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Weekend Investor: Understanding Investment Yields

September 20th, 2011 No comments

Investment yield is the amount of income expressed as a  percentage that you earn on your portfolio in a year. Like a savings or checking account at your bank, or a money market fund, your portfolio will have an equivalent to an ‘interest rate’ expressed as a percentage.

There shouldn’t be much work to figure this out, your broker should calculate it for you when they send you a monthly statement. However, there are different ways of looking at this and there isn’t just one way to calculate it. As we will see, the yield that your broker provides may understate how well your investment is actually doing.

In this article I will discuss (4) main ways of calculating investment yield and what each one tells you.

Why Portfolio Investment Yield Is Important

Here at JavaInvestor, we are more focused on investment yield than portfolio value. There are a number of reasons for this. First, how much you earn on your portfolio and how much it grows over time is more important than what the market value of those investments are. This is somewhat contrary to popular punditry out there, but this is a strategy that can really work for you over time. When your earnings and income in your portfolio increase, the market value of those investments will go up but it isn’t always that case that these two events will coincide. The market can either over price and under price an investment at any given time.

During the Great Recession of 2008, my investment portfolio remained intact because the companies that I owned kept increasing their dividends. This is a more powerful statement about the health of those businesses than what the market valued them at during any given day.

An Example Portfolio

I will use the following portfolio to demonstrate the calculations. To keep it simple, assume that you bought the stocks at the beginning of the year and then totaled up everything at the end of the year. There was an increase of 8% in the value of each position at the end of the year.

Initial Investment: $10,000

Money Added During Year: $2,000

Investment Yield @ Purchase: 5%

Dividend Increase During Year: 10%

Year End Portfolio Value:  $13,608

1) What Your Broker Will Report

The broker will report on your statement the current investment yield as of the statement date. In this case, the investment increased in value of 8% after the investment initially had a 5% yield when it was purchased. This yield is called investment yield on value (IYV), because it uses the current value of the investment in the calculation.

The 8% increase in the investment value reduces the IYV to 4.62%. This would be the same investment yield that Yahoo! Finance, Google Finance, or Wikinvest would report.

2) Investment Yield On Cost (IYC)

The value of the investment changed but the yield on your initial purchase doesn’t change. From this point of view, no matter what the price change of the investment, you will still earn 5% going forward assuming other things constant. The IYV calculated above only comes into play when you are reinvesting money or adding money to the portfolio.

IYC will always go up when the dividends are increased because it does not take into account any price change, only your initial price that you paid. So, the initial IYC is 5.0%. Since the dividend was increased by 10% during the year, the IYC increases to 5.5% by the end of the year.

3) Compound Investment Yield On Cost (CIYC)

The total amount you invested for the year was $12,000 ($10,000 initial investment plus another $2,000 along the way). However, you have more than $12,000 working for you because you reinvested the $600 in dividends you collected along the way. Also, the investment increased its dividend rate by 10% (to 5.5%).

From this point of view the CIYC is 5.8%, when you add it all up.

4) Forward Investment Yield On Value

Eventually, your broker will catch up and apply the new investment yield that will apply to future income earned. When they do, they will again calculate it based upon the current market value of the investment. In the example above, an increase in the dividend by 10%, coupled with the 8% share price appreciation comes up with a FIYV of 5.08%.

Summary

So there you have it, 4 different ways of calculating the investment yield for the same investment during one year.

IYV: 4.62%

IYC: 5.00% (Initial)

IYC: 5.50% (End of Year)

CIYC: 5.77%

FIYV: 5.08%

As you can see, what you broker reports can understate how your investment is really performing. Over time, you want to make sure that CIYC is increasing because that is the one that determines if you are making more money.

Categories: Investing Tags:

Weekend Investor: Should You Own Just One Investment?

September 15th, 2011 No comments

When it comes to investing, the conventional wisdom says to ‘diversify’ to make money over the long term. Diversification is said to work because it limits your exposure to the ‘big’ loss, as well as offering the ability to make money at any given moment because most investments tend to perform/under perform in cycles.

My thought for this weekend is make the case against diversification to the extreme: owning just one investment. And I don’t mean buying a huge mutual fund such as an S&P500 index fund, or that even bigger total stock market fund that has hundreds of investments in one, the so called total stock market fund. I mean just one individual investment, like a company stock.

What The Fed Chairmen Have Picked

The last two U.S Federal Reserve Chairmen both have inadvertently offered up their wisdom on owning just one investment. The former chair Alan Greenspan only owned investment: U.S Treasury Bonds. He has since changed his investments subsequent to his retirement, but the reason that he offered for owning just Treasuries was to avoid any conflict of interest.

As a practical matter, owning just Treasuries isn’t that easy. Because interest rates are changing over time, it is difficult to generate a consistent income stream off of them. The best option would be to have so many bonds such that you could deal with the variability, in other words, very rich.

The current Fed chairman, Ben Bernacke, listed his only stock investment as Altria (MO), which we own in the Income Portfolio. If you owned this company at the time he made this disclosure (2005), you would now own (3) companies due to a breakup: Kraft (KFT), Altria (MO), and Philip Morris (PM).

This choice as a single investment was previously identified as the best performing S&P500 stock by economist Jeremy Siegel over the past 50 years. So, not that bad of a bet, because even though this is thought to be a mature company, Altria easy beat the stock market over the last 10 years as well.

My Choice For The ‘One Investment’

If I had to pick just one investment, I would want a company that has demonstrated consistently that looking out for the shareholder interest is the first priority. Sure other attributes are important, but given that economic cycles are inevitable, you need to have confidence that the company is looking out for your interests. So, from this point of view, I would pick one of these two companies:

  1. Realty Income (O)
  2. Phillip Morris (PM)

These companies have great management and a proven track record of creating shareholder value.

What would your choice be?

Categories: Investing, Weekend Investor Tags:

Use This Nifty Tool To Calculate Investment Return

September 10th, 2011 No comments

Unfortunately, the tool I discuss in this article, from the Sharebuilder site,  isn’t available anymore. I’ll be on the lookout for a potential replacement.

You would think that calculating investment returns would be easy. It can be as complicated as you want to make it because annual returns are calculated based upon not only by what you make, but also over what time frame you made the money. If you are a dividend or income investor like me, you will have perhaps dozens or more transactions over any given year. So, each one will have its own return and the difference in return for each purchase can be quite large during the year even for the same investment.

I like to keep things simple. The easiest way to calculate return is to use the following formula:

Investment Return (%) = Investment Value / (Initial Investment + Added Money)

This way of calculating return is a very simple cash-in/cash-out percentage that doesn’t consider over what time frame that each transaction occurred. I like this because in the end percentages are OK, but you want to know at a high level how much money you made overall.

For example, lets say you invested $10,000 and added $500 during the year in new money + $500 in dividends or other income from the investments. At the end of the year, you had $15,000. Your investment return is $15,000/($10,000 + $500), or 42%. Anyone way of looking at this is that you made $4,500.

How About A Longer View?

If you listen to journalists and financial pundits, you may get a misguided idea about what your returns are over a longer period of time. For example, you will here repeated often that the S&P500 investor didn’t make any money over the last 10 years because the index value didn’t change.

This assumes that you invested your ‘chunk’ ten years ago, didn’t add to it, and didn’t reinvest dividends. This is unlikely to be true for most people. If you are to be a successful investor, you need to have a good idea about what your returns are over a longer period of time, because you may be making (or not making) what you think you are.

You can’t go wrong with the simple formula above, it measures the cash you put in and the total cash you have now.

This tool available at sharebuilder.com, ‘What If I’d Invested’ demonstrates that for even an investment that hasn’t appreciated overall, you can still chart impressive gains due to reinvestment and adding money. This is the way to succeed investing, probably more important than raw returns.

As an example, take Coca-Cola (KO) stock, which as of this writing is about the same price it was 10 years ago. However, when I input a $1,000 initial investment that reinvests dividends, I get an overall total return of about 45% over 10 years. Not too bad for an investment that ‘didn’t go anywhere’. See the chart below that is generated from the tool:

 

Categories: Investing, Make Money Investing Tags:

Understanding Investment Income Tax Equivalence

September 2nd, 2011 No comments

If you have investments that earn income such as savings accounts, dividend stocks, bonds, and investment funds you will never pay more in taxes than what you earn at your job. In many cases you will pay less. This means that you get to keep more of what you earn. Sometimes, it is useful to compare investments based upon how much you actually keep after taxes.

Investments are taxed in different ways depending on what type it is. You might be surprised how much more you get to keep with your investments versus your income.

When it comes to investing, the primary considerations to determine which ones you pick will come down to the quality and attractiveness of them based upon their fundamentals. If you pick the right investments and buy them at attractive prices, you will make money. And then pay taxes. In the grand scheme of things, this is a good problem to have because it demonstrates that your investment strategy is working.

In this article, I talk about what you need to know to compare income investments on their tax equivalent investment yield, which is a calculated yield for comparison to a target investment. This investment yield will help you compare income investments because it takes into account taxes.

We answer the question: What return would a money market fund have to earn to equal the return of other investments after considering taxes?

Read more…

Categories: Investing, Taxes Tags:

How To Play Lorillard With A Put Option

March 5th, 2011 No comments

In this previous article, I talked about the investment opportunity in the stock, Lorillard, which is a tobacco company based in the U.S. If you are trading the stock, you only have a few options to take your position. You could buy the stock, or sell the stock short (this entails ‘borrowing’ the shares, selling them, then at some future point buying back the shares at a lower price to cover your borrowing).

Another way to play this company is to use options. Options are new for me, so the strategy that I will use is to consider simple one position options. Conceptually, it should be evident enough about what we are trying to do with the option (as I’ll explain), but as I’ve found sometimes the terminology about the transactions gets confusing. So, I will give it my best shot to describe this trade (as I am learning it as well).

The uncertainty in the Lorillard stock manifests itself as higher volatility in the options. Volatility is a typical expected large change in the stock price, or perhaps even the expectation that there could be a big change even if the stock price doesn’t typically have high volatility.

The risk for Lorillard is that the FDA could rule that menthol is to be banned as an additive to cigarettes. As I’ve talked about before, I think this is unlikely, but not out of the realm of possibility. So, the question is, if you are a big shareholder, how do you protect yourself from such a risk? One answer is to buy what’s called a Put Option. A Put Option enables the buyer to sell the stock at a set price (the ‘strike’ price) when the underlying stock price trades below the strike price.

As an example, let’s say Lorillard trades for $80/share. The shareholder wants to protect himself from potential downside by buying a Put Option with a strike price of $65. This means that if Lorillard trades below $65 during the life of the option he can always get $65. If catastrophe strikes he will always be able to sell for $65.

This is where we come in. Wherever there is a seller there must be a buyer. We are that buyer who will pay $65, if it ever came to that point. Here’s where the terminology gets tricky. Since the shareholder bought a Put, we will then become a Put Seller. If the Put goes ‘in the money’ at any point (the underlying stock price is below the strike price) we would be obligated to then buy the shares at the strike price. Yes, that’s right we sold a Put to become a buyer of the stock.

This trade has both downsides and upsides. Let’s consider them.

Downside And Risks

  1. By far the biggest risk is that the FDA rules that menthol should be banned, probably phased out over a time period. The advisory committee will offer a non binding recommendation in March 2011, which the FDA could then use or ignore. I would quantify this risk as 30-40 a share, given that any ruling (if it occurred during the life of the option) wouldn’t wipe out profits immediately but over time. So, we would be out perhaps as much as $20/share since we would be obligated to buy the shares.
  2. Another risk of this trade is opportunity cost of missed dividends. Let’s say nothing happens to impact the company, we would have lost dividend income (which is quite substantial for this company, almost 7%) because we don’t own any shares, just the option. A more complicated option strategy, a covered call, could accomplish the same thing while still collecting dividends.
  3. Finally, there is upside risk. Let’s say that the FDA rules that menthol is OK and no changes are required. The stock may go up $10-15, which we would not participate in since we don’t own any shares by taking this option position.

Upside And Profit

  1. The biggest upside to this trade is that we can earn a substantial option premium that we get to keep no matter what happens. If the likely scenario occurs (the ruling causes no big impact to profitablilty), then the option expires worthless and we keep the money. Because the Put Option buyer is paying a premium to get this protection, we earn money on the option by entering into the transaction. Because of the implied volatility of the option, this premium is substantial.
  2. Another possibility is that the market itself causes a sell off in the stock price unrelated to the issues facing this company. This is the best of all possibilities, because we can then own a great company for less money since the shares would be ‘put’ to us. Income investors get ahead buying cheaper, because investment yields go up.

Take This Put Position

This is the trade that I will be establishing, if I can get it at this price:

Sell Lorillard June 2011 Put, Strike Price: $65, Premium: $4.

This means that for each contract (100 shares), I will collect $400 in premium.

Categories: Investing Tags: