Learn the 8 steps needed to buy your next rental property in 90 days or less. For Step 5: Do the Math! I recommend using the Rental Income Property Analysis Spreadsheet for Excel to make sure you are looking at all the facts and figures.
The chart below places MarketCap/GVA on an inverted log scale (blue line, left scale), along with the actual S&P 500 nominal annual total return over the following 12-year period (red line, right scale). Note that current valuations imply a 12-year total return of only about 1% annually. Given that all of this return is likely to come from dividends, current valuations also support the expectation that the S&P 500 Index will be lower 12 years from now than it is today. While that outcome may seem preposterous, recall that the same outcome was also realized in the 12-year period following the 2000 peak.
Caterpillar, one of the icons of American industrial might and a “bellwether” for the global economy, has been having a hard time. It forecast that sales would drop 5% in 2016, an IBM-like fourth year in a row of declining sales, the worst such spell in its history.Now Caterpillar threw in the towel on its formerly most promising market, China. Not for the current year, or even next year – those are already toast. But for future years. And for the entire industry.
It isn’t just CAT’s problem; the industry as a whole is getting whacked in China because of China’s economy. That’s Tom Pellette, Group President of Caterpillar Inc., with administrative responsibility for Construction Industries, told the Financial Times in an interview.
He cited some terrible industry-wide numbers for China, without disclosing Caterpillar’s own: in 2015, sales of hydraulic excavators between 10-90 tons are expected to be in the “23,000 range,” he said. Back during the China heyday in 2010, the industry sold over five times as many: 120,000 excavators. This would include excavators from Japanese, German, and Chinese competitors. In March 2011, the industry sold 27,000 units – in just that month! – more than in the entire year 2015!Those were the good times when China’s huge stimulus program from the Financial Crisis was reaching corporate pockets.
“That shows how far off the peak we are,” Pellette said. The market might never get back to where it once had been, despite the official GDP growth rate in the third quarter of 6.9%, which would be considered a blistering hot pace in other major economies that have somewhat less opaque economic reporting.
On September 24, Caterpillar had already warned of another round of big trouble. Its statement – evocatively titled in perfect corporate speak, “Building for a Stronger Future, Caterpillar Announces Restructuring and Cost Reduction Plans” – announced “a total possible workforce reduction of more than 10,000 people…” and “the contemplated consolidation and closures of manufacturing facilities occurring through 2018.”
“At this point, we are experiencing continued weakness in key industries that we serve,” it said, with sales declining “in all three of our large segments,” namely Construction Industries, Energy & Transportation, and Resource Industries.
Shrinkage, shrinkage, shrinkage. Because of the global economy. Because of collapsing investment in mining and energy. Because of “a convergence of challenging marketplace conditions in key regions and industry sectors.” Because of China.
When it comes to using stock buybacks for management to compensate itself, the crown might belong to Dell. From 1998 to 2006, according to the New York Times’ Floyd Norris, “Dell reported net income of $17.9 billion — and it spent $24.1 billion buying back stock.” The longer the time period you look at the worse it gets. From 1997 to 2012, Dell purchased $39 billion in shares — more than the company has reported in net income over the entire course of its existence.No wonder it went private.The timing of Dell’s buybacks was consistently terrible, but since the costs were paid by shareholders and the proceeds went to management, the C suite never seemed to care much. Harvard Business Review looked at the phenomena and called it “Profits Without Prosperity.” The runner up to Dell might be Qualcomm. As the Times’ Gretchen Morgenson noted this summer, during the past five fiscal years, Qualcomm repurchased 238 million shares at a cost of $13.6 billion.Despite that huge buyback program, the Times wrote, “Qualcomm’s average diluted share count has actually increased over the period by almost 41 million shares. That’s a 2 percent rise since 2010…because the company has been granting a treasure trove of stock and option awards to its executives.”Qualcomm paid an average of $56.14 a share for stock that now trades for about $4 less. In other words, it overpaid by almost $1 billion.This is a pattern we see over and over. Here’s another pattern: Although many companies seem to buy shares just before they start falling, managers tend to do much better at the timing game, selling their own shares right before the slide begins. Just a coincidence, I suppose. Given a choice between dividends or buybacks, I’ll take the quarterly check. But the bigger question is simply this: Why is management at so many companies bereft of better ideas and more productive uses for corporate cash?Maybe it’s because so much of the proceeds of buybacks end up in their own pockets.
As an addition to my Optimal Asset Allocation post yesterday, I thought I’d share this graph which helps explain how I view the current investment landscape.
Principle #1: The goal of investment is to beat inflation over the time period which the investment is held. To paraphrase a Warren Buffett article from 2012 -” investing is the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date. From this definition there flows an important corollary: The riskiness of an investment should be measured by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.”
Principle #2: Again to paraphrase Buffett – investors should put more money into their best ideas – those which offer a higher risk-adjusted return. And the corollary to this principle is “Wait for the fat pitch”, ie. be patient, ignore the daily market moves, and then load up when the market offers a bargain.
With these two principles in mind, the graph below presents my projected asset class returns compared against the expected future inflation rate. Then I allocate among assets using 1) the Standard Deviation and Sharpe Ratio of returns – as risk measures, and 2) the Kelly Formula – to make sure the best ideas get more money applied to them.
The results of my calculations are displayed in the chart on the Optimal Asset Allocation page.
Mid-October is the perfect time to revisit and adjust your portfolio’s allocation to bonds, stocks, TIPS, REITs and Commodities. On October 16th I recalculated the preferred allocation to these asset classes and keep an updated chart on the Optimal Asset Allocation page. Most significantly, I am putting a little more money to work in international and emerging stocks. Emerging stock indexes (I recommend Vanguards ‘VWO’ ETF) are trading near 6-year lows due to currency and commodity bear markets, and offer decent risk-adjusted returns – which is about all I can say, no asset class is particularly compelling right now.
For my IRA and 401(K) accounts, I update these allocations twice a year – in mid-October and mid-April. This timing accords with the well-known seasonal timing strategy proven to beat the market with less risk.
Why focus on Asset Allocation?: One study suggests that more than 91.5% of a portfolio’s return is attributable to its mix of asset classes. Individual stock selection and market timing accounted for less than 7% of a diversified portfolio’s return. William Bernstein says in his book The Four Pillars of Investing, that: “The ability to estimate the long-term future returns of the major asset classes is perhaps the most important investment skill that an individual can possess.”
See the Optimal Asset Allocation page for the percentages.
In 1987/1988 Warren Buffett placed nearly 25% of Berkshire Hathaway’s net worth into Coca-Cola stock. Since then, value investors have wondered what Buffett saw in the stock and how he had the confidence to place such a large portion of his portfolio into one stock. I’ve been able to obtain several of Coke’s shareholder letters from the 1980’s and have been evaluating the numbers myself. The 1988 report in particular shows a company with a clear plan in place to take over the world. Back then Coca-Cola still had plenty of opportunity to benefit from a “Lollapalooza effect” of 1) increasing customer base, as Coke expanded into more world markets, and 2) increasing consumption by existing customers, as sodas became a greater part of the american and developed worlds’ diet.
The 1988 Letter is both a celebration of the turnaround success led by CEO Robert Goizueta, and a realization that billions of people at the time had yet to have their first coke.
Investor Mohnish Pabrai has described several things Buffett might’ve been looking at:
- He found that, like a software company, their gross margin on their syrup sold to bottlers is well over 80%. Coke’s future success was a function of the number of servings of coke sold worldwide. The more the servings, the more the cash flow. He found that over the last 80 years, their syrup volumes sold had risen every single year. The last 80 years included many ugly world events – World War I, the great depression, World War II, The Korean War, The Vietnam War, The Cold War, numerous recessions, being kicked out of India in the 1970s et cetera. Through all of that, Coke has grown every single year. The question Munger and Buffett posed to each other was simple – What volume of syrup might The Coca-Cola Company conservatively be expected to ship in the year 2000…2025…2050? They probably came up with some mouth-watering numbers, then extrapolated free cash flow (about one cent per eight-ounce serving) and finally arrived at a present value of all that future cash flow.
- In 1886, when Coke was first concocted, it sold for five cents per eight-ounce serving. Today, one can buy eight ounces of Coke on sale for under 17 cents. If Coke’s pricing had moved in lockstep with inflation, we’d be paying several dollars for a single can. This is a very unusual product whose unit price has declined dramatically over the years. Very few consumer products have demonstrated the level of decline in prices that Coke has over the last century.
- Billions of people around the world have yet to have their first Coke. In addition, the daily per capita consumption of bottled beverages around the world is miniscule compared to that of the United States and Europe. However, it has risen dramatically in various countries as per capita incomes have risen. We are likely to see big increases in per capita incomes in the third world over the coming decades.
The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the next half century when trying to figure out any given company. No Wall Street analyst’s mental model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon. Individual investors will do well if they only made investments within their circle of competence based on an independent latticework of mental models. When all your mental models all converge at about the same intrinsic value for a given business, and that value is well above the price of the business, back up the truck.
Well enough introduction, read for yourself what Warren Buffett was reading in 1988:
A monthly S&P 500 closing price which is higher than the close 4 months prior is a measure of market momentum made popular by Tom Demark. The markets often swing in approximate 9 month moves. An uptrend lasting 34 months has only happened twice since 1950. Until June of this year, The S&P 500 went 34 consecutive months with each monthly close higher than that 4 months prior. The last time the S&P 500 went this long (exactly 34 months ending July of 1956), it subsequently fell 20% over the following year. These two episodes are the longest such streaks since 1950.
Here’s a picture of this historic market momentum, now broken:
This historic momentum was discussed in: Stock Market Uptrend is the Most Overbought in 40 Years.
The S&P 500 recovered in July to record a new tick in the positive direction, however the overall back of the market’s momentum has been broken. (a 1-month false recovery also happened in 1956 before the market fell hard.)
These signals can be followed with my Trend Exhaustion Stock Market Timing Excel Spreadsheet.
I’ve been moving to cash over the last year, so am looking forward to picking up some stock market bargains if the opportunity presents itself.
It is 1884 in Atlanta. You are brought, along with twenty others like you, before a rich and eccentric Atlanta citizen named Glotz. Both you and Glotz share two characteristics: first, you routinely use in problem solving the five helpful notions, and, second, you know all the elementary ideas in all the basic college courses, as taught in 1996. However, all discoverers and all examples demonstrating these elementary ideas come from dates transposed back before 1884. Neither you nor Glotz knows anything about anything that has happened after 1884.
Glotz offers to invest $2 million, yet take only half the equity, for a Glotz charitable foundation, in a new corporation organized to go into the non-alcoholic beverage business and remain in that business only, forever. Glotz wants to use a name that has somehow charmed him: Coca-Cola.
The other half of the new corporation’s equity will go to the man who most plausibly demonstrates that his business plan will cause Glotz’s foundation to be worth a trillion dollars 150 years later, in the money of that later time, 2034, despite paying out a large part of its earnings each year as a dividend. This will make the whole new corporation worth $2 trillion, even after paying out many billions of dollars in dividends.
You have fifteen minutes to make your pitch. What do you say to Glotz?