treasuries, inflation, and stocks

Treasuries barely give inflation-adjusted returns. To the extent that they fall short of inflation rates, they cannot be called risk-free in its fullest sense. There is the consolation that it happened only twice in the past 18 years, in 2011 and 2012; but not much because there is another evil called tax. Excess of post tax return from treasuries over inflation is the real return earned by investors. That is why treasuries or any other fixed currency investments are not attractive over the long run. Also, they carry reinvestment risks unless you find zero-coupons. Yet for all practical purposes, they are indeed risk-free. 

And they do track inflation rates; well, sort of. Prior to 2008, things were not that bad; I mean things were normal. 10-year treasuries yielded 5.24% in 2000; they were 4.10% in 2007 just matching the inflation rate. Everything changed in 2008 reacting to the financial crisis, and never recovered completely since then. Long term treasury bonds quoted 2.42% in 2008 and reminded us of 1954 when they were 2.51%. During both the years, inflation rates were nearly zero. The difference is that from 1955 onwards the treasury bond rates steadily increased thanks to the buoyant economy; and by 1979 they reached double digits. From 1985 onwards, bond rates started falling, and stood at 5.24% in 2000. 

Inflation was higher during the 1973-1981 period, and started cooling off subsequently. It was 3.44% in 2000; but by 2008, inflation came down to almost zero. In 2009 and 2010, both treasury and inflation rates started showing sparks, but that was it. In the last five years, interest rates have been less than 2.50%, and inflation has only moved to 2% in the last two years. 

As of now, both treasury bond and inflation rates have started moving upwards at 2.40% and 2.10% respectively. 

One of the reasons for the booming stock markets has been lower interest rates. When alternative opportunities are unable to exceed hurdle rates, investors look for greener pastures. What is greener than equities? If bond yields of 2.40% are not good enough for investors, they will continue to back equities. Dividends and buybacks are still better than these bond yields, and there is the added attraction of capital gains from stocks. Furthermore, there is also more buzz due to the revamp of the tax codes. Otherwise stock markets appear to be quite pricey. 

While the value of stocks is the present value of their cash flows discounted at the cost of equity, it will remain higher as long as interest rates remain lower. For 2018, two reasons will keep them afloat: higher earnings leading to higher cash flows, and lower interest rates. We don't know whether earnings will increase as they did in 2017. Fed's struggle with increasing inflation and thus interest rates has been rendered futile so far. Most of its tactics have led to the headline statements rather than being effective. Now the Fed is entering the new year with an intent to increase interest rates; and it appears to be more intense than before. Whether investors will shift to bonds from stocks is a matter of expectations, and only time will tell. 

The danger with the stock markets though is that stocks can fall abruptly without notice, caution, and reason. But that does not mean investors should throw all cash to yield only 2.40%. That said, I reckon some allocation to bonds is inevitable at all times; rather more so now.

risk and reward, and the irony of it

One-upmanship

It's a war out there. Between them and them; who else? Value investors, who always like to keep themselves in good humor and all others. I really don't know what's with the value investors and their value investing. I have mentioned it many times before, there is no such thing as value investing at all. It is either investing, or it is not. It's not investing, if the investor does not find value in it. For an investor, it is always about price and value. The crazy lots, who call themselves value investors and go around trying to punch all others (investors) in the face, are up to something. Well, to begin with, their favorite punching pad is CAPM, which talks about risk and reward. 

The CAPM and margin of safety

What CAPM says is that you segregate the risks into systematic (market risk) and unsystematic (firm-specific) risk. Then it goes on to say that firm-specific risks can be mitigated through diversification; but market risk cannot be, and therefore, needs to be compensated. Market risk is measured by volatility in prices of securities, which is called beta. As per CAPM, the expected return for equity investors is calculated by adding beta times equity risk premium to the risk-free rate. 

Value investors find all kinds of problems with this formula, and therefore, use something called the margin of safety. They say higher risk cannot be compensated by increasing the expected rate of return (the discount rate), but it suits them very well when they increase the margin of safety. 

The irony of business valuation

Expected returns cannot be calculated with precision; as a corollary, we cannot value a cash flow producing asset with accuracy either. Value of an asset is the present value of all cash flows discounted at the appropriate rate of return. Alas, we cannot predict cash flows accurately; neither can we know the expected rate of return from the asset in advance. The irony of valuation is that we cannot value an asset with accuracy. If that is the case, why struggle with it? 

It seems both camps are missing this point. When cash flows are uncomfortable, value investors increase their margin of safety, while other investors increase their discount rate. And the war begins. In fact, I have found value investors, for all their hypocrisy, increasing both the discount rate and margin of safely.

The ideal situation would be to know the future cash flows with certainty, and then use the risk-free rate as the discount rate. That would be your expected rate of return. It would then be equivalent of a risk-free asset, say, government treasury. A business is not a treasury because it has very different set of cash flows, and more importantly uncertain cash flows. Businesses are riskier than risk-free securities. So let's not pretend. 

The alternative

When we are not in an ideal situation, we have to look for an alternative model for achieving our goals. We invest because we need to increase our purchasing power in future; we need to be well ahead of the beast called inflation. We need to be compensated for the uncertainty of future. There is no other reason really. So how do we go about it? 

Well, we need to debunk the widely accepted economic theory called efficient markets. What efficient markets theory says is that market knows everything about the asset; and therefore, its prices are always equal to its value. Because of this, no one can make excess profits out of investment; beating the markets is impossible. If we believe in the efficient markets theory, we have no other models available; just buy the market, and take what it gives. 

If we hold that markets are not always efficient, we are on to something. Then the whole world of opportunities opens up. This is how investors should approach risk, business valuation, and expected returns. There lies the edge for the investors over the EMT proponents.

Markets are stupid more often
It is far better to consider the expected rate of return based on the opportunity costs. These are dependent upon the alternative opportunities available for the investors. Inflation and interest rates play a dominant role in estimating an investor's opportunity costs. It is vital to know that different investors have different opportunity costs at the same point in time because of the differences in skills and behavior. Consequently, for the same asset, their expected rate of return could be different.

Back to risk and reward. The actual realized return is a function of the price paid; the lower the price, the higher the rate of return. Therefore, again as a corollary, the lower the price paid, the lower the risk assumed; and consequently, the higher the expected rate of return. This is the crux of the risk-reward concept. That should always be the case as opposed to increasing discount rates or margin of safety to compensate for risks. The earlier the investors, including those value investors, get it, the better it is for them.

To realize the expected return, three things are important: One, there should be mispricing of securities, i.e. there has to be adequate gap between price and value. Smart investors know that there will be numerous such occasions where markets become inefficient, stupid, and irrational. Two, investors should recognize the mispricing, and act on it. They should buy when price is much lower than the intrinsic value; and sell (or short) when it is much higher. Three, the markets should eventually correct the mispricing and become efficient.

To play this game, you need two things: One, ability to analyze value with price. This involves both quantitative and qualitative approaches; and both are judgmental rather than specific. Two, patience to wait for the opportunities. Investors will be better off shunning greed, fear, and envy; they have no place either in life or in investing.

The advice then is to look for the securities priced much lower than their intrinsic value, and then wait for the market to correct the mispricing. Look for the opportunities where prices become attractive enough to realize the expected returns. We cannot realize higher returns by increasing discount rates or margin of safety. That's stupid.

There is more than one way to select securities. We can make our analysis less complicated by selecting predictable, stable, high quality businesses. Otherwise, the prices will have to be unduly attractive for investment.

the s&p 500 boulevard

S&P 500 closed the year at 2673.61, up 19.42% from the previous year end. Since the beginning of 2000, over the 18-year period, you got an annual upside of 3.68%, and over the 10-year period 6.18%, whereas, if you consider the 5-year period, the index rose 13.39% annually. There is a reason for that: S&P 500 went nowhere from December 2007 to December 2012. Those were obviously frustrating times for the investors, even for those who held long terms views on the markets. In October 2008 itself, the index dropped 16.94%; and closed the year down 38.49% sharply reacting to the global financial crisis. In February 2009, S&P 500 was trading at 735.09, and even corporate earnings fell significantly. Earnings recovery began in the last quarter of 2009. Since the beginning of 2013, the bulls have graced the markets, and there seems to be no stopping; is that so? Except for 2015, we have got only horns held high. 

We have had some five falls during the past 18 years, the positive side of which is that we have had much more rises. From 1394, S&P 500 has moved to 2673 now. Not great; but considering the inflation and interest rate environment, that's what you got. Remember also that you started in January 2000 with the flashes of dotcom era.

Yet, if you did dollar-cost averaging, you would have earned 7.33% annually over the entire period; and that isn't bad. To make it appear more impressive, consider this: If you had thrown $2,500 each month from January 2000 until December 2017, you would be looking at over a million dollars. Start with $1,000 a month, but increase it 5% each year, and you would have over $675,000. In addition, you also got those quarterly dividends.

The moral of the story is that for the index investors, it is the market return that matters. It is far more useful to invest in the index on a periodic basis, say, each month, over multiple decades to get the benefit of equity investing. The cost averages out during the long haul, and returns should be more satisfactory. Never try to time the markets. Periodic investments are the way to go for the index investors. If possible, it is better to make additional lump sum investments into the index during bear markets. 

As for the stock pickers, the story is different. There are opportunities both during bulls and bears, albeit more so during bear markets. They should concentrate on high quality stocks for the very long period, and for other stocks, anywhere up to three years. For them, the gap between price and value is the key to success.

the nifty 50 boulevard

Nifty closed the year at 10530.70, up 28.65% from the previous year end. Since the beginning of 1994, over the 24-year period, you got an annual upside of 9.94%, whereas, if you consider the 20-year period, the index rose 12.06% annually. There is a reason for that: Nifty went nowhere from January 1994 to December 1997. In fact, it fell 18% in 1998 before jumping 67.42% in 1999 reflecting the dotcom mania. It was to see double-digit falls in the next consecutive years prior to setting stage for the bulls. From December 2001 to December 2007, Nifty had a phenomenal annual growth of 34.03%. Just when we thought it was unprecedented, it fell sharply reacting to the global financial crisis, and ended 2008 down 51.79%. Although the rise of over 75% in the next year brought cheers to the markets, we were up to some real bear times until 2014. Consider this: Nifty ended 2007 at 6138.60 and 2013 at 6304. Those were obviously frustrating times for the investors, even for those who held long terms views on the markets.

We have had some eight falls during the past 24 years, the positive side of which is that we have had much more rises. From 1083, Nifty has moved to 10530 now. 

Despite that, what is remarkable is, even the 10-year return up to 2017 has been been pathetic at 5.55%. This is the worst 10-year performance by the index in the past fifteen years. Only time we saw such returns falling below 6% was for 2003 and 2004. This should easily reverse for 2018 because Nifty ended 2008 at 2959.15. The trend should continue for sometime unless we see some sharp fall in the index in the coming years. 

The moral of the story is that for the index investors, it is the market return that matters. It is far more useful to invest in the index on a periodic basis, say, each month, over multiple decades to get the benefit of equity investing. The cost averages out during the long haul, and returns should be more satisfactory. Never try to time the markets. Periodic investments are the way to go for the index investors. If possible, it is better to make additional lump sum investments into the index during bear markets. 

As for the stock pickers, the story is different. There are opportunities both during bulls and bears, albeit more so during bear markets. They should concentrate on high quality stocks for the very long period, and for other stocks, anywhere up to three years. For them, the gap between price and value is the key to success.

do yourself a favor

It's New Year. Again. And this time I decided to give some unsolicited advise. It surprises me how people get conned by the so-called experts in the field of investments. They are advisors, bloggers, talking-heads, money managers, and so forth. But all of them are creeps, who are to be detested vehemently. Alas, people don't; and they get boondoggled. 

All this could be avoided if investors showed some restraint. It's much more behavioral than you think it is. So then, here's my gratuitous.

Behave

Investing is simple, but not an easy operation. Most fail to earn decent returns on a consistent basis because of their behavior. If you learn to control greed, fear, and envy, it will do a lot of good for you both in life in general and investing in particular. This is my investing 101. Learn it, and follow it.

Investing is a business

If you do have time and interest in learning about investing and alternative opportunities, it's a good thing. You can then pick stocks (or bonds) based upon their merits, and make money. You do not need anybody's advice. Don't go looking for it; everybody's advice is incentivized. There are loads of good information online that is freely available; use it. In addition, there are a number of books that can teach you about financial markets bubbles and busts, human behavior, pricing and valuation of securities, investor biographies. And even some text books can be of help if needed. Investing becomes a business operation, where you spend most hours of the day reading financial statements, management call transcripts, and thinking about investing. You are fully occupied with reading and observing most of the time. You engage yourself with analysis and valuation. You compare your value with market prices. And you choose only a few occasions when you have to strike, i.e. buy or sell. Once done, you are back again to your work. Your transactions costs are minimal as you do very few. You are willing to wait until market prices move towards your preference. You buy high quality stocks and hold them for a very long time. For other stocks, generally, your investment horizon is between one to three years, when you will be able to realize your profits. Sometimes, however, markets will be kind enough to offer you opportunities to buy and exit as quick as possible. You are always aware that prices you pay impact your returns greatly. Overall, this investing business will keep you knowledgeable about businesses and markets, and supply with you with opportunities to make decent returns for a long time. It's a business to be run as long as you wish to run; there's no retirement age. Isn't that great? Above all, you will have loads of fun, because your operation involves low-risk, low-stress situations. You are long, not short.

Index investing

If you are not inclined towards investing, or if you do not have time for it, it's not a tragedy. Only that you won't get to pick stocks (or bonds) on your own. You simply have to stick to work that interests you, and enjoy life. For long term investing, you have a superior option: just throw cash into low-cost index funds (broader index), month after month, year after year, for a long, long time. In a decade or two, the market value of investments is likely to be fairly high. The key is not to ask for anybody's advice. The key is to stick to systematic (fixed sum or fixed units) investing over a long period of time irrespective of market prices. You ignore money supply, liquidity, interest rates, production, employment, inflation, elections, and so forth. Of course, you read about them, but not act on them. Your job is to continue doing the work that you enjoy, and throw surplus cash into the index fund consistently. Just don't try to time the markets; no one has ever succeeded in it. Remember greed, fear, and envy. You should be satisfied with market returns, which should be fairly decent when you consider multiple decades. If someone gets richer than you, well, someone is always going to get richer than someone else; hello, envy?

Mutual funds

Usually, I don't recommend this, but if you must, and like some excitement, there is another choice. Pick a minimum of three and a maximum of five all-equity mutual funds to invest for the long run. Here's my advice: At least three different fund houses. Pick the ones that are reputable, low cost, and fairly large sized in terms of assets managed. If you find the fund managers, who have skin in the game, it is much better. You will very rarely find them; and that's why I abhor mutual funds.

If you pick three funds: One broader, not sectoral, index fund. One large-cap long term fund. And one mid-cap long term fund. 

If you pick five funds: One broader, not sectoral, index fund. Two large-cap long term funds. One mid-cap long term fund. And one small-cap long term fund. 

Throw more cash into the index fund and large-cap funds. Throw much less into the small-cap fund. You can even replace small-cap fund with another mid-cap fund, which is actually much better. 

Once funds are selected, invest regularly over a long period of time irrespective of market prices and macro events. 

Shun the media and experts

You really do not need anyone's help in doing this. Use common sense, control your behavior, and aim for a very long period. Investing is really for the long run. There are no short cuts to it. If anyone tries to give you advice, or otherwise tries to lure you (and there are plenty of them), mock them, for if they were really good at their game, they would not approach you; they could use their skills to invest their own cash and get rich. So ridicule them, and drive them away.

costco returns

Costco operates mainly in the US, Canada, the UK, Mexico, Japan, and Korea. It had $129 b revenues for (August) 2017, of which $94 b came from the US operations, and $19 b came from Canada. That's about 12% coming from its international operations. So it has some headway for growth out there. But will it fructify? 

Costco is a pretty straightforward business in wholesale and retail of merchandise. W. Craig Jelinek has been the President and CEO since 2012. In 2012, the market value of equity was $42 b (high) and now it is $81 b. A double in five years is nearly a 15% return; not bad. Earnings per share increased from $3.95 to $6.13. Expansion in the PE multiple from 25 to 30 was another reason. A 9% annual increase in EPS lead to nearly 15% in market value in five years. If you had picked the stock when the market capitalization was $34 b (low) in 2012, the returns would have been even better. Operating earnings increased from $2.7 b to $4.11 b; that's 8.30% annual increase.

In the meantime, the number of shares outstanding increased from 432 m to 437 m. Almost 17 m increase came from exercise of options and restricted stock units. To offset that Costco operated buybacks of 13 m shares. Had it not done that, the EPS in 2017 would have been $5.95 in 2017. In fact, Costco has been buying back its shares for long. In 2007 itself, it repurchased 36 m shares; then in 2008, 14 m more. From 2007 to 2017, Costco bought back 90 m shares. If shares were not repurchased, the total number of shares outstanding would have been 527 m, and that would have brought EPS down to $5.08. With the current multiple, the share price would be 18% lower at $152 instead of $186 now. Yet, due to higher number of shares outstanding, the market value of equity would be surprisingly similar to what it is now ($80 b). Of course, Costco would have retained cash of nearly $6 b assuming the buybacks were carried at low prices of each year, or it could have distributed to the shareholders.

So were those buybacks really worth it? To perform buyback, you need two factors: Excess cash, and low share prices compared to the intrinsic value. 

Where will Costco go from here? Revenues increased just over 5% annually during the last five years, and just over 7% during ten years. Assuming 7% increase in the next decade, we have revenues at year 10 of $254 b. With the current operating margins of 3.19% and net margin of 2.08%, Costco's EBIT would be $8 b and net earnings would be $5.3 b. Assuming no further dilution in equity, to get an annual return of say, 7%, the stock would need a PE multiple of, obviously, 30 at year 10. That is a rather rich pricing. When we use a multiple of 25, the rate of return would be 4.91%; at 20, the return would be 2.60%. When dividends are included, those returns would be 8.06%, 6.08%, and 3.90%. Well, why should Costco trade at a multiple of 30 or even 25, why not 20? Then there is dilution due to restricted stock units program.

When I do an intrinsic valuation of Costco based upon its free cash flows for the next decade and using a stable growth rate thereafter, I find that Costco is a 6% stock. I also converted its lease obligations into debt ($2.3 b) for the purpose of this valuation. But then for similar growth rates, the market has rewarded its shareholders nearly 15% return in the past. You can never tell what's with the markets.

Where is growth in revenues, earnings and cash flows going to come from for Costco? I think both Costco and Walmart should have some strategy to tackle the onslaught from Amazon. Online retail is here to stay and grow. 

stock market riches

Business profits
I have an acquaintance, who has a small business in a small town. He has been running the business for long. It is a profitable operation, and most of the profits are reinvested back into the business. When asked about his investments outside of his business, he brushes aside and says that it is not much. He does not invest in properties, be it plots of land, which is a common investment theme in small towns, or houses and apartments. He does throw some cash into bank deposits regularly, but that's about it. He has a rather lavish lifestyle compared to his friends in that town. There are lots of leisurely travel across the country, and then some foreign trips too. He likes to eat, whenever his family does, in higher quality restaurants, and according to his friends, he does not hesitate to pay up for his lifestyle. Yet, when you ask him the question, he says that it is just fine and that he does not find anything lavish about it. So how does he fund his life? Obviously from his business. There are drawings from his profits, which are called dividends in public markets. 

Highly concentrated

The way I see it is that he is a highly concentrated investor, who has invested almost all of his wealth in one asset, which is a profitable business. He knows much about the business, its long term prospects, competitive advantages, and so forth. We can talk about diversification, etc. But the fact is that he has been doing what he is doing for very long. He has made money, is reasonably rich, at least in terms of being able to fund his lifestyle through retirement. Who is going to teach him about investing? You don't have to do it the way he is doing. You can diversify your investments more reasonably. 

Businesses need time 
The key point is that in order to make money in business, you have to be in the business for long. You cannot start a business today, and then ask to become rich instantly. The business will have to face both good times and bad times more than once. There wouldn't be linear profits all through. It will begin as a startup, it will grow, it will mature, and probably, it will collapse when time comes. It is true for a private business and also for a publicly traded business.

Investing in businesses
If you want to make money in business, you have two options: One, start a business that will be good enough to grow and feed your long term requirements. Two, invest in a business started by someone else. Not everyone is capable of starting a business and seeing through its growth. It is tough to deal with the competition, regulation, and the macro. You have to be good at investing, financing, and dividend decisions of the business. 

The second option is available to most of us, which if carried out diligently has prospects of enormous wealth creation. This can be done through investments in private businesses or in publicly traded businesses. 

Stock markets are an investor's paradise
Now to the purpose of this post. A stock market is nothing but a collection of businesses, which are rated and priced every moment of trading hours. How can we profit from stock markets? I reckon, there isn't a better place than stock market to make money. These markets are a blessing to most of the lay people, who are otherwise incapable of starting out in a business of their own. Equity markets give that opportunity. 

Unfortunately, though, people look at the stock market as a casino. They throw cash at the stock tickers and expect them to throw back more cash instantly. Their time period is immediate. Stocks are tracked on a quarterly basis; a bad quarter, the prices fall, and vice versa. Every day is like a roller coaster, where prices go up or down, or go up and down. No one knows for sure the real worth of the stock, nor does anyone care. Prices are set based upon perceptions, whims and fancies.

A stock is a business
A stock has a business behind it; and it is a real business. The business has earnings and cash flows. Ideally, stock prices should reflect the value backed by the fundamentals of the business: cash flows, growth, and risk. But they don't as we just saw. Nonetheless, over the long term, they do march towards the true value of the business. For instance, if the business generates high cash flows, compared to the capital invested (return on capital), consistently for a long period of time, the markets will eventually recognize the true value of the business and set the price accordingly. The same will be true for a bad business; there can be mispricing during the short term; but eventually, the markets will have to see poor cash flows and price the stock based upon that.

Of course, there are many ways to make money from stock markets. There are traders, who have been making a living buying and selling frequently. There are investors, who take short positions on bad businesses and make money. There are those who have been able to profit from corporate restructuring such as mergers and acquisitions, spin offs; risk arbitrage. There is more than one approach to riches.

We want a low-stress, low-risk, high-return strategy
Yet the way I see it is, there is no other way that is less stressful than going long on stocks backed by good businesses. If you are able to pick pieces (stocks) of good businesses at the right price, and hold them for long, there are three things likely: One, no stress of trading moments or of quarterly juggles. It's a virtually no-stress investment strategy. You will have time for fun in life. Two, it's also a virtually no-risk investment strategy. Because your investment period is a long time, a decade or longer, the effect of short term volatility in stock prices is nullified. The chances of permanent loss of capital or of earning inadequate returns are brought down to very low. Three, the probability of making more than adequate returns from investments will be very high. This happens for three reasons: Participation in a good business for a long time; Extremely low trading costs since there aren't frequent buys and sells; and Prices paid for the stocks are generally low compared to the growth prospects. 

The probability of low stress, low risk, and high returns shapes up nicely because you are giving time for the business to run the way it should be, and because of that you earn business profits, not market profits. And when the business is good, its profits are almost always good. Remember, you are a partner in that business entitled to your share of its profits. Handing cash to a few chosen, trustworthy business managers is a better game to play than running one business of your own; this is true at least for most people. Five to fifteen handpicked businesses should be able to meet your expectations. A manager, who also has a substantial stake in the business is always more trustworthy (other factors being taken care of) because the skin in the game makes it more dependable. And you can rest assured relax and have fun in life.. 

If you are the owner of say, a private restaurant, would you expect to realize profits within a year, and then sell it off to someone willing to pay you more than your invested capital? Sounds absurd, right? You started the restaurant because you wanted to be in food business that you expect to do well and earn profits year after year. It amazes me, and I wonder why people are so hesitant towards their stock pickings. Stocks too are investments in businesses, albeit in small proportions. So what? A minority share in a publicly traded business is no different from a minority share in a private business. 

Choose the right business, and play long
The moral of the story is that if you are wise enough to pick stocks that are backed by businesses having long term competitive advantages and operated by able managers, who understand where to invest, how to finance investments, and when to payback to the owners, you have a high probability that you will make decent money over the period. A low price for the stocks comes in handy. Because good businesses are often priced very high by the markets, it will be prudent to wait for the right opportunity. And opportunities to pick stocks of good businesses at the right price galore in public markets. 

Time is your friend in this game; show patience
Just show intelligence to identify good businesses, wisdom to buy them at the right price, and patience to hold them for long, and you will be able to show a pile of cash. Patience is a virtue. Making money off inefficient markets is more behavioral than intelligence.