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Thoughts on the PEG Ratio and Commodity Investing

July 09, 2009 – Comments (0)

The following is an informational presentation that I am planning on giving to my investment club during our meeting this Saturday.  This was typed up from off-the-top-of-my-head information.  If you think that the information I am presenting is erroneous, let me know.  Thanks.

The SSG mentioned below stands for Stock Selection Guide.  It is the information that is output by the software I use to evaluate companies.  The format is from the NAIC, the association of investment clubs founded decades ago.  For more information on them, you can go to www.better-investing.org for more detail on the SSG and on the cost of their software.

Now on to the presentation.

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PEG Ratio => Price/Earnings Growth Ratio

The PEG Ratio is a valuation metric.  The assertion behind this number is that you should never pay a higher P/E Ratio for a stock than its annualized growth rate.  Thus, if the company is growing earnings 20% per year, the assertion is that the stock's P/E Ratio should not be over 20.  PEG Ratios of 1.00 are considered fairly valued.  Any PEG Ratio above 1.00 will have the PEG followers assume that the stock is overpriced.  Any PEG Ratio below 1.00 will have the PEG followers assume that the stock is underpriced.  

You can have a Historical PEG Ratio or you can have a Projected PEG Ratio, depending on what numbers you use.  If you use the Trailing Year Growth Rate for your calculations, (or in the SSG case, Trailing Years Growth Rate, depending on how far back you take the EPS Growth average), then you are using Historical PEG Ratios.  (This is the one that I always use and which can be found on the SSG.)  If you use analysts' projected earnings growth in future years for your calculations, then you are using a Projected PEG Ratio.  Analysts have proven on average in many studies to be overly optimistic in their growth projections, so the Projected PEG Ratio is frequently going to be lower, (thus making the stock look cheaper), than the actual numbers will bear out when they come in.  Therefore, if you are using Projected PEG Ratio numbers to find cheap stocks, you should probably put in a margin for error in your calculations.  (For example, using 0.75 as the dividing line between underpriced and overpriced stocks instead of the standard 1.00 number used for Historic PEG Ratio calculations.)

The PEG Ratio should not be your only criteria for valuing stocks.  If you use the Historic PEG Ratio calculations, there is no guarantee that the company will continue to grow as fast in the future as it has in the past.  (It should be noted that the SSG does make this assumption and most of our investing criteria is based on this assumption.  You should just realize that this assumption is being made when you fill out the SSG or listen to a presentation referencing an SSG.)  If you use the Projected PEG Ratio calculations, there is not guarantee that the company will be able to meet those projections.  Studies have shown that, on average, companies will NOT meet the analyst projections.  Analysts want to say good things about the stocks they follow.  Their employers often have financial interactions with those companies, (consulting on stock offerings, for example), that would be threatened if the analysts gave disparaging ratings and reviews on the companies that their employers are trying to get future business from.  Therefore, instead of issuing SELL ratings on a stock, an analyst will usually just stop covering it or would rate it as a HOLD.  Because of the above limitations, the PEG Ratio should not be your only investing criteria.  However, if you want to follow a GARP method of investing, (Growth at a Reasonable Price, which is what the club generally does and what the SSG is designed to help you find), then screening for companies with a low PEG Ratio is a good way to get some candidates worth further study.


Commodities

The word "Commodity" is often used in speech to mean "commonplace".  If a product, (such as a computer), is labeled a "commodity", it usually means that there are lots of producers, little differentiation between the producers and thus very little pricing power from an individual producer.  For instance, if Dell tries to price its computers much higher than HP/Compaq is pricing theirs, then in general the consumer will stop buying Dells and will instead buy an HP.  Producers try hard not to let their products become considered "commodities", as a product considered a commodity will in general have a fairly low profit margin due to all the competition.  They will do this through style or marketing, claiming that their product is notably different than the competitions either by styling, reliability or some other metric that they think the consumer will value and will thus be willing to pay a higher price for.  

In the investing world, commodities are either products that are used as feedstocks for other products, (crude oil to gasoline, for example), or are food products, (corn, for instance).  I think of commodities in general as falling in two different categories:  Foodstuffs and others.  Commodities will usually be traded on the Chicago Board of Trade, (the CBOT), the Chicago Mercantile Exchange, (the CME), or the New York Mercantile Exchange.  They are sold in large quantities in general.  (For instance, a single contract might be 1,000 bushels of corn or 1,000 barrels of oil.)  Most of them are traded as futures contracts, (paying a small amount now to guarantee a future price).  For instance, you might pay $1,000 for a contract giving you the right to buy 1,000 barrels of oil for $40 a barrel six months in the future.  Farmers will often use these contracts to sell their crop before they even plant it and use the proceeds to pay for the seed and fertilizer that they need to grow the crop.  This gets them "seed" money, (hence the term), to be able to afford the seed, fertilizer, new farm equipment, etc. that they will need in the coming year to grow the crop.  

The futures contracts can provide a farmer with a guaranteed income to protect him against future developments, but the guarantee can be a two-edged sword.  If the farmer has a crop failure, then the contracts he sold will obligate him to buy enough product from other farmers to fulfill his contractual obligations.  This can be a big expense for the farmer.  Also, if he has a bumper crop but other farmers, (due to drought, for instance), do not have good crops, the value of his crop might exceed the agreed-upon price that he contracted to sell his crop for.  In that case, he will not make as much money as he could have if he were free to sell his crop on the open market.  On the other hand, if a lot of farmers have bumper crops, pushing down the value of his crop at harvest time, then the person that the farmer sold the contract to is obligated to purchase the farmer's crop at the agreed-upon price, even if he could buy the same product cheaper from another farmer.  Many fortunes have been made or lost speculating on futures contracts on various products.

In the Foodstuffs category of Commodities, you have various crops.  You would have corn, wheat, soybeans, frozen concentrated orange juice, (FCOJ, if you remember the movie "Trading Places"), pork bellies and a lot of other items.  A lot of this will go straight to a consumer food manufacturer, (for instance, corn going to Del Monte so that they can can it and sell you a can of corn kernels).  Some of it will go to a feed processor where it will go into animal feed.   Other stuff will go to other companies that will make various other products out of it that will be used to make something else.  (Corn to ethanol, for example.  Or soybeans to soybean oil to plastics, for another example.)  Some of the foodstuffs are never really intended for the consumer directly.  For instance, America is one of the largest growers of soybeans in the world, but most of it, (75% or more, I think), ends up as animal feed, cooking oil, machine lubricant, plastics or other items instead of something that people would directly eat.

The other category would be a catch-all and would be everything else.  Amongst these items would be iron ore, coal, gold, oil, bauxite and others that are raw materials.  Other commodities are refined commodities.  Amongst these would be gasoline, steel, aluminum, etc..  In general, iron ore is iron ore the world over.  The only differential is how much is the concentration.  Some miners might be able to get one ounce of pure gold from every ton of rock they have to mine.  Other miners will have to move 100 tons or more to get that same ounce of gold.  The price of gold will be the same pretty much wherever you buy it, but the miner will have greater or lesser costs they will have to outlay to get that one ounce of gold to sell.  These costs will be based on mineral concentration, cost of labor, cost of energy, (electricity to run the lights, diesel to run the bulldozers, etc.), environmental regulations, (Can you dump the waste product in the local river or do you need to keep it someplace so that you can return the mine to somewhat of a pristine ecosystem after all the gold is gone?), etc..    The same is basically true for a steel manufacturer.  To make steel, you need coal and iron ore and some energy input, (to run the furnaces).  You might also need some other metals, (chromium, for example), to make specialized blends.  Where you get the coal, iron ore or chromium from doesn't matter too much as the elements are all the same, relatively, though access to cheap supplies will give you a definite edge.  It is how efficiently you can run your operation, and your access to cheap raw materials that others might not have access to, that will determine how much profit you can make when you sell your steel.

There are different supply/demand dynamics between food commodities and non-food commodities, so the market forces on them, and thus their reactions to those forces, are different.  Food commodities tend to have fairly even demand dynamics.  People will tend to eat about the same amount of food each year, on average, so the demand for food commodities tends to increase at the same rate as the world population growth rate.  Therefore, fluctuations in price are usually due to some supply disruption, (such as a major drought in the U.S. or Argentina reducing the world's supply of corn or wheat for that particular year or years).  Thus investment in food commodities is usually a bet on the weather and harvest yields.  Bad weather leading to bad yields will drive up prices.  Good weather and good yields will tend to drive down prices.  The big exception to this is some government policy that will either disrupt production, (such as limiting the farmer's access to water due to droughts or ecosystem preservation), or will change the demand dynamic, (such as the U.S. government mandating ethanol usage in gasoline and mandating that it generally come from corn, thus greatly increasing the demand for corn over a short period of time).  

Non-food commodities tend to have fairly stable supply dynamics, (a mine will have a set rate of maximum production over many years time-frame, plus or minus some relatively small variation), but will have large fluctuations in the demand dynamic.  Non-food commodities investing is investing in the future prospects of the local or world economy.  If the local/world economy is growing, then the demand for non-food commodities will increase and thus prices of non-food commodities will go up due to supply/demand.  If the local/world economy is stagnant or shrinking, then demand for non-food commodities will drop, and thus non-food commodities prices will generally stagnate or drop.  The same is true of commodities companies.  If their products are in great demand, due to a growing economy, then the prices for their products will go up, increasing their profits and eventually their share price.  The reverse would also be true.  If their products are not in as great a demand, then the prices on their products will fall, hurting their profits and their share price.  Thus, commodities investing is often used as a bet on the future of the world economy.  If people are bullish on the future prospects for the world economy, they will bid up the prices of commodities and the companies that product them.  If they are bearish on the prospects of the world economy, then they will often bid down the prices of commodities and the share prices of the companies that produce them.

Non-food commodities are also used as a hedge against the rise or fall of a local currency or rising or falling inflation.  If traders think that the price of a local currency, (such as the dollar), will fall against other major currencies, they might invest in commodities or the companies that produce them, especially if the producing company is a foreign one.  The theory is that the price of the commodity in the local currency will go up, thus making a profit for the investor.  The same could be said for a company that produces that commodity.  If their products become more valuable, then their profits should increase, increasing the share price over time.  If the company is of foreign domicile, then the investor would have the added benefit of the company's share price increasing in relation to the value of the investors home currency.

An example of this would be gold.  If an investor thinks that the value of the dollar is going to fall against other major world currencies, (for instance, due to large deficits being run up in the U.S.), then that investor might want to invest in some gold, under the assumption that the value of gold would increase in an inflationary environment, (usually a good bet).  For a potential added boost, the investor might purchase shares of a gold miner instead of buying gold coins or the like.  That way, the value of the company could increase against the investor's home currency, (due to the company's local currency appreciating against the dollar, for example), as well as the company making larger profits due to the general increase of the value of the gold they mine, (assuming that gold is increasing in value on a world basis and not just in relation to the investor's home currency).   Since the industrial usage of gold is a fairly small amount of its total global use, (the rest being for jewelry or for making gold bars or coins), the price of gold is rarely affected by the global economy per se, (rising industrial demand will not add much to the price of gold due to its small proportion of total gold use).  What will affect the price of gold will be the fear of future inflation or monetary deflation, since gold tends to hold up fairly well in those circumstances.  

Other commodities are also used as inflation hedges, or as hedges against the drop in value of a specific currency.  There is speculation that China has recently been a large buyer of many different commodities, (oil, coal, steel, iron ore, bauxite, copper, etc.), as a hedge against a fall in the U.S. dollar.  China is one of the U.S.'s top two creditors and holds hundreds of billions of dollars in foreign reserves.  With the U.S. running trillion dollar deficits for the foreseeable future, many speculate that China is trying to reduce its exposure to the falling dollar by using those dollars to purchase commodities that will not depreciate in value in the future, and that can be used to support future growth.  When the world economy rebounds, increasing demand for all sorts of non-food commodities, their prices will rise due to the increased demand.  By buying them now, China can get the commodities while the prices are still fairly depressed due to the world recession, thus saving themselves a lot of money in the future and protecting themselves against a possible fall in the dollar, (which would also tend to drive up the prices of commodities in dollar terms).

Food commodities are not often used as inflation hedges since it costs more to store food commodities than it does non-food commodities.  Food commodities are subject to spoilage if not kept at a specific temperature and specific humidity levels.  Even grains can be subject to spoilage or loss due to mold, rats, insects, etc., so storage of food commodities involves a lot of care and costs.  This is not usually true of non-food commodities.  Iron ore or bauxite could be stored in a pit or a mine with very little if any care.  Steel or iron might need to be protected against rust, but with painting, galvanizing or just decent storage, it can remain rust-free for quite a while.  Even if some rust is present, iron or steel could often just be resmelted to remove the oxidation, so not too much would be lost.

So commodities can have various usages.  They can be used as raw materials to make things, (iron ore to steel to cars), be consumed directly or indirectly, (corn as cans of corn kernels or in corn syrup or corn oil), and can also be used as investments to hedge against inflation.  Whether or not they are right for you will have to be decided by you, but many think that some commodities, (either as materials, such as gold, or the stocks of the commodities producers), should be a part of everyone's portfolio.  


Craig  [more]

Recs

12

Why invest in the stock market #2.

June 17, 2009 – Comments (2)

I have been giving informational presentations to my investment club as we have some new members and some members fairly new to investing. I have parapharased the presentation that I gave during our June meeting, (to conform to the size limits imposed by the Fool), and am including it here in case anyone might find it interesting and/or useful.  Hope you enjoy this post.
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For a more detailed learning opportunity, see the articles in the Morningstar Classroom at http://www.morningstar.com/Cover/Classroom.html .

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Your perception of stock investing may involve highly frantic traders sweating in front of a half-dozen computer screens packed with information while phones ring off-the-hook in the background.  Feel free to dump these images from your mind, because solid stock investing is not about trading, having the fastest computers or getting the most up-to-the-second information. Though some professionals make their living by creating a liquid market for stocks, actively "day trading" is simply not how most good investing is done by most individuals. Beyond having to expend an incredible amount of effort to track stocks on an hour-by-hour basis, active day traders have three powerful factors working against them. First, trading commissions can rack up quickly, dramatically eroding returns. Second, there are other trading costs in terms of the bid/ask spread, or the small spread between what buyers are bidding and sellers are asking at any moment. These more hidden frictional costs are typically only a small fraction of the stock price, but they can add up to big bucks if incurred often enough. Finally, frequent traders tend not to be tax efficient, and paying more taxes can greatly diminish returns. Just remember that investing is like a chess game, where thought, patience, and the ability to peer into the future are rewarded. Making the right moves is much more important than moving quickly.

If the mechanics of actual trading mean little, what does matter?  When you buy stocks, you are buying ownership interests in companies. So if you are buying businesses, it makes sense to think like a business owner. This means learning how to read financial statements, considering how companies actually make money, spotting trends, and figuring out which businesses have the best competitive positions. It also means coming up with appropriate prices to pay for the businesses you want to buy. Notice that none of this requires lightning-fast reflexes!  You should also buy stocks like you would any other large purchase: with lots of research, care, and the intention to hold as long as it makes sense. Some people will spend an entire weekend driving around to different stores to save $60 on a television, but they put hardly any thought into the thousands of dollars they could create for themselves by purchasing the right stocks (or avoiding the wrong ones). Again, investing is an intellectual exercise, but one that can have a large payoff.

Future profits drive stock prices over the long term, so it makes sense to focus on how a business is going to generate those future earnings.  Competitive positioning, or the ability of a business to keep competitors at bay, is the most important determining factor of future profits. Despite where the financial media may spend most of its energy, competitive positioning is more important than the economic outlook, more important than the near-term flow of news that jostles stock prices, and even more important than management quality at a company. The main purpose of a company is to take money from investors (their creditors and shareholders) and generate profits on their investments. Creditors and shareholders carry different risks with their investments, and thus they have different return opportunities. Creditors bear less risk and receive a fixed return regardless of a company's performance (unless the firm defaults). Shareholders carry all the risks of ownership, and their return depends on a company's underlying business performance. When companies generate lots of profits, shareholders stand to benefit the most.  Companies need money to operate and grow their businesses in order to generate returns for their investors. Investors put money--called capital--into a company, and then it is the company's responsibility to create additional money--called profits--for investors. The ratio of the profit to the capital is called the return on capital. It is important to remember that the absolute level of profits in dollar terms is less important than profit as a percentage of the capital invested.

Creditors are typically banks, bondholders, and suppliers. They lend money to companies in exchange for a fixed return on their debt capital, usually in the form of interest payments. Companies also agree to pay back the principal on their loans. Shareholders that supply companies with equity capital are typically banks, mutual or hedge funds, and private investors. They give money to a company in exchange for an ownership interest in that business. Unlike creditors, shareholders do not get a fixed return on their investment because they are part owners of the company. Shareholders are entitled to the profits, if any, generated by the company after everyone else--employees, vendors, lenders--gets paid. The more shares you own, the greater your claim on these profits and potential dividends. Owners have potentially unlimited upside profits, but they could also lose their entire investment if the company fails.

Companies understand that there is a big difference between borrowing money from creditors and raising money from shareholders. If a firm is unable to pay the interest on a corporate bond or the principal when it comes due, the company is bankrupt. The creditors can then come in and divvy up the firm's assets in order to recover whatever they can from their investments. Any assets left over after the creditors are done belong to shareholders, but often such leftovers do not amount to much, if anything at all. Shareholders take on more risk than creditors because they only get the profits left over after everyone else gets paid. If nothing is left over, they receive nothing in return. However, there is an important trade-off. If a company generates lots of profits, shareholders enjoy the highest returns. The sky is the limit for owners and their profits. Meanwhile, loaners keep receiving the same interest payment year in and year out, regardless of how high the company's profits may reach.

Companies usually pay out their profits in the form of dividends, or they reinvest the money back into the business. Dividends provide shareholders with a cash payment, and reinvested earnings offer shareholders the chance to receive more profits from the underlying business in the future. Many companies, especially young ones, pay no dividends. Any profits they make are plowed back into their businesses.  A company can also use its profits to buy back shares of the company, effectively increasing the percentage of ownership that each of the remaining shareholders has, (and thus giving them a larger claim to any future profits).

The market often takes a long time to reward shareholders with a return on stock that corresponds to a company's return on capital. To better understand this statement, it is crucial to separate return on capital from return on stock. Return on capital is a measure of a company's profitability, but return on stock represents a combination of dividends and increases in the stock price (better known as capital gains).  The market frequently forgets the important relationship between return on capital and return on stock. A company can earn a high return on capital but shareholders could still suffer if the market price of the stock decreases over the same period. Similarly, a terrible company with a low return on capital may see its stock price increase if the firm performed less terribly than the market had expected. Or maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits.  In other words, in the short term, there can be a disconnect between how a company performs and how its stock performs. This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create. Sometimes this perception is spot on; sometimes it is way off the mark. But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business. The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company. The message is clear: What matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.  Over the long term, when companies perform well, their shares will do so, too. And when a company's business suffers, the stock will also suffer.

Now that you know the definition of a stock and the purpose of a company, how do you go about finding more information about a firm you may be interested in? At first, public filings may look like alphabet soup, but when researching a company, they are some of the most important documents you will read.

If a company has a stock on a major exchange like the New York Stock Exchange (NYSE), it is required to file certain documents for public consumption with the Securities and Exchange Commission (SEC). The SEC imposes guidelines on what information gets published in these filings, so they are somewhat uniform. Finally, companies are required to file documents in a timely fashion.

Among the public filings available, the most comprehensive and useful document is the 10-K. The 10-K is an annual report that outlines a wealth of general information about a company, including number of employees, business risks, description of properties, and strategies. The 10-K also contains the company's audited year-end financial statements. In addition to possessing crucial facts and figures, the 10-K also includes management's discussion and analysis of the past business year and compares it with preceding years.  How do you find a firm's 10-K? Just visit the SEC Web site, click on "Filings & Forms," and then "Search for Company Filings." After plugging your company's name into the "Companies & Other Filers" search, you can pick the 10-K out of the list of forms.

The 10-Q contains some of the same data that you'll find in the 10-K, except that it is published on a quarterly basis. Although it's a little less comprehensive and the financial statements are typically unaudited, the 10-Q is a good way to keep tabs on a company throughout the year.

If you're interested in a recent event, typically associated with an earnings release or major company announcement, you can find the details in the most recent 8-K. Also, you may want to occasionally peruse the Form 4's to see if insiders have been trading company stock. Every time company insiders make a transaction in company stock, they are required to file the Form 4, allowing you a peek into whether they are buying or selling shares. While an insider's trading activity may be no smarter than your own, it can at least reveal if management's investment behavior is consistent with its tone.

The investor section of a company's Web site can offer a variety of information. Copies of the public filings are usually available in more flexible, downloadable formats--such as PDF, Microsoft Excel, or Microsoft Word. Also, you can sort through the firm's press releases and examine the latest investor presentations (typically in PDF or Microsoft Power Point formats).  It's definitely worth a visit to the company Web site. It doesn't take long, and reading the press releases will give you some of the most up-to-date information available. Also, it may be useful to see how a company does business on the Web.

I'll plan on posting the one I do for my July meeting also.  Hope these are informative to some people.


Craig  [more]

Recs

8

Why invest in the stock market #1.

June 15, 2009 – Comments (1) | RELATED TICKERS: CSCO , JNJ

I have been giving informational presentations to my investment club as we have some new members and some members fairly new to investing. I have parapharased the presentation that I gave during our May meeting, (to conform to the size limits imposed by the Fool), and am including it here in case anyone might find it interesting and/or useful.  Hope you enjoy this post.
________________________________________________________________________________________________

For a more detailed learning opportunity, see the articles in the Morningstar Classroom at http://www.morningstar.com/Cover/Classroom.html .  [more]

Recs

4

We The People Stimulus Package

April 04, 2009 – Comments (2)


Interesting video that a friend sent me a link to. After reading the Fool story about "How Banks Can Exploit Geithner's Plan", ( http://www.fool.com/investing/dividends-income/2009/03/31/ho...)
and the follow-up story, "More Proof Banks Will Exploit This Bailout", ( http://www.fool.com/investing/dividends-income/2009/04/03/mo... ), I think maybe the teabag idea has some merit. (Actually, I was told just to send the paper tag on the teabag, as the teabag itself would be considered a suspicous substance and would just be thrown away.) Anyway, the video is interesting to watch. I would recommend it to all. Just my opinion though.


Craig


http://www.youtube.com/watch?v=jeYscnFpEyA&NR=1

  [more]

Recs

6

New thought on how to deal with all the toxic assets on bank's balance sheets.

February 11, 2009 – Comments (11) | RELATED TICKERS: FMCC , FNMA , C

I have been reading a lot about the new plan for TARP money and how to get the bad assets off of banks' balance sheets.  I think I have come up with a new plan.    [more]

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