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Looking at Stock Investments From a Fixed Income PerspectiveDavid P. Kirch, PhD, CPA“It’s all in how you look and study on it.” Brother Dave GardnerAcknowledgementsThis is a work in progress. I would like to thank my wife Chris for her many insights comments on an earlier draft. If you want your name here, help me out!!Looking at Stock Investments From a Fixed Income PerspectiveOne of the greatest menaces to a retirement plan is the misunderstanding of the fixed income market. This includes savings accounts, certificates of deposit, bonds and so forth. These investments are classified as ‘fixed income investments’ because the amount earned is fixed at a certain amount or rate. Thus, if you put $1,000 in a savings account paying 1% per year, you will earn $10 per year on that investment regardless of what happens to the economy, the stock market or interest rates. Throughout this paper we will use bond investments as a surrogate for all fixed investments. This confusion by investors over the nature of fixed income investments is especially insidious because investing in bonds over the last 50 years would have gotten you an average return of 5.07% while investing in the stock market, as measured by the return on the S&P 500, would have returned 9.89%! To put this in perspective, investing an equal amount in your retirement plan using stocks during that same period would have allowed a retirement on twice the annual income that investing in bonds would allow you. The downside to stocks as far as most investors are concerned, is the volatility. If you have a bond that is paying you 4%, then you are earning 4% no matter what happens to the stock market, interest rates or to the economy. But this is not entirely true. It is true as far as focusing on the return is concerned, but it ignores fluctuations in the interest rates. Let me explain. Let’s say you bought a $100,000, 10 year, 5% bond with the interest payable annually. Over the ten years you will certainly earn your 5% face rate per year. But what if the interest rates change? You will get your 5%, but what will the value of the underlying value of the bond you invested in be? The table below shows the changes in the value of the underlying bond based on changes in interest rates. FaceCurrent Face Current RateRate Principal Value 5%1% $ 100,000 $ 119,414 5%2% $ 100,000 $ 114,140 5%3% $ 100,000 $ 109,159 5%4% $ 100,000 $ 104,452 5%5% $ 100,000 $ 100,000 5%6% $ 100,000 $ 95,788 5%7% $ 100,000 $ 91,800 5%8% $ 100,000 $ 88,022 5%9% $ 100,000 $ 84,441 5%10% $ 100,000 $ 81,046 Note that changes in interest rates can cause large changes in principal values. Increases in current interest rates cause decreases in the value of the underlying bond and decreases in current interest rates cause the opposite. An increase in interest rates from 5% to 6% causes a decrease in the value of the bond investment of $4,212. A decrease in interest rates from 5% to 4% would cause an increase in the value of the underlying bond of $4,452 (from $100,000 to $95,788). Most investors consider these changes in the value of their bonds irrelevant since they are still earning their 5%. You would look at an investment in an apartment building or similar investments in the same way. What is the income you expect from the tenants? The value of the actual property is only a consideration if you plan on disposing of it.This paper proposes that a person can use this same reasoning to train their brain to look at the stock market in a similar fashion. This would allow a person to mentally ignore the ups and downs of the stock market. After all, the ups and downs of the stock market are simply changes in the value of the stocks, in other words, changes in the “principal”. You will train yourself to focus on the returns and only consider the current stock price if you are thinking about selling it. This will allow you to comfortably ignore day to day volatility in the market and the accompanying anxiety. This decrease in anxiety would allow you to more comfortably enjoy the higher returns of the stock market and still sleep comfortably at night. Again, we ignore volatility in the bond market simply because the focus is on the return rather than variations in the underlying value of the bonds. So we are now going to refocus our attention on the return of the stock market rather than the price of the shares. We will not address the actual selection of the stocks. We will use a sample of stocks from the S & P 500. To calculate the return we are earning on our stocks, we have two possible choices: the earnings of the company or the dividends the company is paying. Both have advantages. We will deal with the second first. Dividends are real returns. We can spend them and, really, they are the reason we buy a stock. In the long term, the only value of a stock is in the dividends it pays. As Warren Buffett says, “If a financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present at the same interest rate.” As applied to a stock, this simply means the value of the stock is the present value of all future cash flows, that is, of all future dividends. So this would seem to end the argument, we will use dividends. But…….There are some real problems with using dividends as the driving force in the value of a stock. First, dividends are a product of earnings. So to project dividends, you need to project the earnings. From that projection, you need to project how much of these earnings the company will pay out as dividends. This last calculation is known as the “payout ratio”. For a few companies this last calculation has proved to be very stable over the years. These companies, though, are a small part of the stock universe. Many of the more attractive stocks are still reinvesting all their profits in their own growth and are paying minimal or no dividends to the stockholders. Valuations of these using the any dividend model requires extremely tenuous assumptions.6 Another problem that has become especially pertinent lately is the rash of stock buybacks by companies. Buybacks are essentially tax-free dividends to non-selling shareholders. The other choice is the use of the Earnings Per Share (EPS) of the company as a measure of its return. This has the advantage of being readily determinable. It is true that if the company is not paying a dividend, you do not have the current “return” in your pocket. But also you have not paid taxes on the dividend and you do not have to find another place to invest it. So if the company is reinvesting your money for you by not paying it out as a dividend, then they are reinvesting your money tax-free. Do you trust them to do a wise thing with your portion of the company’s earnings? If you do not trust the company management, you certainly should not be invested in it!! Current Earnings Per Share is selected as the measure of our current returns.So we are going to change the focus of our investment portfolio from a measure of the current value of the underlying stocks to a measure which focuses on the income generated by these shares. Now we will operationalize our approach using current eps as a surrogate for current return. We selected the first 10 companies, alphabetically, from the S&P 500.SymbolCurrent PriceThree M?MMM144.83Abbott LaboratoriesABT42.73Abercrombie & FitchANF40.42ACE?ACE104.08Adobe SystemsADBE72.55Advanced Micro DevicesAMD3.83AES?AES15.109Aetna?AET84.64AFLAC?AFL63.71Agilent TechnologiesA56.15Next we took the estimated Earnings Per Share from the projections of Yahoo Finance. The estimates, as reported on Yahoo finance, are used only for illustrative purposes. Other sources, such as Starmine or the projections reported by brokerage houses, would allow one to tweak the estimates. The earnings estimates for our ten stocks are: SymbolCurrent PriceEPS Current YearEPS Next YearThree M?MMM144.837.478.22Abbott LaboratoriesABT42.732.232.47Abercrombie & FitchANF40.422.362.8ACE?ACE104.088.889.25Adobe SystemsADBE72.551.232.09Advanced Micro DevicesAMD3.830.190.17AES?AES15.1091.331.44Aetna?AET84.646.547.18AFLAC?AFL63.716.256.55Agilent TechnologiesA56.153.073.41Next, a $100,000 portfolio with $10,000 in each of the securities is assumed.SymbolCurrent PriceEPS Current YearEPS Next YearShare purchased for $10,000 Three M?MMM$144.83$7.47$8.22 69.05 Abbott LaboratoriesABT42.732.232.47 234.03 Abercrombie & FitchANF40.422.362.8 247.40 ACE?ACE104.088.889.25 96.08 Adobe SystemsADBE72.551.232.09 137.84 Advanced Micro DevicesAMD3.830.190.17 2,610.97 AES?AES15.1091.331.44 661.86 Aetna?AET84.646.547.18 118.15 AFLAC?AFL63.716.256.55 156.96 Agilent TechnologiesA56.153.073.41 178.09 The earnings estimated for the current year for each company is next multiplied by the number of shares purchased with $10,000. SymbolCurrent PriceEPS Current YearEPS Next YearShare purchased for $10,000 Investment Current Earnings for Shares OwnedThree M?MMM$144.83$7.47$8.22 69.05 $10,000 $515.78Abbott LaboratoriesABT42.732.232.47 234.03 10,000 521.88Abercrombie & FitchANF40.422.362.8 247.40 10,000 583.87ACE?ACE104.088.889.25 96.08 10,000 853.19Adobe SystemsADBE72.551.232.09 137.84 10,000 169.54Advanced Micro DevicesAMD3.830.190.17 2,610.97 10,000 496.08AES?AES15.1091.331.44 661.86 10,000 880.27Aetna?AET84.646.547.18 118.15 10,000 772.68AFLAC?AFL63.716.256.55 156.96 10,000 981.01Agilent TechnologiesA56.153.073.41 178.09 10,000 546.75 $100,000 $ 6,321.05 SymbolCurrent PriceEPS Current YearEPS Next Year#Shares purchased for $10,000 Investment Current Earnings for Shares OwnedThree M?MMM$144.83$7.47$8.22 69.05 $10,000 $515.78Abbott LaboratoriesABT42.732.232.47 234.03 10,000 521.88Abercrombie & FitchANF40.422.362.8 247.40 10,000 583.87ACE?ACE104.088.889.25 96.08 10,000 853.19Adobe SystemsADBE72.551.232.09 137.84 10,000 169.54Advanced Micro DevicesAMD3.830.190.17 2,610.97 10,000 496.08AES?AES15.1091.331.44 661.86 10,000 880.27Aetna?AET84.646.547.18 118.15 10,000 772.68AFLAC?AFL63.716.256.55 156.96 10,000 981.01Agilent TechnologiesA56.153.073.41 178.09 10,000 546.75 $100,000 $6,321.05 As shown in the previous table, the investment of $100,000 ($10,000 in each stock) represents annual earnings of $6,321.05. As these are only estimates, it is possible, indeed probable, that the earnings will not be equal to the estimates. If one is careful in selecting the stocks to invest in, it is likely that a greater number of the differences will be in the investors favor. In order to complete our analysis we divide the annual earnings by 365, the number of days in the year. The $100,000 investment is earning $17.32 per day. If one focuses on the earnings of the investment, $17.32 per day as opposed to the investment principal, $100,000, then changes in the price of the underlying securities only matters if such changes are the result of changes in the estimated earnings of the company, or if one is contemplating selling the security. This might be appropriate, for instance, if the price of the security has gotten too high, in the investors estimation, in relation to the underlying earningsMutual funds present a unique challenge when using this new perspective. As stated earlier, most mutual funds vastly underperform the general stock markets. However there are funds that do beat the market and time constraints or other considerations might make these the wisest investment for you. Mutual funds invest in many stocks. Assuming that you have chosen a mutual fund which consistently beats the market, to include it in your return calculations, you need to know the P/E ratio of the stocks it invests in. As an example, we will analyze the mutual fund, AMG Yacktman Service (YACKX). If you go to Yahoo Finance and type in YACKX and then click on “Holdings” on the left side, you will see the following:Note that the average Price Earnings Ratio of the stocks that YACKX holds is 17.06. Taking the inverse of that gives the current yield at the current price, 5.86%. Now take that number times the investment you have in the mutual fund, say $10,000 and you get $586 per year. Divide that by 365 and you get $1.61 to add to your daily earnings total. A major problem of this new way of looking at stocks can also be considered one of its strengths. Emphasis on current earnings would tend to cause one to invest in stocks with a low price earnings ratio. The stocks with the lower current price earnings ratio provide the highest current earnings. Given that the intrinsic value of a share of stock is the product of current and future earnings, stocks with higher current earnings as a percentage of current price are those with the lower future earnings growth prospects. As an example, consider two stocks. Stock A has a current yield (current year EPS divided by current price) of 5%. Stock B has a current yield of 2%. If they are both selling at a price that equals a 10% return to the investor, stock A assumes a 5% growth rate into perpetuity and stock B has an 8% growth rate imbedded in its price. Stocks with higher price earnings ratio imply a greater growth rate than those with low price earnings ratios. In many cases this implied growth rate, when tested against stock valuation models, is found to be unrealistic. When selecting stocks one cannot just focus on current earnings but must also consider other factors such as growth rate, returns of other investment opportunities and so forth. The approach advocated in this paper would tend to steer the investor away from those securities with the lower current earnings when compared to the stock price. This might not be such a bad thing. And, with some thorough research, it is possible to find stocks with high current earnings when compared to current stock price, with acceptable projected growth prospects. The relationship between the implied growth rate and the actual growth rate is tenuous. So a higher P/E ratio, and its resultant lower current earnings as compared to the stock price, does not necessary pay off in higher future earnings. ................
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