Use Time to Reduce Your Risk


 

 

jerichopoolIn Risk Allows You to Make Money in the Stock Market, I talked about how taking risks is what allows you to make more money investing in stocks than you could earn from a bank account.  Because you are putting your money at risk, the price you pay for shares of a stock are reduced (or discounted in accountant speak) from the price they would be at if you were assured that the company would make the earnings expected and pay those earnings out in a dividend.  You might get a check for $100 per year for your $1000 investment, or a 10% return, but you might not.  You would therefore invest only $500 and still expect a $100 per year payment if the business does well and things work out.  You get a higher return (20% instead of 10%) to make it worth taking the risk.

Luckily, with the market-based system you don’t need to figure out the right price to pay to get an appropriate risk premium.  Smart people with sophisticated computer programs do that for you by buying shares if they are cheap and selling shares if they are expensive.  As a result, the price of a stock will generally, but not always, already contain an appropriate discount for the amount of risk you are taking.  To improve your chances of getting a good price, you can also follow the share prices for a few weeks before you make a purchase and try to buy when the stock is it the low end of the range.  This can be done easily by placing a limit order, where you set the maximum price you are willing to pay for a stock.  You can also look at the price-earnings ratio, or PE, or the price to sales ratio, or PS, and only buy stocks that are at or below their average PE or PS level, averaged over the last several years.  In general, because I am buying for the long-term, I don’t worry too much about getting an extra ten cents or quarter per share since it won’t really matter in the long run and I may miss out on a big move up if I’m too picky.  Instead I tend to pick stocks from my watch list that have declined in price recently by at least a few dollars when I have money to invest and am ready to buy more shares.

 In Risk Allows You to Make Money the Stock Market I gave three ways to help manage risk and put the odds on your side.  These were:

1.  You invest appropriately for the time frame you have.

2.  You diversify your investments to reduce single-investment risk.

3.  You choose your investments appropriately based on your time frame and objectives.

Today I’ll cover the first item, investing based on your time frame.

The more volatile the investment you’re making is, the less able you are able to predict future values.  If I put $1000 in the bank in a CD paying 5% per year, I can predict with almost certainty that I will have $1050 in a year.  If I put $1000 in a stock that I think has the potential to grow earnings by about 15% per year, I have no clue what the price of the stock will be in a year.  I might have $2000.  I might have $500.  All that I know for sure is that I’ll lose $50 or so immediately due to transaction costs and brokerage fees.

The company I invest in may have a bad quarter, miss earnings estimates, and fall 20%.  The economy in general may run in troubles and the stock price may fall.  A competitor in the same industry as the stock you purchased may run into trouble and people may sell stocks in the whole industry.    The company may even post record earnings, but those earnings may be less than the “whisper numbers” some people may be expecting, and the price of the stock may fall.

While it is hard to time when the price of a company may go up, it is reasonable to expect that the stock of companies that are run well and are growing will increase in price at a rate about equal to the growth rate of their earnings.  This will be in fits and starts, with some declines or even crashes along the way, but over long periods of time you should be able to get a fairly predictable rate of return.  It might be that the stock doubles the first year and then trades within a range over the next few years, it might be that the stock price increases steadily each year, or it might be that it goes nowhere for several years and then doubles in price.

The way to manage the risk that the stock price may not increase over short periods of time is to simply only buy stocks if you are planning to invest for a long period of time.  For mutual funds I’d be reluctant to invest unless I was planning to invest for at least five years and maybe ten years or longer.  For individual stocks I’d probably be looking at ten years or more.  This gives time for the company to grow and people to realize that it is a great company and bid up their stock price.  I don’t have to guess what will happen with the economy, people’s emotions, or understand what trading strategies people are employing will do to the price over any given period.  I just know that if I wait long enough, things should work out and I should get the return needed to justify the risk I am taking.

I therefore would use the following guidelines:

1.  For cash needed within six months, use a bank account.

2.  For cash needed in one to three years, invest in bank CDs or perhaps high quality bonds set to be redeemed within the period.

3.  For cash not needed for five to ten years, split the money between stocks, bonds, and cash, and use mutual funds to diversify.

4.  For cash not needed for a decade or more, invest in stocks through mutual funds and select individual stocks.

By using time to put the odds in your favor, you can get greater returns by collecting the risk premium.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

Looking at Retail Stocks


 

 

farmhouseMy wife is looking to invest some money in her account, so I pulled out my watch list of stocks.  I normally keep a list of stocks that meet my criteria as good, long-term investments handy for just such a time as this.  I then down-select from that list based on 1)the relative price of the stock versus what I consider to be “fair value” based on future earnings potential and 2)how big a position I have in the stock already.

In looking through the list this time,  two retailers looked like good options.  These were Pier One, the ubiquitous chain of home decor items, and The Container Store, a relatively new chain of stores that sell containers to hold the knickknacks you pick up at Pier one but no longer want to have out taking up space on your end table.

I only had a few shares of Pier One in my son’s educational IRA account, so there was room for plenty more.  It had fallen from about $20 where we had bought in to the low teens.  This made an attractive entry point, although it makes you wonder if the chain has lost its luster and is no longer fashionable.  (Note that I consider all of our accounts when deciding whether we are too heavily invested in any one position.  There is no mine and yours when you become married.)

I had bought a fairly sizable position in The Container Store, but I was still building the position during pullbacks in price and it could stand to get a bit larger.  It had also fallen back a bit since I had bought in, although not as badly as Pier One.  The Container Store appears to have a lot of room for growth, but really doesn’t have quite enough history to know if they are going to grow into a retail behemoth or fail as a concept.  There is something attractive about getting in early, however.  Wouldn’t it have been great to get into Home Depot near the beginning when they only had stores on one or two states.

So what are the things about these two businesses that make them SmallIvy stocks?  Well, they have shown a good, consistent earnings growth rate.  I like stocks that are able to grow their earnings year after year.  I find that I tend to buy into retail and restaurants quite a bit because they are really designed for growth.  All they need to do for a period of time is open another store.

The second thing I like about them is they have a relatively high 3-5 year appreciation potential, as listed by the Value Line Investment Survey, the stock rating and screening publication I use.  I look for stocks that are have the potential to grow a large amount over the next several years.  If I can find stocks that have potential returns between 15 and 20% per year for the next several years,  I tend to examine them more closely.

The third thing that I like to see is a steady increase in price.  If I can find a stock that you could lay a ruler over and find an ever-increasing price curve, I’ll definitely take a second look.  That means that they have been able to deliver consistently good results over a long period of time.  A few stocks do that for decades, and those are the truly great ones.  In this case The Container Store doesn’t have a long enough history to say yet, and Pier One has seen a few ups and downs.  Of course, most stocks saw downs during 2008-2009 since people stopped spending since they could no longer use their homes as a piggy bank.

In the end I did what any smart investor would do – I left it up to my wife to decide.  She decided to go with Pier One.  We’ll also put some of the money in an ETF – probably the Vanguard Growth Fund ETF VUG.  No reason to put all of our eggs in one basket, particularly when it’s my wife’s money.  Luckily I’ve done fairly well in the past with her accounts with picks like Sealed Air (bubble wrap) and Equifax (bank transaction services).  Hopefully this pick will work out as well.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

What’s 1%? The Effect of Fees on Your Investment Returns


 

One-percent is such small number.  Many people (but sadly not most people) could afford to put 1% down on a home.  Differences of 1% are normally rounded off and seen as insignificant in most engineering analyses.  So why would it matter if your mutual funds were charging you 1.5% fees versus 0.5% fees each year?  After all, it’s just a 1% difference, right?

Over long periods of time, a 1% lower return each year will make a huge difference.  If you invest $200 per month in bonds, assuming a 7.5% average return over a career, you’ll end up with $200,000 more if you pay 0.5% versus paying 1.5%.  Stocks are far worse.  Over a career, investing the same $200 and assuming a 12.5% average return, you’ll miss out on $1.3 million if you pay an extra 1%!  One point three million dollars just due to a 1% higher fee.

The table below gives the value of both a bond and stock account that is charged a 0.5% and 1.5% fee after 20, 30, 40, and 45 years.  Note that managed funds will typically charge fees in the 1-1.5% range, while unmanaged index fund and ETF fees will be in the 0.5% range or less (I think the Vanguard S&P500 fund charges something like 0.15%!).  All analyses are assuming a $200 monthly contribution and a 7.5% return for bonds and 12.5% return for stocks before fees.

  Bonds Stocks
Years 0.5% fees 1.5% fees 0.5% fees 1.5% fees
20 $92,400 $104,000 $173,000 $198,000
30 $201,000 $244,000 $561,000 $699,000
40 $398,000 $525,000 $1,720,000 $2,350,000
45 $551,000 $759,000 $2,990,000 $4,290,000

Note a couple of things.  First notice that after about 20 years, you’ll have twice as much investing in bonds than you’ll have investing in stocks.  In thirty years that ratio will grow to almost three times.  In 45 years, you’ll have six times as much by investing in stocks.  The stock portfolio will provide a comfortable retirement, while the bond portfolio will not be quite enough to feel truly secure.  This is why you want to invest in stocks when you are investing for a long period of time because the long-term returns are so much better.

The second thing to notice is the huge amount that you’ll give up due to the higher fees in both the stock and bond portfolios.  Over a working lifetime, you’ll have about a quarter of a million dollars less in your bond portfolio with a 1.5% fee as you’ll have with a 0.5% fee.   In the stock portfolio, you’re giving up more than a million dollars.  Perhaps the worst part about paying higher fees is that you lose the ability for a portion of your portfolio to compound because you’re paying it out in fees.  Not only do you pay the fees – you lose the interest on the fees, and the interest on the interest.

Of course, the main reason people invest in managed funds and pay the higher fees needed for research, trading, and the fancy offices in which the mutual fund managers reside is that, theoretically, they make a higher return due to their adept trading than that which would be produced in an unmanaged index fund.  The trouble is, however, because they have to buy so many different stocks, because they have so much money to invest, they basically just end up “buying the market” anyway.  As a result, managed funds typically do worse than unmanaged funds over long periods of time because they get the same returns as the unmanaged funds, yet their fees are higher.

So, if you’re looking for investments in your 401k, it would be wise to choose unmanaged index funds and buy the funds with the lowest fees.  If you have the choice between a large cap stock fund with a 1% fee and an S&P500 index fund with a 0.25% fee, go for the index fund.  When adding mutual funds to your taxable portfolio or your IRA, consider index funds through a provider like Vanguard or ETFs on those index funds.  If you think that a particular manager will be able to outperform the markets over the long-term, maybe put a portion of your investment portfolio in their fund, but I’d still hedge my bets with an index fund.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

Risk Allows You to Make Money the Stock Market


 

 

 

 

jerichopool

Ever wonder why you can make better returns in the stock market than you can in a bank account or even in bonds?  The reason is a four letter word you should learn to love – risk.  People are often told to avoid risk, or minimize risk.  But as many people learn life, certain risks are worth it for the reward they generate.   The scene in the picture is a pool with a neat little waterfall flowing into it at the end of a three-mile hike.  (And believe me, the picture doesn’t do the area justice.)  The hike was not risk-free.  There was poison ivy everywhere.  There were some rather steep areas on the trail, rocks that could have banged up a knee.  There were even two foot bridges, each made of a single flattened log laid across the river with a very flimsy hand rail on one side.  I could have easily twisted an ankle or even broken an arm, gotten dehydrated, gotten lost in the woods, or even been bitten by a snake or attacked by a rabid animal.

But only the ones willing to assume these risks were able to see that pool.  Take a little more risk and climb up the rocks behind the pool and there was an even more spectacular spot waiting for you.  Sometime you make the analysis and make the very valid decision that taking a certain risk is worth the reward.  There are many others who would have decided the risk was too great – perhaps they are unsteady on their feet, can’t make the walk, or are just to scared to make the journey.  They may or may not know the reward they are passing up.

Now some people take risks without really examining them and taking reasonable precautions.  On this trip we saw a family heading down the trail as we were coming out, and it didn’t look like they had any water with them (or anything else).  We had full backpacks with camping gear, fire starting materials, knives, water, water purification tools, food, compasses, and cell phones since we were planning to spend the night.  Even on a day trip I would have everything listed except the camping supplies since there was a real risk I could get lost or injured and need to start a fire and  refill on water.  It is almost certain that I would dehydrated during the two hours it would take to get to the falls and two hours it would take to get back, even if I didn’t stay at the falls at all. 

Taking a risk when it is almost certain, or even likely that bad things could happen is usually not worth the risk.  The only exception is when the bad things that could happen aren’t really that bad.  If I were hiking in a park surrounded by a city, I would only take water (assuming it was a long enough hike) since getting lost was almost impossible and if I ran out of water I would just be a little thirsty for a short time – I wouldn’t die of dehydration.

In investing, we take appropriate risks in order to extract a reward in the form of higher returns.  We do things to manage that risk, so as to put the odds well in our favor unless we are simply taking a chance that might well go badly but the reward is worth the chance of loss and the loss won’t be devastating.  You wouldn’t put all of the money you have for college into a single stock the year before tuition was due because the odds aren’t in your favor that your stock would be higher in a year and there is probably a one-in-ten to one-in-twenty chance that your stock may decline significantly in price over that year, leaving you unable to afford college.  The result would be devastating and therefore, not worth the risk.  You would put the money in a one-year CD since the risk that the bank would default on that CD is very slim, so the increased return over having your money sit in cash would be worth the risk.  You should, however, put money that you are saving for retirement while you’re in your twenties into stock mutual funds, and perhaps even put a portion in single stocks, because the risk would be appropriate and the reward would justify the risk. 

There is a reason that you get better returns when you take greater risks, and that  because of something called discounting and the risk premium.  Think of it this way:  If you knew someone who was very reliable and who had a steady income, you might be willing to lend them $1000 for a year if they would give you $1050 back at the end at year.  You would figure that the money wasn’t doing anything for you anyway and you could have $50 more for just letting them borrow it for a year. 

If there were someone without a steady income (and who stiffed a friend of yours in the past) who also asked to borrow $1000 for a year, you might not lend it to him at all.  If the terms were only for a month, however, and he would pay you $2500 at the end of the month, you might decide that the potential gain was worth the risk and make the loan.  At this point you would be speculating since the odds might be 50% that he would repay and 50% that he would stiff you (in speculating, the odds are against you or only slightly on your side), but if he did repay, you would make a $1500 profit. 

If you did this with four people of equal credit-worthiness, the odds are that two of them would pay you the $2500 and two would default and you’d lose your $1000.  This would mean would make $3000 from those who repaid but lose $2000 from those who didn’t, leaving you with a $1000 profit.  That is a lot better than you did with the trustworthy individual who was sure to pay you, but only pay $50 after a whole year.  Here you made $1000 in a month.

And this is exactly what you do when investing in stocks.  You are investing in things that do not have an assured return and therefore you are taking a risk, but if you manage those risks appropriately, you can almost guarantee you’ll do better than you did when investing in lower-risk assets.  The greater the risks you take, the greater your possible return, but at some point you’re speculating and not investing and therefore taking a large risk of losing money.  So how do you manage your risk when investing? 

1.  You invest appropriately for the time frame you have.

2.  You diversify your investments to reduce single-investment risk.

3.  You choose your investments appropriately based on your time frame and objectives.

I’ll go into these points in more detail in posts that follow.  You can also get a lot more information on risks and returns of investments – far more than I can cover in a post – in my book, The SmallIvy Book of Investing.  Please check it out and let me know what you think.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

The SmallIvy Watch List


Searching around for investments when you have cash burning a hole in your pocket is a little like going to the grocery store when you’re hungry – not a good idea.  I keep a watch list of stocks.  Then, when I have some money to invest, I find a good candidate from among the stocks in my watch list and pick up a few shares.  As I’ve said in the past, about five years ago I changed my previous way of investing, which involved buying several different stocks that I thought would do well for various reasons and then selling if they increased by about $10 per share, and changed to what I’m terming serious investing.  In this new way of investing I buy stocks that I think will do well over long periods of time and then plan to hold them for several years to decades.  I plan to hold through the ups and downs in the economy, so long as the businesses I select continue to be well run, because I’ve found that good companies just emerge from downturns stronger since their competitors go out of business.  

I also tend to buy in larger amounts – 500 to 1000 share positions instead of the typical 100 or 200 share positions I would buy in the past.  This means that when I select well, I can make a huge profit that will really affect my life instead of just a minor profit that is nice to have but doesn’t compare to my work income.   Note that while I do concentrate in some individual stocks, I don’t put all of my money into individual stocks.  I already have mutual funds in my 401K account from work, and I also diversify into some mutual funds in my IRA and even my taxable account as the size of the portfolio grows.  But for the portion of my portfolio I’ve chosen to have invested in individual stocks, I tend to concentrate a lot more than I did in the past because that gives me the chance to significantly outperform the mutual funds and the indexes.  If I were just starting out and had a small portfolio, I would also start with individual stocks while I had little money and a long time to invest – while still squirreling money away into mutual funds in my 401k – and then shift over to more and more mutual funds as my portfolio got large enough to protect.

So what stocks have I selected for my watch list right now?  I’ll list them at the bottom of this post, but first a word of caution:  Just because a stock is on my watch list doesn’t mean it is something someone else should buy right now.  When I’m ready to invest, I’ll review my watch list and decide which stocks look good now and which have already had a recent run-up and look pricey.  If you want to start with my watch list as a starting point and then make your selections from the list, that would be fine (although note these are just my selections, which may be totally inappropriate for you and your situation – use at your own risk).  

Here is my current watch list:

IT/Technology: (I’m not big on IT and tech companies because their earnings tend to be all over the place, but here are a few that have shown consistent growth.)

*Cognizant Technologies

SEI Investments

*Fiserv

Venture Capital: (I usually see venture capital and hedge funds as great for the people running them but bad for the investors and shareholders who buy into them.  This one has been different, however, at least so far.  This one can make your taxes complicated because it is a partnership, however, so talk to an accountant before getting involved.)

*Blackstone Group

Retail: (I love retail because the company can grow just by adding more stores.  I’ve had Home Depot for a long, long time and it may be too pricey now, but it has had a great history.  The Container Store is just a new company with lots of room to grow that may not pan out over the long-term.  Walgreens is just really well run.)

*Chico FAS

*The Container Store

*Dicks Sporting Goods

*Walgreens Boots Alliance

*Home Depot

 

Restaurants:  (I love restaurants for the same reason I love retail – you grow by adding restaurants and franchises.  The danger is that tastes can change really fast – I found this out from Ruby Tuesdays.  BJ’s is my favorite stock right now on a long term basis, but pricey after the recent run-up from $30 to $50 this year.)

*Texas Roadhouse

*BJ’s Restaurants, Inc

*Sonic

Other:  (AFLAC and Rollins have been long-term holdings that have served me well.  American Towers used to be a cell phone tower company, now a REIT made up of cell phone towers.  Greenbrier makes railway cars and does well both when oil goes up or business activity picks up because oil prices are down.  LKQ is fairly risky, but has some potential.)

*AFLAC

*American Tower

*Norwegian Cruise Lines

*Rollins

*Greenbrier

*LKQ Corp

* indicates that this is a stock in which I have a current position of some amount.  I doubt I’ll make any money from my limited readership buying into any of these companies since I doubt the markets would notice, but wanted to be up front with everyone.

Have some Serious Investing picks of your own?  Got something to say?  Have a question?  Please leave a comment or contact me at vtsioriginal@yahoo.com.

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

Why You Don’t Want Your Insurance to Pay for Everything


Stephescope

Many people are disappointed when their medical insurance doesn’t pay for everything.  They want their office visits completely covered, their prescriptions covered, and any type of tests or x-rays covered.  They even want things like birth control, which can be purchased for maybe $20 per month, included in their coverage.  “Free” preventative care sounds great – who wouldn’t want that?  Well, you probably don’t.  Here’s why….

Would you like to buy auto insurance that covered oil changes and tires, not to mention things like transmission fluid changes and that expensive timing belt change?  You probably would, but your auto insurance would cost an extra $1000 per year.  The reason is that when insurance includes something that is certain to happen, all you are doing is paying for it through your policy instead of paying for it separately.  When it gets wrapped up in that policy, there are fees and profit for the insurance company tacked on, costs associated with filing and paying the claim, and additional amounts tacked on by the place doing the oil change for the hassle of needing to file with the insurance company.  While you could go get an oil change for $30 (or do it yourself for $15-20), you’ll pay the insurance company $40 to pay for it for you.  Tires might be $100 each if you just pay yourself, but the insurance company will charge $150 each.  You have involved a lot of middle men, all of whom need to get their cut for providing the service, plus you’ve picked a really complicated way to pay for things, which adds to your costs.

In addition, it is in the insurance company’s best interest to try to control the transaction to increase their profits.  If they find a shop that will give them a break on what they pay for an oil change, they’ll require their customers to use that shop.  With medical care, insurance companies reduce their costs by limiting the doctors that you can see.  Don’t be surprised to see things like group visits to the doctor (several people with the same symptoms see the doctor at once and get a group diagnosis) or call-in and online office visits soon as insurance companies try to reduce the costs they pay and doctors try to still make money with the amounts they are reimbursed declining.  (Note also that the need for insurance companies to reduce costs is being driven by requirements by the Affordable Care Act to cover a wide variety of things and yet do so under specified premium caps.)

Insurance is designed to pay for things that are probably not going to happen, but you could not afford to cover if they did.  Most people would be in really bad shape if the home that they just started a 30-year mortgage on burned to the ground, so they have home owners’ insurance to pay for fires.  In fact, loan companies know that most people would never pay off a loan on a home that was destroyed, so they require insurance on the home while there is a loan outstanding, and they get paid by the insurance company before the homeowners see a dime.  Because the chances of your home burning down in any given year are very remote, the cost for insurance is fairly low.

For example, if you own a $200,000 home and live near a fire hydrant, the insurance company may calculate that the chances of your home burning down this year are 1000 to one.  They would therefore charge you $2000 per year plus a small amount for a profit ($2000 = the value of the home divided by the chance it would be destroyed by a fire this year).   Assuming they covered a thousand homes, on average one home would burn down in a given year, but because everyone is paying say $2200, there would be enough money for the insurance company to cover the cost of the fire and still make a $20,000 profit.  The insurance company also takes advantage of the fact that there are many years when nothing happens by investing the funds they receive until they need to pay out claims.  This is actually where insurance companies make most of their money.

So get home insurance.  Get term life insurance when you are young and the chances of you dying are low but the consequences enormous.  Get liability insurance so that when you have an accident you can pay for the medical bills of others.  Get major medical insurance that pays for the heart operation or the cancer treatments.  These are true insurance and are relatively inexpensive because the risk of the insurance company needing to pay you for a claim are remote, but cover things you probably will not be able to withstand financially if they do happen.  For the things that are certain to happen, however, skip the insurance and pay yourself, right from your pocket. You’re doing it anyway when “insurance covers it.”  You’re just paying the insurance company to write the check, and paying a higher price when you do so.

Contact me at vtsioriginal@yahoo.com, or leave a comment.

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

How Stocks are Priced – It’s All About the Dividend, Even If They Don’t Have One.


A few years ago I got into a lengthy discussion of stock pricing with a reader.  Unfortunately the exchange ended up being by email (I’d much rather readers post comments to the blog – I get so few of them).  I contended that stocks are priced based on the dividend they pay, or actually, based on the potential future dividend.  The reader basically said that I was incorrect and that stocks are based on a lot of factors, the dividend being a very minor one.  (In actuality, we’re both right, and I’ll explain why in a minute).  In any case, he cited Apple as a company that would never pay a dividend; therefore, the idea that it was priced based on potential future dividends was ludicrous.  A few weeks after the exchange, Apple announced that it would start paying a quarterly dividend of about 2%.

How is he right?  Stock pricing isn’t like pricing at the supermarket.  You don’t walk in, pick up an item from the shelf and see a price sticker on it.  (Yes, I know that we’ve gone to bar codes now, and the price (might) be on the shelf, but bear with me – I’m from the 80’s.)  Prices fluctuate constantly and for a wide variety of reasons.  Some people look at earnings and decide what a stock should be worth.  Some look at how likely it is for the stock to have an earnings surprise and bid the stock up accordingly.  Some people sell shares and don’t care what the price is because they have a large profit and just want to unload it, or they need to pay for their daughter’s wedding.  Some people see a stock go up or down in price, and buy or sell it because it went up or down in price.  They figure that if the price is going up, they’ll be able to sell it at a higher price.

Very few of these people are probably thinking about the dividend that the stock is paying.  Heck, a lot of these stocks may not even have a dividend.  So I must be wrong, right?

Well, even though all of these people don’t know it, they are basing the price they pay on the projected future dividend.  Note that the “projected future” part is very important.  Note also that there are fluctuations int he price – the dividend just sets the price range.

You see, the amount that people are willing to pay for a stock depends on its potential future return.  This return must be enough to justify the risk that is being taken on.  If one can get a 5% return from a bank CD, one wouldn’t even think about buying a stock unless one thought a 8% return or greater was possible.  Why trade a certain return of 5% for a possible return of 6%?  You wouldn’t.  You would drop the price you were willing to pay for the stock until the potential return was at least 8%.

Also, the more uncertain the return, the greater the return must be.  If you are buying shares of McDonald’s, for example, you can assume that the amount of traffic at their restaurants won’t change by that much during any given year.  It isn’t like everyone is going to swear off Big Macs at once.  You can therefore predict with reasonable certainty how much the company will earn during the next year (or the next five years), and therefore you know about what the price will be.  (Here you’re also assuming that the price to earnings ratio will remain about the same, which isn’t too bad an assumption.)

On the other hand, if you are buying shares of a silicon chip maker like Cypress Semiconductor, the future becomes far less certain.  You don’t know if research and development won’t pan out, or the Koreans will dump a bunch of cheap chips on the market, or what.   You also don’t know if interest in electronics will remain, or if manufacturers will choose Cypress chips or one from their rivals.  Because they are somewhat of a commodity, the fortunes of a company can be pinned to a few cents savings per chip made.  Because of this uncertainty, shares of Cypress are priced cheaply relative to shares of a company like McDonald’s.  Note that the PE ratio for Cypress is 17.5, while that for McDonald’s is about 18.5.  People are willing to pay a little more for more certain earnings.

But wait, that’s earnings, and I was talking about dividends, right?  Well, let’s say that a company never, ever paid a dividend.  What return would a shareholder receive?  Another way to look at it is, what value would the company be to the shareholder if he never received any share of the profits?  True the company might be making a lot of money, but the investor would never see a cent of that.  Without a dividend, there is no return to the shareholder.  He would not even see capital gains because no one would be foolish enough to buy the shares from him. (OK, someone would be, but that’s beside the point).

So, when people are buying stocks, they are trying to figure out what the future dividend will be, and what their return would be based on that dividend, and then pricing the share price accordingly.  Granted, this is a Ouija board-type of pricing where people may not even know they are pricing it based on the dividend, but they really are.  The reason that people pay more for shares with growing earnings is that if the earnings of the company are higher, they will be able to pay a bigger dividend.  Many who price stocks based on earnings forget this fact, but that is what they are doing (that is why earnings matter at all).  It is kind of like how the main reason people paint houses is because if they don’t the wood will rot, but they are probably thinking more about how the house looks than wood rot when they decide it’s time to paint again.

Note also that the piddling 2% Apple is paying may seem small, but if you bought the shares back a year ago when the price was half of what it is now, you would now be receiving a 4% dividend on your investment.  If you continue to hold the stock and the dividend continues to increase, you effective yield will continue to climb.  You might be making 8%, 12%, or 20% in five years.

So, dividends do matter, even if many people have forgotten that fact.  When it comes to pricing, it’s all about the dividend.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

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