Revenues Will No Longer Be the Same
Posted on June 5, 2014 | Investor Update
Sometimes a sale isn’t a sale. Under accounting rules, the date when a company can record revenues depends on what it sells. A change to rules will simplify matters and change how revenues are booked by a broad range of companies. In the process it will alter valuations and growth rates.
It’s a big change. Even if you view accounting rules as exciting as reading the phone book, you should be spend some time familiarizing yourself with the new rules. I’ll try to make the discussion as least arcane as possible.
The new rules are the result of the work by the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) to establish a unified stance on when companies should recognize revenues. Here is how the IASB and FASB described the change:
“The core principle of the new standard is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services. The new standard also will result in enhanced disclosures about revenue, provide guidance for transactions that were not previously addressed comprehensively (for example, service revenue and contract modifications) and improve guidance for multiple-element arrangements.”
The Wall Street Journal used mobile phones to describe how the rule change will impact reported revenues, and I’m going to do the same. Currently, you can buy an iPhone 5C from AT&T (T) for $99. The price is subsidized and AT&T recoups the difference between what you pay and the wholesale cost of the phone over the life of the two-year contract you sign. Under current rules, AT&T has to book its cost of the phone at the time of the sale, but recognize the revenues for the phone over the life of the contract. The new rules will allow AT&T to recognize more of the revenues related to the phone at the time of sale.
The Difference Between Stock Screens and Portfolios
Many of the more common questions I get asked pertain to our stock screens. Specifically, members ask about the performance of the screens and how replicable it is. Often, the screens are initially mistaken for being portfolios, which they are not.
I’ll use the O’Shaughnessy: Tiny Titans screen and our Model Shadow Stock Portfolio to explain the difference between a screen and a portfolio. Both target micro-cap stocks, but with different approaches. The performance figures for both also have important differences to be aware of.
A stock screen is essentially a database filter. It seeks out stocks matching a specific set of criteria. For example, the Tiny Titans screen identifies U.S. exchange-listed stocks with market capitalizations between $25 million and $250 million, a price-to-sales (P/S) ratio below 1.0 and a 52-week relative strength price rank of 85% or higher. (The last criterion restricts the screen to only those stocks whose price appreciation is better than at least 85% of all other stocks.) Any stock matching these criteria passes the screen, regardless of how positive or negative any of its other characteristics are. This is why it is important to conduct analysis beyond what the screen is designed to look for and not simply buy a stock because it passes a good screen.
The performance reported for each of the more than 60 stock screens on AAII.com is calculated based on the month-end list of passing companies. We determine what stocks pass, group them into a hypothetical portfolio, hold the portfolio for a month and then restart from scratch the next month. This monthly reconstitution works fine for giving you an idea of the type of performance of the screen has produced, but your actual real-world returns may differ. The performance calculations exclude any transaction costs—such as commissions, bid-ask spreads and taxes. They also use prices that may differ from what you would actually be able to trade it at.
Not Updating Your Beneficiaries Can Be Costly
Posted on May 22, 2014 | Investor Update
Much of the conversation about investing focuses on how to realize capital gains and portfolio income, but staying on top of the seemingly minor things is also very important. A court ruling earlier this month showed how seemingly minor missteps can have significant financial consequences. A widow was denied the proceeds from her deceased husband’s life insurance policy because the beneficiary information on the policy was never changed. The case is Hall v. Metropolitan Life Insurance Company.
Here is the summary of events. Dennis Hall obtained a MetLife life insurance policy in 1991 through his employer, Newmont. At the time, Dennis designated his son as the beneficiary. In 2001, Dennis married Jane Hall. In November 2010, Dennis filled out and signed a beneficiary-designation form naming Jane Hall as the sole beneficiary of his policy, but never submitted it. The failure to submit the form proved to be big mistake.
Dennis awoke partially paralyzed on January 26, 2011, and executed a will the next day. The will provided, according to court documents, that “the following specific bequests be made from my estate. Any and all life insurance and benefits shall be distributed to Jane Marie Hall. If this beneficiary does not survive me, this bequest shall be distributed with my residuary estate.” Dennis passed away the same day.
Newmont sent MetLife a copy of the 1991 beneficiary form, which was the most current one on file. Soon afterward, Jane sent MetLife a letter saying that Dennis had changed his will, but did not have enough time to get the approved form from the insurer to change the beneficiary. MetLife denied Jane’s request, explaining that the will had no bearing on a group life benefit.
Blocked From Buying and Selling Mutual Funds
Posted on May 15, 2014 | Investor Update
T. Rowe Price blocked approximately 1,300 American Airlines employees from trading into their retirement plan mutual funds over the past three years due to excessive activity, according to Money Magazine. Some of the airline’s employees received lifetime bans. Southwest Airlines employees have also been warned by Vanguard to end their trading, according to Money.
Those of you who subscribe to Money may have seen the article. It’s not the first one on the subject and likely won’t be last. Though most mutual funds reserve the right to ban an investor from buying and selling its funds, it is rarely used. Investors who do get banned have frequently traded in and out of mutual funds, commonly on the guidance of a newsletter or an adviser.
It is my understanding that in order to get banned, or even to get a warning letter, a large amount of short-term trading has to occur. What prompts the warnings and the bans can often be a group of investors acting in unison, often on the recommendation of a central party (e.g., an advisory service). If enough shareholders move to buy or sell at the same time, the mutual fund could end up with more cash inflows or outflows then it is prepared to handle.
Understanding the structure of mutual funds is key to understanding why investors who trade too frequently can be banned. A mutual fund pools shareholder dollars together to buy and sell securities. It may be helpful to visualize a mutual fund as a group bucket of shareholder dollars. The fund manager, in turn, uses the cash in the bucket to buy various securities on behalf of the shareholders—while taking a small amount out of the bucket for the fund’s fees. When shares of the mutual fund are bought by an investor, new dollars are put into the bucket. When shares of the mutual fund are sold by an investor, money comes out of the bucket.
Mutual fund managers always keep a small amount of cash in the bucket to facilitate typical deposits and withdrawals by shareholders. Problems occur when the flow of cash into or out of the bucket is greater than usual. Such occurrences can give the fund manager more excess cash to work with than he planned on, or, in the case of withdrawals, can cause the fund manager to sell more securities than he would like to at a particular point in time. This is why mutual fund companies take steps to discourage too-frequent trading and ban those who ignore warnings to stop.
Insights from the CFA Conference
Posted on May 8, 2014 | Investor Update
This week, I was at the CFA Conference in Seattle and thought I would share some of the highlights with you. As is often the case when I attend investment conferences, meetings with speakers and other attendees prevent me attending all the sessions I’d like to get to. But I was able to attend several and heard some insights I think you will be interested in reading about.
Director of investor education at the BAM alliance of financial advisers, Carl Richards, does a great job of conveying complex investment concepts with hand-drawn sketches. He spoke about how to reduce the impact of behavioral errors. He believes investors can realize better returns if they focus on simply avoiding behavioral mistakes instead of focusing on finding above-average investments. Richards thinks the investment community can help by admitting they are part of the problem as well as focusing more on making things simple for investors and on client goals and objectives than creating products investors think they want, but don’t need. He said investors can help themselves by focusing more on achieving personal goals and less on their portfolio performance relative to an index.
A BNY Mellon forum focused on risk management. The discussion was oriented toward institutional investors, but there were two key nuggets of interest to individual investors. The first was an observation of an increased focus on matching assets and asset returns to expected liabilities rather than pegging returns to a benchmark. (In other words, ensure you have enough to fund your future withdrawals, rather than trying to beat the S&P 500.) The second was the danger of alternative investments. They warned that alternative strategies don’t always provide diversification benefits in a crisis, and may in fact go “down in flames at the same time traditional asset classes are struggling.”
A Positive Step by Regulators
Posted on May 1, 2014 | Investor Update
The Financial Industry Regulatory Authority (FINRA) took a positive step last week by proposing mandatory background checks on brokers. The proposal requires firms to verify the accuracy and completeness of the information contained in an applicant’s Form U4 (the Uniform Application for Securities Industry Registration or Transfer). Firms would also be required to search public records to ensure the data is correct.
In essence, when a person applies to work for a brokerage firm, either as a new employee or as a transfer from another firm, the hiring company would have to confirm that the job candidate is not misrepresenting himself. This confirmation process would include checking to see if the candidate is hiding any past criminal activity.
FINRA further proposes searching all publicly available criminal records for any registered individuals who have not been fingerprinted in the last five years. The regulatory body then intends to conduct periodic reviews to ensure the information provided to the public is accurate. FINRA operates the BrokerCheck website, which allows individuals to do a background check of a broker. The database has been the subject of criticism for omitting red flags about brokers.
The majority of brokers and advisers are honest, but, as is the case with any field, there are also some who are malfeasant. The difference between a fraudulent broker and, say, a fraudulent car mechanic is the magnitude of the financial damage they can inflict. A mechanic out to rip off his customers might cost you hundreds or perhaps even a few thousand dollars. A broker out to rip off his clients can cost you a far larger sum. In both cases, the bad apples are in the minority, but it does not take a very large percentage of unethical professionals to give an industry a bad name or to create a long list of unfortunate victims. Thus, it is important that you ask questions and do background research.
How I Analyze Earnings Reports
Posted on April 24, 2014 | Investor Update
On Tuesday, I had a triple serving of earnings reports. Two of the stocks I follow for AAII Dividend Investing, Travelers (TRV) and AT&T (T), announced their quarterly results. Skyworks Solutions (SWKS), which I personally own, also released earnings. Compounding matters, the May issue of the AAII Journal was due to the printer. Needless to say, I had quite a bit on my plate.
Fortunately, I’ve learned techniques from years of analyzing earnings releases to streamline the process. It’s not a completely formulaic process since every company has different divisions and statistics. Some even release different documents. AT&T particularly bogs down the process by issuing a press release, two sets of presentation slides and several spreadsheets. Still, there are generalities of what to look for that apply to most companies.
Hone in on Revenue, Earnings per Share and Net Income—The very first thing to do is to determine the rate at which revenues, earnings per share (EPS) and net income have changed. Have they grown or decreased from the same period a year ago? How do the growth rates for each line item compare to the other two? If profits grew faster than sales, the company’s margins widened. If sales grew faster, margins shrank. If EPS grew faster than net income, then EPS was boosted by a reduction in the share count. Depending on how the earnings release is formatted, it can be easier to simply calculate the growth rates yourself.
Don’t Fret Over the Market’s Recent Volatility
Posted on April 17, 2014 | Investor Update
It certainly feels as if Mr. Market has reverted back to being a toddler: happy one minute and cranky the next. Those who own highly valued momentum stocks such as Netflix (NFLX) and Facebook (FB) have certainly felt the impact of the volatility.
Though some stocks have been whipsawing, the markets overall have been less volatile than they feel or some headlines suggest. As of last Friday’s close, the S&P was just 3.9% below its record high closing. The large-cap index has also only ended up or down by 1.5% or more four times this year. The action feels more volatile because the recent decline has occurred quickly, as downward moves typically do. Plus, last year was a calm one. I counted just eight days with a closing price change of 1.5% or greater and only four days with a closing price change of greater than 2% for all of 2013. Depending on what stocks are in your portfolio, you may have experienced more or less volatility than the S&P 500 has this year.
As to whether the recent decline is a precursor of a market correction, I couldn’t tell you. The same holds true for all market forecasters. We are about to enter what has historically been the worst six-month period for stock prices (May through October). On the other hand, optimism in the AAII Sentiment Survey is at a level that has historically been followed by above average S&P 500 returns. Neither indicator has a perfect record, so we might have better accuracy trying to predict who is going to win this year’s World Series.
What can I say is those who stayed invested in stocks all of last year have a nice profit cushion to ride out any retracement that occurs this year. Even if a painful correction of 15% were to occur (and I’m NOT saying it will), a sizeable profit will still exist for an investor who bought an S&P 500 index fund at the start of 2013.
The 200-Day Moving Average’s Record as a Timing Indicator
Posted on April 10, 2014 | Investor Update
One strategy I have heard people discuss from time to time is using the 200-day moving average as a timing indicator. Stocks are purchased when a broad market benchmark is above its 200-day moving average, and stocks are sold when the market benchmark falls below its 200-day moving average. Though there are variations in the type of the moving average used, the basic premise is the same: Own stocks when the market is above the indicator and sell stocks when the market is below it.
In his new fifth edition of “Stocks for the Long Run” (McGraw-Hill, 2014), Jeremy Siegel looked at whether this strategy is beneficial. He ran the numbers from 1886 through 2012 using the Dow Jones industrial average. He applied a 1% band, meaning the Dow had to be at least 1% above its 200-day moving average to trigger a buy signal or at least 1% below its 200-day moving average to trigger a sell signal. The band is important because it reduced the number of transactions. Without it, an investor would be frequently jumping in and out, driving up transaction costs in the process. Siegel also assumed end-of-day prices were used.
Following the 200-day moving average timing strategy would have kept an investor out of the worst market downturns. Specifically, the investor would have avoided the large losses endured during both Black Tuesday (October 29, 1929) and Black Monday (October 19, 1987). The strategy would have also helped the investor avoid the 2007-2009 bear market.
Commenting on the results, Siegel observed, “The timing strategist participates in most bull markets and avoids bear markets, but the losses suffered when the market fluctuates with little trend are significant.” He added, “The timing strategy involves a large number of small losses that come from moving in and out of the market.”
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How to Beat High-Frequency Traders
Posted on April 3, 2014 | Investor Update
Author Michael Lewis ignited a debate within the financial community with his appearance on “60 Minutes” last Sunday. Lewis, the author of “Flash Boys: A Wall Street Revolt” (W. W. Norton & Co., 2014), called the stock market “rigged.” His reasoning? High-frequency traders are seeing what trades are being placed, jumping in line ahead of those investors who placed the trades and profiting at the expense of everyone else.
Brad Katsuyama, the man whose story Lewis tells in his book, used an analogy of buying tickets. Katsuyama described to “60 Minutes” a situation of placing an order to buy concert tickets for four adjacent seats on ticket exchange StubHub at $20 a ticket. A confirmation comes back saying only two tickets have been purchased. At the same time, the price of the other two adjacent seats has risen to $25.
The jump in prices described by Katsuyama, 20%, is a big exaggeration, but it clearly explains the allegation he trying to make: High-frequency traders are getting ahead of investors and are profiting as a result. High-frequency traders and their proponents counter that trading costs are being driven down and liquidity is being improved in the process.
Where’s the truth? The five-year 21.7% annualized return for the iShares Russell 3000 fund (IWV) as of March 31, 2014, shows good returns could have easily been realized by an individual investor who merely tracked the broad market’s performance. (A big reward for participating in the so-called “rigged” market.) Self-described long-term institutional investors Clifford Asness and Michael Mendelson of AQR Capital Management claimed in a Wall Street Journal op-ed that high-frequency trading is reducing their costs. On the other hand, if high-frequency trading firms weren’t making money, they certainly would change their approach.
It’s hard to discuss this subject without igniting emotions. It’s even more difficult to separate the facts from the hyperbole. What’s lost in the conversation is a focus on the market’s complexity. The digital structure underlying the market has become so complex, there isn’t a clear answer as what actual impact high-frequency traders are having on all other investors. Even Asness and Mendelson admitted not being “100% sure” as to whether high-frequency trading is actually reducing their costs. What we do know is that complexity not only can lead to problems such as the flash crash, but it can create anomalies and opportunities for malfeasance (legal, ethical or perceived).
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