Thoughts on Current Market Events: Emerging Markets & Stimulus Wind Down

As sexy as "stimulus" sounds, investors are starting to worry what impact the pulling back of quantitative easing (the Fed's way of stimulating the economy by keeping interest rates low) will have on the markets, both in the U.S. and abroad. Easing up on stimulus should be a good thing, a sign that the economy is doing better, that the unemployment rate is improving, that roses are starting to sprout, and the sun is beginning to shine. But, of course, for every action, there is an equal and opposite reaction (thanks, Mr. Newton), so fears abound.

Pulling back on quantitative easing will likely mean an increase in interest rates here in the U.S. Generally, when Treasury rates rise, other interest rates, including mortgage loans and credit cards, go up, too. Part of the fear here is that the U.S. economy is still fragile. For example, while the unemployment rate has fallen to 6.6%, millions of people have been unemployed for so long that they have stopped looking for work; they are not included in that 6.6%. All told, the labor participation rate is only 63%, according to the Washington Post, the lowest it's been in a generation. Home sales are volatile at best. Consumer spending has been on the rise, but is nowhere near what it was pre-recession. The American middle class is slowly dwindling, which is displayed most simply in the consumer sector, where high-end luxury brands such as Kate Spade and Michael Kors, and low-end retailers like Dollar Tree, are vastly outperforming middle-of-the-roads like Abercrombie & Fitch.   

If interest rates rise too quickly, it could send the U.S. economy into a downward spiral. Credit card interest rates are already high, so consumers could be crippled by higher rates. High gas prices will only compound this effect. High food and health care costs would only make things worse.

Globally, the effect of relieving QE was witnessed recently. When the Fed announced its confidence in the U.S., investors fled emerging markets and ran straight into the arms of U.S. Treasuries. The run-up in the U.S. stock market over the past few years has taken a toll on emerging markets. EM stocks lost 5% in 2013, according to MSCI. EM sovereign debt performed similarly poorly. Leaders abroad have expressed concern about what continued easing will do to their countries' currencies, exports, and inflation levels. 

I like to think of myself as a contrarian investor, as following the crowd rarely leads one to buy low and sell high. That said, I think it's a great time to invest in emerging markets equities while prices are low relative to U.S. stocks. Keep in mind that, as quantitative easing is unwound more and more, EM stocks will likely get more volatile. In the end, I think it will be worth the wait. I'm of the belief that developing countries will not be wiped off the map, that they will continue to grow as time passes. 

I've expressed in previous posts that I don't think the record U.S. stock market levels are sustainable, as they do not reflect the true underlying health (or lack thereof) of the economy. (In fact, the S&P 500 just reached a new high today of 1,853.38.) I expect that they will come down as QE ends. Over time, investments in emerging markets may set off U.S. and other developed markets' losses. 

Can you risk it?

My great aunt had a way with words. Among her best quotes are, "Love is good, but money's better," "Love don't pay the rent," and "Don't marry a man if he don't have a key to something." (Great advice on all fronts.) Once, my sister told her about a guy she'd started dating, and my aunt wanted know if the guy was trustworthy. Instead of asking, "Do you trust him?," she said, "Can you risk him?"

She wasn't all wrong in correlating risk and trust. It's hard to trust the market, since you know it flucurates so much, so it all comes down to how much you stomach.

The first thing to know and remember like your own name is that there is no such thing as a risk-free investment. (Although U.S. Treasuries are called "risk-free" because they are backed by the government, their value is still at risk of being eaten away by inflation. And, it doesn't seem all that possible, but the government could default one day.)

So, if anyone ever offers you an investment opportunity that has "no risk," RUN AWAY because it is a scam.

That said, the amount of flucuation you can stomach is known as your risk tolerance. To help determine your level of tolerance, there are a ton of quizzes you can take. A couple of ones that I found legitimate were from Merrill Lynch and Rutgers University. The one from Merrill focuses solely on investment decisions, while the Rutgers one -- since it is actually a study on risk behavior -- is more broad and user-friendly, in my opinion.

Quizzes like these present you with questions that try to get at how much you are willing to lose for the chance of making gains. It may surprise you how much the magnitude of the potential gain matters versus the magnitude of potential loss. (I won't give it away; I'll let you take the quiz and find out for yourself!)

Some general rules/thoughts regarding risk are:

• If you're younger, you can take more risks. This is because of precious time your portfolio will have to recover from market losses. For example, if you'd invested $100 in the market on January 7, 2000, by December 27, 2002, you would have lost almost $41 dollars. Let's say you decided to hold on to those shares instead of selling them at a loss.* By December 28, 2007, you would have recovered your losses.* Holding for a brief period (that, in this example, was a terrible time for the market overall) would not have served you well, but over a longer period of time, you actually gain.
• Small-cap stocks tend to be riskier than medium- and large-cap stocks. This is because small-cap stocks are from smaller companies that are not as established, but have a lot of growth potential. Take Rocky Mountain Chocolate Factory, which operates in malls, primarily, in 40 states, Canada, Japan, and the UAE. This company is growing in different geographies, but since chocolate is not a commodity, its business can flucuate in hard economic times, so this investment would certainly be riskier than one in Hershey, for example, since the latter has been around for 100 years or so and has a strong global presence.
• Women tend to take fewer risks when investing. Common thought holds that women tend to be more risk averse when it comes to investing. Which could mean that a woman's retirement savings will likely be much lower than her male counterpart's. However, loss aversion can be useful. Women may be more inclined to make more thoughtful investment choices than men and stay out of overly risky investments. Some say that if more women were on the boards of banks, the financial crisis would never have happened.
• Stocks tend to outperform bonds. Historically, stocks have consistently outperformed bonds over time. From 1928 to 2012, the S&P 500 beat out ten-year Treasuries by more than 3 percentage points, which could be the difference between making $871 or $564 off of a $100 investment. It's good to have a diversified portfolio of stocks and bonds that complement each other, but stocks tend to have greater upside potential. Since bonds are debt, the bondholders, like a credit card company, are ultimately more concerned with getting their money back rather than what can be made on top of it. Equityholders, on the other hand, do not have to be paid back, so upside is all they can hope for; in exchange for taking on this risk, they get a higher reward. Get rewarded for holding stocks!

Don't be afraid to take risks, but if you don't have the funds to spare, do not risk them at all. It's much more important to pay down high-cost credit card debt than to start investing. But once you're free from that bondage, fly higher into stocks for [potentially] added financial security.

*Source: Google Finance S&P 500 chart.

Hello, Good Buy (Part 3)

To put skin on the numbers, let's look at a company like Coach (COH). (I would use Michael Kors [KORS], which I've mentioned in previous posts, but an older company like Coach will tend to have more solid numbers.)

Coach is a strong brand, growing around the world. When a woman works her way up the work world, her first luxury handbag well maybe COH. Well-respected by consumers and consistently well-received by the fashion community, Coach is poised to excel as it expands into Asia, particularly China.

Let's look at the numbers, as of market close today.

Range: $61.15 - $62.72 -- Nothing out of the ordinary here. The short range says that there was probably no major news about the company out today, as big news, like earnings hits or misses, can cause a price to flux more during the day.
52-week range: $45.70 - $79.70 -- If you've read news about the financial crisis raging in Europe, you probably already know that it's taken a toll on American markets recently, so some of this variation is likely due to that and not the fault of the company. The current price of $61.82 is about in the middle of the range, which can be a sign that the stock is now not so expensive.

Market cap: $17.77B -- Coach is big -- and growing! Its market cap is about $10 billion more than KORS, due to its higher price and that more of its shares are available in the market.
P/E ratio: 18.47 -- Personally, I think this is the best signal about COH. The S&P 500, one of the most common market indexes referred to, has a P/E of about 14 right now. In a way, this means that the market itself is worth about 14 times what it earns; anything close to that number sets a company up on the road to fair valuation, rather than overvaluation. Basically, you're paying the right price, rather than too much. COH's 18.5 is completely and totally manageable, and actually quite low for a company growing as quickly as COH is. A low PE is a sign of maturity, but can also be a signal strength. Excellent sign here, as its in line with its peers (TIF, with 15.72) but a steal compared to UA, with PE of nearly 57, or KORS, with about 60.

Dividend: $0.30/share, with a dividend yield of 1.94% (Dividend yield, or DY, is the percentage of the current stock price that the annual dividend makes up. The higher the better, of course.) -- YAY, free* money!!! And a DY of nearly 2% for a cyclical consumer stock in the US is a great deal right now since many companies are keeping their cash to expand operations or to save in case of a rainy day that looks like 2008.

EPS: $3.35 -- Again, solid performance in the past year by COH. This means that if you'd bought 10 shares last year, you would have pocketed an extra $33.50 on your investment. Not bad at all.
So, there you have it. Narrative + numbers = a good buy. Coach looks like a pretty good one right now if you can afford the $62 per share.
Next time, I'll take you through the scary stuff: the financial reports. Don't be scared --- they're not that bad, and you don't need a CPA to get what's going on.
Til next time!

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* You know that old saying about the only two envitable things in life are death and taxes? Yeah, we'll talk about taxes later.

Hello, Good Buy (Part 2)

So, you’ve got the narrative. You know the industry well enough to know that this company has room to grow, or you know the company well enough to know that it will shoot for the stars and be on target. Your gut says yes.

But objectively, how do you know this stock is a good buy?

Let’s start with the price.

To find a stock’s price, you can go to nearly any finance-related website. My favorite for straight-no-chaser information is Google Finance (http://finance.google.com), but Yahoo! Finance (http://finance.yahoo.com) is a formidable competitor. I’ll use Google Finance on this blog, just to stay consistent.

Most finance websites these days will let you type in the name of the company to pull up data, but you’ll want to know the company’s ticker symbol as well. It’s basically an abbreviation that identifies the company most quickly on a stock exchange.

When the company profile comes up, the first thing you’ll see is the price per share of the stock. Ask yourself how many shares you can afford at that price. Some brokerages have a required minimum number of shares in order for you to purchase with them (often 1 share is enough). However, ING’s Sharebuilder is unique in that, with the right plan, it will allow you to purchase fractions of a share of stock. There are downsides, though: (a) you can only purchase on a certain day -- typically Tuesdays, (b) you have no control over at what time of day -- and thus, at what price -- the stock is purchased, and (c) you'll wind up paying full commission for a smaller portion of stock. For simplicity’s sake, I’ll assume on this blog that you have a regular broker that will only allow you to purchase full shares of stock. Either way, you should always buy a number of shares whose proceeds will make the cost of commission worth it (see Post 2 for more information).

So, you’ve got money and you know how many shares you can afford – great! But hold on.

Take a look at the information available, particularly:

Range

52-week range
Market Cap
P/E
Dividend
EPS

Range – This is the lowest and highest prices the stock traded at in the past trading day. Basically, it represents a stock’s volatility, or how much the price fluctuated in the past day. Normally, this doesn’t move very much (maybe $1 or $2, or just a few cents), but if the whole stock market went up or down, you’ll see more variability here. You should equate volatility with risk – generally, the more volatile a stock is, the riskier it is. But with high risk comes high reward [in theory]. That said, don’t be afraid if a stock moves up and down more than $2 – Under Armour fluxed between $94 and $102 today, so it definitely happens.

52-week range – Similar to the day’s range, but, in my opinion, a lot more important. This gives the range of prices the stock has experienced in the past year. It’s an even better signal of volatility, especially if the highest price is waaaaaay more than the lowest (like, 3 or 4 times as much). Sometimes, you can look at a 52-week range to judge how “expensive” a stock is – if it’s at the top of the range, you’ll probably want to wait until the price goes down to buy; if it’s at the low end….well, that depends. It could be a signal that the stock is really cheap, but if the company is not doing well financially, it’s a sign of the worst.

Market Capitalization (Market Cap) – This basically tells you how large the company is, financially-speaking (and even more specifically, equity-speaking. I’ll get to debt later.). It is the total of the number of shares the company has available to investors multiplied by the price per share. Generally speaking, large-cap companies like Wal-Mart and McDonald’s tend to have less-risky stocks than small-caps like Basset Furniture.

P/E – P/E stands for price-to-earnings (or price-earnings) ratio. I would say that it’s the most commonly used ratio to decide if a stock is expensive or not, though that idea does not always hold. The P/E ratio can be found two ways: by dividing the company’s market cap by its net income or by dividing its current price by the amount it has earned per share in the past year. Either way, you’ll get the same answer.

Basically, it tells how much you’re going to pay per share for the amount of money the company earned. If the ratio is high (and “high” depends on the company’s industry), you’re paying too much for the stock; if it’s low, you’ve found a bargain. But as I said, this doesn’t always hold. Older, more established companies like GE tend to have lower PEs (GE’s is less than 16) whereas newer companies, such as Lululemon, tend to be higher (LULU’s is 58). This is because the PE can reflect investors’ expectations of a company’s growth. In this example, one would think GE has grown as large as its going to grow, but Lululemon has room to spread itself around.

Dividend – Sometimes, you get a tip from the company to thank you for investing in it. It’s called a dividend, and it’s a portion of the company’s bottom line earnings that it felt it should share with its shareholders. Why would a company do that? Well, they want you to keep investing in the stock and sometimes, they don’t want to keep too much cash on them and a dividend is a good way to get rid of it.

EPS – Stands for earnings per share; it’s a measure of how much the company earned in net income for each share of stock it has available to investors. The higher the better, but this figure can fluctuate wildly depending on what’s going on in the company, the industry, and the world. EPS is also a shadow – what’s happened in the past. There’s no guarantee that the same (for better or worse) will happen in the future, but it can give you an idea of what the company’s stock is capable of earning.

***

Now, you’ve got the story and you’ve got the numbers. Next, we’ll put them together.

Hello, Good Buy (Part 1)

By now, you should have your brokerage account set up and your idea of the company who's stock you would like to own.

But how do you know if this stock is worth buying?

Loook at your company two ways: qualitatively and quantitatively. (Don't be scared of the numbers! Actually, don't think of them as numbers...think of them as dollars. Makes things much less intimidating somehow.) You probably already have the qualitative story down and there's more on the quantitative to come.

The Qualitative Story

Let's take my journey Michael Kors, for example. Michael Kors, the American fashion designer and famous face of Project Runway, took his company public in December 2011 in an initial public offering, or IPO. When a company "goes public," that means that its stock is now listed on a stock exchange (generally the New York Stock Exchange or Nasdaq) and the company received just about all of the proceeds from selling its stock on the IPO day. After that, the shares are traded among investors, but the company does not get any more money; only from the IPO does the company recieve funds.

Anyway, I was ecstatic beyond ecstatic when Michael Kors went public because that meant that I could own, not just a watch or a handbag designed by the wonderful MK, but an ACTUAL PIECE OF THE COMPANY. Owning stock means exactly that -- you own a portion of the company. Empowering!!!

Qualitative analysis: I knew that Michael Kors is very well respected in the fashion community. He creates trends, but is not a [laughably] trendy designer. His designs are typically composed of clean lines and classic silhouettes that flatter girly girls and menswear women alike. His label's reach goes far beyond the US, into Europe and Asia. He is arguably the next Ralph Lauren.

For me, this came through knowledge of the fashion industry and being in touch with my own preferences. I know how much my friends love MK, and how much I look forward to his fashion shows (especially fall. There's always something about fall fashion that just gets you). Basically, it was women's intuition, my gut. I believe that women have a special edge in investing because we have less tendency to get laser focused on the numbers and take the broader picture into view.

From this intuition, I knew that his company was worth more than $31 per share, where it was trading when I first looked into it in early February 2012. I mean, an MK watch is $250 at Macy's! It HAD to be worth more than $31 per share because after the company recieves its money from the IPO, investors are essentially trading the company's reputation. They may sell their shares because they feel the company has done (or not done) something it should have, or the buy shares because they believe that it's an amazing company doing amazing things (see ticker symbol AAPL for an example). The stock price can be a reflection of investors' anticipation of all the great things the company will do in the future, short- and long-term. But sometimes, the stock price hasn't caught up with company's reputation, which I felt was the case with Michael Kors.

Sidenote: Crocs is a great example of the importance of looking at the narrative/big picture. In 2007, Crocs traded at nearly $70/share, and I predicted that it would come crashing down. Why? Because Crocs are ugly. Every fashionista around the world (including Anna Wintour herself) cursed the person who started wearing them outside of a hospital. Suburbanites across the US found them comfortable, and Wall Street cleaned up. Luckily, fashion (and a global financial crisis) slapped everyone, and Crocs now trades at around $20/share. Still worth too much in my view, but meh.

I was sure that MK was a good buy in qualitative terms -- I just needed the numbers to back me up. Tune in to the next post for details!