Hope Is Not A Strategy, Before Investing Have A Precise Calculation Of Return In Mind

Transcription

1 Hope Is Not A Strategy, Before Investing Have A Precise Calculation Of Return In Mind May 2, 2015 by Chuck Carnevale of F.A.S.T. Graphs Introduction Many people make the mistake of investing in a stock simply with the hope or belief that it will or might go up in value. However, there is a very popular mantra that states Hope is not a strategy. Some attribute the origin of this mantra to former New York City Mayor Rudy Giuliani during his speech at the Republican National Convention on September 3, 2008 where he said because change is not a destination, just as Hope is not a strategy. Others credit a well-publicized letter sent to Barack Obama by economist, and Dean of the Business School at Webster University in St. Louis, Dr. Benjamin Ola Akande that was titled Hope is not a strategy. Regardless of its origin, the phrase Hope Is Not a Strategy is profoundly applicable to common stock investing, and all investing for that matter. Prudent investing should always be implemented based on a well thought-out plan and strategy for success. As the admired baseball legend Yogi Berra so aptly put it if you don t know where you re going, you might wind up someplace else. Or perhaps better yet, Yogi also said you ve got to be very careful if you don t know where you are going, because you might not get there. I contend that successful investing implies knowing where you are at least attempting to go. In other words, every investor should have a realistic, clear, measurable and accountable return objective in mind before they make an investment. Russian economist Dr. Vladimir Kvint provided one of my favorite definitions of a strategy as a system of finding, formulating, and developing a doctrine that will ensure long-term success if followed faithfully. Invest With a Clear Return Objective In my most recent article a loyal reader of my work offered this suggestion in the comment thread: However IMO, your first 5 paragraphs are succinctly instructive to diversified equity portfolio construction, and worthy of every reader's thoughtful consideration. It would be worthy of your consideration to repeat that content in a future article. Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 Not only was I flattered, I also agreed with his suggestion which was the inspiration for this article. Therefore, I ve repeated those five paragraphs in this article and offer them as the foundation for this more comprehensive overview about investing in stocks with a clear and precise return objective in mind. Prior to making an investment in any stock, I always proceed with a clear investment objective in mind. However, my objectives are not necessarily the same every time I invest in a stock. There are times when my objective is current income, and in contrast, there are other times when my objective might be maximum total return. At other times, I may be seeking a combination of both income and growth. My investment objective is determined by what my needs are at the time. Additionally, I do not engage in vague or generalized objectives such as trying to beat the market. Instead, I endeavor to have an exact and realistic objective and precisely estimated return calculation that is commensurate with the type of common stock I may be examining. For example, if I was looking for maximum current yield and reasonable safety in order to provide a specific level of current spendable income, that is where my focus and analysis would be. With this need for a current income objective, I might turn to researching high-yield, low-growth utility stocks. However, and this is the crux of my position, I would not invest in a utility stock thinking that I will outperform the market in either capital appreciation or total return. Utilities tend to be slow growers, and as such, do not usually produce high capital appreciation. On the other hand, when I invest in a utility stock, I fully expect to receive significantly more income than the market would provide. Consequently, I would measure the success or failure of this investment based solely on the dividend income I expect to receive. In contrast, if I was looking for high total return, my focus would primarily be on the earnings growth potential of the stock I was considering. If I was desirous of generating a high total return capable of beating the market, I would look for a company that I was confident would generate a higher earnings growth rate than the market. And most importantly, in either case, whether I was investing for current income or total return, fair and sound current valuation would have to be evident. Fair valuation is the universal principle that prudent investors are wise to consider regardless of the type of investment or return objective that is desired. Once my general investment objective is clearly defined and established, my focus then turns toward a specific and precise return calculation. In other words, I never invest in a stock merely hoping that it might go up. Instead, I always have a specific return number and objective that I expect my investment in a specific stock can provide. Moreover, my precise return expectations are always based on rational assumptions, which I input into standard rate of return calculation formulas. These rates of return assumptions, based on rational inputs, become my benchmark that I closely and continuously monitor and evaluate. Fairly Valued Opportunities Consistent with the theme of this article that hope is not a strategy, is also the idea that it s not enough just to identify a great company to invest in. To truly receive results that are commensurate with the Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 risks associated with investing in a stock, the prudent investor must also be disciplined about the valuation they pay when investing. As I have stated many times, you can overpay for even the best company. Consequently, I am a believer that assessing fair or sound valuation is one of the most important considerations that prudent investors should make. As I will soon illustrate, fair valuation will be one of the most critical elements when attempting to calculate future potential returns available from investing in a company. This concept should become self evident as I provide the following examples in order to illustrate how I go about determining the return potential that investing in a given company might offer me. Therefore, I will start with providing examples of companies that I consider fairly valued currently, and then elaborate on my process of calculating future return potentials. For perspective, I will follow these examples with one example of an overvalued company. Assessing the future return potential of a company that you already own, that has subsequently become overvalued is an integral part of a prudent strategy. Current Income Conservative Johnson & Johnson The following earnings and dividends only F.A.S.T. Graphs on Johnson & Johnson (JNJ) represents a quintessential example of the type of conservative income stocks that I personally covet. This is truly a great company that has produced amazingly consistent earnings and dividend growth over many years running. As a conservative retired investor or dividend growth investor, you couldn t find a higher quality company to invest in then AAA rated Johnson & Johnson. Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 Unfortunately, as the following graph on Johnson & Johnson with monthly closing stock prices added (the black line) illustrates, it has historically been very rare to find this blue-chip at an attractive valuation. Since the beginning of 1998, Johnson & Johnson s stock has often commanded a premium valuation. It took the Great Recession of 2008 to bring its stock price down to reasonable and attractive levels. Although I would stop short of calling Johnson & Johnson overvalued today, I do believe that it is currently fully valued, if not slightly overvalued. Consequently, before considering fresh capital I believe it s imperative to evaluate the future returns that Johnson & Johnson might logically offer from these levels of valuation. Importantly, I strongly believe in going through that process with a reasonable case, best case, and a pessimistic case approach. My objective is to forecast a reasonable assessment of what a new investment in Johnson & Johnson might provide under various hopefully rational Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 scenarios. However, before I elaborate on my various future expectations under various scenarios for Johnson & Johnson, I thought it would be interesting to reminisce about my past approach. I am currently long Johnson & Johnson, and I purchased it on April 2, 2009 at an approximate price of $54 per share and a P/E ratio of 11.7 (illustrated by the green dot on the graph below). For added perspective, Johnson & Johnson s current blended P/E ratio is 16.7 approximately a third higher than my initial purchase. But most importantly, I had calculated an annual rate of return objective of approximately 12% per annum based on my expectations for future earnings and dividend growth and an assumed future PE ratio expansion to a fairly valued 15. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 Generally speaking, Johnson & Johnson met my earnings and dividend forecasts (which incidentally I have continuously monitored, quarter by quarter) and happily exceeded my expected P/E ratio expansion. As a result, my annualized rate of return of 13.65% (see red circle) has thus far exceeded my original 12% expectation. But most importantly, I had a clear rate of return expectation when I invested in Johnson & Johnson, and practically speaking, it has been met. When I first invested in Johnson & Johnson in April 2009, I had clear and precise rate of return calculations and possibilities in mind. What follows is a repeat of my exact process based on Johnson & Johnson s current valuation, and various expectations of earnings and dividend growth and future valuation possibilities. I accomplished these calculations by taking advantage of the calculating power of the various F.A.S.T. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

7 Graphs Forecasting Calculators. For those that don t have access to this powerful tool, this same process could be accomplished by importing data into a spreadsheet and running similar calculations. My first calculation, I will call my most rational expected case, utilizes the Estimates forecasting calculator that provides consensus analyst earnings estimates provided by S&P Capital IQ out to fiscal year-end 12/31/2018. The Estimated 5.2% earnings growth capitalized at a reasonable P/E ratio of 15 implies a 5.33% total annual rate of return. This would be comprised of a potential $9.25 of future price gain coupled with $11.87 of potential prorated dividend income. Not a great return by some standards, but perhaps reasonable for this AAA rated blue-chip in today s low interest rate environment. However, the important point is that the investor can decide for themselves whether or not that s an adequate return when they are fully aware of the reality of the calculation. It is certainly better than buying Johnson & Johnson on the hopes that it will go up and continue raising their dividend. Expected Case (Reasonable Assumptions) Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.

8 Earnings Estimates Based on Historical Growth (No Analysts) With my next calculation I utilize the Historical CAGR Forecasting Calculator which provides historical earnings growth rates that I can utilize as a substitute for analyst estimates. By utilizing the drop-down window at the bottom of the calculator, I chose the lowest historical earnings growth rate of 4.6% that Johnson & Johnson has achieved, which happened to be the last completed 6 fiscal years. As an interesting aside, that historical earnings growth rate is only slightly lower than consensus forecast growth out to fiscal year Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.

9 When I run my calculation out to fiscal year-end 12/31/2018, as I did with my previous calculation, my total calculated annual rate of return drops to 4.65%. Once again, not a great rate of return, but considering that this calculation is based on Johnson & Johnson s lowest historical earnings growth rate achievement, it is still at least annually positive. Most Reasonable Conservative Forecast Page 9, 2018 Advisor Perspectives, Inc. All rights reserved.

10 With my next calculation I turn to the Custom Forecasting Calculator in order to run my most reasonably expected conservative forecast. Using the customization capability, I input the 4.6% lowest historical earnings growth that Johnson & Johnson has achieved, and then capitalize those earnings at a P/E ratio of 14.1 which is the lowest historical normal P/E ratio (last 8 fiscal years) that the market has valued this blue-chip at. With these inputs, I only get a total annual rate of return of 3.07%. Again, not a great return, however, I take some solace in the fact that the number is still positive. Page 10, 2018 Advisor Perspectives, Inc. All rights reserved.

11 Most Optimistic Case The final calculation, I will call my best or most optimistic case. With this example I assume that Johnson & Johnson s stock price will once again be capitalized by its 20 historical fiscal year premium Page 11, 2018 Advisor Perspectives, Inc. All rights reserved.

12 normal P/E ratio of 20.2 as shown in the historical graph above. With this highly optimistic case, my future total annual return calculates at 13.72%. That would be more than acceptable for this AAA rated blue-chip, but also begs the question as to which of these calculations I would be willing to risk my money at. However, the important point is that I have several rational expectations of what I might earn by investing in Johnson & Johnson that go beyond merely buying it and hoping it might increase. Page 12, 2018 Advisor Perspectives, Inc. All rights reserved.

13 Scana Corp With my next fairly valued example I present Scana Corp (SCG) a publically traded utility that I referenced in my Invest With a Clear Return Objective discussion above. However, in this case my focus turns from total return to current and future cumulative dividend income. The point being that my calculation recognizes the low-growth nature of utility stocks while simultaneously acknowledging the high current yield. In other words, with this example I am interested in how much potential income I might receive. From the historical earnings and price correlated graph we see that Scana is currently fairly valued at a blended P/E ratio of 14.9 and a current dividend yield of 4%. Historical earnings growth has only averaged 3.9%, so I am not expecting much in the way of capital appreciation. However, I ask that the reader note that Scana was undervalued at the beginning of 2001 with a P/E ratio of 14 and a dividend yield of approximately 4% at that time (see red circles). This is important to keep in mind when I review the performance over this timeframe next. Page 13, 2018 Advisor Perspectives, Inc. All rights reserved.

14 Interestingly, even though I would not invest in a utility stock expecting to outperform the market, as represented by the S&P 500, Scana Corp has in fact outperformed. Since my focus is on income with this example, the fact that it generated over $8,000 in dividend income versus approximately $2,500 for the S&P 500 clearly met and exceeded my objective. The fact that it also moderately outperformed on a capital appreciation basis over that time is simply an added plus. Page 14, 2018 Advisor Perspectives, Inc. All rights reserved.

15 Once again turning to the FAST Graphs forecasting calculators, I could run various potential return calculations on Scana, just as I did with Johnson & Johnson above. Since this is the same process that I conducted with Johnson & Johnson, I will spare the reader additional oratory and let the graphs and calculations speak for themselves. The point is that I am running precise return and dividend calculations as part of a sound investment strategy. The return calculations for each of the following calculations are shown on the pop-ups (red circle) on each graph. The calculations will include Price Gain, Capital Appreciation, Prorated Dividend, Total Gain, Total Rate of Return and Total Annualized Rate of Return. The calculations are made based on the future points selected on the graphs. Reasonable Case Consensus Estimates Page 15, 2018 Advisor Perspectives, Inc. All rights reserved.

16 Conservative Case Historical Normal P/E Ratio Page 16, 2018 Advisor Perspectives, Inc. All rights reserved.

17 Pessimistic Case Lowest Historical Earnings Growth Rate Page 17, 2018 Advisor Perspectives, Inc. All rights reserved.

18 Most Pessimistic Case Lowest Historical Growth Rate & P/E Ratio Page 18, 2018 Advisor Perspectives, Inc. All rights reserved.

19 Current Income Aggressive Omega Heathcare Investors Inc (OHI) Page 19, 2018 Advisor Perspectives, Inc. All rights reserved.

20 The Johnson & Johnson and Scana cases above were both conservative-oriented income considerations. With my next example, the REIT Omega Healthcare Investors (OHI) I am looking for a more aggressive investment for both spendable current and future income, as well as a higher total return. Omega Healthcare is currently trading at a reasonable P/FFO valuation of 12.6 offers a 5.9% current yield and has historically grown FFO at the above average rate of 11.1%. Consequently, if I was in need of both high current income and the opportunity for a higher estimated total rate of return, I would consider this more aggressive income opportunity. However, as it relates to this article, I would apply the same process of calculating expected future returns with Omega as I did with the more conservative income investments above. Page 20, 2018 Advisor Perspectives, Inc. All rights reserved.

21 Even though I consider Omega Healthcare a riskier investment, the historical returns this REIT has produced encourage me to take a closer look. However, even though I like the valuation and the historical returns, I will nevertheless not proceed until I have calculated reasonable future return possibilities. Hope is not a strategy. Reasonable Case Consensus Analysts Estimates Utilizing the Estimates forecasting calculator, I discover that future FFO growth is expected to be approximately half of what it historically achieved. However, when I run the potential return calculations utilizing a reasonable price/ffo multiple of 15, I discover a significant 22.08% potential total return. This is very intriguing for this reasonable case assumption. Page 21, 2018 Advisor Perspectives, Inc. All rights reserved.

22 Optimistic Case Historical FFO Growth If I run an optimistic case utilizing the REIT s 8-year historical FFO growth achievement of 11%, my potential total annual return calculates to 29.82%. Although this is a very aggressive assumption, it is interesting to run the numbers on an aggressive and optimistic calculation based on the REIT s historical achievements. Page 22, 2018 Advisor Perspectives, Inc. All rights reserved.

23 Growth and Income Conservative Apple Inc As indicated above, there are times when my investment objective turns to above-average total return as a function of growth (capital appreciation) and dividend income. Nevertheless, I approach this Page 23, 2018 Advisor Perspectives, Inc. All rights reserved.

24 investment objective with the same precise return calculation strategy as I have with the others. Apple Inc (AAPL) is one of the most widely-followed and written about companies on the planet. As a result, there are many opinions regarding the company s investment merit, or lack thereof. However, I have rarely seen reasonable or precise calculations or expectations about the future returns the company might provide. In other words, it seems as though the Apple bulls embrace hope as their strategy. They support the stock with many platitudes, but I prefer precise calculations. The following earnings, price and recent dividend correlated graph on Apple depict the power that this franchise has historically generated. Earnings growth has averaged over 33% since coming out of the Great Recession, and the recent dividend has also steadily increased. Page 24, 2018 Advisor Perspectives, Inc. All rights reserved.

25 As a result of Apple s historical growth and in spite of the fact that the market has been applying an almost market-neutral P/E ratio of 16.6, the company still generated total returns that were approximately triple what the S&P 500 would have produced. Interestingly, dividend income has also been almost twice that of the market even though they have only been paying one since September of Reasonable Case Consensus Analysts Estimates When calculations are run for Apple based on consensus estimates of future earnings growth of 16.9%, Apple presents the opportunity for comparable future total annual returns of 16.08% out to fiscal year-end 9/30/2017. Since I consider both of those assumptions reasonable, I am comfortable with my Apple investment at today s valuation and future earnings growth expectations. Page 25, 2018 Advisor Perspectives, Inc. All rights reserved.

26 Pessimistic Case Low Historical P/E If I run the calculations on Apple utilizing a more conservative 5-year normal P/E multiple of 14.1 with the same growth expectations, calculated future total returns still come out at 7.98%. Since I believe that that 5-year historical normal P/E ratio undervalues the company, I am quite comfortable expecting positive future rates of return with an investment in Apple at current valuation. But once again, the important point is that my confidence is not based on hope. Instead, my confidence is predicated based on rational assumptions and precise return calculations. Page 26, 2018 Advisor Perspectives, Inc. All rights reserved.

27 Growth and Income Aggressive AutoCanada Inc The following similar analysis is provided on AutoCanada Inc (ACQ), a more aggressive growth and Page 27, 2018 Advisor Perspectives, Inc. All rights reserved.

28 income opportunity. Once again, I will let the graphs speak for themselves. However, the important point is that I have precise return calculations in mind as part of my strategy and/or thesis for investment consideration. Reasonable Case Consensus Analysts Estimates Page 28, 2018 Advisor Perspectives, Inc. All rights reserved.

29 Aggressive Case 8-Year Historical Earnings Growth Page 29, 2018 Advisor Perspectives, Inc. All rights reserved.

30 Conservative Case 8-Year Historical Normal P/E Ratio Page 30, 2018 Advisor Perspectives, Inc. All rights reserved.

31 Conservative Case Historical Growth Historical Low P/E Page 31, 2018 Advisor Perspectives, Inc. All rights reserved.

32 Growth (Maximum Total Return) Air Methods Corp Page 32, 2018 Advisor Perspectives, Inc. All rights reserved.

33 Even when investing in growth stocks for maximum total return, I still believe in going through the process of calculating future return potentials based on rational assumptions. Once again, I will let the graphs and the calculations they provide speak for themselves. Air Methods Corp (AIRM) is a mid-cap growth stock with no dividend. Consequently, future return will solely be a function of capital appreciation potential. Reasonable Case Consensus Analysts Estimates Page 33, 2018 Advisor Perspectives, Inc. All rights reserved.

34 Valuation-Based Sell Candidates Church & Dwight Co Finally, I think it s important to point out that I conduct a similar process and calculation when contemplating valuation-based sell candidates. For example, if I owned Church & Dwight (CHD) at its current abnormally high valuation, it would give me some concern. However, just like I did with my potential buy candidates, I would run reasonable future return calculations in order to assess the risk of Page 34, 2018 Advisor Perspectives, Inc. All rights reserved.

35 continuing to hold. Hope is not a strategy, and I would find it hard to trust today s current high valuation. Running the numbers out to their logical conclusion provides a sobering reality check. Consensus Analysts Estimates If Church & Dwight were to grow as expected and the stock moved to a reasonable P/E ratio of 15 based on that growth, current shareholders would suffer a total loss of more than 24%, or an annualized total loss of -10%. This depicts the risk of holding on to an overvalued stock. Page 35, 2018 Advisor Perspectives, Inc. All rights reserved.

36 More Optimistic Case If we assume that same estimated growth rate as above, but believe that Church & Dwight deserves its historical normal premium P/E ratio of 20.9, our return would be positive, but rather anemic. Based on historical precedent, this is certainly a possibility. Page 36, 2018 Advisor Perspectives, Inc. All rights reserved.

37 Summary Achieving successful long-term investment results is best accomplished through discipline and by following a well thought-out strategy and plan. An integral component of a sound strategy is the establishment of clear and precise calculations of potential future return objectives. There is no substitute for conducting comprehensive and ongoing research and due diligence. Calculating and then Page 37, 2018 Advisor Perspectives, Inc. All rights reserved.

38 continuously monitoring the progress of precise and rational future return possibilities are an important beginning step. Conclusions With your investment portfolios, running the numbers out to their logical conclusions protects against deluding yourself. Hope is not a strategy. Although at first glance it may seem complex, fortunately there are many tools available to assist with easily accomplishing the task. It s always easier to reach your ultimate destination when you have a clear map and precise directions. Since you may encounter roadblocks along the way, it s vitally important to constantly monitor your progress on your journey to success. Disclosure: Long JNJ,SCG,OHI,AAPL at the time of writing. Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation. F.A.S.T Graphs Page 38, 2018 Advisor Perspectives, Inc. All rights reserved.