Friday, January 11, 2008

the price of clarity

If anyone ever tells you that investing is 100% safe, they are lying to you. There are risks present in every investment, and you are taking a risk every time you buy something. Whether you fashion yourself a stock picker, an indexer, or some combination of these investing styles, chances are that you are going to have to make a decision as to when to buy. You could be choosing when you should buy a particular Exchange Traded Fund (ETF), or choosing when to buy a stock that you believe is beaten down or undervalued in some way, relative to where the price should go in the future. Either way you are placing a bet as to the future of that particular security.

The sandbox that I've decided to play in consists of financially stable, established companies with strong brands, favourable demographics, and histories of swift earnings and dividend growth. I believe by making this choice I have inherently taken some of the risk out of the equation. Therefore after I chose the companies that I would focus on, I was stuck with the conundrum of when to buy them. In creating a modelling process where I use a discounted model to determine reasonable prices that stocks should be worth, I have established a framework in order to value firms. I don't expect my models to tell me when a stock is dirt cheap, and therefore guarantee the success of an investment. The purpose my models do serve is to provide a kind of framework in order to prevent me from overpaying for a stock. They also show me what type of earnings growth the market is pricing in for a particular company, so at the very least they tell me what is expected from the company at it's current price. Put another way, how does the market feel about the prospects of this company going forward?

Often times the uncertainty around an industry or a particular company is the key driver that causes bad stock prices to stick to good companies. The more I follow investing and the market, the more I have discovered that bad news often hurts stocks much less than uncertainty (or the expectation or possibility of bad news). I've noticed that many investors take the attitude that during these periods of uncertainly it is always a wiser and more efficient call to wait for the dark clouds to part before buying. It is my opinion though that for a long term investor, uncertainty is a blessing in disguise. Often times if you truly want to obtain the lowest cost on an investment you need to buy during that awful period of uncertainty. Sure, you will always get a chance to buy the stock or ETF after it is discovered where all of the bodies are buried; however, usually by that time much of the market has beaten you to it, with the same information, or they dive into the stock earlier with a little less knowledge than would be ideal.

Personally in a lot of cases, with the type of stocks I follow, I feel that if you are long term you might be better off diving in with less knowledge than ideal, instead of waiting for the perfect moment of clarity. See, because when you wait, that perfect clarity is always reflected in the stock price, whereas dark clouds usually come on the cheap.

This type of strategy won't work all the time; nothing does. Sometimes you are better off waiting for some degree of clarity based on your personal thoughts and analysis of the stock.

Here are some examples right now where I believe there is high uncertainty, and thus low prices...

Home Depot (HD), Lowes (LOW), Masco (MAS), Reitmans (RET.A)
Citigroup (C), CIBC (CM), Bank of America (BAC)


J. said...

I am so leaning towards BAC. But I would rather wait and observe at until after the earnings. I wonder how much this will cost me.

On a side note, have you given any thought to Mergent's dividend achievers (esp. the Canadian version for a non reg portfolio)? Claymore's Canadian Dividend Achievers ETF may be a good one but it is too expensive

MG said...

j. BAC is looking tempting with that juicy yield. Who knows where the bottom is but I really like the investment if they don't cut their dividend, which I am starting to think they will not do, after their acquisition today.

Re: money said...

Ha! great minds think alike :) I posted something similar tonight though with a different slant (I'm sticking with my penny stocks for now).

I disagree that by choosing stable companies (as far as you know them to be) you take out risk out of the equation. Nothing is for certain anymore, is it? Every year some of the most respected companies get tainted by one thing or another, or some legislature gets passed that ruins the investment.

As for the American banks, I don't think they'll be okay for at least a couple of years.

MG said...

re:money, I noted that I take (some) of the risk out of the equation. It is my belief that the types of firms that i invest in are less risky than penny stocks, or stocks with poor earnings and dividend growth track records. My universe of stocks have high Return on Equity, low debt, competitive advantages, etc.

Absolutely there is still lots of risk there. What I was getting at is that not all companies are made equal.

Doug Mehus said...

@mg: why do you think BAC won't cut its dividend yield especially after their acquisition of Countrywide Financial? You may be right, but I just wanted your rationale on the issue.

If nothing else, there will be some significant earnings per share dilution (and, consequently, a lower dividend yield) as I expect the acquisition to be largely a stock swap as opposed to a cash buyout. If they paid $5 billion in cash for the equity portion of the transaction, that would no doubt considerably weaken their balance sheet and may even force them to look to the so-called "sovereign wealth funds" (i.e., foreign government pension plan investment funds) for an investment in BAC or force them to cut their dividend. Either way, I see the dividend yield being reduced in the short- and near-term.

Now, that doesn't mean I think BAC is a bad investment. No, on the contrary. It's a good investment but I would wait for a bit more pullback on the share price before buying in. BAC isn't the riskiest bank but it doesn't have the least risk either - it's somewhere above Citigroup, Washington Mutual, and Wachovia but below that of JPMorganChase, US Bank and Wells Fargo.

Actually, in terms of U.S. bank stocks, my top picks, from I've read, are US Bank and Wells Fargo. Specifically, I like Wells Fargo and its juicy but very reasonable 4.5% dividend yield and the fact it's a slower growing but more stable large retail bank only.


MG said...

Doug, I think you are confusing 'yield with dividend amount. BAC can not control their yield, the market does.

I really have no idea if BAC will cut their dividend, although I have not heard one analyst infer that they will. Regarding CFC, I just believe that the move to buy CFC shows some confidence o BAC's part with respect to their financial stregth. Even though they diluted shares to fund the purchase, making an acquisition in the same year that you cut your dividend just seems counter intuitive. I am sure they could explain it away, but it does now seem like a shareholder friendly thing to do...

Susan said...

MG-Like you, I'm ready to buy when the outlook for a particular stock price is cloudy. If I'm confident in my DD, then it makes sense to me to buy at a lower price. As a buy-and-hold type of investor, I have yet to regret doing this. Although, sometimes I've still jumped in too soon (sigh).
Thanks for another well-thought-out article.