The Home-Investment Duality

Similar refrains echo through my ears comparing real-estate-related articles in Vancouver to those cities with real estate booms in full swing in the US not seven years ago. Nonetheless after an uncharacteristic emotional outburst I had on Twitter regarding the mainstream media's failure to put forward with what I think a reasonable bearish argument for why Vancouver prices are too high, I was somewhat pleased to see the Vancouver Sun at the hands of Harvey Enchin dealing with the "home as an investment" mantra bearish RE bloggers have been highlighting for years now. A few excerpts from the Sun article:

Vancouver homeowners can be forgiven for thinking they've won the lottery.  

House prices have nearly tripled in the past decade and those who successfully timed the market have earned chortling rights. Long-term owners who bought their homes in 1987 for $200,000 could sell them today for $900,000 or more; a gain in the order of $700,000 or 350 per cent! 

But view those numbers like an investor would and a different picture emerges.

The article goes on to highlight a few issues with what property investors look at, including:

• Inflation adjustment
• Opportunity cost on downpayment
• Pointing to past bouts of house price volatility
• Changing asset liquidity
• Sales costs
• Capital gains tax exemption for owner-occupiers
• Financing costs

All valid points, though the summary at the end is interesting:

The notion that one's home is an investment vehicle rather than a consumption good is a relatively recent concept and it's not one that sits comfortably with many homeowners. People buy houses to settle down, start a family, raise children and become part of a community. It's where we conduct the business of living our lives. A house is more than a store of wealth, one homeowner opined, it is a store of memories.

Indeed that is what home ownership offers 70% of Canadian households. There is still, however, the 30% who rent, much of the stock owned by investors, so it seems that home ownership (not "one's home") as an investment is not a "relatively recent concept". Nonetheless it's interesting to see a reporter forage a bit deeper into the home versus investment train of thought and seemingly imply that some are, ahem, taking the home investment concept a bit too far without understanding the investment side too well.

So is a home an investment or just a place to live? Yes. It always has been; a house provides imputed rent, the net monetary value of the services a homeowner receives from a dwelling.

But the most important thing to garner from experiences in other countries and ours -- in all past real estate boom-bust cycles of which I'm aware -- is that investment returns, not homeowners' desires, eventually set the marginal price. I dealt with this concept here a few years ago if you want to understand the argument. In quick summary, investors receive no consumer surplus from ownership as would owner-occupiers, and will eventually set the marginal price of rental properties regardless of the surpluses placed by owner-occupiers, in part because investors make up a significant fraction of available property purchases in any given month (at least for certain property types*).

If you can get past that investors, not owner-occupiers, will set marginal prices, it then becomes incumbent upon all homeowners to understand what gives real estate its value in the long run. A simple, but reasonable, model is using discounted cash flows to estimate an investment's value, and a derivative of this model is validated by CalculatedRisk who shows price-rent ratios have reverted to their long-run average in the US. We should expect no different in Canada and Vancouver. (I outlined the model and derived its link to the price-rent ratio here, with a few caveats).

My advice, for what it's worth, is to get past this home-vs-investment mantra and look at investment returns, compare them to other similar investments available to investors, look critically at the actual risks property investments involve, and figure out why long-term returns in some US markets -- markets destroyed by 7 years of falling prices -- are finally starting to attract investor interest at price-rent ratios far lower than those broadly available in Vancouver.

(See my previous posts here and here for some cursory real estate investment calculations I've seen used by smaller-time real estate investors. In a future post I'll concentrate on the qualitative aspects of real estate investment risks, and how these risks are akin to a reverse lottery. For a sneak-peak at some of these risks and more important a view into how a property manager with years of experience views the current market and general issues surrounding residential property management (based in the GTA but still mostly relevant for Vancouver), I recommend reading Rachelle's wonderful posts over at LandlordRescue.)

* It is true that certain property types are heavily owner-occupied so the price-rent ratio and the concept of marginal investor pricing isn't valid for these dwellings, at least directly. However for the purposes of analysing property as an investment, leave these property types aside for a moment and consider markets with a more healthy mix of owner-occupiers and investors, say condominiums. If it turns out condos are heavily overpriced it is probable, though not certain, that property types with a high owner-occupier percentage will track condos towards lower prices.

Rent or Buy, or Rent and Buy

Another rent vs buy comparison made the CBC website again.

The premise behind the standard buy vs rent calculation, as this one, is comparing two scenarios: buying now and holding for (say) 25 years, or renting now and renting for the same 25 years. Chop off the monthly outlay difference between the two (and putting aside the strangeness of any situation where buying a condo is more expensive than renting, but that's another post altogether!), invest the difference at a "conservative" 5%, extrapolate past appreciation (condos have been appreciating at 5% p.a.), assume current mortgage rates remain for the duration of the loan, and do a comparison. No problem.

The problem, notwithstanding the brazenness of some of the above assumptions, is that there is an embedded out-of-the-money option built into the renter scenario not considered in any of these calculations. That is, a renter need not rent for 25 years; instead he may rent for 5 years and, should prices drop, has the option of buying at lower prices. While lower prices are not an absolute certainty, the option still has value, especially if one calculates a high probability of price drops. (Of course these days landlords are in effect paying renters to hold this option, a bit bizarre when thought of in those terms.)

How Real Estate Investors Invest Part 2

In the previous post in this series I outlined the basic inputs and calculations used by certain investors when determining the investment value of a particular property. In this installment we go through a simple example for a purpose-built rental building. A massive thanks to Rachelle over at Landlord Rescue for allowing me to publish a simple spreadsheet containing the calculations of an actual property in the Toronto area. (Toronto was used instead of Vancouver to avoid investors in Vancouver real estate from soiling themselves.)

link to spreadsheet (Note there is a bug with google spreadsheets; Click refresh if you get an annoying popup window and avoid dragging your mouse over the "anyone with the link" link. Should be fixed soon I hope.)

This is an actual real-life building in the GTA. We have the following inputs:

Purchase Price = $528,800
Closing Costs = $1,000
Deferred Maintenance (Renovations) = $0

Revenue
Rent = 5 units totaling $3725/month

Expenses
Taxes = $4759/yr
Insurance + Utilities* = $4974/yr
Property management** = 8% of revenue
Building maintenance = 10% of revenue
Vacancy allowance = 5% of revenue
TOTAL = $1668/month

* Rent includes utilities
** Property management fees can be a few % higher in Vancouver

Calculations
NOI = Revenue-Expenses = $2057
Cap rate = NOI/Purchase Price = 4.7%
GRM = Purchase Price/Revenue = 11.82 (price/monthly rent = 142)

Financing
Here the investor is putting 30% down and assuming a 5% mortgage interest rate. With these numbers the mortgage payments just cover the NOI and is cash flow neutral, which is the goal of this particular investor.

Discussion
Here we see the investor requires 30% down and 5% mortgage rate to make this property cash flow neutral. Also note the investor does not consider capital appreciation when determining the investment's value; it's all about the cash flow at what they consider to be a sustainable financing rate.

We can see right away the impact of lower mortgage rates on these investors' criteria for a cash flow positive property. They have no earnings, at least initially, save debt repayments. In time, the investor assumes, the rents will increase with inflation and start producing positive cash flow.

After some years there will be some added expenses as the building starts aging. This is partly, but not completely, accounted for in the 10% gross rent maintenance allowance. Significant overhauls may be necessary from time to time and this is accounted for through depreciation allowances, usually a few % of the purchase price on a geometric schedule. Though the spreadsheet does not explicitly cover this, one can expect in time some of the free cash flow to be diverted to capital replacement.

Also for consideration is the 5% assumed mortgage rate. Certainly in today's climate mortgage rates could easily stay at or below this level for some time. I have no doubt some investors are using even lower rates (even variable rates!) when calculating their monthly cash flow. Food for thought, though, that rates this low are borderline deflationary. It is unclear if the projected rental increases will be as large as anticipated if rates remain low.

With this in mind, there is a box at the bottom of the spreadsheet for calculating purchase price for a given cap rate. That is (at least in theory), an investment with revenues that generally track inflation should not vary their present value when inflation changes, therefore the cap rate will stay constant. What cap rate would be considered acceptable? Well the "acceptable" number used by this investor is 7% for that particular property, putting an acceptable purchase price in the area of $308,600. Food for thought.

So there you have it. A real-life example of a cursory analysis of a potential real estate investment. Certainly there is a ton more to consider when evaluating a particular property's investment viability but, following this investor's philosophy for what it's worth, having these numbers work on a particular property (at whatever values one considers acceptable) should warrant some additional investigation. Otherwise, it's probably best to spend one's efforts elsewhere.

How Real Estate Investors Invest

This blog often deals with subjects that border on the abstract when it comes to the nuts and bolts of real estate investing. I recently viewed a spreadsheet used by a full-time real estate investor, one also used by many of this investor's acquaintances in the same line of work. This post is devoted to me explaining what factors they are using in their spreadsheet to calculate returns.

I will be focusing on a spreadsheet for the so-called "buy and hold" strategy -- buy, rent out, and hold indefinitely. We do not assume the property will be sold any time soon but, of course, capital appreciation comes in to calculating total return. So lets get into it.

(Note, I do not have permission to share this spreadsheet directly, however I will summarise how its calculations are performed as well as what inputs are used.)

Purchase Price

The first input into the spreadsheet is purchase price. We add into this closing costs and taxes, as well as any renovations that need to be performed before occupancy:

Total Price = Purchase Price + Closing Costs + Renovations

Revenue (Rent)

The major source of revenue for a property is rent. Here we use the anticipated annual rent from the property. There may be additional income sources, including: parking, vending, storage, interest income (e.g. on capital reserve), laundry, et cetera.

Operating Expenses

Operating expenses are the ongoing costs of maintaining the property. These would include property taxes, insurance, vacancy loss, advertising, repairs, management, strata fees, etc.

A big operating expense that is often overlooked by much of the analysis I see online is the so-called "capital cost allowance" which is effectively building up a reserve for capital replacement. This is, in the extreme, building up a reserve for building replacement but also includes large or small renovations that inevitably occur as the building ages.

Calculations

After determining our purchase price and costs, revenues, and operating expenses, we can calculate a few common values used by investors to determine their return. These are listed below:

Net Operating Income (NOI) = Revenue - Operating Expenses
Cap Rate = NOI/(Purchase Price) *
Gross Rent Multiiple (GRM) = (Purchase Price)/Revenue

* Note one can substitute Purchase Price with Total Price.

None of these calculations take into account financing. They are straight calculations on the investment's operations. They are also based on current, not future, operations; rent or operating expense increases are not calculated. GRM is analogous to the "price to rent ratio" that local commenters like to refer to. (A price to monthly rent ratio R would be equal to GRM*12.)

Debt Service and Financing

Financing is simply where the money to purchase the property comes from. It is either from the investor directly or through borrowing from a lending institution. Total debt servicing is an expense. Debt servicing costs are highly dependent on the interest rate. For longer term calculations, this interest rate may need to be modified to account for higher or lower rolled over financing costs.

Closing costs is the amount of cash required to complete the purchase, equal to Total Cost - Debt. A typical amount for closing costs would be, say, 25% of Total Cost, though other ratios are of course possible.

Capital Appreciation

Like most property, there will be some capital appreciation, usually expressed as an expected average percentage gain year-over-year.

Calculations after Financing and Appreciation

In a nutshell, a total return is comprised of: cash generation, debt repayment, and appreciation. After 1 year:

Cash on Cash Return (COC) = NOI/(Closing Costs)
Equity = (Purchase Price)*(1+Appreciation) + Cash - Debt
Return on Equity (ROE) = NOI/(Equity)
Total Return on Investment = Equity/Closing Costs - 1

NOI is annualised.

Stuff Not Done

As mentioned, there are things that are not calculated. Rental and expense increases, as well as debt repayment schedules are not calculated. There is a good reasons for this, in this particular case. The philosophy is that if the return after the first year is not positive, it generates no income for the investor. This is not sustainable without a large pool of cash to finance the shortfall -- these particular investors want to produce income.

Summary

Above are some of the formulas used by full-time residential property investors to calculate an investment's return. You can plug any property you see for sale on the market into these formulas into and come up with some typical figures, then play around with the financing costs and appreciation (both these have high sensitivity when it comes to calculating return). I'll go through a simple example next time.

These investors own property locally and are actively looking to invest in property in the current market. If you want to know who is looking to buy, it helps to understand what calculations and analysis they perform to determine a property's value and under what conditions they would buy.

Your Home and Other People's Money

One of the many arguments surrounding real estate investment, whether as a true financial investment, or as a lifestyle investment for personal residence, involves using "other people's money" to finance the purchase. That is, use leverage through mortgages and secured lines of credit to provide the necessary financing. This is often touted as a benefit of real estate investing -- lever up and a small investment of $20,000 turns into $200,000. Fancy terms are thrown around by financiers showing double-digit returns on initial capital invested. Wow. But don't sign me up just yet.

Let's look at a simple case of me with a business idea. I want to open a store selling popcorn. I think have a decent business case but, unfortunately, no money with which to carry out my fancy plans. I need to find some capital through investors. One place I can go is the bank which has boatloads of money. I can also see if some of my business contacts are willing to pony up the dough for my venture.

The thing is, when I use "other people's money" they have a funny way of wanting a cut of the returns for use of their money. The bank manager sees me and looks at my business case, offering me a loan at 10% annual interest. My business partners are willing to invest but want an equity share of the business. Some even offered to fund it and have me work as an employee. No matter how I slice it, I have to give up some of my potential returns in exchange for the use of capital.

Now we can turn to real estate and housing. When my family walks into a bank interested in applying for a mortgage, there is little difference between this and my popcorn investment. Sure popcorn is a bit more risky than housing, but for the bank, which has access to a fixed amount of capital, both are considered pretty much equally, adjusted for risk. The bank needs to maximise its returns and manage risk.

It may not seem like it, but when the mortgage specialist fills out the online form including your income, assets, liabilities, credit history, et cetera, she/he is but filling out a streamlined business plan on our behalf. We can sometimes lose sight of this with the big rosy smile on the broker's face and McMenus of financing options.

Mortgages are, in their essence, nothing more than business ventures. The most important thing to realise is that, like most business ventures, you are passing on some of the profits to the initial holders of the capital. Unless you are speculating and benefit from unsustainable capital appreciation, your returns will, on average, be less with borrowed money than they would should you have your own money to invest instead. There is nothing absolutely wrong with this -- one may forgo future savings for present day benefit and borrowing capital is often necessary for a venture to happen at all; both are usually the case with owner-occupied real estate purchases.

Using "other people's money" is not free, especially if other potential non-real estate investments are producing decent returns, such as in the late '90s. I asked a few people why they didn't invest in properties ten years ago that were netting 7-8%. The answer: there were lots of other investments doing better with a lot less overhead. In fact, mortgage rates of the day were over 7%, reflecting how competitive other businesses were for available capital. It seems the trough of money is not bottomless after all, especially when business is booming.

Disagree? Do you think you can always do better with borrowed money? Let's hear it.

How much is your time worth?

I really do want to know because my time is not free given there is not enough of it. So when I look at an investment, be it real estate, stocks, or a business venture, how should I account for my time?

Let’s take a simple example of a couple looking to diversify and add some real estate to their investment portfolio. They talk it over, look at the success and failure stories, think a bit about the responsibilities, and decide to look for an investment property, planning to manage it themselves. After 2 months of searching, driving to open houses and viewings, discussing over dinner, running the numbers, many offers, negotiations, inspections, mortgage approval, negotiation, and signing, and eventual closing proceedings, they purchase a condo with prospects of a cash flow positive rental income.

After countless hours of work they now have a property to rent out. Now comes the easy bit. Rental listings, fielding calls of interest, shortlisting applicants, background checks, interviews, viewings, and the eventual contract signing and logistics of occupancy.

Now the checks roll in. They go to the bank and deposit the cheques. Then there’s the property tax payments, regular reading of strata minutes, (hopefully few) maintenance calls, possibly handling of complaints of neighbours (if they’re really unlucky), and the added complexity to their income taxes.

Then there’s handling termination of occupancy, walkthroughs, and negotiation of damage deposit refund. See paragraph 3.

Every few years there will be some semblance of major repairs. Now there are the contractor interviews, planning, negotiation, reviewing and signing of contracts, oversight, and audit of the work; if they’re lucky not much more than this. Or they can go it themselves and do the plans, buy the materials, work weekends, and hopefully not spend crazy amounts of time doing it.

When they eventually sell this property there are outlays including interviewing Realtors, signing the contract, negotiating, giving tenants notice, employing a lawyer/notary, and the eventual property transfer itself. Never mind the tangible commissions and other taxes and fees.

But still, the property, at least as the cash flow statement indicates, is profitable. But what if we simply look at this investment if we assume we are running a business? Here all costs, including the initial investigation, contract negotiations, operations, accounting, and capital outlays, all must be budgeted for as if employees are paid to perform these tasks. The costs conveniently forgotten on the cash flow statement of a small-time investor start adding up.

I hear countless stories about a property being “cash flow positive” looking at the basic cash outlays: rent coming in, mortgage, maintenance, and taxes going out. Yet if we start including other costs, assuming others were fairly paid for doing this work, all of a sudden, given one’s time has value, the “cash flow positive” investment is anything but. Often I hear the justifications for all this; “sweat equity” is a favourite of mine, putting some intangible return on time spent, but an even better one is that renovation and real estate is really a hobby, a pastime whose efforts would be done for free anyways. Right. To be fair I hear the same for other types of investments too. Investments take time to manage, though some take more time than others.

It is well worth asking how corporate investors, who cannot hide all the "other" costs of managing investments on their balance sheets, make a decent return in the first place. If or when purpose-built rentals become feasible in Vancouver again, what type of yield will be required?

Bull vs. Bear

Various versions of this chart have floated around for some time but I thought I'd post it here for discussion.

I think the conclusion you can draw from this chart is that the duration of bull markets is longer than the duration of bear markets. Additionally, bull markets nearly always rise higher than the previous bear market fell.

Keep in mind that a 50% fall requires a 100% increase to put you back at the same starting point. Additionally the chart is out of date because as of November 20th, 2008 the TSX had fallen 52% since June 18th, 2008.

When will things turnaround? I don't know, trying to time the market is for fools. Stocks are 'quite cheap' right now so I'm comfortable buying stocks because I have a long time horizon and a high risk tolerance. Perhaps the market will go down further but then stocks won't just be 'quite cheap', they'll be ridiculously cheap.

The advice of investing to your risk tolerance still stands.

Value Investing in the Current Environment

From here.

Jeremy Grantham is the Chairman of the Board of Grantham Mayo Van Otterloo, who manages approximately $120-billion in assets, well known among institutional investors but relatively unknown to retail investors. Here are some highlights from both parts of Grantham’s October 2008 newsletter “Reaping the Whirlwind,” and ”Silver Linings and Lessons Learned.”

Part 1, “Reaping the Whirlwind,” published 2 weeks ago:
“At under 1,000 on the S&P 500, US stocks are very reasonable buys for brave value managers willing to be early. The same applies to EAFE and emerging equities at October 10 prices, but even more so. History warns, though, that new lows are more likely than not.
“Fixed income has wide areas of very attractive, aberrant pricing.
“The dollar and the yen look okay for now, but the pound does not.
“Don’t worry at all about inflation. We can all save up our worries there for a couple of years from now and then really worry!
“Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows.
“As for us in asset allocation, we have made our choice: hesitant and careful buying at these prices and lower. Good luck with your decisions.”
You can read ”Reaping the Whirlwind,” in its entirety by clicking here where Grantham has published his views on the fallout from the financial crisis and the investment opportunities he sees.

Part 2, ”Silver Linings and Lessons Learned”, published early this week:
“When asked by Barron’s on October 13 if we would learn anything from this ongoing crisis, I answered, ‘We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term. That would be the historical precedent.’
“That is unfortunately likely to be the case. But over the next several years at least, there are many silver linings and valuable lessons to be learned.
“Chief among the many benefits of this crisis are unprecedented opportunities for investing in some fixed income areas where some spreads are so wide as to reflect severe market dysfunctionality.
“As of October 18, we also have moderately cheap US and global equities for the first time in 20 years. Probably quite soon, global equities too will offer exceptional opportunities after the additional pain that is likely to occur in the next year.
“We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the S&P as a probable low.
“The world faces unavoidable declines in economic activity and profit margins, so this overrun is unlikely to be much less painful than average, although you never know your luck.”
You can read ”Silver Linings and Lessons Learned,” in its entirety by clicking here where Grantham has published his comments on lessons learned from the credit crisis, as well as his proposed strategy.

Source: Jeremy Grantham, GMO, October 2008

Charts

I found this great chart over at Calculated Risk and thought I'd post it here for discussion.

Here is a chart of the TSX as well. As of market close on October 27, the TSX was down 43.3% from its June 18th peak. In terms of speed of the crash, the TSX kicks butt on the S&P500 with a 43% fall in only 20 weeks.

I've Been Busy

With markets around the world declining further by the day, I've been very busy at work and unable to post much recently.

Markets have fallen further and faster than I've expected and I suppose that shouldn't be a surprise but this is clearly presenting a once in a lifetime buying opportunity in equities for those with cash on the sidelines.

Here is a list of the best things you can do right now to position yourself for future investment success:
1) Stay true to your personal risk tolerance. Now is not the time to mess around with your overall risk level unless you can devote more to equities. Be honest with yourself about your risk tolerance. Can you handle a 10,20,30,40+% decline in your investment value?
2) Set up a systematic investment plan and contribute as much as you can afford to a portfolio that matches your risk level.
3) Develop a plan to meet your goals if you don't have one. Be realistic about your return assumptions and your lifestyle needs.

As always you should pay off unsecured high interest debts before you invest a dime.

A Letter From Warren Buffett

From the NY Times.

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.

Things I've Read

Great synopsis from Calculated Risk - The Adjustment Process
Canadian Banks ranked safest in world - Globe and Mail
The Stock Market is presenting buying opportunities now - Canoe Money

Are you reading anything interesting out there?

EVERYBODY PANIC!

The TSX was down over 10% this morning for whatever reason fancies the average investor. The Toronto market is down over 30% in the past 4 months and the S&P500 is down over 30% in the past 12 months. I'm sure some new doom is sure to envelope our country, shuttering our businesses and turning us all into stark raving mad lunatics.

Well maybe it isn't quite that bad and to this observer of human behaviour, it seems a little overdone now. I have recognized that timing the market bottom is an impossible feat but there are two things that are common about market bottoms:

1) Despair and hopelessness. Check.

2) Massive redemptions of mutual funds. Check. See story here.

It's a Random Walk

From Investopedia:

Random walk theory gained popularity in 1973 when Burton Malkiel wrote "A Random Walk Down Wall Street", a book that is now regarded as an investment classic. Random walk is a stock market theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement. Originally examined by Maurice Kendall in 1953, the theory states that stock price fluctuations are independent of each other and have the same probability distribution, but that over a period of time, prices maintain an upward trend.

In short, random walk says that stocks take a random and unpredictable path. The chance of a stock's future price going up is the same as it going down. A follower of random walk believes it is impossible to outperform the market without assuming additional risk. In his book, Malkiel preaches that both technical analysis and fundamental analysis are largely a waste of time and are still unproven in outperforming the markets.

Malkiel constantly states that a long-term buy-and-hold strategy is the best and that individuals should not attempt to time the markets. Attempts based on technical, fundamental, or any other analysis are futile. He backs this up with statistics showing that most mutual funds fail to beat benchmark averages like the S&P 500.

While many still follow the preaching of Malkiel, others believe that the investing landscape is very different than it was when Malkiel wrote his book nearly 30 years ago. Today, everyone has easy and fast access to relevant news and stock quotes. Investing is no longer a game for the privileged. Random walk has never been a popular concept with those on Wall Street, probably because it condemns the concepts on which it is based such as analysis and stock picking.

It's hard to say how much truth there is to this theory; there is evidence that supports both sides of the debate. Our suggestion is to pick up a copy of Malkiel's book and draw your own conclusions.

US Financials Falling Like Dominoes

Sept. 14 (Bloomberg) -- Lehman Brothers Holdings Inc. prepared to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the U.S. securities firm and Wall Street prepared for its possible liquidation.

Lehman and its lawyers are getting ready to file the documents for bankruptcy protection tonight, said a person with direct knowledge of the firm's plans. A final decision hasn't been made, though none of the other options being considered appeared likely, the person said, declining to be identified because the discussions haven't been made public.

Sept. 14 (Bloomberg) -- Bank of America Corp. agreed to buy Merrill Lynch & Co. for about $44 billion, a person with knowledge of the deal said, after shares of the third-biggest U.S. securities firm fell by more than 35 percent last week and smaller rival Lehman Brothers Holdings Inc. neared bankruptcy.

Bank of America and Merrill reached a deal in principle, according to the person, who declined to be identified because the deliberations were private. A final merger agreement hasn't been signed yet, the person said. The boards of Merrill and Bank of America approved the transaction this evening, the Wall Street Journal reported, citing unidentified people familiar with the matter.

Sept. 14 (Bloomberg) -- American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking a $40 billion bridge loan from the Federal Reserve as it tries to sell assets, the New York Times reported.

The insurer has turned down a private-equity investment because it would have meant handing over control of the company, the Wall Street Journal said on its Web site, citing unnamed people. AIG may get access to the Fed's borrowing window in an ``extreme liquidity scare,'' Citigroup Inc. analyst Joshua Shanker said in a Sept. 12 research note.

The Dimensions of Stock Returns

Abbreviated from here.
By Truman A. Clark

An ongoing objective of financial research is to explain the behavior of stock returns. Factors are sought that explain both differences among the returns of individual stocks in any given time period and the variation of stock returns through time. If a factor does both, it is said to explain the common variation of returns. In addition, if a factor is related to non-diversifiable risk and possesses explanatory power independent of other factors, the factor is considered a "dimension" of stock returns.

Fama and French (1992) found that two factors related to company size and book-to-market ratio (BtM) together explain much of the common variation of stock returns and that these factors are related to risk. Small cap stocks have higher average returns than large cap stocks, and high BtM (or "value") stocks have higher average returns than low BtM (or "growth") stocks. Based on Fama and French's findings, size and BtM are dimensions of stock returns.

Fama and French also investigated a market factor. A market factor is needed to distinguish stocks from fixed income securities, and it is important in explaining the variation of stock returns through time. But, among stocks in a given time period, differences in their sensitivities to the market factor are unrelated to differences in their average returns, so the market factor is not a dimension of stock returns.

The Fama/French results have important implications for domestic equity portfolio design. Large capitalization growth stocks constitute large portions of traditional "market-like portfolios" based on indexes such as the S&P 500, the Russell 3000 and the Wilshire 5000. Domestic equity portfolios with greater commitments to small cap stocks and value stocks offer higher average returns than conventional market-like portfolios.

Size and BtM also are dimensions of international and emerging markets stock returns. This confirms Fama and French's interpretation of size and BtM effects as rewards for bearing risk that cannot be eliminated by diversification.

Risk and Return
Controlling for differences in BtM by comparing large cap value to small cap value and comparing large cap growth to small cap growth, small cap stocks had higher average returns than large cap stocks. Controlling for differences in size by comparing large cap growth to large cap value and comparing small cap growth to small cap value, value stocks had higher average returns than growth stocks. The higher average returns of small cap and value stocks represent rewards for bearing risk.

If standard deviation were a complete measure of risk, average returns would increase as standard deviations increase. Controlling for differences in BtM, a direct relation between average returns and standard deviations is found when large cap stocks are compared to small cap stocks. But, controlling for differences in size, a discrepancy appears. Small growth stocks had a lower average return and a higher standard deviation than small value stocks. Since greater standard deviations are not consistently associated with higher average returns, standard deviation is not a reliable measure of risk.

Size, Book-to-Market and Earnings
Seeking a risk-based explanation for the relations of size and BtM to average returns, Fama and French (1995) investigated the behavior of the earnings of stocks grouped by size and BtM. Measuring profitability by the ratio of annual earnings to book value of equity, Figure 2 illustrates the evolution of profitability over long periods before and after stocks are classified by size and BtM. BtM is associated with persistent differences in profitability. On average, low BTM stocks are more profitable than high BtM stocks of similar size for at least five years before and after portfolio formation. Low BtM indicates sustained high earnings that are characteristic of firms that are growing and financially robust. High BtM indicates protracted low earnings that are typical of firms experiencing financial distress.

Expected Returns and the Cost of Capital
Financial markets channel funds from suppliers of capital to users of capital. Expected returns are the rewards investors anticipate for supplying capital. Investors require a higher rate of return (or risk premium) for bearing greater risk. Risk is something that investors collectively shun and that cannot be eliminated by diversification.

The cost of capital is the price users of capital must pay to obtain financing. Competition forces users of capital to bid higher prices to obtain funding for more risky ventures.

In equilibrium, the expected rate of return and the cost of capital are determined jointly as the price at which the demand for and supply of capital are equal. In financial markets that function efficiently, investors only receive risk premiums for bearing risk. As risk increases, the expected rate of return and the cost of capital increase.

High BtM and small size often indicate companies that are experiencing some degree of financial distress. On average, they have higher costs of capital because they tend to be riskier than companies with low BtM and large market capitalization. The higher average returns of small stocks and value stocks reflect compensation for exposure to non-diversifiable risk factors.

The Three-Factor Model
The findings of Fama and French suggest that much of the variation in stock returns is explained by three systematic risk factors.

· The market factor measured by the returns of stocks minus the returns of Treasury bills.
· The size factor measured by the returns of small stocks minus the returns of big stocks.
· The value factor measured by the returns of high-BtM stocks minus the returns of low-BtM stocks.

Portfolio Engineering
Many investors commit high proportions of their domestic equity holdings to portfolios resembling the S&P 500, Russell 3000 or other market-like proxies. Large cap growth stocks are the dominant holdings of the S&P 500 and the Russell 3000. As a result, market-like proxies are poor portfolio structures for investors seeking exposure to the size and/or value factors. Investors can get such exposure by increasing their relative holdings of small cap and/or value stocks.

The potential increases in expected returns due to these tilts can be estimated with the three-factor model. For purposes of illustration, it is assumed that the expected risk premiums are six percent per year for the market factor and three percent per year for both the size and value factors.

Words of Caution
Structured portfolios offer the prospect of higher long-term returns than market-like portfolios, but the expected risk premiums are not sure things. Factor premiums vary widely and randomly. For the 1927-2001 period, the standard deviations of the annual premiums were approximately 21% per year for the market factor, 14% for the size factor and 14% for the value factor. Owing to their high variability, it may take decades before rewards for bearing increased size and value risk are realized.

Cumulative premiums for each factor are computed by adding successive monthly premiums for the period January 1927 through December 2001. Although the cumulative premiums tend to rise over long periods of time, each moves erratically with lengthy episodes of downward drift. The market premium declined from December 1967 to July 1982—a period of more than 14 years. The size premium declined from December 1983 to December 2001—a period of 18 years (and still counting). The value premium declined from December 1987 to December 2000—a period of 13 years.

Structured portfolios are not appropriate for all investors. Structured portfolios have higher expected returns because they are riskier than market-like portfolios. Over periods of less than 20 years, structured portfolios often will have lower returns than market-like portfolios. It is only over periods of 20 years or more that it becomes more probable that structured portfolios will outperform market-like portfolios. Investors with short horizons or aversion to risk should stick with market-like portfolios. Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk.

International and Emerging Markets Equities
Size and value effects are not confined to US equity markets. The MSCI EAFE Index represents a portfolio of international stocks from developed countries similar to the S&P 500. EAFE is composed predominantly of large cap growth stocks. During 1975-2001, international small cap stocks had a higher average return than EAFE indicating a size effect, and international large cap value stocks had a higher average return than EAFE indicating a value effect.Based on the limited amount of data available, size and value effects also appear in emerging markets. The IFC Investables Total Return Index represents a portfolio of tradable stocks in emerging markets countries that non-resident investors are permitted to own. During 1989-2001, emerging markets small cap stocks and value stocks had higher average returns than the IFC index.

The international findings are consistent with Fama and French's interpretation of the size and value effects as rewards for bearing non-diversifiable risk. If size and value effects were related to risk factors unique to the US, forming globally diversified portfolios could eliminate them. Instead, the existence of similar size and value effects in both domestic and international stock returns demonstrates that these effects are global phenomena reflecting exposures to ubiquitous sources of risk.

Implications for Global Equity Allocation
EAFE is the international equivalent of the S&P 500. EAFE returns, expressed in US dollars, are determined jointly by stock returns computed in local currencies and foreign-exchange gains or losses against the dollar. Because the two indexes contain stocks with similar size and value characteristics, it is reasonable to assume that the costs of capital of EAFE and the S&P 500 are approximately equal. If it is also assumed that currencies have zero expected returns, EAFE should have about the same expected gross rate of return as the S&P 500.

Concluding Comments
The identification of size and value factors by Fama and French has important implications for equity portfolio design. Relative to traditional market-like portfolios, portfolios with greater exposures to the size and value factors offer higher expected long-term rates of return.
Structured portfolios can be designed that provide targeted sensitivities to the size and value factors. International and emerging markets equity returns also exhibit size and value effects.
Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk. For the right investors, structured portfolios are promising alternatives to old-fashioned market-like portfolios.

Whoddathunk!

Due to the pressure of falling commodity prices the TSX has fallen from 15,000 points only a couple months ago to around 13,000 points today.

Oil has fallen from nearly $150/bbl to $112/bbl today.
Gold has fallen from its lofty heights around $1000/oz to $780/oz today.
Most other commodity prices have fallen dramatically over the past two months.

For anyone unfamiliar with market volatility in a commodity based economy, you just got your first lesson. It's possible to make and / or lose a lot of money very quickly.

For any long term investment strategy, diversification is important, otherwise you need near perfect timing to avoid the dramatic ups and downs. Diversification doesn't mean holding 5 different energy trusts either, I mean truly non-correlated assets.

Down Payment Dillemna

In response to several of the comments on the previous thread I'm posting some thoughts on what to do with your downpayment if you are patiently waiting for housing prices to have some kind of resemblance to fundamental valuation before you purchase. Here are the essential steps in my humble opinion:

Step 1: Determine your time horizon - this is easier said than done.
Step 2: Determine your risk tolerance - is some level of value fluctuation acceptable and if so, how much? +/-5% in one year? +/-10%? more?

Options:

1) If your time horizon is uncertain and you need stability and flexibility then a money market fund, savings account or short term GIC offers your only real options. Your rate of return will be significantly hindered. The best rate on these short term deposits is approximately 3% right now.

2) If you are confident that you won't see fundamental value for at least one year then you can clearly lock in for a 'good' rate on a GIC for at least one year. This has the advantage of keeping you disciplined but is much less flexible in terms of access to your money. The best rate on a 1 year GIC today was 3.90%. A 2 year GIC was 4.15%.

3) If you don't mind some mild fluctuation in your investments then a low cost bond fund such as the TD eSeries bond index fund could provide you with a decent coupon yield plus some potential upside if you think interest rates are going to fall before you purchase. If you have enough money some higher yielding corporate bonds can be purchased through a brokerage account. A quick search turns up several decent short term bonds with yields over 4%. Bonds have the advantage of being liquid so if you need access to the funds you will likely be able to get your money.

4) Equities - whether we are discussing an exchange traded fund, mutual fund, or an individual stock, be prepared for volatility. Even if you think you are investing in so-called safe securities, don't be fooled, a stock is a stock and the price of that stock is dependent on the perceived value of the corporation's earnings as seen by the buyers on that day. Your values may fluctuate violently and when it comes time to pull your money out, you may have less than you counted on. For a simple lesson on volatility, please look at the standard deviation of an investment before you purchase it. Bond funds have a low standard deviation because they are less volatile than equity funds.

I am not recommending one of these options over any other option but I hope the explanation is helpful. I don't recommend any allocation to equities higher than 30% for any time horizon shorter than 3 years and I don't recommend any allocation to equities higher than 45% for time periods shorter than 5 years.

Shareholder Letter from Bill Miller

The following is a letter to shareholders of Legg Mason Value Trust: Second Quarter 2008

Dear Shareholder,

A group of us were standing around a few weeks ago when Warren Buffett wandered over. Chris Davis had dubbed us the Value Support Group, as we all adhered to that approach to investing. we were commiserating over how badly we had done in this market, how valuation appeared not to matter and had not for the past couple of years, how it was all about momentum and trend, and how we were all losing clients and assets over and above our losses in the market. It seemed like we needed a 12-step program to cure us of our addiction to buying beaten-up stocks trading at large discounts to our assessment of their intrinsic value.

Mason Hawkins said, "Warren, I'm an optimist. I think this whole thing can turn quickly, and surprise people. Are you an optimist?" "I'm a realist, Mason," the sage replied. Warren went on to say he was optimistic long term, and backed that up in a talk the next morning on the remarkable history of growth, innovation, and wealth creation the U.S. had produced over the past 200-plus years. He also offered a sober assessment of the current challenges we face, and said it would take some time to work through them.

He then made the perfectly sensible point that as we are all net savers, we should be happy if stock prices declined a lot more, so we could buy even better bargains. That is a point Charlie Ellis elaborated on in his fine book, Investment Policy, a few years back. As a matter of logic,
it is irrefragable. As a matter of psychology, I think most of us value investors think we have plenty enough bargains already, and may not be able to handle that many more. Or more accurately, our clients may not be able to. We are value investors because we are persuaded of the logic of buying shares of businesses when others want to sell them, and we understand that
lower prices today mean higher future rates of return, and high prices today mean lower future rates of return.

The best time to buy our funds or to open an account with us has always been when we've had dismal performance, and the worst time has always been after a long run of excess returns. Yet we (and everyone else) get the most inflows and the most interest AFTER we've done well, and the most redemptions and client terminations AFTER we've done poorly. It will always be so, because that is the way people behave.

John Rogers, the founder of Ariel Investments, came in to see us last week. John has been an outstanding investor for 25 years or so, but like almost all value types, is going through one of his toughest periods now. His assets are down, similar to the experience we've had. He said it was the most difficult market he'd seen, a judgment I would have given to the 1989-1990 market, up until the frenzy erupted over Fannie Mae and Freddie Mac, which sent financials to what looks like a capitulation low on July 15th. I am now in John's camp. A point he made that I have likewise noted to our staff is that this is the only market I have seen where you could just read the headlines in the papers, react to them, and make an excess return. I have used the mantra to our analysts that if it's in the papers, it's in the price -- which used to be correct. Indeed, it borders on cliche in the business that by the time something makes the cover of the major news or business publications, you can make money by doing the opposite. There is solid academic research to back this up. But in the past two years, you didn't need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).

I am reminded of what John Maynard Keynes, himself a great investor, said once about investing, "It is the one sphere of life and activity where victory, security, and success is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is when I should sell it." It has been explained to me that it was obvious we should not have owned homebuilders, or retailers or banks, and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. "Don't you even read the papers?" was a common comment.

While I am quite aware of our mistakes, both of commission and omission, when I ask what is obvious NOW, there is little consensus. If there is something obvious to do that will earn excess returns, then we certainly want to do it. Is it obvious financials should be bought now, having reached the most oversold levels since the 1987 Crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?

Is it obvious energy stocks should be bought on this correction in oil prices from $147 to $123, a correction that has wiped 25 points off the prices of companies like XTO Energy and Chesapeake Energy in just a few weeks? Or is it obvious that oil had reached bubble levels at $147, and that buying the stocks here, down 30% from their highs, is akin to buying homebuilders down 30% from their highs in 2005? If you had bought Tesoro Petroleum or Valero Petroleum when their prices broke late last fall -- remember the Golden Age of Refining story that took Tesoro from under $4 to over $60? -- you would be looking at losses in this year greater than if you had bought Citibank or Merrill Lynch. I do think some things are obvious: it is obvious the credit crisis will end, and it is obvious the housing crisis will end, and that credit markets will function satisfactorily and house prices will stop going down and then start moving higher. It is obvious that the American consumer will spend sufficiently to keep the economy moving forward long term. It is obvious that the U.S. economy, already the most productive in the world, will get even more productive and will adapt and grow. It is obvious stock prices will be higher in the future than they are now.

Sir John Templeton died a few weeks ago, full of riches and honors, as he so deserved to be. The legendary value investor got his grubstake by famously buying shares of companies selling for $1 a share or less when war began in 1939. He didn't know then that the war in Europe would spread to engulf the world, nor how long it would last, nor how low prices would ultimately go. He always said he tried to buy at the point of maximum pessimism, but he never knew when that was. He was, though, a long-term optimist, as is Mr. Buffett, as am I.

Bill Miller
July 27, 2008

How to Control Your Fears In a Fearsome Market

WallStreet Journal
How to Control Your Fears In a Fearsome Market
Saturday July 19, 1:05 am ET
By Jason Zweig

What goes on inside your head when your portfolio implodes?

One of the fear centers in your brain, the amygdala, can respond to upsetting stimuli in 12 milliseconds, or one-25th the time it takes to blink your eye. These brain cells fire when an attack dog snarls at you, a spider drops down your shirt or the Dow Jones Industrial Average takes a dive.

Merely reading the words "market crash" in this sentence can instantaneously jack up your pulse and your blood pressure, the output of your sweat glands and the tension in your muscles. Stress hormones will flood your bloodstream. Your eyes will widen and your nostrils flare, making you hypersensitive to any further danger. All this occurs automatically, involuntarily and unconsciously. You can't be an intelligent investor if, without even knowing it, you are thinking with the panic button in your brain.

The countless people who bailed out of the market in the horrifying plunge of October 2002 missed out on the generous returns of 2003 through 2007, when stocks returned 12.8% annually. The same is likely to be true of those who cut and run in today's turbulent market.

Fortunately, you can train your brain to stay calm when the markets are gripped by panic. Last week, I spent an afternoon in Kevin Ochsner's neuroscience lab at Columbia University in New York, practicing what he calls "cognitive reappraisal."

I sat at a computer and viewed a series of photographs, each preceded by one of two words: look or reappraise. look was my cue to respond naturally without trying to change my feelings. reappraise told me I should "actively reinterpret" the photo, using my imagination to spin another, less emotional scenario that could have resulted in the same image.

Dr. Ochsner had warned me to eat an early, light lunch, and I immediately realized why: I gasped at the sight of a man's hand from which most of the fingers had been freshly hacked off. But my instruction had been to reappraise, so I forced myself to ask whether this image might actually be a still from a horror movie. Magically, the moment I imagined it was a film prop, the raw flesh seemed to look a bit like plastic, and I felt myself exhale.

If I can think away blood, you can calmly face the red arrows on a market Web site. "Emotions are malleable," Dr. Ochsner said, "but people often don't realize how much [of what you feel] is under your own control."

Here are some ways you can control your fears.

Reappraise. Forget what you paid for that stock or fund; instead, imagine it was a gift. Now that it is priced, say, 20% more cheaply than in December, should you want to return the gift? Or should you buy more while it is on sale? (If rethinking a fallen price this way doesn't make you feel better, maybe you should sell.)

Step outside yourself. Imagine that someone else has suffered these losses. Think of questions you might ask to give that person advice: Other than the price, what else has changed? Is your original rationale for this investment still valid?

Control your cues. Even witnessing someone else's pain, or glancing into another person's frightened eyes, can fire up your amygdala. Because fear is as contagious as the flu, quarantine yourself from anyone who obsesses over the momentary twitching of the Dow. Tear yourself away from the computer or television; better yet, while the market is closed, make an advance date with friends or family to get your mind off stocks during market hours.

Track your feelings. Fill in the blanks in this sentence: "Today the Dow closed down [or up] ___ points, and that made me feel __________." Your emotions shouldn't be hostage to the actions of the roughly 100 million other people who compose the collective beast that Benjamin Graham called "Mr. Market." You need not be miserable just because Mr. Market is.

Finally, if the market is open, your portfolio should be closed. Sleep on any sell decision until the next day, when your fears may have faded. Intelligent investors act out of patience and courage, not panic.