Saturday, June 23, 2007

Is buying high earnings-to-price (or low PE) stocks a good strategy?

Reader's Question: Is buying stocks with high earnings-per-share (EPS) as a percentage of stock price a good investment strategy? I am considering investing in a Bombay-listed Indian bank (current share price of 85 rupies) whose EPS has been about 15% of share price for the past three years. If this trend continues, will I be able to receive my initial investment back through EPS over the next six to seven years? Will all the EPS be deposited into my bank account?

Low PE: An Entree into Low PEG

We can restate your main question in more familiar stock market jargon by inverting your earnings-to-price percentage to get a price-to-earnings ratio: Does buying stocks with low price-to-earnings ratios (P/E) produce higher returns? A wealth of literature exists on this topic of low-PE stocks within the framework of value investing. Rather than rehash the basics, I cite an article available online--This Stock Is So Cheap! The Low Price-Earnings Story--for your edification and perusal. The author of the article draws this conclusion:

The conventional wisdom is that low PE stocks are cheap and represent good value. That is backed up by empirical evidence that shows low PE stocks earning healthy premiums over high PE stocks. If you relate price-earnings ratios back to fundamentals, however, low PE ratios can also be indicative of high risk and low future growth rates. . . . [A] strategy of investing in stocks just based upon their low price-earnings ratios can be dangerous. A more nuanced strategy of investing in low PE ratio stocks with reasonable growth and below-average risk offers more promise, but only if you are a long-term investor.

To the above, I would add that I tend to favor "low PEG" as a more useful indicator of potential upside than low PE. Since PEG is the "super-ratio" of price-to-earnings ratio divided by earnings growth rate ("PEG" = PE/G, where "PE" = P/E), PEG embodies a growth component that PE lacks. In other words, by considering low PEG stocks, investors can concurrently select both good current value (relatively low PE) and good expected growth (relatively high G). For a discussion of stock returns, EPS growth, PE and the importance of low PEG, please have a look at an earlier blog entry.

Investment Cash Flow: Fixed-Income vs. Stocks

If you could find a fixed-income investment that pays 15% current interest (some junior mortgages on real estate and certain junk bonds pay this type of return, though both involve considerable payment default risk), your annual scheduled investment cash flows would be what you have in mind: 15 dollars (or rupies if in India) for every 100 dollars (or rupies) of principal invested. Further, given a seven-year maturity, you would (assuming the borrower does not default) receive more than your initial investment back in interest payments (7 years x 15% = 105%), which, when combined with your principal, would actually amount to total cash flows of 205% (105% interest + 100% principal) over the full holding period.

Unlike fixed-income investments, stocks do not have any pre-scheduled set of cash flows. Although you might be able to buy a stock at an earnings-to-price percentage of 15% (PE of 6.7), there is no direct linkage between your investment cash flows and the company's earnings. Instead of making pre-scheduled payouts to equity investors, companies pay periodic (usually quarterly or semiannual) dividends which are typically some fraction of earnings. Based on earnings results, availability of cash flow and company policy, management can raise or lower dividends from one period to another.

With the exception of very long, multi-decade investment horizons, the primary determinant of your returns from stock investing will be, not dividends, but the terminal market value of the stock when you sell it (or simply wish to calculate your mark-to-market "paper profits" without actually selling). The uncertainty of the future price of a stock is what makes stock investing risky business but also has the potential of delivering great financial rewards to those who succeed over the long haul.

In your example of buying an Indian bank stock (possibly Andrha Bank?) at 85 rupies, your investment cash flows would consist of relatively small dividends, amounting to about two or three rupies per share per year. Whenever you decide to sell your shares, you will receive whatever the market price is at the time of sale, which, of course, can be either higher or lower than 85 rupies and will typically become the main component of your net profit or loss over your holding period. Both dividend payments and proceeds from sale of your shares will end up in your brokerage account and can then be transferred to your bank account if you so desire.

Saturday, June 16, 2007

Should a high-net-worth individual take out a mortgage to buy a home?

Reader's Question: Consider a high-net-worth individual whose assets are fully invested in fairly liquid, leveraged investments that are returning around 15-20% CAGR. If the investor should decide to make a large purchase such as a home, would he be better off A) taking out a mortgage for the purchase, B) liquidating some assets to make the purchase, or C) liquidating assets and purchasing several futures contracts to restore the return potential lost by liquidating the assets?

I will answer your question from two perspectives--first by determining a financial breakeven between the alternatives you propose, and next by referencing behavioral norms among high-net-worth U.S. households.

Financial Breakeven Analysis

Based on wealth data from a 2004 survey conducted by the Federal Reserve, the net worth thresholds corresponding to landmark percentiles in the distribution of U.S. household wealth are: $93,000 at 50th percentile, $830,000 at 90th percentile, $1.4 million at 95th percentile, and $6.0 million at 99th percentile. For concreteness, let's assume that the high-net-worth individual (call him Mr. Rich) in our discussion sits at the 99th percentile, just entering the top 1% of U.S. households with a net worth of $6 million. Further, suppose that Mr. Rich and his family have found a $1.2 million house that will be absolutely perfect for them, and that their banker is offering them a 7% APR loan at 75% loan-to-value (i.e., they can borrow $900,000) for their purchase.

Should the Rich family:

A) Mortgage: Sell investment portfolio assets worth $300,000 to cover the down payment on the home, and borrow the balance of $900,000 at 7% APR to close escrow;

B) Liquidation: Sell assets worth $1.2 million to buy the house, and politely decline the banker's loan offer; or

C) Liquidation and Futures: Proceed as in alternative B above but also call up their broker and place an order to buy futures (e.g., e-mini contracts on the S&P 500) in the amount needed to re-establish the equity market exposure lost through the $1.2 million asset sale?

Using a five-year time horizon, we can run numbers under the three scenarios to arrive at the portfolio return sensitivities shown in the graph to the right.
Notice that there is a breakeven between the "mortgage" and "liquidation" alternatives that sits at the loan APR rate: if Mr. Rich can achieve higher than a 7% annual return through investing his family's assets, he is better off taking out the mortgage (alternative A); on the other hand, if his investment return will end up shy of 7%, he should not borrow money to buy the home (alternative B). The "mortgage" alternative is, of course, the more aggressive of the two, because it adds overall market exposure to the portfolio (adds $1.2 million real estate but reduces equity holdings by just $300,000), rather than swapping one for the other as in the "liquidation" case (which adds $1.2 million real estate by offloading the same principal amount of equities).

The "liquidation and futures" case (alternative C) is a way for Mr. Rich to achieve the economic equivalent of the "mortgage" case (alternative A) without taking out the mortgage. While the mortgage involves an application process, loan fees, a property appraisal, ongoing monthly loan payments and possible prepayment penalties, buying futures contracts also involves management time and costs: initial and maintenance margin requirements, quarterly rolls from current to next contract, brokerage fees, taxable short-term gains and losses, etc. Of course, when all factors are taken into account, there can be measurable cost differences between alternatives A and C; however, since the Rich family's portfolio return five years down the road will be determined largely by the performance of their equity and real estate investments, for the scope of this discussion we can treat A and C as being economically comparable.

Therefore, Mr. Rich really has a choice between 1) maintaining his level of equity market exposure and introducing the real estate market exposure that accompanies buying the house through either of alternatives A or C; or 2) swapping equity market exposure for real estate market exposure to the extent needed to buy the house through alternative B. Alternatives A and C are inherently more aggressive than alternative B, but before deciding on one alternative over another, let's see how other high-net-worth individuals typically manage their personal finances.

How the Rich Differ from the Poor

In an earlier blog entry I discussed U.S. household balance sheets. Here I highlight pertinent results of the Federal Reserve's Survey of Consumer Finances from 2001.

The asset side of household balance sheets shows that as people become wealthier their homes (house) and cars (vehicles) become a lesser percentage of their assets, while their investments (stocks, retirement accounts) and owner-run businesses (closely held business) become their most significant assets. In moving from the bottom 50% to the the top 1% of U.S. households by net worth, the value of the primary residence as a percentage of household assets falls from about 60% to about 10%. As households become wealthier, even though they move into increasingly pricey homes, their homes on average become a smaller portion of their overall portfolio assets. Extreme examples of this inverse relationship between wealth and value of home as a percentage of total assets or net worth are: Bill Gates, whose Medina, Washington, 66,000 sq. ft. mansion, if valued at Zillow's Zestimate of $136 million, comprises just 0.2% of his $56 billion net worth; and the more frugal Warren Buffett, whose Omaha, Nebraska, comparatively modest 6,000 sq. ft. home, if taken to be worth about $1 million, represents a minuscule 0.002% of his $53 billion net worth.

It is also interesting to note that wealthier households tend to have less debt as a percentage of total assets. Whereas the bottom 50% of U.S. households by net worth are leveraged at around 56% household debt as a percentage of total assets, the top 1% of U.S. households have leverage of only about 2% (though I suspect that their businesses and investment holdings could harbor some degree of leverage that escapes coverage by the Fed survey). As a practical matter, people with steady employment and modest savings are typically among those who take out mortgages when buying their homes. On the other hand, I would find it hard to believe that many of the super-rich, such as Gates and Buffett, would ever bother to borrow money against their homes, even though their consistent double-digit portfolio returns tend to exceed single-digit mortgage rates. I would be even more surprised to hear about any of the super-rich actually doing the calculation to buy a handful of futures contracts to replace the equity market exposure they forego by tying up cash in their personal residences.

I, of course, am a mere pauper compared to anyone in the super-rich category, but I too favor the simplicity of owning my home free-and-clear without a mortgage and without having to remember to roll futures contracts every quarter to put my home equity to better use. Sure, when viewed in isolation as a textbook mortgage vs. no mortgage breakeven problem, this behavior may not seem most economically optimal. However, within the real-life context of total portfolio management, I sense that most households in the high-net-worth category are unleveraged, cash buyers of their personal residences who do not bother with futures contracts.

So, if you prefer to focus on your primary investments without bothering with mortgages and futures, just liquidate some assets and use the cash to buy the home (alternative B). On the other hand, if you are eager to give your net worth an incremental boost, confident that your investments will continue to produce the 15% to 20% returns they have been, and don't mind spending a little administrative time on a mortgage or futures, go with either alternative A or alternative C. A factor to consider in deciding between the alternatives is the tax consequences of liquidating assets--if you have large unrealized gains and wish to avoid paying capital gains tax near-term, taking out the mortgage and selling assets only in the amount needed to cover your down payment (alternative A) may be more appealing than liquidating additional assets and rolling futures (alternative C).

Friday, June 15, 2007

How can small investors invest in commercial real estate?

Reader's Question: Could you recommend any investment group where small investors can pool their money to purchase investment properties such as shopping centers, apartments, etc.?

What you appear to be looking for is a reputable national or regional real estate syndication company through which to invest, relying on their deal-sourcing and management expertise to achieve solid returns in commercial real estate. I will assume for the sake of this discussion that as a small investor you are looking to invest anywhere from a few thousand dollars to a few tens of thousands of dollars, but not much more than about $100,000 to begin with.

Basically, there are two primary avenues for achieving exposure to commercial real estate:

1. Direct investment in properties as a self-guided investor either individually or through small partnerships, LLCs or tenants-in-common (TIC) arrangements; and

2. Indirect investment in real estate by purchasing shares of publicly listed and traded REITs.

By doing their own due diligence, small investors can invest directly in a variety of commercial real estate properties, such as free-standing retail locations, apartments, small office buildings, mobile home parks, etc. Loopnet (Nasdaq: LOOP) is a good starting point for seeing what properties are available in markets throughout the U.S. The commercial property brokers who post their listings on Loopnet can provide additional listings and local market information. Since you expressed interest in retail properties, you might also try Net Lease Exchange for listings of triple-net, single-tenant investment opportunities.

The other common way to achieve exposure to commercial real estate is through REITs. The National Association of Real Estate Investment Trusts (NAREIT) offers information about investing in REITs on their website and tracks various REIT indices and the performance of individual REIT stocks across the retail, office, industrial, apartment and other less traditional sectors. More information on individual REIT stocks is, of course, available via their ticker symbols on Yahoo! Finance and other financial websites.

Between these two popular extremes--small investment groups set up locally and publicly listed REITs with thousands of investors--there tends to be a void dictated by securities laws aimed at protecting unsuspecting small investors from fraud and other financial chicanery. Private-equity investment vehicles do exist for so-called "sophisticated" investors with at least $1 million of liquid net worth, typically with minimum investment requirements of $100,000 or more, and there is an active wealth management industry catering to the growing number of such millionaires. However, for small investors with less capital to invest, the practical alternatives are really the two I have outlined.

(Click above image to enlarge)

So, if you are eager to invest in commercial real estate and apartments, here is what I suggest:

1. As I have done over the years, strive to adopt a do-it-yourself attitude and go out and look for commercial real estate and apartment buildings for sale in your local market. Try to identify properties that you believe are attractively priced and offer generous upside potential. If you find a property that you want to buy but cannot because it requires a larger down payment than you can afford or a larger loan than you qualify for, try to find an investment partner or two of like mindset to pool funds with.

2. Using typical financial operating ratios (gross rent multiple, cap rate, cash-on-cash return, price-to-FFO, etc.), compare the direct investment opportunities you are finding in your own local market with publicly listed REITs invested in the same property type, analyzing the income statement and balance sheet of a REIT as if you were buying its entire portfolio of properties. If you find that REITs offer more attractive ratios than you can achieve by investing directly in properties locally, you might be better off buying REIT shares.

Over the years I have achieved exposure to investment real estate both through forming partnerships with small groups of local investors and through buying shares of publicly listed REITs. In 2002, following the dot-com bust when stock prices were depressed and office vacancy rates rose to double-digit figures in many metropolitan markets (where I live in Bellevue, Washington, the office vacancy rate soared to above 25%!), I performed the type of financial ratio comparison I mentioned above and concluded that office REITs were more attractive than any office buildings or apartment properties I could buy directly anywhere in the Pacific Northwest. As good fortune would have it, two of the REITs I invested in--Equity Office Properties run by Sam Zell and Trizec Properties managed by a former Equity Office CEO--were recently bought out by the Blackstone Group at significant premiums to where the shares had been trading prior to the private-equity buyout offers, providing very healthy returns over my five-year holding period.

If you happen to reside in the Seattle-Bellevue area and wish to exchange views on real estate opportunities you are seeing locally, I would be happy to share further information and opinions. For anyone looking to gain exposure to commercial real estate and particularly for those who reside outside of my local market in Washington state, I offer an alternative suggestion: Although most REITs appear to be fully valued following their sequential double-digit returns over the past few years, I believe that a few are worthwhile considering at current price levels.

One such REIT is HRPT Properties (NYSE: HRP), an office REIT now trading at about $11 per share, 17% below its dividend-adjusted all-time high of $13.31 reached in February 2007. With shares priced at below book value (price-to-book ratio is 0.98) and forward price-to-FFO of 9.2, HRPT looks relatively cheap compared to the other major office REITs. Based on its stable long-dated lease portfolio of high-quality government and medical-related tenants and presence in markets offering incrementally higher cap rates and cash flow, HRPT offers very good upside potential with limited downside risk at present price levels. Also, its dividend yield of 7.6% (at $0.84 per share annually) should be appealing to anyone seeking current income beyond money market and bank CD rates. (I do not currently have a position in HRPT but will consider establishing one the next time I rebalance my portfolio.)