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It's Future Cash Flows, Stupid!

From The Financial Times newspaper:

Link to original Letter at FT.com

It’s future cash flows, stupid!*

Published: November 24 2007 02:00 | Last updated: November 24 2007 02:00

From Mr Logan Flatt.

Sir, It is no surprise that an academic study overlaying fundamental company data with equity market data (Long View, John Authers, “Number-crunchers are socially desirable again”, November 17) would conclude that reported earnings or earnings forecasts are the “best predictor” of the market’s valuation of a publicly traded company. After all, the market’s “valuation” represents the market pricing the company’s shares based on supply and demand.

Holding supply constant, market price is determined at the margin by speculative demand for the shares. Most speculators probably formulate their demand for the company’s shares based on a mixture of its most recent quarterly earnings report, analysts’ forecasts of future earnings, unofficial Wall Street whisper earnings, and random online chatter. In the spirit of “group think”, it is entirely possible that most speculators give more weight to earnings measures simply because more people in the market talk about earnings measures than cash-flow measures.

Ah, but there’s the rub: the objective and reasonable valuation of a company has little to do with the supply of and demand for the company’s shares and everything to do with the company’s ability to generate future cash flows. Many successful investors have proven records of using cash-flow-based valuation approaches to uncover and then take advantage of compelling investment opportunities that have exceeded historical market index returns.

They gained their advantage by using estimated future cash flows to assess a company’s intrinsic value – the economic benefit today of holding onto the company’s shares over the long term for the sole purpose of collecting future cash flows from the company – and then asking themselves: “What price am I willing to pay for the company’s shares today given the economic benefit the company’s shares offer me today?”

A quick look at the ticker tape told them whether or not it was prudent to pay the prevailing market price for the company’s shares. If the company’s prevailing market price exceeded the company’s intrinsic value, these successful investors likely took no action. If the company’s prevailing market price fell well below the company's intrinsic value, they probably committed significant capital to the investment opportunity and never looked back.

I submit that speculators’ focus on the company’s near-term earnings measures probably created the short-term market inefficiency that led to the mispricing of the company’s shares vis-a-vis their intrinsic value. Furthermore, I submit that long-term market efficiency probably ensured the successful investors' market-beating returns since, to paraphrase Benjamin Graham, the market is a voting machine in the short term, but a weighing machine in the long term.

Logan Flatt,
PowerWealth.com,
Dallas, TX 75230, US

Copyright The Financial Times Limited 2007

*NOTE: Title chosen by The Financial Times, not Logan Flatt.

Copyright 2007 PowerWealth.com. All rights reserved.

Don't Fool Yourself – Your Home Is Not An Investment.

By Logan Flatt, CFA

   Recently, a respected blogger on the Web misquoted me on their blog in an entry referencing my essay, "You Don't Own Real Estate. Real Estate Owns You." The blogger made a couple of critical errors in quoting me but the errors have, for the most part, now been corrected based on three points I made privately to the blogger by email. Below, I present the text of my email (with some small edits) for all PowerWealth.com readers who have an interest in real estate investing to review and consider.

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   First, I never said on my PowerWealth.com site that a "home mortgage is not an investment." What I said was, "…your home is not an investment…" That's a huge difference! I think your confusion arises out of your merging of two separate and distinct financial considerations from the homeowner/borrower perspective:

1.   The Asset, which is the real estate property we would call "home"; it is an asset because it has marketable value to you and others in the real estate marketplace;

AND

2.   The Liability, that loan or mortgage serving as a lien on the real estate property only because the buyer of the home did not have enough cash on hand to pay for the property outright and had to borrow the money from a bank or mortgage lender to complete the purchase of the real estate property.

   From the borrower's perspective, a "home mortgage" could never be viewed as an investment. It is a legal contract obligating the borrower to pay back the money borrowed, plus interest charges and other fees. In effect, the home mortgage slowly drains the borrower of cash through those interest charges and fees paid out over time. Being legally obligated to pay someone else cash over time is a liability. One "invests" in assets, not liabilities. A freedom loving person seeks to rid themselves of a liability – having no meaningful financial obligations such as liabilities is what "financial freedom" means. Consequently, an investment in a liability is a non sequitur.

   It is important to note here that only the lender would view the "home mortgage" as an investment because that home mortgage is indeed an asset to the lender – in exchange for lending the money to the borrower, the lender gets the mortgage documents signed by the borrower agreeing to pay the money back plus interest charges and other fees. So, what is a liability to the borrower – the mortgage – is an asset to the lender. If you were writing about lenders, then your implication that a home mortgage is an investment would make more sense. Unfortunately, you were writing about borrowers in your post. So, contrary to what you posted, no, I do not agree with you.

   Second, my quoted statement on your site [Editor's note: the quote used from my article was, "To make it your home, you must take cash out of your pocket each month to finance it, insure it, maintain it, fix it, furnish it, and pay property taxes on it. Unlike investment real estate, your home generates no income to offset these out-of-pocket expenses. So, while you likely derive much pleasure from owning your home, you lose money on it every month. Don’t fool yourself – your home is not an investment. It is simply a purchase."] would be true for a home that had no mortgage on it if only we were to delete two words: "finance it." So, the home need not have a mortgage on it to fail my "investment test" – even if the homeowner owns the home free and clear, there are a litany of expenses associated with home ownership that make it difficult to call a home an investment (because the home generates no income itself to offset those expenses). This was the full point of the "Personal Real Estate is Simply a Purchase, Not an Investment" section in my article on PowerWealth.com.

   Third, both you and [a financial services professional who made, in my view, an erroneous comment to the blogger's post] appear confused on the notion that the use of "leverage" to buy a home somehow instantly transforms the purchase of a home into an investment. No, it does not. While "leverage" is a sexy term used by professionals in the trade to romanticize real estate investing and make it sound exciting conceptually, it is a red herring. It masks the truth: to use "leverage" is to legally obligate yourself to a lender. In other words, what you are doing when you "lever a deal" is voluntarily take on a liability and the risk of losing your home to the lender due to your failure to pay back that liability according to the lender's terms. The addition of a liability to your home purchase does not – poof! – make your home an investment.

   To clarify, when you use "leverage" to buy your home, you are essentially completing two separate and distinct transactions at the same time:

1.   purchasing a piece of real estate that will generate no income for you to help you offset all the expense associated with owning said real estate,

AND

2.   entering into a legal agreement to borrow money from a lender whereby you agree to repay the money borrowed plus interest charges and fees according to the lender's terms specified in the agreement.

   Note that the addition of "leverage" to the deal did nothing to change your home's ability to generate income for you one bit. In fact, by borrowing the money to buy your home, you simply increase your home ownership expenses by adding interest charges and fees. Clearly, "leverage" is sexy in concept only; in the harsh light of reality, it is anything but sexy.

   [Blogger], I hope that you and your readers will consider reading again my article, "You Don't Own Real Estate. Real Estate Owns You." at PowerWealth.com to recall and reinforce its key takeaways:

1.   to invest in real estate means to own and operate income-producing real estate;

2.   to speculate in real estate means to buy real estate at the prevailing market price and hope to sell later at a higher market price;

3.   your home is neither an investment nor a speculation – it is simply a purchase of a piece of real estate to enjoy and call "home", not to make money from it;

4.   you really don't own real estate if a government can swoop in and take it away from you because that government thinks your real estate stands between it and a just cause – a cause apparently less important than your personal property rights.

   Thank you,

   Logan Flatt, CFA
   PowerWealth.com

******

Copyright 2007 PowerWealth.com. All rights reserved.

"Growth Investing" Nothing More Than Rank Speculation

By Logan Flatt, CFA

   Recently, Financial Times columnist, John Authers, made a “Long View” case for growth investing over value investing (Market News & Comment – Long View, “Now may be the time to go for growth stocks”, October 6/7, 2007). Unfortunately, Mr. Authers’ case for growth investing is actually a case for rank speculation.

   Thanks to decades of promulgation by the financial services industry, it is now common for many people not unlike Mr. Authers to mistakenly use the terms “value” and “growth” to describe two contrasting styles of investing. However, there are not two styles of investing. Instead, there is investing and there is speculation. What is known as “value investing” is bona fide investing where fundamental analysis, reason, long-term ownership, and patience lead most investors to wealth.  What is known as “growth investing” is rank speculation where fear, greed, short-term trading, and the desire for immediate gratification lead most speculators to treat Wall Street like a casino, placing emotional bets on what seem like ever-increasing market prices. That is, until reason prevails, the tables turn, and the madding crowd rushes for the exits, losses in tow.

   Mr. Authers further errs in his contrasting definitions of growth investing and value investing: “Growth takes advantage of the market’s undervaluation of future earnings while value profits from undervaluations when a company gets into trouble.”  Unfortunately, neither definition is correct. Value investing takes advantage of the market’s mispricing of a company’s shares relative to their intrinsic worth (i.e., the present value of the company’s likely future dividends or after-tax free cash flows expressed on a per-share basis) regardless if the company is in trouble or is as healthy as it can be. For example, it’s the buying of a company reasonably worth $25 a share when the market has it emotionally priced at only $15 a share. In contrast, growth investing takes advantage of the “greater fool theory” – the belief that regardless of what price you pay for a high-flying stock, some other speculator will be there to pay you a higher price when you are itching to sell it.

   Another Financial Times columnist, Arne Alsin, had it correct months ago (Columnists – Inside Curve, “Two simple questions that protect against the siren’s song”, March 9, 2007) when he stated, “All great investors, from Warren Buffett to Peter Lynch to Michael Price, understand a single, fundamental premise. That is, in order to be a successful investor you have to be able to answer two simple questions: ‘What does it cost?’ and ‘What is it worth?’” As Mr. Alsin went on to point out, if an investor does not answer the second question, the answer to the first question is meaningless. We can surmise then that the speculator, in contrast, finds ignorance of the answer to the second question to be perilous bliss.

   That “growth investing” is rank speculation is made clear by Mr. Authers’ concluding statement, “…stick to stocks whose fundamentals are really growing and then be ready to sell at the first sign of trouble.” Only a speculator would think this way. Warren Buffett – investor par excellence – has suggested that selling the shares of a company with sound fundamentals may very well be the last thing an investor should do when “trouble” arises. Instead, Mr. Buffett suggests we take a harder look and determine whether the trouble at hand is short-term operating trouble or long-term strategic trouble. If the company has hit a rough patch operationally but nothing about the company’s winning strategy has changed, a reasonable investor would stand pat or even buy more of the company’s stock. After all, if the company was good enough for you to buy its shares in the first place, why not consider buying more of it when speculators overreact to “trouble” and post their shares up for sale at significantly lower prices?

   Ultimately, if Mr. Authers is correct and growth investing is “due for a period of outperformance,” we are entering – or, more likely, have already entered – a period of widespread speculation in stocks. Caveat emptor.

Copyright 2007 PowerWealth.com. All rights reserved.

Classic Analysis Always Wears Well

From The Financial Times newspaper:

Link to original Letter at FT.com

Classic analysis always wears well

Published: September 7 2007 03:00 | Last updated: September 7 2007 03:00

From Mr Logan Flatt.

Sir, Luke Johnson pines for high-quality stock research focused on the intrinsic worth of a company:

". . . classic analysis of shares will come back into fashion one of these days. I look forward to its renaissance." ("Bring on the rebirth of classic analysts", Ft.com September 4.)

Mr Johnson should note that classic, fundamental analysis never goes out of fashion. It is timeless in its design and wears extremely well. Also, I am happy to inform him that the renaissance festival is alive and well in downtown Chicago at the offices of Morningstar, Inc.

The company's five-star rating system is based on the "margin of safety" between market price and intrinsic worth, just as the dynamic duo of Warren Buffett and Charlie Munger advocate.

Furthermore, Morningstar's classically trained analysts can be an investor's source of calm amid the storm - they often remind their readers to remain focused on intrinsic worth when market prices get choppy and speculators get sloppy. Why wait for fashions to change when one can be wiser and richer today?

Logan Flatt,
PowerWealth.com,
Dallas, TX 75230, US

Copyright The Financial Times Limited 2007

Copyright 2007 PowerWealth.com. All rights reserved.

Inflation Nation

By Logan Flatt, CFA

    It’s more than just Texas springtime temperatures and global warming you may be feeling: the U.S. economy in 2007 is on the verge of overheating.

Real Estate Bird Watching

    As I travel on business to cities across the United States each week, I spot large flocks of cranes hovering over many a new oasis of Class A office towers and luxury high-rise condominiums. Dallas is no different. Take a drive along Woodall Rogers Expressway near downtown and count all the cranes and newly-built towers you see in the skyline around you. That infamous verb from Dallas’ real estate history – “overbuilding” – comes to mind.

    After its six-year injection of cheap, easy money into the veins of the U.S. economy, the Federal Reserve Board has cut back the economic steroids of low interest rates by yanking the Fed funds rate up 17 times since June 2004, from a 46-year low of 1% up to today’s 5.25%. Yet, like a doped-up bodybuilder, the U.S. economy rages on: corporate earnings are at record levels; consumer borrowing and spending remains profligate; the Dow Jones Industrial Average floats above the psychologically important (but fundamentally meaningless) 13,000 threshold; the U.S. unemployment rate hovers at a six-year low of 4.4%; and real estate developers continue to put new cranes high into the sky. Clearly, our American sense of optimism is flexing mightily, showing off its muscles from all the best angles.

The Pressure Builds

    Unfortunately, exuberance extracts a price. America’s tightening labor supply is requiring companies in many industries to pay higher wages to attract and retain employees with the right skills and talent. In turn, some companies are raising the prices of their products and services to help offset the higher wages.

    At the same time, politics and violence in the Middle East, Venezuela, and Russia keep adding to the global uncertainty that is pushing up the price of oil and natural gas. Breakneck growth in the developing economies of Brazil, Russia, India, and China continues to put upward pressure on prices of other key input commodities as well.

    To make matters worse, the U.S. dollar has weakened severely against other major currencies over the past year. The U.S. dollar just doesn’t buy as many Euros, Yen, and Pounds as it used to. So, Americans must use more dollars this year to buy the same imported goods from Europe and Japan that they bought last year.

    Perhaps most damaging of all, our elected officials in Washington, D.C. keep spending hundreds of billions of our hard-earned tax dollars – from both this year and, through debt financing, many years to come – like drunken sailors on shore leave. All of the billions our federal politicians bond out and then push into the U.S. economy through government procurement contracts only pours gasoline on an already raging economic fire.

    In short, we have a U.S. economy awash in cash, a U.S. dollar beaten down by foreign currencies, and global commodity prices near record highs. The specter of a dastardly economic demon – inflation – rears its ugly head.

The Ravages of Inflation

    Over time, inflation degrades the purchasing power of a $1 bill. Decades ago, the price of a loaf of bread was a mere nickel. Back then, you could buy 20 loaves of bread for $1. Today, the price of a loaf of bread is at least $2.00. For a $1 bill today your baker will hand you back just half a loaf. The bread didn’t change; the value of the $1 bill declined.

    The erosion of purchasing power caused by inflation is why investing for the future is an absolute requirement for a financially successful life. For your investments to maintain for the future the purchasing power you enjoy today, the average annual rate of return on your investments must exceed the average annual rate of inflation in the general economy. To get ahead financially over the long term, your investment returns must trounce the rate of inflation by a wide margin.

    We could run into real trouble if inflation accelerates and spirals out of control. Remember the hyperinflation rates of the 1970s and early 1980s? If inflation in the United States takes off in 2007 like it did from 1973 until 1983, the Fed will be compelled to crank interest rates up significantly – not unlike what Federal Reserve Board Chairman Paul Volcker did back in 1980 - 1982 to squelch rampant price inflation.

What If Interest Rates Increase?

    A significant increase in interest rates could be disastrous for investors in stocks, bonds, or real estate. When interest rates go up, holding on to stocks, bonds, or real estate becomes relatively less attractive: why leave your cash tied up in assets that carry a real risk of loss when you can instead stash your cash in low-risk money market funds or FDIC-insured bank CDs now paying an attractive rate of interest? Consequently, market prices of stocks, bonds, and real estate could fall dramatically as owners wanting to exit these investments struggle to find buyers willing to enter them.

    What can you do to help insulate your investment portfolio? Ask your financial adviser about investment alternatives that can offer positive rates of return during periods of high inflation and interest rates. Short-term Treasury Inflation-Protected Securities (TIPS) and inflation-adjusted Series I Bonds are the safest. Some riskier alternatives include publicly-traded investment trusts that quickly translate price increases into benefits for their unit holders, such as oil and gas royalty trusts; gold, silver, iron ore, and other commodity trusts; and real estate investment trusts based on short-term leases and rental periods, like many apartment, hotel, and storage unit REITs.

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NOTE: This article first appeared in the Spring 2007 issue (Volume 5 Issue 2) of The Swan, a publication of the Lake Forest Community Association, Inc., a nonprofit Texas corporation (www.lfhoa.com).

Copyright 2007 PowerWealth.com. All rights reserved.