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What Determines Value?

October 21, 2014

Last week, the stock market took a tumble. Not pretty! What happened to cause so much loss of value?

News happened. Some of it was shocking, scary and upsetting. On January 28, 2014, I posted a blog entitled, The Market Tanked Last Week – Does it Matter? I suggest you re-read it. Today, I want to take a different approach and discuss what determines value for stocks.

Many things determine value on a short-term or temporary basis for stocks, but I submit that sustainable earnings growth determines value for the long haul. With some weird exceptions, the expectation of a payout either in the form of growing dividends and/or stock growth will determine the value. Temporarily, anything can happen and values can and do fluctuate widely, but on a long-term basis it is sustainable earnings growth. For investment purposes, I consider periods under seven years as “temporary.”

Steady and measured dividend growth is a good way to assess valuation. So does the expectation that the shares can be sold at a later date at a profit. Analysts and economists contend that the price of a stock is the present value of expected dividends plus the growth in the value of the stock. Statistically, periods longer than a dozen years do not have much weight in the present value calculations. Dividend and stock price growth over about the next 10 or 12 years are what should be looked at when assessing current stock prices. Differences in thinking and evaluating data cause people to buy or sell creating trading activity. There are also traders, not investors, looking for temporary inequities that go in and out as they see it creating some sort of balance to the current stock pricing.

An exception is Warren Buffett’s Berkshire Hathaway (BRK) that does not pay dividends. Mr. Buffett believes he can invest the money at much greater returns than his stockholders, so BRK keeps growing and growing and growing. There is also a self-created floor on the value with Buffett’s stated indication that BRK will buy back shares if the price drops below 120% of book value. However, a return on investment from BRK can only be realized when the stock is sold.

Besides traders and company performance, there are many outside factors affecting valuations on a short-term basis such as price to earnings ratios, interest rates and yields, meeting or missing earnings’ expectations, the overall level of the stock market, volatility of trading, prices of raw materials, currency exchange rates, availability of suitable labor, company and economy growth expectations, tax rates and policy, profit margins, competition, and continued viability of the company and its products – current and new ones in the pipeline, its management and its role in the overall marketplace, to illustrate just a few value drivers.

The issue is that investors generally do not always agree. Valuing stock too high has you giving up growth for a period of years. Too low can provide you with an opportunity to make an extra buck. There have been protracted periods when the overall market or sectors were simply valued too high, and we know the effects of this [The NASQAQ is still lower than its high of 5408 on March 2000]. But over the long-term, the current price needs to provide a reasonable dividend that will grow and a reasonable stock valuation that will also grow. Not tomorrow, or a year from now, or even five years from now, but over a long-term because at the end of the day – most of us invest to assure our long-term financial security. That is what needs to determine the value of what we buy today.

Managing Risk

October 16, 2014

Investors need to consider calculated risks based on their needs and goals with the understanding that no matter what is done, there will be risk.  Risk avoidance is impossible – what is possible is avoiding certain risks over others. 

Prudent investing requires choosing the risks you feel comfortable with and avoiding the risks you are most uncomfortable with consistent with pre-stated goals.  Uninformed choices of what risks to avoid in many instances will not get you where you want and need to be.

I believe that many of yesterday’s rules regarding risk that suggest that as you get older you need to reduce your equity position in favor of fixed income and reduced bond terms are outdated.  The rules you need to follow are new ones that recognize longer life expectancies, all time low interest rates, an intertwined global economy, almost instant availability of news and individual inflation rates based on older people’s spending patterns.  A husband and wife both 70 have a life expectancy where at least one of them will live 27 years.  A couple at age 75, 23 years and age 80, 18 years.  You can outlive your money if you invest using yesterday’s rules and the feelings and tolerance you had yesterday.  Anyone with a greater than ten year time horizon should consider taking on greater “risk” dictated by the changed conditions.  This can mean longer-term fixed income investing periods or more funds allocated to equities than previously suggested by the old rules.  Properly considered, this can actually come out to be less risky in the long run.

Knowledge, understanding and clear goal-setting also help allay fears and insecurity.

The ultimate test is to understand whether the types and levels of risk you assume will get you to your goals.  If not, then you will need to consider different risks – or change your goals.

Understanding Risk

October 14, 2014

Many people are concerned about risk, but don’t really understand it.  Risk is ubiquitous – it is always there.  There just are different types or forms of risk.

Risk is also unknown because it is a gauge of something that will happen in the future.  What you need to do is make your decisions based on what you know, what you might be able to control and your expectations of the future and then hope for the best.  This does not mean you should ignore what has happened in the past because it is a guide – or a warning – of what can occur in the future.

Another thing to consider is not only how secure you will be in the future, but also how secure you will feel. You can be fully secure but not know or recognize it and feel insecure.  “Secure” means that you strongly feel you will not outlive your assets after withdrawing sufficient amounts to live your life the way you want.

If you need more than what you presently have to feel secure, then pick a targeted amount at a given time and set a plan to reach it.  If your plan is attainable, good for you.  If not, then you might need to change your goals or current or planned spending.  But, at some point, you will either be there or you won’t.  That is how you will determine whether you feel secure.

Risk will always be there and just because you are uncomfortable or insecure about certain forms of risk doesn’t mean you are making the right investment decisions bypassing them.  In my opinion, it does mean (in most cases) a lack of knowledge about investing and a lack of understanding about those types of risk.  Risk cannot be avoided.  It can be reduced, transferred, accepted, decreased or increased, but it cannot be avoided.  One simple illustration is the prevalence of inflation.  You accumulate an asset base to provide cash flow to be spent.  If your earnings are lower than the inflation rate, over any reasonable period of time, your asset base will eventually be reduced.  Right now, short term Treasury Bills, perhaps the most risk-free investment in the world is yielding less than 10% of the inflation rate.  One year insured bank CDs are paying less than 25% of the inflation rate.  Things may change, but they may not, and if they don’t, you will run out of money unless you have a humongous amount where this is not a concern.  This is not the case for more than 99% of the people in the United States.  Investing risk-free can possibly drive you into the poor house.

A second illustration is to assume that investing “risk free” will not permit you to attain the degree of security you need, but undertaking a measured risk such as investing in the same items but for longer terms providing higher yields might.

Risk needs to be considered, but measured against realistic priorities.

Will Your Successor Be a Caretaker, Innovator or Empire Builder?

October 9, 2014

Businesses reach a point where they can no longer be maintained by the present owners and leaders.  If that is not recognized, then the leaders will work until they drop.  No problem for them.  Their heirs will dispose of the business in some manner and take what they can get for it. 

If the present owners realize they cannot handle it forever, no longer want to and do not feel they have people who can carry on afterwards, they can sell it.  They will be exchanging the continuing income from the business for the sale proceeds and a substantial part of their life, i.e. time, they can use for other endeavors.  However, if they want the time, continuing cash flow and eventual sale proceeds they can transfer the business to successors.   One question to consider is the type of successor the business will be trusted to.

Certain businesses can continue without the original guiding force.  Those continuing it can include key employees, long time consultants, a child or grandchild, spouse or a group of these people able to work together to continue the business.  This is particularly important if the owner dies suddenly without prior plans being made. 

Even with careful plans and a successful transfer it is still difficult to assess beforehand what type of new owner will take over.  Will they be a caretaker, innovator or empire builder?  I have seen all three (and many others) and under the right circumstance, each type of person can be appropriate.  For instance, a caretaker can maintain a business and its cash flow and while not expanding the business, can work to maximize the earnings, streamline production capabilities, increase efficiency and improve product or service delivery and customer service.

An innovator will look to grow the business and be willing to assume measured degrees of risk.  They might need additional financing and while trying to expand the business might not pay as much attention to the details a caretaker would losing opportunities that might be easier to achieve.

An empire builder is usually someone using the business as a stepping stone – something that makes him a player.  His interest might be much less than either a caretaker or innovator.  This business is just the ante in the pot for bigger gains.  These feelings can sometimes be latent in employees who bide their time for an opportunity they crave but do not usually feel will materialize.

Everything in business needs care, consideration, careful planning and the upmost thought.  There are many ramifications and nothing should be overlooked, especially the type of successor.

Succession Planning

October 7, 2014

Succession planning is an important process that many business owners need to consider and which many do not.  For those that plan, it can work out very well.

Succession planning is a process that establishes new ownership and management and provides the ways and means to put them in place with a reasonable likelihood of success. The successor is usually a person already working in the business or a knowledgeable family member not presently working there.  Part of the planning is how the price will be determined and payments structured considering that the buyers most likely will not have independent funds to make payment with.  If not done with family members, it is done with a long employed group of loyal people that have become a sort of quasi family.  Succession planning also needs the desire and resolve of the owner to see the business continue.

Succession planning needs to deal with the realities of the perception and feelings of family members that do not work in business.  There also needs to be recognition that there might be an unequal distribution among family members working in the business and how they will feel about the choice of the new leader.  Succession planning needs to provide for the equitable transition to the next generation where payment can be made and the business continues and maintains its “cash cow” status for the owner and family.  Succession planning also protects the value for the owner since customers, staff, suppliers, landlords, bankers and others dealing with the business will have confidence of a continuing relationship.

Succession transactions are usually private events with not much public fanfare.  Most of the background information comes from professionals assisting clients with little details of actual transactions disclosed.

Succession planning requires a carefully thought out plan or chaos could result.  Succession planning should be done, even if there are no immediate plans to retire. Life insurance is purchased even though there are no immediate plans to die and prenuptial agreements are signed even though there are no immediate plans to get divorced. So, too, should succession plans be formulated as a precaution against unforeseen, unintended and perhaps inevitable future events. There is a responsibility of the owner to consider the needs of all those involved.  Many times the owner is an inner directed person even though they are outgoing when they are with people. They simply may not be aware of the people that would be affected by what is done or what is not done properly.

If you own a business and haven’t developed a plan, why not start thinking about it?

Additional information can be found in a blog I posted on August 22, 2013 – 8 Steps for Successful Succession Planning.

Entitled Royalty

October 2, 2014

There is a type of person that I find very annoying and I will refer to him (or her) as “Entitled Royalty.”  These people have no concern for anyone else believing they are entitled to whatever they do.  Some examples follow:

  • Someone whose spouse needs a handicapped permit for their car and they go to the mall without that person and park in a handicapped spot.  They are screwing those that really need that spot, but they are “entitled.”   They should pray to God they do not eventually need that spot.
  • A person I send a gift to – perhaps a book, photo or a shirt – and they do not respond with a “thank you” or even that it was received.  They are “entitled.”
  • A person driving ten miles below the speed limit in the left lane while also talking on their cell phone with perhaps a cigarette in their mouth and when you beep them they give you the finger.  They are “entitled.”  Actually, I have a theory about what the finger means.  It means “I am an a$$hole!”  Anyone displaying that gross gesture is usually doing something they shouldn’t and they are really a$$holes.  Their finger supports that hypothesis.
  • People that do not take the time to explain clearly what they want done to people working for them and then get upset when it is not done right.
  • Anyone that yells at people working for them.  I am always surprised that anyone stays.
  • People who inherit a hefty investment portfolio and truly believe they earned it neglecting to seek any type of professional assistance.
  • People that hire a well-known investment advisor that overcharges and spends no time on their client’s portfolio, but name drop who their advisor is.  They are both “entitled royalty” and in these situations the person making the payments loses.
  • People who are a strong #2 in a business, but who never, ever, initiated a single change in anything and who just can’t wait until their boss croaks so they could take over and run things “right.”
  • Police officers driving police cars that do not signal when turning, who do not stop at stop signs or that go 45 mph on a 30 mph road when going for coffee.  There are safety rules that they should follow.
  • Customer service call centers that repeat “your call is important” every 2 minutes for the 15 or so minutes you are waiting to speak to a person about your problem.  Also, the IRS and many state tax authorities frequently have one-hour waiting times for customer service calls that are “important to us.”  Bull.

There are others, but these came up recently.

The Role of Taxes in a Financial Planning Strategy

September 30, 2014

Taxes are a major expense item and need to be managed separately and carefully.

At a minimum, you should be aware of your tax situation with projections prepared regularly and big picture explanations of what is taxed, how, why, when and potential strategies that could reduce them.

Many people become overly consumed with saving taxes and miss the point that their goal should be to become wealthier, with saving taxes being one tool.  For example, I could wipe out all of a business client’s taxes if they pay me a fee equal to their profits.  As ridiculous as this sound’s, many people do similarly dumb things.  Here are some strategies to consider:

  • I talk to clients that have large gains in a stock they recently purchased but want to hold off selling until it qualifies for long term capital gains.  My advice is that once they no longer think the stock would keep appreciating, or are doubtful it would remain at the present level they should consider selling it and taking their profit, albeit that they will pay tax at higher rates. I’ve seen this holding/lower tax attitude erode large gains into eventual losses.
  • Many people believe that taking large mortgages is a great strategy to save taxes because the interest is tax deductible. They will save taxes that way, but will be poorer in the long run since they will be paying more interest than they need to. Even if they are in a combined federal and state 40% tax bracket, 60% of the interest paid is still their money!
  • Another bad “strategy” is when you have funds in a tax-deferred account such as an IRA and also in your own name and you allocated your investments so stocks are in the IRA and tax free bonds are in your own name.  The bond interest will not be taxed. However, by reversing this strategy and buying the stocks in your own name and investing in higher yielding corporate bonds in the IRA you will pay more current tax but in the long run be wealthier since the stocks and dividends will be eventually taxed at favorable rates, while the bond interest will accumulate at a tax deferred basis.
  • Contributing to employer sponsored 401(k) or 403(b) plans or if self-employed, then one of the many qualified retirement plans available for those businesses, is a way to get current tax deductions, accumulate investments on a tax deferred basis and build wealth for your future financial security.  Also, many employers contribute some matching funds to their employees’ 401(k) accounts increasing the benefits of these accounts.
  • Another issue to consider is whether to convert an IRA to a Roth IRA.  The amounts converted will be taxed now, but once the funds are in the Roth IRA, the principal and income will never again be subject to taxes.  This can also be very beneficial if done in a year your income is unusually low.
  • You should consider employer sponsored cafeteria salary reduction plans allowing you to pay medical costs that otherwise would not be deductible with a portion of your pretax salary.

Contributing to a charity can be easier (and better) tax-wise if appreciated long-term held securities were donated rather than cash.  You would get a full charity tax deduction for the current value of the securities and would not be subject to capital gains taxes on the appreciation. Tax savings are important, but they are only one piece of the strategy in a much bigger picture of becoming wealthier.  Consider all the issues and the big picture before acting.

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