Understanding The Subtleties Of ROA Vs ROE

With all the ratios that investors toss around, it's easy to get confused. Consider return on equity (ROE) and return on assets (ROA). Because they both measure a kind of return, at first glance, these two metrics seem pretty similar. Both gauge a company's ability to generate earnings from its investments. But they don't exactly represent the same thing. A closer look at these two ratios reveals some key differences. Together, however, they provide a clearer representation of a company's performance. Here we look at each ratio and what separates them.

ROE
Of all the fundamental ratios that investors look at, one of the most important is return on equity. It's a basic test of how effectively a company's management uses investors' money - ROE shows whether management is growing the company's value at an acceptable rate. ROE is calculated as:

Return on Equity = (Annual Net Income/Average Shareholders' Equity)

You can find net income on the income statement, and shareholders' equity appears at the bottom of the company's balance sheet.

Let's calculate ROE for the automotive giant General Motors for 2003. To get the necessary data, go to the GM's Investor Information website and look for the 2003 Annual Report. You'll see on GM's 2003 Income Statement that its net income totaled $3.822 billion. On GM's 2003 Balance Sheet, you'll find total stockholder equity for 2003 was $25.268bn and in 2002 it was $6.814bn.

To calculate ROE, average shareholders' equity for 2003 and 2002 ($25.268bn + $6.814bn / 2 = $16.041 bn), and divide net income for 2003 ($3.822bn) by that average. You will arrive at a return on equity of 0.23, or 23%. This tells us that in 2003 GM generated a 23% profit on every dollar invested by shareholders.

Many professional investors look for a ROE of at least 15%. So, by that standard alone, GM managements' ability to squeeze profits from shareholders' money appears rather impressive.

ROA
Now, let's turn to return on assets, which, offering a different take on management's effectiveness, reveals how much profit a company earns for every dollar of its assets. Assets include things like cash in the bank, accounts receivable, property, equipment, inventory and furniture. ROA is calculated like this:

Return on Assets = (Annual Net Income/Total Assets)

Let's look at GM again. You already know that it earned $3.822bn in 2003, and you can find total assets on the balance sheet. In 2003, GM's total assets amounted to $448.507bn. GM's net income divided by total assets gives a return on assets of 0.0085, or 0.85%. This tells us that in 2003 GM earned less than 1% profit on the resources it owned.

This is an extremely low number. In other words, GM's ROA tells a very different story about the company's performance than its ROE. Few professional money managers will consider stocks with an ROA of less than 5%.

The Difference is All about Liabilities
The big factor that separates ROE and ROA is financial leverage, or debt. The balance sheet's fundamental equation shows how this is true: assets = liabilities + shareholders' equity. This equation tells us that if a company carried no debt, its shareholders' equity and its total assets would be the same. It follows then that their ROE and ROA would also be the same.

But if that company took on financial leverage, ROE would rise above ROA. The balance sheet equation - if expressed differently - can help us see the reason for this: shareholders' equity = assets - liabilities. By taking on debt, a company increases its assets thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks, and since equity is the ROE's denominator, ROE, in turn, gets a boost. At the same time, when a company takes on debt, the total assets - the denominator of ROA - increase. So, debt amplifies ROE in relation to ROA.

Look again at GM's balance sheet and you will see why the company's return on equity and return on assets were so different. The car-maker carried an enormous amount of debt - which kept its assets high while reducing shareholders' equity. In 2003, GM had total liabilities that exceeded $422bn - more than 16 times its total shareholders' equity of $25.268bn.

Because ROE weighs net income only against owners' equity, it doesn't say much about how well a company uses its financing from borrowing and bonds. Such a company may deliver an impressive ROE without actually being more effective at using the shareholders' equity to grow the company. ROA - because its denominator includes both debt and equity - can help you see how well a company puts both these forms of financing to use.

Conclusion
So, be sure to look at ROA as well as ROE. They are different, but together they provide a clear picture of management effectiveness. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders' investments. ROE is certainly a “hint” that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company's fortunes.

Principles behind equity investing

HISTORICALLY, stocks have achieved higher returns than bonds or cash over the long term. Stocks are also seen as investments that will outpace inflation. But stock investing also carries greater volatility and risk. The basic principle of buying low and selling high may sound easy, but is tough to carry out in reality.

Drivers of stock prices

Stock prices can be affected by many macro and company-specific factors. Macro factors include changes in regulations, economic conditions, political climate, industry competition, and behaviours of overseas financial markets. Asset classes (eg stocks, bonds) change in their perceived values and they perform differently at various phases of the business cycle.

Company-specific matters such as business prospects, dividend policy, management track record, product innovations, changing consumer tastes, management-labour relations and other company developments all influence stock price movements. Sometimes, changes in research analysts' stock recommendations would also cause share price volatility.

The goal is to make informed forecasts and a valuation judgement on the attractiveness of a stock/company. A starting point to measure a company's worth would be its financial statements. Among the key information analysed would be a company's earnings power, debt ratio, management quality, business model and relative share price performance.

Different valuation methods can be applied to determine the fair value of stocks. These valuation techniques may include cash flow discounting, and widely-used ratios such as price-to-earnings ratio (P/E), price-to-cash flow ratio (P/CF), price-to-book value (P/BV), and enterprise value to earnings before interest, taxes, depreciation and amortisation (EV/EBITDA). An investor or analyst may use a combination of valuation methods to arrive at a range of fair value for a stock. Even though models are quantitative, they rely on subjective inputs. Hence, one needs a clear understanding of the firm and its business.

Investors use these valuation methods and ratios to help them screen stocks. Typically, investors prefer stocks that are considered under-valued - that is, the current share price is trading below the stock's fair value, derived by applying the equity valuation methods. If the stock is trading above its fair value, it is over-valued. For over-valued stocks, investors may want to avoid or sell them until the stocks fall back to more attractive levels.

Some investors also learn from other successful investors such as Benjamin Graham, Warren Buffett, John Neff, Peter Lynch, John Templeton, Mark Mobius and many others. They get insights on how these investment gurus think and assess opportunities. Investors hope to understand their investment philosophies, and learn from their successes, trading styles and strategies. For instance, Benjamin Graham laid out the principles of 'value-oriented investment' - the use of fundamentals - in guiding the valuation of stocks. Many investors also follow Warren Buffett's investment strategy of discipline, patience and value.

Stock picking

The basic stock price is the fundamental value based on tangible assets in a company. As assets become increasingly intangible, there is a so-called 'weightless price' which is the price based on qualitative and intangible assets such as business connections, management expertise and human intellectual capital.

Stocks in different sectors have diverse operational and financial characteristics. They also produce different performances at various stages of the economic cycle. Stocks in the cyclical sectors such as auto, leisure, tourism and property, are the best performers during economic expansion. Stocks in defensive sectors like utilities, healthcare and food staples are steady performers regardless of how the economy behaves. When the economy slows, investors tend to seek refuge in defensive sectors and stocks. Recognising that various sectors perform diversely during different economic phases, stock investors would rotate or switch among the sectors/stocks.

Financial markets are driven by investors' expectations. The aggregate decisions of individual human beings are manifested through financial market and stock price movements. Human beings, however, are not always rational. Greed and fear are commonly known to influence our investment decisions and cause wild swings in stock prices. Investors are prone to be extremely optimistic at the top of the market when prices are high and very pessimistic at the bottom when prices are low.

History is replete with examples of financial market bubbles such as the Tulip craze, South Sea Company bubble, Japanese Stock Market and Dotcom mania. Charles Mackay's book, 'Extraordinary Popular Delusions and the Madness of Crowds' depicted how greed and fear led to speculative human behaviours and the bursting of bubbles in the last few centuries. The human element in investment decision-making introduces a 'psychological price' that is influenced by market pressures and irrationality.

Conclusion

To discover undervalued stocks before other investors do is the objective of most market savvy investors. However, undervalued stocks or companies do not announce their existence. Investors have to look out for them. Accurate stock valuation is a complex process. While uncovering the signs that point to valuable opportunities, investors need to have a clear understanding of the company and stay mindful of psychological blunders.

Stock investors would do reasonably well if they learn from the past, understand the present and think in the future. Understanding why we invest in these companies, having clear quantitative criteria for buying or selling, diversifying and overcoming our biases would be helpful. Undoubtedly, good analytical skills, patience and sound judgement are important to successful stock investing. But one learns also from bad experiences! Equity investing is a lifelong apprenticeship.

Institutional Investors And Fundamentals: What's The Link?

Many investors quickly learn to appreciate the significance of institutional shareholders - the mutual funds, pension funds, banks and other big financial institutions. These types of investing entities are often referred to as "smart money" and are estimated to account for as much as 70% of all trading activity. This professional stock buying is called institutional sponsorship and is believed by many stock watchers to send a strong message about a company's health and financial future.

However, investors with a fundamental approach need to understand the connection between a company's fundamentals and the interest the company attracts from large institutions. Institutional sponsorship, often driven by factors other than fundamentals, is not always a good gauge of stock quality.

The Dependability of Institutions
The argument that institutional sponsorship signals strong fundamentals makes a lot of sense. Big institutions make their living buying and selling stocks. Working hard to buy stocks that are undervalued and offer good prospects, institutional investors employ analysts, researchers and other specialists to get the best information about companies. The institutions meet regularly with CEOs, evaluate industry conditions and study the outlook for every company in which they plan to invest.

Besides, the institutions with large stakes have a vested interest in increasing the value of their shareholdings. Big institutional investors can exercise significant voting power and impact strategic decision making. These shareholders tend to promote value-driven decisions and create shareholder wealth by ensuring that management maximize the stream of earnings. Broadly speaking, research shows that high ownership concentration generally leads to better monitoring of management, leading to higher stock valuation.

Academic research suggests that institutional holdings pay off. In their study "Does Smart Money Move Markets?", which is published in the Spring 2003 edition of Institutional Investor Journals, Scott Gibson of the University of Minnesota and Assem Safieddine of Michigan State University, compare changes in total institutional ownership to stock returns over the each quarter from 1980 to 1994. During the 15-year period, stocks with the largest quarterly increase in institutional ownership (about 20% of all stocks) consistently posted positive returns.
William J. O'Neill, founder of Investor's Business Daily and creator of the CANSLIM stock selection methodology, argues in his book "How to Make Money in Stocks" (1988) that it is important to know how many institutions hold positions in a company's stock and if the number of institutions purchasing the stock now and in recent quarters is increasing. If a stock has no sponsorship, the odds are good that some looked at the stock's fundamentals and rejected it.

When the Dependability Becomes Instability
Of course, you can have too much of a good thing. O'Neil is careful to point out that while institutional sponsorship is attractive, a lot of institutional ownership can be a sign of danger. If something goes wrong with a company and all the institutions holding it sell en masse, the stock's valuation can tank - regardless of fundamentals.

Think of a stock as a swimming pool. The water level is analogous to the stock price, and elephants represent institutional investors. If the elephants suddenly start stepping into the pool (buy the stock), the water level (the price of the stock) will rise very quickly. But if the elephants get spooked and leap out of that pool (or sell the stock), then the water level (price of the stock) will fall rapidly.

Remember, institutions are not only investors but also traders. In principle, they will put money into stocks only after lots of fundamental analysis, identifying where the stock price should be and compare that to where it is. In practice, however, they often forego fundamental analysis for the signals emitted by technical indicators. Because their main worry is whether the stock price is going up or down, institutions will often concentrate on whether the price direction has any momentum.

A stock with a lot of institutional support may be close to the peak of its valuation, or full of elephants. When every mutual and pension fund in the land owns a chunk of a particular stock, it may have nowhere to go but down. Look at the meltdown of technology stocks in 2000 and 2001. Companies like Cisco, Intel, Amazon and others had an unprecedented amount of institutional sponsorship, but, as the subsequent collapse of their share price demonstrated, they also had unattractive fundamentals.

The legendary investor, Peter Lynch, thinks institutional investors make poor role models for individual investors. In his best-selling book "One Up on Wall Street", he lists thirteen characteristics of the perfect stock. Here's one of them: "Institutions Don't Own It and the Analysts Don't Follow It." Lynch brushes aside the notion that companies without institutional support carry the risk never being discovered: he argues that the market eventually finds undervalued companies with solid fundamentals. These companies are never out of sight for long. By the time institutional investors discover these hidden gems, the companies will no longer be hidden but fairly valued, if not overvalued.

Finding Out Who Holds the Institutional Sponsorship
It all comes down to the quality of institutional sponsorship. With a little extra research, investors can find out which institutions own the stock. For spotting companies with good fundamentals, you can determine if the stock is owned by funds with good track records.

One way to see if a stock has some institutional support is by checking its trading activity for block trades. A block trade, which is a single trade of a large number of shares, typically has a value of at least $100,000. Normally only an institutional investor has the money to buy such blocks.

Of course, the easiest way to find out if a company has some institutional sponsorship is simply to ask it. Often the company's investor-relations web page will provide a listing. Otherwise ask the company's representative if any of their shares are held by mutual funds, pension funds or other institutional investors. They should be able to tell you which institutions are shareholders.

Conclusion
Although logic and statistics show that institutional sponsorship is a good indicator of a good company, investors should be aware that institutional investing is not always driven by quality fundamentals. Before you depend on the assumption that smart money is the leader in judging fundamentals, make sure you determine whether the institutions are investing for the same reason you are.

by Ben McClure

Eight Common Investing Mistakes

1. Investing in Something You Don't Understand

One of the world's most successful investors, Warren Buffett, cautions against investing in businesses you don't understand. This means that you should not be buying stock in companies if you don't understand their business models. The best way to avoid this is to build a diversified portfolio of exchange-trade funds (ETFs) or mutual funds. If you do invest in individual stocks, make sure you thoroughly understand each company those stocks represent before you invest.

2. Falling in Love with a Company

Too often, when we see a company we've invested in do well, it's easy to fall in love with it and forget that we bought the stock as an investment. Remember: you bought this stock to make money. If any of the fundamentals that prompted you to buy into the company change, consider selling the stock.

3. Lack of Patience

How many times has the power of slow and steady progress become imminently clear? Slow and steady usually comes out on top - bet it at the gym, in school or in your career. Why, then, do we expect it to be different with investing? A slow, steady and disciplined approach will go a lot farther over the long haul than going for the "Hail Mary" last-minute plays. Expecting our portfolios to do something other than what they're designed to do is a recipe for disaster. This means you need to keep your expectations realistic in regard to the length, time and growth that each stock will encounter.

4. Too Much Investment Turnover

Turnover, or jumping in and out of positions, is another return killer. Unless you're an institutional investor with the benefit of low commission rates, the transaction costs can eat you alive - not to mention short-term tax rates and the opportunity cost of missing out on the long-term gains of good investments.

5. Market Timing

Market timing, turnover's evil cousin, also kills returns. Successfully timing the market is extremely difficult to do. Even institutional investors often fail to do it successfully. A well-known study, "Determinants of Portfolio Performance" (Financial Analysts Journal, 1986), conducted by Gary P. Brinson, L. Randolph Hood and Gilbert Beerbower covered U.S. pension-fund returns. This study showed that, on average, nearly 94% of the variation of returns over time was explained by the investment policy decision. In laymen's terms, this indicates that, normally, most of a portfolio's return can be explained by the asset allocation decisions you make, not by timing or even security selection.

6. Waiting to Get Even

Getting even is just another way to ensure you lose any profit you might have made. This means you are waiting to sell a loser until it gets back to its original cost basis. Behavioral finance calls this a "cognitive error". By failing to realize a loss, investors are actually losing in two ways: First, they avoid selling a loser, which may continue to slide until it's worthless. Also, there's the opportunity cost of what may be a better use for those investment dollars.

7. Failing to Diversify

While professional investors may be able to generate alpha, (or, excess return over a benchmark) by investing in a few concentrated positions, common investors should not try to do this. Stick to the principal of diversification. In building an ETF or mutual fund portfolio, remember to allocate an exposure to all major spaces. In building an individual stock portfolio, allocate to all major sectors, and selectively to underweight sectors you feel might have potential. Do not allocate more than 5-10% to any one investment.

8. Letting your Emotions Rule the Process

Perhaps the No.1 killer of investment return is your emotions. The axiom that fear and greed rule the market is true. Do not let fear or greed overtake you. Focus on the bigger picture. Stock market returns may deviate wildly over a shorter time frame, but over the long term, historical returns for large cap stocks can average 10-11%. Realize that, over a long time horizon, your portfolio's returns should not deviate much from those averages. In fact, you may benefit from the irrational decisions of other investors.

What You Can Do to Avoid these Mistakes
Here are some other ways you can avoid these mistakes and keep your portfolio on track:

1. Develop a plan of action. Proactively determine where you are in the investment life cycle, what your goals are and how much you need to invest to get there. If you don't feel qualified to do this, seek a reputable financial planner. Try to find one who will work for a fee and one who does not receive incentives to sell you high-commission products. Remember why you are investing your money, and you will be inspired to save more and may find it easier to determine the right allocation for your portfolio. Temper your expectations to historical market returns. Do not expect your portfolio to make you rich overnight. A consistent, long-term investment strategy over time is what will build wealth.

2. Put your plan on automatic. As your income grows, you may want to add more. Monitor your investments. At the end of every year, review your investments and their performance. Determine whether your equity-to-fixed-income ratio should stay the same or change based on where you are in life. (Find out more in How Portfolio Laziness Pays Off .)

3. Have some fun money. We all get tempted with the need to spend sometimes. It's the nature of the human condition. So, instead of trying to fight it, go with it. Set aside your "fun investment money". You should limit this amount to no more than 5% of your investment portfolio. Do not use retirement money. Always seek investments from a reputable financial firm. Because some may liken this particular process to gambling, follow the same rules you would in that endeavor. 1) Limit your losses to your principal (do not sell calls on stocks you don't own, for instance), 2) be prepared to lose 100% of your investment and 3) choose and stick to a pre-determined limit to determine when you will walk away.


Conclusion

Investing mistakes are part of the investing process. Knowing what they are, when you're committing them and how to avoid them will help you succeed as an investor. To avoid committing them, develop a thoughtful, systematic plan and stick with it. If you must do something wild, set aside some fun money that you are fully prepared to lose. Follow these guidelines, and you will be well on your way to building a portfolio that will provide many happy returns over the long term.

Take your lead from the world's great stock pickers

THERE'S no mystery to what makes a great stock picker. Great ones review hundreds or thousands of companies looking for clues to the right mix.

Warran Buffet
HE FAVOURS concentrated positions in companies he has carefully researched, and he sometimes holds stocks for decades.
-> Look for a long history of positive operating profits: five years or longer.
-> Be sure the company's resources are generating ample profits. Rather than focusing purely on earnings and earnings growth, look for high returns on equity: at least 15 per cent.
-> Look for shares that are cheap relative to real cash earnings. You can do this by looking for low price to free cash flows.
-> Be sure the company is creating profits for shareholders in the form of higher stock prices. Look for share price growth that has exceeded retained earnings growth over the past few years.

Peter Lynch
HE DIVIDES companies into six categories, such as stalwarts, turnarounds and fast growers, and gives different promising signs to look for in each. Small, fast-growing companies are among his favourites, so let's focus on those.
-> Look for earnings growth that's fast but not too fast. Growth rates that are too high might not be sustainable for long. Favour companies that are growing earnings at between 20 per cent and 50 per cent a year.
-> Look for relatively undiscovered companies. You can do this by searching for low levels of institutional ownership, which show that investment funds and the like haven't yet caught on to the stock. You can also look for stocks that are covered by no more than a few Wall Street analysts.
-> Look for insider buying.
-> Look for manageable debt levels. Watch for debt to capital ratios that are below industry averages.

Excerpted from Jack Hough's Your Next Great Stock, published by John Wiley & Sons, Inc.

Buy Low and Sell High

There is an important financial measure called "opportunity cost."

Basically, this means that if you spend money on something you automatically lose the opportunity to spend it or invest it on something else.

Or, as my Grand Dad used to say:

"You can't spend the same money more than once!"

Over time, the stock market has outperformed all other types of investments, including bonds, bank deposits, government securities and mutual funds.

The stock market may not always seem rational, but it's usually right in the long haul.

Over the short term, the market moves based on enthusiasm, fear, rumor and news. Over the long term, though, it is mainly earnings and dividends that determine whether a stock's price will go up, down or sideways.

A good stock may go up even when the market is going down, while a stinker can go down even when the market is booming.

Some days stock prices make absolute sense. Other days they seem ridiculously expensive or extremely cheap. The key to investing is to determine which is which on any given day, and then take advantage of it!

Prices are set by where a company appears to be going, not where it"s been. Investors buy stocks with the expectation that they'll be able to sell them for higher prices at some time in the future.

That means they expect that earnings will likewise grow. And if they don't, the best past performance in the world isn't going to help.

Historically, a well managed and widely diversified portfolio of correctly selected stocks has produced substantial returns with relatively modest risk!

"Buy low and sell high" or, buy high and sell higher!

We all heard these simplistic bits of advice. Unfortunately, as market cycles move up and down, and security prices rise and fall, it's hard to pinpoint the precise time when it's the most advantageous for either transaction.

One way to weather market cycles more successfully is with disciplined, periodic investing, often termed cost averaging. This simply means putting an equal amount of money at regular intervals into one or more securities.

Periodic investing can be an easy way to build up your portfolio! Employ this technique by setting aside a fixed amount of savings every month to invest.

When you invest the same amount every time, you buy more shares when the prices are low and less when the prices rise. The result:

You can potentially lower your average cost per share.

Investments allowed to grow over time can increase in value surprisingly fast. The systematic re-investment of stock dividends can be a painless, automatic way to build up a sizeable "nest egg."

The re-investment method creates a really powerful compounding effect on investments.

This is reflected in the words of Einstein, who once said that, the "Eighth" wonder of the world is compound interest!

The Five Investing Essential Truths

Markets are notoriously hard to read and people see only what they themselves want to see.

Bulls will find reasons why certain stocks will go higher, while at the same time, Bears will find many reasons for the same stocks to go lower.

The seldom-admitted truth is that most of the time, markets exist in some indeterminate state!

The main thing is that you cannot trust consensus and you cannot rely on the "Establishment."

You can't find refuge in the herd and you must resist the urge to join the crowd.

Your passion of the moment will most certainly create a disaster over the years!

On the other hand, if you do stick with the following five essential truths, you do stand a better than average chance to invest profitably!

1. Markets are unpredictable and ill-suited to forecasts.

2. Long-term fundamentals are key.

3. Investor emotion leads to volatility.

4. Valuation discipline should guide investment selection.

5. Perspective and patience are always well rewarded.

REITS

Introduction to REITS

Investing in income-generating real estate can be a great way to increase your net worth. But for many people, investing in real estate, particularly commercial real estate, is simply out of reach financially. But what if you could pool your resources with other small investors and invest in large-scale commercial real estate as a group? REITs allow you to do just that.

REIT stands for real estate investment trust and is sometimes called "real estate stock." Essentially, REITs are corporations that own and manage a portfolio of real estate properties and mortgages. Anyone can buy shares in a publicly traded REIT. They offer the benefits of real estate ownership without the headaches or expense of being a landlord.

Investing in some types of REITs also provides the important advantages of liquidity and diversity. Unlike actual real estate property, these shares can be quickly and easily sold. And because you're investing in a portfolio of properties rather than a single building, you face less financial risk.

REITs came about in 1960, when Congress decided that smaller investors should also be able to invest in large-scale, income-producing real estate. It determined that the best way to do this was the follow the model of investing in other industries -- the purchase of equity.

A company must distribute at least 90 percent of its taxable income to its shareholders each year to qualify as a REIT. Most REITs pay out 100 percent of their taxable income. In order to maintain its status as a pass-through entity, a REIT deducts these dividends from its corporate taxable income. A pass-through entity does not have to pay corporate federal or state income tax -- it passes the responsibility of paying these taxes onto its shareholders. REITs cannot pass tax losses through to investors, however.

From the 1880s to the 1930s, a similar provision was in place that allowed investors to avoid double taxation -- paying taxes on both the corporate and individual level -- because trusts were not taxed at the corporate level if income was distributed to beneficiaries. This was reversed in the 1930s, when passive investments were taxed at both the corporate level and as part of individual income tax. REIT proponents were unable to persuade legislation to overturn this decision for 30 years. Because of the high demand for real estate funds, President Eisenhower signed the 1960 real estate investment trust tax provision qualifying REITs as pass-through entities.

A corporation must meet several other requirements to qualify as a REIT and gain pass-through entity status. They must:

-- Be structured as corporation, business trust, or similar association
-- Be managed by a board of directors or trustees
-- Offer fully transferable shares
-- Have at least 100 shareholders
-- Pay dividends of at least 90 percent of the REIT's taxable income
-- Have no more than 50 percent of its shares held by five or fewer individuals during the last half of each taxable year
-- Hold at least 75 percent of total investment assets in real estate
-- Have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries
-- Derive at least 75 percent of gross income from rents or mortgage interest

At least 95 percent of a REIT's gross income must come from financial investments (in other words, it must pass the 95-percent income test). These include include rents, dividends, interest and capital gains. In addition, at least 75 percent of its income must come from certain real estate sources (the 75-percent income test), including rents from real property, gains from the sale or other disposition of real property, and income and gain derived from foreclosure of property.

In Singapore, characteristics also include:
- at least 70% of assets invested in real estate.
- 75% or more of income comes from rents.
- debts of less than 35% of deposited property.

REITs are relatively new to the Singapore market. The first Reit, CapitalMall Trust, was launched in 2001.

How REITs Operate

Because REITs are required to distribute 90 percent of their taxable income to investors, they must rely upon external funding as their key source of capital. Just like other stock offerings, publicly traded REITs collect funds via an initial public offering (IPO). Those funds are used to buy, develop and manage real estate assets. The IPO works just like other security offerings except that instead of purchasing stock in a single company, the buyer will own a portion of a managed pool of real estate. Income is generated through renting, leasing, or selling the properties and is distributed directly to the REIT holder on a regular basis. When a REIT pays out its dividends, they're equally distributed among shareholders as a percentage of paid-out taxable income.

REITs have a board of directors elected by its shareholders. Typically, these directors are real estate professionals who are highly respected in the field. They are responsible for selecting the REIT's investments and hiring the management team, which then handles day-to-day operations.

REITs earn money from rented space or sales of property. The preferred method for measuring REIT earnings is called funds from operations (FFO). The National Association of Real Estate Investment Trusts (NAREIT) defines FFO as:

Net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis.

Basically, REITs add or deduct from net income (rent and sales computed according to generally accepted accounting principles [GAAP]) any gains or losses due to depreciation, sale of property and unconsolidated partnerships and joint ventures. Essentially, FFO measures a REIT's operating cash flow produced by its properties, less administrative and financing costs.

Under generally accepted accounting principles, net income typically assumes that the value of assets goes down over time -- somewhat predictably. Real estate generally retains or even increases in value. On the balance sheet under GAAP, however, land remains at its historical cost and buildings gradually depreciate to zero. Since a REIT's primary business involves real estate, the depreciation charges negatively skewed the company's true profitability. FFO was adopted to address that problem by excluding depreciation costs from the net income figure.

FFO is not a foolproof measure, however. Not all REITs calculate it according to the NAREIT definition and items such as maintenance, repairs and other recurring capital expenses are missing from the formula. In order to get a true FFO, investors must often read a company's quarterly report, and any supplemental disclosures.

Investing in REITs

Because many REITs are publicly traded, they offer investors a powerful tool for portfolio balancing and diversification. They also provide investors with ongoing dividend income, while offering the potential for long-term capital gains through share price appreciation.

REITs have an advantage over other types of stocks. Because of their pass-through taxation, REITs have greater profits from which to pay shareholder dividends than similar sized corporations. As long as a REIT maintains its tax-qualified status by paying out 90 percent of its net income to common shareholders, it doesn't have to pay federal income taxes. Without a tax bite to reduce profits, shareholders get more of the REIT's earnings.

REIT investors receive value in the form of dividend income and potential share value appreciation. Because REIT income often comes from commercial properties with long lease periods, REITs can offer a relatively predictable revenue stream. They also are somewhat resistant to inflation. Unlike bonds with pre-determined rates of interest, which lose relative value in times of high inflation, REITs with rental incomes adjust themselves in line with the cost of living. This makes them less vulnerable to inflation-related devaluation.

In the Singapore context, unlike common stocks REITs are only taxed on individual basis. The Singapore listed REITs are not subject to corporate tax and distribute close to 100% of net income. Whereas some stockholders suffer from ‘double taxation’ of income. Secondly, one of the most prominent features of REITs is high dividend yield as compared to most common securities. Not a very surprising feature if one recalls that REITs pay out almost all their net rental income to shareholders.

Not all bonus issues are good news

BONUS share issues are usually viewed positively. Investors welcome them and companies always present such issues as efforts to reward shareholders. And there have been no shortage of bonus issues on the Singapore Exchange (SGX) in recent months. At least a dozen or so SGX-listed companies have announced bonus issues, according to filings with the stock exchange.

However, like most things, bonus issues aren't always all that they are made out to be.

A bonus issue refers to the issue of new shares to existing shareholders at no cost and in direct proportion to their existing shareholdings in the company. So in a 1-for-4 bonus issue, for instance, shareholders get one new share for every four existing shares they hold.

Because bonus issues are free, it is well understood that they do not directly benefit the company. This is unlike rights issues (where shareholders pay for rights shares at a discount to the market price) which raise funds for the company. Bonus issues also do not materially alter the balance sheet of a company. They are normally done using the retained earnings of a company and involve a book entry transferring an amount from retained profits to share capital. This is also known as the capitalisation of reserves.

But do bonus issues really benefit shareholders, as companies make them out to be?

This is debatable. It can be argued that, theoretically, a bonus issue brings no additional benefit to the shareholder.

While it is true that the shareholder would end up with more shares at no cost, the share price would - theoretically at least - also adjust downwards accordingly to what the market calls the theoretical ex-price. Issuing bonus shares also has the effect of diluting earnings per share.

One way shareholders would benefit from a bonus issue is when the adjusted lower share price makes the stock more affordable and encourages more investors to invest in it. This would result in more liquidity and potentially more upside for the share price.

This would be what companies want shareholders to believe, and indeed, is the rationale given in every bonus issue announcement. Such an outcome is not a given, however, and the share price performance depends not just on having more shares in issue but on a host of other factors.

There are, in fact, some hidden dangers in bonus issues.

For one, companies may be making bonus issues in lieu of dividends. So while getting more shares at no cost, shareholders may be forgoing cash dividends. In some cases, like when a company needs to conserve cash to expand its business, there are sound reasons for a bonus issue in lieu of dividends. But this does not apply to all situations, and shareholders should ask if a bonus issue is masking the lack of dividends when these should be forthcoming.

Another danger is when a penny stock makes a bonus issue. While there may be a good reason for a high-priced stock to make a bonus issue to improve affordability and boost liquidity, it's harder to apply this logic to penny stocks which are already affordable in the first place. So if a penny stock becomes even cheaper, it may pull in speculators rather than long-term investors. Indeed, institutional shareholders - which companies value - are known to shun very low-priced stocks. Attracting speculators and the syndicates may boost the share price in the short term, but if this comes at the expense of having serious investors as stakeholders, it could ultimately curb the upside potential of a stock in the long term.

The other thing to watch out for is when recently listed companies make bonus issues. Companies often say they are rewarding shareholders' loyalty when they make a bonus issue. For a newly listed company, however, there really is no shareholders' loyalty to speak of. So the motives a company has in making a bonus issue in such a situation should be questioned.

Of course, there are many bond fide bonus issues made by companies which are doing well, are confident of their future prospects and are genuinely seeking to reward shareholders. But investors should not see all bonus issues as good news. There may well be a sting at the end of the tail.

Super stock returns: ROE/PTB v ROE v PTB

A company that is able to generate a high return on equity - one that exceeds its cost of equity - should trade at a higher price than the book value of its equity. And vice versa. But if a company generates a relatively high ROE, yet is trading at a relatively low price-to-book ratio (PTB), careful analysis is warranted.

There could be legitimate reasons for the low valuation. For example, the earnings were due to exceptional items. If not, the stock may be under-priced.

But without any detailed analysis other than simply grouping stocks based on ROE/PTB, I found that investors can actually generate super returns.

By investing in the 10 per cent of stocks with the highest ROE/PTB every year between 1990 and 2006, and holding each portfolio for a year, one could have turned $100 into $34,000 over the past 17 years. That's a compounded return of 41 per cent a year. All the calculations exclude transaction costs.

If we assume that the investor had lost 10 per cent of the portfolio value to transaction costs every year, the return is still a respectable 27 per cent a year. But in absolute terms the portfolio value today, at $5,678, is significantly less than the $34,000 which excludes transaction costs.

From the above, we can see that ROE/PTB is a good screening tool.

Separate rankings

If we pick stocks just based on ROE or just based on PTB, do we get results that are as good?

I decided to test this based on the same set of data last week. This time around, I ranked stocks based purely on their ROEs first. Again, I grouped them into 10 portfolios, with the first 10 per cent or first decile being stocks with the lowest ROEs. The 10th decile was made up of stocks with the highest ROEs.

As can be seen from the chart, screening stocks using just their ROE still yields good returns. $100 invested in the highest ROE portfolio every year would grow to $8,752 today. That's a compounded annual return of 30 per cent.

But it would lag the performance of the basket of stocks with high ROE yet low PTB.

For both the first and second screening, I excluded loss-making companies.

Next, I ranked the stocks based on their PTB ratios. For this, I did not remove loss-making companies. The first decile is made up of stocks with the lowest PTB ratios. Some could even have negative PTB ratios. And the 10th decile consists of stocks with high PTB ratios.

As you can see from the third chart, there is a clear distinction in performance as well. The lower the PTB, the higher the return. And conversely, the higher the PTB, the lower the return. The lowest PTB stocks generated about 15 per cent return a year, while the highest PTB stocks chalked up a 7.3 per cent loss a year.

However, the returns of portfolio ranked purely on PTB ratio lagged those screened by ROE/PTB or purely on ROE.

One of the reasons for the under-performance could be the continued poor performance of loss-making companies. Other studies previously have found PTB to be the best predictor stock performance. Particularly so when there is a turnaround in the economy. This is also evident in five portfolios that The Business Times tracks every Monday.

But it takes guts to go against the crowd and buy into downtrodden stocks.

So perhaps, the ROE/PTB is a more comfortable approach for many. And as the results above indicated, it is rather rewarding as well.

It does, however, require a little more work. The use of ROE/PTB takes into consideration not only the underlying earnings capacity of a company, but also how much of that has been factored into its stock price.

So if a company can rake in good earnings and good growth and its share price has fully reflected that, it may not be a good stock to buy. What one wants is good earnings growth that is not recognised by the market.

Variations

A reader pointed out that with some simplifications, ROE is earnings per share (EPS) divided by net tangible assets (NTA). And PTB is price per share divided by NTA.

Dividing the former by the latter gives us EPS divided by price per share, which is earnings yield. So stocks with high ROE/PTB are also those with high earnings yield.

And we could go one step further. Earnings yield is the inverse of price-earnings (PE) ratio. So stocks with high earnings yield are also low PE stocks.

'Notwithstanding the mathematical accuracy, ROE relative to value is an interesting approach to investing,' he wrote. 'I have been using something similar for some time to good effect (ROE divided by PE coupled with some other criteria like minimum dividend payout and low debt to equity).

'A variation was also suggested in the book The Little Book That Beats The Market by Joel Greenblatt which uses ROE divided by return on invested capital (to correct for the use of excessive financial leverage). He even has a website www.magicformulainvesting.com to automatically select US stocks that meet the criteria.'

The reader added that the most comprehensive book he has come across on this is What Works On Wall Street by James P O'Shaughnessy.

Below is a table - using data from Bloomberg - showing 30 stocks with high ROE/PTB. Some of the numbers may be skewed by one-off items, so some analysis is advised before any action is taken.

Go for stocks with high return on equity but low price-to-book ratio

ONE way to value a company is to ascertain how much abnormal earnings - that is, earnings above the cost of its capital - it will be able to generate in the future. This stream of abnormal earnings is then discounted to its present value. Add that number to the current book value of the capital and you arrive at how much the company is worth.

This way of calculation has intuitive appeal. It implies that if a company can earn a rate of return that is equivalent to its cost of capital, then investors should be willing to pay no more than the book value for the stock.

Book value is the original capital invested by the company in its various assets to start up its business after taking into account depreciation.

On the other hand, if the company is able to generate earnings above its cost of capital, then investors should be willing to pay more than the book value of its assets. Conversely, if a company's net earnings cannot even cover its cost of capital, then investors will only invest in the company if it is trading below its book value.

We can see how much the market is valuing a company by comparing the market value of its equity, that is its market capitalisation, with the book value of its equity.

So if a company's market cap is $100 million, and the book value of its equity is $50 million, then this company is trading at two times its book value. This measure is also referred to as the price-to-book (PTB) ratio.

A PTB ratio of two times implies that investors are confident that the company can earn significantly above its cost of capital for a sustained period of time.

We can actually derive the formula for PTB from the abnormal earnings formula. The latter says that to arrive at what a company's shares are worth, we take the current book value of its equity, and add the discounted future stream of net profits which is in excess of the cost of equity. The discount rate used is the cost of equity.

So if we scale the formula with book value on both sides, we get PTB value on the left-hand side, and abnormal return on equity (ROE), among other things, on the right-hand side.

This suggests that a company's PTB ratio is a function of three factors: its future abnormal ROE, the growth in its book equity, and its cost of equity.

Abnormal ROE is defined as ROE less the cost of equity.

Firms with positive abnormal ROE are able to invest their net assets to create value for shareholders, and as mentioned earlier, will have a PTB ratio greater than one.

Strong ROE-PTB links

The whole point of what has been said so far is to show that there is a strong relationship between PTB ratios and ROEs. Companies with high ROE should trade at higher PTB ratio compared with those with lower ROE.

So perhaps one way to spot mispricings by the market is to identify stocks with high ROE but low PTB ratio.

Will such a strategy pay off? Well, I did some back-testing and the results are phenomenal.

I download the ROEs and PTBs of all the companies listed on the Singapore Exchange from 1990 until 2007. These are the yearly numbers on Jan 1 of each year.

I then divide the ROE numbers with PTBs, and rank the stocks based on that number. The top-ranked stock would have the highest ROE relative to its PTB. The lower-ranked stocks would have low ROE and high PTB.

I then split all the stocks equally into 10 groups. The first group, or the first decile, is the top 10 per cent of stocks with the highest ROEs relative to their PTB ratios. The 10th decile comprises those with the lowest ROEs and highest PTB ratios. Then there's a group of loss-making companies.

Compounded returns

Assuming that an investor did this on Jan 1, 1990. Based on data from Thomson Financial Datastream, there were 39 stocks then. After ranking them, he invested $100 in the top four stocks with the highest ROE/PTB.

On Jan 1, 1991, he did the same screening again. Then he divested the initial four stocks and reinvested the proceeds into a new batch of stocks with the highest ROE/PTB.

And he consistently did that for the past 17 years. How do you think his $100 would have grown to? A whopping $34,048.

That's a compounded return of 41 per cent a year. The above calculations did not take into consideration transaction costs. If it did, a huge chunk of profits would disappear.

But the point is, there is a very clear relationship between stock returns and ROE/PTB. As can be seen from the chart, the top 10 per cent of companies with the highest ROE/PTB turned $100 into $34,048 in 17 years.

The next 10 per cent managed to grow the pot to $4,710 - that's still quite a decent 25 per cent a year. The following 10 per cent, or the third decile, managed $958 for a return of 14 per cent a year.

And as we move to stocks with lower and lower ROE/PTBs, the return shrinks correspondingly.

The fifth decile grew only 3.8 per cent a year and the 10th decile - the 10 per cent of the market with the lowest ROE/PTB - shrank the $100 to just $25. It is very clear from the findings that it doesn't make sense buying stocks with low ROE and high PTB.

This screening process takes into consideration the underlying earnings capacity of a company in relation to how the market is valuing the company. Those with high ROE but low PTB are clear cases of mispricing. That's why the back-testing shows such a phenomenal performance.

But of course, a firm's ROE is affected by such factors as barriers to entry in their industries, change in production or delivery technologies, and quality of management. These factors tend to force ROEs to decay over time. But since in the above testing, the holding period is just one year, the decay is not so much a factor.

So the next time you study a stock, look at its ROE relative to its PTB as well. If the ROE is high, but its PTB is high as well, then perhaps the good fundamentals have been reflected in the share price. However, if you find a stock with high ROE but relatively low PTB, then you may potentially have on your hands an undiscovered gem.

Investing tricks of the wealthy

Average investors can apply the same techniques to their own investments, no matter the size of their portfolio

By BEN FOK
Dec 19, 2007

RECENTLY, I asked a wealth manager whether an average investor can make more money by mimicking the investment strategies of the rich. He answered: not really. Later he explained that the rich invest differently because, well, they're different. They can take more risks because they have more money to lose. Furthermore, they can speculate and have a short-term view because losing money is not a problem for them.

Well, I do not totally agree with his opinion. For the past few years, I have been advising wealthy people on their financial well-being. As a financial adviser, my job is to help these rich clients search for financial services who meet their needs. Throughout my interaction with them, I have gained an insight into how they accumulate wealth.

I can tell that the rich don't necessarily have any special insights into which stocks or assets are going to soar. But what they do have is the confidence to apply a disciplined and systematic approach to managing their money. They have the habit of applying common sense to each investment opportunity facing them. Even though the interests of wealthy investors are not always necessarily aligned with those of the average investor, there are a number of principles and strategies employed by wealthy investors that do apply to virtually anyone who seeks to invest for the future.

It is a common fact that most financial textbooks teach us that in order to build wealth we need diversification, wealth preservation and strategic growth. To me, this not an accurate statement in itself because two of those strategies - diversification and preservation - don't help to build wealth. Perhaps the rich use these two strategies to maintain wealth.

After they have accumulated great wealth, they didn't use the strategies during the accumulation phase and they tend to preserve the wealth they have built. Yet average investors have not yet reached the ranks of the financially independent, so they are generally more concerned about investment growth and losses. The wealthy, as a general rule, do not have this concern. At the same time, they also learn how to avoid taxes legally so that they can keep their money working for them and learn how to pass their assets on to the future generations without the government taking a huge part of what they spent their lives building.

Another common perception is that the rich take more risk, therefore they accumulate wealth faster. However, the truth is that the majority of rich people do not build their fortunes by speculating on high-risk investments as is commonly believed. My experience tells me that the rich do not heavily rely on high-risk investment vehicles like hedge funds or venture capital funds but are moderate risk takers who put more than half of their money into listed securities and keep a large amount as cash. The reason for this is that they have so much money that even if they do not meet their goals for investment growth, it would not be bad news to them; however losing their financial independence would be devastating.

So how do the rich invest? Unlike the average investor, the rich think long term in most of their investment strategies. They believe that there is power in long-term thinking and many of them make it habit of doing so. Great investors like Warren Buffett - his successes in investment include Washington Post Co, where Berkshire invested US$11 million in 1973 and which investment was worth US$1.3 billion at the end of 2006. That is 33 years of holding power which demonstrates his investment philosophy - always invest for the long term. Hence, most rich do not engage in short-term speculation but have a long-term goal in mind.

However, the rich make use of risk by taking advantage of risk. They often build fortunes using volatile assets and investments but that does not mean they were engaging in risky behaviour. They understand the risk and embrace risk because they know it always brings an opportunity for growth; however, the average investor is fearful of risk. Nevertheless, taking risk for the rich does not mean taking a shot in the dark. The rich take calculated risk that means to gain knowledge first and to consider the consequences of failing before taking action. The rich overcome fear with knowledge as knowledge can cause fear to fade away.

The rich also demand value for their money. Otherwise, how do you think they got to be rich in the first place? Value to them is buying assets at a discount to its intrinsic value. So for them the right time to buy is when there is weakness in the market. They buy when others are despondently selling and sell when others are greedily buying. This requires the greatest fortitude but also has the greatest rewards. This bargain-hunting approach to buying value will enable them to buy quality assets at reasonable prices. So they buy when there is bad news and sell on good news. For instance, some of the wealthy invest because they understand that the weakness is only temporary, and the stock price had fully priced in negative news and it was time for them to hunt for bargains again.

If we look back at the Singapore stock market, there are many opportunities for investors to bargain hunt and buy on bad news, e.g. the Asian financial crisis in 1997/98, the Sept 11 terrorist attack and SARS. The rich take advantage of these negative events to buy assets, whether in real estate or stocks and that's where value can be found. However, the average investor will seek to sell and get out of a bear market fearing that the asset will fall in value.

To the rich, probably now is the best time to sell and get out of the market, where all assets prices have gone up in value. Over the past years, we have very good reports about our economic growth and all the good news are now factored into the stock price, so for the rich it's time to sell.

Another investing secret of the rich is that they approach investing like a business. They set up a business plan, establish annual targets, then analyse the results and they have reasonable expectation. At the end of the day what they want to achieve is increasing their net worth and not their income. The rich truly understand the meaning of working smart not working hard: to focus on growing your net worth is working smart but working for an income is working hard. As their net worth grows, they do not increase their spending, instead they increase their investment. By repeating this over the years, once their net worth is built to a certain level, they are free to do what they want. Hence, to increase your net worth you need patience, knowledge, and wisdom.

Often they are not willing to pay more for investment services simply because they find a particular adviser to be charming or knowledgeable. Nor do they chase after the hottest manager or the most publicised fund. Instead, they go shopping for the best combination of reasonable fees and consistently good performance. However, they will pay for advice from people who have specialised knowledge in a field they need to learn about. They don't believe in free advice as it can often be the most expensive advice.

As you can see, most investing secrets of the rich are nothing more than a combination of basic common sense and knowledge. The difference between the rich and the average investor is that they have the self-confidence to stick to the basics and to find out what they need to know. They don't get caught up in the theory of the week or the trend of the month. It's an approach that's easy to articulate but difficult to follow.

However, average investors can learn important lessons from the wealthy, specifically the need to manage both risk and their own investment expectations. The failure to match expectations to the risk an investor is willing to take can result in frequent switching among investments, or even worse. Now the good news for the average investor is that you can apply many of the same techniques to your own investments, no matter how big or small your portfolio is.