Author: Team Editor

Passive Income

A Different Way to Invest in Amazon

Posted on by Team Editor

Source: Amazon.com

Warren Buffett has frequently written about his investment strategies. One, value investing, is well known. Buffett searches the world looking for assets he can buy below their true value. This is the goal of value investors and Buffett has been more successful than others in the field.

Generally, Buffett is buying for the long run, having famously said that his favorite holding period is forever. But, Buffett will also seek gains from value investing for the short term when those gains are available.

One of the strategies for short term investing that he has been known to use is mergers and acquisitions arbitrage trading.

Reduce the Risk of the Market By Using Multiple Markets

Buffett is known for investing in announced deals. This involves following the news. Takeovers are frequently announced and an example based on an announcement may be the simplest way to explain this concept.

When a takeover is announced, traders might learn that Company ABC plans to buy Company XYZ at a price of $100 a share. The deal is expected to close in six months, subject to securing financing and regulatory approval.

Sometimes, there are significant risks associated with the closing conditions. This will be reflected in the stock price of XYZ. Although the deal is for $100 a share, the stock price might move up to just $92. The difference reflects the risk of the trade and the fact that the trade will not close for some time.

Assuming the deal closes on schedule, investors buying now can make $8 a share. This would represent a significant gain in most market environments.

This an example of mergers and acquisitions arbitrage. Traders can also pursue more traditional arbitrage trades, which involve making a risk free profit on the different prices assets might trade at in different markets.

Here, again, an example might help. Assume you could buy shares of a stock like BP in New York and sell it in London at a higher price, after accounting for transaction costs and currency exchanges. This would be a risk free profit involving two separate markets.

Although these opportunities are difficult to benefit from, they are possible and there are some hedge funds that do specialize in arbitrage.

Web Sites Also Offer Arbitrage Opportunities

It’s also possible to trade items in different markets using the internet. In some ways, this was the intent of online auction sites like eBay when they began operations.

The idea was that collectors could find items they wanted in markets far from their home. The auction would also bring new sellers into the markets, allowing them to benefit from markets beyond their local areas.

When the markets started, there were questions about how the new technology would affect the price of collectibles. There was an increase of demand from collectors around the world. There was also an increase in supply from collectors and others around the world.

This was a new laboratory for economists and the answer was what the answer always seems to be in markets, it depends. Some prices went up, some went down but there was general agreement that markets become more efficient.

That efficiency could provide a source of passive income for many individuals.

Amazon Arbitrage

It’s now possible for any individual to buy and sell on web sites like Amazon. While the buying process is well understood, the selling process may be less understood. Amazon does make the process simple with a service known as fulfillment by Amazon, or FBA.

Amazon describes the service, “You sell it, we ship it. Amazon has created one of the most advanced fulfillment networks in the world, and your business can benefit from our expertise.

With Fulfillment by Amazon (FBA), you store your products in Amazon’s fulfillment centers, and we pick, pack, ship, and provide customer service for these products. Best of all, FBA can help you scale your business and reach more customers.”

The process makes Amazon the warehouse and shipper for small businesses. Amazon can handle displaying the product on their web site, taking the order, processing payments, shipping products and handling returns.

Amazon

Source: Amazon.com

These services are not free, but they are reasonably priced especially considering the cost of arranging for all services on your own.

Amazon fees

Source: Amazon.com

The prices shown above are an example and could change at any time. They are what is shown on the Amazon web site in May 2018.

There is a great deal to learn about this strategy, such as understanding how Amazon provides information to consumers which includes multiple ways to buy.

Source: RePriceExpress.com

This illustrates that it is important to research this and all income investment opportunities.

Stocking Your Store

Now, to generate income, there is a need to find and maintain inventory. There is a wealth of ideas online. Some sites recommend stocking up on clearance items at local stores. These items tend to be available locally rather than nationally and bargains can be found.

There is a wealth of ideas on how this process can work. One example that is available online covers buying a stylus pen for a smart device at a local target and then reselling the items through Amazon. This example could help explain the process and help you determine if this passive income strategy is right for you.

While this strategy could provide income, it is not a risk free arbitrage. There is the possibility there will not be customers for the products that you are attempting to arbitrage. There is also the possibility that the costs may increase or delays in sales can result in higher than anticipated costs.

There is also the possibility that Amazon can change its rules and make it impossible for an individual to resell certain products. This has happened with some suppliers in the past and is a risk that cannot be ignored.

However, there is really no source of income that carries absolutely no risks. It is simply important to consider potential rewards and risks when reviewing any income strategy.

To learn more about this potential source of passive income, consider searching online for “Amazon FBA” or “Amazon arbitrage.” This process could also be considered for implementation on eBay or other web sites in addition to Amazon.

 

 

 

Stock Picks

Pet Spending Could Drive These Stocks

Posted on by Team Editor

Pet owners tend to treat their animals well. This includes feeding them high quality foods and ensuring they receive the best medical care possible. There are tradeoffs and good care does not mean unlimited spending. But, good care does result in relatively high expenditures on pets.

About 68% of U.S. households have a pet, according to the American Pet Products Association. That includes nearly 90 million dogs and more than 94 million cats along with millions of fish, birds and other animals.

Americans spent an estimated $69.5 billion on their pets in 2017 and that figure is expected to grow 3.8% to more than $72 billion this year according to the American Pet Products Association. This figure has grown every year since 2000, including during the recession years of 2008 and 2009.

pet spending

Source: Mekko Graphics

While pet spending may not prove to be recession proof in the future, it is likely to remain high under any economic conditions. Vet care is the second largest expense, accounting for $17.1 billion last year, trailing only food. Expenses associated with veterinary care are expected to grow 7% this year.

There are approximately 66,000 veterinarians and 31,000 animal health clinics in the U.S., according to the Census Bureau.

The Association found that dog owners spent an annual average $731 on routine and surgical vet visits combined while cat owners spent an average of $427.

Leaders in Veterinary Medicine

These trends point to several possible investment themes. One is simply to buy shares of companies that deliver products and services to pet owners. This would include Petmed Express (Nasdaq: PETS), a stock that broke out in 2016 and is now bouncing off of long term support.

PETS chart

Another opportunity could be in companies that make drugs from pets. This includes Idexx Laboratories (Nasdaq: IDXX).  According to Investors.com, “Wall Street pros laud this veterinary diagnostics company’s management as “brilliant,” with an “unbelievable grasp of their business.”

“Simply put, the company’s execution continues to be second to none,” Raymond James analyst John Ransom said in a recent note to clients.

Ransom went on to say: “Further, it is not often that a player in any space with dominant (approximately) 60% market share is able to maintain the base in highly competitive markets, yet Idexx posted placement numbers that suggest it could even be gaining share.”

Idexx is the industry leader in supplying vets with the technology to run in clinic tests and blood work. It focuses on dogs and cats. Canaccord Genuity analyst Mark Massaro believes the company’s market share in the U.S. is about 60%.

In clinic products give vets the ability to run chemistry panels. Other products include rapid test kits, veterinary instruments and analyzers. There are also external laboratory services such as diagnostic imaging and testing.

According to company data, some kind of diagnostic test is administered about 40% of the time when animals are brought to the clinic.

Idexx’s animal diagnostics unit generated more than $1.7 billion in net revenue in 2017, about86.5% of its overall $1.97 billion in revenue for the year.

The company has seen success with SediVue, the industry’s first in-clinic urine sediment analyzer. And its recently launched product, Catalyst SDMA, an in-clinic test used by vets to look for kidney disease, was adopted by 42% of its North American customers in the first few months of its debut.

 Idexx Chief Executive Jonathan Ayers believes that’s “an amazing, amazing accomplishment.”

“Nothing happens fast in veterinary,” he told analysts on the company’s most recent quarterly conference call. “The adoption rates are typically very slow. And in that context, the adoption of SDMA on the slide has been exceptional. And so we’re very, very pleased with the success we’ve had.”

This also impressed Canaccord Genuity’s Massaro who said, “They beat on every single line, every single reference category.” He noted that “it gets down to extremely strong commercial execution. (Idexx has) one of the most savvy sales organizations I’ve ever seen.”

He points to the company’s unusually large direct sales force — 435 sales reps in North America and more than 100 in Europe — as a particular strength.

This could explain the stock’s market leading performance.

IDXX monthly

Gains in Idexx are likely to continue as management raised its full-year earnings guidance by 2 cents. They now expect earnings per share to be between $4.06 and $4.20. Management also It reaffirmed its sales outlook, adjusted for exchange rates, at 12% to 14% growth.

Even though Raymond James’ Ransom had high praise for the company, he only reaffirmed his market perform rating in the same note to clients, citing the high price-to-earnings multiple as a hindrance to a more positive rating.

Another analyst who liked the company is Ryan Daniels from William Blair who believes that the company is “a durable business franchise that warrants a premium multiple,” and wrote in early May that the firm “would be more aggressive with share purchases on pullbacks.”

More broadly, Raymond James’ Ransom said in April that investors shouldn’t expect growth to ramp up in the end-market for companion animal diagnostics.

That means shares of companies like Idexx, and competitors are “more likely to move on individual successes (share gains, new product launches, etc.) than to move uniformly on an all-encompassing cyclical dynamic.”

But given the baseline growth rate of the animal health diagnostics industry, Canaccord Genuity’s Massaro says that means that “even the worst company in the space would grow 6% to 8%” each year.

“It really is a spectacular industry,” he said.

Investors could also consider competitors which include Heska (Nasdaq: HSKA) where analysts expect earnings growth to average 25% a year and Zoetis (NYSE: ZTS) which is expected to grow earnings at about 16% a year.

Zoetis is acquiring Abaxis, another large company in the field which could drive additional growth.

Americans are unlikely to neglect their pets and that means growth should continue in the veterinary sector. This sector, however, might not be represented in the portfolio of many investors and these stocks could help deliver gains in what appears to be a growth industry.

 

Value Investing

Value Factors: Buzzwords and Profits

Posted on by Team Editor

Some investors argue that price moves are impossible to predict. But, many of these investors will consider that there are some methods that improve the probability of success for investors. They might point to value investing as an example.

The idea of value investing can be thought of as seeking to buy stocks that are trading at a discount to their fair value. It’s the idea of buying a dollar worth of assets for less than a dollar. It’s popular among both practitioners and academic researchers.

In the academic community, investment strategies that can deliver market beating profits are called “factors.” The value factor is widely studied and shown to deliver profits in the long run when properly implemented.

Factors Have a Long History

Factors have been used to explain abnormal market performance since at least the early 1960s when the Capital Asset Pricing Model (CAPM) was introduced.

This model identified a market risk factor to explain that some stocks carry more risk than average, other less risk than average and the risk of the individual security explained its performance relative to the broad stock market.

Nearly thirty years later, two business professors, Eugene Fama and Kenneth French, explained that the single market risk factor did not fully explain performance Fama would later be recognized with a Nobel Prize in Economics for his work.

The two developed the Fama–French three factor model to describe stock returns. The three factors are (1) market risk, (2) the outperformance of small versus big companies, and (3) the outperformance of high book/market versus small book/market companies.

The second factor is known as the size factor and the third is the value factor. Basically, on average, we should expect small cap stocks to deliver larger returns in the long run and we should expect value stocks to outperform in the long run.

The pace of progress accelerated after that. Just four years after the Fame-French model was published, the Carhart four factor model was published. This is an extension of the Fama–French three-factor model and introduces a momentum factor for asset pricing of stocks.

momentum factor for asset pricing of stocks

Source: Wikipedia

Factors Became a Zoo

Now, as one noted finance professor says, there is a “factor zoo” with hundreds of factors identified in the literature.

factor zoo

Source: AlphaArchitect

While some quantitative investors are using many factors, with one reported to be using an 81-factor model to build equity portfolios, that is simply not practical for individual investors. In fact, it could be best for individual investors to ignore many of the papers claiming to find factors.

In fact, new research shows that the size factor may not even exist anymore. One paper says, “The small-cap anomaly has not been observed in the United States since the early 1980s and does not exist outside the U.S. dataset.”

small cap anomaly

Source: Research Affiliates

The table shown above is typical of the type of research into factors. The researchers are looking for statistically significant relationships. They may not be looking for economic significance or ideas that can be profitably traded. That is important for investors to remember.

With these techniques, the identification of factors is virtually guaranteed. As Research Affiliates explains:

“Recognizing the dangerous combination of cheap computing power and overzealous young finance Ph.D. students, our professors explained that if one runs 10,000 back-tests, one is bound to discover a few incredible factors which generate huge Sharpe ratios.

These “data-mined” factors will unfortunately offer no future premia.”

What Is Important for Individual Investors to Know

One recent paper, written by Cam Harvey, a widely respected past editor of the Journal of Finance, with co-authors Yan Liu and Heqing Zhu, studied 315 factors from top journal articles and highly regarded working papers.

Adjusting for “data snooping,” Harvey, Liu, and Zhu (2014) conclude that only a handful of the factors in the zoo are actually statistically significant. Using this adjustment technique, the value, low volatility, and momentum anomalies are very significant.

It should also be noted that risk factors like market and illiquidity are significant. But, the researchers concluded that the size factor is insignificant, confirming earlier research.

They also found that many of the newer factors, such as idiosyncratic volatility and various definitions of quality like default risk, ROE, and ROI, are also insignificant.

Applying What’s Important

All of this research does have practical implications for individual investors. In large part, they can ignore much of the research except as an intellectual curiosity. If they are focusing on finding profitable investing ideas, value stories should be considered.

Here, the research is robust and almost any measure of value can be used. The price to earnings (P/E) ratio could be used, for example. With this metric, low value stocks would be bought and stocks with high P/E ratios would be sold or avoided.

Other popular ratios, including the price to sales (P/S) ratio and price to book (P/B) ratio, could also be used.

Now, remember that adjusted for data snooping, value, low volatility, and momentum factors were very significant. Value can be measured in a number of ways. Low volatility can be measured with beta, a readily available metric that shows how volatile a stock is relative to the broad stock market.

Momentum is also widely available. An investor could, for example, screen for stocks with low P/E ratios, a beta lower than 1 and a market beating return over the past six months. That is a strategy supported by research.

The researchers also noted that factors associated with illiquidity are significant. This could mean buying stocks with low trading volume could be beneficial. This would most likely require a long term outlook and could benefit small investors, since large investors cannot readily exploit this factor.

Overall, this is good news for individual investors. Focusing on value, perhaps combined with momentum, can beat the market. The data for this research is readily available and the time required to implement the strategy is minimal, consistent with the demands on the schedule of individuals.

Complex strategies, requiring more time and effort, may not be worth the effort.

 

 

 

Cryptocurrencies

A Chance to Trade the Ground Floor

Posted on by Team Editor

Many investors look at great performing stocks and wish they had gotten in “on the ground floor” or before the company’s value was obvious to everyone. Well, right now, the opportunity to invest on the ground floor might be possible in the cryptocurrency markets.

To understand the potential of the markets, and to review how early opportunities can be easy to dismiss, it can be beneficial to consider the history of options, a type of derivative investment security that is widely used and accepted now.

Options Were Once Unknown

Although options are now commonly employed by large and small investors, they are a recent development.  The first options exchange, the CBOE, didn’t open until 1973. But, options had existed for centuries by that time.

timeline of options trading

Source: optiontradingpedia.com

Notice in the history of options there was a time when the product was illegal. This was obviously a time when the product was perceived to be less than reputable. However, the true value of options was evident to the financial community and the ban was reversed.

Over time, the math of the markets also advanced. Coincidentally, or perhaps not, in addition to being the year the CBOE opened, 1973 was also the year a mathematical breakthrough made the products easier to trade.

It was in 1973 that two economists, Fischer Black and Myron Scholes, published an article explaining a model for calculating the theoretical estimate of an options price over time.

At the same time, their colleague Robert Merton published an additional study and mathematical amplification of the Black-Scholes model.

Black-Scholes model

Source: Wikipedia

The Black-Scholes model so changed the landscape for the pricing of options that Myron Scholes and Robert Merton were awarded the Nobel Prize in Economics for their work years later, in 1997. Merton had prematurely died by that time and only living persons are awarded the Nobel Prizes.

As FINRA, the financial regulatory authority explains, “With an exchange created and a solid model for pricing, new options contracts were issued subject to standardized terms, such as uniform expiration dates and established “strike” prices, or the price at which the option could be exercised.

The market flourished and was subject to regulatory oversight on par with U.S. stock markets, with trades guaranteed by a central clearing house, The Options Clearing Corporation.”

Standardization Led to Acceptance

At that time, in 1973, there was no way of knowing if the options contracts would be popular with investors and if they would serve an economic purpose for investors. There were reasons to think of the new market as a novelty.

Early trading at the CBOE was restricted to call options, which give the buyer the right but not the obligation to buy shares of stock at a predetermined price for a predetermined amount of time, in just 16 stocks.

Over time, the listed options market spread to additional exchanges and new products were created, including put options, which grant the buyer the right to sell shares at a predetermined price for a specified period of time.

Another popular product that was created was options on stock market indexes which are settled in cash. These products allow investors to easily manage or hedge portfolio exposure and smooth portfolio returns against indexes like the broad based S&P 500 and Russell 2000, or narrower indexes like the NASDAQ 100.

In less than ten years, by 1982, the listed options market hit a milestone when more than 500,000 contracts were traded in a single day. Options popularity continued to increase with more than 3.8 billion equity options traded a year, an average of 16.9 million contracts a day across a dozen exchanges.

Crypto Could Be In the Early Days

Many of the pioneers in the options market were richly rewarded. Crypto investors could be looking at a similar opportunity.

This opportunity could be illustrated by the existence of a reputable exchange, Coinbase. With $150 billion in assets traded across more than 20 million customers and 2017 revenue reported at $1 billion, it’s plowing money back into a master plan to stay ahead in a much larger cryptocurrency economy.

Coinbase

Source: Coinbase

According to CNBC, the company is best known as the leading U.S. cryptocurrency trading platform. But, the company has additional plans.

“We don’t see ourselves as a crypto exchange,” said Coinbase president and COO Asiff Hirji. “We are very focused on the establishment of the crypto economy. We see ourselves as enabler of that future economy.”

Coinbase is working to make crypto trading more accessible and recently announced that it is launching a new version of its GDAX platform called Coinbase Pro and acquiring crypto trading relay platform Paradex.

The new platform seeks to “make the trading experience easier and more intuitive,” according to the startup. Other features include a new chart system which provides streamlined access to historical data and a consolidated portfolio view.

But, competition is on the way.

The parent company of the New York Stock Exchange has been working on an online trading platform that would allow large investors to buy and hold Bitcoin, according to emails and documents viewed by The New York Times and four people briefed on the effort who asked to remain anonymous because the plans were still confidential.

Competition could improve the trading experience for many investors. It should reduce the costs of trading and that would potentially improve the profitability of trading. Competition is also an important step towards more widespread acceptance of cryptos.

Multiple markets make products more accessible to large traders who can then split orders to lower their costs and improve the liquidity they need for trading. This is almost a necessity for the entry of very large traders like those that are found in stock and fixed income markets.

There are many parallels between the history of options and where we are in the crypto markets today. Both require math to understand and the math is becoming increasingly accessible. Both require the acceptance of the financial community and both at times have unsavory reputations among some.

However, options delivered large gains to investors and crypto may very well do the same.

Weekly Recap

Weekly Review

Posted on by Team Editor

Trading Bitcoin Through Your Brokerage Account

Many traders might like to trade bitcoin but are unsure how to get started. They know that the process can be rather involved and requires setting up new accounts. They also know the new accounts will not have any type of regulatory insurance and will not be as safe as brokerage accounts.

There is at least one opportunity for at least some investors to access bitcoin through their brokerage account and we explain that right here.

Finding Value Overseas

Investors tend to have a “home court” bias. For investors in the US, that means they often invest too much in the US, their home country. The home court bias isn’t limited to the US. One study found this bias exists around the world to varying degrees.

In this article, we discuss those biases and help you find value overseas. You can read more by clicking here.

Higher Interest Rates Could Hurt These Stocks

The Federal Reserve is raising interest rates and is expected to deliver more rate hikes before the end of the year. Rising rates impact stocks in a number of ways.

We share the potential impact of those rising rates and identify stocks that could be hurt. You can find the details here.

Income with Inflation Protection

Income investors face a number of risks. One of the greatest risks is that inflation will increase before their investment matures. This is especially true right now.

We have researched those risks and found a way for you to earn income with inflation protection. Check it out right here.

 

 

 

 

Passive Income

Income with Inflation Protection

Posted on by Team Editor

Inflation

Income investors face a number of risks. One of the greatest risks is that inflation will increase before their investment matures. This is especially true right now.

Now, a US Treasury note maturing in ten years offers a yield of about 3%. Let’s say an investor buys a bond with a face value of $1,000. Every year, for the next ten years, they will receive $30, the interest payment on a 3% yield. They will also receive their $1,000 back in ten years when the note matures.

What Could Go Wrong?

Since this is a US Treasury, we assume that the investor’s principal, their $1,000 investment, is safe and will be returned in 10 years. We also assume the Treasury will make all interest payments. These assumptions do not apply to corporate where there is a credit risk but we will address other risks in future articles.

In this article, we are only considering the inflation risk and that is the biggest thing that could go wrong for the investor.

Interest payments compensate the investor for the use of their money. Ideally, the interest rate also protects the investor against inflation. For most of the past ten years, inflation has been below 3% so the 3% yield on ten year notes might protect against inflation.

inflation chart

Source: Federal Reserve

If inflation rises above 3%, the investor in the ten year note will not keep up with inflation. In other words, they will lose money after inflation is considered. This is an important risk to consider.

Given the risk, it is reasonable to ask why investors would consider accepting a low and fixed return on their investment. Well, there is no choice. Interest rates are low and to boost income in dollar terms the investor must buy investments with a longer time to maturity.

There is, however, an important investment to consider that, like the Treasury note, carries no credit risk but also includes a guaranteed return after inflation is factored in. These investments are called Treasury Inflation-Protected Securities, or TIPS.

As their name clearly states, they provide protection against inflation. The principal of a TIPS (the amount of the face value of the investment, or $1,000 in the example above) increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI).

When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. So, even if deflation brings the face value of the security lower, you receive your original investment amount back. This is a strong hedge against inflation.

TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

You can buy TIPS through TreasuryDirect, the government’s web site that charges no commissions. You also can buy TIPS through a bank or broker.  You can hold a TIPS until it matures or sell it before it matures.

How TIPS Work

TIPS sound like an ideal income investment in theory. But, an example can help explain exactly how they work. The chart below shows an example that is hypothetical.

hypothetical example

Source: Investopedia

Notice how the principal rises along with inflation. This is important because that could be where the gains in the investment come from. The yield on TIPS is usually lower than the yield available on Treasury securities that are not protected by inflation.

This is shown in the next chart which shows the yield based on Federal Reserve data.

yield based on Federal Reserve data

Source: Federal Reserve

Notice that the yield turned negative for a time. Remember that the principal paid at maturity is always equal to the original face value so the negative yield does not imply a certain loss. Of course, it might not make sense to buy when the yield is negative, but it could make sense to buy when the yield is low.

The current yield is near 0.8%. This is after inflation yield. In effect, if inflation is 2%, the yield would be 2.8% since the principal is increased by 2%. This is below the yield on the noninflation protected Treasury which is 3%, In that case, it might seem better to buy the noninflation protected Treasury.

That ignores the risk of future inflation. If inflation rises to 4%, the TIPS would pay 4.8% and the noninflation protected security would still pay 3%. With the inflation protection, a fixed income investor could fall behind.

TIPS can be bought directly or they can be added to a portfolio with an exchange traded fund, or ETF. The iShares Barclay’s TIPS Bond Fund (NYSE: TIP) is one ETF that could be used. This ETF holds government issued securities. It’s long term performance is shown in the next chart.

TIP monthly bars

TIPS might sound like the ideal income investment but there are some risks to consider.

These should be considered as long term investments. As the chart of TIP shows, the price of the ETF and of the securities themselves will fluctuate. In the bear market that began in 2008, the TIP ETF lost about 12% of its value on a total return basis.

However, if you buy individual TIPs and hold them to maturity, you are guaranteed to receive 100% of your investment back with all interest payments and with inflation protection. If you invest $1,000 now, you will receive at least $1,000 back at maturity.

If inflation rises, you will receive more than $1,000 but the higher amount will have the same buying power that $1,000 has today. For example, you might receive $1,500 but in theory that would buy the same amount of goods you could buy for $1,000 today.

There could also be some tax considerations with TIPS as there are with many fixed income investments. For that reason, you should consider consulting a tax professional before investing in these securities.

Even with these concerns, if you are searching for protection against inflation and current income, TIPS or the TIP ETF could be worth adding to your portfolio.

 

Stock Picks

Higher Interest Rates Could Hurt These Stocks

Posted on by Team Editor

Federal Reserve

The Federal Reserve is raising interest rates and is expected to deliver more rate hikes before the end of the year. Rising rates impact stocks in a number of ways.

One of the most widely cited ways is the alternative investment thesis. The idea here is that stocks and bonds are alternative investments. When rates rise and bonds offer better returns than they currently do, many investors will increase their allocation to bonds.

This will impact the broad stock market and could trigger a bear market in stocks if interest rates rise too much. But, beyond the alternative investment thesis, there are other factors affecting individual companies.

Higher interest rates will also affect sales for many companies. Consumers will face higher costs, especially those with variable rate loans such as credit cards or some mortgages. The higher interest rates will reduce their ability to spend in other areas.

Higher interest rates could also dampen demand for large purchases that are often financed. Cars, for example, are often financed and the cost of a loan will rise which means some consumers will be priced out of the market. Others will have to find vehicles that sell for less. Both outcomes can hurt manufacturers of cars and other big ticket items.

Many businesses borrow money to finance their operations and to obtain funds for growth. Many of these loans carry a variable interest rate. Higher rates will almost immediately increase the cost of borrowing for these companies and that could immediately affect earnings.

As an example, we can consider Netflix, Inc. (Nasdaq: NFLX). The streaming entertainment giant has been spending billions of dollars on content.

While strong cash flow from operations finances a significant portion of that activity, Netflix has increased its long term debt from $2.4 billion at the end of 2014 to more than $6.5 billion in its most recent quarterly statement.

That debt requires cash to service. In the most recent quarter, the company reported an interest expense of $0.63 per share over the past twelve months. This cost was just $0.12 per share in 2014. A relatively small increase in interest rates could reduce earnings per share by several cents.

While the expense might sound small, NFLX is a high flying stock with a rich valuation.

NFLX weekly chart

The stock is priced at nearly 200 times trailing earnings, more than 100 times this year’s expected earnings and more than 70 times 2019 expected earnings. The price leaves little room for bad news and a spike in interest rates could have a significant impact on these shares.

An Expert Advises Caution

Rich Familetti, president and CIO of New York-based LDI (liability-driven investing) expert Ryan Labs Asset Management, told investors.com in an interview, that he’s watching carefully for those sectors that have used more debt than the value of their assets or are showing cash flows that are not as stable as they may appear.

Homebuilding stocks are one sector to be concerned about. The industry depends on consumer financing and higher financing costs could have an adverse impact on sales. Rising mortgage rates threaten the industry.

In that sector, Cavco Industries, Inc. (Nasdaq: CVCO) stands out as potentially overvalued. Its price to earnings (P/E) ratio of 33 is more than 50% above the industry average.

CVCO weekly chart

There are a variety of ways to find potential risky stocks. Familetti’s team looks at debt to EBITDA (earnings before interest, taxes, depreciation and amortization). Investors.com suggests looking at the ratio of long-term debt to shareholders’ equity.

With this method, in a rising rate environment, it could be best to avoid companies that have a ratio of more than 100%. One study found that about 14% of high growth companies had a worrisome debt ratio.

Among the fast growing stocks with potential problems are Zebra Technology (Nasdaq: ZBRA) with a ratio of more than 260%. NFLX has a ratio of 160%.

Other high flyers have little or no debt. Facebook (Nasdaq: FB) has no debt while Alphabet Inc (Nasdaq: GOOGL), the parent company of search engine Google, has a ratio of 2.5%. Amazon.com (Nasdaq: AMZN) and Apple (Nasdaq: AAPL) both carry significant debt.

However, it is likely that AMZN and AAPL have sufficient cash flow from operations to continue servicing debt even if interest rates rise sharply. This demonstrates that debt is just one factor that should be considered, however it is an important factor that should not be ignored in the current market.           

A Strategy for the Risks

Stocks of companies with significant risks from rising interest rates might not be the best buys for now. This is especially important to remember as stock prices fall and investors search for bargains. Many of these debt laden companies could fall 50% or more.

Since they carry such high risk, they could be short sale candidates. A short sale involves selling a stock without owning it. This creates an obligation to buy the shares later and if the price drops, the investor benefits from a price decline.

There are many risks and costs associated with selling shares short and this strategy may not be suitable for all investors. However, an alternative to benefit from a price decline does exist. An investor could buy put options to benefit from a sell off.

A put provides the buyer with the right but not the obligation to sell 100 shares of stock at a predetermined price for a predetermined amount of time. If the stock declines, a put can increase in value. A put option can decline in value if the stock prices rises.

However, when buying a put, the loss is limited to the amount paid to open the trade. A trader can never lose more than 100% of their investment and puts are often relatively inexpensive with many requiring less than $100 to open.

Put options provide one way to trade high debt companies. But, even if an investor doesn’t benefit from the decline, this information could still help them avoid losses. Selling companies with high debt to equity ratios could be a prudent strategy in the current market environment.

 

Value Investing

Finding Value Overseas

Posted on by Team Editor

Investors tend to have a “home court” bias. For investors in the US, that means they often invest too much in the US, their home country. The home court bias isn’t limited to the US. One study found this bias exists around the world to varying degrees.

home court bias

Source: University of Glasgow

Notice that in some countries, investors allocate more than 90% of their investments to their home country. This is particularly true in many emerging markets where risks can be relatively high and overseas investment could be beneficial.                                                                              

Quantifying the Bias

How big is the bias? To allocate funds with the size of their market cap, many investors should consider almost doubling their allocation to markets outside the US.

Quantifying the Bias

Source: Janus Henderson

Experts at Janus Henderson attribute the home court bias to persistent beliefs in myths:

  • The myth that owning US multinationals makes a portfolio truly global
  • The misconception that all global managers provide meaningful overseas exposure
  • The overseas equity blind spot in income portfolios

The first myth that large cap stocks provide exposure is widespread. However, investing in multinationals through domestic markets doesn’t necessarily provide broad or balanced international exposure.

It’s important to consider that no two countries have the same sector exposure footprint. The U.S. is skewed toward technology and health care sectors, while the outside of the US portion of MSCI World Index has its highest concentration in financials and industrials.

Therefore, an equity investor in solely U.S. equities may be subject to large biases to a short list of U.S. sectors.

Then there is the belief that a global fund provides adequate exposure overseas. But, in some funds, the US market may account for 60% of holdings, despite the fact that global is in the fund name.

Finally, income investors tend to look at the US market and ignore the fact that the international high income equity universe is arguably much larger than what most investors find in their more familiar U.S. hunting grounds.

Overcoming the Home Bias Can Be Difficult

Many investors may believe they can’t adequately research opportunities in other countries. This belief could be accurate.

Companies may follow different accounting standards in different countries. This means even the ability to expertly analyze financial statements in the United States is not a guarantee that financial statements of companies in other countries will be the same.

Some investors turn to exchange traded funds (ETFs) to overcome this difficulty. There are ETFs available, tracking indexes in dozens of countries. This provides diversification and reduces the risk associated with investing in single companies.

This presents the problem of selecting the country to invest in. Here, again, investors can turn to ETFs and obtain a diversified portfolio. Funds are available to track the entire global market, sectors that have holdings across countries or regional groupings.

Here, the investor can target value precisely. Recently, countries in emerging Europe were the countries offering the greatest value using the CAPE ratio.

greatest value using the CAPE ratio

Source: Star Capital

The CAPE is the cyclically adjusted price to earnings ratio, which is also called the Shiller P/E, or P/E 10 ratio. It is a valuation measure that can be applied to any global stock market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.

Because it includes ten years of data, the CAPE is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.

The chart of the lowest CAPE ratios offers a hunting guide for value on a global scale. To buy low CAPE countries, investors could consider iShares MSCI Poland ETF (NYSE: EPOL). These ETFs provide a diversified portfolio but do not provide diversification on a country basis.

A popular approach is to obtain exposure to emerging markets, which are generally believed to offer the greatest potential returns while carrying the greatest degree of risk.

Diversification and Safety in Emerging Markets

Emerging markets are characterized by greater market access and less potential for operational risks when compared to frontier markets, which leads to a larger base of potentially eligible investors. This is the middle of the three classes of countries which includes frontier markets, emerging markets and developed markets.

Dividends are a risk reduction tool that could help investors achieve returns. Wisdom Tree applies an index methodology to select a diversified portfolio.

The WisdomTree Emerging Markets Dividend Index is a fundamentally weighted index that measures the performance of dividend-paying stocks selected from the following 17 emerging market nations: Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey.

Companies are weighted in the Index based on annual cash dividends paid. The Index was established with a base value of 300 on May 31, 2007. The Index is calculated in US dollars and is updated to reflect market prices and exchange rates. It is rebalanced at least annually.

In the most recent rebalance, banks and energy stocks were the largest sectors while Taiwan and China were the largest countries in the index.

banks and energy stocks

This index is available as the WisdomTree Emerging Markets Dividend ETF (NYSE: DVEM). The ETF has a limited trading history, having started trading in 2016 and been available only a period of generally rising markets.

However, the ETF is based on an index whose holdings are defined by specific rules. This means it is possible to back test the portfolio to find its hypothetical performance. WisdomTree provides the results of this test which is shown below.

$10,000 investment

Source: WisdomTree

This indicates the fund could sell off sharply in a bear market as it did in the global market meltdown that began in 2008. Investors worried about a potential market decline may want to put this ETF on their watch list rather than buying now.

Or, they could dollar cost average into the ETF. This is a popular strategy for mutual fund holdings and could work equally well with ETFs.

 

 

 

Cryptocurrencies

Trading Bitcoin Through Your Brokerage Account

Posted on by Team Editor

Bitcoin

Many traders might like to trade bitcoin but are unsure how to get started. They know that the process can be rather involved and requires setting up new accounts. They also know the new accounts will not have any type of regulatory insurance and will not be as safe as brokerage accounts.

Several companies have tried to overcome these obstacles by creating exchange traded funds (ETFs) that provide exposure to bitcoin but the Securities and Exchange Commission (SEC) has not approved any of the proposals.

There is at least one opportunity for at least some investors to access bitcoin through their brokerage account. The Bitcoin Investment Trust (OTC: GBTC) trades over the counter and is a way to gain exposure to the cryptocurrency.

A Unique Structure

GBTC is sometimes referred to as an ETF but it is a grantor trust. Under that structure, it is not registered with the SEC under the Investment Company Act of 1940 and it doesn’t trade on an exchange. It trades on the over-the-counter market, which has less stringent participation rules than exchanges.

The trust was initially launched as a 506 (c) private placement in September 2013 and is managed by Grayscale Investments, a unit of Barry Silbert’s Digital Currency Group.

DCG is a holding company focused on cryptocurrencies and blockchain technology that also owns CoinDesk, a leading blockchain news site and has investments in more than 110 companies including the Kraken Bitcoin Exchange.

Since 2013, accredited investors have had the ability to purchase restricted shares of Bitcoin Investment Trust directly from Grayscale at the daily net asset value, which is tied to the trailing 24-hour volume-weighted average price of the TradeBlock XBX Index. The NAV is approximately 0.0010023 bitcoin per share.

GBTC recently held more than 187,000 bitcoins. The number of coins held by the trust fluctuates substantially as investors move money in and out of GBTC. Recently, the trust held $1.7 million.

“The trust is solely invested in Bitcoin and does not hold any other asset, nor does it trade its holdings, have leverage, lending or the like,” said Michael Sonnenshein, managing director at Grayscale Investments.

“In 2015, through the approval of a Form 211, working with the Financial Industry Regulatory Authority (FINRA) and the OTC Markets Group, we were approved to quote the trust on the OTCQX market, the top tier of the OTC Marketplace.”

Shares are sold directly to accredited investors. After holding shares for one year, investors who purchased shares directly from the trust become eligible to sell their “seasoned” shares into the public market, said Sonnenshein. The rules for selling unregistered shares are listed under SEC Rule 144.

After shares are sold into the secondary market, any retail investor can buy them.

“This is highly unusual. Most private placements don’t convert into shares that trade OTC,” said Kathleen Moriarty, a partner at Chapman & Cutler LLP and, as specialist on 40 Act funds, she was actively involved in the creation of the first ETF, the SPDR.

“It’s not unique, but it’s not common. Not that none do: The rule permits it, but they are made for high net worth individuals.”

GBTC is eligible for tax-advantaged accounts such as IRAs, Roth IRAs and 401(k)s.

Trading Can Be Expensive

GBTC has a 2% management fee but that is just the start of the fund’s expenses. It trades like a stock and the chart shows some degree of liquidity.

Bitcoin Investment Trust

Source: Yahoo! Finance

However, the market price is significantly greater than the value of the underlying assets.

market price and holdings

Source: Grayscale.co

The difference is similar to the premium seen in closed end funds which often trade at a price greater than the fund’s underlying net asset value.

The reason for GBTC’s premium is the high demand for the small supply of shares. It has only 176 million shares outstanding. The trust has an open-end structure as it can raise assets through the private placement, but those shares need to wait a year to trade.

“If GBTC was more liquid and larger, and Bitcoin had wider acceptance, then there would be closer correlation between the price of GBTC and the price of the underlying asset,” said David Foster, a securities fraud litigator in Farmington Hills, Mich. “This is a speculative investment for a speculative commodity.”

“There are other approaches (to investing in Bitcoin), just not another exchange-traded approach, which is why GBTC has been successful,” said Matt Hougan, chief executive of Inside ETFs, an ETF education company.

“It obviously fills a need in the market, that’s why investors are buying it. I just don’t like products that trade at substantial and varying premiums. There’s enough risk in crypto prices before you layer on a premium issue.”

“Since the shares began quotation on the OTCQX market in early 2015, they have traded at a premium valuation to the NAV,” said Sonnenshein. “While we cannot pinpoint a singular reason for the premium, we can surmise several factors. Firstly, there are fewer shares available on the market than there is demand.  Secondly, it is the only U.S.-based investment vehicle that provides direct exposure to Bitcoin through the purchase of a security.”

There has consistently been a premium built into the market price of GBTC.

GBTC

Source: Grayscale.co

A Solution?

Grayscale recently declared a 91-for-1 stock split for the trust for shareholders of record in January. This lowered GBTC’s share price and increased the supply adding more shares to meet demand, thus increasing liquidity. The premium of share price over NAV has fallen but is still more than 60%.

Grayscale offers other products, including a diversified Digital Large Cap Fund that provides exposure to bitcoin (BTC), Ethereum (ETH), Ripple (XRP), Bitcoin Cash (BCH) and Litecoin (LTC). The company also offers products that trade each of those currencies individually.

It is possible those products will begin trading over the counter.

In the meantime, if this seems like the right investment for you, consider watching the premium and buying when the premium is smaller than it is now. In time, the premium could disappear as other products come to market so overpaying could be a long term losing strategy.

Weekly Recap

Weekly Review

Posted on by Team Editor

Cryptocurrencies Could Be Right for Your Retirement

Many individual investors face conflicting advice about their retirement accounts. They are told, in at least some ways, to be both conservative and aggressive in their approach to investing in these accounts. Conservative and aggressive investing seem to be polar opposites.

These two conflicting philosophies may leave investors feeling as if selecting the right investment opportunity for their retirement account is similar to squaring a circle, a phrase used to describe a task that is almost impossible. We explain how to square the circle and you can read more, right here.

Earnings Season Says Stocks Are Undervalued

Analysts have been watching earnings season for clues about the direction of the stock market. Earnings season comes four times a year and it is the busiest weeks of the years for analysts who need to incorporate new information into their models.

In this article, we sort through the details of earnings season and discuss stocks that are undervalued. You can find out more by clicking right here.

Gaining Insights from a Private Company

More and more research is being done on behavioral finance in an effort to understand how investors think. Research has already revealed that losses hurt. In comparing emotional responses of losses and gains, losses generate stronger emotions.

This explains why investors often hang on to losers and sell winners too soon. This aspect of behavioral finance is well known. In a recent article, we share a less well known example and you can read about it by following this link.

A Possible Alternative to Funding College

We know that college is expensive, and we know that many families will make the necessary sacrifices to send children to college. This implies there will be a steady stream of new students into schools, especially the large schools with reputations for excellence.

One company is offering an investment opportunity based on that implication, check it out here.