Mutual Funds and ETFs

Mutual-Funds-and-ETFs

Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or busy investors to participate in financial markets. This post will help you learn about the different types of funds, their pros and cons and other considerations of owning mutual funds and ETFs.

What is a Mutual Fund?

A mutual fund is pool of money collected from the investors in the fund. The investors own shares in the mutual fund itself, but not in the individual securities owned by the fund. However, other than closed-end funds discussed below, an investor’s return is his or her share of the returns of the aggregation of the returns of the individual securities owned by the mutual fund. That is, if, on average, the securities in the mutual fund issue dividends of 3% and appreciate by 2%, fund owners will receive a dividend distribution equal to 3% of the value of their share of the pool plus the value of their ownership share will increase by 2%.

Most mutual funds also issue capital gain distributions once or twice a year. If the mutual fund had a gain on the aggregate amount of securities sold in the year, it will often distribute the amount of the gain to investors as a capital gain distribution in proportion to their ownership shares in the pool.

Mutual funds can be purchased directly from the fund manager or through a broker. Most mutual funds are not traded on exchanges. Purchases and sales of mutual funds occur once a day, with all buyers and sellers receiving the same price which is equal to the net asset value of the underlying assets. (See below for more information and exceptions.)

What is an ETF?

Exchange-traded funds or ETFs have several characteristics in common with mutual funds:

  • They are pools of money collected from their investors.
  • Investors share in the returns of the aggregation of the individual securities.
  • ETFs can hold a wide range of securities, including stocks, bonds and commodities.

These are a few of the ways in which ETFs differ from mutual funds:

  • They are exchange-traded securities (as implied by their name), so they can be bought and sold any time the exchange is open. As such, the price you pay or receive when you buy or sell an ETF can vary over the course of a day.
  • While many mutual funds have a minimum investment requirement, most ETFs do not.

Types of Mutual Funds and ETFs

There are many features of mutual funds and ETFs that are important in determining the best funds for your portfolio. Almost all of these features apply to both mutual funds and ETFs.

Active vs. Passive Management

An actively managed fund has a fund manager who is responsible for selecting the securities that will be owned by the fund. The manager decides when to buy and sell each security.  By comparison, the securities owned by a passively managed fund are determined so that the performance of the fund tracks a certain basket of assets.

Index funds are a common type of passively managed funds.   An index fund is a mutual fund or ETF that has a goal of matching the performance of an index, such as the S&P 500, the Dow Jones Industrial Average or the Fidelity US Bond Index.

There are other passively managed funds whose trades are determined so as to produce returns similar to a certain segment of a market, such as a particular industry or region of the world, that may or may not have an index that measures those returns.

Securities Owned

Funds can own a wide variety of securities – everything from stocks and bonds to commodities, among others. As you are looking for a fund, you’ll want to decide what type of security you are seeking.

Geography

Most funds focus on a specific geography. Many mutual funds focus on US investments, while others purchase securities from within a region of the US, the whole world or segments thereof, such as the developed world excluding the US. While I hold most of my North American equity positions in individual companies, I use mutual funds to diversify my portfolio globally.

Market Segment

Just as funds focus on a specific geography, they sometimes invest in one or more market segments.   Some funds focus on a specific industry, such as natural resources or technology or financial companies. If you think a particular industry is going to benefit from trends in the economy, such as healthcare as the population ages, you might want to buy a fund that focuses on the healthcare industry. On the other hand, you might want to avoid healthcare stocks if you think that the healthcare industry might be at risk of significant disruption from changes in the government’s role in healthcare.

Other funds focus on the size of companies.  For example, an S&P 500 Index fund only buys positions in companies in the S&P 500 which, by definition, are large.  Other funds focus on middle-sized companies (middle-sized capitalization of mid-cap) or smaller companies (small-cap).

Another “industry” on which many funds focus is municipal bonds. These funds invest in bonds issued by municipalities. In many cases, interest from municipal bonds and municipal bond funds is not taxed by the Federal government or in the state in which the municipality is located. For example, if you buy a bond issued by the City of Baltimore, it is likely that it will not be taxed at all if you are a Maryland resident.

Appreciation vs. Dividends

Some funds focus on high-dividend investments, while others focus on appreciation in the value of the securities they own. You can learn the focus of a fund by looking at its details either in a summary or its prospectus. Funds that focus on high-dividend yields often have “high-dividend” in their name, but not always. The type of return targeted by funds you purchase will impact the specific securities owned by the fund. In addition, the type of return impacts the taxes you will pay (discussed below).

Growth vs. Value

Companies are often categorized between growth and value, reflecting the two primary reasons that stock prices increase. The stock price of a growth company is expected to increase because the company will increase its profits. By comparison, the stock price of value company is expected to grow because its valuation, often measured by the price-to-earnings or P/E ratio, is considered low and likely to return to normal.

Closed-end vs. Open-end Funds

Most funds are open-end funds. The price you pay for these funds is equal to the market value of the securities owned by the fund divided by the number of shares outstanding.   This price is known as the Net Asset Value. You can buy shares from and sell shares back to the fund owner at any time at the net asset value.

A closed-end fund differs in that the number of shares available is fixed when the fund is first created. When you buy and sell shares in a closed-end fund, the other party to the transaction is another investor, not the fund owner.  In fact, closed-end fund shares trade in the same manner as if the fund were a company. As such, the price is not the net asset value, but rather has a market value that reflects not only the net asset value but also investors views of the future performance of the fund.

I found Investopedia to have some great information about open-end funds and closed-end funds.

Advantages and Disadvantages of Mutual Funds and ETFs

The biggest advantage of mutual funds and ETFs is the ease with which you can diversify your portfolio, especially in asset classes or market segments with which you are unfamiliar. I think index-based ETFs are a terrific way for new investors to participate in markets. As I mentioned above, I use mutual funds for international stocks, as I don’t know enough about economies and market conditions outside the US, much less about individual companies, to make informed buying decisions.

A drawback to actively-managed funds is that they tend to underperform the market. That is, there are not many money managers who can consistently produce returns that exceed their target benchmarks. This difference is even greater when returns are reduced for fees paid by investors (discussed later in this post).

There are many sources for statistics about mutual fund returns. CNBC states that, in every one of the nine years from 2010 through 2018, more than half of actively managed large-cap funds produced returns less than the S&P 500. The same article also indicates that 85% of those funds underperformed the S&P 500 over a ten-year period and 92% underperformed over a 15-year period. As such, care should be taken when investing in actively managed funds. If you are looking for funds that will produce returns similar to broad market indices, such as the S&P 500, an index fund might be a better choice.

Income Taxes

There are four types of returns that are taxed when you own mutual funds or ETFs that hold stocks or bonds held in taxable accounts. Funds held in tax-deferred or tax-free accounts will have different tax treatment. The taxable returns on other types of funds will depend on the types of returns generated by the underlying assets.

Capital Gains

When you sell your ownership position in a fund, the difference between the amount you paid when you bought it and the amount you received when you sell it is a capital gain.   The taxation of short-term capital gains (related to securities owned for less than one year) is somewhat complicated in the US. Long-term capital gains are taxed in the same manner as dividends in the US, at 15% for most people. In Canada, capital gains are taxed at 50% of the rate that applies to your wages.

Interest

When you own a bond fund, interest paid by the issuers of the bonds owned by the fund is taxable in the year the interest payment was made. In the US and Canada, interest held in taxable accounts is taxed at the same rate as wages, except for certain municipal and government bonds which may be exempt from state or Federal taxes.

Dividends

Dividends paid by companies owned by a fund are taxable in the year the dividends payments are made. For most people in the US, there is a 15% Federal tax on dividends from investments held in a taxable account plus any state taxes. In Canada, dividends are taxed at the same rate as wages.

Capital Gain Distributions

Over the course of a year, a mutual fund may sell some of its assets. The capital gains earned from those assets are distributed to owners as capital gain distributions. Capital gain distributions are taxed in the same manner as capital gains.

Fees

There are generally three types of fees that can affect your returns on ETFs and mutual funds: front-end loads, operating expenses and commissions. Schwab identifies two other hidden costs that are a bit more obscure, so I’ll refer you to its post on this topic if you want more information.

Front-End Loads

Some mutual funds require you to pay a fee when you make a purchase. The fee is usually a percentage of your investment. For example, you would pay $10 for every $1,000 you invest in a fund with a 1% front-end load. If you purchased this fund, its total return on the underlying investments would need to be 1% higher over the entire period over which you owned it than the same fund with no front-end load for you to make an equivalent profit.

Funds that don’t have a front-end load are called no-load funds.

Operating Expenses

Mutual funds and ETFs, even those that are passively managed, have operating expenses. The operating expenses are taken out of the pool of money provided by investors. Every fund publishes its annual operating expense load, so you can compare them across funds. Funds with higher expense loads need to have higher returns on the underlying investments than fund with lower expense loads every year for you to make an equivalent return.

ETFs tend to have much lower operating expense loads than mutual funds. Similarly, passive funds tend to have lower operating expense loads than actively managed funds.

Commissions

If you purchase a mutual fund or ETF through a broker, you may pay a commission both when you buy the fund and when you sell it. A commission is a fee paid to the broker for the service it provides allowing you to buy and sell securities. Many brokers have recently reduced or eliminated commissions on many ETFs. If you purchase the mutual fund or ETF directly from the fund manager, you will not pay a commission.

Dividend Reinvestment

Many funds allow you to automatically reinvest distributions (i.e., interest, dividends and capital gain distributions). Although it includes all types of distributions, it is often called dividend reinvesting or reinvestment. It is a great way to ensure that all of your returns stay invested, as you don’t have to keep track of the payment dates on any distributions so you can reinvest them.

I have a few cautions about dividend reinvestment.

First, you want to reevaluate your choice of fund periodically. If you blindly reinvest all of your dividends and something changes that makes the fund a poor fit for your portfolio, automatic dividend reinvestment will cause you to have more money invested in something that you don’t want.

Second, you’ll want to be aware of the tax implications of dividend reinvestment – one of which is helpful and one of which requires some care – if you hold the fund in a taxable account.

Increased Cost Basis

As indicated above, when you sell a fund, you pay capital gains tax on the difference between your proceeds on sale and what you paid for the fund. The distributions that you reinvest are considered part of what you paid for the fund. You’ll need to take care to keep track of the amounts you’ve reinvested, as they increase your cost basis (the amount you paid) and decrease your capital gains tax.

Taxes on Distributions

Even if you reinvest your distributions, you need to pay taxes on them in the year in which they were paid. As such, if 100% of your distributions are automatically reinvested, you’ll need to have cash available from another source to pay the income taxes on the distributions.

Selecting Mutual Funds and ETFs

There are thousands of mutual funds and ETFs from which to choose. Here are my thoughts on how you can get started.

Set your Goals

  1. Determine what type of fund you are seeking. Are you trying to focus on a small niche or the broader market?
  2. Narrow down the type of fund that will meet your needs. Do you want an actively managed fund or a passive one? Are you interested in an open end or closed end fund?  Do you want the fund to look for growth companies or those with low valuations?

Identify Some Funds

  1. Once you’ve narrowed down the type of fund you’d like, you can use a screener to help you further narrow down your choices. Most large brokerage firms, as well as many independent entities, have mutual fund and ETF screeners. For example, Morningstar, a global investment-research and investment-services firm, has a free screener (after you sign up at no charge) at this link.
  2. Look at the ratings of the funds that are identified. The entity assigning the ratings usually expects higher rated funds to perform better than lower rated funds.
  3. Look at the historical returns. While past performance is never a guarantee of future performance, funds that have done well in the past and have consistent management and strategy may do well in the future.
  4. Read the details of the fund either on the fund manager’s web site or in the prospectus. Look to see if the objectives of the fund are consistent with your objectives. Make sure the types of securities the manager can purchase are in line with what you would like to buy. The names of some funds can be much narrower than the full range of securities the manager is allowed to buy. Find out if the fund management and objectives have been stable over time. Some funds can change their objectives on fairly short notice, potentially exposing you to risks you may not want to take or lower expected returns that you desire. To learn more about reading a prospectus, check out the article on Page 9 of this on-line magazine.
  5. Compare the fees among the funds on your list. If the underlying assets are similar and are expected to produce the same returns, funds with lower fees are more likely to provide you with higher returns (after expenses) than funds with higher fees. Don’t forget to look at both front-end loads and annual operating expense ratios.

Make a Decision

  1. Buy a position in the fund(s) that best fit your requirements. As indicated above, you can buy most funds either through a broker (which can sometimes add a commission to your expenses) or directly from the fund manager.
  2. Last, but not least, be sure to monitor your positions to make sure that the fund objectives, holdings, management and fees remain consistent with your objectives.

The Canada Pension Plan And Your Retirement

Canadian-Pension-Plans

Note from Susie Q:  When I published my post on Social Security, I promised my Canadian readers a similar post about the Canada Pension Plan.  It took a while, but here it is!  Graeme Hughes, the Money Geek, was kind enough to write it for me.

Graeme Hughes is an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of his career he completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products. He believes that financial independence is a goal anyone can aspire to, and is passionate about helping others to live life on their own terms.

The Canada Pension Plan (CPP) is a foundational part of all Canadians’ retirement plans, as it represents, for many, the single largest government benefit they will receive during retirement. Over the years, opinions on the plan have varied widely, with many suggesting that younger Canadians shouldn’t count on receiving CPP benefits in retirement.

As it stands today, is this a realistic opinion, or is the reality something different? How does the CPP work, and can it be relied upon to deliver a meaningful amount of pension income to future retirees?

How The Canada Pension Plan Differs From Old Age Security

There are two core retirement benefits that the vast majority of Canadians are eligible to receive: the Canada Pension Plan and the Old Age Security (OAS) benefit.

OAS is a benefit that is funded from tax revenue. Both eligibility and the benefit amount paid are based on the number of years an individual has been resident in Canada prior to his or her 65th birthday. Benefits may be reduced for high-income seniors.

The CPP, on the other hand, is a true contributory pension plan. This means that benefits are available only to those who have contributed, and the amount you receive is directly linked to the amount paid into the plan over your working life. CPP contributions are held separate and apart from other government revenue, and CPP benefits are not income-tested.

A Brief History of The Canada Pension Plan

The CPP has had more than 50 years of success in providing pension benefits to Canadian seniors. But a lot has changed along the way:

  • The CPP started in 1966 as a pay-as-you-go plan. In short, it was expected that contributions from workers each year would fully cover the benefits paid to retirees in the same year. The contribution rate for the first couple of decades was just 3.6% of a worker’s pay, which is a very modest amount, indeed.
  • In the mid-1980’s, it started to become clear to the federal government that this model would not be sustainable in the face of a large wave of baby boomers that would be retiring in future years, so changes had to be made. These involved increases to the contribution amounts, reductions in some benefits, as well as changes to the management of the plan itself.
  • These changes culminated in 1997 with the formation of the Canada Pension Plan Investment Board (CPPIB), an entity at arm’s-length from the government that would be entirely responsible for investing CPP assets and funding the distribution of CPP benefits going forward. This effectively removed the government from the management of the pension plan, and the new board was given one overriding mandate above all – to maximize the returns on invested assets while managing risk.
  • As of September 30, 2019, the CPPIB had $409.5 billion in assets under management.

Is the Canada Pension Plan Sustainable?

Many pension plans, both public and private, have been struggling with sustainability over the last many years given demographic changes (the retiring boomers) combined with very low yields on fixed-income investments which often form the backbone of pension assets.

Fortunately, the CPPIB has an oversight regime that continues to account for such changes. Canada’s Office of the Superintendent of Financial Institutions appoints a Chief Actuary, who has as one of their responsibilities a review of the sustainability of the CPP. This review is conducted every three years.

The last reported review, in 2016, concluded that the CPP would be able to fully meet its commitments for at least the next 75 years (the length of time covered in the review), as long as a target rate of return of 4% in excess of inflation was maintained.

In the CPPIB’s 2019 annual report, it was able to boast an average annual return over the preceding 10 years of 11.1% (net nominal). Portfolio investments include public equities, private equity, real assets and fixed-income instruments. The portfolio has widespread geographic diversification, with only 15.5% of assets invested in Canada.

The chart below, from the 2019 annual report, highlights the sustainability of the plan as reflected in the historical and forecast growth in assets:

Clearly, the CPP is in great shape to serve the needs of Canada’s current and future retirees. Even if this should change at some point in the future, the Chief Actuary has the authority to adjust contribution rates to maintain sustainability, should that be necessary at a later point in time.

How Are CPP Contributions Calculated?

CPP contributions are based on an individual’s income, and split equally between employer and employee. Contributions are calculated on the amount of annual income earned that is between $3,500 (the lower cutoff) and $57,400 (the 2019 upper cutoff). Up until 2019, the contribution rate on these amounts had been 9.9%, but a new CPP enhancement that started in 2019 raised that to 10.2%.

As an example, an individual who earned $50,000 in 2019 would have a total CPP contribution of $4,743.00 ($50,000 – $3,500 = $46,500 x 10.2%). Half this amount would be paid by the employee and half by their employer. Of course, self-employed individuals are responsible for the full amount.

It’s important to note that, while the lower cutoff amount is fixed, the upper cutoff is adjusted each January to reflect changes in average Canadian wages. Remember too, that the contribution rate of 9.9% had been in place until last year, with the CPP “enhancement” starting in 2019. The impact of the enhancement will be looked at later in this article.

What Benefits Can I Expect from the CPP?

The “base” calculation for CPP benefits assumes an individual applies for benefits at the normal retirement age of 65. In 2019, the maximum benefit for new retirees under this base scenario is a CPP payment of $1,154.58 per month. All CPP benefits are adjusted each January to account for changes in the Consumer Price Index.

However, most Canadians do not receive that maximum benefit. The amount you actually receive is based on the contributions made to the plan from the age of 18 until the date you apply for CPP benefits. If your total contributions during those years averaged, say, 70% of the maximum contributions permitted, your CPP benefit at age 65 would be approximately 70% of the maximum amount payable.

In short, the higher your working wage, the more you will have paid into the plan, and the more you will receive in benefits, up to the applicable maximums.

There are also a variety of adjustments made to the calculation of your CPP entitlement. For instance, you are allowed to drop your 8 lowest-earning years from the calculation. There are also adjustments for years spent rearing children under the age of 7, for periods of disability and for other circumstances. For these reasons, calculating your potential future benefit at any point in time is virtually impossible to do on your own. Fortunately, the good folks at Service Canada are happy to do the work for you, and an estimate of your individual benefit can be obtained by phone, or online through your My Service Canada Account.

As of October 2019, the average CPP benefit Canadians were receiving amounted to just $672.87, or about 58% of the maximum.

Lastly, CPP benefits paid are fully taxable as regular income.

When Should I Apply for the Pension?

Although the “base” calculation for CPP benefits assumes retirement at age 65, in reality, you have the option of applying for benefits anytime between the ages of 60 and 70. However, the amount of benefit you receive will be adjusted accordingly:

  • If you decide to take your pension early, your pension will be reduced by 0.6% for every month prior to your 65th birthday that benefits begin. So, if you decide to start payments as early as possible, on your 60th birthday, you will receive a 36% total reduction in your entitlement (0.6% x 60 months).
  • Conversely, if you decide to delay the start of benefits, you will receive an extra 0.7% for every month after your 65th birthday that you delay taking benefits. So, delaying benefits all the way to your 70th birthday increases your monthly amount by 42% (0.7% x 60 months).

The chart below outlines the change in monthly benefit given the age at which benefits commence, assuming an individual was eligible for $1,000 per month at age 65:

As seen above, the difference between taking your Canada Pension at age 70 versus age 60 is significant. You’ll receive over double the monthly amount. But the decision as to when to apply depends on a number of factors.

A big factor is, of course, your views on life expectancy. If you enter your early 60’s in poor health, or with a family history of shorter life expectancy, you may want to take the CPP as soon as you are eligible. If the opposite is true, you may want to wait until age 70 to ensure you receive the maximum amount of this inflation-adjusted and government-guaranteed benefit, to protect against the risk of running short of savings and income later in life.

Of course, the amount and structure of your own savings, the amount and source of other retirement income, along with your actual date of retirement, will all weigh on your decision. If in doubt, consult a qualified financial planner to assess the merits of different options.

2019 Changes – The Canada Pension Plan Enhancement

Up until 2019, the CPP was designed to replace about ¼ of a person’s average employment earnings once they retire. The current government has decided that should be enhanced such that the CPP will eventually cover about ⅓ of pre-retirement earnings.

To accomplish this, and to ensure that the newly enhanced benefits are self-funding, the CPP enhancement is being operated almost like an add-on benefit to the existing CPP.  CPP contributions for employers and employees are being increased above the previous 9.9% rate, over time, as follows:

In addition to the increased premiums noted above, the maximum annual earnings for CPP contributions will have an additional, “second ceiling” amount that will allow higher-income earners to contribute proportionately more to the CPP, starting in 2024.

The extent to which this CPP enhancement will increase your retirement benefits is dependent entirely on how much you individually contribute to the enhanced portion prior to retirement, both as regards the increased premium amount, as well as within the elevated earnings cap. However, those who end up contributing to the enhanced amount for a full 40 years could see their CPP benefits increase up to 50%.

Of course, if you are retiring in the next few years, you won’t have enough credit toward the enhanced amounts to make much of a difference to your benefits. These changes are really designed to have the most impact on younger workers who are in the earlier stages of their careers. Given the added complexity this new benefit adds to benefit calculations, it makes more sense than ever to keep track of your entitlement by obtaining occasional estimates from Service Canada.

More information on the CPP enhancement can be found here.

CPP And Your Financial Planning

In this article we have looked exclusively at the CPP as it pertains to retirement benefits. In addition, there are survivor, disability, and other benefits to consider as part of a well-rounded approach to managing personal finances. More comprehensive information on the Canada Pension Plan can be found on the pension benefits section of the Government of Canada’s website.

Remember that a good retirement plan is holistic and accounts for all sources of income, whether from government pension and benefits, employer-sponsored plans, personal savings or business ventures. Ideally, the information above will help with your planning and give you confidence that the CPP will indeed be there for you, regardless of your retirement date.

How to Raise Financially Smart Kids

I recently wrote a guest post for Grokking Money about how to raise financially smart kids.  Here is the start of it, to read the entire post, click here.

Instilling your children with good financial habits will increase their likelihood of success, just as is the case with many other types of habits.  In this post, I’ll provide you with eight things you can do to help your kids become financially smart.  All but one of these ideas are based on my experiences growing up or those I provided for my children.

1. Open a Bank Account

We opened savings accounts for our children with the money they received when they were born.  As they got older (probably around 5), we made them aware of . . . Read More

Do I Really Need to Budget

I recently wrote a guest post for The Smart Investor about deciding if you need a budget.  Here is the start of it, to read the entire post, click here.

Budgeting is critical to your financial health, especially when you are just getting started handling your own money.  A budget will help you figure out whether you can afford to make big purchases – a car, a home – whether you can afford a nice vacation and whether you need to find a way to make more money.  However, not everyone needs to make and stick to a budget.

In this post, I’ll talk about the characteristics of people who will benefit most and least from making a budget and will provide a questionnaire you can use to help figure out . . . Read More

Good Debt vs Bad Debt: Key Characteristics

Not all debt is bad! The specific definitions of good debt vs bad debt will vary from person to person. For people who plan to retire very early and live on a limited income or for people who know that they have a hard time paying their bills either for lack of money or organization skills, most debt is likely to be problematic.  For other people, taking on debt is less of an issue.

One of my followers was thinking of expanding his business and was concerned that taking on debt would be harmful. As part of helping him with his thinking, I identified general characteristics that distinguish good debt vs bad debt. He ended up selling his business instead of expanding it, but I am sharing my insights in this post. These characteristics may not apply to your particular situation, so be sure to think about them in the context of your own situation and temperament.

Characteristics of Bad Debt

Here are five characteristics of debts that I would consider bad.

You Don’t Understand the Terms

Loans and other sources of borrowing, such as credit cards, all have different terms. It is important that you understand the terms of your debt. For example, some loans, mortgages in particular, have adjustable rates. That is, the interest rate that you pay on your loan will change as a benchmark interest rate changes. If the benchmark interest rate increases, your loan payments will also increase.

Credit cards also can have interest rates that change. A teaser rate is an interest rate that applies to credit card debt for the first several months to a year. After that initial period, the interest rate charged on credit card debt can be very high.

Another example of a loan provision that can be problematic is a balloon payment. Some loans, including some mortgages in the US and many mortgages in Canada, have balloon payment provisions. For the initial period of time (often five years for Canadian mortgages), you make payments on your loan as if you were re-paying the loan over 30 years. However, at the end of the fifth year, the entire balance of the loan is due. The Canadian mortgage I reviewed requires the lender to re-finance the loan at the end of the fifth year, but at an interest rate that reflects the then-current interest rate environment and your then-current credit rating. In effect, that loan has an adjustable interest rate that depends not only on a benchmark interest rate but also changes in your credit score.

I consider any debt for which you don’t fully understand the terms, best avoided by reading the entirety of the loan document, as bad debt.

You Can’t Afford the Payments

When you enter into a loan agreement, you will be provided with the amount and timing of loan payments. With credit cards, the payments are usually due monthly and are a function of how much you charge and the card’s interest rate. Any debt that has payments that don’t fit in your budget is bad debt.   I would even take it one step further and say that any debt that has payments so high that you aren’t able to save for emergencies, large purchases and retirement is bad debt.

High Interest Rate

Some types of debt, such as credit cards and payday loans, have very high interest rates. The definition of a high interest rate depends on the economic conditions. Currently (around 2020), I would say any interest rate of more than 8% to 10% is high. By comparison, when I was young in the early 1980s, the interest rate on a 10-year US Government bond was more than 15% and mortgage rates were even higher.

If you have debt with high interest rates, you will be better off re-paying them as quickly as possible as you can’t earn a high enough investment return on any excess savings to cover the interest cost. That is, the investment return you can earn on the money, especially after tax, is going to be less than the interest rate you pay on the debt. In that case, it doesn’t make financial sense to invest any excess cash but rather you will be better off by using any excess cash to pay off the debt.

Depreciating Collateral

In many cases, debt is used to purchase something large, such as a boat, a home or a car. When you make a large purchase, the item you bought is considered collateral and the lender can take the collateral if you don’t make your loan payments.

The value of some items goes down (depreciates) faster than the principal of the loan. If you default on your payments when that happens, the lender is allowed to make you pay the difference. Determining whether your purchase is something that will retain its value or will depreciate quickly is a good test of whether it is financially responsible to use debt to make the purchase. If not, I would consider the purchase a poor use of debt.

No Long-Term Benefit

Many other purchases for which debt, such as credit cards and payday loans, is used have no long-term benefit. For example, if you buy a knick-knack for your home with a credit card and don’t pay the balance when the credit card is due, you will be paying interest for something that has no long-term benefit to you. I consider using debt for items or experiences with no long-term benefit to be bad.

There is a gray area. If you use debt to buy clothes that are required for your job, the clothes themselves don’t have a long-term benefit, but they could be considered as creating the ability to go to work and earn money.   As such, while I would normally consider clothes as a poor use of debt, I can see how work clothes that allow you to increase your income might need to be financed for a month or two on a credit card.

Characteristics of Good Debt (vs Bad Debt)

The first requirement of good debt is that it doesn’t have any of the characteristics of bad debt. That is, good debt:

  • Has terms you fully understand.
  • Fits in your budget, especially if your budget also includes saving for retirement, large purchases and an emergency fund.
  • Is one that has a reasonable interest rate.
  • Isn’t backed by depreciating collateral.
  • Is used for something with long-term benefit.

There are many ways in which a debt can create a long-term benefit. I’ve mentioned buying clothes required for a job that allows you to earn money, in particular a lot more money than the cost of paying off the debt.

Your Primary Residence

Most people borrow, using a mortgage, to purchase a home.   The market values of homes generally increase over long periods of time, though there are periods of times when the market values of homes decrease. In addition, there are a lot of carrying costs of owning a home, such as insurance, property taxes, maintenance and repairs. However, by owning a home, you don’t have to pay rent which, in theory, covers all of the costs of home ownership.

I think that buying a house is a good use of debt as long as the mortgage meets all of the criteria identified above. Although not specifically related to the use of debt, you might want to think carefully about buying a home (with or without debt) if you plan to live in it for only a short period of time. The transactions costs of buying and selling a home are high and you increase the likelihood that the value of the house will decrease if you own it for only a few years.

Your Car

Using debt to buy a car is also quite common. If you are using the debt to cover the cost of your only mode of transportation and you need it to get to work, it can be a good use of debt. Again, you’ll want to check that it has the other characteristics of good debt identified above.   Using debt to buy a car that is more expensive than you need or leads to loan payments that are higher than you can afford is not as good a use of debt.

Your Education

Many people use student loans to pay for college. From an economic perspective, student loans can be either good or bad. The criteria for evaluating the student loans are:

  • Will the increase in your wages will cover your loan payments?
  • Will you earn enough after graduation to allow the loan payments to fit in your budget?

For example, let’s say you can earn $30,000 a year if you don’t go to college and $40,000 if you get a degree. If you borrowed $50,000 a year for four years at 5% with a 10-year term, your payments would be more than $25,000 per year.

First Criterion

Over the term of the loan, your increase in wages ($10,000 per year) is less than your loan payments. Over your working life time, the return on your investment in your student loans is about 3.5%. The return on investment is positive, so the use of debt could be justified using the first criterion.

Second Criterion

It might be very difficult to cover the $25,000 of annual student loan payments on annual wages of $40,000 a year. If you are willing and able to live on $15,000 a year until your student loans are re-paid, they could be considered a good investment economically.

A smaller amount of debt or a larger increase in salary will improve the economic benefit of student loans. If you are considering student loans to finance your education, you’ll want to look at their economic costs and benefits carefully.

Your Business

When you start your own business, you often need to invest in one or more of equipment, inventory or a place to run your business.  Many people borrow money to make these initial investments. Starting a profitable business can be a very good use of debt, as it provides you the opportunity to increase your net worth. However, 30% of businesses fail in the first year and 50% fail in five years, according to the Small Business Administration, as reported by Investopedia. If you borrow money to start a small business and it fails, you will often still be liable for re-paying the debt, depending on whether you had to personally guarantee the loan or if the business was able to procure the loan.

Investing

There are at least a couple of ways you can use “debt” to invest.

Don’t Pre-Pay Your Debt

The most common way to use debt to invest is to invest extra money rather than using the money to pre-pay your mortgage or other debt. Whether it is good or bad to use this “debt” to increase your investing depends on several factors and your financial situation:

  • The longer the term on your debt, the better the choice is to invest instead of pre-paying your debt. If your loan payments only extend over a year or two, it is more likely that your investments will lose money making you worse off than if you pre-paid your loan. Over long periods of time, your investment returns are more likely to be positive.
  • The lower the interest rate on your debt, the better the choice it is to invest instead of pre-pay your debt. If the interest rate on your debt is higher than you can expect to earn on the investments you would buy (after considering income taxes), you will almost always be better off pre-paying your loan. If your interest rate is low, e.g., less than 3% or 4%, you are more likely to earn more in investment returns than the interest cost on your debt.
  • You have another source of income to make your loan payments if your investments decrease in value. For example, if you were planning to retire in the next few years, pre-paying your debt is more likely to be a better decision than investing. On the other hand, if you plan to have other sources of income besides your investments for the next 10 or more years, you might be better off investing rather than pre-paying your debt.

Investing on Margin

Another way you can use debt to invest is to buy your investments on margin. Under this approach, you borrow money from the brokerage (or similar) firm to buy your investments using your existing invested assets as collateral. In many cases, you can borrow up to 50% of the value of your existing assets. So, if you have $100,000 of stocks, you could borrow $50,000 to make additional investments.

The drawback of buying investments on margin is that the lender can make you re-pay the loan or a portion of it as soon as the value of the assets you own (the $100,000 of stocks in my example) decreases to less than twice the amount you’ve borrowed. Unfortunately, the amount you borrowed may have decreased in value at the same time while the amount you borrowed as stayed constant. As such, buying investments on margin is considered very risky and should be done only by people who fully understand all of its ramifications.

Final Thoughts on Good Debt vs. Bad Debt

Debt, when used carefully, can greatly improve your life and your ability to earn money. However, if you take on too much bad debt, it can lead to significant financial problems. This post has provided a framework to help you decide whether any debts you have or are considering are likely to be good debt vs bad debt.

Picking Stocks

Many investors create their own portfolios by picking stocks in individual companies. As discussed in my post on the basics of stocks, picking stocks in individual companies is one of several strategies for creating an investment portfolio. Alternatives to picking stocks in individual companies include buying mutual funds and exchange-traded funds. I’ll talk about those strategies in another post.

When I first started investing in the early 1980s, mutual funds were quite common but index funds and exchange-traded funds, while they existed, were not well known. I started my investment story by picking stocks in individual companies. One of the best books I’ve ever read on investing is One Up on Wall Street by Peter Lynch, originally published in 1989.

Confirmation of Independence: I have no affiliation with the author or publisher of the book I am reviewing. I do not receive any compensation for recommending it or if you purchase it.     I truly think it is a great source of investing information.

Lynch was the manager of a very successful mutual fund, the Fidelity Magellan fund, from 1977 to 1990. During that time, the fund had a 29.3% annual average return or more than twice the average return on the S&P 500 over the same time period. If you are considering picking stocks in individual companies, I recommend his book even though it is quite dated. It references companies and trends with which you may not be familiar, but the fundamental concepts are still relevant and it is a quick, easy read.

In this post, I’ll essentially provide an overview of some of the key points I learned from One Up on Wall Street and illustrate them with some personal examples when I can.

Picking Stocks in Companies You Know

One of the first concepts that Lynch introduces is that you are your own local expert. You are familiar with the business in which you work and shop. You are a consumer and you can observe trends in the area in which you live. By watching the world around you, you can identify possible investment opportunities, possibly even before the “market” or “experts” discover them. In many cases, if you identify a trend very early and invest in a company that will benefit from it, you can earn a much-higher-than-market-average return on your investment. In fact, Lynch points to this opportunity as giving individual investors a better chance of beating the market than professional investors who have to invest larger amounts so tend to purchase more mature companies.

Our Kids’ Choices

To illustrate what I mean by “invest in what you know,” I will use an experience we had with our children as an example. When they were in their early teens (probably around 2004 or 2005), we gave them each a very small amount of money to invest. Our son, who was very interested in trains and large equipment, chose the following companies:

  • Microsoft
  • John Deere
  • Canadian Pacific Railway
  • Canadian National Railway
  • ASV – a company that makes skid-steer loaders.

Our daughter, who was much more aware of what was happening in the retail space, chose the following companies:

  • Apple
  • Nordstrom
  • JC Penney
  • Target
  • One other company that I don’t recall.

How it Turned Out

I don’t remember exactly when we started this exercise, so have looked at the two- and five-year average annual returns starting on January 1, 2006. By using two-year returns, I have excluded the impact of the market decline in 2008 and early 2009. The five-year returns go through December 31, 2010, so include the market decline and part of the recovery.

The S&P 500 averaged a 4.5% increase per year during the two-year period and was essentially flat for the five-year period. By comparison, my daughter’s stocks increased at an annual average rate of 9% over the two-year period and 8% over the five-year period. My son did even better, with annual average returns of 15% over the two-year period and 9% over the five-year period.

What is even more impressive about my son’s returns is that his returns were dragged down significantly by a single company – ASV. When my son bought it, the company had its own patented suspension system for its tracks. As I recall, not too much later, it had a change in management. The new management decided to license the patent to Caterpillar. Unfortunately for ASV, Caterpillar’s much larger market share caused a large reduction in ASV’s sales that couldn’t be made up by the licensing fees. Over a several year period, ASV’s stock price went down by about one-third. This experience illustrates another lesson when looking a company’s fundamentals for investment decisions – carefully follow the decisions of any new management teams.

Without ASV, our son’s returns were much more impressive – 19% over the two-year period and 13% over the five-year period.

Don’t Invest in What You Don’t Understand

A related concept, but somewhat different one, is to avoid picking stocks in companies and sectors you don’t understand. Lynch has all sorts of great examples of why people buy stock in companies whose business they don’t understand – hot tips from a “rich uncle,” aggressive buy recommendations from a broker and so on and so forth.

Not understanding a company’s business can be everything from it having a very technical focus to not being familiar with its marketplace (i.e., to whom and how it sells its products) to being so diverse that it is hard to figure out what drives profits.   Essentially, his advice is that, if you can’t explain to someone what the company does in a few sentences, you shouldn’t buy its stock.

One Example of My Choices

I fell into that trap. We had a little extra money many years ago and decided to take some risk by making a very small investment in a private placement. When a company sells its stocks to a small group of investors and not the general public, it is called a private placement.

The two choices we were offered were a company that was marketing telemedicine to the Veterans Administration and a barbeque restaurant that was just opening its first locations. Our assessment was that the restaurant space was grossly overcrowded and that telemedicine would catch on quickly with the aging population and increases in technology. Not understanding that the telemedicine company didn’t actually have any customers or the challenges of getting a contract with the Veterans Administration, we made a very small investment in it.

Were we wrong! Many years later, we wrote off the entire value of the investment in the telemedicine company as it had become worthless. The restaurant was Famous Dave’s.

Ten Baggers

One of Lynch’s goals is picking stocks that are ten-baggers. These are companies whose stocks appreciate to at least 10 times what you paid for them in relatively short periods of time. By identifying trends in your local area, you are more likely to be able to earn the high returns associated with companies that start small and grow rapidly. As an example, consider the increases in Apple’s stock price.

The picture above shows the annual appreciation of Apple stock from 1981 through 2018. If you had owned the stock during any of the years circled in green, you would have more than tripled your money in two years. Not quite 10 times, but 3 to 5 times in 2 years is still a return anyone would envy. If you look at the returns in more recent circled in orange, you’ll see much more modest appreciation. The returns were still very attractive, but much lower than the earlier period.

Lynch points out the benefit of having just one ten-bagger in a portfolio with otherwise mundane performers. For example, if you invest the same amount in 9 stocks each having a total return of 5% per year, your total return in 5 years will be 27.6%. If you add a ten bagger to the mix, your total return increases to 115% or 16.5% per year.

Although our daughter didn’t have any ten baggers, her portfolio benefited from a similar effect. From 2006-2010, her three retail stocks had an annual average return of -1.6%. Apple, on the other hand, was almost a 4.5-bagger (its price at the end of 2010 was 4.4 times its price at the end of 2005). The addition of that one company to her portfolio increased her return from -1.6% to +8.2%!

Do Your Research

Once you’ve identified a company with an appealing product or service, it isn’t time to buy yet! Lynch suggests looking at the company’s financial statements and several financial metrics. I’ll talk about a few of them here.

Percent of Sales

The first thing to check is whether the new “thing” is big enough to have an impact on the profitability of the company. To illustrate, let’s look at two companies that make widgets. Company A makes primarily widgets, so 90% of its sales is from widgets. Company B makes a lot of things. Only 5% of Company B’s sales is from widgets. A new thingamabob has been designed that will double the sales of widgets with no impact on the profit margin (percent of sales cost that turns into profit). Company A’s profit will increase by 90%, whereas Company B’s profit will increase by only 5%. Because stock prices are driven in large part by estimates of future profitability, you would expect that Company A’s stock price would increase much more if it added thingamabobs to its widgets than Company B’s stock price.

Future Earnings

For many reasons identified by Lynch, stock prices don’t always move in line with earnings. Nonetheless, the more that earnings increase, the more that the stock price is likely to go up. Lynch suggests that you make sure you understand how a company plans to grow its earnings.

Ways to Increase Earnings

He identifies the following five ways for increasing earnings:

  • Reduce costs
  • Raise prices
  • Expand into new markets
  • Sell more product to existing markets
  • Revitalize, close or otherwise dispose of losing operations

If you plan to hold the company’s stock for a fairly short time, any of these ways of increasing earnings could provide nice returns. I tend to buy and hold my stocks for a long time (over 25 years in several cases), so I prefer companies whose growth strategies include expanding into new markets or selling more product to existing markets. The other three approaches tend to produce one-time increases to earnings that can’t be replicated over and over again.

Expanding into New Markets

One of the most common ways existing companies expand into new markets is through acquiring other companies. There are many companies that have grown very successfully through acquisition.

Berkshire Hathaway

One such company is Berkshire Hathaway, whose chairman is Warren Buffett. Over the past 40 years, Berkshire Hathaway has purchased such companies as Burlington Northern, Dairy Queen, and Fruit of the Loom, among others. The graph below shows the value of $1 invested in Berkshire Hathaway (stock symbol: BRK-A) since 1980 as compared to a $1 investment in the S&P 500.[1]

Clearly, Berkshire Hathaway has been highly successful in its acquisition strategy.

General Electric

Other companies have been less successful with their expansion and acquisition strategies. One such example is General Electric (GE). When I was young, I thought of GE as primarily manufacturing appliances and light bulbs. The graph below shows how the value of $1 invested in GE increased between 1962 and 2000 as compared to the same investment in the S&P 500.

Clearly, over that time frame, GE was very successful. In fact, my in-laws bought a few shares of GE for each of my kids when they were young (in the 1990s) because it was considered such a great, stable company.

Over the past 20 years, it has expanded its operations into loans, insurance and medical products and related services.   In hindsight, it appears that GE wasn’t sufficiently familiar with all of the business it entered or acquired.  It also used a lot of debt to finance its acquisitions and expansions.  As a result, its stock price suffered. The graph below shows how much a $1 investment in GE’s stock has changed over the past 20 years as compared to the S&P 500.[2]

Comparison

From 2000 to late 2019, Berkshire Hathaway’s stock price went up by a factor of almost 5 while GE’s stock price decreased by more than 50%. Interestingly, GE’s new CEO (hired in 2018) announced a transformation plan that includes selling several of its businesses, allowing it to focus primarily on “safely delivering people where they need to go; powering homes, schools, hospitals, and businesses; and offering more precise diagnostics and care when patients need it most.”[3]

You’ll want to make sure you understand which new markets a company plans to enter, think about whether management has sufficient experience or expertise to expand successfully and understand how much debt the company is using to finance these expansions.

P/E Ratio

The ratio of the price of a company’s stock to its annual earnings is known as the P/E ratio. A P/E ratio is one way to measure whether a company’s stock price is expensive. A rule of thumb mentioned by Lynch is that a stock is reasonably priced when its P/E is about the same as its future earnings growth rate. He acknowledges the important point that the future earnings growth rate isn’t ever known and that lots of experts spend a lot of time incorrectly estimating the earnings growth rate.

Nonetheless, you can at least look to see if a company’s P/E ratio is the right order of magnitude. For example, if you are looking at a company that slowly expands its sales in its current market, its earnings growth rate might be 5% to 7%. If that company’s P/E were 25, you’d know it was expensive. If the P/E ratio were 2, it might be an attractive buy. So, it isn’t necessarily important to know whether the company’s earnings growth rate is going to 5% or 7%, but rather whether it is likely to be 5% or 25%.

Schwab has an entire post on using the P/E ratio as part of stock analyses.

Debt/Equity Ratio

Companies can get cash from three sources to finance their operations – equity (selling shares of stock), borrowing and profits. Long-term debt is the amount of money that a company has borrowed, other than to meet short-term cash needs (such as through a line of credit). Long-term debt frequently is in the form of bank loans or bonds issued by the company.

The ratio of the amount of long-term debt to equity (the difference between assets and liabilities which is an estimate of the value of the company to the stockholders) is known as the debt-to-equity ratio. There are both advantages and disadvantages to a high debt-to-equity ratio. Let’s look at an example.

Company A has $100 of profit before interest (and ignoring taxes) and $60 of interest payments, for net income of $40 ($100 – $60). Company B is the same as Company A but it has no long-term debt, so its net income is $100. If profit before interest went down by 40%, Company B’s net income would also decrease by 40% to $60. Company A’s net income, though would go from $40 to $0 or a 100% decrease. The primary disadvantage of debt is that it magnifies the impact of bad news. The 40% decrease in profit before interest turned into a 100% decrease in net income for Company A with all its debt. This magnification is called leverage or debt leverage.

On the plus side, increases in profits are also magnified. If Company A’s profit before interest increased by 50% to $150, its net income would increase by $50 to $90. The percentage increase in net income in this case is +125% as compared to the +50% increase in Company B’s net income.

Other Metrics

Lynch discusses several other things to check on a company’s financial statements before making an investment.   I talk about one of them, the dividend payout ratio, in my post on investing for dividends. I’ll let you read One Up on Wall Street to learn more about the other metrics and to get Lynch’s views and examples on the ones I’ve discussed here.

Create Your Story

For every company in which you invest, Lynch recommends that you create a story. There are two parts to the story.

Two-Minute Story

First, you should be able to describe the company’s business in what I would call an “elevator speech.” That is, it is important to be able to explain to someone else what the company does and why you think it will grow all in two minutes. If your explanation takes longer, it is likely an indication that the company’s business is too complex to benefit from a trend you observe or you don’t fully understand its business.

Additional Details

Second, you’ll want to have a story for yourself that includes a bit more detail about what you think will cause earnings (and hopefully therefore the stock price) to increase. Is it one of the one-time actions, such as cutting expenses or increases prices, or a longer-term plan to increase sales?

If the former, you’ll want to monitor the progress of those actions. Are they being implemented? Have they been effective? Has their full impact been reflected in earnings and/or the stock price? If the company’s plans don’t come to fruition or they were successful and reflected in earnings, you’ll want to evaluate whether you want to continue to own the company’s stock or whether it is time to sell it.

If the latter, you’ll want to understand what steps the company plans to take to increase sales. You can then monitor the company’s progress towards those plans. If it doesn’t appear to be on track, it might be time to considering selling the stock and investing in another company.

Final Thoughts

As I re-read Lynch’s book in preparation for writing this post, I was reminded how many useful tidbits he provides in it. Interspersed among the anecdotes are lots of lists, checklists and guidance on everything from identifying a company in which to possibly invest to determining the company’s growth pattern to reading financials to designing your portfolio. If you plan to start picking stocks in individual companies, I highly recommend One Up on Wall Street by Peter Lynch as a good first book on the topic. If you are looking for a shorter source for similar information, I suggest this post from Schwab.

 

 

[1] Taken from Yahoo Finance, November 8, 2019.

[2] Taken from Yahoo Finance on November 8, 2019

[3] General Electric 2008 Annual Report, https://www.ge.com/investor-relations/sites/default/files/GE_AR18.pdf, p3.

Investing for Dividends

Investing for dividends is one of many strategies investors use to identify stocks for their portfolios. Among the strategies I identified in my post on what you need to know about stocks, this is not one that I have ever used.  So I reached out to one of my Twitter followers who uses it to get more information, Dividend Diplomats (aka Lanny and Bert) to get some real-life insights. With Lanny’s and Bert’s help, I will:

  • define dividends.
  • talk about the criteria that Lanny and Bert use for selecting companies and why they are important.
  • show some historical returns for dividend-issuing companies.
  • explain the tax implications of dividends on your total return.

What are Dividends?

A dividend is a cash distribution from a company to its shareholders. The amount of the dividend is stated on a per-share basis.  The amount of cash you receive is equal to the number of shares you own times the amount of the dividend. When companies announce that they are going to pay a dividend, they provide two dates.  The first is the date on which share ownership is determined (also known as the ex-dividend date).  The second is the date on which the dividend will be paid. For example, a company might declare a 15₵ dividend to people who own shares on May 1 payable on May 15. Even if you sell your stock between May 1 and May 15, you will get 15₵ for every share you owned on May 1.

When a company earns a profit, it has two choices for what to do with the profit. Under one option, the company can keep the profit and use it to support future operations. For example, the company might buy more equipment to allow it to increase the number of products is makes or might buy another company to expand its operations. Under the second option, the company distributes some or all of its profit to shareholders as dividends. My experience is that companies that are growing rapidly tend to keep their profits, whereas companies that can’t find enough opportunities to reinvest their profits to fund growth tend to issue dividends.

Dividend Diplomats – A Little Background

Lanny and Bert have been blogging for over 5.5 years and have been best friends for 7.  They both are pursuing the same goal of reaching financial freedom and retiring early to break the “9 to 5” chains.  They hope to achieve financial freedom through dividend investing, frugal living, and using as many “personal finance” hacks as possible to keep expenses low and bring in additional income. For more information about the Dividend Diplomats, check out their web site at www.dividenddiplomats.com.

Why Use the Investing for Dividends Strategy

As you’ll see in future posts, I have used several strategies for my stock investments, but have never focused on investing for dividends.

My Preconceived Notions

I have always considered investing for dividends as most appropriate for people who need the cash to pay their living expenses, such as people who are retired. I am retired, but currently have cash and some bonds that I use to cover my living expenses. As I get further into retirement, I will need to start liquidating some of my stocks or start investing for dividends.

Lanny’s & Bert’s Motivation

So, when I started reading about Lanny and Bert, I wondered why people who are still working (and a lot younger than I am) would be interested in investing for dividends.   Here’s what they said.

“There were a few different motivating factors.

Lanny had endured a very difficult childhood, where money was always limited and his family had struggled financially.   Due to this, he personally wanted to never have to worry about money, period.

Bert was not a dividend growth investor until he met Lanny.  Once he talked to Lanny, learned about dividend investing, and saw the math, he was sold and hasn’t looked back since.

Therefore, we are looking to build a growing passive income stream so we can retire early and pursue our passions.  Building a stream of growing, truly passive dividend income has always been a very attractive option to us.  We love the fact that dividend income is truly passive (outside of initial capital, we don’t have to lift a finger) and we are building equity in great, established companies that have paid dividends throughout various economic cycles.

Second, the math just makes sense.  It is crazy how quickly your income stream grows when you are anticipating a dividend growth rate of 6%+ (on average).  Lanny writes an article each quarter showing the impact of dividend increases and we have demonstrated the impact of dividend reinvesting on our site in the past. When you see the math on paper, it is insane. “

Lanny and Bert provided links to a couple of their posts that illustrate the math: Impact of Dividend Increases and Power of Dividend Reinvesting.

Lanny’s & Bert’s Strategy

Lanny and Bert developed a dividend stock screener that helps them identify undervalued dividend growth stocks in which to consider investing.  At a minimum, the companies must pass three metrics to be further considered for investment:

  • Valuation (P/E Ratio) less than the market average.
  • Payout Ratio Less than 60%. (Unless the industry has a higher benchmarked figure. i.e. oil, tobacco, utilities, REITs, etc., then they compare to the industry payout ratio.)
  • History of increasing dividends.

They don’t consider dividend yield until later in the process.  They never advocate chasing dividend yield at the risk of dividend safety. That is, they would rather a dividend that has very low risk of being reduced or eliminated (i.e., safety) than a higher dividend be unsustainable over the long term.

That’s why they don’t look at yield initially.  It allows them to focus on the important metrics that help them gain comfort over the safety of the dividend.  Here is a link to their Dividend Stock Screener.

Payout Ratio

Lanny and Bert mention that that one of their key metrics is a payout ratio. A dividend payout ratio is the annual amount of a company’s dividend divided by its earnings per share.  For more about earnings per share, check out my post on reading financial statements.

A dividend payout ratio of less than 1 means that a company is retaining some of its earnings and distributing the rest. If the ratio is more than 1, it means that the company is earning less money than it is paying out in dividends.

I worked for a company that had a payout ratio of more than 1. When I first started working there, the company had more capital than it could use. The company was returning its excess capital to its shareholders through the high dividend. After several years, the company’s capital approached the amount it needed to support its business. If it had cut its dividend to an amount lower than its earnings, the stock price might have decreased significantly. Instead, the company was sold. Had the company not been sold, its shareholders might have had both a decrease in future dividend payments and a reduction in the value of their stock at the same time.  This double whammy (dividend cut at the same time as a price decrease) is a risk of owning a stock in a dividend-issuing company especially those with high dividend payout ratios.

Performance – Lanny and Bert’s View

Lanny and Bert are not assuming they can do better than management or the market.  As noted above, they tend to focus on companies with a dividend payout ratio less than 60%.  This approach allows for all three of increasing dividends to shareholders, share repurchases, and internal growth for profit.  Also, this approach ensures the company is continuing to invest in itself as well.  You can’t pay a dividend in the future if you can’t grow, or even maintain, your current earnings stream.  Therefore, if revenues are stagnant or shrinking, the safety of the company’s dividend comes into question.  Companies “can” pay out a dividend that is larger than your earnings over the short-to-medium term.  However, it is not sustainable as was the case with the company for which I worked.

Historical Performance

I was curious about how stocks that met Lanny and Bert’s criteria performed. I have a subscription to the ValueLine Analyzer Plus. It contains current and historical financial data and stock prices about hundreds of companies. I looked at two time periods.  I first looked at the most recent year (November 2018 to November 2019).  Because I was curious about how those stocks performed in the 2008 crash, I also looked at the ten-year period from 2003 to 2013. I would have used a shorter period around the 2008 crash and the period thereafter, but didn’t save the data in the right format so had to look at time periods for which I had saved the data in an accessible manner.

How I Measured Performance

For both time periods, I identified all stocks for which the data I needed for the analysis were available at both the beginning and end of the period.  There were 1,505 companies included in the sample in the 2018-2019 period and 952 companies for the 2003 to 2013 period.

I then identified companies (a) whose dividend grew in each of the previous two fiscal years, (b) whose dividend payout ratio was less than 60% and (c) whose P/B ratio was less than the average of all of the companies in the same. That is, I attempted to identify the companies that met Lanny and Bert’s criteria. There were 332 companies in the 2018-2019 period and 109 companies in the 2003-2013 period that met these criteria.

ValueLine ranks companies based on what it calls Timeliness, with companies with Timeliness ratings of 1 having the best expected performance and those having a rating of 5 having the worst expected performance. Because I suspected that Bert and Lanny’s screen would tend to select more companies with favorable Timeliness ratings than those with poorer ones, I looked at both the overall results, as well as the results by Timeliness rating.

November 2018 – November 2019

In the most recent year, the stocks that met Lanny’s and Bert’s criteria had an average total return (dividends plus change in stock price) of 11% as compared to 8.5% for the total sample. That is, in the current market, dividend issuing companies meeting their criteria returned more than the average of all companies.

Interestingly, when I stratified the companies by Timeliness rating, it showed that for companies with good Timeliness ratings (1 and 2), the Lanny’s and Bert’s companies underperformed the group. For companies with two of the three lower Timeliness ratings (3 and 5), though, Lanny’s and Bert’s companies not only did better than the average of all companies in the group, but also did better than even the group of companies with a Timeliness rating of 1! It looks to me as if their approach might identify some gems in what otherwise appear to be poorer performing companies.

The chart below shows these comparisons.

2003 to 2013

Over the longer time period from 2003 to 2013, the companies meeting Lanny’s and Bert’s criteria didn’t do quite as well as the average of all companies. In this case, the stocks meeting their criteria had a compound annual return of 5% as compared to 7% for all stocks in the sample. Without more data, it is hard to tell whether the difference in return is the sample of dividend-issuing companies is small, because those companies didn’t fare as well during the Great Recession or something else.

I looked at the total returns by Timeliness rating and the results were inconsistent for both the “all stocks” group and the ones that met our criteria. A lot can happen in 10 years! Nonetheless, it was interesting to see that the dividend-yielding stocks that had Timeliness ratings of 5 in 2003 out performed all other subsets of the data. So, while these stocks didn’t have quite as high a total return over the 10-year period in the aggregate, there are clearly some above-average performers within the group.

Tax Ramifications of Dividends

One of the drawbacks of investing in companies with dividends, as opposed to companies that reinvest their earnings for growth, is that you might need to pay taxes on the dividend income as it gets distributed.

Types of Accounts

If you hold your dividend-yielding stocks in a tax-deferred (e.g., Traditional IRA or 401(k) in the US or RRSP in Canada) or tax-free (e.g., Roth IRA or 401(k) in the US or TFSA in Canada), it doesn’t matter whether your returns are in the form of price appreciation or dividends. Your total return in each of those types of accounts gets taxed the same. That is, if you hold the stocks in a tax-deferred account, you will pay tax on your total returns, regardless of whether it is interest, dividends or appreciation, at your ordinary income tax rate. If you hold the stocks in a tax-free account, you won’t pay taxes on any returns.

The only type of account in which it matters whether your return is in the form of price appreciation or dividends is a taxable account. In the US, most people pay 15% Federal income tax plus some additional amount for state income taxes on dividends in the year in which they are issued. They pay taxes at the same rate on capital gains, but only when the stock is sold, not as the price changes from year to year. In Canada, the difference is even greater. Dividends are taxed at your ordinary income tax rate (i.e., they are added to your wages) and capital gains are taxed at 50% of your ordinary income tax rate and only when you sell the stock.

Dividend Reinvestment

When you earn dividends from a company, you often have the option to automatically reinvest the dividends in the same company’s stock. This process is a dividend reinvestment plan. Lanny and Bert take this approach.

Dividend reinvestment plans are terrific ways to make sure you stay invested in companies that you like, as you don’t have to remember to buy more stock when the dividend is reinvested. The drawback of dividend reinvestment plans is that you will owe tax on the amount of the dividend, even if you don’t receive it in cash. If you reinvest 100% of your dividends, you’ll need to have cash from some other source to pay the taxes unless you hold the investments in a tax-free or tax-deferred account.

Illustration

Let’s assume you are a US investor subject to the 15% Federal tax rate and pay no state income tax. You have two companies you are considering. You expect each to have a total return of 8%. One company’s return will be 100% in dividends, while the other company issues no dividends. You plan to own the stock for 10 years. Your initial investment will be $1,000 and you will pay your income taxes out of your dividends, so you reinvest 85% of the dividends you earn each year.

At the end of the 10th year, you will have $1,931 if you buy the company with 8% dividends. If you buy the company with no dividends, your stock will be worth $2,159. After you pay capital gains tax of $174, you will have $1,985 or 2.8% more than if you buy stock in the company that issues 8% dividends.

If you pay Canadian taxes, the difference is even bigger because of the much lower tax rate on capital gains than dividends. Over the full ten-year period, you will end up with almost 11% more if you buy stock in the company with no dividends than if you buy stock in the dividend-issuing company.

As such, you’ll want to put as much of your portfolio of dividend-issuing stocks in a tax-deferred or tax-free account as possible to minimize the impact of taxes on your total return.

Reading Financial Statements

Reading financial statement guides many investors in their decisions to buy and sell stocks.   Investors who focus on financial fundamentals look at recent financial statements in the context of other trends to estimate how much a company’s future profit might grow.  High-dividend yield investors need to understand the company’s financial statements to evaluate the sustainability of current dividend payments into the future.

Before investing in the stock of individual companies, it is good to understand the basics of their financial statements. In this post, I’ll identify the important values in the income statement and balance sheet and discuss important ratios that investors use to evaluate financial performance.  This post provides the basics of how stocks work.  In future posts, I’ll illustrate how these values can be used to evaluate companies and their stock prices under different investment strategies.

McCormick

Every company’s financial statements will be slightly different because every business is different. For illustration, I will use excerpts from the financial statements in the McCormick 2018 Annual Report. McCormick sells spices under its own name, but also owns the French’s mustard, Club House crackers and Lawry’s seasonings brands, among others. To be clear, my selection of McCormick for illustration is not intended to be a recommendation.

In this post, I’ll explain the key line items in McCormick’s financial statements.  If you are interested in other line items, you can either ask me in the comments or by e-mail or do some research on your own.

Income Statement

An income statement presents a summary of the financial aspects of a company’s operations and other financial transactions that occur during the financial reporting period. Publicly traded companies are required to provide their income statements to financial regulators (e.g., the Security & Exchange Commission in the US) quarterly and annually in reports known as the 10-Q and 10-K, respectively.

Here is a picture of the income statement from the McCormick 2018 Annual Report.[1]   All of the numbers in the excerpts from McCormick’s financial statements are in millions.

Revenue is the money that a company receives for the goods and services it delivered during the year.  As you can see in its income statement McCormick had $5.4 billion in total revenues (net sales) in 2018.

Expenses

Expenses represents all the money that a company spends in the year, with one exception.

Depreciation

When the company purchases something that is expected to last for a long time, it is called a capital asset. Companies don’t include the full cost of capital assets in expenses in the year in which they buy them. Rather, they spread the costs of capital assets over several years. The amount spread to each year is called depreciation. The depreciation of capital assets is included on the Income Statement, not the actual cash expense.

Operating Expenses or Cost of Goods Sold

Operating expenses, sometimes called Cost of Goods Sold for sellers of products, are those that are directly related to the manufacture of products or provision of services sold in the year. For McCormick, these expenses were $3.0 billion in 2018.

General and Administrative (G&A) Expenses

G&A expenses, sometimes called overhead expenses, represent the cost to run the company and are not directly related to specific products or services. Some companies include research and development (R&D) expenses with G&A expenses while others show them separately. For McCormick, these expenses were about $1.4 billion, an amount I had to find in its Notes to Financial Statements.

Other Income/Expenses

There are many types of income and expenses that don’t relate to products and services and aren’t G&A expenses. These items are usually small relative to the other line items on the income statement. For McCormick, there are three line items that fall in the Other Income/Expenses category

  • Transaction and integration expenses of $22 million
  • Special charges of $16 million
  • Other income, net of $13 million

These amounts combine to a net total of $25 million (=$22 million + $16 million – $13 million) in 2018. Compared to the other revenue and expense items, all of which are measured in billions of dollars, these amounts are small, as expected.

Interest Expenses

Interest expense represents interest that the company pays on its debt.  McCormick’s had $175 million of interest expense in 2018.

Income Taxes

These expenses represent income taxes that the company pays to any federal, state or local governments. McCormick had a tax benefit of $157 million in 2018. By looking at the Notes to Financial Statements included in the Annual Report, I found that McCormick owed $183 million in taxes related to 2018 operations, but the reduction in the US Federal tax rate on corporations in early 2018 caused an adjustment to McCormick’s tax liabilities. The decrease in tax rate created a benefit of $340 million. The $157 million tax benefit on the income statement is equal to the $183 million for current operations offset by the $340 million reduction in future taxes. When looking at McCormick’s profits going forward, the $183 million of taxes for current operations is the more important number because the $340 million is a one-time adjustment.

Accrual Basis vs. Cash Basis

One of the hardest things for most people to understand about income statements is the difference between the values on the income statement and the cash the company receives and pays. The income statement is said to be on an “accrual” basis. Accrual amounts relate to goods and services delivered during the year, regardless of when the cash is actually received or paid.

To clarify, revenues on the income statement represent the amount of cash the company has or will receive for goods or services delivered in the year. If the company hasn’t received some of its compensation for goods or services by the end of the year, it creates an asset on its balance sheet for accounts receivable. If it receives the cash before it delivers the goods or services, it creates a liability for goods or services due to customers.

Similarly, the expenses on the income statement relate to the products or services delivered in the year. If a company has to pay for components of its products, for example, before it delivers them, it will create an asset on its balance sheet for inventory. If it hasn’t paid all of the bills related to products delivered in the year, it creates a liability on the balance sheet for accounts payable.

As you can see, many balance sheet items (discussed further below) are really differences between amounts accrued on the income statement and actual cash received or paid.

Measures of Profit

Companies have several measures of profit. They can be measured as either dollar amounts or percentages or revenues. In this post, I’ll put “%” after the type of profit when I’m referring to the profit as a percentage of revenue.

Gross Margin

The gross margin is calculated as revenues minus operating expenses. This line is labeled as “Gross profit” in the McCormick income statement. In 2018, McCormick’s gross margin was $2.4 billion and corresponds to 44% of revenues. It represents the amount of profit the company would have had if its only expenses were those directly related to products and services.

Operating Income

Operating income is calculated as the gross margin minus G&A expenses and some components of other income and expenses. For 2018, McCormick’s operating income was $903 million or 17% of revenues. It represents the amount of profit the company would have had if it didn’t have any interest expense or taxes. It is sometimes called EBIT or earnings before interest and taxes.

Pre-tax Income

Pre-tax income is calculated as operating income minus interest expense and some components of other income and expenses. For 2018, McCormick had $741 million of pre-tax income (also known as EBIT or earnings before income taxes) or 14% of revenues.

Net Income

Net income is the bottom-line profit after taxes. It is calculated as pre-tax income minus income taxes. For 2018, McCormick had net income of $899 million. Recall, though, that McCormick had a one-time benefit from the change in tax rate of $340 million, so its net income would have been $559 million on a “normalized” basis or 10% of revenues. This adjusted net income is a better value for estimating future profits, as McCormick won’t get the benefit of a tax rate change every year.

Other Comprehensive Income

There are some values that impact the net worth of a company that don’t appear in the calculation of net income, but rather appears either at the bottom of the Income Statement or on a separate schedule in the financials. These items are referred to as Other Comprehensive Income. They can include the impact of changes in foreign exchange rates, certain transactions or changes in valuation related to investments and changes in the value of pension plans. As with other income, Other Comprehensive Income is usually small relative to other values on the income statement. If it isn’t, you’ll want to read the Notes to Financial Statements to understand the sources of Other Comprehensive Income and how it might affect profitability and growth in the future.

Balance Sheet

A balance sheet shows everything that a company owns or is owed (assets) and owes (liabilities) on a particular date.  As I mentioned earlier that many balance sheet items represent the differences between what the company has accrued on its income statement and what it has actually paid or received in cash. The balance sheet also shows the difference between assets and liabilities, which corresponds to its net worth or shareholders’ equity.

Here is a picture of McCormick’s 11/30/18 balance sheet taken from its Annual Report.[2]

Assets

Assets represent the value of things the company owns and amounts it is owed. Current assets are assets that a company can sell and turn into cash within a year. They are usually reported separately on a balance sheet.

McCormick had $10 billion in total assets on November 30, 2018. As you can see, inventory was its largest current asset at $786 million. Inventory represents the amount already spent on products that are ready to be sold or are in the process of being manufactured.

McCormick’s largest assets overall are its $4.5 billion of goodwill and $2.9 billion of intangible assets. These assets appear on some companies’ financial statements but not others. As you look at the net worth of a company, you’ll want to understand these assets.

Goodwill is created when one company buys another for a price that is higher than the net worth of the acquired company. That difference between the price and the net worth is intended to represent the present value of future profits on the acquired business. Goodwill is generally reduced as the profits emerge. In 2017, McCormick’s bought RB Foods which includes the French’s mustard, Frank’s RedHot and Cattlemen’s brands. More than three-quarters of McCormick’s goodwill was created when it bought RB Foods.

In McCormick’s case, the intangible assets represent the value of its brand names and trademarks. Although not exactly correct, the amount can be thought of as the present value of the future profits McCormick thinks it will get as the result of owning the brand names and trademarks.

Liabilities

Liabilities represent money or the value of products or services a company owes to others. McCormick had $7.1 billion in liabilities on November 30, 2018. The largest of these liabilities was Long Term Debt of $4.1 billion. McCormick issued roughly $3.4 billion in debt to finance its acquisition of RB Foods in 2017.

Equity

Shareholders’ equity represents the difference between assets and liabilities. It represents what is known as the “book value” of the company. On November 30, 2018, Boeing’s shareholders’ equity was $3.2 billion.

Key Financial Ratios

When deciding whether to buy or sell stock in a company, there are a number of ratios that many investors consider. I’ve highlighted a few important ones in this section, using the McCormick financial statement excerpts from above for illustration. I note that I have used simplified versions of the financial statements and the calculations, so you will likely see published values for McCormick that differ a bit from those calculated here.

ROE or Return on Equity

Return on equity (ROE) can be approximated as Net Income for the year divided by Shareholders’ Equity at the beginning of the year. For McCormick, it is approximated for 2018 as the $899 million of net income divided by the $2,571 million of shareholders’ equity at the end of its 2017 fiscal year or 35%. That ROE is very high. Recall, though, that McCormick had a one-time tax benefit of $340 million in 2018. If we exclude that benefit as it won’t be repeated in the future, we get an adjusted ROE of 22%.

According to CSI Market[3], the average ROE for the total market for 2018 was around 13%. ValueLine, a source for lots of qualitative and quantitative information about companies, reports that the average ROE for companies in the food processing industry (in which McCormick falls) is about 15%.[4] As such, even McCormick’s adjusted ROE is higher than these averages.

P/E Ratio or Price/Earnings Ratio

The Price/Earnings or P/E ratio is the stock price divided by the earnings per share. McCormick had roughly 130 million shares of stock outstanding in 2018. As such, its earnings per share was about $7 (=$899 million/130 million shares). McCormick’s stock price on November 30, 2018 (the date of the financial statements) was $150, which corresponds to a P/E ratio of about 22.

According to ValueLine, the average P/E of companies in the food processing industry on October 31, 2019 was 23. By comparison, the average P/E for the market has been between 16 and 18 for the past year or so. As such, McCormick’s P/E is in line with its peers. If we adjust McCormick’s earnings to exclude the one-time tax benefit, its earnings per share would have been about $4.25 per share. When we divided the $150 stock price by this smaller number, the adjusted P/E is about 35 or much higher than its peers.

P/B Ratio or Price/Book Ratio

The Price/Book or P/B ratio is the stock price divided by shareholders’ equity (book value) per share. McCormick’s equity as of November 30, 2018 was $3,182 million. When divided by the number of outstanding shares, the book value per share was $24. The stock price divided by the book value is about 0.90. ValueLine indicates that the average P/B ratio on October 31, 2019 for the food processing industry was about 3.3 or much higher than McCormicks’ P/B ratio.

P/B Ratio > 1

When the P/B ratio is greater than 1, the difference between the stock price and the book value per share is the present value of future earnings estimated by investors. The higher the P/B ratio, the higher the value investors place on future earnings.

P/B < 1

When the P/B ratio is less than 1, it means that investors either think that the future earnings are going to negative (which doesn’t appear to be the case for McCormick) or they don’t think shareholders’ equity is fairly valued. In the case of McCormick, it could be that investors think that the goodwill and intangible assets might be overvalued or they might be concerned that the future reductions to income as the goodwill and intangible assets are reduced will have a significant adverse impact on earnings. If either of those is the case, investors may be adjusting the company’s book value (equity) in their analyses for their perceived overstatement of goodwill and intangible assets.

Within the group of investors who look at financial fundamentals for decision-making, there is a subset called “value investors.” Value investors look for companies whose stock price doesn’t full reflect the value of the company which is often determined by P/B ratios of less than 1.00. A value investor who was confident that McCormick could maintain its current profitability and that the company had fairly estimated its goodwill and intangible assets might find McCormick to be an attractive stock.

Debt-to-Equity Ratio

Both debt and equity are ways in which a company can get money to finance their operations – either when it issues bonds or new shares of stock. The sum of the two is sometimes called total capital.

The Debt-to-Equity ratio is the amount of long-term debt divided by shareholders’ equity and is a measure of the mix the company has chosen to use for financing its operations, growth or acquisitions. McCormick has a total of $4.1 billion of debt ($4.05 billion recorded as long-term debt plus $84 million reported as the portion of long-term debt on its balance sheet). The debt-to-equity ratio is 1.30 (=4.1/3.2).

The higher the debt-to-equity ratio, the more leveraged a company is said to be. To clarify, when there is a lot of leverage, its ROE will be much higher than if some or all of the debt were equity instead. For example, McCormick’s ROE for 2018 was 35%. If all of its debt had been equity instead, its ROE would have been 13% (=$899 million/[$3.2 billion + $4.1 billion]).   The opposite it true when a company has a negative ROE. If McCormick’s ROE in 2018 had been -10% based on its current leverage, it would have been only -4% if it had only equity capital instead of its current mix of debt and equity.

Tangible Equity/Total Equity

I wasn’t planning to talk about tangible equity in this post, but my choice of McCormick almost forces me to. If you recall, I pointed out earlier in this post that McCormick’s two biggest assets are Goodwill and Intangible Assets. If a company encounters financial difficulties, it sometimes has to reduce or write-off the value of any goodwill or intangible assets. When these assets are reduced, its total equity will be reduced by the same amount, after adjustment for income taxes. In addition, goodwill and intangible assets are reduced as the future profits are expected to be earned. As such, goodwill and other intangible assets cause future net income to be lower than it would otherwise be, even if there are no write-offs.

Tangible equity is equal to total equity minus goodwill minus intangible assets. Because these assets can’t be quickly turned into cash and can have their value reduced, many investors look at ratio of tangible equity to total equity. The total of McCormick’s goodwill and intangible assets was $7.4 billion. This amount is more than twice its shareholders’ equity. What this means is that McCormick’s book value would become negative if it were required to write-down more than half of its goodwill and intangible assets.  As long as everything goes as expected, though, McCormick will be just fine. As such, this ratio is a measure of the riskiness of the stock price.

Earnings Growth Rate

Another important metric that investors consider is the earnings growth rate. When considering when to buy a stock, investors try to estimate future earnings growth rates. In the estimation process, they often consider historical growth rates. The historical earnings growth rate is the ratio of this year’s net income to last year’s net income minus 1.00.

For McCormick, after adjustment for the one-time tax benefit, the earnings growth rate from 2017 to 2018 was 25% (=$559 million / $444 million – 1). From 2016 to 2017, it was a much more modest 2%.

Stock prices tend to reflect estimated future earnings as well as estimated future earnings growth rates. There are many investment analysts who estimate the future earnings growth rates for publicly-traded companies. Yahoo Finance and most large brokerage firms’ web sites include information about analysts’ estimates of future earnings growth rates. Also, some investors look at recent growth rates and trends in the markets in which companies operate to estimate the future earnings growth rates.

Investing Decisions

These ratios, along with others, are often used by investors to evaluate the financial condition of the company and the reasonableness of its stock price. For example, one rule of thumb is that stocks are fairly priced when the P/E ratio is less than the expected future earnings growth rate. I’ll take about this rule of thumb and other decision criteria in future posts in my series on investing in stocks.

[1] https://ir.mccormick.com/financial-information, 2018 Annual Report, p50.

[2] https://ir.mccormick.com/financial-information, 2018 Annual Report, p. 51.

[3] https://csimarket.com/Industry/industry_ManagementEffectiveness.php?&hist=4, November 7, 2019

[4] ValueLine Investment Analyzer, October 31, 2019.

What You Need to Know About Stocks

Stocks are a common choice for many investors.  There are two types of stocks – preferred and common.  Because most investors buy common stocks, they will be the subject of this post.  I’ll talk about what you need to know about stocks before you buy them, including:

  • Stocks and how they work.
  • The price you will pay.
  • The risks of owning stocks.
  • Approaches people use for selecting stocks.
  • How stock are taxed.
  • When you might consider buying stocks.
  • How to buy a stock.

What are Stocks?

Stocks are ownership interests in companies.  They are sometimes called equities or shares.  When you buy a stock, you receive a certificate that indicates the number of shares you own.  If you buy your investments through a brokerage firm, it will hold your certificates for you.  If you buy them directly, you will usually receive the certificate (and will want to maintain it in an extremely safe place as it is your only proof that you own the stock).  Some companies track their stock’s owners electronically, so you may not always get a physical certificate.

How Do Stocks Work?

Companies sell stock as a way to raise money.  The company receives the amount paid for the shares of stock when they are issued, minus a fee paid to the investment banker that assists with the sale.  The process of issuing stock is called a public offering.  The first time a company offers its shares to the public, it is called an initial public offering (IPO).

Stockholder-Company Interactions

After the stock has been sold by the company, the stockholder has the following interactions with the company:

  • It receives any dividends paid by the company.
  • It gets to vote on matters brought before shareholders at least annually.  These issues include election of directors, advisory input on executive compensation, selection of auditors and other matters.
  • It has the option to sell the stock back to the company if the company decides to repurchase some of its stock.

In addition to these benefits of owning stock, you also can sell it at the then-current market price at any time.

Why Companies Care About Their Stock Prices

Interestingly, after the stock has been sold by the company, future sales of the stock do not impact the finances of the company other than its impact on executive compensation.  That is, if you buy stock in a company other than when it is issued, you pay for the stock and the proceeds go to the seller (who isn’t the company)!

You might wonder, then, why a company might care about its stock price.  That’s where executive compensation comes in!  Many directors and senior executives at publicly traded companies have a portion of their compensation either paid in stock or determined based on the price of the company’s stock.  When the leadership owns a lot of stock or is paid based on the stock price, it has a strong incentive to act in a way that will increase the price of the stock.  As such, with appropriate incentive compensation for directors and executives, their interests are more closely aligned with yours (i.e., you both want the price of the company’s stock to go up).

What Price Will I Pay?

The price you will pay for a stock is the amount that the person selling the stock is willing to take in payment.  Finance theory asserts that the price of a stock should be the present value of the cash flows you will receive as the owner of a stock.

In my post on bonds, I explain present values.  They apply fairly easily to the price of a bond, as the cash flows to the owner of a bond are fairly clear – the coupons or interest payments and the return of the principal on a known date.

By comparison, the cash flows to the owner of a stock are much more uncertain.  There are two types of cash flows to the owner of a stock – dividends and the money you receive when you sell the stock.

Dividends

Dividends are amounts paid by the company to stockholders.  Many companies pay dividends every quarter or every year.  In most cases, the amount of these dividends stay fairly constant or increase a little bit every year.  The company, though, is under no obligation to pay dividends and can decide at any time to stop paying them.  As such, while many people assume that dividends will continue to be paid, there is more uncertainty in whether they will be paid than there is with bond interest.

Proceeds from the Sale of the Stock

The owner of the stock will receive an amount equal to the number of shares sold times the price per share at the time of sale.  This cash flow has two components of uncertainty to it.

  1. You don’t know when you will sell it. You therefore don’t know for how long you need to discount this cash flow to calculate the present value.
  2. It is impossible to predict the price of a stock in the future.

What are the Risks?

The biggest risk of buying a stock is that its value could decrease.   At the extreme, a company could go bankrupt.  In a bankruptcy, creditors (e.g., employees and vendors) are paid first.  If there is money left after creditors have been paid, then the remaining funds are used to re-pay a portion of any bond principal.  By definition, there isn’t enough money to pay all of the creditors and bondholders when there is a bankruptcy.  As such, the bondholders will not get all of their principal re-paid and there will be no money left after payment has been made to bondholders and creditors.  When there is no money left in the company, the stock becomes worthless.

Any of the following factors (and others) can cause the price of the stock to go down.

Economic Conditions Change

Changes in economic conditions can cause the interest rate used for discounting in the present value calculation to increase. When the interest rate increases, present values (estimates of the price) will go down.

Company Changes

Something changes at the company that causes other investors to believe that the company’s profits will be less than previously expected. One simple way that some investors estimate the price of a company’s stock is to multiply the company’s earnings by a factor, called the price-to-earnings ratio or P/E ratio.  Although P/E ratios aren’t constant over time, the price of a stock goes down when its earnings either decrease or are forecast to be lower than expected in the future. For more about P/E ratios and how a company calculates and reports on its earnings, check out this post

Increased Risk

Changes either in the economy or at the company can cause investors to think that the future profits of the company are more uncertain, i.e., riskier. When a cash flow is perceived to be riskier, a higher interest rate is used in the present value calculation.  This concept is illustrated in my post on bonds in the graph that shows how interest rates on bonds increase as the credit rating of the company goes down.  Recall that lower credit ratings correspond to higher risk.  The same concept applies to stock prices.  The prices of riskier stocks are less than the prices of less risky stocks if all other things are equal.

How Do People Decide What to Buy?

There are a number of approaches investors use to decide in which companies to buy stocks and when to buy and sell them.   I will discuss several of them in future posts.

Reasonable Price Investing

Reasonable price investors look at the financial fundaments and stock prices of companies to decide whether and when to buy and sell them.

Technical Analysis

Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks.  Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

Rather than invest in individual companies, some investors purchase either mutual or exchange-traded funds.  Under this approach, the investor relies on the fund managers to select the companies and determine when to buy and sell each position.

How are Stocks Taxed?

There are two ways in which stocks can impact your income taxes:

  • When you receive a dividend.
  • When you sell your ownership interest in the stock.

The total amount of the dividend is subject to tax.  The difference between the proceeds of selling the stock and the amount you paid for the stock is called a realized capital gain or loss.  It is gain if the sale proceeds is more than the purchase amount and a loss if the sale proceeds are less than the purchase amount.

In the US, realized capital gains and losses on stocks you have owned for more than a year are added to dividends.  For most people, the sum of these two amounts is taxed at 15%.  For stocks owned for less than a year, the realized capital gains are taxed at your ordinary tax rate (i.e., the rate you pay on your wages).

In Canada, dividends and half of your realized capital gains are added to your wages.  The total of those amounts is subject to your ordinary income tax rate.

When Should I Buy Stocks?

Understand Stocks

The most important consideration in determining when to buy stocks is that you understand how stocks work.  One of the messages I wished I had given our children is to invest only in things you understand.  If you don’t understand stocks, you don’t want to invest in them.

Understand the Companies or Funds

You also want to make sure you understand the particular company or fund you are purchasing.  One of the biggest investing mistakes I made was when I was quite young and didn’t understand the business of the company whose stock I owned.

My parents gave me some shares of a company called Wang Laboratories.  In the 1970s and early 1980s, Wang was one of the leaders in the market for dedicated word processors.  Picture a desktop computer with a monitor that’s only software was Microsoft Word, only much harder to use.  That was Wang’s biggest product.  At one time, the stock price was $42.  Not understanding that PCs were entering the market and would be able to do so much more than a dedicated word processor, I was oblivious.  As the stock started going down, I sold a few shares in the high $30s.  When the stock dropped to $18, I told myself I would sell the rest when it got back to $21.  It never did.  A year or so later, the stock was completely worthless. Fortunately, I was young enough that I had a lot of time to recover and learn from this mistake.

Be Willing and Able to Understand the Risks

You should also not buy stocks if you can’t afford to lose some or all of your principal.  Even though only a few companies go bankrupt, such as Wang, the price of individual stocks can be quite volatile.  As discussed in my post on diversification, you can reduce the chances that your portfolio will have a decline in value by either owning a large number of stocks or owning them for a long time.  Nonetheless, you might find that the value of your portfolio is less than the amount you invested especially over short periods of time when you invest in stocks.  If you want to invest in stocks, you need to be willing to tolerate those ups and downs in value both mentally and financially.

Market Timing

There is an old investing adage, “Buy low, sell high.”  In principle, it is a great strategy.  In practice, though, it is hard to identify the peaks and valleys in either the market as a whole or an individual stock.

People who invest over very short time frames – hours or days – often use technical analysis to try to identify very short-term highs and lows to create gains.  I anticipate that most of my followers, though, will be investing for the long term and not day trading.  While you will want to select stocks that are expected to produce a return commensurate with their riskiness, it is very difficult to time the market.

That is, my suggestion for new investors with long-term investment horizons (e.g., for retirement or your young children’s college expenses) is to buy stocks or mutual funds you understand and think are likely to appreciate whenever you have the time and money available to do so.  If you happen to buy a fundamentally sound stock or index fund just before its price drops, it will be difficult to hang on but it is likely to increase in the price by the time you need to sell it.

As Chris @MoneyStir learned when he reviewed the post I wrote about whether he should pre-pay his mortgage, a fall in the stock market right after he started using his extra cash to buy stocks on a monthly basis was actually good for him!  While he lost money at first on his first few month’s investments, the ones he made over the next several months were at a lower stock price and produced a higher-than-average return over his investment horizon.  The process of buying stocks periodically, such as every month, is called dollar-cost averaging.

How and Where Do I Buy Stocks?

You can buy stocks, mutual funds and ETFs at any brokerage firm.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

Once you have an account, you need to know the name of the company or its symbol (usually 2-5 letters that can be found using Google or Yahoo Finance, for example), how many shares you want to buy and whether you want to set the price at which you purchase the stocks or buy them at the market price.

Limit Orders

If you determine you want to buy a stock at a particular price, it is called a limit order.  The advantage of a limit order is you know exactly how much you will pay.  The disadvantages of a limit order are:

  • You might pay more than you have to if the stock price is lower at the time you place your order.
  • You might not buy the stock if no one is interested in selling the stock at a price that is a low as your desired purchase price.

Market Orders

If you place a market order, you will buy the stock at whatever price sellers are willing to take for their stock at the moment you place your order.  In some cases, you may end up paying more than you want for a stock if the price jumps up right at the time you place your order.  The advantages of a market order are (1) you know you will own the stock and (2) you know you are getting the best price available at the time you buy the stock.

Transaction Fees

Many of the major brokerage firms have recently announced that they will no longer charge you each time you purchase or sell a stock.  Some firms charge you small transaction fees, such as $4.95, each time you place a buy or sell order.  Other firms have higher charges.  You’ll want to consider the fees when you select a brokerage firm.

Annual Retirement Savings Targets

Once you know how much you want to save for retirement, you need a plan for building that savings.  Your annual retirement savings target depends on your total savings target, how many years you have until you want to retire and how much risk you are willing to take in your portfolio.  In this post, I’ll provide information you can use to set targets for how much to contribute to your retirement savings each year.

Key Variables

There are several variables that will impact how much you’ll want to target as contributions to your retirement savings each year.  They are:

  • Your total retirement savings target.
  • How much you already have saved.
  • The number of years you are able to contribute to your retirement savings.
  • How much risk you are willing to take in your portfolio.
  • The impact of taxes on investment returns between now and your retirement. That is, what portion of your retirement savings will be in each of taxable accounts, tax-deferred retirement savings accounts and tax-free retirement savings accounts.  For more information on tax-deferred and tax-free retirement savings accounts, check out this post.  I provide a bit more insight on all three types of accounts in these posts on how to choose which assets to buy in which type of account in each of the US and Canada.

Some of these variables are fairly straightforward.  For example, you can check the balances of any accounts with retirement savings that you already have and you can estimate (within a few years, at least) how many years until you retire.

Other variables are more challenging to estimate.  For example, I dedicated a whole separate post to the topic of setting your retirement savings target.

Your Risk Tolerance

Your risk tolerance is a measure of how much volatility you are willing to take in your investments.  As indicated in my post on risk, the more risk you take the higher your expected return but the wider the possible range of results.  My post on diversification and investing shows that the longer period of time over which you invest, the less volatility has been seen historically in the annualized returns.

Here are a few thoughts that might guide you as you figure out your personal risk tolerance.

  • If you have only a few years until you retire, you might want to invest fairly conservatively. By investing conservatively, you might want to invest in money market or high-yield savings accounts that currently have yields in the 1.75% to 2% range.
  • If you have five to ten years until you retire or are somewhat risk averse (i.e., can’t tolerate the ups and downs of the stock market), you might want to invest primarily in bonds (discussed in this post) or bond mutual funds. Depending on the maturity, US government bonds are currently yielding between 1.5% and 2% and high-quality corporate bonds are currently returning between 2.5% and 4%.
  • If you have a longer time period to retire and/or are able to tolerate the volatility of equities (discussed in this post), you might invest in an S&P 500 index fund or an index fund that is even more risky. These funds have average annual returns of 8% or more.

As can be seen, the more risk you take, the higher the average return.  As you are estimating how much you need to save each year for retirement, you’ll need to select an assumption about your average annual investment return based on these (or other) insights and your personal risk tolerance.

Taxability of Investment Returns

In addition to considering your risk tolerance, you’ll need to adjust your investment returns for any taxes you need to pay between the time you put the money in the account and your retirement date.  For this post, I’ve assumed that your savings amount target includes income taxes, as suggested in my post on that topic.  If it does, you only need to be concerned with taxes until you retire in estimating how much you need to save each year.

In the previous section, you selected an average annual investment return.  The table below provides approximations for adjusting that return for Federal income taxes based on the type of financial instruments you plan to buy and the type of account in which you hold it.

US – Taxable

Canada – Taxable

All Tax-Deferred & Tax-Free Accounts

Money Market

Multiply by 0.75

Multiply by 0.75

No adjustment

Bonds and Bond Mutual Funds

Multiply by 0.75

Multiply by 0.75

No adjustment

Equity Mutual Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Equities and Index Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Further Refinements to Tax Adjustments

You’ll need to subtract your state or provincial income tax rate from each multiplier. For example, if you state or provincial income tax rate is 10%, you would subtract 0.10 from each multiplier. For Equities and Index Funds, the 0.85 multiplier in the US-Taxable column would be reduced to 0.75.

The assumptions in this table for equities and index funds in particularly and, to a lesser extent, equity mutual funds, are conservative.  Specifically, if you don’t sell your positions every year and re-invest the proceeds, you will pay taxes less than every year.  By doing so, you reduce the impact of income taxes.  Nonetheless, given all of the risks involved in savings for retirement, I think these approximations are useful even if they cause the estimates of how to save every year to be a bit high.

Also, the tax rates for bonds and bond mutual funds could also be conservative depending on the types of bonds you own.  The adjustment factors shown apply to corporate bonds.  The tax rates on interest on government bonds and some municipal bonds are lower.

Calculation of After-Tax Investment Return

From the table above, it is clear that calculating your after-tax investment return depends on both the types of investments you plan to buy and the type of account in which you plan to hold them.  The table below will help you calculate your overall after-tax investment return.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

0.75

Equity Mutual Funds, Equities, Index Funds

Taxable

0.85 if US; 0.87 if Canada

All

Other than Taxable

1.00

Total

There are three assumptions you need to enter into this table that reflect the types of financial instruments you will buy (i.e., reflecting your risk tolerance) and the types of accounts in which you will hold those assets in the Percent of Portfolio column.  These assumptions are the percentages of your retirement savings you will invest in:

  • Money markets, bonds or mutual funds in taxable accounts.
  • Equities, equity mutual funds and index funds in taxable accounts.
  • Tax-deferred or tax-free accounts (IRAs, 401(k)s, RRSPs and TFSAs).

For each of these three groups of assets, you’ll put the average annual return you selected from the Risk Tolerance section above in the Pre-Tax return column.  You also may need to adjust the multipliers as discussed above.

Once you have filled in those six boxes, you will multiply the three numbers in each row together to get a single product in the last column of each row.  Your weighted average after-tax investment return will be the sum of the three values in the last column.

Illustration of Weighted Average Return Calculation

I have created an illustration in the table below.  For this illustration, I have assumed that you will invest 50% of your portfolio in bonds and 50% in equities.  You are able to put 60% of your portfolio in tax-deferred and tax-free accounts.  Although not consistent with my post on tax-efficient investing, you split your bonds and stocks between account types in the same proportion as the total.  As such, you have 20% of your portfolio in taxable accounts invested in each of bonds and equities.  The 60% you put in your tax-deferred and tax-free accounts goes in the All Other row.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

20% 3% 0.75

0.5%

Equity Mutual Funds, Equities, Index Funds

Taxable

20% 8% 0.85 if US; 0.87 if Canada

1.4%

All

Other than Taxable

60% 5.5% 1.00

3.3%

Total

5.2%

I’ll use a pre-tax return on bonds of 3% and equities of 8%.  Because the All Other category is 50/50 stocks and bonds, the average pre-tax return for that row is the average of 3% and 8% or 5.5%.

I then calculated the products for each row.  For example, in the first row, I calculated 0.5% = 20% x 3% x 0.75.  The weighted average after-tax investment return is the sum of the three values in the product column or 5.2% = 0.5% + 1.4% + 3.3%.  The 5.2% will be used to help estimate how much we need to save each year to meet our retirement savings target.

Annual Savings Targets

By this point, we have talked about how to estimate:

  • Your total retirement savings target
  • The number of years until you retire
  • An after-tax investment return that is consistent with your risk tolerance and the types of accounts in which you plan to put your savings

With that information, you can now estimate how much you need to save each year if you don’t have any savings yet.  I’ll talk about adjusting the calculation for any savings you already have below.

I assumed that you will increase your savings by 3% every year which would be consistent with saving a constant percentage of your earnings each year if your wages go up by 3% each year.  For example, if you put $1,000 in your retirement savings this year, you will put another $1,030 next year, $1,061 in the following year and so on.  In this way, your annual retirement savings contribution will be closer to a constant percentage of your income.

Annual Savings/Total Target

The graph and table below both show the same information – the percentage of your retirement savings goal that you need to save in your first year of savings based on your number of years until you retire and after-tax annual average investment return.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

17.6% 7.8% 4.6% 3.0% 2.1% 1.6% 1.2% 0.9%

3%

17.3% 7.4% 4.3% 2.8% 1.9% 1.4% 1.0% 0.8%

4%

16.9% 7.1% 4.0% 2.5% 1.7% 1.2% 0.9% 0.6%

5%

16.6% 6.8% 3.7% 2.3% 1.5% 1.0% 0.7%

0.5%

6% 16.3% 6.5% 3.5% 2.1% 1.3% 0.9% 0.6%

0.4%

7% 16.0% 6.2% 3.2% 1.9% 1.2% 0.7% 0.5%

0.3%

8% 15.7% 6.0% 3.0% 1.7% 1.0% 0.6% 0.4%

0.3%

As you can see, the more risk you take, the less you need to save on average.  That is, as you go down each column in the table or towards the back of the graph, the percentage of your target you need to save in the first year gets smaller.  Also, the longer you have until you retire (as you move right in the table and graph), the smaller the savings percentage.  I caution those of you who have only a few years until retirement, though, that you will want to think carefully about your risk tolerance and may want to use the values in the upper rows of the table corresponding to lower risk/lower return investments, as there is a fairly high chance that your savings will be less than your target due to market volatility if you purchase risky assets.

How to Use the Table

First find the percentage in the cell with a row that corresponds to your after-tax investment return and a column that corresponds to your time to retirement.  You multiply this percentage by your total retirement savings target.  The result of that calculation is how much you need to save in your first year of saving.  To find out how much to save in the second year, multiply by 1.03.  Keep multiplying by 1.03 to find out how much to save in each subsequent year.

Earlier in this post, I created an example with a 5.2% after-tax investment return.  5.2% is fairly close to 5%, so we will look at the row in the table corresponding to 5% to continue this example.  I have calculated your first- and second-year savings amounts for several combinations of years to retirement and total retirement savings targets for someone with a 5% after-tax investment return below.

Years to Retirement

Savings % from Table (5% Row) Total Retirement Savings Target First-Year Savings Amount Second-Year Savings Amount

5

16.6% $500,000 $83,000 $85,490

15

3.7% 2,000,000 74,000

76,220

30 1.0% 500,000 5,000

5,150

40 0.5% 1,000,000 5,000

5,150

The first-year savings amounts in this table highlight the benefits of starting to save for retirement “early and often.”   It is a lot easier to save $5,000 a year than $75,000 or $85,000 a year.  By comparing the last two rows, you can see the benefits of the extra 10 years between 30 years of savings and 40 years of savings.  With the same starting contributions, on average, you end up with twice as much if you save consistently for 40 years than if you do so for 30 years.

Adjusting for Savings You Already Have

The calculations above don’t take into account that you might already have started saving for retirement.  If you already have some retirement savings, you can reduce the amount your need to save each year.

The math is a bit complicated if you don’t like exponents, but I’ll provide a table that will make it a bit easier.  To adjust the annual savings calculation for the amount you already have saved, you need to subtract the future value of your existing savings from your total retirement savings target.  The future value is the amount to which your existing savings will grow by your retirement date.  The formula for future savings is:

where n is the number of years until you retire.  The annual return is the same return you’ve been using in the formulas above.  If you don’t want to deal with the exponent, the table below will help you figure out the factor by which to multiply your current amount saved.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

1.10 1.22 1.35 1.49 1.64 1.81 2.00 2.21

3%

1.16 1.34 1.56 1.81 2.09 2.43 2.81 3.26

4%

1.22 1.48 1.80 2.19 2.67 3.24 3.95 4.80
5% 1.28 1.63 2.08 2.65 3.39 4.32 5.52

7.04

6% 1.34 1.79 2.40 3.21 4.29 5.74 7.69

10.29

7% 1.40 1.97 2.76 3.87 5.43 7.61 10.68

14.97

8% 1.47 2.16 3.17 4.66 6.85 10.06 14.79

21.72

Illustration of Adjustment for Existing Savings

Let’s say you have $50,000 in retirement savings, 25 years until you retire and have selected an annual return of 5%.  You would use the factor from the 5% row in the 25 years column of 3.39.  You multiply $50,000 by 3.39 to get $169,500.

If your total retirement savings target is $1,000,000, you subtract $169,500 and use an adjusted target of $830,500.  Using the same time to retirement and annual return, your annual savings target is 1.5% of $830,500 or $12,458.  This annual savings amount compares to $15,000 if you haven’t saved any money for retirement yet.

Caution

Having been subject to Actuarial Standards of Practice for most of my career (which started before the standards existed), I can’t finish this post without providing a caution.  All of the amounts that I’ve estimated in this post assume that you earn the average return in every year.  There aren’t any financial instruments that can guarantee that you’ll earn the same return year in and year out.  As mentioned above, riskier assets have more volatility in their returns.  That means that, while the average return is higher, the actual returns in any one year are likely to be further from the average than for less risky assets.

As such, you should be aware that the amounts shown for annual savings will NOT assure you that you will have your target amount in savings when you retire.  I suggest that, if possible, you set a higher target for your total retirement savings than you think you’ll really need or save more each year than the amounts resulting from these calculations. You don’t want to be in the situation in which my friend found herself at age 59 starting over financially.