Wednesday, June 29, 2011

Asset allocation methods from the masters part II: Benjamin Graham

In the first article of this 3 part series, I talked about an asset allocation method suggested by Peter Lynch which advocated that the investor have his portfolio consist of as high a stock component as he can tolerate. This is the case as a portfolio of stocks generally outperforms a portfolio of bonds or a portfolio of part stocks and part bonds over the long-term.

In this article, I will be talking about an asset allocation method suggested by the father of value investing, Benjamin Graham.

Benjamin Graham once suggested an asset allocation method where an investor would put 50 percent of the money in his or her portfolio in bonds while the other 50% of his or her portfolio would consist of stocks. The investor can then tweak the portfolio up to 75-25 stocks or 75-25 bond, depending on whichever asset class the investor thinks is attractive enough to commit more money to.

This asset allocation method is good for emotional investors who might panic when the price of stocks fall and might make some decisions that they could potentially regret. With at least 25% of the portfolio allocated to bonds at any one time, the investor might not get so emotionally affected even when stocks do take a tumble. This is the case as even if the value of the stock component of his portfolio falls, the investor would still receive interest income from the bond component of his portfolio which should help in keeping the investor’s emotions stable during the bear market.

Here are some other investing principles from Benjamin Graham:

Benjamin Graham came up with the margin of safety concept which advocated buying stocks at a significant discount to intrinsic value. This would give investors at least some protection against any impairment in the businesses behind the stocks that the investor bought for his portfolio. Benjamin Graham also advocated that investors do not invest in stocks trading above 1.5 times book value or stocks trading at a P/E ratio of above 15. Investors can buy stocks with a P/E ratio higher than 15 provided that the stock is trading below 1.5 times book value and vice versa. However, the sum of the P/E ratio multiplied by the price to book value ratio shouldn’t exceed 22.5.

Note: Benjamin Graham suggested calculating the earnings for the P/E ratio by averaging out earnings over 3 years. This should help in giving the investor a more accurate picture of the company’s financial performance.

I can’t remember the exact amount of EPS growth Benjamin Graham suggested that a stock should have for the long term, but investors should only invest in stocks that have grown EPS at a decent rate in the past and which they believe can keep growing EPS at decent rates in the long-term future so as to keep ahead of inflation. I personally would require a long-term growth rate of at least 6-7% (the minimum rate of growth that you should require is of course up to you).

I’m not 100% sure, but I think that the Benjamin Graham investing principles and asset allocation method I talked about in this article are meant for investors which Ben Graham called ‘defensive investors’ or investors that are not very experienced and don’t have much time to devote to investing. But even if you’re an experienced investor, there’s no harm in knowing these investing principles.

If you have any questions or have anything that you would like to share please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

This article is featured in the carnival of value investing, check it out for interesting investing articles! 

Saturday, June 25, 2011

Surviving inflation part 2: Treasury inflation protected securities

In the first article of this series I talked about why I believe investing in stocks of good companies is the best way to protect yourself from inflation. But unless stock prices are really attractive (and even then I believe investors should still maintain ample liquidity), investors should probably have a certain percentage of their portfolio invested in cash and other short-term liquid assets such as CDs and treasury bills.

While it’s prudent to hold some cash in your portfolio, the value of your cash holdings can get significantly eroded in periods of high inflation. As a way to give their cash holdings and portfolios better protection against inflation, investors can consider substituting some of their cash and cash equivalents with treasury inflation protected securities or TIPS.

TIPS pay a fixed rate of interest that’s based on the TIPS’s principal that rises with inflation. The consumer price index determines the increase in the TIPS principal.

Here’s an example: Let’s say you bought a TIPS at auction with a $1,000 face value that pays a fixed coupon of 2% on the TIPS’s principal. The consumer price index is at 10% for the first six months which will cause the treasury inflation protected security’s principal to rise by 5% or $50 when it’s adjusted at the end of the first six months (The principal only increased by $50 or 5% instead of the CPI’s 10% because the principal is adjusted on a semi-annual basis not on an annual basis). And because the coupon payments are based on the principal of the TIPS which have been adjusted to $1050, the investor would get a $10.50 coupon at the end of the first 6 months (again, the investor only received 1% in interest or half of the TIP’s 2% annual fixed interest rate as the coupon was a semi-annual coupon).

It is important to note that the TIPS’s principal can also decline with deflation. This will cause interest payments to decline as interest is fixed to the principal of the TIPS. TIPS do, however, protect the investor’s principal in the sense that the investor will receive at maturity either the adjusted principal or the face value of the TIPS, whichever is greater. This will only work if you buy TIPS at auction or on the secondary market when they’re trading at or below face value.

It is also important to note that in the US, investors are taxed on the interest payments of the TIPS as well as any increases in the principal even if the TIPS did not mature, and regardless of whether or not they sold the TIPS. That’s why it’s important to hold TIPS in tax-advantaged retirement accounts.

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio.

Thursday, June 23, 2011

Surviving inflation part 1: Stocks

No matter how you cut it, inflation is a bad thing for your investments. Be that as it may, there are some investments that would be less affected by inflation than others. In this 2 part article series, I’ll be talking about 2 asset classes that can provide us with significant protection against inflation; stocks and treasury inflation protected securities or TIPS.

Businesses, whether it’s private businesses or stocks, have been and will continue to be the greatest generators of wealth over the long-term. Some would say that stocks are a good hedge against inflation as a company can raise prices to maintain profits in real terms. But that isn’t completely true as lousy companies might find it difficult to raise prices. In other words, stocks can be good hedges against inflation, but only stocks of good companies.

But shouldn’t we be investing only in good companies, regardless of whether or not there’s high inflation? Yes, we absolutely should. That’s why I’m always puzzled when people start panicking when there’s inflation and look to some guy on TV to tell them where to invest. If you invest in good companies at a reasonable price and hold on to those stocks for the long-term, you should do fine.

Here are a few characteristics we should look out for when identifying good companies that are resistant to inflation:

Good returns on capital

Good companies generate attractive returns on capital (hence the reason why they’re good). A company that’s asset-light and earns good returns on capital will be more resistant to inflation than one that’s asset-intensive and earns poor returns on capital. This is the case as in times of inflation, the company with a lower return on capital has to tie up more money in things like inventory and accounts receivable than a company that earns high returns on capital to stay even in terms of real profits.

For example: Suppose both company A and company B earns $1 million. But company A only needs to put up $5 million to earn the $1 million (high return business) while company B has to put up $20 million to earn $1 million (low return business). Now, let’s say that inflation has caused prices to double, and while both companies managed to increase prices at the same pace as inflation, both of the companies also had to put up two times as much capital just to stay even in terms of real profits. While inflation has hurt both companies, company A only needed to put up an extra $5 million in capital while company B had to put up an extra $20 million in capital.

It's hard to tell the exact return on capital a company enjoys as the company might be holding on to a lot of excess cash and etc. But generally, if a company consistently earn good returns on equity and good returns on assets without having to reinvest a lot of cash in the business to maintain profitability, then that would most likely be a company that can employ capital at good returns.

Pricing power

When trying to find good companies, it’s always useful to start out by looking for companies with strong brands that differentiate their offerings from that of their competitors and give them pricing power. But how do we know which company has a strong brand and which don’t? Doesn’t every CEO say that their company has a strong brand and pricing power? To answer this question, we need to look at the gross profit margin of the company and compare it to the gross profit margin of its competitors. If the gross profit margin is significantly higher, then the company has pricing power as customers are willing to pay more for the company’s products than for the products of the company’s competitors.

Here’s an example: There are 2 burger stands, both sells 100 burgers a day and the cost of the ingredients to make 1 burger (let’s just say $5) is the same for both burger stands. But if burger stand A has pricing power and is able to sell its burgers for $7 while burger stand B is only able to sell its burgers for $6, burger stand A will earn higher revenue than burger stand B ($700 for A and only $600 for B). And because both burger stand A and B have the same cost of ingredients at $500, but burger stand A has pricing power, burger stand A will earn a higher gross profit and have a higher gross margin than burger stand B. That’s why it’s important to look at the gross profit margin of a company in comparison to its competitors to determine if the company has pricing power.

Note: When I talk about using the gross profit margin to give us an idea of a company’s pricing power, I'm mainly talking about companies that sell physical goods. This method might not apply to certain industries or companies. There might also be more accurate methods to measure pricing power. But nevertheless, I think comparing the gross profit margin of a goods selling/producing company to that of its competitors is a good way to get a general idea of the company’s pricing power.

Operating profit margin

Good companies manage their costs well and should have higher operating profit margin than their competitors. By earning a higher profit margin relative to their competitors, good companies are able to weather inflation better than their competitors in the sense that they can better absorb cost increases (increases in raw material prices, increases in employees’ wages, and etc) than their competitors. They can wait a longer time before increasing the prices of their products and win market share from their competitors who have to pass on the costs to customers earlier or operate at a loss.

I believe the best way for investors to fight inflation is to do what they should always be doing regardless of what’s happening with the economy or how high inflation is going to get, that is to just invest in stocks of good quality companies at reasonable prices and hold those stocks for the long-term. Inflation might even cause stock prices to fall giving the savvy investor attractive buying opportunities.

If you have any questions, or have anything that you would like to add, please feel free to comment. Thank you for reading and may you always sustain good returns on your portfolio. Take care.