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I am retired and live off my portfolio income and real estate rental income. I follow a simple investment strategy: (1) spend less than I earn; (2) use the savings to add more dividend paying stocks and rental properties to my portfolio. By doing this for many years, I've been able to grow my... More
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  • Latest Valuation Study For S&P500

    (click to enlarge) Attached is a chart I created using data from Robert Shiller's homepage. The chart shows the "earnings yield premium" - which I calculate as follows. First, for each year, I calculate the average earnings over the preceding five years, and divide it by that year's price for the S&P500. I picked five years because doing so leaves me with more data points - you could do the same exercise with ten-year average earnings (or any other time period, for that matter).

    Second, I divide the average earnings yield for that year by the then-prevailing interest rate on a ten-year US Treasury. When the earnings yield on stocks is the same as ten-year interest rates, the "earnings yield premium" is 1, when earnings yields on stocks are higher than ten-year interest rates, the premium is more than 1, and when earnings yields are lower than ten-year interest rates, the premium is less than one.

    The earnings yield premium is a measure for comparing whether stocks are "cheap" or "expensive" relative to risk-free investments. It measures how many dollars of risky earnings an investor earns on average for each risk-free dollar's worth of interest she gives up when she buys stocks instead of bonds. We see that the earnings yield premium is relatively high today, on par with the 1950s (thanks in no small part to today's very low interest rates).

    But what do "cheap" and "expensive" mean? To many investors, the words "cheap" or "expensive" mean "higher or lower than a historical average?" Not to me. I feel like I got a bargain when I end up making money, and a rip off when I loose it. After-the-fact performance is about as objective a measure of investment expense as I can think of.

    The next line on the chart is labeled "ten year return." This line shows how much an investor who bought stocks in any given year would make on her investment over the following ten years (that is, capital gains as well as ten years' worth of average dividends). I picked a ten year period simply because I'm comparing stock returns to ten-year US Treasuries. You could do the same exercise with five-year returns, or any other investment horizon.

    The chart shows a tight correlation between the earnings yield premium and subsequent ten year returns - with the notable exception of the 1980s and early 1990s, when investors could have bought stocks with earnings yields less than the rate on a US Treasuries, but still done very well (thanks to the stock market bubble in the 1990s). The correlation suggests that when the earnings premium is higher than 1, stocks are often cheap, and when it's less than 1, stocks aren't.

    Today, the earnings yield premium is 2.2 - higher than the average premium of 1.33 that's prevailed since the 1950s. In the past, investors have done well when they purchase stocks at an earnings yield premium like we have today, so all things being equal, investors could look at that and conclude that stocks are cheap today - but for the fact that interest rates are hovering near historic lows and may rise in the future. If corporate earnings and stock prices remain flat, and interest rates jump to 3.3%, then the earnings yield premium would equal the average earnings yield premium since 1950, and investors could conclude that stock prices are about average. If interest rates soar higher in the near term and corporate earnings and stock prices both remain flat, stocks would become expensive. If interest rates remain the same as where they are today, then stocks appear as cheap today as they've been in 60 years.

    May 31 10:51 AM | Link | Comment!
  • Why I Don't Care What The Stock Market Does

    It never ceases to amaze just how much time, effort and anxiety investors devote to the futile effort of trying to predict the future. Predicting the future is not possible, and therefore, it is irrational to try. It doesn't matter if we're talking about the future of stock prices or anything else. If it hasn't happened yet, you cannot know how it will happen.

    Moreover, if you are an investor, it doesn't matter if the stock market goes up or down. Suppose you own ten shares of General Electric (NYSE:GE). If the stock price doubles or falls by 50%, you haven't made or lost money. You still own the same ten shares of GE, and still own the same percentage of GE's profits as you did before. If GE's profits go up or down, THAT is when you can say that you've made money (you can only lose money if GE posts losses instead of profits).

    The numbers you see in your brokerage statement each month tell you absolutely nothing about how much money you have - the reason why is that stocks are not money, and the price of stocks tells you little to nothing (in the short term) about the profits that your companies are earning for you.

    As it happens, I own shares of GE. I like to imagine that GE is a private company. It's earning profits, keeping some to reinvest in the business, paying some to me, and I can say without a doubt that GE is making me money. If the village idiot comes up to me and says "I will buy your shares in GE for half what you paid", does that mean I have suddenly lost half my investment? Of course not! I tell the village idiot to go stuff it, and keep on happily collecting my dividend checks. I don't care if it is one village idiot or an entire chorus of village idiots. I don't care if it's a chorus of village geniuses offering to buy my shares in GE at half off. GE is earning money for me, and I am not selling. In fact, the only time I even care what the chorus of village idiots or geniuses is offering me is when they offer me a price for GE shares that is unreasonably high, something far far far above the value of profits GE is earning for me or is ever likely to earn for me in the next twenty years. Until that day comes, there is nothing that the chorus of village idiots can tell me that I care to hear.

    Another word for "chorus of idiots" is "the stock market." If you own stock, you are a business owner, and the money your business earns for you is the only thing that determines whether you are making or losing money on your investment. You won't find that information looking at the bottom of a brokerage statement, and since you won't, there is no reason to even look at the bottom of your brokerage statement. And it is simply irrational to try and guess what that number will be in the future.

    Disclosure: The author is long GE.

    Jul 13 9:13 AM | Link | 4 Comments
  • Is Today's Sell Off In Apollo Investments Overdone?
    There are at least five reasons why Apollo Investment Corp. (ticker symbol AINV) shed nearly 11% today. First, the company trimmed it's dividend from 28 cents per share down to 20 cents per share - not unexpected given that recent dividends have exceeded net income per share. Second, Fitch Ratings downgraded the company from stable to negative. Third, the company announced that it is considering diluting existing shareholders by raising additional capital of $200 million. Forth, management announced that they will broaden their investment exposure beyond market segments in which the company has niche expertise. Fifth, the company announced an extensive shake up of senior management.

    The question is whether those developments warrant the 11% drubbing the market awarded the company today for it's performance? To answer that, you have to step back and consider the fact that like any business development company, AINV is something like a closed-end mutual fund in the sense that what the company is, simply put, is a pile of money that management lends and invests in other companies, passing the net income out to taxpayers. Because of this mutual fund-like business model, business development companies often tend to trade close to their net asset value, as is the case today with several of Apollo's competitors. AINV, however, now trades at nearly a 14% discount to NAV as of today's market close, which is unusual for the stock in particular and for business development companies in general.

    So does that make AINV a bargain? Not necessarily, and the reason why has to do with the company's surprise announcement that they were considering raising new capital, and the reaction of Fitch Ratings.

    Think it through. As a shareholder, would you rather own 2% of a business development company with $1m in assets, or 1% of a business development company with $2m in assets? Considering the mutual fund-like business model of a business development company, a shareholder really ought to be indifferent to dilution, PROVIDED, however, that the company is able to raise new capital without taking a valuation discount on the newly issued shares in the process.

    And that's quite likely the reason for the 14% discount to NAV and the 11% plunge that took the company there today. The market may be pricing in a risk that the company is not in a position to raise new capital on a dollar-for-dollar basis. If not, then existing shareholders would see their percentage stake in the company drop without an equal and offsetting increase in the company's capital base. And that is precisely one of the concerns Fitch articulated in it's press release today as to why they were downgrading their outlook for AINV.

    So the question for shareholders is not simply whether an 11% stock price decline is overdone, or even whether a 14% discount to NAV represents a bargain entry point. Instead, it probably makes more sense for an investor to ask whether the market has correctly priced in the likelihood and extent that AINV's existing shareholders will see their stake in the company sold to new investors at bargain levels.

    Disclosure: I am long AINV.

    Additional disclosure: I am not an investment advisor, and nothing contained in this article should be considered, or relied upon, as advice as to any particular investment, or any particular investment approach, or as a guarantee or endorsement of any statement of fact, whether contained in this article or referenced in any quarterly statement or news release issued by AINV, Fitch, or any other company or individual.

    Feb 08 8:36 PM | Link | Comment!
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