Consider these amenities when researching homes you might purchase for yourself or as rental income properties:
U.S. homeownership dropped to a record low in the second quarter as more Americans opted to rent, data showed Tuesday. The number of occupied housing units grew, but all on the renter side. The number of owner-occupied units fell from a year ago. No wonder both rents and occupancies continue to soar.
More Americans are renting than ever before. That means this is the greatest opportunity in our lifetimes to own rental property. Earn consistent passive income while the value grows through property price appreciation. If you’re interested in analyzing properties for potential purchase, take a look at my Rental Income Property Analysis for Excel Spreadsheet.
The Rental Income spreadsheet analyzes 10 years of cash flows and gives your true return on investment.
I’m proud to release the Fix-N-Flip Rehab Program For Excel. This Excel calculation tool provides a comprehensive look at the buying, holding, selling and repair costs in order to determine the Maximum Purchase Price you should offer on rehab real estate projects. You can Fix and Flip real estate for great profits if you enjoy doing the research to analyze good candidate properties. Use the program to analyze your profits and minimize risks! The Program includes the popular “70% Rule” for house flipping. The accompanying article contains a short video tutorial and screenshots.
Full Article: Fix-N-Flip Rehab Program For Excel
The Fix-N-Flip Program is available from the Research Offers Page.
In other site News:
- The Rental Income Property Analysis Excel Spreadsheet has been updated! Version 4 includes an accurate ‘Return On Investment’ tab sheet. Standard Real Estate ‘returns’ have weaknesses (ie. the ‘Cap Rate’ does not account for your initial investments). The new Version of the Rental Income spreadsheet evaluates ALL projected cash flows for a more realistic analysis. See the article for a video tutorial!
- The Net Worth Calculation Spreadsheet has also been updated! I’ve added a ‘Return On Personal Equity’ (ROPE) analysis. The ROPE measures your personal profitability by revealing how much profit you generate with the money you have invested thru saving and paying down debt. The historic average ROE of the Dow Jones Industrials is about 11%. Can you beat that?
Warren Buffett in his 1998 Letter to Shareholders:
When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding.
Paying employees with stock options is an expense that affects the intrinsic value of a firm. Be sure you are fully accounting for them. Thankfully in 2004, the Financial Accounting Standards Board (FASB) mandated that the cost of options be reflected in the Income Statement, not buried in the footnotes. Investor’s however must still be on guard:
1) Unfortunately almost every company still reports their quarterly earnings to the media as excluding the cost of stock-based compensation. These non-GAAP earnings do not follow the FASB principles. Do not base your P/E multiples off those earnings. See this Fortune article for a description of the problem. This means investors must analyze the Income statement to determine true economic earnings.
2) Use Diluted Shares Outstanding – these account for current in-the-money stock-based compensation (and convertible preferreds) that are outstanding and not yet exercised.
3) Finally, refer to the Notes to Financial Statements to see the Fair Value of remaining unexercised options and other share-based plans (ie. Restricted Stock Units – RSU’s). Reduce your intrinsic value estimate of the firm by this amount. Search for the term “unrecognized compensation cost” within the 10-k or annual report to locate. Add up all values for remaining stock options, RSU’s, etc. For example, Google has $9.7 Billion (about $14 per share) of “unrecognized compensation”, which are future earnings that will go to employees rather than shareholders.
For some companies this is a gigantic expense. From the Fortune article:
over the past two decades, Adobe has spent almost $11 billion repurchasing shares, mainly to offset the dilution resulting from the exercise of employee stock options. Despite all the cash that has gone out the door, the share count is not much lower than it was 20 years ago. If you consider that cash as an expense of running the business (offset by the proceeds and the tax benefits from the stock issuance) then Adobe’s free cash flow over the last two decades is not a robust $9.3 billion, but rather a meager $2.3 billion.
The historic average Return on Equity (ROE) of the Dow Jones Industrials is about 11%. Can you beat that? I mean in your personal financial life. This is a statistic I recommend you follow – your Return On ‘Personal’ Equity, or ROPE. Much like a business ROE, your personal return tells you how much income is returned to you as a percentage of your equity. The ROPE measures your personal profitability by revealing how much profit you generate with the money you have invested by saving and paying down debt.
The Net Worth spreadsheet available on my Research Offers page, calculates your ROPE as you track your Net Worth. Here’s a close-up to show how the mechanics of your ROPE might look:
By the way – why aren’t you tracking your Net Worth? As an investor, you should have only one goal: To increase your Net Worth over time. Unless you regularly evaluate (Total Assets minus Total Liabilities), you will not know what financial direction you are going in.
Net Worth is essential as a personal finance tool. It’s the ultimate measure of financial health. By reviewing your finances on a regular basis you can get a good feel for your financial well-being. If your Net Worth is rising, you’re probably in good financial health. If you’re net worth is shrinking, you’ll want to take a closer look at your finances to see what’s wrong.
My goal is to increase my Net Worth over the previous quarter, which means that either my expenses for the quarter were less than my income, and/or my investments have increased in market value.
The exercise of calculating your Net Worth and ROPE is really powerful. It will help you consider every major purchase you make and every loan you take or investment you make. It will have you asking a very simple question… what am I spending my money on that is increasing my net worth or decreasing my net worth?
Again, the spreadsheet is available on the Research Offers page. Keep using the spreadsheet for years and it will help you reach your financial goals.
Rob Arnott on buying inflation hedges [ie. TIPS] in his April 2015 letter:
“Inflation expectations are now 24 months into a severe bear market,
having fallen by nearly 40% from more than 2.5% in March 2013 to
a low of 1.5% in January 2015. I’ve previously said that in such an
environment, a conventional response – especially from those who
are anchored on mainstream stocks – is to question the need for
inflation hedges. The correct response is the opposite. “
[My ‘Optimal Asset Allocation’ model agrees with this. TIPS are the largest holding.]
Warren Buffett: Had missed this but apparently Buffett said in February: “”The last asset I would want to buy is a 30-year government bond”
He must not be in US long-term bonds at the moment: http://dailyreckoning.com/warning-warren-buffett/
Original interview was early February 2015 Fox Business News: http://insider.foxnews.com/2015/02/04/what-we-learned-warren-buffetts-sit-down-fox-business-liz-claman
[My asset allocation model sold out our successful position in long-term bonds in October 2014]
Last year I completed a Strategic Asset Allocation model. The model calculates the optimal allocation to stocks, bonds, commodities, TIPS and REITS by evaluating the projected future return of each asset class against that investment’s projected price volatility. The results of the model can be followed on my Portfolio page under the tab ‘Asset Allocation’.
First, here’s a view of the available investment yields currently offered to us by the major asset classes:
(Projected future returns are calculated using dividend-discount models and estimates from John Hussman, Jeremy Grantham, and Rob Arnott.)
There are no great bargains across the investment landscape right now. All asset classes have a projected average future return below 2%. The Bull Market and Central Banks have pushed available yields down to almost nothing. Ideally, an investment would have its projected return AND it’s entire range of price volatility above the zero line.
The projected returns and price volatility are then fed into a model which uses the Kelly Formula to determine the optimal asset allocation. Here are the current results:
In summary, we are increasing our exposure to TIPS and Emerging market bonds, while decreasing exposure to US treasuries, European and Emerging Market Stocks. I am using low-cost Vanguard ETF’s to follow this strategy – the ETF symbols are in the chart above. I’m using this in my 401-k but have to be creative and combine some of the asset classes based on the funds offered.
Some more detail on the model can be found in this article. The accounts that follow this model are up an average of over 7% in the past year, not bad for a primarily bond and cash portfolio in this late stage of the stock bull market. I will continue to respond to the opportunity set given by the markets.
This ‘Optimal Asset Allocation’ model will be updated twice a year – in April and October (these months are chosen based on the work of Sy Harding’s Seasonal Timing Strategy).
The stock of online retailer Amazon (AMZN) is seriously overvalued.
- Amazon fails Warren Buffett’s Retained Earnings test. Over the last 5 years it has spent almost 3 times as much on new operating assets (property, plant, equipment) as the earnings it has retained. It is no longer profitably growing. They have done this by increasing debt (total debt/equity now >1) and to a lesser extent issuing shares. The fixed-charge coverage ratio has fallen below 1; it should be more than 2.
- Amazon’s Gross Margins are the same as Wal-Mart’s, around 25%, and profit margins are less than it’s rival (Wal-Mart a consistent 4%, Amazon 1-2%).
- Amazon’s cash return on invested capital (CROIC) has fallen from 29% in 2010 to 5% currently.
- Not all free cash flow is truly ‘free’, as in able to be returned to shareholders. My calculation of ‘unrestricted’ free cash flow gives Amazon an earnings yield of a paltry 0.3%. You can get more than that on US Treasurys. At current price you are paying too much for Amazon’s growth.
With their new focus on building regional and local product warehouses, it’s almost like Amazon is becoming Wal-Mart. Before the recent push into many new physical warehouses (say pre-2012), Amazon was growing profitably, able to expand out of retained earnings. Besides the capital cost, these warehouses require maintenance capex expenditures. Perhaps the most significant piece of info is that while revenue has grown +30% per year for many years, depreciation (DDA) has grown hundreds of percent (from $100-200M in early 2000’s to nearly $5 billion currently).
Perhaps a larger threat is that Wal-Mart could become Amazon – what’s to prevent Wal-Mart from teaming with Fed-Ex (or hell using drones) and using their stores as a base for speedy home delivery? Wal-Mart knows a thing or two about low prices, and will not stand by and let Amazon take over the retailing world. While Amazon has expanded into other markets (Prime TV, cloud services), there’s plenty of competition there too (Netflix, everyone else is in the cloud).
Note: The calculation of free cash flows etc. are my own. I do not short individual stocks and do not recommend shorting Amazon. In fact I’d never recommend shorting a wonderful company growing revenues at as high a rate as Amazon. My thesis here is just that Amazon stock has risen beyond any ‘Growth At A Reasonable Price’ value.
I’ve begun re-reading Berkshire Hathaway’s historic letters to shareholders. In the letters from the late 1970’s / early 80’s, Buffett spends a lot of time describing the increasing ‘hurdle rate’ investors should demand due to the rampant inflation of the time period. It is hard to believe, but annual CPI inflation reached above 16% here in the United States in the early ’80’s. Berkshire’s book value was increasing nicely in this period, but Buffett reminded investors they must account for inflation and taxes. The return of a taxable investment (ie. stocks, corporate bonds) must beat the inflation rate experienced during the holding period in order for the investor’s pricing power to have increased. And its not just inflation investors must account for. Investment returns are eaten up by taxes as well. Buffett referred to this combined “Misery Index” of inflation and investment taxes as the minimum ‘hurdle rate’ of return an investor should seek.
High rates of inflation create a tax on capital that makes
much corporate investment unwise – at least if measured by the
criterion of a positive real investment return to owners. This
“hurdle rate” the return on equity that must be achieved by a
corporation in order to produce any real return for its
individual owners – has increased dramatically in recent years.
…For only gains in purchasing power represent real earnings on investment.
If you (a) forego ten hamburgers to purchase an investment; (b)
receive dividends which, after tax, buy two hamburgers; and (c)
receive, upon sale of your holdings, after-tax proceeds that will
buy eight hamburgers, then (d) you have had no real income from
your investment, no matter how much it appreciated in dollars.
You may feel richer, but you won’t eat richer.
…For example, in a world of 12% inflation a business earning
20% on equity (which very few manage consistently to do) and
distributing it all to individuals in the 50% bracket is chewing
up their real capital, not enhancing it. (Half of the 20% will go
for income tax; the remaining 10% leaves the owners of the
business with only 98% of the purchasing power they possessed at
the start of the year – even though they have not spent a penny
of their “earnings”).
Warren Buffett, 1980 Letter To Shareholders,
Buffett even compared Berkshire’s return against the return received from gold and oil. During this time he often referred to the return an investor could receive from tax-free muni bonds as well. From the 1981 Letter:
During the past year, long-term taxable bond yields exceeded
16% and long-term tax-exempts 14%. The total return achieved
from such tax-exempts, of course, goes directly into the pocket
of the individual owner. Meanwhile, American business is
producing earnings of only about 14% on equity. And this 14%
will be substantially reduced by taxation before it can be banked
by the individual owner. The extent of such shrinkage depends
upon the dividend policy of the corporation and the tax rates
applicable to the investor.
Thus, with interest rates on passive investments at late
1981 levels, a typical American business is no longer worth one
hundred cents on the dollar to owners who are individuals. (If
the business is owned by pension funds or other tax-exempt
investors, the arithmetic, although still unenticing, changes
substantially for the better.) Assume an investor in a 50% tax
bracket; if our typical company pays out all earnings, the income
return to the investor will be equivalent to that from a 7% tax-
Warren Buffett is often asked at Berkshire’s annual shareholder meeting what is the rate of return (hurdle rate) he seeks when investing in stocks. I’ve found several references to 13% (early 2000’s) and 15% (mid-90’s). On reading his letters, I propose that Buffett’s thinking along these lines is:
Minimum Hurdle Rate on taxable investments = (Inflation rate) + (Yield on long-term tax-free muni bonds)/(1-Cap. gains tax rate) + (Equity Risk Premium)
Diving in to each of these:
(Inflation rate): As Buffett has described, inflation is quite mean-reverting. I think Buffett would actually use the average of ‘current inflation rate’ and ‘long-term average inflation rate’. In a late 1990’s Fortune article Buffett described inflation as mean-reverting and mentioned 4.3% as the long-term rate of inflation. So the initial equation factor becomes ((Current Inflation) + 4.3%))/2
(Yield on Long-Term Muni Bonds): Buffett referred to a basket of national Muni bonds as the safer, tax-free alternative to stocks and other bonds. Muni bonds offer another advantage as well – they have a fairly wide range of credit ratings (ie. AAA to A and lower). So for an individual stock you are reviewing, you might use the muni yield which has the same credit rating as your stock (ie. AAA rated stock use AAA rated muni bond rate). National muni bond yields can be found here.
(1- long term Capital Gains tax rate): This factor ensures the taxes you pay after owning the stock or other taxable investment at least 1 year do not take away from your final purchasing power. The current capital gains tax rate is either 0%, 15% or 20%, depending on your tax bracket. For most investors it is 15%, so this factor is 1-0.15 = 0.85
(Equity Risk Premium): Without an ERP, the equation results in a final return that only matches the yield on long-term tax-free Munis. Obviously you expect a higher return from stocks vs muni bonds. I’ve seen ERP estimates from 2% to 6%. I’ll use an average 4%.
2015 Minimum Hurdle Rate (era of low inflation, low yields, relatively low taxes)
Current Inflation = 1.6%, Long-term AAA Muni Bond Yields = 2.65%
2015 Hurdle Rate = (1.6% + 4.3%)/2 + 2.65%/0.85 + 4.0% = 10%
1981 Minimum Hurdle Rate (era of high inflation, high yields, higher taxes)
Inflation = 16%, AAA Muni Yield = 14%, Capital Gains tax rate = 20%
1981 Hurdle Rate = (16% + 4.3%)/2 + 14%/0.80 + 4.0% = 31.7%
Quite the difference. 1981 was of course a historically high era in the U.S. for inflation. And taxes were higher as well.
How to Use This Equation:
Buffett was referring to the necessary minimum Return on Equity (ROE) of stocks he was evaluating for investment. I believe the equation can also be used for inputs into stock Discounted Cash Flow (DCF) calculations. So right now you might use a 10% discount rate. Then when inflation returns and other rates respond by rising, just remember to adjust your requirements higher.