So today IBM announced that it was going to be buying back $15 billion worth of stock. In response, IBM rose nearly 4.5% (markets still haven't closed at this point, but it's getting late here in Europe). Moreover, the news actually helped boost the market amid worries of falling consumer sentiment and rising core wholesale prices (warning: stagflation).
So why is the IBM buyback important? Well, many saw it as a ray of hope in an increasingly troubled market. The news thus far has been pretty grim, and any sort of positive news is being put on a pedestal the market. However, there is a more fundamental reason behind why this news is positive, which I'll get to shortly.
A stock buyback is just that. The company buys back its own stock/shares. Just like a dividend, it's a way of returning wealth to the shareholders of the company. So, that's pretty good, but if that's all it is, why is there such a generally positive, sustained reaction to the announcement of a share repurchase. Well, think of it this way. In a stock buyback, the company takes spare cash it has lying around (or even sometimes issues new debt to raise cash to buyback shares) and reinvests this cash in itself, by buying back shares. This action essentially reduces the number of shares outstanding. Since there are fewer claims against the company's assets, each investor holds a greater proportion of the total shares. This is good news for the shareholders as it juices up the EPS.
There is another reason why stock buybacks are often so positively received. In essence, as mentioned earlier, the company is investing in itself. Now, a rational investor would only make an investment if they saw a large potential upside; that is, they believed the shares of the investment were undervalued. Thus, a share buyback has a signaling effect. Clearly, one would think that the management of a company would have better information about the prospects of a company compared to some analyst sitting in New York. It's only logical. The managers live and breathe the company, they know it inside and out. If they choose to pump money into its shares, logically, there should be some sort of reason for that. So investors recognize the information asymmetry and take this buyback as a cue to invest in the company.
In theory, this all sounds pretty dandy. However, there can be two flaws with this thinking, maybe you've already recognized them. First off, managers know about this signaling effect, and may try to fool investors into thinking their shares are undervalued. That is, they may make a sub-optimal investment in their companies' shares in order to reap the short-term benefits of a price boost. This short-term price boost could lead a sneaky manager to large profits, as he (or she) could then exercise his stock options. The problem with this is, in the long-run, investors will find out, and they will really punish the firm. The second flaw with the reasoning is that managers often have a biased, overly optimistic view of the firm's prospects. It's sort of a rah-rah-sis-boom-bah attitude that pervades the top management of many firms. The management's hubris is such that they feel that the market has really undervalued their shares, and that surely the prospects are much brighter than currently reflected in the share price. This can be dangerous, and actually does happen in real life, especially in smaller, family-run firms.
Another dubious reason for management issuing a stock buyback is to improve the financial ratios. For instance, a stock buyback reduces the number of outstanding shares. Fewer shares, same return, higher return on equity (ROE). A buyback also reduces cash. Fewer assets, same return, higher return on assets (ROA). ROA and ROE go up, everything is roses, right? Well, technically, yes. However, if this is the only reason why a company has initiated a buyback, then all those roses suddenly have a lot more thorns (yes, that was a veiled reference to Poison). Moving on, if you were paying attention earlier, you'd remember that I said that a buyback juices up your EPS, due to the fewer number of outstanding shares. This becomes important when considering the P/E ratio. Follow me here... fewer shares, higher EPS; higher EPS (ceteris
paribus), lower P/E. Many investors tend to think a lower P/E ratio is indicative of better 'value'. So the company is now cheaper, even though it has the same earnings.
There is another brief considerations regarding share buybacks. Many companies have buyback programs in place already, so why is there such a big hubbub when they announce more buybacks. These extra buybacks are usually above and beyond the baseline buybacks, which are in place to reduce the massive diluting effect of stock options. Each time someone exercises their options, the company mints some new shares. Thus, there is dilution. This dilution is usually eliminated through company buyback programs. Investors like this.
So, in summary, buybacks are pretty interesting things. They are generally viewed very favourably by investors for the reasons outlined above. When looking at a company in which to invest, take a look-see and find out if there is a share repurchase plan in place, or if there are rumours of one coming up. A company with lots of cash on the balance sheet, and not many strategic acquisition prospects on the table is a prime candidate for a share buyback, or a dividend*. So keep a look out for these companies, they could give a nice boost to your portfolio.
Note: Dividends are now taxed at an equal rate to share buybacks (capital gains tax). In 2003, President Bush signed a law which equalized the rate, leading to a huge boom in dividends, which were not as historically popular as buybacks.
Wednesday, February 27, 2008
Sunday, February 17, 2008
A brief note on dividends
Dividends, dividends, dividends. Even if you're new to the investing world, one of the first things you'll hear about is dividends, the importance of them, or the lack thereof. Investors often fall into two camps: those that seek a moderately high dividend yield (too high is not usually considered good), and those that do not feel dividends add value.
Basically, dividends are payments of cash or stock (usually cash) that a company makes to its shareholders. In essence, if a company earns a profit, it can either re-invest this money in the business, or pay it out to shareholders. Usually, the nature of the company's business and industry will be the main determinant of the size or existence of a dividend. If a company can earn a higher return than its shareholders (r > k), this company will generally not pay out a dividend, or its dividend will be small. This is just common sense. The company can do more with $1 of earnings than the shareholders can. The shareholders, therefore, would rather have the company put that money to work. This type of company is known as a growth company. A prime example would be Google.
If the shareholders can do more with $1 of earnings than the company, then they will seek a high payout ratio. In a perfect world, they would want a 100% payout ratio. Now, this obviously never happens; nevertheless, the point stands. A declining company should seek to return more of its earnings to the shareholders. Now, it's always hard to explicitly identify companies that are said to be declining (because no CEO would ever want to admit that their industry is dying or shrinking). However, take a look at BCE.TO or ROC.TO (Bell - 4.1% yield and Rothman's 5.5% yield), both companies are in semi-declining industries, and their payout ratio is on the higher end of the scale.
"Normal" companies with r = k will generally have an ambiguous policy towards dividend payouts. Many companies would rather try to claim they are a growth firm (note: there is a difference between growth and growing - earnings can be growing, but that doesn't mean it's a growth firm), and they will not pay out a dividend. Other companies will pay out a dividend for several reasons. One main reason is related to clientele theory. Some theorists believe that investors are attracted to a company because of its dividend payout ratio. For instance, some older investors seek current income, and thus, would want to invest in companies that have a high payout ratio. This was a major factor in the rise of income trusts over the last few years, and why so many grumpy old men went ballistic after the governments decision to implement a new tax scheme on the income trusts (more on that in another post to come).
Another key reason why investors prefer companies that pay dividends is that they impose a form of discipline on management. Sometimes, there is a lot of spare cash lying around. If a company doesn't pay out dividends, managers and executives could be tempted to try to put this money to work. This would lead to accepting projects that perhaps have a negative NPV or earn less than the IRR.
Another benefit of dividends is their ability to dampen fluctuations in return. For instance, many REITs have lost a lot of money over the last year. For example, say a stock lost 15% of their value over the past year, this stock however, has successfully paid out a dividend 4 times over the year. This guaranteed return lessens the overall loss on the stock, to say 8%. Furthermore, dividends allow investors to dollar-cost average, by taking the payouts and re-investing them at prices lower than the original purchase price. In the long-run, this can prove to be very enticing, and reinvesting dividends can yield significant returns.
This post has been intended to give a brief overview and introduction to dividends. Clearly, though, it's from a 50,000 foot level. There is a lot more to be discussed, and I suggest reading through your textbooks or taking a look at some sites online. For the purposes of the competition, it might be interesting to take a look at a site like www.thestreet.com, which often has a list of companies that have hiked their dividends. This is usually a very positive sign in the market, and something that investors typically look for. On the flip side, companies that cut their dividends are usually in a lot of trouble. Citigroup, for instance, recently had to cut its dividend in order to free up cash to preserve their capital ratios. So generally, in the short-run, if you see a company cut its dividend, it is usually a sign of bad times ahead in the immediate future. For a foundationally solid company like Citigroup, it could signal something close to a bottom.
Basically, dividends are payments of cash or stock (usually cash) that a company makes to its shareholders. In essence, if a company earns a profit, it can either re-invest this money in the business, or pay it out to shareholders. Usually, the nature of the company's business and industry will be the main determinant of the size or existence of a dividend. If a company can earn a higher return than its shareholders (r > k), this company will generally not pay out a dividend, or its dividend will be small. This is just common sense. The company can do more with $1 of earnings than the shareholders can. The shareholders, therefore, would rather have the company put that money to work. This type of company is known as a growth company. A prime example would be Google.
If the shareholders can do more with $1 of earnings than the company, then they will seek a high payout ratio. In a perfect world, they would want a 100% payout ratio. Now, this obviously never happens; nevertheless, the point stands. A declining company should seek to return more of its earnings to the shareholders. Now, it's always hard to explicitly identify companies that are said to be declining (because no CEO would ever want to admit that their industry is dying or shrinking). However, take a look at BCE.TO or ROC.TO (Bell - 4.1% yield and Rothman's 5.5% yield), both companies are in semi-declining industries, and their payout ratio is on the higher end of the scale.
"Normal" companies with r = k will generally have an ambiguous policy towards dividend payouts. Many companies would rather try to claim they are a growth firm (note: there is a difference between growth and growing - earnings can be growing, but that doesn't mean it's a growth firm), and they will not pay out a dividend. Other companies will pay out a dividend for several reasons. One main reason is related to clientele theory. Some theorists believe that investors are attracted to a company because of its dividend payout ratio. For instance, some older investors seek current income, and thus, would want to invest in companies that have a high payout ratio. This was a major factor in the rise of income trusts over the last few years, and why so many grumpy old men went ballistic after the governments decision to implement a new tax scheme on the income trusts (more on that in another post to come).
Another key reason why investors prefer companies that pay dividends is that they impose a form of discipline on management. Sometimes, there is a lot of spare cash lying around. If a company doesn't pay out dividends, managers and executives could be tempted to try to put this money to work. This would lead to accepting projects that perhaps have a negative NPV or earn less than the IRR.
Another benefit of dividends is their ability to dampen fluctuations in return. For instance, many REITs have lost a lot of money over the last year. For example, say a stock lost 15% of their value over the past year, this stock however, has successfully paid out a dividend 4 times over the year. This guaranteed return lessens the overall loss on the stock, to say 8%. Furthermore, dividends allow investors to dollar-cost average, by taking the payouts and re-investing them at prices lower than the original purchase price. In the long-run, this can prove to be very enticing, and reinvesting dividends can yield significant returns.
This post has been intended to give a brief overview and introduction to dividends. Clearly, though, it's from a 50,000 foot level. There is a lot more to be discussed, and I suggest reading through your textbooks or taking a look at some sites online. For the purposes of the competition, it might be interesting to take a look at a site like www.thestreet.com, which often has a list of companies that have hiked their dividends. This is usually a very positive sign in the market, and something that investors typically look for. On the flip side, companies that cut their dividends are usually in a lot of trouble. Citigroup, for instance, recently had to cut its dividend in order to free up cash to preserve their capital ratios. So generally, in the short-run, if you see a company cut its dividend, it is usually a sign of bad times ahead in the immediate future. For a foundationally solid company like Citigroup, it could signal something close to a bottom.
Thursday, February 7, 2008
Recession-Proof Stocks
As noted by James in the previous post, an excellent way to eliminate risk is to go long or short on stock index futures. However, if you don't feel comfortable doing this, or you just enjoy the thrill of picking stocks, there is another way to position your portfolio for an economic downturn.
There is an easy and intuitive way to pick companies and stocks that will generally outperform the market in economic downturns. You can generally pick these companies and stocks out fairly easily.
First off, they will have a low beta (less than one, often much less). Beta is a measure of risk, and in a CAPM world, it is the only measure of risk that matters, as all unsystematic risk can be diversified away. So, low beta stocks are not as correlated with the market as higher beta stocks. This is good in bad times - the market goes down, the stock is neutral or goes up. Say we have a stock with a beta of .5. If the market goes down 10%, this stock will only go down 5% (as the market beta is 1.0). Conversely, if the market goes up 10%, this stock will only go up 5%.
Well, which stocks have a low beta? Companies that are non-cyclical, and provide essential goods that people will buy no matter what the economic outlook. For instance, take Altria (MO). Altria, parent of Philip Morris, makes cigarettes. No matter what the outlook, people are going to smoke and buy cigarettes (they may even buy more due to the stress of the poor economy re: lost jobs and plunging equity markets). So, in a recession, Altria is probably a good pick.
So when picking out a stock to invest in during periods of economic turbulence, think about the business model, and how inelastic the demand of the product the company is. Church and Dwight's (CHD) product (baking soda and Trojan condoms) are almost always in demand - no need to explain why. Their beta is .13. Is CHD going to make you rich overnight, absolutely not, but it provides protection in periods of economic downturn, which is always a good thing.
Of course, not all low beta stocks will outperform the market when the market sours. You of course still have to look at the actual company, it's performance, it's expected performance, and the industry in which it operates. You cannot ignore the stock-specific or sector-specific information as well. One clear example right now would be food-processing companies like General Mills (GIS) or Kellogg (K). These stocks have low betas (.25 and .53, respectively); however, they haven't been burning up the market recently. Why? Well, you have to pay attention to macro factors as well, such as the rising cost of commodities. A bushel of wheat now costs $10 - an all-time high. As input costs continue to rise, investors have become wary about these stocks and their ability to continue to pass on cost increases to consumers. So, in summary, low-beta stocks are generally a good play during recessions or bear markets, but don't become over-exuberant and jump in without considering all the pertinent information related to the stock.
There is an easy and intuitive way to pick companies and stocks that will generally outperform the market in economic downturns. You can generally pick these companies and stocks out fairly easily.
First off, they will have a low beta (less than one, often much less). Beta is a measure of risk, and in a CAPM world, it is the only measure of risk that matters, as all unsystematic risk can be diversified away. So, low beta stocks are not as correlated with the market as higher beta stocks. This is good in bad times - the market goes down, the stock is neutral or goes up. Say we have a stock with a beta of .5. If the market goes down 10%, this stock will only go down 5% (as the market beta is 1.0). Conversely, if the market goes up 10%, this stock will only go up 5%.
Well, which stocks have a low beta? Companies that are non-cyclical, and provide essential goods that people will buy no matter what the economic outlook. For instance, take Altria (MO). Altria, parent of Philip Morris, makes cigarettes. No matter what the outlook, people are going to smoke and buy cigarettes (they may even buy more due to the stress of the poor economy re: lost jobs and plunging equity markets). So, in a recession, Altria is probably a good pick.
So when picking out a stock to invest in during periods of economic turbulence, think about the business model, and how inelastic the demand of the product the company is. Church and Dwight's (CHD) product (baking soda and Trojan condoms) are almost always in demand - no need to explain why. Their beta is .13. Is CHD going to make you rich overnight, absolutely not, but it provides protection in periods of economic downturn, which is always a good thing.
Of course, not all low beta stocks will outperform the market when the market sours. You of course still have to look at the actual company, it's performance, it's expected performance, and the industry in which it operates. You cannot ignore the stock-specific or sector-specific information as well. One clear example right now would be food-processing companies like General Mills (GIS) or Kellogg (K). These stocks have low betas (.25 and .53, respectively); however, they haven't been burning up the market recently. Why? Well, you have to pay attention to macro factors as well, such as the rising cost of commodities. A bushel of wheat now costs $10 - an all-time high. As input costs continue to rise, investors have become wary about these stocks and their ability to continue to pass on cost increases to consumers. So, in summary, low-beta stocks are generally a good play during recessions or bear markets, but don't become over-exuberant and jump in without considering all the pertinent information related to the stock.
Wednesday, February 6, 2008
Stock Index Futures
With so much volatility in the markets these days, many of you may be wondering: how can I reduce the risk of my portfolio without selling out of my long (or short) equity positions? The answer: stock index futures.
A stock index tracks changes in the value of a hypothetical portfolio of stocks. We all can name the major broad-based indices across the globe: the DJIA, S&P 500, FTSE 100, and many others. These benchmark portfolios can be used to hedge (reduce) the risk in well-diversified equity portfolios by using futures contracts.
Futures are exchange traded derivatives; which is to say, they are standardized contracts traded on regulated exchanges. In Canada, all futures trade on the Bourse de Montreal; the largest futures exchange in the world is the Chicago Mercantile Exchange (CME). By combining the cost-efficiency of futures and the breadth of stock indexes, investors have a power tool to significantly diminish their exposure to risk without drastically altering their portfolios.
For example, let’s say you are a long-term investor. You may feel that you have “picked” some winning stocks in your portfolio, and you expect they will outperform the market. However, due to recent market events and economic data, you are concerned about possible short-term downturns in the market. In this scenario (a likely one for many investors closer to our parents’ age) it may well make sense to utilize stock index futures.
Let’s assume an investor has a portfolio of $1 million and has bought many large companies traded on the S&P 500. On February 4th, the S&P 500 closed at 1,381; we also know that each futures contract for the S&P 500 trades for $250. Thus, the current value of the stocks underlying one futures contract is 1,381 x $250 – let’s call that $350,000 to keep it simple. To calculate the number of futures contracts to buy or sell, divide the total value of your portfolio ($1 million) by the value of the underlying stocks ($350,000). In our hypothetical scenario, our investor needs to (in this case) short about 3 futures contracts of the S&P 500. Since we have assumed that the investor is “well-diversified,” this example implies a beta of 1.0 for the portfolio. If you have a particularly risky portfolio compared to the market (a beta of 2.0, for example), you use twice as many futures contracts. This technique could also be used in reverse if you hold short equity positions, and you expect the stock prices to rally in the near future (in that case, you would buy stock index futures that mirror your portfolio).
Why would an investor do this? Again, if the person hedging the portfolio feels that the stocks in the portfolio have been chosen well, this strategy makes sense since it eliminates the risk of the market. Another reason to do this would be if the hedger is planning to hold the portfolio for a long period of time and requires short-term protection in an uncertain market situation. Indeed, many people with a clever investment advisor may have received this advice once the subprime fiasco grabbed hold of the market late last summer. Remember, while an investor still holding long equities may have their gains wiped out, their portfolio value would be safe because they bet against the market. Finally, the alternative strategy of selling the portfolio and buying it back later would likely involve unacceptably high transaction costs.
In summary, hedging is a way to reduce risk. Stock index futures – such as the S&P 500 traded on the CME, can be used to hedge the systematic risk in an equity portfolio. In simpler terms, instead of selling all the stocks in your portfolio, you can short the market (using futures contracts on stock indices). Now, your portfolio is exposed only to the risk associated with each stock, and not to market fluctuations. This is a valuable tool that has very real-world applicability to investors like you and I. Of course, you can’t do this on investopedia, but hopefully next year this could come in handy!
A stock index tracks changes in the value of a hypothetical portfolio of stocks. We all can name the major broad-based indices across the globe: the DJIA, S&P 500, FTSE 100, and many others. These benchmark portfolios can be used to hedge (reduce) the risk in well-diversified equity portfolios by using futures contracts.
Futures are exchange traded derivatives; which is to say, they are standardized contracts traded on regulated exchanges. In Canada, all futures trade on the Bourse de Montreal; the largest futures exchange in the world is the Chicago Mercantile Exchange (CME). By combining the cost-efficiency of futures and the breadth of stock indexes, investors have a power tool to significantly diminish their exposure to risk without drastically altering their portfolios.
For example, let’s say you are a long-term investor. You may feel that you have “picked” some winning stocks in your portfolio, and you expect they will outperform the market. However, due to recent market events and economic data, you are concerned about possible short-term downturns in the market. In this scenario (a likely one for many investors closer to our parents’ age) it may well make sense to utilize stock index futures.
Let’s assume an investor has a portfolio of $1 million and has bought many large companies traded on the S&P 500. On February 4th, the S&P 500 closed at 1,381; we also know that each futures contract for the S&P 500 trades for $250. Thus, the current value of the stocks underlying one futures contract is 1,381 x $250 – let’s call that $350,000 to keep it simple. To calculate the number of futures contracts to buy or sell, divide the total value of your portfolio ($1 million) by the value of the underlying stocks ($350,000). In our hypothetical scenario, our investor needs to (in this case) short about 3 futures contracts of the S&P 500. Since we have assumed that the investor is “well-diversified,” this example implies a beta of 1.0 for the portfolio. If you have a particularly risky portfolio compared to the market (a beta of 2.0, for example), you use twice as many futures contracts. This technique could also be used in reverse if you hold short equity positions, and you expect the stock prices to rally in the near future (in that case, you would buy stock index futures that mirror your portfolio).
Why would an investor do this? Again, if the person hedging the portfolio feels that the stocks in the portfolio have been chosen well, this strategy makes sense since it eliminates the risk of the market. Another reason to do this would be if the hedger is planning to hold the portfolio for a long period of time and requires short-term protection in an uncertain market situation. Indeed, many people with a clever investment advisor may have received this advice once the subprime fiasco grabbed hold of the market late last summer. Remember, while an investor still holding long equities may have their gains wiped out, their portfolio value would be safe because they bet against the market. Finally, the alternative strategy of selling the portfolio and buying it back later would likely involve unacceptably high transaction costs.
In summary, hedging is a way to reduce risk. Stock index futures – such as the S&P 500 traded on the CME, can be used to hedge the systematic risk in an equity portfolio. In simpler terms, instead of selling all the stocks in your portfolio, you can short the market (using futures contracts on stock indices). Now, your portfolio is exposed only to the risk associated with each stock, and not to market fluctuations. This is a valuable tool that has very real-world applicability to investors like you and I. Of course, you can’t do this on investopedia, but hopefully next year this could come in handy!
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