Tag Archives: money

The fallacy of dividend paying stocks – Part II

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Over the past few weeks, we’ve taken a deep dive into a strangely emotive subject: stock dividends.

In fact, the two articles (the first being a reader poll) that I wrote on a hypothetical real-estate transaction was not really about real-estate at all … it was also about DIVIDENDS.

Did anybody pick up on that?

You see, the problem with the real-estate deal is that if the property isn’t good enough to generate its own profits, the Rental Guarantee forces the developer to dig into project reserves, excess cashflows, or even future profits (by borrowing more money to pay the investors the ‘guaranteed’ amount) … none of these things are good for the project, the developer, or (ultimately) you as an investor!

Lets face it, everybody who invests wants to make a profit … so, do your due diligence before you get in and let the project deliver what it can …

Similarly, a company that focuses on issuing ‘high’ dividends through thick and thin to attract shareholders – with a board of directors that doesn’t adjust their dividend strategy to market realities quickly enough – is facing just the same problems as the developer forced to offer income guarantees to attract investors to a real-estate project … it’s all great when things are going well, but when the economy sours, things change – for the worse – very quickly, under these sorts of deals.

Now, I haven’t said that you shouldn’t invest in dividend-paying stocks … others, are just saying that you should – just because they are dividend payers – which is just plain dumb.

To my mind, the fact that a company offers dividends is just one factor – a relatively small one at that – in my decision to invest in a stock …

… to my way of thinking, it’s like choosing a dentist for your kids on the basis of the volume of candy that he hands out at the end of the visit:

– Shouldn’t we choose the dentist on the overall quality of his work (and, maybe price as well)?

– Doesn’t handing out candy at a dental practice seem somewhat strange to you?

Well, that’s exactly what you are doing if you choose a company because it pays great dividends …

… now, you may use other criteria as well, but if you are EXCLUDING great companies from your list because they DON’T happen to pay a dividend, then this also applies to you!

Instead:

– Shouldn’t you choose a stock on the basis of its great past/future BUSINESS performance?

– Since CASH is the lifeblood of a business and the driver of future investment and growth (eg for R&D, retooling, opening new stores, etc., etc.) shouldn’t we prefer a business that conserves it, rather than one that doles it out like candy to attract shareholders?

Look, just because a company issues dividends doesn’t mean that it’s making profits … the two SHOULD be directly related, but often they are not:

1. Profits (better yet, free cash flow) are a function of a sound business model,

2. Dividends are at the whim of the board of directors.

So, why not go direct to the source: look for companies with a strong current and (expected) future cashflow, and take your money out when YOU need it, not when the board of directors says you can have it?

So, is there a place for investing in dividends … surprisingly, YES.

But, not when and how you think:

Instead of laying out dividend paying stocks against other Making Money 101 and Making Money 201 activities, hold your thoughts until you reach your Number and are looking at preserving your wealth (i.e. with various Making Money 301 strategies).

You COULD then invest in solid, dividend-paying stocks (although, you may elect to go for a company’s Preferred Stock, rather than their Ordinary Shares) because having a semi-reliable income stream may be more important to you than overall return (i.e. you are trading off convenience for you against leaving your children or church a sizable inheritance) …

… or, you could try one of these MUCH better Making Money 301 strategies:

1. Buy Inflation-Protected TIPS (treasury bonds) or inflation-Protected MUNI’s (municipal bonds) with 95% of your portfolio, and put the remaining 5% in year-long call options over the S&P 500, to give you exposure to the potential upside of the market.

2. Buy (and hold) a rental property or five – live off the income (well, 75% of the income – leaving the rest as contingency against vacancies, repairs & maintenance, etc.) and bequeath the capital appreciation to your children/charity/church.

3. If you MUST look for dividends, buy Preferred Stock instead of ordinary/common stock (just as Warren Buffett has of late); these are a special class of stock that act more like corporate bonds, but: are less volatile than a stock; have more upside/downside than a bond; often produce higher dividend returns than the dividend on an ordinary share in the same company; and, are more likely to be paid … the issuing company usually pulls out all stops to maintain the dividend on these Preferred Shares even while lowering dividends on Ordinary Shares (a.k.a. Common Stock).

There, you are now better equipped to make decisions on dividends – at all stages of your financial life – than 99% of so-called ‘dividend experts’ 🙂

Car or curse? 7 case studies …

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fred-flintstone-barney-rubble-carWe all have a car … otherwise, we’d be cycling to work. But how much car? Do you buy new/old or somewhere in-between? After all, our car is one of our largest purchases … if not, largest purchase outside of our own home.

So, here’s 7 case studies from our 7 Millionaires … In Training! ‘grand experiment’.

Let me know what you think …

Scott – like so many of the 7MITs featured here – loves his BMW’s … in fact, even AJC happens to have one, at the moment! The best thing, for Scott, is that his employer provided his current BMW for ‘free’ … but, is there really such a thing as a ‘free lunch’? We explore that very issue …

Ryan also likes BMW’s, which cause Josh to recommend buying a new one because it means NO “maintenance bill for 4 years, 50,000 miles” … is this a good deal?

Josh is obviously the other BMW-fan; we use his post to re-introduce the 5% Rule for cars and other possessions; should Josh have broken the rule to get int his first car? You might be surprised by the answer (it’s in the comments)!

Lee sure knows how to run a truck into the ground! Take a look at his attitude towards financing vehicles and how long you should hold on to your truck for …

Mark – the savvy investor – shows the other BMW-lovers how to buy a good used one off e-Bay and negotiate the price lower AFTER you have already ‘bought it’ … nice!

Diane and I have a discussion around what comes first, the “debt or the car”? It’s moot … Diane know what she needs to do!

Jeff has the cars the boat and the airplane (well, the airplane is supplied by the Navy!) … but, at what point is it better chartering a boat than owning one?!

… oh, and I finally come clean on my own car-related successes and failures, here

Let me know about yours!?

Where do all these rules come from?

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I’m a maverick, yet I like rules … how do you figure that?

Well, the rules that I like are actually ‘rules of thumb’. You see, when I was $30k in debt, I was in the financial wasteland with no idea how do dig my way out …

… so, I did the only thing that I am really good at: I read books. A lot. All non-fiction. Mostly about how to make money.

I can read a 100-pager non-fiction book in the matter of an hour or so and absorb most of the salient points … I may then go back and work at snails pace through detailed explanations, if necessary.

And, I like to read books for instructions: do this, do that. Which I’m then pretty good at modifying for my own use.

So it was for my financial troubles; I started reading:

First Rich Dad, Poor Dad – the first book (and best, in terms of how it opened my eyes) on personal finance that I ever read.

Then The Richest Man In Babylon – which explained the power of compounding and reinvesting.

Then every other Robert Kiyosaki book that came out over the next four or five years.

And, I attended every financial spruiker seminar that came to town (Robert Kiyosaki, Peter Spann, Brad Sugars, and so on … )

… all the time looking for the ‘rules of the money game’.

What I found was that there was no ‘one size fits all’ set of financial rules that everybody should follow … but, there were various recommendations as to what you should do in this circumstance or that.

Over the years, by trial and error (largely a lot of trial – and tribulation – and plenty of error) I found various ‘rules of thumb’ that seemed to make sense to me, and some that I had been following without even realizing it, just like the rules that Jeff questions:

Where are all these rules coming from? Did I miss a bunch of information in the brochure?

If I understand correctly, we have the 20% rule for home equity vs. net worth, 25% rule for mortgage vs. income, and now the 5% rule for cars.

I had been following these rules, largely by coincidence, for most of my successful working life (i.e. during my 7 year journey), when I chanced upon a book that I had never heard of, written by a guy I had never heard of, who lived in a (now) bushfire ravaged area not far from my home in Melbourne, of all places!

Naturally, I had to read the book …

He worked from the premise – one that I happened to agree with – that at least 75% of your Net Worth should be in investments – OUTSIDE of your home, your car, your possessions, and basically anything else that is unlikely to yield you an income or be readily salable at a profit (where will you live if you sell your house?).

That leaves 25% of your Net Worth to spend on: houses, cars, possessions, as follows:

20% House

2.5% Cars

2.5% Possessions

Simple; except that I’m happy to blur the lines a little between cars and other possessions into one 5% ‘pool’.

Of course, this only helped to understand how much equity to hold in these items, and not how much you should finance on a house (that’s where the 25% Income Rule comes in) and cars/possessions [AJC: Easy … buy used and pay cash!].

I have explained how these rules work in practice in these three posts (please follow any backlinks):

Your House

http://7million7years.com/2008/04/11/applying-the-20-rule-part-i-your-house/

http://7million7years.com/2009/01/12/how-much-house-can-you-afford/

Your Cars and Other Possessions

http://7million7years.com/2008/04/12/applying-the-20-rule-part-ii-your-possessions/

Left Brain v Right Brain

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brain

Are you left-handed?

I find myself noticing actors in movies and on TV who are left-handed …. it seems (but, maybe my reticular activating system is blinding me to the statistics) that more leading actors are left-handed than the typical 10% or so that is the society ‘norm’.

Artists, too …

So, is there truth that the right-brain controls the left hand? And that the right-brain is responsible for our emotional / creative side? In which case, left-handed people are more creative?

I’m not sure.

But, I DO know this to be true:

Most decisions are made emotionally then justified rationally

I heard this once many, many years ago … and, even though it is widely quoted, I have not managed to find the source … but, I have found it to be true in business, investing, and in life.

It helps to explain impulse purchases despite reading the classic ‘frugality’ blogs like Get Rich Slowly.

It helps to explain the behavior of the stock market, supporting the findings of the Dalbar Study.

It helps to explain my wife 🙂

It helps to explain why the real answer to the Deal or No Deal conundrum is “Not Sure” …

… the reality is, you will NOT know what you will do in the same situation until you are faced with the same ‘on the spot decision’ yourself.

UNLESS …

Unless You Have A System to Guide You

Anytime you have a ‘rational’ decision to make – and, you can at least anticipate that you will one day need to make such a decision – then you MUST prepare ahead of time with a system that  you strongly believe that you must follow in order to achieve [insert very strong emotional outcome of choice].

The System, of course, will be a rational system: it will be well grounded in research, logic, and proven results.

And, it must be one that – in advance of the real decision that you will face – you strongly believe and/or have faith in.

Religions offer such a system for Life … if you subscribe to one, you do it because of Belief and Faith and then you follow it ‘religiously’ – according to your level of belief – or suffer the consequences …

… consequences that may range from guilt and/or discomfort on the mild end of the ‘consequences spectrum’ to great fear of [insert religious punishment of choice] on the extreme end of that same spectrum..

And, this blog is slowly unfolding such a system for Personal Finance. If you do not follow it, you may (on the mild end) feel guilt and buyer remorse, and (on the extreme end) fear that your money may run out before your do. Somewhere in the middle should be the very real fear that you won’t achieve your Number in time (i.e. by your Date)

The key is that when the decision pops up, the emotions around failing to follow the system must outweigh the emotions (temptations?) leading you towards the irrational decision …

…. ultimately the execution of the decision will always be made ‘in the moment’ and emotionally, and then you will justify your success – or failure – rationally later on so that you can live with your choice.

That’s why you need to commit the 7million7years version of this ‘truism’ to memory:

Most decisions are made emotionally then justified rationally unless you have a system to guide you!

Now, go find a system for personal finance that you feel that you MUST follow – and, a strong reason for doing so (e.g. so you can get on with living your Life’s Purpose … seems a pretty strong reason to me; how about you?) – and then follow it, or suffer the consequences … harruummph! 😉

Real Cashflow, Fake Cashflow – Part II

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Last week I told you that there are three types of positive cashflow Real Estate:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

Today, I want to discuss the first of these … cleverly designed to make Negatively Geared real-estate look like a good deal!

Tax Cashflow

In the first installment, I explained that most real-estate (especially residential real-estate, and single family homes and condos in particular) has more costs (e.g. mortgage interest, vacancies, repairs & maintenance, provisions, etc.) than income (i.e. rents), forcing us dumb investors to gamble on the future appreciation of the property … and, we can see where that has lead us!?

So, those developers and promoters with lots of real-estate that costs way too much to buy found some money to help you cover your losses and turn them into a ‘profit’ … from this, comes our first opportunity for the Holy Grail of Real Estate: Positive Cashflow property i.e. one that puts money INTO your pocket each year.

Now, I said each year for a reason: tax.

Uncle Sam will help you to help these property promoters to become rich by encouraging you to buy their overpriced, under performing real-estate! Take Scott, for example:

My wife and I have been pondering this very same topic with our rental(which was our previous home). We are negatively geared by $250.00/month on that property, have great renters that have completed their 6 month lease and are continuing to rent month to month while they continue to try and get their home in Connecticut sold, then move on to purchase their own home here in Louisville.

Money seems to be tight for them from all that I can see, however they are able to make this rent each month, so I’m a bit afraid of raising rent on them, but it really troubles me to be negatively geared for the moment. This property (according to this years filing) has given us a pretty large tax deduction, which has certainly saved us money, perhaps enough to pay us back the monthly amount we have lost to make us break even. Not to mention, it is in one of the most premiere areas of the city and has enjoyed one of the highest appreciation rates this city can offer, but as your post suggests, we don’t want to get caught up in the hope of appreciation.

As Scott has discovered the ‘secret’ is in tax-deductions …

… naturally, almost all the expenses that you have on an INVESTMENT property are tax-deductible, not just including mortgage interest (as in your own home) but, also ‘business’ expenses like repairs and maintenance … even vacancies allow you to earn a little less income, so you pay a little less tax … but these will probably not make a property cash-flow positive on their own.

Actually, the real secret is in the ‘provisions’ … a provision is a fund that you build up over time to allow you to cover major costs later (e.g. an Emergency Fund is a kind of provision).

You see, Uncle Sam allows you to ‘build up’ a fund over time to replace the building that you have on the property, and all the things that you have inside the property (e.g. stoves, lights, carpets, curtains, etc., etc.). You probably borrowed the money to buy all these things – and, are tax deducting the mortgage interest – but, the nice people at the IRS allow you to take a ‘double deduction’ in the form of a Depreciation Allowance on these items, as well.

It becomes another expense that you can get a tax deduction on, and because the property may not have enough income (hey, it’s already Negatively Geared!) you can lower your personal tax bill instead.

By paying less personal income tax, the promoters of these schemes will show you that the property can pay it’s own way (Neutrally Cashflow or Neutrally Gear) or even Positive Cashflow!

Unfortunately, it’s all on paper … and, it relies on you earning a high income … and, will probably only work for one or two properties because you won’t have enough personal tax to ‘save’ for more properties than that.

When you ‘run out’ of personal tax deductions you can’t make any more properties Tax Cashflow Positive … it’s all smoke-and-mirrors.

So, when it comes to real-estate, you want tax deductions and you want tax cashflow, but you don’t want to buy a property that only has this kind of cashflow, if you can find something better.

In the next installment, we’ll look at something even more fun: Fake Cashflow.

My spectacles are still cracked!

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On the subject of diversification and rebalancing (you can’t have the latter without the former, although the reverse is certainly NOT true), Rick says:

I don’t expect the market to behave consistently over any significant period of time. The reason I chose an example with no gains was to show that rebalancing can make a profit from volatility even when there is no underlying price appreciation. I suspect that is the mathematical explanation behind the study SiliconPrairie referenced. If a market was continually increasing then 100% stocks should do better- not that that is very realistic either!

I can believe some rebalancing could do better- especially with all of the market volatility we’ve had this year. I really wish I could time the market. I console myself with the fact that no one can really time the market with long term success.

I can rebalance though- as it can be done with a calculator rather than a crystal ball!

What Rick says is true …

… just understand that if you are committed to a diversification / rebalancing strategy, you will most likely:

a) under-perform the market over LONG periods of time (simply because you will have less in the market – on average – than a 100% stock portfolio)

Remember: the market (DJIA) has NEVER returned less than 8% in ANY 30 year period over the past 100+ years – I strongly suspect that if you were 100% invested the day before the market started to crash in October 2007 and simply waited 30 years, the same will hold true – and,

b) have to content yourself with not being able to reach a Rich(er) Quick(er) Number:

http://7million7years.com/2008/09/30/its-the-gradient-of-the-curve/

That’s OK for some … but, the premise under which I write is that it’s not OK for my target audience. That’s all 🙂

Is it OK for you?

No such thing as a free lunch …

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no-free-lunch

This concept has come up three times recently, so it deserves a post of its own!

First Time

My son asked me why he can’t buy a car (when he’s old enough) on finance, and I explained it to him…

… he then asked me the million dollar question:

What about if there is a 0% finance deal on the car? Can I finance it then?

And, my answer was:

There’s no such thing as a free lunch.

Second Time

Ryan was posting about his car and Josh commented:

I would suggest buying used until you have cash to buy a new…BMW, you have no maintenance bill for 4 years, 50,000 miles.

And, my answer was:

There’s no such thing as a free lunch.

Third Time

I wrote a post about a hypothetical real-estate deal, with the key feature of a rental return guarantee. Rick said:

The description sounds like a good deal to me for a low risk- a guaranteed 7.5% return + possibility of great appreciation. It really sounds too good to be true.

And, it is (too good to be true); you see:

There’s no such thing as a free lunch.

… really, there isn’t. Somewhere along the line you are paying.

Let’s take the last case first: guarantees are usually not worth the paper they’re written on. Especially when they are “thrown in” to make a “great deal” sound even better. In the real-estate deal the ‘guarantee’ could actually cost you money, if the developers/promoters have to borrow money against the future value of the project to make a current payment to you.

In most  new projects where, say, a 2 year rental guarantee is offered, the value of the guarantee is built into the price that the property is offered to you at … might explain some of the very dramatic rises and falls in RE values in Florida, for example.

Similarly with the second example of the ‘free servicing’, which is – of course – built into the price of the car. Naturally, if you simply MUST have a brand-new BMW then you will get the ‘free’ servicing with it. On the other hand, if you can buy a used BMW just after the ‘free servicing warranty period’ has expired, you will be buying at the best possible price point, because (in a normal market) you should expect a sudden drop in the value of the car … this sudden drop represents the real, current value of the ‘free servicing’.

If you understand this concept, then so-called 0% down deals should become obvious … YOU are actually paying for all of the interest, at commercial rates, up front!

I did some consulting work for a finance company that underwrote so-called “2 year interest free” loans on furniture sales for large retailers; they made their money because the store paid a fixed amount up front when you signed up to the deal, then the finance company HOPED that you would not be able to make all your payments on time, because the ‘fine print’ on the deal then let them charge you interest at credit card rates (19% p.a. to 29% p.a.) on the entire financed amount for the entire time that you had the “0% loan”.

Here’s the test; always ask:

… and, if I don’t take the [insert: free lunch du jour] how much do I have to pay then??

Then you can decide if the free lunch is something that you can afford!

Time to hop back in?

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buffett_chart1

Fortune Magazine publishes the above chart and says:

There should be a rational relationship between the total market value of U.S. stocks and the output of the U.S. economy – its GNP. [Warren Buffett] visualized a moment when purchases might make sense, saying, “If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you.”

Well, that’s where stocks were in late January, when the ratio was 75%. Nothing about that reversion to sanity surprises Buffett, who told Fortune that the shift in the ratio reminds him of investor Ben Graham’s statement about the stock market: “In the short run it’s a voting machine, but in the long run it’s a weighing machine.

Now, I don’t have a crystal ball, but it appears that most of the world’s greatest Value Investors (a technical term for ‘cheapskates’) are hopping back into the market, as this article – this time from Forbes – says:

Over the past several weeks, more and more of history’s most successful investors have turned bullish. Warren Buffett, John Neff and David Dreman–all of these gurus and others have said that they are now in full buying mode. Even Jeremy Grantham, a notorious bear, has said that stocks are cheap, as cheap as they’ve been in two decades, in fact.

I’m wondering: if you were prepared to buy when the market was high and people were beginning to speculate whether it would last, why wouldn’t you be prepared to buy (and hold for the long-haul) now, when the market is closer to the bottom than it was then?

I have some money that I can get an immediate 33% ‘kick’ by moving it from the US to Australia (due to favorable exchange rates), yet I am sorely tempted to keep it in the US and trade options with it, as I feel that there will be great volatility between a Dow of 8,000 and 9,000 … the time when traders make (and lose) fortunes.

Not suggesting that you do the same, but I am suggesting that if ever there were a time to buy (for the long-term), it might be right now … there might be deeper bottoms still to come, but there will be higher, highs as well … by buying and holding now, you will ride out those bottoms (if they come) and guarantee that you will reach the highs (when they come) … how can that be a bad thing?

… and, loving it!

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Monday’s post set out to use a reasonably obscure study on the success of Warren Buffett [hint: it’s NOT due to luck] to ‘prove’ that the efficient market theorists are wrong …

… but, first, what is Efficient Market Theory, anyway?

Well, our trust Wikipedia entry says:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or newsin the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

The principle is that there are thousands of stocks to choose from and each company is divided into millions of pieces (i.e. each piece of stock) with millions of individual buyers and sellers (from large institutions to small, individual buyers and sellers) all operating in a regulated, open market that ensures that all information that may affect the current or future share price is published.

Therefore, everybody should be factoring all of the same information to come up with a fair value for each stock, all of the time …

… or, so the theory goes.

But, there are some obvious ‘cracks’ in this theory:

Enron

When a company like Enron misreports its numbers and misrepresents its business prospects and business model, the price of the stock can be widely different to its real (or, intrinsic) value. We know the result of this one 🙂

Martha

When a person has access to special information about a company – that may affect its current or future price – through ‘inside’ contacts … and, that knowledge has not yet been published … then they can purchase (or sell) a stock a a price that may change dramatically once that information does reach the market. Of course, this is not legal; it’s called ‘Insider Trading … and, we know the result of this one, too 😉

Warren

The study that I mentioned yesterday clearly shows that Warren Buffett’s success is NOT the result of luck, or taking additional risks, but clearly and unequivocally due to his “superior stock picking skills” …

… but, how is this possible if Warren is acting legally, ethically, and with the SAME information available to everybody else?

It’s simple: efficient market theory is wrong … SOME of the time. In fact, often enough to allow investors like you and I – and, especially Warren Buffett – to make a killing … IF we are patient in both buying and selling:

Warren Buffett’s mentor, Benjamin Graham, discovered that some stocks were priced less than their current book value and he bought those stocks, typically looking to make a quick (< 2 year) killing and move on … he was successful enough at this that Warren, as his star pupil, took notice.

Warren soon found that he could simply buy and hold such stocks – and, look for ANY stock trading below it’s ‘intrinsic value’ (the discounted value of its future cashflows, as compared to treasury bonds + a suitable ‘risk’ margin).

Needless to say, student eventually outperformed teacher … but, BOTH outperformed the Efficient Market Theorists.

Here’s how YOU can do the same:

Pick up a book such as Rule #1 Investingby Phil Town (which, despite the title, is NOT Warren Buffett’s OR Benjamin Graham’s methods) or any other credible book on Value Investing (which simply means to buy a stock at less than its ‘true’ value).

Use that book to help you find stocks that some Efficient Market Fool is willing to sell to you for current market price, which HE believes is also fair market price (after all, if its that price, efficient market theory says it MUST be fair), but YOU know is a helluva bargain, and …

… wait until time and circumstance reprices that stock dramatically upwards, so that its market price and your estimate of its true/intrinsic value pretty much match.

What should you do then? Simple.

Sell it back to the same (or some other) Efficient Market Fool!

You see, you rely on these few facts:

1. Efficient Market Theory IS correct MOST of the time,

2. But, it is wrong SOME of the time,

3. And, when it is wrong – as long as the business of the underlying stock is sound – the Market will (eventually) correct its mistake!

The trick is simply to have the time and energy – and, the simple tools – to find such stocks, and the patience and discipline to wait for the correction …

… it makes Warren 21% a year; it should make you at least 15%