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My Favorite Ratios – Part 1

When the dog bites, when the bee stings, when I’m feeling sad, I simply remember my favorite things, and then I don’t feel so bad!” -The Sound of Music When Julie Andrews sings about bright copper kettles and whiskers on kittens, she’s trying to calm her charges during a violent thunderstorm. When the market gets turbulent and frightening, I turn to my favorite indicators of financial performance. I’ve noted before how – sooner or later – stock market performance has to come back to fundamentals. There has to be a way to evaluate how well a company is performing, whether it’s providing insurance or selling tractors. Most analysts use financial ratios. But there are literally hundreds of these, evaluating credit quality, efficiency, growth, even management’s language in their quarterly conference calls. Which ratios should we choose? I like to look at financial disclosures as a tripod, the three legs being the income statement, the balance sheet, and the statement of cash flows. The most basic analysis looks at earnings per share and (perhaps) sales as an indicator of how a firm is doing. But management sometimes manages those numbers. An investor once told of visiting a corporate loading dock on September 30th at lunch time. He asked the shipping manager how the quarter had gone. The manager looked at his watch and said he couldn’t tell, the quarter was only half over. Principal Financial Statements. Source: Douglas Tengdin But it’s hard to manipulate the entire financial picture. So I look at ratios that evaluate how these three principal disclosures interact. The most basic relationship is that between income and the balance sheet. This indicates how efficiently management is utilizing the assets that are under its control – how effective they are at turning an investor’s cash into earnings. So I use Return on Invested Capital – net earnings divided by the book value of equity and the market value of debt. I like to include debt in this analysis, because that doesn’t incent management to borrow money just to boost their return on equity. Second, I evaluate the ratio of cash from operations – part of the Statement of Cash Flows – to net income. This gives me, in broad terms, an indication of how much of the corporation’s earnings are based on cash receipts, versus accruals of one sort or another. Warren Buffett has said that cash is to a business as oxygen is to an individual. This relationship can give us a sense whether a company might need CPR soon. Finally, I examine the ratio of cash delivered to shareholders – both through dividends and net share buybacks – to the market value of equity. This ratio is the Shareholder Yield . This gives analysts a sense of how committed management is to returning cash to the company’s owners. We may be uncertain about many things that companies may disclose, but one thing we can be sure of is how much they pay us to hold their stock. And stock buybacks are important, as they can be a more tax-efficient way to return money to shareholders. Each of these numbers is independent of a company’s size. A mega-cap like GE (NYSE: GE ) with billions in capital is on the same footing as a 1000-person firm like Box. But taken together, they measure how efficiently a company is at generating cash from their businesses and how willing they are to send some of it to their investors. These indicators aren’t perfect. They are biased towards established companies that are in the process of paying shareholders – rather than taking in money and using it to grow, or even just redeploying their own internally-generated resources. And it’s important to look at footnotes as well, especially when accounting standards are changing. But when things go wrong, it’s comforting to know that a company’s management team is committed to distributing cash to me quarter after quarter. When a firm can do this from its own efficient operations, this can become an anchor of value in a storm of market turbulence. So, to paraphrase Maria (from The Sound of Music ), when the economy slows, when interest rates rise, when investors are feeling sad, I simply remember my favorite ratios, and – hopefully – my investments won’t do so bad.

Vanguard 500 Index Fund: A Mutual Fund Anyone Can Appreciate In Their 401k

Summary VFIAX is a mutual fund designed to track the S&P 500 with a lower expense ratio than SPY. The mutual fund is a great holding for investors wanting to replicate the performance of “the market” without getting devoured by fees. This is a solid option for the retirement account. The Vanguard 500 Index Fund Admiral Shares (MUTF: VFIAX ) offer investors an excellent way to handle their investments. While I’m a huge fan of using ETFs in the construction of a portfolio, Vanguard is offering some mutual funds with very compelling expense ratios. The nice thing about these mutual funds is that investors are able to buy fractional shares which are excellent for dollar cost averaging. Volatility The standard deviation of returns (monthly) shows very similar levels of volatility to the S&P 500 index as tracked by (NYSEARCA: SPY ). Correlation is also running around 99.9%. The holdings are very similar, but these shares are offering a lower expense ratio and the ability to use dollar cost averaging very effectively. Expense Ratio The mutual fund is posting .05% for an expense ratio. There is really nothing to complain about here. It beats SPY and it beats most mutual funds and ETFs in existence. Largest Holdings The diversification within the fund is good. There are not as many holdings as the whole market index funds that I often prefer, but all around this is a very solid fund. (click to enlarge) Risk Factors The biggest issue for VFIAX is the risk that the S&P 500 is getting fairly expensive on many fundamental levels. For instance, the P/E ratio on the index is fairly high (running over 20). The high P/E ratio comes at a time when corporate profits after taxes are also very high relative to GDP. My concern is about the valuation level of the market. When it comes to ways to buy the market, VFIAX is one of the best funds to use for the task. When it comes to risk assessment, I’m not sure I’d go with Vanguard’s scale, shown below: Vanguard has a tendency to mark any primarily equity investment as being fairly high risk. Relative to other equity investments, the risk level here is very reasonable. The fund still scores high on risk for Vanguard’s scale because they are comparing it to other funds stuffed with lower risk securities than equity. Compared to a very short term high credit quality bond fund, I have to agree that VFIAX has substantially more risk. Compared to the broad universe of equity investments, VFIAX is doing a solid job of holding a diversified portfolio of large capitalization companies with solid histories. Other Things to Know Minimum investments for opening a position were $10,000 according to the Vanguard website. After that additional purchases could be in increments as small as $1. This is a solid fund for dollar cost averaging. Based on my macroeconomic views, I would want to use a fund like VFIAX for equity exposure but I also believing hold some cash on hand is wise given the potential for a reduction in equity prices. When it comes to using mutual funds, I think the best way to deal with them is to dollar cost average in. I like using ETFs to adjust my portfolio exposure but the mutual funds can be set as a “set it and forget it” investment vehicle. When making a meaningful contribution to a fund month after month without checking up on it, it would be wise to make sure the fund is reasonably diversified and that the expense ratios are low. The Vanguard 500 Index Fund Admiral Shares easily sail through both of those tests. Conclusion While I am concerned that market valuations are a little on the high side, I’m still investing each month. I choose to hold more in cash than I would if the market looked cheaper, but I still see dollar cost averaging into the right funds as a viable long term strategy. The biggest challenge for investors is to resist the urge to pull back when the market falls. We should all expect that the stock market will fall within the next 30 years. When those drops happen, investors need to be able to stomach stepping into the market to buy. Since those times are often very scary, one solution is to set up automatic purchases for a fund like VFIAX. To avoid overthinking things, I keep automatic contributions running as a baseline for investing. I use my other accounts to make additional purchases. If your employer sponsored plan offers VFIAX, it is a mutual fund worthy of consideration. Figure out your own risk tolerance and determine if the equity exposure is right for you. The biggest potential mistake an investor could make with buying VFIAX would be to put 75%+ of their portfolio in the fund when they are only a couple years from retirement and will be required to sell off shares to take distributions. So long as the total level of risk is appropriate for the investors, this is a great fund to use as the core of a passive retirement portfolio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

What Would Larry Tisch Do?

I am a long-time admirer of Larry Tisch, as well as a disciple of his investing principles, along with those of Warren Buffett. I was fortunate enough to have been invited many times to Larry’s “power breakfasts” at the Regency Hotel, where virtually everything in the news, and also not in the news, was discussed openly and freely. The debates were fierce, and everyone left the table a little bit smarter. Larry was an asset buyer, and loved to buy at fire-sale prices and then wait for a return to normalcy, at which time, he would sell. He also loved cash flow, and especially free cash flow, which is why the Loews (NYSE: L ) empire comprised hotels, tobacco, financial, real estate and CBS for a while. He was a contrarian thinker, out of the box, with a long-term outlook to create long-term value. I remember when he bought a fleet of tankers at liquidation value and sold them when shipping recovered. Gosh, I admired Larry Tisch. I emulate in many ways his investment principles. He taught me to be patient and keep your eye on the long term. He definitely bought low and sold high, and had the liquidity to wait it out. He did not measure himself in quarters, but in years. Sounds like Buffett, doesn’t it? Larry died in 2003, and I miss him and his breakfasts. Why do I bring up Larry at this time? I have mentioned the need to both have and monitor your core investing beliefs. While I consider myself an investor with a several-year time horizon, it is so easy to get sucked into the daily gyrations in the marketplace and marking to the market each day forcing us to question our beliefs. Those days are certainly not fun, but are worthwhile and teach a valuable lesson. Never get too comfortable and complacent. I do not consider myself a contrarian as Larry was, but I am a value buyer who has consistently made singles and doubles over 35 years with only a few setbacks. How else did I compound at over 18% over 35 years, with only 4 down years. I buy value, maintain my liquidity and am an investor rather than a trader. My portfolios tend to have very low turnover. Sounds like Buffett too, doesn’t it? By the way, why would Berkshire Hathaway ( BRK.A , BRK.B ) consider buying Precision Castparts (NYSE: PCP ) today? It’s an out-of-favor industrial whose earnings are depressed, has underperformed for three years and sells at 18 times current earnings. But Buffett sees it as a great value play having a good future with strong cash flow. By the way, this would be a standalone acquisition for Berkshire, so there are no merger synergies as in most mergers today. Sounds like a Tisch play! Mine, too. So what is the point of all of this? As I mentioned last week, the market has bifurcated, with perceived growth companies doing well, while industrial companies have languished a la Precision Castparts. I will come back to this point later, but you can sense where I am going. The key event of last week was clearly the employment numbers in the United States. There was a gain of 215,000 jobs in July, the unemployment rate stood at 5.3% (down from 6.2% a year ago), average earnings of workers were up 2.3% from a year earlier, and the broader measure of unemployment, which includes discouraged workers and part-time employees, fell to 10.2%. Since the Fed’s goal is 5-5.2% unemployment, the general consensus is that the first Fed rate increase is near. As I mentioned last week, the Fed is caught between a rock and a hard place, as it MUST maintain its credibility, so a rate increase is at hand, despite weakness overseas and a strong dollar. Do you really believe that an increase in the funds rate of 25 basis points from near zero will stop out the economy? No, and if the dollar increase dramatically more as foreign capital is sucked into the United States, our exports will only suffer more depressing growth. But the financial markets think differently, as the stock market fell on fears of the negative impact of a Fed hike on growth, and the yield curve flattened as the long end rallied. Something that we predicted would possibly occur after the Fed did raise rates even by a token amount. The U.S. economy continues to chug along at a 2.5%-plus rate led by the consumer, with inflation staying beneath 1.5%. By the way, did any of you go to the pump this weekend? I paid $2.80 a gallon. Consumer sales in the eurozone were weak in June, held down by fears of a Greek default and its potential negative impact. But I believe it that the slowdown is transitory and will pick up for the remainder of the year, bolstered by a strengthening economy led by exports and higher consumer disposable income benefiting from lower energy prices. German manufacturing orders have surged, and the country’s trade surplus will hit an all-time high this year. Germany is the clear winner of a weak euro. Maybe by design! China has continued to stumble along, at least compared to its historical growth rates. While the country’s Services sector has improved, with a reading of 53.8 last month, its exports have weakened more than anticipated due to lower demand from Europe, the United States and Japan. As I mentioned last week, I expect that the Chinese government will permit the yuan to weaken in order to bolster exports, and implement additional stimulus to boost domestic demand. Don’t cry for China, as growth in 2015 will still exceed my 6.5% growth target. The country reported that its inflation rate rose to 1.6%, so Bill Gross’ fears of deflation appear to be off the mark. The stock markets weakened every day last week, led by the industrials, and finally, some of the high-fliers like biotech. The pundits are clearly anticipating that a Fed rate hike will be the beginning of the end for our economy, so it’s time to honker down now and get defensive. Tisch would disagree, and Buffett, too, would clearly disagree, as he is putting his money where his mouth is in purchasing Precision Castparts – and I would disagree as well. I mentioned last week that I was beginning to cover many of my commodity shorts, excluding in the energy patch, as I began to see aggressive cuts in capital spending and a rationing in production to bring it in line with growth. Finally, the decline in many commodity prices has fallen beneath cash costs of production, which is a precursor for bankruptcies. All good for the well-capitalized, low-cost producers. Not only did I cover my shorts, but I went long BHP and RIO, which both have strong balance sheets, good cash flow and dividends over 5.5%, which are well-supported. Like Tisch, I am willing to wait for a return to normalcy in industrial commodity prices. I cannot say the same about energy, though, for many reasons which I have discussed over the year. Politics play a large role in continued over production of oil, and that won’t change with Iran likely to come on-stream. I started adding to my industrials, including chemicals, last week as they weakened as mentioned earlier. If Buffett could buy a Precision Castparts, I could add to General Electric (NYSE: GE ), Honeywell (NYSE: HON ) and United Technologies (NYSE: UTX ). There is tremendous value out there if you are patient. Find those companies making strategic changes to enhance their future prospects that are not fully recognized. There is so much to discuss with all of you that I have decided to begin a weekly webcast in September. It will create a forum, much like Tisch’s power breakfasts, where we can discuss the global events impacting investing and brainstorm on its implications. I will say more about this and some other things that could enhance our relationship in a beneficial way soon. I have enjoyed putting myself on the firing line week in and week out. I hope that you find it helpful too. The results are in after 18 months of writing weekly blogs, and I have been told that I batted over 750 during that period, which is way above the norm even for the most successful money managers whom I have been compared to, like Leon Cooperman. My funds under management during this period were up over 50% net of fees, including up 16% year-to-date averaging less than 92% net long. Next on my agenda is to build our relationship by maximizing my strengths in the area of your needs. The weekly webcast is the start. More to come. Remember to review all the facts, step back and take a deep pause to reflect, control risk at all times and… Invest Accordingly!