Daily Bitesize: The value today of a dividend tomorrow part II

In part one of this series of valuing dividends we looked at a simple Dividend Discount Model to understand the current share price of TeliaSonera, a telecommunications company that pays out a high dividend yield.

The assumptions required in this model, assured dividend payout and known dividend growth to eternity make this model in my eyes just slightly limited in its application! How can you seriously predict the dividend growth to infinity?? The less said about a company (or even the universe) existing for infinite amount of time the better!

Clearly we need to shorten the timeline....and dramatically. There are some ways around this but of course these modified models introduce their own assumptions. One way is to predict the dividends just a few years out, say for example 3 years, and then sell the stock at a predetermined price.

We then discount the sum of these dividends and the proceeds of stock sale at a certain discount rate. This is driven by the risk of investment and partly judgemental. Would I prefer $100 today or $105 next year? Perhaps then $110?

In the example below I have chosen 9%, for simplicities sake let's just say I like my money and the number nine! You are welcome to choose a higher or lower value, that's the beauty of the markets.

In example one (yellow) we have a 2.85 kr dividend being paid out for three years (i.e. no growth) and then sell the stock at today's price of 48kr. The sum of those pay outs and sale is discounted to give a present value. So for example the year 1 dividend is worth 2.85/1.09^1 which is 2.61kr, the year 2 dividend is 2.85/1.09^2= 2.40 and so forth.

As you can see the total price in today's money is 44kr, around 8% less than the current price. The second example (blue) has the dividend growing 5% each year but that doesn't really change the valuation at 45kr. Clearly over this relatively short period of time it is the selling price which drives the value.

As you can imagine one can modify the growth rate, discount rate and selling price ad ifinitum until you get a price you wish. The last example shows what selling price would be required in combination with 5% dividend growth and 9% discount rate i.e. 53kr to get a present value of around 48kr per share. This is now around 10% above the current market price.

Who knows what the future holds for TeliaSonera, maybe it will raise it's dividend in the near future, maybe it won't. If you value the company solely on its dividend and ignore other ways it may create value such as additional cash flow, reinvestment etc then it doesn't look a screaming buy.

However, let's change our mindset regarding this trade. We could be an optimist and conclude the stock may just be reasonably valued based on it's dividend and has upside potential as anything else it may produce would be a bonus.

The Horseman of Inflation

"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens."- John Maynard Keynes

Here is a summary of what I learnt from the second chapter of William Bernstein's book 'Deep Risk: How History Informs Portfolio Design'

The list does not contain all the key facts from the book only those that were new or interesting to me.

• Curiously only 7 countries have had a combination of high long term equity returns (> 1% real, capital only) and tolerable inflation (<5%): US, Canada, Denmark, Netherlands, Noway, Switzerland and Sweden.
• Brazil had an annual inflation of 148% between 1947 and 1996!
• Severe and persistent inflation seems to reduce equity returns yet it does not always savage them e.g. Chile had 31% annual inflation 1927-1996 (508 million-fold rise in prices....mindboggling!!) but real equity returns were still 2.99% per year.
• Stocks suffer short term to inflation but protect against it in the long term, hence stocks add short term shallow risk but protect wealth over longer periods.
• Bonds in those nations with lowest trailing inflation had the lowest returns, whereas bonds in countries with the highest trailing inflation had the highest returns.
• It is surprises to the upside in inflation that decrease prices and damages bonds. (It is this point that really highlights for me the potential fragility and risks in the current bond market if/when inflation occurs).
• One possible strategy would be to wait a few years after inflation has kicked in and then jump in by buying bonds.
• A well diversified portfolio of international stocks is likely a good hedge against the deep risk of inflation.

The Four Horsemen

"Go to bed smarter than when you woke up." - Charlie Munger

Any new book by Bill Bernstein is a must read for me

'Deep Risks: How History Informs Portfolio Design' by William Bernstein

This is an excellent guide that takes a step back and looks at the bigger long term picture of investing and wealth building/protection.

Below is a list of what I've personally learnt so far or has tweaked my interest from reading the first chapter.

• The four deep risks: Inflation, Deflation, Confiscation and Devestation
• Capital managed in the long term (>30 years) should be guided by deep risk.
• Discipline (e.g portfolio re-balancing), cash and courage which act against short term shallow risk, do not mitigate deep risks.
• An example of a deep long term risk: Japanese large caps lost -58.2% from 1990-2013
• Historical studies show gold protects poorly against inflation, in fact performs better in deflationary periods.
• Harry Browne's permanent portfolio is flawed as it equally weighs the probabilties of prosperity (shares), inflation (gold), deflation (long bonds) and 'tight money' ( T-Bills) equally as well as their consequences and costs.
• Deflation less likely historically than inflation which savages bond returns.
• From 1941 to Sept 1981 (an inflationary period) US bonds lost 67.3% of real value (interest reinvested).
• Hence, bonds are an expensive insurance against the relatively unlikely long term outcome of deflation.

Daily Bitesize: Simple yet effective

Was amazed to see Avanza Zero is the fourth best performing Swedish equity fund from the past 5 years. It's a simple index fund (SIX30RX) that buys the top 30 traded companies, plus has no fees! So simple yet so effective.

I also plan to write about some simple strategies that have been shown to increase returns in these type of index funds.

Daily Bitesize: The value today of a dividend tomorrow

'Price is what you pay. Value is what you get'-Warren Buffett

When buying a dividend paying stock it's prudent to know if you are getting value for your hard earned cash. Pay too much and it could take many years, if at all, to get your money back.

One very simple way of valuing an income stream from a dividend is the 

Dividend Discount Model DDM.

The discount rate is a measure of how highly you value your money today and is connected to the risk of the investment. The more precious your money and the higher the risk of the company/dividend then the higher the discount rate.

For example the 'risk free' discount rate would be 10-year government bond as you are certain to get your money back at the end (we'll ignore inflation at the moment!). Due to the risks associated with a companies stock the discount rate would be some percentage points above this, around 5%, give or take a few points.

TeliaSonera is a Sweden based telecommunications company, most countries have them and as is the case with these companies it pays out a high dividend of 6%, 2.85kr. It's the most owned stock by Swedes and has a pay-out ratio of around 62%, so returns a significant amount of its profits back to shareholders in the form of dividends.

We will try to value its stock price purely by its dividend and the cash flow it provides, as if it were a perpetual bond. Below is a table of valuations based on the equation above using different inputs for the discount rate and dividend growth rate.

Ignore the purple areas, that is where the calculation breaks down as the discount rate must always be higher than the growth rate (it's one of the limitations of the calculation). I've highlighted in green the combinations that closely match the current stock price of 47.8kr.

At one extreme we have TeliaSonera being evaluated by the market as having no dividend growth with a fairly low discount rate of 6%. As the growth rate increases then so can the discount rate to compensate for any extra risk.

It should be noted the Telia's dividend has grown since the lows of 2008 but is still below 2005 levels. That's a rear view analysis of the dividend and doesn't really tell us what will happen in the future.

So there you go, the share price doesn't seem extremely overvalued based on the simple dividend discount model but is a little bit too rich for my tastes. Certainly no bargain.

This valuation does assume however that the dividend will be paid out for an infinite period of time and as we all know the saying goes, 'in the long run we are all dead'!

More valuations coming in future parts.

Mr Market: EM gets the cold shoulder

Let's take a quick look at which markets are most out of favour by Mr Market. Below is a table of the top 10 losing funds from the past 3-months (Source: Avanza)

We see big losses in the emerging market countries of Indonesia, India and Turkey. A deeper look reveals painful 40% falls since the highs of May. We must remember of course these markets may have moved from being overvalued to being reasonably valued.

As investors though what we really want to know is, are they are buy yet? Have they moved too far to the down side giving upside opportunity?

Without digging into valuations such as CAPE but looking purely % drawdowns at least 60'% may be a good time to buy in order to get good 3-year returns (Mebane Faber analysis).

That would imply another 30% drop from where we are now! Think about what that would really require in fortitude to buy an EM fund cut in half and act against 'end of the world' discussions in the news feeds. 

Today's Bitesize: Sweden & Taiwan

I must admit I was taken slightly aback today when reading the following report
 'Want Diversification? Invest in Sweden' by Morningstar UK. It grabbed my attention as it not only covered portfolio diversification but also mentioned Sweden in particular.

Well.....take a look at the the following graphic. It shows which stock markets are mostly correlated over 13-week periods the past 10 years. A blue line is a positive correlation and a red line a negative correlation.






Yes, that's right, Swedish equities positively correlate with the Taiwan market! Very strange but not only that, there has been a negative correlation with the US stock market. Sweden (along with the UK) seem to stand out from other European equities.

This is good news for diversifying your portfolio and provides an extra reason to assign Swedish equities their own allocation in your portfolio.

Remember: Correlations can change and what may have been true the past 10 years may not continue going forward.

Blog Reactivated & Rebooted

It's been a while since my last blog entry but the siren call became too difficult to resist, so I'm excited to say I've decided to reactivate and reboot this blog!
I'll probably redesign and reorganise things but as a start I've added to two new pages named 'Wall of Worry' and 'Mr Market'.

The 'Wall of Worry' is admittedly a slightly tongue-in-cheek look at the ever ongoing worries in the market. It's a simple list of reasons to be fearful and not invest but has a serious point. There will always be something to be worried about, that you can be sure of! Looking at this list I hope will put it all into perspective and help us to release it is a never ending and intrinsic part of the markets.

For those of you who have read 'The Intelligent Investor', Mr Market will be familiar to you. The difficult question is how do we really know what he is feeling and thinking? How do we take advantage of his mood swings? It is always obvious with hindsight but more difficult to gauge in the moment. This page may point us in the right direction and highlight possible opportunities.