My Life In and Out of Real Estate Markets, conclusion

Part III: Lessons Learned

In Part I of this series, I explained why I decided to become a real estate investor, and how I came to own a rental property. In Part II of this series, I described my frustrations with owning a rental property, and how I got out of the real estate market just in time.

In this final post in this series, I will share with you what I learned from my time as a landlord. It is my sincere hope that you learn from my mistakes, and consider carefully whether real estate investing is the right investment for you before taking the plunge.

So, what did I learn from my three and a half years as a landlord?

• Real estate can pay off big.
  
• Owning a rental property can be painful.
  
• Real estate has some drawbacks compared to stocks.
  

Real Estate Can Pay Off Big

By investing in real estate, you can use credit to leverage a down payment into a pricy asset, which generally appreciates over time. This means that you can make big gains, even with only a modest appreciation in the value of a house.

For example, if you make a down payment of 20% on a property that appreciates 3% in the first year, your down payment has netted you a return of 12% in one year - not bad at all, especially if your mortgage payment is close to what you were previously paying for rent. Buying a home with a large down payment and the intention of living in it for a long period of time makes great sense, especially if you don’t overpay for your house, and if you don’t buy more house than you need.

Owning a Rental Property Can be Painful

When you invest in a rental property, on the other hand, you’re not paying a mortgage instead of rent – you’re paying a mortgage in the hope of recovering some or all of your costs by renting to others. Over time, rental inflation will bring your rental income above your costs, assuming that your mortgage payments remain the same.

If your costs exceed what you are able to rent the property for by a wide margin, or if you are using an adjustable-rate mortgage, then you are not really investing; you are speculating: Speculating that interest rates will stay low and so will your payment; Speculating that house prices will go up fast enough to bail you out.

Whether you are a risk-adverse investor like me, or a reckless speculator, you will be on the hook for making mortgage payments when the property is vacant, and unless you pay several thousand dollars a year, you will be responsible for managing the property as well. This may sound fine, but unless you enjoy working on weekends and holidays, you will not be happy about it; take my word for it.

Stocks perform better over long periods of time than most asset classes, including real-estate. Stocks also include built-in management (of admittedly varying quality), so if you can find the right individual stock or fund, you can do as well as you would owning rental properties, especially if you account for the value of the time that you don't have to spend managing the companies that you are invested in.

I could have purchased any number of stocks, including real-estate stocks such as Boston Properties (BXP) or Caterpillar (CAT), and made the same money that I did with my rental in the same period of time, without the same frustrations.

Real Estate Has Some Drawbacks Compared to Stocks

Since we’re on the subject of comparing real estate to stocks, here is my complete list of shortcomings of real estate as an asset class:

1. Personal Responsibility. You have duties as a landlord, from making timely repairs to spending Saturdays showing the house to prospective tenants. It is a second job, and paying someone to manage your property is not cheap.
   
2. Financial Responsibility. You are on the hook for those mortgage payments, whether you have a tenant or not.
   
3. Illiquidity or Slippage. You have to find the right buyer. You need to have the house vacant. Houses are not identical (or fungible), and yours could have or develop an attribute that makes it undesirable, such as a neighborhood that becomes blighted by foreclosures.
   
4. High transaction costs. 6% in, 6% out, unless you want to try to sell the house yourself, which means even more responsibility and another part-time job.
   

So, Do You Really Want to Be a Landlord?

So, when a co-worker mentions to me they are thinking of taking advantage of the current downturn in house prices to buy a rental house, I ask them: Are you sure that you want a second job? Are you sure that you can afford to have a vacant rental for several months? Do you enjoy calling people to ask for money that they owe you? Are you good with a hammer and power-tools?

If you are like most people, the answer to one or more of these questions is an emphatic “no”.

So, do you really want to be a landlord?

I don’t.

My Life In and Out of Real Estate Markets, continued

Part II: Getting Out

In the first post in this series, I told the story of how my wife and I came to own a rental property at the start of 2004. In this post, I will tell you about the problems that I had with tenants, how I was tempted by mortgage brokers who prey on landlords with vacant properties, and why I concluded that owning a rental property was more trouble than I needed.

This reminiscence is especially timely given what is happening in the real estate and mortgage markets currently. As I look around at the wave of foreclosures and at all of the borrowers who are facing increased mortgage payments as their exotic mortgage products reset to higher interest rates, I am reminded of how fortunate I am to have been born with a cautious streak. So many real estate investors lost thousands of dollars because they were tempted by mortgages offering lower monthly payments.

But I am getting ahead of myself, again. My last post ended with telling the story of how I became a landlord. This post gets into the reasons that I decided to quit my second job as a landlord.

Did I mention that being a landlord is a second job?

The Honeymoon Ends

As the person who had come up with the idea of buying a rental property, my wife rightly pointed out, it was my job to find and manage the tenants. She was glad to co-sign the mortgage and help with cleanup and repairs (bless her heart for her patience), but the day-to-day finding and management of tenants would be my job.

An important factor that I failed to consider, as it turned out, was that a lot of people who had good credit and were in the habit of paying rent on time were becoming homeowners at the same time that we were becoming landlords. So, the initial plan of only renting to people with good credit quickly went by the wayside. Landlords who had such tenants were eager to keep them, and there were fewer such tenants by the day as people with good credit and a few thousand dollars to their names purchased their own homes.

As competition between landlords intensified, long-standing practices such as collecting the first and last month’s rent during the move-in inspection also went by the wayside. I quickly discovered that the descriptions of “ideal tenants” in my real estate books, like so much of the other information in those books, no longer corresponded with reality.

So, I settled for tenants who simply met some basic employment and income guidelines, such as having a job for more than a year and having gross income in excess of three times rent. And I only collected the first month’s rent and a small deposit. I figured: they had the money to pay rent and would make it a top priority, just like I make paying the mortgage on time a top priority.

I was wrong. They often had other priorities. It seemed like every time that tenants left town before the end of their lease, or left without paying the last month’s rent, they left behind a child’s fantasyland of high-priced toys or a well-stocked home bar.

Part of the problem was that the tenants were not good with money, but part of the problem was that I was not firm enough. When I was told a sufficiently harrowing sob-story, I would volunteer to waive late fees and accept rent a few days (or even a few weeks) late. As soon as they sensed that they were dealing with someone who would cut them some slack, they started taking advantage.

Eventually I felt so taken advantage of that I began enforcing the late fees no matter what the story. Then they would often cut and run, leaving my wife and I to shampoo the rug, spackle the walls and seek out another tenant, usually in the depth of winter when few people move. The low point of my life as a landlord was when my wife and I spent New Year’s Eve, 2005, cleaning the house late into the night so that we could rent it out again.

Happy New Year, indeed.

It is when your spirits are low, when you are eating that mortgage payment by burning up your savings, when the metaphorical blood is in the water, that the sharks begin to circle.

Fending off the Exotic Mortgage Sharks

“We have a great mortgage product for you” said the chipper-sounding young woman on the other end of the phone. She had apparently pulled my business number from the advertisement that I had placed in the Seattle Times. “It is designed for landlords just like you.”

Like me? The hair on the back of my neck started to stand up and I furrowed by brow. I don’t like being pitched to, and something seemed really wrong already, just five seconds into this call.

“You get to decide what payment you want to make” she continued. ”You can make a full payment with principal and interest, a payment on just the interest for the month, or nothing at all. Skipping a payment really takes the heat off when you have a vacancy.”

This piqued my interest. I certainly loathed taking the mortgage for the rental out of savings when the property was vacant. She was reading my mind.

“So,” I replied, “If I skip a payment, what happens to the interest? Is it a fixed-rate mortgage?”

“If you skip a payment, the interest is added to your principal. But at current rates, that doesn’t add up to much. And it is tied to the London Interbank Overnight Rate, or LIBOR, so you don’t have to worry about the Federal Reserve hiking rates – they don’t set this rate!”

“That sounds a bit risky,” I said, realizing that that my first instincts had been correct. I had no interest in playing interest-rate roulette.

“Well, I would love to meet you at Starbucks to walk you through our program,” she said, “Let me give you my number.”

“No, thanks.” - I hung up.

This was the first of many, many attempts by mortgage brokers to lure me away from the straight and narrow path of the 30-year mortgage with exotic mortgage products; but after fending off a cheerful voice on the phone promising to dispel my worries over vacancies, I had no problem throwing the mailed solicitations from the other mortgage brokers straight into the recycle bin. Even the ones offering cash-out refinancing, formatted as fake checks. So, I managed to avoid the mortgage sharks that preyed upon many other homeowners. I stuck with conventional 30-year fixed rate financing. Here, again, The Expert (the realtor who I mentioned in my last post) played a key role, telling me “30-year mortgages are simple and predictable. I have always left the exotic mortgages alone.”

A Little Help from USA Today

USA Today publishes a feature called Close to Home each Tuesday that takes an up-close look at house prices in cities scattered around the country. For each city, they provide three arrows to show the gains (or losses) in the last 12 months for the city, the state and the nation. At first, all of the arrows were pointed up. Boston was featured several times, and in 2003 and 2004, it had some of the strongest gains in the nation. But early 2005, it started to slow down, and by the end of 2005 Boston housing markets were down from the previous year.

I read this feature each week because I had learned about how housing markets in one part of the country can sometimes help to predict the course of housing markets in other parts of the country. And after my first tenant, I was thinking about shorter and shorter timeframes for holding this rental property. Over the course of 2006 more and more cities profiled in USA Today began turning down: Miami. Denver. By the end of 2006, only a few markets such as Seattle and Austin were still up over the last 12 months.

I had had enough with problem tenants by this point (I was starting to lose my longstanding faith in the goodness of humanity), and it looked like the appreciation was about to end for a while. I was ready to get out, and my wife agreed. We were convinced. If the rental had been a stock, I would have fired up my Web browser and sold in January, and been out at the end of that same day.

But a house is not a stock. It must be vacant and ready to sell. Then you must find a buyer, and that buyer will need to find a willing lender.

Slippage, part II: Waiting out the Lease

Thus began my second lesson in “slippage”, that great gulf between the transaction that we want and the transaction that we get. We had to wait until July for the end of the lease.

At the top of the market in April, we could have sold the property for $290,000. It took a few weeks to fix up the property after it became vacant in July – which would have been months if The Expert had not found the right people to do the repairs. We listed the property at $280,000 and waited for the buyers to arrive.

No dice. The pool of buyers was starting to dry up in response to tighter lending standards, spurred by the beginning of the subprime mortgage crisis. Also, caution was starting to reign in the real estate mania that was still alive and well in the greater Seattle area.

So, we lowered the price to $272,000. We found a buyer and haggled our way to $265,000. Between the date that the offer was accepted and the date that it closed in September, a larger house across the street went on the market for $275,000. If we were still holding that house today, we would be lucky to get $250,000.

We were very fortunate to have The Expert on our side, and to have the good sense to trust him and make use of his knowledge. I told him when discussing the sale of the house, “Please do exactly what you would do if it were your house and you were trying to sell it in this market – in terms of repairs, and in terms of the listing price”.

Considering the commissions that you pay when buying and selling real estate, it is foolish not to make full use of the specialized knowledge that your realtor has to offer.

Salvation from the Storm

My life as a landlord ended on Sept. 18, 2007, when the sale closed and I picked up the check from the escrow company. I was rewarded for doing my homework, resisting mortgage offers, being patient, and suffering through weekends and holidays cleaning up the house and making repairs - but I was also lucky. If my wife and I had lived in a part of the country that was hit by sudden job losses, as was much of Michigan, we would not have escaped with our principal, or our credit, intact.

In the next and final post in this series, I will discuss the lessons that I learned from my life as a landlord, and provide you with a list of issues that you should carefully consider before taking the plunge and becoming a landlord, yourself.

My Life In and Out of Real Estate Markets

Part I: Getting In

It all seemed so simple in 2002.

Like many Americans, my wife and I had seen our stocks lose much of their value since 2001, while the value of our house first held steady, then began to swiftly rise.

I started thinking to myself “if my home appreciates this fast, I should really buy a second one. I can rent it out while it appreciates.” I didn't really understand why house prices were rising; nor did I understand how much more work it is to be a landlord than to be a homeowner.

If I had, would I have done it? Hard to say, and hindsight is of course 20-20. I can, however, tell you a few things you should consider before you take on ownership and management of a rental property:

• A landlord must be fair (which I was) but firm (which I wasn’t).
  
• A landlord must be familiar with the ins and outs of the state and local Landlord-Tennant Acts (as I was).
  
• Lastly, a landlord must also have deep pockets to cover repairs and to pay the mortgage during vacancies (my status on this front varied from year to year), and should ideally be adept at implementing some of the simpler home repairs with their own hands (I am a miserable handyman, alas).
  

If these points don't describe you, then you need to seriously consider whether buying a rental property is a good idea. When buying a stock, you simply have to ask yourself what the price is likely to be a few years from now; with a rental property, you must consider more than the future price. You have to ask yourself if you can afford or handle the responsibilities of being a landlord.

Real estate investing suits many people quite well, especially people who are good at saving, good with people and good with their hands. My realtor, a person who I like to call “The Expert” because of his deep understanding of the Puget Sound real estate business, has done well by buying and managing small rental properties over the last 20 years. He is compassionate but firm, and he is good at doing minor repairs himself and at finding people who can do sound repairs at a reasonable price.

Having his guidance on the purchase and sale of my rental property is one of the main reasons that this post describes bumpy ride to success, rather than the financial equivalent of a car accident.

It also helped to be able to avoid temptation. I stuck with a straightforward, fixed rate loan even when aggressive salespeople touted the very sort of interest-only, adjustable mortgages that have gotten so many people in trouble.

But I am getting ahead of myself. Let's get back to the run-up to my investment in real estate

A Little Knowledge

In 2003, I began buying books on real estate investing and liquidating some of my stocks to add to my savings so that I could come up with a down payment. Although many of the books that I read extolled the virtues of building real estate assets using “no money down” financing, I was determined to come up with a substantial down payment so that I could get a 30-year fixed-rate mortgage. I knew that I was speculating, but a cautious streak kept me from really playing with fire. I did my homework to reduce the risk as much as possible – at least on paper. I learned about the importance of looking at homes that were near major highways and job centers, and the importance of understanding local rental markets. And I began to follow mortgage rates.

The Mirror Test

However, I did not understand the human factors that would make real-estate investing particularly challenging for me. In other words, I failed to conduct what Peter Lynch calls “the mirror test:” that moment when you take a breath, think about what you are about to commit to, and then look yourself in the mirror to see if you are cut out for this kind of investment. Lynch was talking about stocks, and stomaching volatility and uncertainty; but a landlord’s mirror test should include facing the reality you might end up paying the mortgage for several months with the property vacant and no rent coming in.

Slippage, part I: Investor in Mark-up Land

I was fortunate to know a realtor who was an expert in helping people buy rental properties, and when my wife and I had finally saved enough for a modest down payment, we started hunting for houses within an hour’s drive of our home. In short, we had made the decision to buy a house – now it was merely a matter of finding the right house and the right seller.

The real estate market was moving up all around us in 2003. We knew that we wanted a house, but did not really know what we were looking for beyond that. My realtor was immensely patient with his very indecisive clients. We looked at a house that needed a bit more work than we had in mind, but which had a view of a nearby lake and was listed at $179,000 – a bargain for a view home in the greater Seattle area. We mulled it over, but by the time that we decided that it warranted another look, it was gone.

That left us ready to act when the next house that looked right came along, but we had to wait a while for that to happen. We needed the right house at the right price. This is an example of what stock traders call slippage: the difference between the price of an asset when you decide to buy and the price of that asset when your transaction actually takes place. The fact that each house is unique makes the process difficult, especially if you are hunting for a bargain.

Making the Buy

We eventually found our bargain. A new spec house, 1000 square feet, and priced at $175,000. We made an offer. The homebuilder accepted. We signed the paperwork at the beginning of 2004, placed an ad, and suddenly we were landlords. Landlords in search of a few good tenants.

In my next post, I will describe why being a landlord was a lot more trouble than I needed, and how I finally got out of speculative ownership of real estate.

The Commemorative Correction

The Dow Jones Industrial Average was down over 360 points today. It hurt to be a shareholder today, but it was a pale shadow of the pain endured by investors 20 years ago to the day on October 19, 1987; a day when the stock market dropped over 20% and so deeply scarred the memories of investors that it is known by not one, but two, nicknames today – “Black Monday”, and “The 87 Crash”.

Of course, the stock market did not drop today because it is the anniversary of Black Monday – traders are not that sentimental. Bad news on many fronts provided ample reasons for traders to dump shares, including:

• Standard and Poor’s downgraded more mortgage-backed securities, creating further doubt about the health of the credit markets.
  
• Oil prices made a new all-time high, crossing above the $90 level for a short time before closing at $88.
  
• Lackluster earnings reports and cautious words about the economy from companies such as Caterpillar, 3M, and Harley Davidson.
  

So, where does that leave us, as individual investors? Relatively calm, if we have been careful to buy “great companies at great prices”; as Warren Buffett would put it. We’re also not overly concerned if we have focused our mutual fund assets in the better managed funds that are available to us, with the right mix of stocks and bonds.

It is hard to tell which direction the stock market will go in the next few days or the next few weeks, but one thing that history teaches us is that the day after a substantial drop in the market indices is not the time to sell your shares indiscriminately. It is a time to calmly assess your financial situation and your risk tolerance, and to make some adjustments to your portfolio if it is out of sync with either of these. And, if you are in the fortunate position of having cash available to invest, it is a time to buy shares in a great company that is selling at a great price because of the drop (or correction) that you have just endured.

Selling all of your stocks on October 20, 1987 would have been a big mistake, and selling all of your stocks on Monday, October 22, 2007 when the US markets next open, will almost certainly prove to be a big mistake if you choose to take that course of action.

After all, the only reason that it is possible to earn higher returns as a stockholder than you can earn in a CD is because stockholders suffer through days like today, (and occasionally, those like Black Monday). This suffering is what accounts for what Jeremy Siegel calls “the equity risk premium” – or, in plain English, the compensation that an investor gets for making a good long-term investment, and then enduring the inevitable bad days that will occur while that investment comes to fruition.

Just remember:

The payment for the pain is the chance to make a gain.

Footnotes and Foreshadowing

I’ll go into more detail about how well-chosen investments reward us for our patience (and our pain) in my next column, where I will discuss my experience owning, managing, and selling a small rental property.

Uncork the Bullish Champagne... But Avoid the Hangover: The Case for General Electric and Johnson and Johnson, Part II

In part I of this column, I discussed how recent market developments will help large companies with strong credit ratings to replace private equity groups as the players best positioned to buy out smaller companies. In this column, I will go into more depth about a few of the characteristics that make Johnson and Johnson (JNJ) and General Electric (GE), two of the many companies that benefit from this trend, such good investments at current prices. These companies share the following outstanding characteristics:

• Exceptional track records of making smart acquisitions (and smart divestitures)
  
• They are well positioned to ride long-term macroeconomic and demographic trends
  
• They have a long history of shareholcder-friendly dividend policies
  

Smart Acquisitions, Smart Divestitures

Both JNJ and GE have a long history of finding good businesses to acquire, and successfully integrating those businesses with existing businesses after each acquisition. As I mentioned in my previous column, GE took advantage of the liquidation of Enron to buy that company's wind power assets, which gives GE a strong position as the demand for green electricty continues to soar in response to forward-looking regulations. GE also made a smart move when it divested its slow-growing plastics business for $11 billion.

Johnson and Johnson recently purchased Pfizer's Consumer Healthcare business, adding an armada of well-known consumer staples brands to its already impressive fleet of products. Have a cut? sterilize it with Neosporin, and then dress it with a Band-Aid. Quitting smoking? Some Nicorette gum will help. Not so successful in your attempt to kick the habit? Then you'll need some Listerine to cover that up from your spouse. With so many staple products in its fleet, you would have to go out of your way to avoid generating sales for Johnson and Johnson on your next visit to the grocery store - never mind the money that they will make on your next trip to the hospital.

A Foot in the Future, A Foot in the Past

But, you say, consumer staples are a boring, old-economy business. What is forward-looking about acquiring consumer staples brands? Quite a bit. In Jeremy Seigel's The Future For Investors, the author examines the long-term returns of companies in the Standard and Poor's 500 index, and draws the following conclusions:

The consumer staples sector has been marked by unusual stability. Most of the largest firms in this sector have been around for fifty years or more, and provided investors with superb returns.

Unusual stability and superb returns are a winning combination in my book. Additionally, if you consider that any healthcare reform legislation that comes out of Washington D.C. in the next few years is much more likely to negatively impact the makers of pharmeceuticals and medical devices, rather than the makers of consumer staples brands such as Listerine and Nicorette, then this acquisition makes even more sense. By adding additional consumer staples brands to the company with this acquisition, Johnson and Johnson has reduced its exposure to the political uncertainty that is a fact of life in its core health care businesses. And regardless of what sort of health care reform comes out of Washington, demographic trends assure that Johnson and Johnson will do well as the United States moves from spending 16% of GDP on healthcare to 20% of GDP on healthcare in the next 20 years.

GE Places Bets on the Future of Energy and Water

Speaking of staples, few things are as essential as energy and water - and GE is no slouch when it comes to looking toward the future and finding ways to align itself with long-term trends in these areas. It is well positioned to benefit from the current (and worsening) energy shortage by selling the world's most fuel efficient locomotive. On the power-generation front, GE will benefit regardless of whether we get more of our electricity from nuclear, coal, or wind energy - after all, they build equipment needed to generate electricity from all of those sources. Even the looming world water shortage will benefit GE as the foremost leader in desalination technology, which converts sea water into drinkable water.

Dividends

So how does all of this smart planning benefit you as a prospective shareholder? Both GE and JNJ sport higher-than-average dividend yeilds of 2.7 and 2.5% respectively, and have a long history of increasing their earnings and dividends over time. It is rare to find such a combination of strong performance, high dividends, and good prospects for the future in one company, much less in two companies at the same time. I own a few shares of each of these companies for the long term, and you could do worse than to buy a few shares for yourself. My 12-month price target on GE is $52, and my 12-month price target on JNJ is $75.

Dow 14000 - The Pros Sustain the Close

Today the Dow Jones Industrial Average closed above the psychologically important 14000 mark. The last time that this number was in the news, it marked the end of a rally in the stock market. This time, it looks like the 14000 level will mark the beginning of a rally, rather than the end of one. As I stated previously in Dow 14000 - The High Water Mark?:

...when a market average such as the Dow passes through 12000, and then 13000, confidence and buying momentum build. And when the next much heralded number, 14000, becomes a barrier that the market can reach, but that the Dow average cannot close above, then that is a worrisome sign for the stock market.

The last time that the Dow average crossed the 14000 line, it closed below that number as traders rejected the new valuation for the 30 Dow stocks. Today, the Dow charged through the 14000 mark on high volume and closed above this number for the first time ever, providing a buying signal as strong as the sell signal that was provided by the rejection of this level last July.

And while we are taking a stroll down the (admittedly short) memory lane of previous columns posted to this blog, I should mention that the "festival of falling knives" that caused so many investors so much pain between the end of July and mid-September appears to be over. Only 40 companies had their shares hit new record low prices for last 52 weeks today, well down from the record of 1,107 new low prices which was set on August 16, 2007.

Certainly, investors have plenty to worry about, from fears of recession to the uncertainty that comes with a prededential election on the horizon, but for the moment we can take solace from a Federal Reserve that is apparently more eager to avoid a recession than to support the dollar or to contain inflation, and from a stock market which is rebounding from a substantial correction. Now is a good time to buy rationally priced assets, using the screen that I described in Avoiding the Pitfalls of Growth Investing, parts I and II, especially if you are investing with a time horizon of a year or more.

In my next column, I will discuss the reasons why you should hold your stocks for over a year, and why the shares of General Electric and Johnson and Johnson look so inviting at the moment.

Uncork the Bullish Champagne... But Avoid the Hangover: The Case for Investing in Safe, Steady Companies like General Electric and Johnson and Johnson

When Ben Bernanke and the other governors of the Federal Reserve lowered the discount rate last Tuesday, it sparked a massive rally. Bankers, hedge fund managers, and individual investors in the stock market and real estate markets alike breathed a collective sigh of relief. Those of us who tend to invest aggressively when good news arises have already started buying stocks again, thinking that the Fed will bail us out if things should go wrong. And yet, even in the wake of a Fed rate cut, it pays to observe how the investing landscape has changed since the giddy heights of Dow 14000 back in July, and to adjust our investment strategies accordingly.

This is especially important when we stop to consider that the Fed would not cut rates by 50 basis points right now, with inflationary risks looming, if they did not believe that we are in danger of entering a recession. In this column, I will provide two recommendations that I believe are poised to outperform the market, over both the short-term (the next 6 months) and the long-term (5+ years), and explain why companies such as GE and JNJ are poised to replace all but the best-run hedge funds as the new kings of the buyout boom.

What has changed?

The first thing that has changed in the investing landscape is that the buyers of debt who helped to keep the leveraged buyout boom going; mostly pension funds and hedge funds; are now asking for (gasp) a significant premium over treasury interest rates to buy the debt that funds these deals. Back in July, the credit spread between junk bonds and treasuries were at historic lows, but they have widened significantly since then, making it more costly to take companies private by issuing junk bonds, so called because of the low credit ratings associated with this debt.

Buyouts of publicly traded companies (and the prospect of buyouts) had provided a significant boost to share prices over the last few years. Buyouts leave fewer companies for investors to purchase shares in, reducing the supply of shares as the demand for shares remains steady. Buyouts have also caused small and medium-sized companies to outperform their large-cap peers as investors scramble to buy shares in the next buyout target before the deal is announced. A slowdown in buyouts by hedge funds changes the market landscape significantly.

Who are the new buyout kings?

OK, you say, enough about the big picture – how does this affect me, and why does this shift make GE and JNJ look more attractive?

Good question. The declining fortunes of hedge funds, the kings of the current buyout boom, benefit the buyers of large companies that pay dividends and have strong credit ratings, due to three important characteristics possessed by these companies:

• Safety: If the current economic slowdown gets worse, buyers of stocks will tend to prefer large companies with strong credit ratings and dividends because these companies have a demonstrated ability to survive recessions, and pay growing dividends to compensate shareholders for the risk of holding stocks in a recession. As Kelly Wright observes, growing dividends are one of the best attributes an investor can seek in an investment.
  
• Value: Large companies (for example, GE and JNJ) have lagged the S&P 500 over the last 5 years, partially because they are too large to be viable targets for buyouts. As a result, GE and JNJ are selling at low PE ratios relative to their historical averages. With the “buyout premium” that was underpinning the share prices of smaller companies fading away along with the mania of the buyout boom, companies like GE and JNJ will no longer be at a disadvantage compared to smaller companies.
  
• Opportunity: With great credit ratings and abundant free cash flow, large companies like GE and JNJ are well positioned to become the kings of the new buyout boom. Both companies have demonstrated skill at buying companies to add to their business. For example, GE entered its strategically important renewable energy business when it purchased Enron’s wind farms during the liquidation of that former high-flyer.
  

Neither of these companies will make you the coolest person in the room when the subject of investing comes up at the cocktail party, but investing isn’t about proving how smart you are, it is about having a comfortable (and preferably early) retirement and being able to meet your own essential needs, as well as those of your family.

In my next column, I plan to dig into what makes JNJ and GE outstanding in terms of their strategies for future growth, and in terms of their valuation.

The Importance of Attitude and Planning In Investing

Many investors believe that their success or failure in the market is solely the result of their skill at choosing investments, or their luck, while forgetting to take another important variable into account: attitude and planning. To better understand this area, we can turn to an emerging field of psychology called behavioral finance, which focuses on why smart people do dumb things with their money. Behavioral finance offers plenty of useful insights for those willing to study, but here are a few of the key points from this field that you should keep in mind when investing:

• If you do not plan for success, you plan for failure: Before you make an investment, you should have a plan for what to do with that investment if it gains value or loses value. For example, in the investment system popularized by Investor’s Business Daily, the rules are pretty simple: if a stock loses more than 8% of the purchase price, you sell and take a loss; if a stock gains over 20% from the purchase price, you sell and take a profit. Conversely, a value investor would generally buy more stock if the price dropped below their purchase price, and would only sell if the underlying business deteriorated or the stock became overvalued. Having a plan is essential, because otherwise you are very likely to sell at a loss when frustrated or afraid, or to fail to take profits when you have them due to greed.

  Remember: your instincts evolved to help you hunt, evade predators, and find food; as such, they are poorly suited to helping you to operate in the stock market. Success requires more than instinct; it requires planning. Your plan can be simple, but it will still be well worth the few minutes that it takes to put it in writing.
  

• Don't fixate on the past: We all have the tendency to give great weight to memorable events when making decisions, in a process that psychologists call "anchoring". Anchoring can cause us to make bad decisions when memorable events are irrelevant to the current situation. For example: the stock that you lost your shirt on in 2000 may be the best one to buy right now, but you will find yourself reluctant to even consider buying it because of the pain that you associate with your previous experience, just as a child is reluctant to touch a stove element after getting burned. Similarly, a great stock that you noticed and considered buying at $10 may still be the best available investment opportunity after it has soared to $20, but you will be reluctant to buy it because your mind is anchored on that lower price, and making the purchase now will mean admitting that you probably should have purchased it when you saw it at $10.
  Pull the anchor: The solution to this predicament is to select your investments using screens or other analytical methods that will help you to make sound decisions without regard to vivid, but irrellevant, memories.
  
• Be tax aware, but don't let the IRS think for you: Many of us have met or heard of investors who had the phenomenal good fortune to hold the right stock at the right time, and to become wealthy, at least on paper. In many cases, these investors failed to take profits in their stock, even when they thought that it was probably going to lose value for one reason or another, because they did not want to pay taxes on their gains. This makes no sense at all, especially now when capital gains taxes are at their lowest levels in years. Ask yourself the following question: Would you refuse a 200% raise because you don't want to get moved into a higher tax bracket? If your answer is no, as I suspect that it is, then why would you choose not to pay capital gains on an investment that has met your price target, and is now overvalued? The key thing to remember is: If you are paying more taxes than last year, it is because you are making more money than you did last year. Deciding not to follow your plan and stick to a rational investment strategy because you fear losing some of your gains to taxation is basically a decision not to make money.
  Don't obsess over the IRS: If you are deathly afraid of paying taxes on your gains, the market will accomodate you by taking those gains away from you and giving them to someone who will pay taxes on them. This also touches on the first point that I made: people who give away fortunes for tax reasons are generally operating without a plan that tells them when to sell. They make excuses for holding a previously winning investment as it loses value, rather than putting a plan in writing before investing and then sticking to that plan. Besides sound planning, another way to keep yourself from falling into this trap is to hold your largest investments inside of an IRA or other tax-sheltered account, where you will be able to make investment choices without regard for capital gains or other tax concequences.
  

I could write endlessly on the pitfalls of investor psychology, but Barry Ritholtz has saved me the trouble with his excellent Lessons for the Apprenticed Investor series. If you are serious about investing or trading and have not already equipped yourself with a winning attitude and plan, these free articles are essential reading.

Festival of Falling Knives, Continued

Apparently, the "festival of falling knives" that I found so impressive two days ago was just the beginning. On July 24, a three-year record was broken on the NYSE when 351 companies listed on that exchange traded at their lowest prices in the last 52 weeks. A day later, 418 companies hit new low prices, even as the Dow Jones Industrial average recovered some of its losses from the day before.

Today, the Dow Jones Industrial Average suffered the biggest one-day loss since February 27, but much more significantly, 780 companies hit new low prices for the last 52 weeks - over twice the number that hit new 52-week lows on any day in the last 3 years. After the incredibly strong stock market performance that we have seen in the first half of this year, and with problems with subprime mortgage lending starting to snowball into what Barry Ritholtz has dubbed "The Great Credit Contraction of 2007", I have to wonder whether this market has further to fall. I also have to wonder whether it will be quite a while before the Dow Jones Industrial Average closes above the DOW 14000 mark that everyone (ok, not everyone) was so excited about just last week.

Does this mean that you should run out and sell all of your stocks and mutual funds? Certainly not. Only a few people are successful at timing the market, even when they have a well-developed system that they apply rigorously. This might be a good time to sell any stocks that have already hit the price targets that you have set for them, though, and to ease off any buying of high-risk shares - remember, high PE stocks tend to fare poorly in a serious market correction.

This is also a great time to buy high quality investments selling at low prices that are poised to benefit from the effect of a falling dollar on overseas sales. Two that come to mind, because I already own shares of them, are Johnson and Johnson and GE. Both have been market laggards over the last few years, but several trends are aligned in their favor, as I plan to detail in my next post.

Until then, I suggest that you remember the immortal words of Douglas Adams, as you keep a cool head during this sell-off:

Don't Panic!

Festival of Falling Knives: NYSE 52-Week Lows

When a company's shares trade at their lowest price in the last 52 weeks, it is a sign of pervasive fear among many of the holders of that company's stock. Because most listed shares trade hands several times a year, it means that most current holders of that stock are sitting on an unrealized loss. Their fear often leads them to more selling as their shares hit new 52-week low prices, which is one of the reasons that buying companies hitting new 52-week lows is often referred to by traders as "Catching a Falling Knife": because you can be badly hurt if you buy such a company and it's shares continue to fall.

Today's trading on the NYSE exchange was, therefore, a sort of "festival of falling knives": 351 companies listed on the NYSE had their share prices hit new 52-week lows - more than at any time in the last 3 years. Unlike the previous "festivals" of 200 or more new 52-week lows, which occurred on October 12, 2005 and June 13, 2006, this festival did not occur after a broad decline had already occurred.

At the top of the chart shown above, I have added a barometer which shows the percent of shares listed on the NYSE that are trading above their average share prices for the last 50 days ($NYA50R). Such 50-day moving averages are widely used by traders and money managers, and are often used as shorthand for the trend of a stock: if a stock is above the 50-day moving average, it is trending up; if it is below the 50-day moving average, it is trending down.

When this barometer shows that only 20 percent of the shares listed on the NYSE are above their 50-day moving average, the market has usually already sold off pretty well (to what is called an oversold condition), and is generally due for a rebound. The previous festivals occurred when this barometer was showing just such an oversold condition, as shown by the green circles in the drawing above. These festivals punctuated long bouts of selling that left most of the companies on the NYSE trending down, and marked the end of the down trends for many of those companies.

Today's festival, in contrast, occurred when 37.27% of the companies listed on the NYSE are above their 50-day moving average - nearly twice the number seen in the previous events. So, if recent history is any guide, the market may have further to fall, and this festival may be just the warm-up for a bigger event in the near future.

To investors with a long time horizon and a hard nose for value, such events provide buying opportunities. But for most investors and traders, a new 52-week low in a stock that they own is a very unwelcome event. And a festival of falling knives, occurring out of the blue, when the NYSE is not oversold, is a very ominous event, indeed.

Dow 14000 - The High Water Mark?

Last week, all eyes were on the next all-time record for the oldest and one of the most important barometers of stock market performance: the Dow Jones Industrial Average (or Dow Average), which was fast closing in the 14000 mark. The Dow Jones Industrial Average includes large established companies such as Boeing, 3M, and Disney; companies that are often bellweathers for their various industries. For this reason, many people watch the Dow Average to get a sense of the direction of the overall stock market.

Round numbers, in this case 14000, tend to function as "pivot points"; points that either provide resistance to further price increases, or, once surpassed, serve to support to prices when they pull back to that level. This behavior, in both individual stocks and in market averages, was first observed by Jesse Livermore, an innovative speculator of the 1920s. The reasons for this behavior have their basis in human psychology - people tend to anchor their attention on numbers that are easy to remember, and to make decisions based on the performance of share prices relative to those anchors. The effect of this anchoring is to cause buy and sell orders to cluster around round numbers, making these levels difficult to pass through unless the momentum of the market is particularly strong. Another effect of this "anchoring" behavior is that the media trumpets the arrival of each new round number (first 12000, then 13000, then 14000), drawing attention to the performance of the stock market, and drawing in more buyers.

So, when a market average such as the Dow passes through 12000, and then 13000, confidence and buying momentum build. And when the next much heralded number, 14000, becomes a barrier that the market can reach, but that the Dow average cannot close above, then that is a worrisome sign for the stock market.

The stock market is certain to cross 14000 sooner or later, but for at least the time being, the market is taking a breather, and a close above 14000 is most likely weeks away, in the opinion of this humble scribe.

Avoiding the Pitfalls of Growth Investing II: There is no such thing as a buy at any price

Price is what you pay. Value is what you get.
-Warren Buffett

The preceding quote is one of my favorite quotes from Warren Buffett. These two simple sentences - and the clear implication that the price and value of an asset are not always the same - stand at the core of what value investing is all about. This line of argument also stands sharply at odds with the conventional wisdom that you "You get what you pay for", the concept that underlies the efficient market hypothesis, which essentially states that the price of an asset is always an accurate reflection of that asset's intrinsic value, given the available information.

But do you really get what you pay for?

If anyone in the reading audience bought shares in a company like Etoys, which I mentioned in the first part of this column, then your experience has showed you that price and value are not always the same thing - sometimes price can be based purely on speculative excess, and have no connection to the value of a tiny, unproven business like Etoys.

The first part of this column highlighted a few of the pitfalls of invesitng in growth stocks - specifically the traps presented by unprofitable "growth stories" and companies with high growth expectations baked into their stock prices. In this column, I will discuss why sometimes even great growth stocks are simply too expensive to consider purchasing, and the tendency of growth stocks to suffer more than other stocks during broad stock market downturns.

David Dreman Looks at Growth Stocks as a Group

David Dreman, Chairman and Chief Investment Officer at Dreman Value Management, wrote an excellent book, Contrarian Investment Strategies: The Next Generation, in which he shares the results of his analysis of the Standard and Poor's Compustat database, a comprehensive database that contains decades of informaiton about stocks traded on exchanges in the United States. As part of his research, Dreman divided up the companies listed in the database by fifths (or quintiles) according to their PE, or Price to Earnings ratios, with the aim of seeing how stocks in various PE quintiles - raning from the cheapest quintile at the bottom, to the most expensive quintile at the top - performed over different time periods and under different conditions. The most expensive quintile contains shares that are "priced to perfection" - meaning that the expectation of smooth, rapid growth is already reflected in th estock price.

Dreman draws a wide variety of conclusions from this work, but the overall conclusion is that (as a group) the stocks in the cheapest qunitiles tend to outperform the stocks in the most expensive quintiles over most time periods greater than 1 year - and also outperform the broad stock market. For example, in the 27 year period between 1970 and 1996, the growth stocks in the highest PE quintile turned $10,000 into $137,000, only 47% of the return offered by the broad market, which was $289,000. Better yet, the value stocks in the lowest PE quintile turned that same $10,000 into $708,000!*

These results support Buffet's statement, demonstrating that value is what you get, and you are likely to get more of it when you buy a shares of a business at a low price. The case for price-concious investing is reinforced by the data that Dreman presents on another issue that is dear to the hearts of many investors: how to survive a bear market.

When the Bear Growls

One of the more interesting conclusions that Dreman draws in his book regards the performance of growth stocks vs. value stocks during a bear market. For the sake of simplicity, Dreman looked at each quarter in the 27-year period of the study, and deemed any quarter where the Compustat market average of 1500 companies dropped a "bear market quarter". During these quarters, the stocks in the cheapest PE quintile dropped 5.7%, less than the overall market, which dropped 7.5%. As usual, the results from the stocks in the most expensive quintile were the worst - an average drop of 9.5%!

So, what does it all mean?

Dreman's studies make a compelling case for being concious of value when buying stocks. Ultimately, we must trust our own judgement and research more than we trust the the market when it comes to determining the appropriate price for a stock.

None of the information presented in this column is intended to suggest that it is impossible to find a winning investment among the growth stocks that have the highest PE ratios, or that appear to be expensive by other measures. However, there is convincing evidence that it is very difficult to find outstanding investment returns by buying growth stocks, and that you will do better if you find stocks with great fundamentals and stromg prospects for growth before those prospects are already reflected in the PE ratios. The screen that I provided in part one of this column will help you to find such investments, and hopefully this two part column has provided some very good reasons to look for investments using this screeen.

* Contrarian Investment Strategies: The Next Generation, pgs. 155-157.

Avoiding the Pitfalls of Growth Investing

Investing in stocks with high expected growth rates - also known as growth stocks - can be exciting; it can also be difficult and dangerous. Everyone loves to buy a company that is firing on all cylinders, growing sales and earnings at a rapid clip, and watch as the combination of improving business fundamentals (and recognition of those improving fundamentals) brings in the profits. Investors who bought into Apple (AAPL) or Google (GOOG) in 2004 and held on did very well. Examples such as these make growth investing look like a cinch – a sure ticket to easy street. And yet, that is not necessarily the case.

It pays to be aware of some of the risks that tend to afflict investors who favor fast growing companies, and to be aware of the steps that you can take to protect yourself.

There are four basic risks that growth investors face to a greater extent than other investors:

1. The “Growth Story”: purely speculative growth or unprofitable growth
   
2. If a company is growing quickly, it will be expected to keep growing quickly
   
3. Growth stocks tend to suffer more in market downturns
   
4. Growth stocks can become overpriced
   

In this column, I will discuss the first two of these risks – growth stories and elevated expectations. I will address the other risks that face growth investors in the second part of this column, to be published next week.

The “Growth Story”: purely speculative growth or unprofitable growth

The first problem with growth investing is that some stocks touted as growth stocks have no track record of strong financial growth, or have a track record of growth which is rapid, but not financially sustainable. I call this kind of company a “growth story”, by which I mean that the growth of the business is more of a story than a reality. The story may be compelling and make intuitive sense, but it is still a story, not yet a company which can be counted upon to deliver growth. There are two types of “growth stories”: purely speculative growth stories, and unprofitable growth stories.

Examples of purely speculative growth stories are seen each day by anyone with an e-mail account. Most of us are barraged daily by unsolicited “spam” messages in our inbox, touting stocks with a minimal history of creating revenues and no history of earnings, and which trade on the OTC exchanges as “pink sheet” stocks. Most of these stocks are available for a few dollars a share, and are nearly surefire ways to lose money.

Some purely speculative growth stories are listed on more reputable stock exchanges, and may have merit as speculative investments for those investors who are able to pick out the next big biotech stock while it is still a start-up. Still, even the best purely speculative growth story is a destination for money that you can afford to lose, or risk capital; not the place to find the companies that will serve as the foundation for your retirement portfolio. Investors who bought shares in eToys during the dot-com bubble and held on, hoping for the growth story to become a reality, experienced first-hand the difference between a growth story and a profitable and growing company. Despite a great story (and lots of hype about how eToys was sure to outflank its brick-and-mortar competitor, ToysRUs) eToys never turned a profit or reported great revenue growth, and shareholders were left with nothing but a sob story when eToys entered chapter 11 bankruptcy on March 7, 2001.

The second type of growth story – fast but unprofitable growth - is more dangerous, and more difficult for the average investor to recognize because it is usually accompanied not only by extensive hype in the media, but also by revenue growth. An example of a company that has grown rapidly, but not profitably, is Sirius Satellite Radio (SIRI). Like many unprofitable growth stories, Sirius financed its expansion by taking on debt and offering additional shares. Between fiscal year 2002 and 2006, sales at Sirius Satellite Radio moved from $810,000 to $637 million as it expanded its customer base, but the number of shares outstanding soared from 77 million to 1.4 billion, and total liabilities increased from $670 million to $1 billion. Yet the value of a share of SIRI moved from a closing price of $3.67 on June 7, 2002 to $3.03 as of this writing (July 2, 2007).

Shares of Sirius did experience a price spike to in the interim, closing as high as $9.01 on December 7, 2004, driven largely by the hype generated by the deal inked with Howard Stern; but unless you sold into that price spike, that didn’t do you and good. And the shares given to Howard Stern to recruit him to Sirius contributed to the dilution of existing shareholders. The point is that while SIRI was building their business, growing revenues 768 fold between 2002 and 2006, they were not building shareholder value. People who stuck with this stock underperformed the holders index funds..

Unprofitable growth stories can be avoided simply by refusing to take a major position in any company which does not report current profit in the form of earnings per share (EPS). To screen out companies without current earnings, enter the following parameter into the MoneyCentral Deluxe Stock Screener, located at http://moneycentral.msn.com/investor/finder/customstocks.asp:

Latest Fiscal EPS >= 0

These types of “growth story” stocks are not what we are looking for – we want stocks that are growing and have been growing consistently and profitably for the last several years. We can do this by requiring reasonably high current and 5-year average ROE, ROA, and ROI, all of which measure profitability by measuring profits as returns against equity, assets, or invested capital respectively. I will go into more detail about how these rates are calculated and how to use them in a future column, but for now it is enough to know you can enter the following parameters into the Moneycentral Deluxe Stock Screener to avoid investing in an unprofitable company.

Return on Equity >= 7
ROE: 5-Year Avg. >= 8
Return on Invested Capital >= 8
ROI: 5-Year Avg. >= 8
ROA: 5-Year Avg. >= 5

We will also add another parameter to ensure that the company has grown revenue over the last 5 years at a compounded rate greater than inflation –we will use 4%:

5-Year Revenue Growth >= 4

Additionally, we will let the stock exchanges do some of the work of separating the growth stock wheat from the growth story chaff by requiring that our candidates are listed on the New York Stock Exchange, or NYSE. The NYSE has some of the most stringent listing requirements in the world, but lists enough companies to provide a wide array of opportunities. If you would prefer to focus on companies that are a part of the S&P 500, which is another very exclusive group of stocks, you can substitute the NYSE-listing parameter for the following parameter, which will narrow your field to the 500 companies that are currently components of the S&P 500 index:

Exchange = NYSE

Or:

S&P Index Membership = S&P 500

If it is growing fast, it will be expected to keep growing fast

Another problem with investing based on high expected growth rates is that companies with high, sustainable, EPS growth rates are the exception, rather than the rule. Many companies can achieve high rates of growth for a few quarters, but few can do so over longer periods of time. Picking the wrong stock, the one with the unsustainable growth rate that will revert back to more normal levels in a few quarters, can cost you dearly. If you purchase a stock with high current and recent growth rates, the expectation of future growth is usually already discounted, or incorporated into elevated analyst consensus expectations for the stock, higher than average PE ratios, or both. If other investors get the unwelcome surprise that EPS growth was below analyst expectations, they will react by dumping your stock.

The only way to address this issue is to buy stocks with low, achievable expected growth rates and PE ratios that are not much higher than average. To screen for reasonable growth expectations, we’ll require that the analyst consensus expected EPS growth for the next 5 years is less than 40%. To screen for reasonable PE ratios, we will require that our companies have a PE ratio that is less than twice the PE ratio of the average company included in the S&P 500 index:

EPS Growth Next 5 Yr <= 40
P/E Ratio: Current <= 2*S&P 500 P/E Ratio: Current

If you are using the version of this screen which searches within components of the S&P 500, you have narrowed your field from 500 companies to only 154 companies which pass this screen as of this writing. The stocks on this list include consistent, profitable growers such as computer and iPod maker Apple (AAPL), software giant Microsoft (MSFT), apparel maker Coach (COH), beverage and snack conglomerate Pepsico (PEP), latte king Starbucks (SBUX), healthcare behemoth Johnson and Johnson (JNJ), and mutual fund manager T. Rowe Price (TROW).

The NYSE version of this screen still presents more than 200 candidates, the maximum number of results that can be displayed on the deluxe screener, but many of the more speculative stocks listed on the NYSE have been removed from consideration by this screen. The refinements that I will add to this screen in the second part of this column will reduce the number of candidates from the NYSE exchange

Please check the next posting of this column, when I will go into detail about the risks of holding growth stocks during market downturns, as well as the risks of buying growth stocks at any price.

Fog Light Finance: Cutting through the fog of the financial world

Welcome to Fog Light Finance!

The purpose of this web log (or blog) is to share my interest in finance, while sharing some insights to help cut through some of the "fog" that each of us face when making financial decisions. I also plan to share some thoughts on a few other topics, including interesting themes in fiction, chess, media and economics.

This blog was inspired by the work of Charles Kirk on The Kirk Report, Barry Ritholtz's work on The Big Picure, the books and Web site of Victor Neiderhoffer, and the many brilliant books written by Robert Hagstrom - most especially his book Latticework.

This site is for educational purposes only. Please do your own homework before buying or selling any asset, and take any free advice (including mine), with many grains of salt.