Financial Reference

I was driving home this evening and happened to pass a gas station that was overflowing with cars (mainly SUVs) to the point that I wondered if I should call Brian and see if there was gas shortage and that I too should join the masses and fill up my tank.

Being that I had our son in the car, I chose to drive pass the backup of mainly bright, shiney, new SUVs and head home, despite the fact that I was down to a ¼ tank.

I did happen to glance in my rear view mirror and check the price: $2.49. Up until that point I had been ignoring the gas prices figuring that I’d fill up tomorrow when the tank was much closer to empty.

Naturally, figuring that some gas crisis was on hand (which is the logical conclusion to jump to… for someone that tends to overreact to just about everything) I noticed that the next gas station was no where near as full. Actually, there weren’t any cars at the next station. Because… well, I can only assume that it’s because the next station had prices of $2.66.

I know. It’s more. It’s $0.17/gallon more. It’s 6.8% more.

I’m all for frugality when it’s justified. But spending five to ten minutes waiting to fill up the tank (and it would have taken that long at a station with six pump and at least 10 people waiting spilling out onto the business street) is a little absurd.

How much should you expect any one of your investments to return? If you’re investing in highly-rated bonds and expect to hold the bonds to maturity, the answer is easy: you should get the yield to maturity minus a small amount for the small probability of default.

However, what if you are trying to forecast the returns of stock? The analysis becomes much more complicated and is often misunderstood — even by experienced market commentators. Even, Michael Sivy, in the April 2006 issue of Money magazine (p. 78), gets the analysis wrong. He claims that since certain stocks are projected to have earning growth above 10% per year for 5 years and currently pay dividends above 1%, investors should expect average returns above 11%.

The problem with this analysis is that it assumes the future outlook of the company is the same as the current outlook. There is an embedded assumption in Sivy’s analysis that the P/E multiple is not going to contract (or expand). If the outlook becomes less favorable for these companies (i.e. the projected growth rate drops below 10%), the P/E ratio will probably contract and reduce the actual returns.

(On a side note, 10% growth is an optimistic assumption. The market as a whole can only grow as fast as GDP. GDP growth has averaged 3-4%, so 10% growth is 3 times the growth of the market as a whole. While 10% doesn’t seem like a crazily optimistic assumption, be careful of overly-optimistic growth projections — they can throw your whole analysis off.)

The shortcut used by Sivy to arrive at a projected ruturn is often used by laypeople to justify overpaying for growth stocks. The calculation that should be used is to value the company using a discounted cash flow analysis (whether it’s discounted dividends, free cash flow, etc.) to arrive at a current value for the company and it’s shares. You can then calculate a value for the company at any date in the future using the same assumptions you used in your initial calculation.

Many investors use multi-stage models (in which the growth assumption decreases over time) to reflect (1) that the near-future is more certain than the distant future and (2) eventually growth companies lose their growth potential and increase their earnings at the rate of GDP. If you assume a multi-stage model, the P/E will contract over time and your returns will be lower than simply adding the growth rate to the dividend rate.

Don’t fall for lazy solution Sivy falls for; go through the calculations (or at the very least reduce P/E expectations and return expectations) to arrive at a better forecast of your return.

We’re building a house. Actually, we’re building The House. This is the one that we plan on raising our son in and growing old in. We plan on staying there long enough to make planting trees a worthwhile endeavor and our son’s handprints will be put in the driveway.

We’re trying to plan for 20 years worth of contingencies. Which means that while we might not need an extra bedroom right now, where would we want it to be if the need arises. And while the basement won’t be finished right away, we’re planning on finishing it someday and everything needs to be in the right place for that to happen.

It’s not the most financially responsible thing that we’ve ever done. Talking to my mother about the way we’re taking out a bedroom to make a sitting room in the master bedroom, she said “you need to think about resale value” and I was able to say that I wasn’t planning on caring one bit about resale value. This will, hopefully, be it for us.

But there’s a slew of other financial considerations.

For our current place, we got a 3 year arm mortgage. It kept the payments down and we really weren’t planning on staying here any longer than that. Now we’re learning the ins and outs of construction loans and locking in rates and all the fun stuff that goes along with that. Unfortunately lendingtree.com doesn’t handle construction loans so we’re left to the mercy of the salespeople at our local banks.

Then, of course, there’s the price. It’s well over what we were planning on spending when we started looking, although it’s still affordable. I have my days in which the massive amount of the mortgage overwhelms me a bit.

I think that the one thing that makes us pause every once in a while is that this is the first time we’ve ever had conspicuous consumption. It’s a pricy place. It looks like a pricy place. People will know that we have more than most people our age. And we’re not used to that.

We drive cars that are several years old. Our current place in nice, but cozy. I tend to wear name brand clothes, but I make no secret of the fact that my mother takes me shopping whenever I see her and foots the bill. I can count the number of toys we’ve bought our son on one hand (the grandparents are responsible for the massive pile of toys that take up half our living room). We don’t eat out all that often; I take my lunch to work. We don’t have any expensive hobbies – even when Brian plays golf it’s at a public course 99% of the time.

A few people know that we have substantial savings. My business partner realizes that Brian and I were able to fund our start up without blinking an eye.

So to think that everyone will know, is going to be a bit weird for us. But we’ll get used to it. And that’s not why we’re building it. We’re doing it because we want our son to have a place to grow up, and I want to finally unpack all the boxes because I will have found a place to call home and, as Brian said,

“What else are we saving all this money for?”

And because it’s going to be perfect. Absolutely perfect.

The following is a comment to Merk Cuban’s recent post on blogmaverick.com

Mark,

An well understood point by experienced investors; sadly, not a well understood point by “mom and pop” investors.

In law school, we gave a presentation to our professor (a very experienced investor) about options and how they incent management to meet a target for their stock price. The incentive does not align the interests of management with long term investors. Management is incented to barely beat numbers they provide to analysts so they can get a “pop” in the stock price.

They are also incented to create volatility in the stock price (which increases the value of options) by playing games with their numbers. Experienced investors know that accounting is more art than science; management also knows this and uses this fact, legally and sometimes illegally, to their advantage. (Our professor had problems with our analysis, thinking that options were good, but I still stand by our analysis.)

The emphasis on diversification and long term investments (although both good things in the abstract) exacerbate the problem. Since each holding is only a small part of your portfolio, the agency problem becomes bigger.

Sadly, I don’t see an end to this problem. The only solution is more active management which brings its own greedy set of problems. (See, e.g. Warren Buffet’s latest letter to shareholders at berkshirehathaway.com.) As public markets become more public, the agency problem grows and management will continue to enrich itself at the expense of shareholders.

Experienced investors can only help themselves; they cannot help everyone else. I wish there was a better solution to this problem, but until investors are smart enough to solve this problem for themselves they will suffer the consequences of their mis- or non-information.

By the way, I loved your reality TV show. It was much better than any of the ones still running. In particular, the “you’re fired”, everyone selfish, B.S. show. Thanks for trying to inform people about what it takes to be successful.