Empower young investors with savings plans.

May 29, 2016

The purpose of this article is to help young people make long range savings plans.  It’s a three-step process: 1) Set the goal. 2) Adjust for inflation. 3) Make recurring payments. I begin by presenting a retirement savings plan and conclude with a generic process for making other savings plans.

Planning for retirement

QUESTION: How much money should I save to start retirement?

ANALYSIS: I know people save money for future expenses even though inflation increases those expenses. Thank goodness my current budget is designed to pay for emergencies and pay all debt before retirement. If I live within my means and save 25 times my annual salary, I could safely withdraw 4% of those savings in the first year of retirement and keep withdrawing that amount, adjusted for inflation, each year of retirement. Life would be good! [refs 1-3]

GOAL: Save $25 per dollar of annual salary, plus an adjustment for inflation. The goal has 2 parts: 1) The savings account should hold at least $25 for every $1 of gross annual salary. 2) Every saved dollar should be inflated to match the Economy’s inflation rate.

STRATEGY: Start to invest regularly at the beginning of my career.

  1. Starting at approximately age 25 and finishing at approximately age 75 will provide 50 years of opportunity to save for retirement.
  2. At an annual inflation rate of 3%, the average price of everything that costs $1 today will likely be $4.38 fifty years from now (check this estimate with a future value calculator).
  3. My real savings goal is $25 X $4.38, which rounds to $110 for per dollar of salary.  The planning table in Fig. 1 will help me select a regular deposit.

Fig. 1

Fig. 1

For instance, a stock index fund that’s expected to earn a 10% annual rate of return could accumulate $110 when 9 cents per year are deposited into the account for 50 years.

How does this apply to me?  Suppose I start earning $50,000 a year at age 23 and invest in a stock index fund that earns an 8% rate of return. Thanks to the help from my parents, I already have $1,000 to open an investment account. According to the 50-year plan in Fig. 1, I will choose to deposit 18 cents per year for every dollar of salary. That means my annual deposits will be $9,000 from the $50,000 salary. If things go right, my investment account will be worth $5,546,902 after 50 years. Really?!!?

  • The future value of $1,000 is $46,902 based on an annual return of 8% for 50 years {test this calculation with the future value calculator}.
  • The planning table in fig. 1 is designed to earn $110 by making regular deposits for every $1 of salary; $110 X $50,000 = $5,500,000.
  • $46,902+$5,500,00 = $5,546,902.  Happy retirement!

THEN WHAT? Plan on safely withdrawing 4% of your savings at the beginning of retirement in order to match your annual salary before retirement; 4% of $110 is $4.40. Next year withdraw the same amount plus extra cash to adjust for inflation. The adjustment factor is (1+I) for the annual rate of inflation. Assuming that I is a 3% rate of inflation, (1+0.03) X $4.40 = $4.53. Each succeeding year, withdraw the same amount as the previous year plus an adjustment for inflation. In the first 5 years of retirement your annual withdrawals will be $4.40, $4.53, $4.67, $4.81, and $4.95 per $1 of pre-retirement salary and you will have plenty of savings for the rest or retirement [refs 1,2].

Risk management

There’s no guarantee that your plan will work. What could go wrong and how do you avoid failure? Some likely risks are missed deposits, taxes, low rates of return, brief time, and market declines.

  1. Missed deposits- Deposits energize the process of compounding interest to accumulate savings [ref 4]. Avoid missing deposits by making automatic payments through an employer sponsored savings plan –e.g., 401(k), 403(b)– or through payroll deposits into an individual retirement account (IRA).
  2. Taxes- Tax-deferred savings plans reduce your taxes. Deposits into employer-sponsored retirement-savings plans and traditional IRAs are not taxed until withdrawals are made after retirement when the withdrawals are taxed as regular income. Deposits into a Roth IRA are taxed at the time of deposit, but never taxed again. If the traditional and Roth IRAs are not affordable for you, the U.S. Government offers an affordable Roth IRA called the MyRA. If you wish to invest in Treasuries and corporate bonds, beware that they ares taxed at a higher rate than the long term capital gains from stocks.  Use a tax-deferred account to invest in bonds [ref 5].
  3. Low rates of return- Stocks reputedly pay higher rates of return than bonds. Investing in individual stocks is a risky and time-consuming effort; joining an investment club may be helpful. Consider buying shares of index funds that invest in market sectors with the understanding that investing in market sectors is riskier than investing in broad markets.
  4. Brief time- Start investing while you’re young. Starting later will require larger payments.
  5. Market declines- Since 1929 the average stock market cycle was 40 months divided into 30 months of price inclines and 10 months of price declines [ref 6]. The net effect was an uptrend in prices over long time periods. Individual investors can protect their investment returns from market declines in two ways: 1) Continue investing during market declines when regular deposits will purchase more securities at lower prices. 2) Diversify by adding bonds to your stock portfolio. This is best done by making supplemental payments for bonds in tax-deferred accounts such as MyRA.

Generic savings plan

Any long range savings plan can be made in 3 steps:

1. Set a goal for how much money you want to save. Your goal becomes the accumulated amount calculated by the compounded interest calculator [Fig. 2].

2. Adjust for inflation by multiplying your goal by the factor (1+I). I is the decimal value of the annual inflation rate. If you choose last century’s average annual inflation rate of 3.2% [ref. 7], the factor is (1+0.032). If 3.2% seems too high, use your internet search engine to discover more recent inflation rates.

3. Determine recurring payments needed per $1 of annual salary.  Display them in a customized planning table similar to Fig. 1.  Here’s how:

  • The columns are values of N for the number of years. Choose at least 2 time periods for the sake of versatility.
  • The rows are values of R for an investment’s annual rate of return. Choose a practical range of stock and bond returns for the sake of versatility.
  • The cells display fractions of $1 for making the minimal recurring deposit (d). Determine the deposits by testing trial values of d in the compounded interest calculator (Fig. 2). For example, start with d = 10 cents at the highest rate of return (R) for the longest time period (N). 10 cents represents the idea of depositing 10% of every dollar in your annual salary [Hint: it’s practically impossible to deposit more than 50 cents per dollar of salary].
  • In Fig. 2, the value of PV can be $0 unless you already have an initial deposit.

Appendix: All-purpose Savings Calculator

Try fig. 2’s all-purpose savings calculator that’s in the open-source publication of PracticalMoneySkills.com [ref. 8].

Fig. 2

CompdInterestCalculator

Note: Fig. 2 can be validated by tests using the compound interest formula for annual additions discussed in ref 4.

References

1. Jane Bryant Quinn. How to make your money last. The Indispensable Retirement Guide. 2106, Simon & Shuster, New York. 366 pages.

2. William P. Bengen. Determining withdrawal rates using historical data. Journal of Financial Planning, pages 171-180, October, 1994.

3. Craig L. Israelsen. The importance of diversification in retirement portfolios. AAII Journal, April, 2015. pages 7-10. American Association of Independent Investors.

4. Miranda Marquit. How does compound interest work for investments? ©️2016 empowering media inc. 2/18/2016.

5. Types of Retirement Plans. IRS.gov, 10/7/2015.

6. Paul A. Merriman. 22 things you should know about bear markets. Aug 24, 2015. MarketWatch.Inc, ©️2016.

7. Tim McMahon. Average annual inflation rates by decade. June 18, 2015.

8. Compound interest calculator. PracticalMoneySkills.com. ©️2010 Visa.

Copyright © 2016 Douglas R. Knight


Book review: The Index Card, by Helaine Olen and Harold Pollack

May 5, 2016

The Index Card. Why Personal Finance Doesn’t Have to Be Complicated. Helaine Olen and Harold Pollack. Penguin Random House, New York, 2016.

Genesis

The authors converged their experiences from  journalism (Helaine Olen) and academia (Harold Pollack) into the worthy effort of demystifying the world of personal finance for everyone’s benefit. Author Pollack began the process by devising an index card of rules for recovering from financial hardship and staying solvent. Author Olen’s experience with the Personal Finance Industry validated Pollack’s scheme. Together, they explain the index card to readers of this valuable book.

Rules from the Index Card

  1. Strive to save 10-20% of your income.
  2. Pay your credit card balance in full every month.
  3. Max out your 401(k) and other tax-advantaged savings accounts.
  4. Never buy or sell individual stocks.
  5. Buy inexpensive, well-diversified indexed mutual funds and exchange-traded funds.
  6. Make your financial advisor commit to the fiduciary standard.
  7. Buy a home when you are financially ready.
  8. Insurance- make sure you’re protected.
  9. Do what you can to support the social safety net.
  10. Remember the Index Card

Highlights

Rule #1. The household budget is essential for living comfortably. Be sure to save 10-20% of your income for future needs. The most important savings account is an emergency fund; every household should save 3 months of income in an accessible savings account to use for emergency expenses. —An emergency expense is both immediate and necessary; something bad has happened.—

Rule #2. Unpaid debt has top priority in your budget. Credit card debt is a preventable financial illness that must be corrected. Other forms of debt must also be managed within the framework of a budget.  Unfortunately, there may be unpreventable causes of overwhelming debt such as health care bills and other catestrophic events. Overwhelming debt may require seeking legal advice to file for bankruptcy; don’t feel ashamed.

Rule #3. The second most important savings account is your retirement fund and/or educational savings account. Start while you’re young to take advantage of the compound interest (a.k.a. compounding returns) from investments in either account. DON’T REJECT employer-sponsored retirement savings plans and DO participate in them to the full extent. You can also open personal retirement savings accounts. Facilitate your savings plan by making direct deposits into the retirement and educational savings accounts.

Rule #4. The media’s ‘toxic’ message is that playing stocks is easy and fun. But no matter how much research you do, buying stocks is still a matter of speculation. Stocks are a pay-to-play business where only the broker can always win. Forego the dream of a big win by investing in a small selection of index funds.

Rule #5. Index funds are designed to automatically match the performance of a selected stock- or bond market index. Index funds are true buy-and-hold investments. Most exchange-traded funds (ETFs) and a few mutual funds are index funds. They charge lower management fees than the actively managed mutual funds. Actively managed funds charge higher fees in order to pay for the research needed to outperform the stock or bond market. Few actively managed funds succeed in their effort to beat the market on a sustained basis. Annual management fees for index funds (~0.12%) are lower that for actively managed funds (~0.89%). The average household loses $155,000 in potential investment gains due to the unnecessary fees of actively managed mutual funds.

Rule #6. Most financial advisors are salespeople who chase a profit at your expense. They are not your friend. However, you still have to pay for good advice from a fiduciary advisor. A fiduciary advisor is responible for acting in your best interest, hopefully providing the best advice at lowest cost. The fiduciary advisor is usually a certified financial planner (CFP), registered investment advisor (RIA), fee-only advisor, or robo-advisor who is a proven fiduciary. It’s important to seek a fee-only advisor who is paid by you and only you. The advisor may charge a percentage of your assets under management, a flat fee, or an hourly fee.

Rule #7. Spend no more than 30% of your budget on housing. There are risks and advantages to either renting or buying a home. The authors discuss both.

Rule #8. Insurance is complicated but necessary. Don’t be exploited by salespeople. The 6 Golden Rules of Insurance are:

  1. buy term life insurance
  2. buy high-deductible property insurance
  3. buy a health care plan that pays your provider
  4. buy umbrella insurance that is twice your net worth
  5. avoid complicated annuities
  6. keep an emergency fund

Rule #9. We can’t protect ourselves from everything; sometimes we need a little help. The government is our insurance-backer of last resort. 96% of us have used government financial support to improve our financial situation. Isn’t it our fiduciary duty to Society to support the best government insurance programs?

Conclusions

I concur with the authors’ advice. The strength of their advice is supported by pages of references at the end of the book. Read and re-read their book.


Income statements can surprise investors

March 15, 2016

[updates: 3/18/2016, 3/28/16 addition of the ‘customer-derived profit’ concept of EBIT]

No other report of profit exerts greater influence on the Stock Market than that of a company’s net income. Why? Stock analysts make predictions of future net income that influence the decisions of investors.  Eventual announcements of actual net income may be very pleasing or disappointing news to investors who then generate a surge of trading in the market place.

The company’s only sources of income are customers, investments, and investors.  For an established company, customers are the preferred source of profit!  Operating income (a.k.a. EBIT) is the profit earned from customers.  The adjustment of EBIT by extra items yields net income.  Net income (a.k.a. Earnings, EPS) represents the profit that a company can share with its stock holders. Market regulators require companies to reveal the operating income and net income in quarterly and annual income statements.

Income statements are designed to reveal how business operations generate net income. The purpose of this article is to describe the income statement of companies outside the banking and insurance industries. Hopefully this article will help you perform a fundamental analysis of most companies listed in the stock market.

Structure

The Income Statement is one of 3 financial statements that companies report to investors on a quarterly and annual basis. Accountants prepare the statement by consolidating all of the company’s non-cash transactions into a standardized ledger that measures the business operations used to earn a profit. Chart 1 shows the main elements of an income statement:

incomestatement

Chart 1

Total Revenues are also called the top line of the income statement. They measure the net sales of all products. Operating expenses are used to acquire, sell, and distribute the products. Extra items are additional transactions that don’t generate sales, but increase or reduce the profit from sales. Net income is also called the bottom line of the company. Net income is the profit that a company can share with its stock holders.

Relevant information

In my opinion, the “LINE ITEM” column in Table 1 lists the income statement’s most relevant information for individual investors. The “$” column shows the relevant measurement in units of U.S. dollars. The “% OF SALES” and “PROFIT MARGIN” columns display convenient ways of analyzing the income statement. At the time of this writing, I collected the “$” and “% OF SALES” data from a company’s ‘financials’ tab in morningstar.com. I simply toggled the statement’s ‘view’ command to switch from $ to %.

mainitems

Table 1.

“Revenue” (a.k.a. Total revenues, Sales) is the total value of all products shipped to customers during the reporting period. The revenue is usually recorded at the time of delivery before any cash payment is made by the customer. “Gross profit” is the remaining revenue after deducting all costs of production from the Sales. “Operating income” is the remaining revenue after deducting all other expenses of operating the business from the gross profit. “Income before taxes” is the remaining revenue after adjusting the operating income available to pay taxes. Net income is the company’s earnings after the revenue is reduced by all operating expenses and extra items.

There are several line items of net income listed in every income statement.

  • “Net income available to common shareholders” represents the residual net income after payments of dividends to the company’s preferred shareholders.
  • “Diluted Earnings per share” (EPS) is the portion of “net income income available to common shareholders” divided by diluted shares. Diluted shares are all outstanding shares (“basic shares”) plus the potential gain of shares from convertible securities.

Fundamental analysis of profitability

Profit margins are percentages of Revenue that represent intermediate and final profits. The profit margins in Table 1 measure the impact of production, operating expenses, and extra items on the company’s sales. Here are the units of measurement:

  • Gross margin = 100 * Gross profit / Revenue = 41.3% = 43.1 cents of every sales dollar.
  • Operating margin = 100 * Operating income / Revenue = 22.4 % = 22.4 cents of every sales dollar.
  • Net margin = 100 * Net income / Revenue = 14.2% = 14.2 cents of every sales dollar.

In table 1, the gross margin reveals that after paying all costs of production, the company is left with 43.1 cents from every dollar of revenue to pay for the remaining operating expenses. Costs of production include all expenses of manufacturing goods and providing services. The manufacturing process requires equipment, labor, and basic materials to build an inventory of finished goods. The provision of services requires labor and equipment. A company can be more profitable by reducing its costs of production.

The operating margin (Table 1) represents a residual revenue of 22.4 cents per sales dollar after paying all costs of production plus the costs of maintaining the business and selling the product. Think of the operating margin as customer-derived profit.  A company can earn more profit from its customers by cutting some of its operating expenses.

Net income is the remaining profit after paying operating expenses and adjusting for extra items such as government taxes. In table 1, the net margin is 14.2 cents for every dollar of revenue. The company could be more profitable by cutting some of its expenses or earning extra income. The net income is available to reward share holders in a variety of ways that eventually translate into capital gains and possibly dividends. For example, the earnings per share (a derivative of the net income) enables thousands of stock market participants to place a value on each share of ownership in the company. An increase in market value would allow stockholders to sell their shares for a capital gain.

Fundamental analysis of the competition

The business performance of 2 or more companies in the same industry can be compared by assessing their profit margins. Table 2 provides an hypothetical example of how 2 competitors manage their business revenue. For every sales dollar, company A is less profitable than company B as revealed by A’s lower profit margins. Why is B more profitable? Its 66% gross margin reflects a lower cost of production that ultimately generates a higher net margin of 24%. Game over!

Table 2.

Table 2.

Notice that company A is more efficient at maintaining its business and selling its product. Company A’s 19 percentage-point difference between 41% and 22% is less than company B’s 33 percentage-point difference between 66% and 33%. For every dollar of sales, Company A was better at squeezing some profit from its customers with lower maintenance and sales costs. Also notice that the impact of extra items (e.g. potential taxes) was nearly the same for both companies; 8 percentage-point versus 9 percentage-point differences between the operating and net margins.

Conclusions

Income statements report a set of measurements that investors can use to analyze a company’s business operations and its ability to earn a profit. The company’s operating income (‘EBIT’) and net income (‘EPS’) are the key elements of an income statement.  Operating income is used to calculate the operating margin, which measures how much profit the company earns out of every sales dollar from its customers.  The net income  depends on total revenue and efficient management.  For every dollar of revenue, the company that operates more efficiently has a better chance of earning a net income as measured in separate ways by the net margin and EPS.  The company’s earnings per share (EPS) represent the profit that the company can share with its stock holders. There are several ways to increase the EPS: boost sales, trim costs, retrieve shares, and seek extra income.

Copyright © 2016 Douglas R. Knight


Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.


What is a good growth stock?

December 22, 2015

Theme

—profitable companies attract investors—

A good growth stock represents the profitable company that sells desirable products. The company’s business earnings should grow nearly 6% annually so as to match the growth rate of the U.S. Economy (about 3.5%) and compensate the rate of U.S.Inflation (about 2%); otherwise, the company might do well to liquidate its business and reinvest in securities.

Growth stock investors seek an annual rate of return that exceeds the U.S. Stock Market’s historical 8-10% annual rate of return. The basic approach is to buy stocks at a low price and sell them at a high price, but that is easier said than done. Investors can help realize high returns by selecting stocks from well managed companies, holding the stocks through an adequate growth period, to offset price volatility, and diversifying their stock portfolio.

Evaluating the company

Does the company earn respectable profits with a sustainable business? The answer is yes if the company has a:

  • growth rate of earnings that surpasses 6% annually.
  • future growth rate of earnings that surpasses 6% annually.
  • durable business with a sustainable growth rate.

Growth rate. The company that recognizes and satisfies the needs of customers will accumulate sales with the demand for its product. Profitability is the combination of sales growth coupled with efficient management of business expenses. In other words, the profitable company has a respectable growth rate of sales with respect to time, respectable rate of earnings with respect to sales, and consequently, a respectable growth rate of earnings with respect to time.

Earnings are the net income from sales after payment of expenses. The growth rate of earnings matches the growth rate of sales when the company runs its business in a consistent manner. Both sales and earnings should grow annually by at least 6% to outperform the national economy and compensate for the effect of inflation. Growth investors typically monitor the company’s earnings per share (EPS) on a quarterly basis. The EPS should grow at a compound annual growth rate of 6%, or more, as determined from at least 5 years of historical data. When evaluating a company’s earnings, consider the possibility that management is manipulating the EPS to earn higher compensation.

Future growth rate. The earnings estimate is an analyst’s quarterly or annual forecast of the EPS. The estimate is more uncertain when the forecast extends to 3-5 years. Investors use the earnings estimate to track a company’s performance and to derive a future range of share prices. The growth investor should seek companies with earnings estimates above the 6% compound annual growth rate.

Durable business. Any company can be driven out of business by an economic disaster in the entire industry, strong competition, and a declining market for the company’s product. The durable company has sufficient financial strength to survive hard times coupled with the competitive advantages needed to maintain its market position. The sustainable growth rate is a measure of the company’s capacity for earnings growth, assuming there’s room for growth of sales in the product’s market. An analysis of market opportunity is used to estimate the future demand for the company’s product.

Evaluating the stock

If a profitable company attracts investors, its stock price will rise with investors’ demand for shares. The attractive stock may be detected by a:

  • favorable valuation
  • price momentum
  • projected annual return above 10%

Favorable valuation. Growth investors place a high value on the company’s EPS for the simple reason that EPS represents the net income that generates an investment return. The 2 sources of investment return are dividends and capital gains. If the company choses to pay dividends, they are derived from the net income. Capital gains are the amount of profit from an increase in share price generated by investor-demand.

The price of a growth-stock tends to increase with the rise in EPS. This relationship is measured by the price-to-earnings ratio (P/E or PE). The current P/E is today’s price divided by the EPS of the past 12 months. The current P/E reveals what investors are willing to pay for each dollar of company earnings. The relative P/E is a ratio of the current P/E to past P/Es or to some benchmark P/E such as the average P/E of the stock market. At parity, the relative P/E is 1.0. Stocks below parity are undervalued by market participants and may be trading at prices that favor buyers. Conversely, stocks above parity are overvalued and may be trading at prices that favor sellers. There are other ways of assessing the value of a stock such as the calculation of fair value performed by stock analysts.

Price momentum. Another characteristic of the growth stock is that its share price is likely to continue in the direction of an upward trend as long as there’s a demand for shares. A review of historical prices will reveal the direction of price momentum.

Projected annual return. The reason that growth investors should seek returns above the 8%-10% total return of the stock market is that an alternative investment in index funds will capture the market’s return. One way of projecting the stock’s annual return is to multiply the future EPS by a P/E ratio to obtain the future share price. The difference from today’s price represents the future capital gain. Factoring in the stock’s dividend yield will give the projected annual return.

Risk management

The primary hazards of incurring a loss are,

  • company risk
  • market risk
  • portfolio risk

Company risk. Poor management can weaken the company and reduce its profitability. A fundamental analysis of the company, which includes a review of the financial statements, can help reduce the possibility of investing in a poorly managed company. Periodic reviews of financial statements and company news are needed to reassess the company’s management efficiency and help prevent a serious capital loss from investment.

Market risk. Volatility is the moment-to-moment fluctuation in share price that results from trading activity in the stock market. Greater volatility produces greater upside and downside risks. Upside risk is the potential gain from an investment. It represents a reasoned guess of the future peak share price. Downside risk is the potential loss. Volatility, upside risk, and downside risk are calculated in several ways. Generally speaking, riskier investments should be held for longer time periods to improve the chance of earning an estimated return.

Portfolio risk. A concentrated portfolio has a large investment in one stock compared to others. Any capital loss from the largest holding could seriously degrade the investment return of the whole portfolio. The potential impact of capital loss from a large investment can be reduced by re-allocating the principal among stocks that are diversified with respect to industry and company size.

Conclusions

A good growth stock outperforms the stock market because the company’s earnings grow faster than the Economy. One way detecting a good growth stock is to find the company that has a good sales record, bright future for earnings, and durability. Then determine what value other investors place on the stock in today’s market and future years. A potential capital gain of 10% or higher is a good growth investment.

Copyright © 2015 Douglas R. Knight


Business stories in financial statements

December 11, 2015

[updated on 2/6/2016]

Companies report their business results in financial statements on a regular basis.  Otherwise, how could they, the companies, attract serious investors?

Financial statements describe the use of money to sell products and grow a business.  The statements are prepared by accountants who consolidate business transactions into standardized measurements of profitability, cash flow, and net worth.  Those measurements represent stories of business success. The purpose of this article is to describe the framework and core stories of financial statements.

Accounting

Companies use financial accounts to perform a large variety of business functions. The effective use of accounts generates a profit for the company and its investors.

There are accounts for banking, payroll, supplies, customers, investors, shipping, advisors, taxes, and many other essential functions. Non-cash and cash transactions are recorded in the appropriate accounts. For example, each sale to a customer is initially recorded as a non-cash transaction in the customer’s account based on the price in the shipping statement. Later, the customer’s payment is recorded as a cash transaction in the company’s bank statement. In another example, the company initially records its purchase of supplies as an non-cash transaction recorded on a receipt. Later, the company’s payment to the supplier is recorded as a cash transaction in the company’s bank statement.

Accrual accounting. Accrual accounting is the practice of recording non-cash transactions at the time of transaction. The data are collected from invoices, promissory notes, and other documents of unpaid transactions.

Non-accrual accounting. Non-accrual accounting is the practice of recording cash payments. Data for cash payments are collected from bank statements and other documents of paid transactions.

GAAP. U.S. stock companies are required to publish financial statements that conform to Generally Accepted Accounting Principles (GAAP). Foreign countries may allow companies to publish financial statements using non-GAAP methods.

Framework

framework.001

Numerous financial transactions during the entire fiscal period are consolidated into line items of the income and cash flow statements. The values of all assets and liabilities at the end of the fiscal period are consolidated into line items of the balance sheet.

Income statement. The unpaid transactions of business operations are organized into revenues, expenses, and net income (Eq. 1). The statement’s top line is called total revenues and represents all recorded sales during the fiscal period. Every sale is typically recorded at the time the product is shipped to a customer. Cash payment is expected at a different time and is not recorded in the income statement. The statement’s bottom line is called net income and represents the residual value of all sales after deduction of all the expenses incurred during the fiscal period.

net Income = Total revenues – Total expenses          (Eq. 1)

Cash flow statement. The company’s payments are separated into categories of net operating cash flow (CFO or OCF), net investing (CFI), and net finance (CFF). The net value of each category is the balance between total cash inflow and outflow for the entire fiscal period. All cash surpluses and deficits are relegated to the category called net Cash Flow (Eq. 2). Companies that focus on growth attempt to maintain their net Cash Flow close to a zero balance. Investments in growth are paid through the CFI with funds obtained from the CFO or the CFF.

net Cash Flow = net CFO + net CFI + net CFF          (Eq. 2)

Balance sheet. The total book value is the net value of all corporate assets and liabilities at the end of the fiscal period (Eq. 3). The total book value is sometimes called the shareholders’ equity, net worth, or net asset value.

Total book value = Total assets – Total liabilities          (Eq. 3)

Core stories

Financial statements are designed to measure profitability and cash flow during the fiscal period and net worth at the end of the fiscal period. A simple analysis of measurements can reveal the company’s business performance.

Profitability.  The income statement describes how the company used sales and expenses to earn a profit during the fiscal period. The income statement might reveal that expensive business operations forced the company to sell a large number of products in order to be profitable.

Cash flow.  The cash flow statement describes how the company used its money during the fiscal period. If the company paid for growth, the basic scheme was to use its cash from customers or investors to grow by purchasing more assets for the business or investing in other companies.

Net worth.  Net worth is measured by the total book value at the end of the reporting period and provides a momentary valuation of the company. A company with considerable net worth has much greater value in total assets than in obligations to pay future expenses. The investor would judge that company to be financially strong.

Publications

Companies distribute their financial statements to the U.S. Securities and Exchange Commission (SEC), investors, financial services companies, and brokerage firms. Free copies can be obtained from the SEC.gov website, corporate websites, financial websites, and brokerage firms.

Domestic companies listed in U.S. stock markets file forms 10-K and 10-Q with the SEC. Form 10-K is an annual filing that contains financial statements for the fiscal year. 10-K is useful for performing a fundamental analysis of the company. Form 10-Q is a quarterly filing that also contains financial statements. 10-Q is useful for making quarterly reviews of the company.

Summary

Financial statements measure a company’s profitability, cash flow, and net worth. These measurements reveal the company’s business performance as a factor for making investment decisions. Free copies of financial statements are available in the internet.

Copyright © 2015 Douglas R. Knight


Lessons from ”Black Monday”

September 19, 2015

August 24, 2015: Stock prices in China’s Shanghai Exchange had the biggest one-day fall of nearly -9% since 2007, earning that event the title of “Black Monday”. Exchanges around the world followed suit. Next day, the Shanghai crashed below -15% (ref 1,2). Stunned investors worried about sliding into a bear market, then into a recession. Crashes, bear markets, and recessions produce losses of investment earnings. What are they and how do they occur?

Cycles

The stock market is one component of the larger economy. Both systems expand and contract in cycles governed by the net influence of buying and selling in diverse markets. Stock market cycles are gaged by real-time and historical stock prices. The real-time prices fluctuate according to traders’ demands for shares at any moment in time. The historical prices are chosen from four real-time prices: the Open and Close are the first and last prices of the trading day”; the High and Low are maximum and minimum prices of the day; and, the adj Close is an adjustment of the Close to account for a cumulative effect of stock splits and dividends.

Stock prices are compiled into market indices.  A market index measures the collective value of prices from a given group of stocks. The index Close changes from day to day, but when successive Closes are strung together over a period of weeks to months they form an observable trend called a market cycle. In chart 1, the market cycles of two indices are plotted over 25 years. Both plots show that the collective value of stock prices expanded in three “Bull markets” (1990-2000, 2003-2007, and 2009-2015) and contracted in two “Bear markets” (2000-2003 and 2007-2009). Orange circles identify recent trends and events leading up to the writing of this post on September 11, 2015.

chart 1

chart 1

Long market cycles

A long market cycle is comprised of a bull market and bear market (ref 3).
Bull market– a period of rising prices, by 20% for at least 2 months
Bear market– a period of falling prices, by -20% for at least 2 months

Short market cycles and brief events

Short cycles and brief events are tremendously exciting interruptions of the long market cycle. They represent an extraordinary change in market behavior caused by flows of investment capital or responses to influential news.

The short market cycle is either a rally or correction. Both are brief changes in the Close that interrupt a bull or bear market.
rally– an increase in stock prices due to a burst of buying that subsides when the money is spent.
correction– a 10% price decline (ref 3).

Spikes and crashes are brief events . Both are characterized by a large, sudden shift of the index value from its previous Close.
Spike– a large upward or downward price movement (ref 3)
Crash– a 10% decline in market value lasting 1-2 days (ref 4)
Crashes are precipitated by the sellout of inflated stock prices. Chart 2 shows both a correction and a crash of the NASDAQ Composite Index during the six-month period leading into September 11, 2015. Blue squares depict the daily Close of the NASDAQ. There was a 4-week correction of –13.5% (solid black line) from July 17th to August 25th. The 12% crash (dashed red line) occurred between the Close of August 21st and the Low of August 24th (the market was closed on 2 intervening days). August 24th was “Black Monday”.

chart 2

chart 2

Circuit breakers

Circuit breakers are automatic pauses in trading that enable market participants to evaluate their trading orders in a rapidly changing environment. SEC Rule 80B defines the following halt provisions and circuit-breaker levels that impose a pause on trading (ref 5):
• the S&P 500 is the benchmark index for measuring a market decline below the prior day’s closing price
• 7%, 13%, and 20% market-decline percentages initiate trading pauses of 15 min, 15 min, and rest of the trading day.

Business cycles

Business Cycles are broad fluctuations of business activity that affect the entire economy. The total value of business production is measured by the gross domestic product (GDP). The Real GDP is “the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production, adjusted for price changes” (ref 6). The main components of GDP are personal spending, investment (e.g., the stock market), net exports, and government spending (ref 3). Swings of the GDP are produced by the net buying and selling within these business categories. An upswing signifies economic expansion and a downswing signifies economic recession. Expansion is the default mode of the economy that typically outlasts a recession and ends when overproduction leads to general economic decline. Recession (ref 3) is the decline in economic activity lasting about 6-18 months. Interest rates usually fall during a recession and stimulate the next expansion by easing the cost of borrowing money. In technical terms, a recession is 2 consecutive quarters of decline in the GDP (Chart 3).

chart 3

chart 3

While a recession occurs with every business cycle, depressions happen very infrequently. A depression is an extreme fall in economic activity lasting for a number of years. In a depression, consumer confidence and investments decrease as the economy collapses (ref 3).

Economic Recovery is the period of increasing business activity signaling the end of a recession (ref 3). Similar to a recession, an economic recovery may be unrecognizable for the first several months. The stock market may be a leading indicator of economic recovery because stocks are priced on the basis of future expectations. Unemployment often remains high in early recovery until employers determine the long-term need for hiring.

Conclusion

Market sentiment is “the overall attitude of investors toward a particular security or larger financial market” (ref 3). Investors become optimistic (“bullish”) during a bull market and pessimistic (“bearish”) during a bear market. Optimism encourages stock purchases and pessimism stimulates stock sales. Crashes generate panic and a rush to sell stocks in the declining market.

Opportunistic investors incur an upside risk and downside risk when timing the market cycle for profitable trades. The upside risk is a gain in profit by selling shares at a high price and buying them at a low price at the appropriate time. But don’t bet on it, especially not with big bets. Successful timing requires a big dose of good luck and crashes are always unpredictable. Conditional trading orders may be helpful in timing the market if a limit price is included in the order; otherwise, any unexpected market event could trigger an undesired order. The best upside risk in a bear market or economic recession is taken by buying good stocks of financially stable companies at low prices.

The famous downside risks of a recession are speculative buying and frustrated selling. Speculators, beware of the falling share prices of high-risk stocks. The worst possible outcome is to suffer a steep capital loss by repeatedly purchasing shares until the recession drives an unstable company into bankruptcy (I know from personal experience). Some frustrated investors suffer a steep loss by selling out a good stock at bottom prices, only to miss the eventual recovery of their investment earnings after the recession.

Copyright © 2014 Douglas R. Knight

References

1. Financial markets. The Great Fall of China. The Economist, page 11, Aug 29th 2015 |
2. Briefing, China and the world economy. Taking a tumble. The Economist. Pages 19-22, Aug 29th 2015.
3. Investopedia Dictionary. www . Investopedia . com / terms. © 2015, Investopedia, LLC.
4. Kimberly Amadeo. Stock Market Crash. What Not to Do in a Stock Market Crash. © 2015 About.com. http://useconomy.about.com/od/glossary/g/Market_Crash.htm
5. SECURITIES AND EXCHANGE COMMISSION. (Release No. 34-68784; File No. SR-NYSE-2013-10), January 31, 2013. https://www.sec.gov/rules/sro/nyse/2013/34-68784.pdf
6. U.S. Department of Commerce. Bureau of Economic Analysis. Gross Domestic Product. http://www.bea.gov/


Good companies attract investors

August 21, 2015

Our economy is based on the fact that good companies attract lenders and stock holders. The lenders are confident of receiving a full payback plus interest. The stockholders are confident of earning future capital gains. More stock buyers are attracted as the company grows in value and profitability. These buyers are called ‘growth’ investors.

corollary 1. If good companies fail to attract investors, the stock price will fall. Bargain hunters then wait for the stock price to approach historically low values (“fire sale”) to scoop up shares for a potentially large capital gain. The bargain hunter is a ‘value’ investor.

corollary 2. Bad companies may attract investors when stock market participants are in a euphoric mood. For example, frenzied investors bought shares of technology companies that were selling unproven products during the 2001 dot com crisis. Those investors who sold out at the right time made fortunes and those who held shares lost fortunes when the market crashed.


Frugality

August 18, 2015

No individual can avoid paying fees for investing in securities. The basic costs of investing are:

  1. brokerage fees
  2. taxes

High costs of participation will erode investment returns. Potentially high costs include:

  1. middle manager’s fees (e.g., fund managers, investment advisers)
  2. subscriptions (e.g., memberships, tool kits)

Tips for minimizing costs

  1. use a discount brokerage firm that provides accounting services (e.g., cost basis, tax reports)
  2. enroll in tax-deferred, retirement savings plans
  3. avoid middle managers.  do your own research by starting in the library and using search engines.
  4. invest in index funds designed to capture the market’s returns
  5. choose your membership subscription wisely (review the benefits; seek ratings and recommendations, etc.)  use trial subscripts first.

Where do good stocks come from? From good companies!

July 17, 2015

Good companies issue good stocks!
There’s a strong relationship between good companies and their stocks. That’s why some of the most successful investors rely almost exclusively on picking good companies for investment (ref. 1). Conversely, companies on the verge of bankruptcy are very risky investments. Some investors don’t understand this. Case in point was the declaration of bankruptcy by Lehman Brothers. After Lehman declared bankruptcy and its stock was delisted from the New York Stock Exchange, some investors continued to trade Lehman’s stock in the over-the-counter market at pennies per share; it was a big loss for them.

References
1. Growing Rich with Growth Stocks, by Kirk Kazanjian. New York Institute of Finance, Paramus, ©1999.


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