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Security Selection: Part 1


What Are Investment Securities?

Investment securities are similar in nature to the goods we find in the grocery store. We have the produce aisle (stocks?), the protein department (bonds?), and many forms of carbohydrates (cash?). My last blog post highlighted the importance of gauging the risk tolerance of an investor and allocating asset classes to provide a balanced portfolio for the long term - much like we combine different types of foods for optimal health. Investment securities all have the following common attributes: (1) they are registered for sale with a governing body, (2) they are available for purchase in a central marketplace, (3) they have an intrinsic value or relative value compared to other securities. Examples of investment securities include the following broad groups.

  • Stocks
  • Bonds
  • Cash
  • Real Estate
  • Commodities

There are also "derivatives" which derive their value from the underlying asset. The futures and options markets are regulated examples of derivatives. As of this writing, Bitcoin (and other cryptocurrencies) are not registered with the Securities and Exchange Commission (SEC) and therefore are not available for purchase by registered investment advisory practices like JQR Capital. The party line is to proceed with extreme caution when speculating on an unregistered asset.

One of the key features of investment securities is that they can be further grouped into various "bins" that look uniform from far away, but that may be very different upon closer inspection. Some analysts call the process something akin to "peeling back the onion" as we discover more about our potential investment (or dinner ingredient). This is the "fun" part of security selection!



What Is The Value Of A Security?

There is the saying that "beauty is in the eye of the beholder." There is both an art and a science to placing a value on an investment security. In the basic form, an investment is purchased for a certain price with the expectation (but not the guarantee) that it will either provide periodic payments (interest or dividends) or a price increase - preferably both! The general idea is to buy low and sell high in order to reward us for the risk of investing our money. But, this is usually much easier said than done. An objective approach to placing a value on a security is to tally up all the previous payments made over the history of the security. These can be interest payments for a bond or cash flow payments for a stock. Cash flow is an especially foggy term in the stock world as there is research supporting using everything from quarterly dividend payments (which rarely get cut) to net earnings (which are an accounting estimate) to what is called free cash flow. Past performance is - of course - no guarantee of future results.

The art part is taking these historical payments and forecasting them into the future. The chart shown above shows diluted earnings per share (EPS) for Apple Inc. over the last 35 years. We then used average estimates from the 30+ analysts for the 2020 and 2021 numbers. Analysts further project that AAPL will grow their earnings at over 12% for the next five years. After that, we simply capped our estimates for EPS just shy of $8 per share. Because investors value $1 today more than an uncertain $1 in the future, we discount these future payments to account for this uncertainty. The general formulation is shown as:

E(Ri) = E(Rf) + Badj * (E(Rm) - E(Rf)),

where;

E(Ri) is the expected return on the security,

E(Rf) is the expected return from a risk-free security (usually the yield on a 90-day Treasury Bill),

Badj is the expected relative risk for the security in relation to the market (most people use the S&P 500), and

E(Rm) is the expected return on the overall market (most people use the S&P 500).

Pulling all of this together, we get a very quick estimated value for AAPL  of $137 per share. The shares are currently trading around $123 and analysts have a price target just shy of $127 per share. This same methodology can be used to place a value on a bond - using expected interest (usually called coupon) payments instead of diluted earnings per share. Bonds are actually easier (in theory) to value because they have a fairly well-defined life span. The risk parameter in the bond world is known as the credit rating. Just like a personal credit score, it is a measure estimating the likelihood that the issuer of the bond (the company you are lending money to) will default on some - or all - of their payments. Again, tallying up the expected future payments and discounting them using a credit-based risk factor gives us an intrinsic value for this investment security. Monthly rent would be the payment metric in the real estate world. 



What Is The Value Of A Stock?

Another way of determining the value of a stock is using what is referred to as a relative value approach. This is similar to visiting the grocery store (again hitting up the produce aisle) and seeing that they are running a special on green peppers this week. The snap peas we planned to add into our stir fry tonight no longer look like such deal. They are both vegetables. They are both green. So, it is similar to the relative value one might place when choosing between Pepsi and Coke in the soft drink aisle. The metrics used to assess relative value in the grocery store could be shown buried in the nutrition label on the back of the product or the taste or consistency of the food.

In the stock market, there are countless measures of relative value. Some of the more popular ones include the dividend yield (dividend/price), the earnings yield (earnings/price), or the cash flow yield (cash flow/price). Profitability factors - such as return on equity or net profit margin - can also be effective metrics. Finally, items on the balance sheet can be used to estimate the relative value between the sea of stocks available to purchase.



How Do We Value A Stock?

The chart shown above is a quick estimate of the expected returns for all stocks in the S&P 500. The valuation metric used here is the earnings yield. We can see that the maximum expected return is almost +49% and the minimum expected return is -71%. The median of the 500+ stocks is just north of 3% - meaning that the S&P 500 appears (by this measure) to be primed for returns below the long term average annual return of roughly 10%. This is a very basic relative value approach that enables us to make a quick ranking for candidate stocks to use in our portfolios. There are an infinite number of ways to value stocks using nobel prize-winning theories, detailed business analysis, and a pinch of luck.



What Can Go Wrong?

In a word - EVERYTHING! Just like browsing the produce aisle in the grocery store, that lettuce that looked so good from 30 feet away could look much less appetizing from 6 feet away. Much of our investment success is due to the ebbs and floods of the markets. This is why it is so important to accurately gauge our own risk tolerance and allocate our assets according to that metric before selecting the individual securities. The accounting numbers provided by the underlying firm may not be accurate. The industry could be disrupted by innovations or regulations. A series of natural disasters may destroy property or endanger employees. These are just some of the risks inherent in business that affect the value of company stock or bonds. The past may not have any bearing on the future and we will never have as much information as we would like in a timely manner. Unfortunately, we have to make an educated estimate at a security value and invest for our future before the lettuce goes rotten.

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