Sunday, August 19, 2012

THE CURSE OF THE ORDINARY ... Facebook Share Price Down 50% ... Could Drop Another 50% ... Pension Fund Investing and Individual Investing are Very Similar ... Buy (at good prices) and Hold (for a long time) the Shares of Good Companies

Yesterday we discussed the sickening "pass it on to the grandkids" approach to public sector pension funding for California school districts. Today let's ask how those and other pension funds will be invested in order to earn enough money to be able to pay those pension benefits down the road.

In my view, the funds should be invested heavily, if not completely, in a diversified portfolio of blue chip, dividend paying and growing stocks. Not in bonds or so-called high P-E stocks.

Although there are many ways to value stocks, I prefer to look carefully at two basic metrics before buying: (1) the stock's P-E (price-to-earnings) multiple; and (2) its cash dividend yield (dividend-to-price). Today "Mr. Market's" stocks are priced at roughly 14 times earnings (S&P at $1,400+ and Earnings at ~$100). Its dividend yield is over 2%, although it's not hard to find rock solid companies with a yield of 3% or more (GE, Intel and Pfizer, for example).

I also prefer not selling once I've made the purchase, so it's important not to overpay when buying. In that regard, I stay away from new stock issues of stock market darlings that don't have a long track record and solid future outlook with respect to rewarding shareholders with cash dividends. I also don't often pay more, and often pay less, than the market multiple when buying. So if the P-E is ~14, like today, that's pretty much the top for me. I generally adhere to the "value" style of investing.

With respect to dividends, the stock's dividend yield and prospects for increases over time are also important considerations. Discovering the dividend yield of any stock is a simple calculation. If dividends of $1 annually are compared to a share price of $40, the dividend yield is 2.5% (1 divided by 40 = 2.5%). Since today interest rates on government bonds and other fixed income investments are often lower than the dividend yield on many blue chip stocks, that makes these stocks a most attractive value, if only for the dividend income.

But stocks also protect investors from inflation over time, unlike bonds and other "safe" fixed income investments, through the appreciation of their shares over time. Preserving and enhancing real purchasing power is another great reason, for individuals and pension funds alike, to own stocks and not bonds these next fifty years or so.

In other words, since the yield on earnings (not dividend yield but earnings yield -- earnings divided by share price or earnings reciprocal) are approximately 7% of the overall stock market's value ( $100 divided by $1400 = ~7%), that compares quite favorably to fixed income returns (bonds, CDs, etc.) of less than 1% to 3% to 5% currently.

7% beats them all, and 10% (P-E of 10) beats them all by a bunch.

Hence, "Mr. Market" isn't overvalued on the whole. For long term investors, it's definitely not a bad time to buy if you can stomach the daily, weekly and even annual volatility of share prices.

But that doesn't say anything about which individual stocks to purchase and own. Today let's look at Facebook as an example of what NOT to own. As a starter, Facebook pays no dividend and probably won't for some time, if then.

So far Facebook shares have been a lesson in betting on faith and hope over evidence and experience.

The faith and hope part is that it's a new "hot tip" juggernaut that can do no wrong. The evidence and experience part is that there's no objective way to tell just how successful a financial investment the company or the company's shares will be over time. It has no track record and has been priced "sky high" with respect to its offered price compared to its earnings.

Finding the Facebook Magic tells of the "curse of the ordinary" danger signal for individual investors:

"Want to better understand the crazy world of technology stocks? That requires having a grasp of something that can best be described as the curse of the ordinary.

What’s more, that curse could mean that Facebook, already down by nearly 50 percent from its offering price to $19.05 on Friday, could drop to less than $10, if you consider valuations.

As is often typical in the market for shares in technology companies, the usual stock valuation methods can only take you so far.

Most efforts to value companies rely on guessing the worth of future profits. But the future for technology companies is often less knowable than for firms using traditional approaches to generate earnings in traditional industries.

In times of optimism, that knowledge dearth can actually work to the advantage of technology companies. Executives fill that emptiness with promises of new, paradigm-breaking ways of doing business, while Wall Street analysts follow behind projecting amazing profits. In short, it’s all about being seen as extraordinary.

That has allowed Facebook to go public at a stock price that was 100 times its earnings per share. The belief was that Facebook could entwine advertising into all interactions on its site to generate enormous revenue.

Indeed, each of the companies that have gone public in recent months has needed one main magical story. For Groupon, it was that the company had found a revolutionary marketing tool that was perfect for small businesses. The untapped market was theoretically huge.

But the nightmare begins when investors stop believing in that central story. Earnings don’t have to be terrible, and they haven’t been at Facebook, Groupon and Zynga, the hardest hit. They just have to contain a few clues that the dream won’t be achieved.

Then, the transition from extraordinary to ordinary is brutal. . . .

This is a critical time for Facebook.

The faith level in the company is declining, but it may drop further. Right now, the social network is trading at 32 times the earnings that analysts are expecting for 2013. That’s not terribly expensive, but it’s far above Google’s 2013 price-to-earnings ratio of 14 times.

If Facebook traded at 14 times analysts’ 2013 earnings forecast, its shares would be just below $9."

Summing Up

Facebook shares are still way overpriced compared to any standard metric of value. 

The price to earnings ratio (P/E) of the market is roughly 14 currently, and that's also the approximate value attached to Google's share price.

{NOTE: To repeat, to arrive at the stock's P/E, simply divide the price of a share by the per share earnings of the company. Thus, a $100 share price for a company earning $5 per share would be 20 and for that same company earning $10 per share would be 10 and so forth. All other things being equal, the lower the P-E the better when buying.}

That's another good reason to stay with established companies with a track record of solid earnings behind them. If they're selling for less than the market multiple, they probably aren't overvalued.  Of course, there are other metrics but that's the main idea behind not overpaying.

Thus, when buying it's wise to stay with the proven companies that aren't overvalued, that pay cash dividends, and have solid prospects for increasing earnings and dividends over time.

As individual investors, there's no reason to speculate or gamble with our money. Just invest for the long haul in the shares of known and proven companies --- at good entry prices. 

In baseball, while the batter knows it's always best to wait for the right pitch, he's up against the three strikes and you're out rule.

With stock purchases, there is no such rule. We don't have to swing until we decide the time is right. Just let Mr. Market keep serving them up.

Finally, when it comes to investing for the long term, boring is good.

Thanks. Bob.

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