The Return of the IPO

Tweet

Investments: Episode 51

Facebook raised another $500 million and looks to be on a course for IPO in the next year or so.

The market for initial public offerings (IPOs) has been anemic since the dot-com bubble burst in the early 2000s. But venture capital and angel investment has been very robust over the last five years. Eventually those investors are going to want to realize their gains.

IPOs serve three main purposes:

1. To raise additional capital to fund the cash needs of the business.
2. To facilitate liquidity of existing investors.
3. To create a form of currency, in shares, for acquisitions.

It's highly unlikely that Facebook needs the cash at this point. With over half a billion eyeballs viewing the ads it serves up they are almost certainly raking in tons of cash. And that cash makes acquisition relatively easy for all but the largest of targets.

Facebook's maneuvers are most likely aimed at facilitating liquidity. All those billions in valuation are worthless until they are turned into cash. 

Movember Day 19: The Case for a Big Bad Ass Bull Market

Tweet

Investments: Episode 45

It's Movember Day 19 and the Mo is ready for manscaping.

Please stop by my Movember page and donate what you can.

Now that the mustache has spoken it's on to the show...

Are we on the eve of a MASSIVE bull market?

The law of large numbers ia about as difficult to escape as gravity. Eventually everything reverts to the mean. This can be a positive thing or a negative thing depending how you look at it. Just as markets can't go up forever they can't stay down forever either. 

As an asset class stocks, as represented by the S&P 500, have returned an average of 8.4% per year since 1950. However, if we exclude the years 2000 - 2010 stocks have actually had a historic average annual return of 10.2%. Yet, over the last 10 years the S&P 500 has had a negative 0.48% average annual return. This is just way out whack for the asset class.

The Worst Decade on Record

If we look at the 611 ten year periods (comparing January 1950 to January 1960 and so on) between 1950 and November 1, 2010 we see the worst 10 year period on record happened between Feb 1999 and Feb 2009 when the S&P lost 40.6% of its value. This is nearly twice as bad as the previous worst decade which occurred between Sep 1964 and Sep 1974 when the S&P lost 24.5% of its value.

A Typical Decade

Historically the S&P 500 has increased in value by 120.2% per decade (123.7% if we exclude 2000 - 2010). This means that an investor in the S&P 500 should expect to see his money double every eight or nine years or so. 

The Best Decades on Record

Remember the stock market crash of 1987? Well the decade that followed beginning in Dec 1988 and ending in Dec 1998 the S&P grew by 342.6%! You may also remember we had the savings and loan scandal in that period as well as the first gulf war. And if we look at Aug 1990 to Aug 2000 we see even more astounding growth at 370.5%.

Reverting to the Mean

Things average out. The S&P 500 and other stock indexes are upwardly biased. Notice that the extreme markets on the upside were much more extreme than the downside markets.

From the examples above we know that the market can go on decade long bear runs and huge decade long bull runs with an average run that produces 123% returns. 

To get back to this average stocks will need to produce an annual return of 22.6% for the next ten years. Will they do it? History suggests they will. At least at some point they will.

Liquidity: The hidden investment risk.

Tweet

Investments: Episode 26

Liquidity is incredibly important to a successful investment strategy yet few people pay much mind to the fact that it may be hard to sell their assets in the future. Not all assets can be converted to cash quickly and with ease. Liquidity risk is the chance that you will either need time to convert an asset to cash or the conversion of an asset to cash will materially impact its value negatively.

A profit is only realized when you sell an asset for more than you paid for it. Until then you only have an unrealized "paper" gain. We use cash in our society to buy goods and services. Even gold, which some view as a storage of wealth, is priced in dollars and must be converted to cash to be used for exchange for the things you want to buy.

There a few factors that impact liquidity:

1. Size of the Market: The more potential buyers in the market for your asset the more likely it is that you will be able to sell it at a fair market price within a reasonable time. If the market is small it may take awhile and you may be at the mercy of the buyer.
2. Activity of the Market: If the market is small it may still be active. Think of all the instances where there are specialists trading frequently. 
3. Ease of Valuing the Asset: How much is your house worth? How much is a share of Apple stock worth? How about the paint store in the center of town, what would you pay for that? Some assets are easier to price than others.
4. Ease of Transferring Ownership: It's not always easy to transfer ownership. When selling real estate you need to get the government involved to transfer the deed and make sure the title is clean. Selling stock is easy, just click sell or call your investment manager.

Types of assets and their liquidity profiles:

• Cash and near cash assets like money market funds are very liquid.
• Open ended mutual funds are very liquid but you have to wait for the closing price. If the fund prices lower than you hoped you'll experience a liquidity risk bummer.
• Stocks and bonds of large volume and active trading are very liquid. Click sell at market price and you've liquidated your position. But, T+3 means you need to wait three days to get your hands on the cash.
• Small cap and emerging market stocks are often less liquid than their larger more developed counterparts. Selling your shares may actually push the stock price down.
• Private companies, real estate and physical assets can take a while to sell. And you might not get what you emotionally feel the asset is worth.

Why do analysts think Apple's stock price is going much higher?

Tweet

Investments: Episode 18

Apple's stock price seems to defy gravity and yet many analysts seem to think it is going much higher. My friend Nicolas Ward (aka @UltraNurd) asked via Twitter: "@Investments What do you think of some the analysts very high price targets for AAPL? How do they come up with such numbers?"

A quick look Apple's stock (symbol AAPL) on FinViz shows most analysts have targets well in the $300+ range with strong buy or overweight/outperform recommendations. With the stock closing at a price of $287 per share yesterday these targets suggest that Apple will have another double digit growth year in 2011.

Context

Whether a stock's price is considered a bargain or overpriced has less to do with its dollar per share price but rather its price per share compared to its earnings per share (EPS). The price to earnings ratio (or P/E) is a common measure used to assess a stock's relative price.

P/E ratios can be used in two ways:

1. As a comparison against its competitors. As an example: Apple is currently has a P/E of 21.5 while Google is priced at 22.75 and Microsoft is priced at 11.6. The technology sector as has an average P/E of 17.4. So, AAPL is cheaper than GOOG but much more expensive than MSFT and industry as a whole.
2. P/E's can also be used to assess whether a company is getting more or less expensive over time. Apple's P/E ratio at the end of its 2008 fiscal year was 17.7 compared to today's 21.5. Apple is getting more expensive.

Some Math for Price Targets

If you click the link below you can open the quick and dirty spreadsheet I pulled together for the show. Here's how the math works:

• Basically what I did was look Apple's earnings for the first three quarters of fiscal year 2010 and assumed they would report a similar number in the fourth quarter. That gave me an estimated EPS of $13.38 for 2010. This would be a 45% increase over 2009's EPS.
• I then assumed that Apple would grow earning in 2011 by 40% and that its P/E ratio would stay at 21.5. Some simple math later, $13.38 X 1.40 X 21.5 = $402.59. This is much higher than most of the analysts' targets.
• If assumed that Apple's P/E would come down to the industry average of 17.4 I got $325.82 per share. Math: $13.38 X 1.40 X 17.4 = $325.82
• Note: It's kind of funny that $13.38 X 21.5 = $287.56 which is VERY close to yesterday's (9/29/10) closing price of $287.37 for AAPL.

Socially Responsible Investing

Tweet

I had lunch with a client yesterday who suggested I share my thoughts on this topic with you.

She and her husband had expressed a desire to avoid oil stocks in their portfolio as a matter of ethical conviction. I presented them with the following information to help them make their investment decisions:

• Stocks are traded on secondary markets. When you buy stock of Exxon or Haliburton or any other company none of your money goes to the company. It goes to the seller of the shares. Companies get their money at initial public offering.
• If you buy index funds it is true that some of your assets will be invested in oil companies but only as a matter of index tracking not because the fund manager has a penchant for oil.
• It's really difficult to separate the nasty from the nice. Microsoft sells a lot of software to Exxon. Green energy companies sell to tobacco companies.
• Invest in something because it is a good investment.
• Your job as an investor is to invest successfully so you can achieve your financial goals. If one of your goals is to reduce demand for oil, use your profits to put solar panels on your house and buy and electric car. You most likely put more profits in the oil companies' hands now through consumption than through investment.
• There is little evidence that socially responsible investment funds are worth the premium they charge.
• Voters and governments regulate business behavior. Managers of companies are required to maximize shareholder value and follow the laws of the land.

By the way: The clients do not hold any individual shares of any companies in the oil industry.