Financial health

May 17, 2020

Long-term investors depend on their stocks to remain viable during economic recessions.  In today’s Coronavirus Pandemic, businesses of all sizes are losing income from the forced reduction of consumer spending, which may destabilize companies to the brink of bankruptcy.  Investors can assess stability by reviewing the financial health of their companies.

Financial health is the ability to pay all obligations in a timely matter.  Credit ratings and analyst reports use propriety methods to measure financial health.  You can independently rate the financial health of a public company using a single numerical score from 0 to 10 based on liquidity and solvency; the higher the score, the healthier the company (eq. 1).

equation 1:    Health = Liquidity + Solvency

Liquidity

Liquidity refers to the ease of converting current assets into cash for payments of current liabilities.  Current assets are considered convertible to cash within one year.  Some assets are more liquid than others. Savings accounts, checking balances, money market funds, and receivables [i.e., customers’ IOUs] represent liquid assets. Inventory [i.e., unused supplies and unsold products] is considered an illiquid asset.  Current liabilities are the costs of paying business expenses such as wages, payables, and interest on short-term credit.  The following ratios provide useful measurements of liquidity:

  • Current ratio = Current assets / Current liabilities.
  • Quick ratio = (Current assets – Inventory) / Current liabilities
  • Interest coverage = EBIT / Interest  [EBIT is the company’s earnings before accounting for the charges of interest and tax; EBIT is a measure of recurring income]

 

liquidity

chart 1

Solvency

Solvency refers to the liquidation value of a company in case the company must pay all of its short-term and long-term liabilities. I use the shareholders’ equity [aka net worth or book value] as a common denominator for the measurement of solvency.  Solvency ratios and free cash flow provide useful measurements:

  • Debt-to-Equity = Long-term debt / Shareholders’ equity.
  • Financial Leverage = Total assets / Shareholders’ equity.
  • Free Cash Flow = Operating cash flow – Capital expenses

 

solvency

chart 2

Examples

Chart 3 displays health scores for a list of companies identifiable by stock tickers; they are the current holdings of my investment club.  The data were calculated with the formula in eq. 1 using open source data for liquidity and solvency.  Three stocks received low health scores of 2.

health

chart 3

From chart 3, I selected five strong competitors of VZ and CMCSA to determine if the low health score represents a larger group of 7 competitors listed in the trading sector of Communication Services.  The additional competitors are listed below in chart 4. Three of the additional competitors matched the scores of CMCSA and VZ, inferring that most companies in that select group operate with low liquidity and solvency.

competitors

chart 4

Another comparison was made using a sample of stocks with an open-source, proprietary grade of low financial health (chart 5).  One stock, JCP, recently filed for chapter 11 bankruptcy.

others

 chart 5

Risk management

The health scores in chart 3 are based on historical data at least 3 months old.  Stocks with the lowest scores are considered more unstable.  If, in your informed opinion, there’s a credible risk of bankruptcy and delisting, you can protect your investment by either selling the stock or placing a stop-loss order on it.

Conclusion

Open-source financial data can be used to assess the risk of potential bankruptcy and delisting among publicly traded stocks, especially during an economic recession.  Combined assessments of liquidity (chart 1) and solvency (chart 2) additively form a health score of 0 to 10, with lower scores implying poor financial health.  The scoring system is easy to implement, but unreliably predicts financial failure of public companies with low scores.  Additional fundamental analysis of the company is strongly recommended and meanwhile, if you wish to protect your investment from a substantial loss, place a temporary stop-loss order on the holding.

Copyright © 2020 Douglas R. Knight 

 

 

 

 

 

 


Websites for retirement-planning

February 19, 2016

[updates: 3/4/2016, 3/18/2016]

Resources

http://DOL.GOV/EBSA/PDF/RETIREMENTTOOLKIT.PDF , federal programs and retirement calculators
http://SOCIALSECURITY.GOV , benefits & ‘retirement estimator’
http://MEDICARE.GOV health insurance for retirees
http://WISERWOMEN.ORG Women’s Institute for a Secure Retirement
http://HHS.GOV/AGING , health- and legal information
http://USA.GOV/BENEFITS-GRANTS-LOANS , federal benefits
http://AGING.OHIO.GOV , quality of life
http://economiccheckup.org , to plan retirement, reduce debt, find work, and cut spending.

Money management (‘financial planning’)

http://DOL.GOV , search for “Taking the mystery out of retirement planning” and download this excellent pamphlet of useful advice.
http://MYRA.GOV , A safe, affordable Roth savings account for wage earners.
http://WESTERVILLELIBRARY.ORG , search for “Investments 101”

Portfolio management

http://apps.finra.org/Calcs/1/RMD , find link to “required minimum distribution”
http://BANKRATE.COM , click on “RETIREMENT” tab, then on “Retirement Calculators” subtab, then on “Asset allocation calculator”
http://53.COM, click on “Financial calculators”, then click on the “Retirement Planning” tab, then click on the “Retirement Income Calculator” to estimate your longevity of savings; click on the “Retirement Account Calculator” to compare retirement savings accounts.

Risk management

http://IRS.GOV , search “identity protection”, about Identity theft
http://FINRA.ORG (securities help line for seniors, 844-574-3577), Check the credentials of a broker or financial advisor; about Investor protection; http://apps.finra.org/meters/1/riskmeter.aspx to assess your risk for Financial fraud
http://NELF.ORG , about Elder Law
http://ELDER.FINDLAW.COM  , about Elder Law
http://LONGTERMCARE.GOV , about LTC health insurance
http://PBGC.GOV ,  to assess pensions
http://immediateannuities.com , to shop for simple annuities
http://annuityreview.com , obtain a second opinion about variable annuities

Low income assistance nationwide and in Ohio

http://benefitscheckup.org
http://OHIOHERETOHELP.COM
http://OHIOBENEFITS.ORG


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


Conditional orders for stock trades

September 6, 2014

[The basic concept of ‘price diligence’ was inserted on 3/20/2015.  The MockTrades planner was updated on 12/11/2014]

Introduction

Individual investors typically use a market order to buy and sell stocks, ETFs, and REITs.   Market orders activate the trade immediately at the next available price; this controls the time rather than the price.  You can exert more control over trading conditions by placing a conditional (a.k.a. advanced, automated) order.  Conditional orders are considered a form of ‘price diligence’ because they specify the share’s price for activating the trade at any time during approximately 60-90 days, depending on your brokerage firm’s expiration date.  The conditional order controls the price rather than the time of the trade.  After reading this article, you may wish to download SmallTrade’s MockTrades4 for free; it’s uniquely designed to account for market volatility when planning a conditional order.

The trading arena; a simplified description

Stocks and other securities are traded for cash by an auction process in the stock market.  The participants are investors who make offers, brokers who generate orders, and traders who finalize the orders.  Individual investors submit offers to brokers through a computer terminal or by direct communication.  Use of the computer terminal gives the illusion of directly participating in the auction process, but there are several intermediary steps occurring at the speed of light along with a few brief delays.  The first delay is at the brokerage firm where all offers are filtered, recorded, and transmitted to traders in the stock market.  At any moment in the stock market, there are millions of orders to buy and sell securities.

The broker’s computer program, called a trading platform, provides investors with a market quote plus commands for placing a trading order.  The market quote reports a current purchasing price (“ASK”), sales price (“BID”), last-traded price, and latest number (a.k.a. volume, quantity) of traded shares (a.k.a. units).  Valid trading orders are announced to all market participants and filled at the next available price. The next available price is determined by an auction of the available shares for which a trader serves as the auctioneer.  The price can fluctuate between trades and is not protected from fluctuation until the order is filled.  Brokers and traders are always paid a fee for their services.  Custodians are hired by brokers to store traded securities in electronic accounts on behalf of the investors.

Trading orders

As an individual investor, you may place one of several types of trading orders in your broker’s trading platform.  The simplest, called a market order, merely specifies the number of shares to be traded.  The market order is filled immediately unless a time delay is imposed by an undersupply of available shares.

A limit order specifies the preferred price of the trade.  This order is filled when the next available price either matches the limit price or provides a better price {in other words, the limit price is YOUR minimum selling price or maximum purchasing price}.  There is only one opportunity for the limit order to be filled after it is placed in the market.  In rare instances, an unusual market event may shift the next available price out of your limit’s price range, in which case the order is cancelled without an exchange of cash for shares.  Your only recourse is to place a new limit order.  The limit order is used to protect from shifting prices.

Stop and stop-limit orders are useful for protecting against losses of investment capital.  The stop is a specific price at which your trading order will be submitted as a market order.  Your stop is stored in the exchange’s computer until it is submitted or expires at the end of a time period called the time-in-force (“TIF”).   The market order is then filled immediately at the next available price, which may shift to a better or worse price than the stop’s price.  The stop-limit is a specific price at which your trading order will be submitted to the stock exchange as a limit order.  It too has an expiration date.  The limit order protects your trading price until the order is filled, cancelled by the expiration date, or cancelled by an unusual market event. Your only recourse to a cancelled order is to place a new stop-limit order.

Trailing stop orders provide opportunities to seek a better trading price in the market.   The trailing stop is a specific point spread (1 point equals $1) by which the stop price will trail the movement of market prices toward a better price.  In general, the trailing stop can move toward a better price but won’t move toward a worse price.  The trailing price resides above or below the market’s price by the cash value of the point spread.  The trailing price adjusts upward with market prices when you offer to sell shares and downward when you offer to buy shares.  Reversal of the market price initially stops the adjustment of the trailing price and eventually triggers the submission of a market order.   The trailing stop order is stored in the brokerage firm’s computer until its expiration date or the submission of a market order.

Setting the stop

Trading platforms are designed to set stops above the ASK and below the BID of a market quote.  For example, when you offer to purchase shares with a stop or trailing stop order, a market order is submitted when the market’s ASK increases to the stop price.  Or when you offer to sell shares with stop-limit order, a limit order is submitted when the market’s BID decreases to the stop price.

The likelihood that daily fluctuations in market price will trigger any type of stop order depends on the width of the margin between the stop price and market price.  Exceptionally narrow margins may trigger an order the same day and exceptionally wide margins may cause the order to expire before being triggered.  The width of the margin depends on your trading strategy.  What is your acceptable price range for buying and selling a security?  Do you prefer using the same margin for all stops or customizing the margin based on price volatility?  The SmallTrades MockTrades4 is a free, useful worksheet (in Microsoft’s Excel™ format) for customizing the stop margin of your trading order.

Applications

Stop and stop limit orders are typically used to protect against capital losses when market prices are declining.  Trailing stop orders can help maximize a sales price or minimize a purchase price.   Examples of these applications can be found online in the educational materials of brokerage firms.  This user-friendly version, “Secure your position”, was a free download provided by the Commonwealth Securities Limited (“CommSec”), Sydney, web site.

Copyright © 2014 Douglas R. Knight

 


Investment strategy of the SmallTrades ETF Portfolio

February 14, 2014

An index ETF is designed to capture the investment returns from a financial market.  The SmallTrades ETF Portfolio (“Portfolio”) uses index ETFs to invest in several financial markets.  The goal of the Portfolio is to earn returns at a faster rate than possible by investing in risk-free bonds or the broad market of U.S. stocks, thereby ensuring that the accumulation of returns outpaces the inflation of prices in the American economy.  Success is measured by the following benchmark indices:

Investment strategy

The Portfolio is a high-risk, high-return investment in ETFs that duplicate well-established market indices for global stocks, U.S. bonds, U.S. real estate investment trusts, and gold bullion.  Twenty five percent of the portfolio’s market value is allocated to each index.  The ETFs generate at least 99% of the portfolio’s value and any remaining value is stored in a money market fund.  The ETFs will be held indefinitely except when faced with the advantage of replacing one with a more suitable ETF for the same index.

Table of holdings

ETF trading symbol Market Allocation
 AGG   U.S. bonds 25%
 GLD   Gold bullion 12.5%
 SGOL     Gold bullion 12.5%
 VNQ     U.S. real estate investment trusts 25%
 VT  Global stocks 25%

Expected return

Unfortunately there is no 50-100 year history of ETF performance that enables the forecast of an expected return.  To compensate for this limitation, two models were used to test the allocation plan shown in the table of holdings.  In one model of the 15-year recovery from the 1997 Asian Financial Crisis, the allocation plan outperformed the U.S. stock market.  In the other model of the 5-year recovery from the 2008 Global Financial Crisis, the allocation plan underperformed the U.S. stock market.  Among both time periods, the lowest return of the model portfolio was 8.5%.

  • MARKETS portfolio of financial-market returns from 1997 to 2011: The global-stocks market was simulated by a mixture of 75% U.S. large capitalization stocks and 25% emerging markets stocks.  Trading and management fees were excluded from the model.  The annualized return of the portfolio was 8.5% in comparison to the 5.7% annualized return of U.S. large capitalization stocks.
  • ETF portfolio of historical prices from 2008-2013: Trading fees, but not management fees, were included in the calculations (– management fees are charged in the primary market before ETFs are listed in the stock market).  The annualized return of the portfolio was 10.9% in comparison to the 17.8% annualized return of SPY, an ETF that tracks the Standard & Poor’s 500 Total Return.

Risk management

The holding period will be at least 5 years.  Fluctuation in market prices is the main risk of investing in index ETFs.  The likelihood of incurring a loss from a declining market decreases as the length of the holding period increases (– e.g., the risk of loss from stocks and bonds declines by 50% as the length of the holding period increases from 1 to 5 years; and, the risk declines by 80% when the holding period is extended to 10 years (1)).

The Portfolio will be rebalanced as needed to maintain the allocation plan within an acceptable limit of 28% error.  The Portfolio is concentrated in 4 markets and losses may occur when one or several markets decline.  The 25% allocation plan assigns equal weightings to each financial market in order to smooth the effect of market declines.  After accounting for trading fees, the strategy of rebalancing a large allocation error is more cost-effective than using a rebalancing schedule.

The Portfolio holdings are investable, have established reputations, charge low management fees, and are safely structured.  Although there’s no guarantee that the index ETFs will sustain their historical performance, the stock market, bond market, and real estate market ETFs provide diversified investments in underlying assets.  The risk of investing in these ETFs is lower than the risk of investing in an underlying asset.  Gold bullion ETFs are non-diversified investments in the volatile gold market.  Gold bullion is theoretically susceptible to physical damage by theft or fire.  This risk is diminished by investing in two funds, GLD and SGOL, that store the bullion in separate vaults located in London and Lucerne.

The investor’s tax burden can be reduced by holding these index ETFs in a tax-deferred retirement account.

Copyright © 2013 Douglas R. Knight

References

1.           James B. Cloonan, A lifetime strategy for investing.  American Association of Individual Investors, Chicago, 201


#Bracket orders

January 28, 2014

[updated the bracket order calculator on 6/25/2014.  Updated the text on 7/18/2014]

The bracket order is a trading order to buy a stock or other exchange-traded security while also placing an advanced order to sell the entire purchase at a future profit or loss.  The profit and loss exits are the brackets.  Some brokerage firms offer the bracket order to individual investors (1).  I use it to limit the loss that I might incur any time after buying the stock for a long position.  The bracket order has 4 elements: 1) Entry share price for buying the stock from the market. 2) Quantity of shares to buy. 3) Profit exit share price for selling the stock at a capital gain. 4) Stop loss exit share price for selling the stock at a limited capital loss.  Click on this link to the bracket order calculator worksheet to follow the discussion or plan your automated trade.

Taking the long position

Taking the ‘long position’ means to purchase a stock with the idea of selling it at a higher price.  But if the price falls, you suffer a loss in proportion to the size of the investment.   You can manage the risk of a loss by deciding how much money to sacrifice and using the bracket order to limit your loss.  Some investors typically plan to lose between 1% and 3% of their capital in a single trade.

Bracket order’s prices

LongPositions

The chart shows price movements for two imaginary stocks during a recent time period.  The wavy black lines are series of historical stock prices that end at the latest price on the right hand side.  Assuming that prices will continue to behave in the same way, the future prices will fluctuate between the levels of support (red dashed line) and resistance (green dashed line) until a substantial event dictates a change.  The support is the price ‘floor’ and the resistance is the price ‘ceiling’.   In between are the opportunities for profit and loss.  The ideal situation is to buy any stock near its support level and then sell near its resistance level, repeating the process over many trades to accumulate wealth.  The bracket order helps plan for these outcomes.

Suppose the latest price is suitable for investment.  Then plan to purchase the stock at approximately the latest price by placing either a market order to trade immediately at the current price or a limit order to trade at a specified or better price. Your desired purchase price is called the entry (yellow circle on the chart).   Your bail-out price is called the stop loss exit (red square), an automated order to sell the stock at a planned loss.  Your price for earning a profit is the profit exit (green square), an automated order to sell the stock for a capital gain.

Bracket order’s quantity

The final step is to calculate the quantity of shares to purchase.  The quantity is constrained to the planned loss on a per-share basis.

  • “Planned loss” is the amount of money you are willing to lose from a trade in the event of a market downturn
  • (loss/share) = entry – stop loss exit
  • quantity = planned loss / (loss/share)

The planned loss is typically less than the principal amount spent to purchase the shares (principal = entry x quantity).  You may choose to reduce the quantity in order to lower the principal.

Comments

CAUTION:  There’s no guarantee that the stop loss exit can prevent losing more than the planned loss when market prices are exceptionally volatile.  Prices typically move in small increments except in rare instances when they might plunge below the stop loss exit by several points to create a deep loss.  That’s why the SEC recently enacted “circuit breaker” rules to stop trading for any stock whose price changes sharply within a five-minute period (3).

RECOMMENDATION:  The future prices of any stock are uncertain.  Put more effort into determining the stop loss exit than in determining the profit exit by using historical prices to select a safe level of support (red square in the chart).  The profit exit reflects how quickly you want to sell for a gain; it’s better to think high and wait longer unless you’re a bonafide day trader.   Expect a longer holding period for the higher profit exit. If your brokerage firm’s trading platform allows changes, you can update the bracket order to protect gains and reduce losses as the prices rise with time.

Consider using the bracket order calculator to plan your automated trade.  If the program inspires your investing to support the betterment of society, consider making a tax-deductible contribution to your favorite charity or my favorite charity.

References

1.       Jean Folger. The pros and cons of automated trading systems.  Investopedia.com, August 24, 2011.  © 2014, Investopedia US, A Division of IAC.

2.       Investor Bulletin: New Measures to Address Market Volatility, SEC.gov, 4/9/2013.


%d bloggers like this: