What we are reading on 1/20/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Is simple better in asset weighting?
Charles Ellis: avoid competition!
On the perils of trend extrapolation
There’s something to be said for investment consistency.
Multitasking doesn’t work.
The risk of overpaying for a college’s reputation.
Latest asset class return forecasts from GMO
Latest asset class return forecasts from Research Affiliates
Real assets may be a contrarian bet.
How to read faces.

What we are reading on 1/18/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Trump’s conflicts of interest are here to stay …
It’s tricky to define risk.
Another victory for AI?
Ray Dalio thinks populism is taking us back to the 1930s
Obamacare Repeal Will Be Individual Insurance Disaster
The ins and outs of timber investment.
A review of Altucher’s latest book…
Goodbye dentist?
Can we shower too much?
Downward revenue pressure for the securities industry …
California’s tax base may be too narrow.

Our mixed feelings about REITs

We have mixed feelings about REITs.  We believe that too many REIT managements try to do too much:  provide an attractive level of income and an attractive level of growth.  The REIT makes sense for maximizing income.  The structure is not well suited to delivering both growth and income.

To understand why, consider four investment scenarios:

Scenario #1

  1. a company has good growth prospects and its stock is undervalued.
  2. the company pays a modest dividend; it retains enough of its income to fund entirely its growth plan.

We like this kind of stock because time is on the side of the patient investor.  Management does not depend on fickle investors to provide fresh capital for expansion.  Assuming they can execute the growth plan, the availability of capital is not a constraint to growth.

If management can deliver the growth, eventually the stock’s valuation will improve.

Scenario #2

  1. a company has good growth prospects and its stock is overvalued.
  2. the company pays a modest dividend; it retains enough of its income to fund entirely its growth plan.

This is not our cup of tea because we don’t like investing in overvalued stocks.  However, this type of stock could work for growth investors.  We would worry about

However, this type of stock could work for growth investors if the growth can be sustained for as many years are needed for the company’s income to “grow into” the stock’s valuation.

“Growing into” the valuation will require a consistent source of new capital to fund growth.  The company has a capital source in the form of retained income generating by its own business operations.  Other barriers may stand in the way of long-term growth (e.g., competition, market saturation, management ability, etc), but at least access to capital will not.

Scenario #3

  1. a company has sub-par growth prospects and the stock is undervalued.
  2. the company mostly pays out its income and retains just enough income to fund internally its low rate of growth.

There’s a place for this kind of stock in a well-managed investment portfolio.  It may not be an exciting investment but at the right stock price it can provide a respectable long-term return.

Many REITs could fit this profile.  Qualifying REITs do not pay corporate income tax but must pay at least 90% of their income in dividends.  Limited to retaining no more than 10% of income to fund future growth, REITs should have a low growth rate (less than 3% per year).

Scenario #4

  1. a company has good growth prospects and its stock is overvalued.
  2. the company mostly pays out its income; it does not retain enough income to fund internally its growth.
  3. management fills the growth funding gap by selling – opportunistically – more stock to the public.

This is scenario #3 with a twist:  a high rate of growth for which the company lacks funding.  The solution:  management promotes the stock’s growth prospects, causing the stock price to rise to the point of overvaluation.  At that point, the company sells more stock to the public in order to fund the growth!

The stock must remain undervalued for long periods of time for the strategy to work.  If the stock declines to fair value or to undervaluation, it will be too expensive for management to raise funds for growth and the promised growth will not happen.  At that point, investor skepticism could mean that the company never gets the capital it needs to deliver on the growth plan.

Growth-oriented REITs could fit this profile.  The higher the promised growth rate, the more the real growth rate depends on management’s ability to talk up the stock price.

Dividends and Depreciation

“Depreciation” is an expense of doing business. It arises because certain types of costs provide economic benefits that span more than one accounting period. Instead of recognizing all of the cost in the first period, one spreads the cost over the relevant time period using one of a few different accounting methods.

For example, imagine that a company spends $300,000 on a building that has an economic life of 30 years. The company’s tenant has signed a 30-year lease for rent of $15,000 per year. Without depreciation, the company have revenue of $15,000 in the first year offset by a $300,000 cost for the building, for a loss of $285,000. In subsequent years, the company would have $15,000 in revenue but zero costs.

These numbers do not comport to economic reality. Instead of losing all of its value in the first year, the building slowly loses value over the term of the lease. A better way to account for this is to “depreciate” the building over the thirty years. A simple method of depreciation divides the capital cost by the building life. Thus, a $300,000 building depreciated over 30 years incurs a depreciation cost of $10,000 per year. Rent is $15,000. The difference is taxable income: $5,000 per year for 30 years.

For accounting purposes, “depreciation” shows up as an expense. However, other than in the first year no cash is being paid out for depreciation. It’s a “non-cash” expense. The owner of the building receives the full $15,000 and has no cash expenses. But for income tax accounting, the owner can offset the income to the extent of annual depreciation. The cash flow is $15,000 but the income is only $5,000.

The depreciation expense reflects the deterioration in the value of the building over time. If the owner wants to maintain the value of the building, then he will need to put money back into it in the form of repairs. If costs do not change, the annual expenditure required to maintain the value of the building should be approximately equal to the annual depreciation expense.

An unsophisticated income investor could easily confuse cash flow and income, to his detriment. As a matter of policy, management can choose to distribute all available cash flow and not reinvest to maintain the value of a partnerships assets. In this case, the assets will have no value on termination of the partnership because they have not been maintained. The investor may be surprised to discover that he received generous dividends for many years, but that his capital has disappeared in the end.

An unscrupulous promoter may go even further by describing the dividend as partly “tax free.” The portion of the dividend that is equal to depreciation represents a return of capital. The return of capital/depreciation may not create a tax liability, but it is not without cost. The cost is the diminishment of the investor’s capital.

If one wants to avoid these problems, one should compute the dividend yield using only the income portion of the distribution. Ignore the portion of the dividend that is depreciation. One can identify the depreciation by reading the statement of cash flows.

An Alternative to Dividend Investing

In an environment of low-interest rates, some investors have become much more focused on investing in stocks that offer attractive dividend income. Dividend-paying companies have many ways to play games potentially to the detriment of investors who focus too much on the dividends and not enough on other aspects of the investment.

We favor an alternative approach: while not dismissing dividends altogether, we suggest that the dividend investor consider two other questions: (a) is the stock price significantly less than the intrinsic value per share of the company and (b) does management have a track record of making wise use of the company’s cash.

Intrinsic value

There is considerable evidence that undervalued stocks tend to do better than overvalued stocks over the long-term. Dividend yield is one way of measuring valuation, with high-yield stocks possibly being a better value than low- or no-yield stocks. However, it is not clear that dividend yield is the best way to measure value. Other metrics such as Price-to-Sales (P/S), Price-to-Free-Cash-Flow (P/FCF) and Enterprise-to-Earnings-Before-Interest-and-Taxes (EV/EBIT) may be more effective at predicting returns than dividend yield. One may be able to develop a better valuation model by using one of these metrics or by diversifying (using an amalgamation of them, possibly including dividend yield).

Use of cash

Investing the shareholders’ cash is one of management’s most important jobs. The dividend investor would be wise to consider this variable. One wants to assess to the issue from two perspectives: (a) does the company have good future investment opportunities and (b) does management have the ability to identify and exploit the opportunities.

One cares about a company’s future investment opportunities, not past investment opportunities. The company’s profitability metrics (e.g., return on equity, return on assets, pretax margins, etc.) today reflect the decisions of the past. Tomorrow’s opportunities may or may not offer the same potential.

It is not enough for a company to have good future investment opportunities. Some management teams have poor ability to recognize and to exploit such opportunities for the benefit of the shareholders. A past track record of success may indicate management investment competence. On the other hand, past success could be the product of an average management team stumbling upon great opportunities.

Financed Dividends

Sometimes a management team will insist on paying dividends in excess of a company’s earnings power. At first, the company may have sufficient cash on hand to fund the dividend payments, notwithstanding the earnings shortfall. When management depletes the company’s cash on hand, they will have to find financing if they plan on continued and large dividend payments.

Financing comes in two basic forms: borrowing money or selling equity.

Borrowing money

A company can borrow money from different types of investors. Smaller companies may rely on banks. Larger companies may have the flexibility to tap the banks or to sell bonds to the investing public.

In either case, the result is the same: The company is taking money from one set of investors (the creditors) in order to pay out cash to another set of investors (the shareholders). The creditors may acquiesce to this situation for a while, but will eventually pull the plug because the payments to shareholders reduces the likelihood that the company has enough money to pay off the creditors.

Selling equity

If a company cannot or will not borrow money to pay unearned dividends, they can sell equity. Management finds people who want to invest in the company’s stock and sells new shares to them. The proceeds from the stock sales help pay dividends to the all the shareholders, the new ones and the old ones.

Selling equity to pay dividends may work for a little while, but eventually the shareholders will figure out what is going on. At that point, new stock investors may be impossible to find and the dividend will have to be reduced.

Where to look

One can determine if a company is financing dividends by inspecting its financial statements. Specifically, find the financial statement that has the title, or a title like, “Statement of Cash Flows.” The Statement of Cash Flows has three sections: (a) Cash from Operations, (b) Cash used in investing and (c) Cash from Financing.

The investor can find changes in borrowing, changes in equity and dividend payments in the third section of the Statement of Cash Flows (cash from financing). If the company is obtaining cash from equity and borrowing in an amount that appears significant in relation to the company’s dividend payments, further research may be warranted.

It is possible that the Statement of Cash Flows may not have all the information necessary to evaluate financing and dividend sustainability. In that case, a reading of the entirety of the financial statements (including the footnotes) may be necessary.

Dividends and Earnings Quality

Just because a company has a consistent record of past earnings and dividend payments does guarantee the future security of the dividends. Analyzing earnings quality can provide clues as to the safety of future dividend payments.

In analyzing earnings quality, one should consider three different approaches: the nature of the business itself, changes in the character of earnings and management’s accounting policies.

The nature of the business

Some companies by their very nature enjoy high and stable profitability over time. Such companies tend to have leading market shares in their industries and sell products that are consistently in demand. Such companies may be among the most consistent payers of dividends over the long-term.

Other companies may have lower average levels of profitability and somewhat less stability. These companies may have leading market shares but sell products for which demand is more cyclical. Alternatively, they may an average or below average market share in a stable position. The dividends of such companies may be at greater risk over time.

Finally, some companies have low average levels of profitability and/or highly cyclical earnings. They may operate in brutally competitive businesses and/or may sell products that experience booms and busts in demand. The ability of such companies to pay consistent dividends may be highly suspect.

Changes in the character of earnings

A dividend investor should consider paying attention to potential changes in the character of earnings over time. Companies that have demonstrated consistent earnings and dividend growth over time face great pressure to continue such trends over the long term. If the business starts to deteriorate, management may resort to short-term fixes to maintain the appearance of growth.

For example, imagine a soap company for which investors expect $40 million of earnings to grow 10% in the coming year, just as the earnings had grown 10% in each of the past ten years. Management has a plan to grow earnings to $44 million but an increase in competition make it more likely that they will earn just $42 million. To meet investor expectations, management sells some land and books a $2 million capital gain. Earnings are on plan ($44 million) and investors may overlook the change. But the change has happened and it does not look good.

Accounting policies

The dividend investor should also consider management’s accounting policies. Financial statements are much more a “point of view” than an incontrovertible “truth.” The dividend investor can take greater comfort from a company that achieves consistent earnings growth with conservative accounting policies than from a company that achieves erratic earnings growth with liberal accounting policies.

What we are reading on 1/11/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Are junk bonds overpriced?
Strict airport security is encouraging people to drive.
Embracing uncertainty … easier said than done!
Value investing and time arbitrage.
Social ramifications of declining employment.
Problems with backtests.
Skew and managed futures.
2016 was tough for managed futures.
The polling experts have been getting it wrong.
Email productivity ideas.
They kill Obamacare, and then what?
The legal industry could be disrupted
Hussman’s latest

Dividends and Capital Intensity

Many managements want their company’s stock price to be as highly valued as possible. A popular and efficient way to achieve this is for the company to grow over time, year after year. The key point is that the total return of a stock is the sum of its growth rate and its dividend yield.

  • Total Return = Growth + Yield

For example, let’s imagine two companies that pay a $4.00 dividend. Investors want a 5% rate of return. If the first company cannot grow, the stock price will be $80.00 per share ( = $4 / 5% ). The sum of the growth rate and the dividend yield = 0% + 5% = 5%.

The second company can grow just 2% per year. For a 5% total return, the dividend yield must be 3%. For a $4.00 per share dividend, a 3% dividend yield implies a stock price of $133.33 per share ( = $4 / 3% ).

Thus, for a 5% total return moving a company from no long-term growth to just two percent long-term growth lifts the stock price by 66.67%.

Growth usually requires at least some capital. Industries like consulting do not require much capital to grow. But growth in other industries consumes vast quantities of capital. Growing a portfolio of real estate assets – land and buildings – obviously requires lots of capital. The assets often found in publicly traded master limited partnerships (MLPs), such as pipelines and energy assets, also require large amounts of capital.

Tax-advantaged capital intensive industries like real estate investment trusts (REITs) and MLPs can be problematic for the income investor.

The U.S. Federal Tax Code bestows a special tax benefit on REITs and MLPs: the exemption from corporate level tax. For REITs, the exemption requires that the REIT distribute to its owners nearly all of its annual income. For MLPs, the incentives are a little different but as a practical matter MLPs also distribute large shares of their income.

Lush dividends mean REITs and MLPs seldom have sufficient capital on hand to fund growth initiatives. But management teams still want to grow, because even a little long-term growth can so dramatically improve the price of a stock. To come up with the capital, the management teams borrow what they can. They will also have to raise fresh equity capital. Unfortunately, each offering of equity may harm the REIT and MLP investors by diluting their shares.

Base money update 1/9/2017

Each month, we track the monetary base for the world’s major central banks.  Changes in the monetary base may have an effect on the prices of financial assets such as stocks and bonds.

Here is the data through the end of the last month:

Here’s the month-by-month data:

Nov -217,026
Dec 94,350
Jan 41,483
Feb 294,299
Mar 333,907
Apr 328,052
May -220,649
Jun 490,995
Jul 50,963
Aug 12,767
Sep 246,331
Oct -277,932
Nov -297,030
Dec 79,544