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Investing

Performant Companies Can Sometimes Be Uninvestable

Prior to the censorship of my stock analysis on this website, long-time readers will have often seen me refer to my PE graph which I use to justify higher PEs for growth companies. The idea behind this is that if you’re investing based on an expected 5% ROI, you might be willing to accept a lower ROI in the earlier years of an investment that’s growing in exchange for a higher ROI in later years.

But what if a company has growth that is affecting the share price, but that growth is driven from external sources (such as market forces) or otherwise is not annually repeatable?

I would argue that some types of growth should not be represented by valuations that rely on multiples, such as a straight PE calculation. This is because the growth isn’t due to an underlying, repeatable improvement in the business, such as an increase in the number of stores.

Along that line, I would argue that growth of this type should be added to the overall share price (or tucked into a DCF as a one-off), rather than be multiplied out in a PE or DCF valuation where consistent growth is assumed.

Sometimes the market doesn’t always consider reasons for growth and the same old formulae are used with the new numbers. As a result, companies can be overpriced, even though they are selling at prices on the same metrics. This can only result in a drop of ROI when conditions fall back to normal in future years. This is how performant companies can sometimes become uninvestable (during or directly after a period of one-off growth).

I advise watching out for this when doing valuations, particularly at times like these where we are seeing changes in market forces which may be temporary (such as industries that have benefited from altering consumer patterns during lockdown).

If you do have your heart set on doing a PE valuation of a company that has grown in a manor that is not sustainable growth, perhaps you could consider altering your valuation to match this theoretical company valuation:

Company earnings: $100m.
Typical annual growth 5% (affording a PE of 22, based on expected ROI of 5% in 2 years).
Annual growth in the last year 10% (affording a PE of 24.5, based on expected ROI of 5% in 2 years).
Assuming the next year will follow former years, we multiple $100m by 21 (PE of 22, minus 1), then add $111m (which is a ratio of the higher PE, divided by the lower PE and multiplied by earnings to account for one year of growth at the higher value of 10%), giving a valuation of $2,211m.

If you’re struggling with this logic behind this, consider that this is approximately (but not) the same as considering PE as the number of years you expect to get your money back, but considering one of those years as being at the abnormally higher rate earnings.

That said, you might just consider a PE of 22, then add the value of cash on hand, which will account for the boom year and distributable/reinvestable funds in the company as well. Long-time readers will know that I usually like to add net cash and equivalents to my valuations.

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Investing

Thought Of The Day: The Three Ways To Get Rich

As I see it, there are 3 ways to get rich; These are: by getting lucky, by starting a business or by investing.

Getting Rich By Luck

There’s luck in everything we do, whether it’s in business, investing, or any other part of live. But this way to get rich by luck refers to things like lottery wins or being born rich. This isn’t a valid strategy to make yourself rich, and if it were, it would be mega risky and really fast (assuming you were lucky straight away). Clearly gambling is not a strategy for getting rich that you should consider.

Getting Rich By Creating A Business

This method is more work that getting lucky. In fact, I would say that creating a business is the most work of the three ways to get rich. I would say that it’s medium risk (less risky than gambling, but more risky than investing) because compared to investing, you have all your eggs in one basket (in terms of money and time). The benefit to starting your own business (as a strategy to get rich) is that it’s a faster way to get rich than investing. When you consider that luck isn’t a strategy, I would say that creating a business is the fastest way to get rich.

Getting Rich By Investing

Finally, this is the slowest way to get rich, but it’s also the most reliable and least work (excluding getting lucky, which isn’t really a strategy to get rich). This is good news because anyone with a regular job can become an investor, which means than anyone can become rich with time.

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Investing

How To Become An Angel Investor

Every now and then I get asked about angel investing. Questions such as “What is an angel investor?”, “How do I become an angel investor?” and “What do I need to become an angel investor?” are common and sensible questions.

What Is An Angel Investor?

Let’s start with the most obvious place to start, and easiest question to answer: What is an angel investor? Most simply, an angel investor is a person who invests in companies that are not listed on the stock exchange.

What Is The Difference Between An Angel Investor And A Venture Capitalist?

In a word: size. An angel investor is typically investing 4 to 6 figure sums of money, while a Venture Capitalist (VC) is typically investing 7+ figure sums. Angel investors are typically one person, while VCs are typically a group of people or a company. While angel investors may or may not have things to offer the company above money (mentorship, contacts, etc), VCs typically have more expertise and may even have teams dedicated to assist. Another difference is that an angel investor may not require a position on the board, while a VC almost certainly will want a position. VCs tend to want a larger share of the company and may be more ruthless / pushy to deal with (which can be a good or bad thing).

How Do I Become An Angel Investor?

This is probably the most common question after “What is an angel investor?”. Realistically though, the first question to ask should be “Should I become an angel investor?”.

This is an important question because for most people, angel investing won’t fit in their investing strategy and they won’t have the skills required to be an angel investor.

Angel investing is illiquid, meaning that often it’s extremely difficult to sell your shares. Typically the time-frame for return on your money is very long (5-10 years) and you have little to no control over your investment. For example, if the controlling shareholders decide they will never return money to shareholders because they want to keep growing the company, it’s difficult to do anything about that; hence angel investing doesn’t fit in most people’s investment portfolios. Typically you need a lot more money than you’re investing so that you have the option to partake in future capital raises (so you aren’t unfairly diluted) or sue the directors if things turn bad.

Angel investing also requires a lot of skills, experience and effort beyond other types of investing. Not only do you have to be able to calculate value in a company, understand basic accounting and have an eye for picking companies (researching industries, headwinds, tailwinds, etc.) as with normal investing, you also have to be knowledgeable in legal matters; dealing with people; identifying risks, conflicts and darn right traps; and have business experience way beyond what’s required of a normal investor. Here’s a quick checklist for angel investors that I put together, which might give a clue about some of the requirements to be an angel investor.

If you’re still interested in becoming an angel investor, you might also research the differences between a wholesale investor and a retail investor. It is not the requirements to be a wholesale investor that are of interest, rather the lack of protection and expectation of knowledge that are worth exploring, because this gives a clue about the sort of things one must consider as an angel investor.

If I haven’t scared you off and you’re confident that you have the skills and finances to be an angel investor, and such an endeavor is an appropriate form of investing for your strategy, then I probably don’t need to tell you how to be an angel investor; you probably just need pointed in the right direction to start hunting down investment opportunities. In which case, I refer you to Snowball Effect, which is where I bought my first angel investment. Snowball Effect have a selection of well put together offers for retail and wholesale investors that take out a lot of the effort and (massive amount of ) time in getting the opportunity correctly prepared (business cases, swot analysis, business plans, checking the strategy, use of finances, legals, valuations, etc.), though ultimately it’s important to remember that even if you’re only a retail investor, the responsibility still lies on you, not Snowball Effect. So you have to know what you’re doing.

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Investing

So Long And Thanks For All The Fish

Following the new financial advice law that took effect in March 2021, I will no longer be sharing my stock market research publicly on this website.

I would like to take this opportunity to thank my readers and subscribers for all the warm regards and kind words I have received as a result of sharing my research. It’s been really nice to hear how useful this website has been to everyone.

I may continue to share general matters of discussion regarding this subject, but will not discuss specific stocks, funds or other financial instruments so as to avoid falling foul of the new law.

To anyone who knows me personally and wants access to my research, drop me a message and I’ll give you access.

I wish you all the best of luck with your investing endeavors.

Lewis Hurst
Categories
Investing

How Will US Inflation Affect NZ Companies?

Inflation seems to be kicking off in the USA, according to the news. I expect that this will cause the Fed to increase interest rates, which will cause the USD to increase in value as currency traders flock to benefit. This could be good for companies selling to the USA and converting their currency back to NZDs, and other companies that benefit from a strong USD.

Of course that’s not to say that any company that trades in USDs will automatically be a good investment or that it will be correctly priced for a purchase.

Can you think of any companies on the ASX or NZX that could benefit from a strong USD? Please mention them in the comments below.

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Investing

Inflation Risk In NZ

As I approach retirement, inflation (which was formerly my friend) is becoming my foe. While saving for retirement I’ve used cheap debt (mortgages) to fund various investments which have returned higher rates than the cost of the debt. Essentially I’ve leveraged the bank’s money to profit, rather than my own (comparatively pitiful) savings. This has had a two-fold benefit over the years. Firstly it has enabled me to get rich from someone else’s money, and secondly inflation has made the cost of my debt lower as time goes by. For example, a $240k mortgage to buy a $300k house 10 years ago isn’t much when the house is now worth $1m and my salary is double what it was.

Unfortunately inflation is the enemy of the retired. The value of the savings a retiree has are eroded by inflation. So as a “young” retiree (I’ll be nearly 40 when I retire next year) my retirement strategy will have to consider inflation. Whilst my strategy does consider inflation (I plan to have a component of my income to cover my costs and another component to grow), recently proposed political policies have made me concerned. Specifically I’m concerned that inflation may not be evenly spread across all asset classes, which creates risk to business (and therefore potentially my investments) and risk to my future living costs / lifestyle choices. I’m also concerned that inflation may be greater than the growth on my income.

It’s important to be aware of inflation whether you’re retired, planning retirement or currently investing because it will probably affect your strategy / opportunities.

Lewis Hurst

Let’s look at the inflation risks that are present in the current economic and political environment (existing policies put in place by the current government are in darker text, while policies proposed in the recent Climate Change Report are accented in a lighter colour. As I’m an opinionated fellow, I couldn’t help adding my opinion of the policy, but I’ve put this in italic so you’re free to ignore the italic text if you wish):

  • Increased minimum wage. This should cause general inflation as people have more money to spend, which creates increased demand and an ability to pay more for any particular goods or services. It has been hypothesized by economists that distributing more money amongst the poorest of the populace is the best way to spur an economy as all the extra money gets spent, vs. more affluent people who may save some of the additional money.
    At the time I thought this was a bad policy because the inflation would cancel the some of the gains, and therefore there are better ways to achieve what the policy set out to achieve. Additionally the policy was risky because it could put many businesses out of business. The policy also came at a really bad time with COVID19. However, after the policy was implemented, most businesses seemed to be able to handle the new costs, so it was probably the right thing to do (although I think there was a lot of luck in the success of this policy).
  • Quantitative Easing (QE, AKA Printing Money). There is currently a massive amount of QE going on in NZ and around the world. Both QE and increasing the minimum wage are policies that create general inflation.
    I believe that Western countries around the world have been using QE in a battle to reduce the value of their currency, in order to make themselves more competitive exporters and at the same time deflating their debt with the inflation that goes along with QE.
  • Banning oil exploration. This policy is inflationary because it reduces supply of oil, which therefore pushes the price up.
    I believe that this is another of Labour’s policies that does the opposite of what was intended because it doesn’t reduce demand, so demand will just be fulfilled from oil imports – which will create more strain on the environment as extra fuel is used to import the fuel. The argument for the policy was to create strain on the market to produce motors that use alternative fuel sources, but as NZ has no such motor industry, will import the fuel anyway, and is too small to influence foreign motor industries, I believe that no such technology will emerge from this change. Again, there are better ways to achieve what this policy set out to achieve.
  • KiwiBuild. This policy is inflationary because builders were attracted away from the NZ private sector (who would have otherwise been building houses) to build houses for the government. This inflates the price of builders as it creates extra demand, while at the same time not increasing supply as those builders would have otherwise been fulfilling private demand for housing. Increasing the cost of builders makes new housing more expensive.
    Additionally the government bought houses from the private sector for political reasons, so they could tout the success of the failing build rate of the KiwiBuild policy. This temporarily inflates the price of housing because it creates temporary extra demand as the private sector bids for housing against the government.
    Another Labour policy that did the opposite of what it was intended to do, whilst at the same time adding inefficiency into the market in terms of admin cost, and in the case of houses that were built as part of the KiwiBuild policy, placing houses where people didn’t want them – further increasing house prices due to an effective reduction of supply due to lack of housing in areas that required it.
  • Reducing the amount of dairy cows to reduce methane emissions. This will reduce the supply of meat, which will inflate the price.
    I imagine it would be better to put restrictions on the thing they are trying to regulate (the emissions) rather than the thing creating the emissions. That way the free market can find the best way to reduce emissions, leaving the reduction of herds as a last resort.
    There is talk suggesting that NZ dairy farms have lower emissions than foreign farms. If this is true, this will be another Labour policy that does the opposite of what it intends, because demand for dairy will not decrease, so foreign supply will fill the gap, resulting in an over all increase in emissions.
  • Phasing out natural gas. This will decrease the supply of energy, increasing the demand on other sources such as green electricity. Probably a good thing, but this will cause inflation in the price of alternative sources as supply decreases.
  • Ban the importing of cars with combustion engines. Again, reducing supply increases prices.

Regardless of political views, these policies are inflationary. Having a quick look at the list, it seems that existing policies are generally inflationary, with a leaning towards inflating transport and housing; while proposed policies could cause inflation in food, energy and transport.

To summarize my position, as I intend to get part of my income from rental income, NZX.SUM, NZX.SCL and gentailers, I only have transport costs to worry about. Still, with all this additional inflation, I may need to ensure that the growth rate of my income is more heavily weighted. This means that I may need more money to be able to retire safely. As usual, I’ll be playing it by ear, and evolving my strategy to my situation as it changes.

Sources:

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Investing

2021 Stock Picking Competition

Each year there is a stock picking competition, which I believe started on ShareTrader.co.nz, and is now sponsored by NZ Herald (I may be wrong about that). The competition requires each participant to select 5 stocks at the start of the year and a backup stock in case one gets bought out. The winner is the participant who’s stock price (adding any dividend payments) has increased the most from the start of the year to the end of the year.

I find the competition quite difficult because of the time of year it starts. Typically I don’t do a lot of research over the Christmas break, and it’s often a time that is between company announcements, so it’s a bit of a guess where things are at, at that time of year. Also prices are a bit random due to the annual Santa Rally.

Nevertheless, here are my picks for the 2021 competition:

  • FPH
  • SUM
  • RYM
  • EBO
  • HLG (I was very tempted to pick ATM, but I don’t expect the Daigou Channel [Australia/China travel] to have recovered by the end of the year – ATM will likely be my pick for the following year)

Feel free to record your own picks in the comments at the bottom of this article, or head over to the sharetrader.co.nz website to enter officially (though I think it might be a bit late if you haven’t already entered – still, there’s no reason you can’t comment your picks below and join in the fun).

Addendum: These picks (or anything on this website) does not constitute financial advice and [as inferred in the article] very little research has gone into this selection of stocks for the purpose of this competition.

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Investing

Changing My Investing Strategy – Part I

Past Strategies

I’ve had a number of strategies for investing over the years. Initially I was a property investor who planned to do a FIRE (Financial Independence, Retire Early) type approach to saving in order to buy 5 houses to rent, then give up the aggressive FIRE saving to live a normal life for 30 years until those houses were paid off so I could live off the rent.

The property market changed a few years into my plans, which altered my strategy as each year passed, changing from a strategy to buy and sell to retire, to a buy and leverage to buy stocks, eventually becoming too much of a burdon in the effort to do my tax returns and dealing with bad tenants, causing me to part ways with property and focus solely on stocks.

I then discovered Angel Investing, and have made significant gains investing a number of six-figure sums in a handful of companies in this arena, which has altered my retirement timeframes significantly.

With my retirement timeframe brought forward, I now need to change my investment strategy from investing in growth stocks that will eventually pay dividends in 5-10 years time, to a new strategy that will give me an income and security in my retirement, which will be either next year or the year after – though truthfully I haven’t decided if I want to work for a few more years to get more security, socialize while my friends are at work, or become mega rich (the later is possibly less interesting to me, unless it would facilitate some other interest, such as making a business out of some of my inventions – yes, I’m also an inventor!).

How To Make An Investment Strategy

Having a strategy is something often talked about, but not often explained. People new to investing will always say:

“My strategy is just to make a bunch of money.”

“Buy low, sell high!” – words often proclaimed by the least educated of investors.

“I will invest in shares until I have enough money to buy a house.”

New Investors

Actually to be fair, the last one in the list of quotes there is almost a strategy.

To build an investment strategy, you first need a goal. That goal will most likely be to buy a house or save for retirement, though it could be as simple as buying a car or saving for a holiday. In fact, I would suggest that everyone’s goal should be to save for retirement, and holidays, homes and cars are things that you include in your strategy as interruptions along the way.

Once you have a goal for your strategy, you need to do some financial modelling. This will tell you what you need to do in order to meet your goals.

To do a financial model, first work out how much money you’ll need to attain your goal(s). Then work out how much you can save, how much you’ll need to invest each year, and how much your investments need to grow to attain the goal(s) set out. You’ll need to do several of these models to model what happens if things go right, wrong or somewhere in between. You’ll need a strategy for each scenario (or at least a strategy to deal with the near term issues).

Once you’ve got your models sorted out, you should think about whether they are tolerable. Do they prevent you from having the sort of life you want? If so, perhaps you can make another model that has some compromise? Your compromise should not involve making your financial models rely on your situation becoming more fortuitous than you might realistically expect. Alternatively this might be the nudge you need to put in the effort to get that higher paid job.

Once you have your financial model, you should refine your investment strategy around this. There might be a few investment strategies that fit your models. For example, at for the past few years, my strategy was to save like crazy then put my savings into investments that will grow at a rate that does not require me to save any of my salary – which I then used as a giant leisure budget as compensation for my time spend saving. Of course this was balanced by a backup plan which involved my savings being redirected back to investing if things didn’t go to plan.

You should always have at least one backup plan.

In fact, not only should you have backup plans, but you should have multiple plans that phase in and out of existence as situations change, much like my car keys seem to when I’m looking for them.

My Investing Strategy For 2021

My goal remains the same, which is to retire, but my timeframes have changed significantly. Therefore my new goal is to invest in things that will:

  • Give me dividends within the next 1-2 years, every year. This basically means that I need investments that give me dividends now, which have a history of paying dividends, so I can be sure that they will produce dividends in 1-2 years.
  • Gives me security of income for decades to come. This means that I’ll need access to a pot of money that can get me through bad times, with possibly a Plan C in case that goes awry. This also means that I’ll need my dividend producing stocks to grow the dividend return at a rate higher than inflation to be comfortable, or come up with an alternative strategy such as buying growth stocks that may not pay dividends, but can be sold at a later date to cover the failings of my dividend growth stocks – not my preference. I will also need a significant amount of diversification such that the loss of a few stocks from my portfolio will not make my lifestyle untenable, or have a Plan D that makes my lifestyle less expensive while I save / work for enough money to replenish my position.

As I’ve written a lot today, I think I might write up the rest of my Investing Strategy for 2021 another day. In the next article of this subject I will cover my costs, how I plan to diversify and cover my risks, and my investing strategy for the coming year prior to the preparation for my retirement, which will involved divesting my holdings in companies and investing in dividend paying stocks (unless those companies start to pay reliable dividends backed by a policy in the Company Constitution).

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Investing

Reviewing The Year

Since 2021 is just around the corner I thought it might be a good time to look back and review my analysis on this website. The benefit of this would be to ensure that I’m providing quality analysis to others, but most importantly, to myself! Without reviewing yourself, it’s easy to let your ego convince you that everything you do is right, which stops you improving or even ensuring that you’re doing the right thing.

How will I measure the performance of my analysis?

This is a tough question. If I were a trader, I could just look at the “Buy” ratings I gave stocks and see if the share price went up after the article. I could then further quantify the success by weighting my results against how much I could have made on my trades. But I’m not a trader. I am an investor who has a specific strategy to attain my goals. For such an investor, it’s not about buying a stock and seeing if the market pushed the share price up; it’s about buying a stock and seeing if the reasoning was justified.

Good investing (as opposed to trading) is not measured by prescience of the share price, but sound reasoning within a fitting strategy.

Lewis Hurst

Given that, I will now go through the years articles written under the Investing section of my website and see what I can glean…

My Performance

Looking through my articles over the past year, I can draw the following conclusions:

  1. I was almost always right with my analysis when I did thorough research.
  2. I was good at predicting where share prices would go.
  3. I was bad at acting on minute indications that something might be wrong – even if I was able to detect that there was possibly something wrong.
  4. I was terrible at predicting the impact of Coronavirus and the recovery, particularly around retail stocks where there has not been enough information to perform a proper analysis or where directors have not been forthcoming with information.
  5. I have seen people on the internet (Facebook and Sharetrader.co.nz) using logic that was written in some of my articles – both in valuation techniques that I created and in explaining the logic around why stocks are priced the way they are.
  6. I have bought stocks without doing the full research, which caused me to sell them after doing the work that I should have done in the first place. Specifically, my assumptions have been very wrong when I did not do the full research required.
  7. I was bad at predicting where the economy was going.
  8. I was good at predicting the effect of fiscal stimulation.
  9. I managed to publish information about the Chinese producing a COVID19 vaccine before it reached national media.
  10. Finally, there are a LOT of speeling mistakes in my articles. I apologize for this.

Despite a lot of red in the above list, I think I didn’t do too badly. Basically I’m good at pricing stocks, picking opportunities and doing the research, but bad at predicting things when there’s not much information, and I need to make sure I don’t buy without researching things thoroughly.

I think the one thing of concern is that I need to react quicker to the suggestion that there might be bad news, and I need to somehow address my inability to predict the future of the economy.

To do this, I will keep trying to predict the future of the economy until I get good at reading the signs (assuming that such a thing is possible). Until I get good at this, I will re-engineer my investment strategy to account for my inability to mitigate this risk – which is something that I intended to do anyway in light of my changing financial circumstances as I accelerate towards retirement (or perhaps I should say “financial independence”, as I’ve not decided what to do about my work plans), which should be at the end of 2021 or some time in 2022.

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Investing

Legal Matters: Convertible Note Gotcha’s

I’ve never invested with Convertible Notes before, the idea has always had a funny smell that’s put me off. I feel too inexperienced with Convertible Notes, and therefore don’t feel like I know all the risks and things to look out for when buying Convertible Notes.

What Are Convertible Notes?

Convertible Notes are an alternative to buying shares, in order to invest in a company. Essentially Convertible Notes are a legal contract that defines a thing you get, which at some point should convert into actual shares in the company.

Convertible Notes are a great way to invest if it’s hard to place a value on the company. For example, if a company has limited financial history making a valuation difficult, then Convertible Notes can be used to invest, such that the notes convert into shares after a period of time has passed that would enable a valuation. The value that they would convert into would then be based on that future value and an investor would either get a large chunk of a small company, or a small chunk of a big company.

Problems With Convertible Notes (From An Investors Perspective)

Like any legal contract, you have to read and understand the terms so you don’t get caught out. You also need experience in the area to know what gotcha’s need covered off, and what snakes could be hiding in the long grass.

As I am inexperienced when it comes to investing in companies via Convertible Notes, I thought it might be useful to use this article to store information about Convertible Note gotcha’s that I come across or can think of. I expect this list to grow organically as I discover new information or am forced to investigate this more thoroughly due to investment opportunities popping up with Convertible Notes. If you are aware of things that should be added to the list, please leave a comment below.

  • Convertible Notes must have a condition that ensures that they convert into shares, and it must be impossible for that condition not to not come true, otherwise the Convertible Notes will never be worth anything.
    An example of a Convertible Note that never matures would be one that is converted to shares based on the market value ascribed at the next capital raising. Existing shareholders / directors could then ensure that they never raise any more capital, causing the Convertible Notes never to convert to shares.
  • You don’t have the same rights as a shareholder, which means the terms of your investment could change if the existing shareholders vote to change the Company Constitution.
  • In the case of investing in very early stage companies, the (typically 20%) discount to the next capital raise that you get in buying the Convertible Notes is probably not enough to represent the level of risk of investing in a less mature company – so the risk premium is not fairly reflected in the price of the Convertible Notes.
  • What happens if the company is bought out? Is this covered by the conditions of the note?
  • What happens if the subsequent fund raise which dictates the value of your Convertible Notes is not at arms length from the existing shareholders? They could manipulate the share price higher, so you don’t get fair value for your investment.