Newsletter March 18, 2012
InvestorsFriend Inc. Newsletter March 18, 2012
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And, our performance suggests that our analyses and our approach to investing is quite sound (either that or we have been uncommonly lucky over the past twelve years).
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Is it Too Late To Invest in Stocks?
The best time to plant a huge oak tree in your yard was probably 50 years ago. But the best available time is today.
In general, almost anytime can be a good time to invest in stocks. Exceptions would include when the stock market is clearly over-valued or when “something bad” is about to happen to the markets. The problem is that “something bad” can happen at any time but is generally not predictable. So, it probably seldom makes sense to avoid investing on the basis that “something bad” might happen, although if one can’t afford or can’t stomach the risk then investing in stocks (at any time) may be unacceptable.
In terms of whether or not the stock market is over-valued, we recently took a look at three large North American Stock Indexes and they did not appear to be over-valued.
Wiley Warren Buffett Wins Again
The financial genius of Warren Buffett is still under-appreciated. Consider the following example.
On August 25, 2011, it was revealed that Berkshire Hathaway would invest $5 billion in newly created Bank of America perpetual preferred shares.
What would Buffett / Berkshire get for its $5 billion?
Firstly a yield of 6% per year. That will continue until the Bank of America redeems the shares in which case it has to pay a 5% one-time premium.
Okay, so far that sounds like an “okay” investment but nothing to really write home about.
But wait!, there was more…
Berkshire also received warrants (or options) to buy 700 million shares in Bank of America at a price of $7.142857 at any time in the next ten years. That price seems rather odd and exact, but it turns out that it means that Berkshire has the right to invest exactly another $5 billion at any time in the next ten years, for which it will receive 700 million shares.
It’s not immediately obvious what would be the value of these 700 million 10-year options.
On August 24, Bank of America shares closed at $6.99. So, at issue these options had no intrinsic value. (They could not be immediately exercised for a gain.) But they definitely had a value. The value of options increases with their term, and these were ten year options.
I suspect that standard calculations would have suggested that these options may have had a value of very roughly $3.00 per share or a total value in the range of $2 billion. And I suspect that Buffett figured the true value was more than the standard models would suggest.
In December 2011, the Bank of America shares dropped briefly to as low as $5.00 and it may have appeared that Berkshire’s options were not worth much.
However, as of March 17, 2012, the Bank of America Shares have (rather suddenly) risen to $9.80.
Suddenly, Berkshire’s 700 million options to buy at $7.142857 have an intrinsic value of $1.86 billion. And if we add another (say) $2 billion to account for the time value of these options which don’t expire until August 2021 we can see that these options are worth perhaps $3.9 billion.
Looking at these numbers, and considering that Bank of America appears to be on the mend, it is very easy to predict that Buffett will end up making $5 billion, or probably a lot more, in addition to continuing to collecting 6% per year on his $5 billion investment.
Even for Berkshire, a $5 billion gain is significant. Berkshire’s common equity at the end of 2011 was $169 billion.
And, when Berkshire ultimately exercises these options it will end up owning, at a bargain price, about 6.3% of the Bank of America Corporation, assuming its share count has not increased by then.
I fully expect that these shares will result in several billions in unrealized gains for Berkshire by the end of 2012.
Should a Business Rent or Own its building space?
Most people would probably guess that a business would be a better off to own its building space rather than rent from others.
After all, why pay rent when you can own?
Individuals know that owning a house rather than renting has usually proven to be a good way to build equity over the years. The U.S. has certainly had its faith in home ownership shaken to the core in the past few years. The Canadian experience however has definitely been that owning a house has been better than renting. Canadians tend to believe that even if the value of the house does not rise, the payment of a mortgage represents a beneficial forced savings plan.
Business owners as well, often conclude that it is better to own space than to rent.
But, in fact, it is easy to think of examples where a business is better off renting.
Imagine a retail operation that has ample opportunity to expand. Imagine that it makes 20% on the capital (money) that it invests in its retail operations. Also imagine that it has only a limited amount of capital from its borrowing capacity and its retained earnings each year. (Certainly private businesses tend to have limited capital and even publicly traded companies do not find it easy to go to the market and raise new equity capital). Landlords recently have been happy to lease out space at annual rents that amount to about 7% of the value of the building. In this case, it makes perfect sense for the business to rent multiple locations. It can preserve its scarce capital to invest in adding to the number of its locations which are earning 20% on capital rather than tie up its capital in owning space that can be rented at 7% of the capital cost it would take to buy the building. In other words it does not make sense to forego a 20% return in order to avoid an expense of 7%.
Dollarama is an example of this. The retail chain is highly profitable and has expanded very rapidly. It does not own its stores. It leases the space.
How much money went “into” the Stock market in Canada in 2011? (try none!)
Consider the following figures regarding the Toronto Stock Exchange, for the year 2011:
Total value of all stocks: $2,202 billion (end 2011)
Total raised in public offerings in 2011: $40 billion
Total paid out in Dividends in 2011: $40 billion (Based on dividend rate of about 1.8%)
Total paid out in share buy-backs: $unknown
Based on the above I would conclude that the total net amount invested in (or more properly through) the Toronto Stock Exchange in 2012 was something less than zero. While $40 billion was raised by selling shares to investors , this was completely offset by about $40 billion paid out as dividends. In addition there was some unknown amount of share buy-backs.
Perhaps this should not be too surprising, large corporations tend to make money and to pay dividends. They usually can finance expansion through retained earnings and borrowed money. Large established companies on the TSX seldom need to go to the market to raise new equity.
When people buy shares they tend to think of it as investing “in” a company or investing “in” the market. In reality, if pressed, they would admit to knowing that the money they paid for their shares went not to the company but to whomever sold the shares.
We constantly hear about investors (as a population) “pulling” money out of a company. It’s nonsense. While an individual investor can indeed pull his or her money out, investors as a whole population must be content to trade with each other. With rare exceptions they have no ability to sell their shares back to the company. Investors as a population can bid the value of a company up (thereby creating wealth) or down (destroying wealth), but they cannot inject or pull out money as a population, except to the extent that the company wishes to raise equity money, buy back shares or pay dividends.
In Toronto in 2011, investors, as a population, made trades, among themselves, worth $1,480 billion. The companies whose shares were traded certainly take an interest in both the volume of trading in their shares and especially in the price paid. But (with the rare exceptions of buy-backs and public offering of shares from the company) the companies are not a party to these trades and certainly do not receive or pay the amounts traded.
With trading at $1,480 billion and a total market value of 2,202 billion, it is interesting to note that the value of the Toronto Stock Exchange “turned over” about 0.67 times in 2011 implying a dollar-weighted average holding period of 1.5 years (18 months).
The situation on the Toronto Venture Exchange is somewhat different.
Total value of all stocks $49.0 billion (end 2011)
Total raised in public offerings in 2011: $10.1 billion
Total paid out in dividends: unknown but likely less than 1% or 0.5 billion
Total paid out through share buy-backs: (unknown but probably tiny)
Based on the above it appears that the total amount invested into the Toronto Venture companies in 2011 was roughly $10 billion or 20% of the market value.
The total trading among investors was $42.5 billion. This suggests that the Toronto Venture exchange shares “turned over” about 0.87 times and that the average dollar-weighted holding period was about 1.15 years (14 months).
Shawn Allen, CFA, CMA, MBA, P.Eng.
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