Become An Owner Instead of a Worker


When we’re young, we trade our health for money.  We work long hours.  We lift heavy things and wear down our tendons. We spend hours typing or doing other repetitive motions that cause carpal tunnel syndrome.  We spend hours on our feet and wear down the disks in our backs and develop heel spurs.

We trade this wonderful gift of youth and health that we’ve been given, the ability to keep pushing it for may hours, to bounce back when we fall down and heal fast when we get cut, for cash by working way too many hours.  We go in before dawn and leave after dark, never getting out to see the sun and the woods and the oceans.  We work hard to go on a vacation, which is then rushed and filled with work thoughts and emails back to the office the whole time.  We buy large, beautiful homes that we spend all of our free time maintaining and cleaning when we aren’t working to pay the mortgage.  We buy things on credit and then spend a quarter to half of our time working to pay interest payments.

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While we’re young we can make extra money by just pushing it a little harder.  We can make that car payment if we work overtime on weekends so we can drive that shiny new car to work and have it sit in the parking lot all day, slowly decaying away.   We can take on that second job and get all of the cable packages and five different web streaming services.  We can keep buying clothes to impress people we don’t like and buying all of the latest gadgets to look good for people we don’t even know.

When we get old, we trade our money for health.  Any money we’ve saved up through those long hours of work goes to treatments, surgeries, and drugs to reduce the pain our weary bodies feel.  We spend money to try to have the ability to walk and run and jump and heal like we did so easily while we were young.  We get surgeries to be able to walk after long hours of carrying heavy loads have destroyed our knees.  We buy prescriptions to lower our blood pressure after years of sitting idle at a desk, eating poorly, and letting our health decay.

Stop.  Stop today.  Stop right this minute and change your life.

Become an owner instead of a worker.  Instead of getting that new car, drive your old one for a few more years and send those car payments you would have made into a stock mutual fund and become an owner in a group of companies.  Buy a smaller house for cash and invest the money you save on interest.  Stop buying things to impress people and just buy what you need so that you can spend time with your family who don’t care what the label on your blouse or jeans says.

Start building a portfolio so that you will be getting dividend payments and capital gains instead of paying interest payments and penalties.  Let others work for you so that you don’t need to work those extra hours.  Expand your lifestyle by waiting a little while to buy things, instead investing the money in mutual funds, then using the distributions from those mutual funds to add to your income.  Direct some of that money back into buy more mutual funds, and your income will expand on its own.

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Everybody can become an owner.  You can start a mutual fund account with Schwab for only $1.  You can start investing through Vanguard funds for only $3,000 ($1,000 if you start a retirement account).  Start an account and start sending a little of your paycheck in each month to build your wealth.  Own things.  Build things.  Stop just using all of your effort to generate entropy.  Stop having your money flow into your back account through direct deposit and then back out again to bills through auto pay without your even seeing it.

The next SmallIvy book, Cash Flow Your Way to Wealth, will be coming out in about a month.  It gives the game plan to go from worker to owner.  Subscribe to this blog to make sure you get your copy when the time comes and don’t miss out.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What Factors to Use When Picking Stocks


jehericotopfalls

Stock picking is an art form that requires experience and an inherent feel for which companies will do well, but there are many factors that can be used to screen stocks and narrow the choice down to a few. Today I thought I’d discuss my method of picking stocks.  I’ll start my listing the factors I look at, and then discuss some of the factors in detail.

The theme of this blog is serious long-term growth, not trading stocks or making small profits then selling.  We’re looking for stocks that will grow over the next several years, not just short-term fads.  I’ve found it is easier to spot long-term trends than predict what the market will do over any short stretch.  In fact, the long-term trends are often pretty clear – it is surprising that more people don’t seem to look for them.  Here are the factors I look at, relatively in order of importance:

  1. The long-term price trend
  2. Earnings growth rate
  3. Dividend growth rate
  4. Return on Equity
  5. Debt
  6. Cash flow
  7. The business type/strategy

Let’s go through each of these factors in detail.
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The long-term price trend

The first thing I tend to look at, which is an obvious but an often over-looked trait, is the price of the stock itself.  As said above, the market price will tend to follow the fair value, just as a paper boat floating downstream in a turbulent river will tend to move at the average velocity of the stream, although there may be many changes in velocity if observed for only a short period of time.  If a company is increasing share holder value, making the company’s stock more valuable, this will be reflected int he price of the stock eventually.

When looking for candidates, I will flip though several stocks looking at the 5-10 year price history (High-Low-Open-Close charts or candlesticks, preferably) and look for those that I could set a ruler on and draw a relatively flat line.  This can be done in a chart book (Dailygraphs, for example), in a publication like Valueline, or, less easily, on the web at Yahoo or another site.  The issue with doing this online is that you often need to provide the symbol for the company, so you can’t easily flip through a set of price graphs, and you obviously won’t look at the charts of companies of which you have not heard.

Also, I try to avoid companies that are increasing very rapidly in price.  While these companies are the lifeblood of the momentum investor, which is also a perfectly valid investment method, these companies tend to fizzle out and fall back down to earth, producing a bell-shaped curve (see Krispy Kreme for an example).  In a later post I’ll go into the two main investment philosophies, momentum and value, and provide some tricks for those wanting to do momentum investing.

An example of a company with this type of price trend is Aflac (AFL).  While there are some deviations, over the period growth is relatively steady, so the people running the company obviously know how to grow the business.  As long as they don’t change what they do, and the business climate is such that what they have done will continue to work, and the company has not grown as big as it can following that business model, then I would expect this trend to continue.
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Earnings growth rate

A second factor I look at when picking stocks is the earnings growth rate.  As said previously, we’re looking for stocks that have shown persistent growth and that we expect to continue to grow over the next several years.  As also said, a stock price will tend to grow along with the underlying value of the company. Why is this true?  To understand the reason, we need to look at the reason people buy stocks and other securities.   This is a little complicated, so please bear with me.

The value of an investment depends upon the rate of return and the risk of the investment.  In general the greater the risk, the greater the investment return required by investors.  For example, a bank account carries very little risk, and therefore people will put money in the bank even when they receive very little interest in return.  The interest rate paid by banks is based on the rate at which banks can loan out the money and the rates at which the bank can borrow money.  Because the risk on commercial bonds is greater than for a bank account since companies tend to default on bonds more often than banks default on deposits, and because banks are insured by the Federal Government against default, the interest rate paid by bonds will be higher than bank account interest.  Note also that if the interest rate that banks goes up, the price of commercial bonds will drop so that their effective yield increases (a bond pays a fixed amount, so if the price of the bonds drops the effective interest rate increases).  This is because investors need the bond to pay a certain percentage more than the bank in order for them to take on the additional risk.

Stocks also pay “interest,” although in the case of stocks the payout comes in the form dividends — current and expected future dividends — rather than interest.  When a company is new, it pays little if any dividend as it retains capital in order to grow the company, but as it matures it begins to pay a larger and larger share of profits out as dividends until the company becomes fully mature and pays most profits out as dividends.  The fair value of a stock is based upon what individuals expect to be the future dividend of the stock, the degree of certainty that individuals believe that the future dividends can be predicted, and the perceived risk of investing in the company (the perceived likelihood that the company will cease to exist).  Because the dividend is related directly to the earnings of the company, the larger the company’s earnings, the larger the future dividend.

Now, investing in stocks is more risky than investing in a bank account, so investors will require that the rate of return from an investment in a company is several percent higher than what they could receive from a bank.  If not, why take the added risk?  The rate of return when the company is mature and paying dividends will be the dividend amount per share divided by the price of a share of stock (the yield).  So, the price of a company’s stock will grow if earnings increase since they then would be able to pay a bigger dividend.  This price will increase as long as the yield is sufficiently greater than what can be earned in the bank.

So, if earnings are increasing by 10% per year, say, all other things being equal (bank rates remain the same), then the fair value of the company will grow by about 10% per year, so the price of the stock should also grow by about 10% per year, over the long-haul.  In general I look for earnings growth rates of 10-30%.  Less than this will not be worth the additional risk of owning stock, more than this is unsustainable, and will usually result in the shares being overpriced.

Care should also be taken not to buy a company that has had good earnings growth but now earnings will be slowing.  An example of this is Freddie Mac in the mid 90’s.  Up to that point, FRE’s earnings grew reliably.  In the mid-nineties, however, the opportunities for making good mortgages began to decline, and so earnings growth rate began to decline.  This caused the stock to stagnate for many years.  Because investors pay more for a stock with a high earnings growth rate than one with a low growth rate, the relative price of the stock (reflected in the price/earnings ratio) will also tend to contract as the rate of growth in earnings slows.

Dividend growth rate

Continuing on with what I look for when picking a stock, we turn to a factor closely related to the earnings growth rate, dividend growth rate.  As I said during the post on earnings growth, the fair value of a stock is based in part on the return people expect to get from the stock relative to what they can get from the bank, bonds, and other sources.  While people will buy stocks early on expecting to make most of their profits from capital gains (when the stock goes up in price and they sell the shares), as a stock matures and stops growing rapidly investors who are looking for a steady return will start buying the stock.  They will buy primarily based on the dividend rate.

Because people will be willing to pay more for the stock if the dividend is higher than what they can get from other investments of equal risk, a stock will tend to go up if the dividend is increasing.  If it is increasing very rapidly, because earnings are increasing rapidly, people may actually bid the price up to the point where the yield drops below equilibrium because they are buying the stock based on future dividends, not current dividends.  The price of the stock will also go up if interest rates are falling (because bank interest rates will also be falling), and vice-versa.  The rate of taxes on dividends relative to those on capital gains will also have an effect.  If the Bush tax cuts expire as is expected and dividend tax rates return to 20%. more investors will start buying stocks with small dividends, opting instead for price appreciation, so that they can delay paying taxes.

I therefore look for stocks that have a steady dividend growth rate of at least 10%, if the stock is fairly mature, since I can then expect to get both a good dividend and a growth in price of at least 10% over the long-term.  Care must be taken to ensure that earnings are also growing at a steady rate or the company won’t be able to continue to raise the dividend.

Return on Equity

Continuing the traits I look for when picking stocks, one that I took from Warren Buffett’s playbook is Return on Equity (ROE).  ROE is a measure of how well a company is run.  Basically it is the amount of earnings that a company makes on the money that it has.  (For a more detailed description, along with some formulas for its calculation, see: http://beginnersinvest.about.com/od/incomestatementanalysis/a/understanding-return-on-equity.htm ).

I tend to look for companies with ROE of around 15-25%.  It is also important to compare the ROE of the company against that of its peers in the industry, since this will indicate how well it is run compared to its competitors.  Note that some industries, such as retail, tend to have larger ROE’s than other industries, so ruling out a company simply based on ROE of less than 15% would not be advisable.

Debt

The next trait I look for when picking stocks is debt.  Here, opinions differ on whether debt is good or bad for a stock.  If a company takes on debt, they can fund more rapid expansions, buyout competitors or businesses that bring them into new markets or that they can use to fill a gap in their company, and take advantage of other like opportunities.  Just as with personal debt, however, it always costs more for a business to buy things using debt since they must then pay not only for the item they are acquiring, but also the interest.

I find that the types of companies I want to own generally have little if any debt.  Ideally a company will be making enough of a profit from its business and have managers who manage the business well, allowing them to make needed purchases without going into debt.  Often when you find stocks with the type of price movement I favor — steady increases in price — you’ll also find a balance sheet free of debt.  A free balance sheet also allows the company to take on debt if needed for an opportunity if needed.  Once a company is laden with debt, it becomes far less nimble.

Note, however, that some types of businesses, banks for example, will generally have more debt because they are in the business of borrowing money, loaning it out to others, and then making money on the difference between the interest they can charge and what they must pay.  I would therefore not rule out a company entirely just because they have debt.  I would compare their debt load with those of their competitors, however.

Cash flow

elated to a low amount of debt or an entirely clean balance sheet is the 6th trait, a good solid cash flow.  Cash flow is the amount of money the company has coming in from their business.  A company with a good cash flow has more than enough funds for day-to-day operations, and can use their cash flow to pay for expansions, research, and other opportunities.  An ideal company would be one that has a large cash flow from a solid business line that allows them to develop other business lines.  For example, a software company that creates a software package that everyone buys, such that they make far more from the software than they need to spend on marketing and support, can then take the extra profits and use the money to develop other software packages or even move into other business lines.  They take far less risk than a company that does not have the cash flow because they do not need to borrow to do development.  If the new business line fails, they simply close it down and move on.  They do not have a huge debt hole to dig out of.

One unusual example of this is McDonald’s.  While one may think of their business being burgers, they have actually amassed a large real estate portfolio.  Using profits from one restaurant, they earn enough cash to buy a second restaurant.  This continues until they have acquired all kinds of properties.  As the cities grow around them selling their burgers and fries, the value of their land increases.  Later, if the business at the restaurant begins to slow, they can sell the land for a nice profit and acquire more restaurants elsewhere.


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The business type/strategy

The final trait I look at when picking a stock is the type of business and general traits, demographics, market conditions, etc….  This might seem like the first thing to look at, but I generally find it is easier to look for stocks with the other traits of which I spoke and then look at the business and decide if I think they will be able to continue to grow.  The trouble with going the other direction is that a company may have a good business and the climate is right, but the company is run poorly so even though they may sell a lot of products all of the money goes out the door.

As a side note, Warren Buffett has said that he will not invest in a company unless he fully understands the business.  He therefore has been reluctant to invest in technology companies, instead buying insurance companies, retailers, and the like.

When I’m looking at a business, I look to see if they have a product/business line that will continue to be needed and profitable in the future.  For example, at the present time Baby Boomers are getting towards their 60’s, a time at which they will start needing hip and knee replacements, giving up some hobbies and turning to others, and so on.  Harley Davidson has been an excellent company for the last several years, during the time that the Boomers were making a large disposable income and buying Harleys for rides on the weekends.  These folks have already bought their bikes and all of the gear, and are now starting to look at retirement (many shocked to see that they don’t have as much to show for their years of high income as they would like).  I therefore would be reluctant to buy Harley Davidson, even though they’ve had a great run, because I can’t see at this time where they have a good opportunity for growth.  Perhaps they will find a market I’m not aware of, however, and prove me wrong.  At that point I may buy in again.

Got a question or comment about personal finance or investing?  Please leave a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Could You Become a Billionaire like Trump?


jehericotopfalls

Funny thing.  Pretty much since I started working a real job, paid off my car, and decided that I would never have a car payment again (or a credit card interest payment, ever), I started projecting how much our net worth would be at different stages of our lives.  I had always assumed that I would work until I was about 70, and that long work career, combined with regular investing and living a comfortable but financially responsible lifestyle that grew with time but always allowed a substantial majority of the income from our investments to compound, caused me to project that we would have no issues with money by the time we retired.  Despite a terrible ten years or so in the stock market after I first made those projections (right before the dot-com bubble burst, the housing bubble burst, and then the multiple years of slow growth ensued), we are tracking well with my original projections.  Depending on the rate of return I assume over the next 25 years, I think we’ll end up somewhere between maybe four times and fifteen times what I would consider the bare minimum needed for our minimum income needs in retirement.  Probably closer to the former, but if the stock market does great and we see returns at the top of the possible range, the latter.

But then I started playing around on the Vanguard website the other night.  They have a neat tool that runs a whole series of Monte Carlo simulations for you.  (In a Monte Carlo simulation, you run a whole series of calculations to determine the range of possibilities of where you could end up.)  These simulations take a mix of cash, stocks, and bonds and run simulations based on random but historically accurate returns for each of these categories and project where you’ll be twenty, thirty, or forty years out after retirement under different market conditions.  The purpose of the simulator is to show how much income you’ll be able to spend and have a good chance of making it all the way through retirement without running out.  For example, if you expect to have $1 M at retirement and pick a portfolio of 50% bonds, 40% stocks, and 10% cash, you may find that you’ll make it through a retirement of 30 years without running out of money maybe 70% of the time.  It is also meant to show the advantages of adding bonds and cash to your portfolio since your risk of running out of money will generally go way up if you stay in all stocks and spend a healthy amount of cash each year if you start with a modest nest egg at retirement.

If you start with substantially more than you need, and plan to spend an amount that is very modest compared with the size of the portfolio (less than 1% per year, for example), a funny thing happens.  Even in the all stock portfolio, your chances of making it all the way through a 30 year retirement without running out of money can become almost certain.  Even in the worst of circumstances where the stock market does terrible a lot of the time, you can still expect to die with a few hundred thousand dollars net worth because you started out so far ahead of the game.

                       

What is really odd, however, are the best scenarios – the ones where the economy does really well, like it did back in the 1980’s and 1990’s, and everything just works out really well.  In that case, because you’re entirely invested in stocks, you can see your net worth grow from the simply comfortably wealthy into the leagues of unreal wealth – $100 M, $300 M, even the ultimate level, a billion dollars!   Imagine joining that elite circle with Warren Buffett, Donald Trump, and Bill Gates.  OK – so I still wouldn’t be quite at their level, and they still wouldn’t return my calls.  And they would be like trillionaires by then.  And they’d all be dead by then.  And I’d be the next day.  But still!

Standing where I am today, that hardly seems possible.  But then again, starting out with a couple of thousand dollars in an emergency fund when we were in our twenties, I could not image being where I am twenty years later even though the math said it would happen if the economy continued to perform as it had for the last couple of hundred years.  The power of compounding at stock market returns, which can average anywhere between about ten and twenty percent annualized over a given fifteen-year period, does not stop just because you’re retired.  That thirty year period between retirement and death is no different from the one between twenty-five and fifty-five, provided you don’t withdraw funds too rapidly and allow your investments to continue to grow.

So will we die as billionaires in fifty-five years?  Probably not.  But we’ll probably leave a significant inheritance and make a sizable donation to some cause unless the markets do really badly between now and then.  Historically badly.  Still, it shows the advantage of working to retire with more than just the bare minimum, since then you can let your money continue to grow in the stock market rather than needing to convert it all to cash and bonds, or worse – give it to some insurance company to get an annuity.  So here’s to all the potential future billionaires out there who just look like middle-class workers with older cars right now.

Got a question or comment about personal finance or investing?  Please leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.