Any discussion on the appropriateness of any “investment” strategy should start with a discussion on the important differences between investing versus speculating. Although these are radically different concepts, it is all too common in finance jargon to ubiquitously reference all financial activity as investing, even when speculating would be the more precise term. I believe it is vitally important for people to understand the distinctions between investing and speculating, and it’s even more important to be cognizant of which you are engaging in.
However, before I dig deeper into the subject, I want to be clear that being precise with defining investing or speculating does not automatically imply a good versus bad value judgment. When it comes to allocating capital both concepts can be successfully profitable, or not. Great fortunes have been made and lost by both true investors and true speculators. Furthermore, both investing and speculating activities can be intelligently or unintelligently engaged in.
Moreover, some of the distinctions that differentiate investing with speculating are subtle in nature, while others are more distinct. Unfortunately, the scope of this article cannot facilitate delving into all the subtleties that differentiate these two financial concepts. Therefore, this article will only discuss two of the most important elements that differentiate investors from speculators. The first relates to the objective timeframe or holding time, and the second relates to what the person is focusing on.
True investing implies the objective of a long-term allocation of capital. In contrast, speculating tends to be more short-term oriented. In line with the timeframe differential is what the person focuses on. The shorter term orientation of the speculator requires them to be very price focused. In contrast, the longer term orientation of the investor directs them towards focusing on the fundamentals of the business behind the stock. Ben Graham summarized this nicely in his seminal book “Security Analysis” in chapter 4 titled “Distinctions between Investment and Speculation” where he offers the following definition of investment:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
This brief introduction on the differences between investment and speculation provides a backdrop and foundation for the primary thesis of this article suggesting that market timing is not appropriate for retired investors. Market timing is a strategy that is both short-term oriented and price focused. Therefore, market timing falls into the category of speculative activity.
My personal view is that retired investors are no longer working for their money; instead, they are required to have their money working for them. Consequently, I believe it is more prudent for those in retirement to focus on investing more and speculating less. This is not to say that retired investors should not speculate at all, but it is to say that the majority of their capital allocations are best based on sound and prudent investing strategies.
Fundamental Based Value Investing Is Not Market Timing
My personal but anecdotal experience suggests to me that a large number of people focus solely on price when judging past, present or future investment performance. Consequently, people that focus exclusively on price and price movement are analogous to the proverbial man with a hammer who sees everything as a nail. Since these people typically see nothing but price, every investment strategy - no matter how fundamental it may be - is automatically considered a form of market timing in their mind’s eye.
My position was supported as a result of numerous comments in my most recent article “How Much Bond Duration Could You Endure?” where I was accused of market timing bonds, even though I never made such a reference. This instigated a lot of discussion on market timing bonds where I was falsely accused of promoting it, and thankfully defended by other comments pointing out that I was not attempting to market time bonds.
So this article was, to a great extent, inspired by what I consider to be an off-topic discussion in the comment thread of my previous article. However, it can also be looked at as a follow-up article allowing me to elaborate more on what I was discussing in my previous article referenced above. Moreover, what follows ties into my discussion about investing versus speculating presented in my introduction.
Sound fundamental investing strategies are fundamentally (no pun intended) conducted devoid of any forecasts about near or even intermediate-term price actions. To be clear, sound fundamental investing implies focusing on the intrinsic values or true worth aspects of what an investment under consideration offers. At its core, sound fundamental investing is first about determining the current return on your invested capital that a given investment offers.
Fundamental Valuation of Bonds (Fixed Income)
When evaluating fixed income instruments such as bonds, this determination is simple and straightforward. This is true because bonds are, by their nature, simple investments to analyze. A bond has a par value, also known as the face value, which is simply the denomination they are issued in. Bonds are typically issued in face values of $1,000 or increments such as $10,000, etc. Bonds are also issued in various maturities ranging from a few months to 30 years or longer. Bonds offer a specific periodic interest payment or coupon that the bondholder receives over the life of the bond.
For example, a current 10-year Treasury bond has a 2.32% coupon. Therefore, if you invest $10,000, you will receive precisely $232 each year for 10 years for a total of $2,320 and get your original $10,000 back at maturity in nominal dollars. An investment cannot be any simpler than that. However, Treasury bonds are also liquid, which simply means you can sell them at any time prior to maturity.
But liquidity implies volatility with bond prices, just as liquidity provides volatility with any other investment - including stocks. In other words, over time a previously issued bond can sell for a premium or a discount to its par value depending on what has occurred with interest rates in the interim. If new 10-year bonds are issued at higher coupon rates, previously issued 10-year bonds will sell at a discount and vice versa. This again relates to the simplicity of bond investing. Changes in interest rates are the primary driver of any potential changes in bond prices or values.
The only real complexity that comes into play is what many bond advocates refer to as duration. Here is a definition and explanation of duration presented by PIMCO a recognized leader in bond investing:
“Duration: The Most Common Measure of Bond Risk
Duration is the most commonly used measure of risk in bond investing. Duration incorporates a bond's yield, coupon, final maturity and call features into one number, expressed in years, that indicates how price-sensitive a bond or portfolio is to changes in interest rates.
There are a number of ways to calculate duration, but the generic term generally refers to effective duration, defined as the approximate percentage change in a security’s price that will result from a 100-basis-point change in its yield. For example, the price of a bond with an effective duration of two years will rise (fall) two percent for every one percent decrease (increase) in its yield, and the price of a five-year duration bond will rise (fall) five percent for a one percent decrease (increase) in its yield. Because interest rates directly affect bond yields, the longer a bond’s duration, the more sensitive its price is to changes in interest rates.”
At first glance the above definition of duration may appear complex, therefore, allow me to attempt to simplify bond principles for you. Since bonds are issued for a specific timeframe with a specific coupon, I will again emphatically state that bonds are simple. If you bought a 10-year bond 5 years ago, you effectively now own a 5-year bond because that is when your bond will mature.
Consequently, your originally 10-year bond now has a “duration” of only 5 years left until it matures at par value. Therefore, it will be priced higher or lower than par value based on the current coupon rate offered on a newly issued 5-year bond. Therefore, the yield to maturity on your now 5-year bond will be more or less than its original coupon rate, depending on whether it is trading at a premium (interest rates have fallen) or a discount (interest rates have risen) to anyone that you might sell your bond to.
The primary point that I am attempting to convey is that conducting a fundamental analysis of a bond is not only simple; it is absolutely not a form of market timing. In my previous article referenced above I stated that I am currently avoiding investing in bonds because of the low level of interest that they currently offer. My position is based on a simple fundamental reality that bonds do not offer an adequate enough return on my invested capital to currently interest me. That is my primary level of fundamental bond analysis.
However, there is the added risk of bond prices potentially falling if interest rates do rise. The PIMCO quote above addresses and quantifies that risk. But again, that is not a form of market timing, it is a form of fundamental analysis driven by the possibility that if I bought bonds today, I might need to sell them before they mature. But most importantly, when interest rates were higher and bonds produced greater interest income than the dividend income available from stocks, I routinely invested in them to meet income objectives and risk tolerances. In other words, and in the spirit of what I presented in my introduction, when I did choose bonds, I invested in them (held to maturity), I never speculated in them (traded bonds).
At this point, I will again state that bonds are simple based on what I articulated above. However, in all fairness to bonds, there are many different types of bonds with each possessing different risk characteristics. In other words, the simple principles articulated above apply to all bonds, however, when considering bonds there are other factors that can come into play. Fellow seeking Alpha Author Adam Aloisi recently penned an article titled “How Much Bond Duration SHOULD You Endure?”
I believe, although I am not sure, that some of his article was written in order to rebut what I presented in my previous article. Nevertheless, he presented a concise explanation of many of the other factors to consider when evaluating bonds as follows:
“When a bond is analyzed, the investor should be taking issuer credit, time to maturity, tax repercussions, and call risk, amongst other variables, into account. Just like stocks, some bonds represent a higher level of risk/reward relative to others. It's impossible to paint a wide brush here…
A 30-year investment grade bond possesses a much different risk profile than a 3-year junk bond, just as a zero-coupon 20-year insured muni. has different risk compared to a 2-year non-rated corporate. An investor who has an already well laddered, diversified bond portfolio can approach future purchases with markedly different risk perception than someone who is considering a bond for the first time.”
I will conclude this section of the article by repeating what I have previously and emphatically stated and emphasized about bonds. They are simple investments that I believe are best evaluated based on the easily calculable return on invested capital that they offer. This is simply the coupon or interest rate that they offer at the time of consideration on new bonds, and yield to maturity on existing previously issued bonds. This further implies that bonds should be invested in and not speculated in. At their core, they are primarily predictable income producers and not capital appreciation or total return producers.
Fundamental Stock Analysis Is Not Market Timing
Just as I did with fixed income above, I am now going to address the undeniable principle that fundamental stock analysis is not market timing. This again relates to my discussion about the difference between investing versus speculating presented in my introduction. Therefore, I will start this section by presenting the definition of market timing according to Wikipedia, and then provide contrasting arguments supporting my contention that fundamental analysis is not a form of market timing:
“Wikipedia definition of market timing:
Market timing is the strategy of making buy or sell decisions of financial assets (often stocks ) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market, rather than for a particular financial asset.”
Since I believe in investing over speculating, my first argument that differentiates fundamental investing versus market timing relates to my sell philosophy. Since it is my strategy to conduct thorough fundamental analysis on any stock under consideration, my intention is to find high quality fairly valued companies that I can own indefinitely (ideally forever).
Therefore, my focus is solely on the buy side. My primary goal is to become a partner/shareholder/owner of a wonderful and profitable business. In other words, I never buy the stock, I invest in the underlying business, with no intention or desire to trade. How can I be “timing the market” when I have no intention of ever selling? There is always the possibility that future circumstances might cause me to initiate a sell, but that is not my objective when I initially make the investment.
Another fact that differentiates my fundamental approach with market timing is that the majority of my analysis is conducted devoid of any price consideration. Stated more plainly, price is typically the last thing I look at. And more importantly, I only bring it into the equation to determine one simple fact. Does the valuation (price) that I must pay in order to purchase my ownership in the business offer me an adequate and attractive enough current return on my invested capital?
I do this with no forecasts regarding what the stock’s price action might do, especially in the near-term future. Stated differently, does the fundamental value of the business represent an attractive earnings or cash flow yield at current market price (valuation)? In order to articulate this more fully, I will present PepsiCo (PEP) as one example of a blue-chip dividend growth company where I will illustrate the fundamental process that I typically conduct.
To be clear, I am not going to present a comprehensive detail of my typical fundamental analysis. Instead, my objective is to illustrate the fundamental process that I go through which I believe clearly supports the fact that fundamental value investing is not a form of market timing.
PepsiCo Fundamental Investing Process
To argue my case I present the following two F.A.S.T. Graphs™ on PepsiCo where I first look at earnings and dividends only, followed by looking at cash flow and dividends only. The primary point behind these graphs is that prices are not included. When I designed the F.A.S.T. Graphs™ research tool, I purposely included the function of eliminating stock price from the graph.
I did this because I like to start out by evaluating the important fundamental metrics of earnings, cash flows and dividends, as these are the metrics that are most likely to support and provide me an adequate return on my invested capital that I desire. At this point stock prices can be a nerve-racking distraction, therefore, I find it more rational to analyze the business without the biases that stock price brings.
When I look at PepsiCo based on earnings and dividends, I see a paragon of consistency. Earnings growth has been very steady with only the occasional flattening (the orange line on the graph). Dividends (the honeydew or white colored line) have been even more consistent and have increased each and every year. The payout ratio has also been both generous and consistent over time. This tells me that management is committed to providing shareholders a reliable and growing dividend.
When I look at PepsiCo based on cash flows and dividends, I discover an almost identical result as I saw when I examined earnings and dividends. This is important because PepsiCo is one of those high-quality blue-chip dividend Aristocrats/Champions whose appeal is often based on dividend yield and dividend growth.
As a result, PepsiCo is the type of dividend growth stock that often commands a premium valuation based on earnings. However, although dividends are often thought of as the percentage of earnings paid out to shareholders, cash flow is an important metric for ascertaining the company’s ability to maintain its dividend record. This will become clearer later when I bring stock price into the equation on both the earnings and the cash flow graphs.
PepsiCo’s Balance Sheet
Once I have established a clear record of earnings, cash flows and dividends, I will then turn to an examination of the company’s balance sheet. The following FUN Graph presents PepsiCo’s entire balance sheet over the past five years. Note that there is no price contamination or data when viewing the company’s balance sheet. Since market timing is price oriented, examining a company’s balance sheet cannot be attributed to a form of market timing.
The metrics displayed on the graph are:
- assets per share (atps)
- cash and equivalents per share (cashps)
- common equity or book value per share (ceps)
- debt long-term per share (dltps)
- debt per share (dtps)
- invested capital per share (icaptps)
PepsiCo’s Cash Flow Statement
Since dividends are supported by cash flows next I will typically turn to the company’s cash flow statement after I’ve examined its balance sheet. Pepsi’s cash flows clearly support the company’s dividend policy. And once again, there is no price data to contaminate or bias the analysis.
The metrics displayed on the graph are:
- capital expenditures per share (capxps)
- cash flow per share (cflps)
- dividends declared per share (dvxps)
- dividends paid per share (dvpps)
- levered free cash flow per share (lfcflps)
PepsiCo’s Income Statement
To complete my review of PepsiCo’s financial statements, I then turn my attention to the company’s income statement. Once again, there is no price data to contaminate or bias my analysis. I am continuing to only evaluate the company’s fundamentals. There is no market timing involved.
The metrics displayed on the graph are:
- basic earnings per share (epsb)
- cost of goods sold per share (cogsps)
- depreciation and amortization per share (dpps)
- diluted earnings per share (epsd)
- normalized basic earnings per share (epsnb)
- normalized diluted earnings per share (epsnd)
- operating earnings per share (opeps)
- revenue per share (revps)
PepsiCo’s Profitability and Returns
Once I have thoroughly examined the company’s financials I like to look at its profitability and returns. Therefore, I am continuing to evaluate the business behind the stock without any stock price distractions. Sound fundamental value investing is about buying the business instead of the stock, which is clearly not market timing.
The metrics displayed on the graph are:
- gross profit margin (gpm)
- net profit margin (npm)
- return on assets (roa)
- return on equity (roe)
- return on invested capital (roi)
PepsiCo’s Share Buybacks
Since dividends and share buybacks are two common indicators of the shareholder friendly nature of a company’s management, I will usually look at common shares outstanding (csho). PepsiCo shares have been moderately decreasing over the past five years. This supports profitability (EPS) and dividend growth.
Price Relative to Fundamentals the Last Thing I Look At
Finally, once I’ve completed a comprehensive fundamental analysis of the business behind the stock, I will then bring stock price into the equation. However, my primary purpose at this point is to assess valuation. What first strikes me about the PepsiCo earnings and price correlated graph is the premium valuation as referenced by the dark blue normal P/E ratio line.
With the exception of the Great Recession and a few years immediately following it, PepsiCo has been typically awarded a quality premium valuation by the market. On that basis, the company appears moderately overvalued or arguably fully valued at this time. This is my first valuation assessment and the value of finally bringing price into the analysis.
As I previously indicated, earnings and cash flows will be the primary drivers of long-term shareholder returns. Therefore, I always take advantage of all the analytical horsepower that the F.A.S.T. Graphs™ research tool provides. For most companies the earnings and price correlation is very reflective of fair value. However, when looking at many of the highest quality blue-chip dividend growth stocks, the price and cash flow correlation is often more revealing. That is clearly the case with the blue-chip dividend growth stock PepsiCo. PepsiCo’s stock price and its cash flows are highly correlated and, therefore, clearly reveal periods of fair valuation, overvaluation and undervaluation. On the basis of cash flows, PepsiCo appears moderately undervalued.
Before I invest in any company, I like to have a definitive expectation of what my potential returns might be. However, I do not consider that a form of market timing. Instead, I am calculating my future return potential based on my expectation of future fundamentals growth coupled with the market appropriately valuing that growth. In the case of PepsiCo, near-term analyst estimates would indicate a total annualized rate of return in excess of 9% out to fiscal year-end 2016. This is not market timing, it’s calculating fundamental value potential.
Finally, I will evaluate forecasting calculators in order to discover what analysts think future earnings and cash flows might be over the next few years. In the example below, I am examining consensus analyst estimates for PepsiCo’s cash flow growth out to fiscal year-end 2017 and calculating the return potential it might offer.
Summary and Conclusions
I do believe that retired investors should manage their retirement portfolios more prudently since they are no longer earning a paycheck. To me this implies positioning themselves as investors, as I described above. Market timing is a speculative activity, and as such, I believe it should be avoided by retired investors.
Additionally, I take this position because I also believe that timing the market is impossible to consistently do. Occasionally, the speculator might time the market correctly, but when they do it is more a matter of chance than skill. In contrast, sound fundamental analysis is a more prudent and proven long-term strategy. But most importantly, sound fundamental analysis can be conducted within the confines of time-tested business and accounting principles.
Disclosure: Long PEP at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.