The Other Book

December 27, 2015

Here’s hoping everyone had a good Christmas.

Investors use several different metrics to judge the value of a company.  Probably the most common is the Price to Earnings, or P/E, ratio.  This is the stock’s price divided by the earnings per share that the company has generated over the past twelve months.

Another common measure is the Price to Sales (P/S) ratio: the stock price divided by the Revenue per Share.  A third yardstick is the Price to Book (P/B) ratio, the stock price divided by the Book Value per Share.  What is book value?  Subract the debt of a company from its assets and what is left is the book value of the company.  If a company were to be liquidated, the shareholders get everything that belongs to the company after the creditors are paid off.  Book value does not include intangible assets like intellectual property and the power of a well-known brand, sometimes referred to as “blue sky.”

Some investors may argue that book value understates the true value of a company because it ignores these vague assets.  A value investor, on the other hand, might counter that the intangible value of a brand can dwindle rapidly in a highly competitive and rapidly changing environment.  As an example, remember Palm?  Don’t know who or what that is?  In the 1990s, there was a lot of blue sky baked into market valuations that dissipated quickly as investors regained their senses.

Even long time retail stalwarts like Sears have learned that brand is sand, eroding under the relentless pounding of shifting tastes, technologies and  competition.

Combining the P/S and P/B ratio – a mashup, so to speak – is the S/B ratio, the Sales to Book ratio, and is sometimes called the Buffet indicator, after Warren Buffet, a well known value investor.   While this ratio may not appear in the key valuation ratios for a company, it is derived easily by dividing the P/B ratio by the P/S ratio.

Let’s look at two examples in the same industry.  Apple has a P/S ratio of 2.59 and a P/B ratio of 5.08.  Using simple math we get an S/B ratio of 5.08 / 2.59 which we round off to 2.  Microsoft has a P/S ratio fo 4.91 and a P/B ratio of 5.76, giving us an S/B ratio of 5.76 / 4.91, or approximately 1.2.

The difference between those two ratios, 2.0 for Apple and 1.2 for Microsoft, tells us that the market values Apple’s blue sky a lot more than it does Microsoft.  Fifteen years ago, the situtation was reversed.  This was before the introduction of  the iPod, the iPhone and iPad.  Apple’s brand has become the dominant force in the consumer technology market.

Using the book value of all companies we can construct a ratio that tells us the relative richness of asset valuations.  We will flip the S/B ratio used with individual companies and substitute GDP, the economic activity of a nation, for sales or revenue.

Here is a decades long chart of that indicator.  Higher interest rates and inflation in the late 1960s and 1970s helped lower this ratio.  By the early part of the 1980s stock valuations, using this method, were so beaten up that they had nowhere to go but up.  Lower interest rates and an  explosion of technological innovation in the past few decades have contributed to the rise in this indicator.  It wasn’t until about 1995 that the ratio was an even 1.0.

To the value investor, the ratio and the direction of changes in the ratio are equally important.  How much blue sky is baked into current market valuations? Is the ratio rising or falling?  Has the market overpriced the future value of the corporate blue sky?  If so, future price gains may be muted as investors correct their valuations.  Like 2011, the SP500 index will probably show little gain or loss this year.  Here’s a closer look at recent years.  The ratio is falling but still above 1.0.

 New Year’s Resolutions

Readers who are looking for one more resolution to add to their list can try this one: remembering stuff using spaced repetition with Anki Flashcards.  The desktop app is free and there are a number of shared decks of flashcards available for download.  In no time, you’ll be able to remember your wedding anniversary.  You’ll be able to retrieve French or Spanish phrases stored in some dark corner of your brain along with the lyrics to a 1980s Devo song.  Anything is possible.  Who was the actress who played Princess Leia?  Easy.  Who was the director of the movie Touch of Evil?  Oooh, repeat that one again.

Year End Approaches

December 19, 2015

For those of you who pay attention to crossing averages, the 50 day average of the SP500 index just crossed above the 200 day average.  This long term buy signal is often referred to as the Golden Cross.  The Death Cross, when the 50 crossed below the 200 day average in early August, is a sell signal.  Those who sold some of their holdings at that time missed the volatility of the past few months.  The index was at 2100 in early August.  It closed at approximately 2000 on Friday.  The index has lost about 4% in the past two days.

Past buy crosses were June 2009, October 2010, January and August 2012 and this past week.  Recent sell crosses were December 2007, July 2010, August 2011, July 2012, and August 2015.

In buy, sell order they were December 2007 (sell), June 2009 (buy), July 2010 (sell), October 2010 (buy), August 2011 (sell), January 2012 (buy), July 2012 (sell), August 2012 (buy), August 2015 (sell) and December 2015 (buy).  Note the three year period between buy and sell signals from August 2012 to August 2015.  The market gained 55% during that period.

As you can see from the list above, the market usually regains its footing after a few months – except when it doesn’t, as in 2008.  This buy sell rule avoided the protracted market downturns in 2000 and 2008 at the expense of acting on signals that are false positives, or what is known in statistics as Type I errors.


Cost Basis

Mutual fund companies typically calculate an investor’s cost basis for their funds.  Some investors mistakenly think that cost basis reflects the performance of their investment.  It doesn’t. Let’s look at an example of a cost basis entry:

At first glance, an investor might think they have lost $186 since they first started investing in the fund.  Usually, that’s not the case.  In this case, the fund has earned more than $5000 in ten years.

Let’s look at some basics.  An investor in a mutual fund has the option of having dividends and capital gains reinvested in the same fund or transferred to another fund like a money market.  To begin our simple example, let’s choose to NOT reinvest.

Let’s say an investor put $1000 in a bond fund BONDX.  Each share sells for $100 so they have bought 10 shares.  Every quarter the fund pays a $1 dividend per share.  A day before the dividend is paid the fund’s share price is $101.  The fund then distributes the $1 dividend.  The market value of each share instantly falls by the amount of the dividend – $1 – so that after the dividend the market value of each share of BONDX is $100.  What is the investor’s cost basis?  $1000.  The market value is 10 shares x $100 = $1000.  Capital gain or loss? $0.  Does this mean the investor has made no money?  No, they have an extra 10 shares x $1 dividend per share = $10 in their money market account.

When opening up a fund the default option may be to reinvest capital gains and dividends.  This is where some investors get confused.  So, let’s change the reinvest option and choose YES. Now, as before, the fund distributes the $1 dividend and the share price of the fund falls to $100, just as before.  Now, however, the money is not transferred to the money market fund.  Instead it is used to buy more shares of BONDX.  The $10 that the investor receives buy a 1/10 share of BONDX.  Now the investor owns 10.1 shares of BONDX at a cost of $100 per share = $1010 cost basis.  The market price of the fund is $100 per share x 10.1 shares = $1010.  Captial gain or loss: $0.  Again, the capital gain or loss does not reflect the total performance, or profit and loss, of the investment.  The profit is $10.

So, the capital gain or loss should be used only to calculate the tax effect of selling a fund, not the performance of the fund.  The fund company will calculate the performance, or the rate of return (IRR) on an investor’s funds on a separate screen.  Choose that option instead of the cost basis screen.


The Investment Cycle

Investments tend to rise and fall in price over the course of a business cycle.  At the end of an expansionary cycle, commodity prices start falling.  Yardeni Research has some good graphs which illustrate the ongoing plunge in commodity prices.

As the economy begins its contraction phase, the prices of bonds start to fall.  As we enter recession or at least a contraction of growth, stocks fall.  In the recovery, comodities rise first, followed by bonds, then stocks.  Here is more information for readers who are interested in exploring the details and background of this cycle.


The American Diabetes Assn puts the direct costs of treating diabetes at $150 billion.  That is 25% of the $600 billion spent on Medicare in 2014.  Indirect costs add another $75 billion in costs.  Much of the increased expenditure is for treating late onset Type II diabetes.  Expenses are sure to grow as the population ages and people do not make the life style changes needed to delay or moderate the onset of the disease.

Credit Spreads

Several weeks ago, I noted the growing “spread” between Treasury bonds and high yield junk bonds.    The graph I showed was the benchmark of junk bonds, the Master II class. Let’s call them Bench Junks. The bottom of the barrel, so to speak, are those company bonds rated CCC and lower.  These are companies that are more likely to default as economic growth slows or contracts. Let’s call them Low Junks. While the Bench Junks’ spread shows investor concern, the Low Junks’ spread shows a stampede out of these riskier bonds.  A rising spread means that the prices for those bonds are falling, effectively giving buyers a higher interest rate. Investors want the higher yield to compensate them for the higher risk of owning the bonds.

Here is an article explaining the composition of some high yield bond ETFs for those readers who are interested. in learning more.


Income Taxes

Turbo Tax may be the most widely used individual income tax software but there are many providers of tax software.  Each state usually lists the software programs it has approved.  You can Google “approved income tax software” and insert your state name at the beginning of the search term. Here is a link to Colorado‘s list of approved software.  Here is the list for Texas, New York and California.

Lastly, have a wonderful Christmas!

Risky Biz

December 13, 2015

How low can crude oil prices go?  Older readers may remember the Limbo, a party dance popular in the early 60s.  After breaking through the “limbo stick” of $40 per barrel, gas prices sank even lower when the IEA indicated that the supply glut will continue through 2016 (Story).

A popular energy ETF, XLE, has fallen 11% in nine trading days.  Yes, an entire sector of the economy has lost more than 1% per day this month. Some oil service companies lost more than 3% on Friday alone. The large integrated oil companies like Exxon (XOM) and Chevron (CVX) say they are committed to maintaining their dividends (Exxon now near 4%, Chevron near 5%) but investors are concerned that continuing price pressures will make that ever more difficult. This article provides a good overview of the structure, revenue and profit streams of large integrated oil companies.

So we lie around at night worried about our stock portfolio.  Why would we do that?  Because someone – who? – is going to pay us a little extra to worry about our stocks.  Or, at least, that’s the way it’s supposed to go, isn’t it? The extra return we are supposed to get for our worries is called a risk premium, or the plural – premia.  One measure of that premium is the total return on stocks minus the total return on a safe long term bond like a ten year Treasury bond.

In his book Expected Returns, An Investor’s Guide to Harvesting Market Reward,  Antti Ilmanen reviews the historical returns of several types of assets during the past century. He wrote a free summary of the book in 2012 (Kindle version  OR PDF version).  Mr Ilmanen presents an investing cube (pg. 3) as a visualization of the factors or choices that an investor must consider.   On one face are assets categorized into four types of investment.  On another face are four styles of investment.  On the third face of the cube are four types of risk.

A surprising find was that the risk premia of stocks over bonds was only 2.38% (p. 12) during the past fifty years.  Investors are not being paid much for their worry.  When the author compared the returns on stocks to longer term twenty year Treasury bonds (an ETF like TLT, for example), the risk premium has been negative for the past forty years.

The author emphasizes that “a key theme in this book is the crucial distinction between realized (ex post) average excess returns and expected (ex ante) risk premia.” (p. 15)  Historical averages of risk premia may be exaggerated by high inflation, which hurt the returns on bonds in the 1970s and part of the 1980s, and made returns on stocks that much better by comparison.  In a low inflation environment such as the one we have now the risk premia for owning stocks may be rather muted.

Ilmanen’s analysis of past returns reveals several historical trends that can help an investor’s portfolio.    Value investing tends to produce higher returns over time.  So-called Dividend stocks also generate additional return.

I was surprised at the relative stability of per capita GDP growth over 100 years.  We wring our hands in response to a crisis like the dot-com meltdown or the Great Recession but these horrific events barely show in the average aggregate output of the country over a person’s working years. Here is a table from the PDF summary.

A mutual fund QSPIX was formed last year based partly on the research in the book.  However, the minimum investment is $5,000,000.    The fund is currently 28% in cash.


Social Security Strategies

A resource on the right side of this blog is Maximize My Social Security (MMSS), a personally tailored – and inexpensive – advisory service to guide older people to better informed Social Security choices.  The site does not use your social security number.  If you already have an online account with the Social Security Administration, you can complete the forms at MMSS and get some results in under twenty minutes.

Old people who used to talk about the latest Pink Floyd or Led Zep album when they were younger now talk about Social Security, Medicare and their aches and pains.  Always a popular topic:  hey, what do you think about waiting to file for Social Security?

Pros of waiting:

1.  Where else  can any of us earn a guaranteed 8% on our money each year?  Sign me up!  For each year we wait, our Social Security annual benefit increases by 8%.

2. Inflation adjusted:  On top of the additional 32% we get from SS when we start collecting SS at age 70, we are getting an inflation adjustment on that higher amount.

3.  If we need to borrow money to get by during the 4 years we wait, we may be able to borrow the money using our house as collateral.  Depending on our tax circumstances, the interest we pay on the borrowed money could be deductible, reducing the net cost of borrowing.

4.  If we are a guy, we will probably die before our spouse.  Wives who may have a lower benefit will get their benefit amount bumped up to what we were receiving.

Cons of waiting:

1.  We could die before the “payoff” age, between 79 and 82.  This is the age when the inflation adjusted benefits we receive by delaying our benefit matches the total we would have collected by claiming at an earlier age.  However, we often don’t factor in the advantage of the #4 Pro above in which our spouse collects a higher amount till her death.

2.  Congress could change SS payments and rules.  The institution does not have a good track record for keeping its promises.  The swelling ranks of the Boomer generation contributed far more than recipients of earlier generations took out in benefits. Congresses of the past few decades have spent all the extra money accumulated in the Social Security coffers.  After 2020 the system will come under greater cash flow pressure as the Boomers continue to retire and claim benefits.  If Congress does reduce benefits,  then those of us who waited to file for benefits will probably regret our decision.  By the way, MMSS allows users to estimate the long term impact of such a reduction.

3.  We may have to borrow to make ends meet while we wait to collect benefits.  Banks don’t usually loan money to retirees with no job income, necessitating some asset-backed mortgage. Older people may be averse to assuming any new debt.

4.  Withdrawing money from savings while we wait will reduce our savings for a time, which will lessen the “endowment” base of our lifetime wealth.  While the additional 8% per year from SS should more than offset that loss, we can never be certain.  As an example, let’s imagine a retiree at the beginning of 1995 who decided to draw down savings and wait four years to start collecting SS benefits.  The stock market had gone nowhere during 1994.  She sold some stocks and bought a 4 year CD “ladder” for the amount she would need to tide her over till she started collecting benefits.  During those next four years, the SP500 index rose from 459 to 1229, a 167% gain – more than 25% annually excluding dividends.  Even with the additional money our retiree was making each month in SS benefits because of her decision to delay, it was the worst time to get out of the stock market!

A Change Is Gonna Come

December 6, 2015

A horrible week for many families.  When we count the dead and injured in mass shootings, we often neglect to include the family and friends of each of these victims.  If we conservatively estimate 20 – 30 people affected for each victim, we can better appreciate the emotional and economic impact of these events. Shooting Tracker lists the daily mass shootings (involving four or more victims) in the U.S. in 2015.  What surprised me is that, in most cases, the shooter/assailant is unknown.

A strong November jobs report sent equities, gold and bonds soaring higher on Friday.  Markets reacted negatively on Thursday following a lackluster response from the European Central Bank(ECB) and comments by Fed chair Janet Yellen indicating that a small rate increase was in the cards at the mid-December Fed meeting.  The SP500 closed Thurday evening below November’s close.  Not just the close of November 2015, but also the monthly close of November 2014!

Overnight (early Friday morning in the U.S.), the ECB said that they would do whatever it took to support the European economy. Shortly after the cock crowed in Des Moines, the Bureau of Labor Statistics released November’s labor report, confirming an earlier ADP report of private job gains.  By the end of trading on Friday, the SP500 had jumped up 2%.  However, it  is important to step back and gain a longer term perspective.  The index is still slightly below February 2015’s close – and May’s close – and July’s close.

Extended periods of price stability – let’s call them EPPS – are infrequent.  Markets struggle constantly to find a balance of asset valuation. Optimists (bulls) pull on one end of the valuation rope.  Pessimists (bears) pull on the other end.  Every once or twice in a decade, neither bears nor bulls have a commanding influence and prices stabilize. Markets can go up or down after these leveling periods: 1976 (down), 1983 (up),  1994 (up), 2000 (down), 2007 (down), 2015 (?)


Year End Planning

Mutual funds must pass on their capital gains and losses to investors.  Investors who have mutual funds that are not in a tax-sheltered retirement account should take the time in early December to check on pending capital gains distributions either with their tax advisor or do it themselves.  Most mutual fund companies distribute gains in mid to late December.  Your mutual fund will have a list of pending December distributions on their web site.  For those retail investors in a rush, you might just scan through the list and look for those funds that have a distribution that is 5% or more of the value of the fund, then look and see if it is one of your funds.

An EPPS tends to produce relatively small capital gains but this year some mid-cap growth funds and international funds may be declaring gains of 7 – 10% of the value of the fund.  An investor who had $50,000 in some mid-cap growth fund might see a capital gain distribution of $4,000 on their December statement.  When an investor receives the statement in January 2016, it is too late to offset this gain with a loss.  Depending on the taxpayer’s marginal tax rate, they could be on the hook to the tax man for $700 – $1200.

Let’s say an investor is anticipating a $4000 capital gain distribution in a taxable mutual fund in late December.  Most mutual fund companies list the cost basis of each fund in an investor’s account. An investor who had a cost basis that was higher than the current value of the fund could sell some shares in that fund to offset some or all of the capital gain distribution in the other fund.  This is called tax loss harvesting.  Again, remind or ask your tax advisor if you are unclear on this.

Here is an IRS FAQ sheet on capital gains and losses.  Here is an article on the various combinations of short term and long term gains and losses.


The latest ISM Survey of Purchasing Managers (PMI) showed that the manufacturing sector of the economy contracted in November.  October’s reading was neutral at 50.1.  November’s reading was 48.6.

The services sector, which is most of the economy, is still growing strongly.  Both new orders and employment are showing robust growth.   

However, manufacturing inventories have contracted for five months in a row.  For now, this decline is more than offset by inventory growth in the service industries.  However, the drag from the manufacturing sector is affecting the services sector.  The trough and peak pattern of growth in employment and new orders since the recession recovery in 2009 has begun to get a bit erratic.  Nothing to get too concerned about but something to watch.

The Constant Weighted Purchasing Index combines the manufacturing and service surveys and weights the various components, giving more weight to New Orders and Employment.  Both components anticipate future conditions a bit better than the equal weight methodology used by ISM, which conducts the surveys.  In addition, there is a smoothing calculation for the CWPI.

During this six year recovery, the CWPI has shown a wave-like pattern of growth.  Since the summer of 2014, growth has remained strong but there has been a leveling in the pattern as the manufacturing sector no longer contributes to the peaks of growth.

Despite the underlying growth fundamentals, there are some troubling signs.  In response to activist investors, to boost earnings numbers and maintain dividend levels, companies have bought back shares in their own company at an unprecedented level.  In some cases, companies are taking advantage of low interest rates to borrow money to make the share buybacks. (U.S. Now Spend More on Buybacks Than Factories, WSJ 5/27/15)


Labor Report

46,000 jobs gained in construction was a highlight of November’s labor report and was about a fifth of all job gains.  Rarely do gains in construction outweigh gains in professional services or health care. This is more than twice the 21,000 average gains of the past year. The steady but slow growth in construction jobs is heartening but a long term perspective shows just how weak this sector is.

Involuntary part-timers, however, increased by more than 300,000 this past month, wiping out a quarter of the improvement over the past year.  These employees, who are working part time because they can not find full time work, have decreased by almost 800,000 over the past year.

The core work force, those aged 25-54, remains strong with annual growth above 1%.

Other notable negatives in this report are the lack of wage growth and hours worked.  Wage growth for all employees is a respectable 2.3% annual rate, but only 1.7% for production and non-supervisory employees.  This is below the core rate of inflation so that the income of ordinary workers is not keeping up with the increase in prices of the goods they buy.

Hours worked per week has declined one tenth of an hour in the past year, not heartening news at this point in what is supposed to be a recovery.  Overtime hours in the manufacturing sector has dropped 10% in the past year.



The core CPI is a measure of inflation that excludes the more volatile price changes of food  and energy.  While the headline CPI gets the attention, this alternative measure is one that the Federal Reserve looks at to get a sense of the underlying inflationary forces in the economy.  The target annual rate that the Fed uses is 2%.

October’s annual rate was 1.9%.  November’s rate won’t be released till mid-December. However, Ms. Yellen made it pretty clear that the Fed will raise interest rates this month, the first time since the financial crisis. I suspect that prelimary reports to the Fed on November’s reading showed no decline in this core rate.  With employment gains and inflation stable, the FOMC probably felt comfortable with a small uptick in the bench mark rate.