories per hour.

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Then earlier this week I welcomed Netflix (NFLX) into my stock portfolio. 😀

16-01 netflix nflx-buy

The price of oil is falling, the global economy is slowing, many countries are in recession, and company earnings aren’t growing. But none of the gloomy financial and economic news in the world today have a negative impact on the the business of Netflix. 😀

However, this is somewhat of a contrarian play. 😌 NFLX has a price to earnings ratio of over 300 so it’s not a value stock. It also doesn’t pay a dividend so everything depends on the future appreciation of the stock price. Am I bullish on Netflix? Nope. 😥 But I decided to buy some shares anyway as an insurance against global cord-cutting.

Cover all the bases

I believe that media and entertainment will always be a strong industry. It’s hard to figure out which media conglomerates will expand their market share in the long run so my investment strategy is to diversify and own all of the big companies. This way, I don’t have to choose potential winners and losers because I’ll profit from the entire sector. 😉 A few years ago I blogged about doing the same thing for the coffee industry where I invest in large franchises such as Starbucks and McDonald’s. As it turns out all my coffee stocks have gained over 100% in value since I bought them! I’m using the same reasoning again now. Some people watch HBO while others prefer Netflix. I don’t know which service will have more viewers 10 years from now, but if I invest in the entire sector then I should be covered. 🙂 With the addition of NFLX, my basket of media and entertainment stocks now feels complete.

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Dec 212015
 

Maximizing Utility

Earning money is a learned skill. If we put in the time and effort, we can learn to increase our earning potential. But making money is only half the battle.

An equally important aspect of personal finance is spending money. 🙂 Some people may not realize it, but spending is a learned skill as well. This means we can learn to become better shoppers. Knowing where to look for deals, buying in bulk, and eating with the seasons will naturally help us save. But if we buy an expensive blazer on sale and only wear it once, then are we really saving money, or are we spending our earnings on something we don’t really want to keep? 😩

This is why part of being a skilled spender is understanding how much utility we’ll get out of our purchase. Utility refers to the total satisfaction received from consuming a good or service. For example I normally wouldn’t pay for a donut. 🍩 In fact, even if it was free I probably still donut want one. I’m just not a big fan of the hole thing. 😆 But I’ll gladly pay for a Hershey’s Cookies ‘n’ Creme. That’s my favourite chocolate bar!🍫 So to maximize my utility I would pick a Hershey’s over a donut given those two choices, even though the Hershey’s is likely more expensive. In other words, the value of my purchase comes from how much enjoyment it gives me, – not from what I paid for it. 😉

Consumers who understand this correlation between their spending and utility are smart. 🙂 They tend to be excellent spenders since they don’t waste their hard-earned income on rubbish that doesn’t give them much fulfillment. Economists even have a unit of measuring enjoyment or utility, called Utils. 😀 At the end of the day it’s not about maximizing savings, but it’s rather about maximizing happiness. 🙂 Instead of looking for deals on pricing, we should be looking for bargains on satisfaction. 😀

My $1,500 Gift

I noticed I had some money sitting around. So after considering what brings me enjoyment and satisfaction, I’ve decided this year for Christmas to buy myself some new stocks in my tax deferred account. 🙂 So last week I purchased 20 shares of media company Viacom Inc (VIAB,) and 10 shares of the well-known retailer, Wal-Mart (WMT.) The total cost came to about $1,500 USD, rounded to the nearest hundred. This will be my last investment of the year.
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