Flooding sucks, big time.  I know – I have experienced a flood first hand.  The flood water comes in and destroys everything.  It gets into your walls and soaks your drywall and insulation.  It all has to be torn out and replaced.  Wood flooring is destroyed, as is furniture.

Homeowner’s Insurance

But you are insured – you have homeowner’s insurance.  Right?  Wrong!  Homeowner’s insurance does not cover damage from flooding.  Rule of thumb:  If the damage is caused by water falling from the sky, then homeowner’s insurance covers it.  If the damage is caused by water coming up from the ground, homeowner’s insurance does not cover it.  But, you say, the cause of the water coming up from below is the rain falling from above.  Therefore, I’m covered, right?  Unfortunately, you are not covered.

Flood Insurance

To be insured for flood damage, you need flood insurance, which is only available through the Federal Government.  It is called the National Flood Insurance Program through FEMA.  If you live in a flood zone, or a flood-prone area, guess what?  You can’t get flood insurance, or it will be prohibitively expensive.  In short, you are:

Risk Avoidance

Let’s use the Texas flooding as a teachable moment.  Flooding is a risk.  (It’s also a hazard, but for the purposes of my blog, it’s a risk.)  The best way to address a risk such as flooding is to avoid it altogether.  For your housing, this means that you don’t live in a low-lying area that is prone to flooding.  If you do live in such an area, then live up – live on a higher floor of a high-rise, or raise your building so that your ground floor is higher.  If you live in Houston, it is difficult if not impossible to live on high ground.  If you live in California, as I do, then don’t live at sea level.  There are spectacular homes available near the beach or on the harbor, but if you want to avoid the chance of flooding, then don’t buy one.  If you live on higher ground, then your chances of enduring a flood will be much less.

Risk Transfer

Insurance is Risk Transfer.  Transfer means a third party (the insurer) undertakes the flooding risk.  FEMA provides the only available outlet for flood risk transfer, and it is prohibitive, or expensive, or both.  Also:  Insurance is not the same as Indemnity.  Indemnity means the insurer will reimburse the insured for 100% of the loss, or the insurer will replace the lost property with something that is identical.  With insurance, there is usually a deductible, and then there is either a dollar limit or a percentage limit after the deductible.

Self Insurance

Instead of paying premiums for flood insurance, take the premium money and put it into an account and invest it on your own.  It will grow over time and hopefully the flood hits later rather than sooner.  Go and get an actual flood insurance quote, and use that price quote as your goal.  Your price quote is based on the insurer’s actuarial tables.  If you actually do this, you could use the money for any natural disaster that might happen, not just a flood.  Pray that you are fortunate and no disaster befalls, and then you will have built up a nice nest egg.  Insurance premiums, once paid, are gone.  How many people self-insure?  Probably not that many, but it’s a good strategy if you have the discipline to keep putting in money every year and not withdraw it for any reason other than to pay for disaster recovery.

Risk Sharing

Most insurance policies of any type are a form of risk sharing.  Most medical insurance policies involve a deductible and then cost-splitting.  Same with property insurance.  Insurers understandably want policy holders to limit claims.  Therefore, they make sure the policy holder comes out-of-pocket, even to a small extent.

IMO

The main purpose of this blog is to show that Avoidance is the best way to handle flood risk.  Just don’t live in a flood-prone house.  This may be hard or even impossible to do, but if you are moving into a flood-prone area, then pay a premium and live on higher ground.  If you are moving to Houston, find a place that was not damaged by the Harvey flood.  Flooding is not the only natural disaster.  California is prone to forest or brush fires.  Don’t buy a house in an area you think might be in a fire zone.  Avoid the risk entirely.

The stock market has been more volatile lately.  The VIX volatility index, also known as the Fear Index, has traded as high as 17.2 earlier in August, after having traded as low as 9.4 in late July.  As I write this, the VIX is at about 12.3.  The source of this uptick in this volatility has been political and/or news headlines, both here in the US and overseas.  I think the fear of the worst related to these news stories is overblown, and I think investors need to “take a chill pill” and exhibit calm amidst these headlines.  Also, since we have been in a bull market since Wednesday, November 9, 2016, and since every bull market in the past has been followed by a correction, perhaps investors overall are just concerned that the bull run is over, or about to be over.  I believe we remain in a long-term uptrend and these mini-corrections based on scary headlines are opportunities to buy.  Let me go through some of these recent headlines:

• North Korea:  North Korea is not able to launch nuclear missiles that will hit Guam or any other US territory anytime soon.  Not gonna happen.  They don’t have the technology to do so and won’t anytime soon.  There is evidence out there that the “successful test” that the Norks “announced” early in August may have been a fraud.  This is what forced the VIX to 17.2.  Then, there was the media overreaction to President Trump’s “fire and fury” statement.  What did that even mean?  Trump and the Nork leader are acting like Batman and The Joker.  All political posturing and a lot of hot air on both sides.  The problem was that the media took it all seriously.
• Nazis:  The US is not being overrun by Nazis.  Nazi ideology is not permeating our politics.  No sane political leader in the US will provide any cover or acceptance for Nazis.
• The KKK:  Same with the KKK.  They are an extreme fringe group with ideas that are not growing and will not be mainstream anytime soon.  They were more mainstream a century ago.  Extremely sad chapter in American history.  Totally overblown by the media.
• Government Shutdown:  There is not going to be a government shutdown over raising the debt ceiling, building a wall on the Mexican border, or any other issue.  All we are seeing is political posturing played out in prime time.  With the 24-hour news cycle and many people more engaged than ever (and others less engaged than ever), the media focus on all of these issues is over the top.  Even if there is a government shutdown, it will be short term and will make no difference to publicly-traded companies.
• Trump’s Ineffectiveness:  Now this is an issue that may have some legs.  The bull market since 11/9/16 has been rooted in the notion that Trump’s economic agenda is expansionary and would be good for public companies.  Regulations would be relaxed, and that would be good for smaller companies, hence the over-performance of the smaller-cap Russell 2000 Index.  With the Obamacare repeal failed (at least for now), there is less investor confidence that Trump’s expansionary agenda, including tax cuts and/or tax reform, will be enacted.  We’ll see, but, again we are witnessing the political process in action, and it isn’t pretty to watch.

IMO

Instead of worrying about nuclear fallout or Confederate statues or the rights of neo-Nazis, let’s look at some positive news.  Corporate profits are up.  Interest rates are low and don’t appear to be going up anytime soon.  Fund flows continue to move into equities.  There is no follow-through to any of these mini-corrections.  This is not to say that I think the stock market will go up more.  It could very well hold steady or pull back some from its current level.  But I think that investors should keep all of these sensational headlines in perspective and keep a closer eye on market fundamentals, which are good right now.

In my earlier blog post about the Constant Dividend Growth Model of valuation, I stated that it was not a practical way to value your investments in the stock market because, as a small investor, you have no control over how the cash flow from the company is used.  I then stated that there is one renowned investor who does use the CDGM as a model and is able to pull it off.  Who is it?  Of course, it is the Sage of Omaha, Warren Buffet.

Control Premium

Mr. Buffet is able to make it work because he buys entire companies at once.  He usually pays all cash – no junk bond, financially-engineered deals for Mr. Buffet.  (When I say “he”, I mean his company, Berkshire Hathaway).  As a result, he appoints the company’s management, and he controls how the company’s cash flow is utilized.  Typically, the newly-acquired company becomes a subsidiary of Berkshire Hathaway.  This is what happened with a recent acquisition, Burlington Northern Santa Fe Railroad.

Ever notice that when news breaks that a company is being acquired, the stock price jumps up?  That is because the acquisition price announced is usually higher than the stock’s closing price the preceding day.  (Acquisition deals are usually made public when the stock market is closed – often over the weekend or Monday morning prior to market opening, or otherwise usually any morning prior to opening.)

The amount by which the stock moves up after announcement of a deal, or the difference between the closing price prior to acquisition and the acquisition price, is the Control Premium.  It is often 15% or more of the prior closing price.  It answers the question, “How much more (per share) would you pay for this company if you could control everything about it?”.   The flip side of the Control Premium is the Minority Discount – the amount less per share that a minority shareholder (i.e., you) pays than would a controlling owner.

Fishing

There is an entire genre of investing called Event Driven investing that seeks to profit on acquisition announcements.  Another pejorative name of this type of investor is a Corporate Raider.  Think of it as fishing.  Throw your hook in the water and wait for a fish to bite.  Throw many hooks in the water and wait for many fish to bite.  When one fish bites, reel it in, cook it up, and wait until the next bite.  The “fish” that you are eating in this case is the Control Premium.  Famous investors have made fortunes doing this.  Some of those famous investors have tried to rig the game by digging for information about companies who are in the process of being acquired but haven’t yet announced it.  This is called Insider Trading.  One of the most famous of the convicted insider traders/corporate raiders was Ivan Boesky, back in the 1980’s.  Maybe I am showing my age by resurrecting his name.  Boesky went to jail.  Not every “fisher” goes to jail.  Fishing (not “phishing”) for acquisition target, if done without the assistance of insider information, is a perfectly legal, legitimate investing strategy.

IMO

Stocks are very highly valued right now, according to historical metrics such as P/E Ratio.  Many of the Indexes are hitting all time highs.  When the market is at a high, there are fewer arguments that individual stocks are undervalued.  When there are few undervalued stocks, there are fewer acquisition deals.  Long way to say:  This is not a good market for those looking to fish and look to cash in control premiums.  Notice that Buffet himself has not made a lot of acquisitions lately.  Everything he would want to buy is too expensive.  No “margin of safety”.  That’s why acquirers of entire companies have to be long term investors.  They have to be patient and not bet the house on a new acquisition when prices are high.  They have to hold through ups and downs.

In my prior post, I discussed the Constant Dividend Growth Model.  In this post, I will discuss other valuation methods.  Are these others more in use or more practical than the Constant Dividend model?  Yes, they are more practical for private (i.e., not publicly-traded) investments, maybe less so for stock investing.

Discounted Cash Flow

Related to the Constant Dividend Growth Model is the Discounted Cash Flow (DCF) method.  In the DCF method, the modeler projects the investment’s cash flows, both outflows and inflows, over the entire cost of the full investment period.  Legions of financial analysts on Wall Street and in financial centers all over the country are intimately familiar with DCF modeling.  Microsoft Excel is the software king in this space.  How quickly one can model is a source of pride for these analysts, and it can result in strong raises and bonuses.

The modeler starts in Year 0 with the full cost of the acquisition of the investment.  That cell will be a negative number because it is cash outflow.  Subsequent Years will be either positive or negative, depending on whether the investment throws off cash flow or requires additional investment.  Finally, it is assumed the investment is sold at some point in the future.  That will be a positive cash flow to the owner.

All of these cash flows are mathematically discounted at some hoped-for return number.  Perhaps I should have previously had a post about the Time Value of Money, but suffice it to say that $100 3 years from now is not worth as much as $100 today because of inflation, opportunity cost, and other factors.  Hence, the discounting rate.  If you hope to earn 10% on this investment, then discount the cash flows by 10%.  If the resulting number after discounting at your required rate is a positive number, then you should make the investment.  If the resulting number is negative, then don’t make the investment, or negotiate the initial investment price down so that the resulting discounted number will be positive.

Internal Rate of Return

If the resulting number after the discounting exercise is Zero, then you have successfully calculated the investment’s Internal Rate of Return, or IRR.  Being able to calculate and then to communicate the IRR is a very important Financial skill.  It’s required in an elevator pitch – or in a handshake pitch.  As in, “I have an investment in a small plating business that’s a 13.4% IRR.  Are you interested?”  Or:  “My apartment building is 97% occupied with a 12.8% IRR.”  A great, quick way to communicate that something is a good investment.

Comparison Method

IRR’s from different projects can then be compared with one another to determine which is the best investment, at least on paper.  The Comparison Method has many forms, and it is probably the most used method of evaluation of investments.  Usually, you think of a real estate appraisal:  An appraiser compares the house you are interested in with others that have sold in the marketplace (i.e., comparables), and makes adjustments up or down depending on differences between the subject property with the comparables.  Likewise, you can compare the stock you are interested with others based on some metric such as the Price/Earnings Ratio (PE), or even maybe dividend yield.  Why should I invest in this investment when this other one over here is at a lower PE?  That question implies you are using the Comparison Method to evaluate your investment.

IMO

DCF or IRR-type methods are useful for private investments, but only somewhat.  Why only somewhat?  Because of the level of reliability of the assumptions in the cash flow model.  It is very difficult to model accurately the cash flows of an investment over the next several years.  There are too many variables and unknown unknowns (Rumsfeld) that could occur.  Additionally, as with the Constant Dividend Growth Model, the DCF/IRR is not as useful for investments in the stock market because you don’t have control over the use of the company’s cash flow.  The Comparison Method is more useful, but the main problem is, in any investment, What if the basis of comparison, i.e., your comparable, is wrongly valued or just plain wrong?  Then you are comparing where you may invest your own money with something that is wrong.  Conclusion:  It is difficult to value an investment and have a strong level of confidence that the valuation is valid.  You are always operating in the opaque.  That’s why making money through investing is difficult.

The Initial Public Offering (IPO) of Snap, Inc. (SNAP), the parent company of the Snapchat app, has been a disaster.  Here is its chart, as I write this:

All of those red candles are not good news.  In the parlance of our current President, this IPO was a Bad Deal.  The stock that was offered in the IPO had no voting rights.  The founding owners retained all voting rights.  What good is that?  Now that users are finding more and more alternatives to Snapchat, together with the no voting rights issue, SNAP has some major fundamental issues to overcome.  Its long term prospects do not look good.

First Investment

It is too bad because, at the time of the IPO, it was stated that a lot of Snapchat users, who were mostly young people, made SNAP their first investment in the stock market.  This experience will leave a bad taste in their mouths for future stock investing.  One can question their wisdom, but such was the story.  Those investors probably did not consult professionals prior to their purchase.

What To Do?

When one buys a stock that subsequently goes down, one’s impulse often is to hold tight and not sell.  This impulse reflects optimism in the future of this company and this investment – it’s a good thing to be optimistic.  It also reflects a sense that, if one sells something that has gone down, one is either not admitting one’s own mistakes, or not willing to recognize a loss, or both.  Even worse, one may be tempted to double down and buy more – If you liked SNAP at $22, you will love it at $14!  It is on sale!

Sell Your Losers

My rule is to sell positions that don’t work out.  If a position goes down 7% or more from the price you bought it at, sell it.  That’s a fast rule for me.  You don’t have to put in a Stop-Loss order, but you need to monitor your positions to make sure you don’t violate this rule.  By selling your losers, you are not admitting defeat.  Get over it!  Instead, you are living to fight another day.  The top movie currently playing is “Dunkirk”.  The evacuation of the Allied troops at Dunkirk was a major victory because it allowed the Allies to live to fight another day.  An evacuation as a victory?  Sounds like an oxymoron, but in the case of WW II, the Dunkirk evacuation was a victory.  Likewise, by selling your positions that are down 7% or more from your purchase price, you are living to invest another day.  All it means is that you bought the stock originally at the wrong price, and now is not the time to be owning it.  A precipitous decline may portend bigger problems in the company.  Losing 7% of your investment is painful but losing 100% is worse.

Long Road Back

The math is against you, as well.  If a stock goes down by 50% from your purchase price, how much does it thereafter have to appreciate before you get your money back, which is before any profit?  100%!  It has to double in price!  That’s a tough road to travel.  Losing stocks can decimate your portfolio returns.  It can be tough for one’s ego, but it is best to sell.

IMO

I am advocating anyone out there who has a position in SNAP that has declined 7% from their purchase price to sell it.  Anyone who has just bought in at the current lows:  Good luck to you!  Anyone for whom SNAP was their first stock investment:  I am sorry for your situation, but SNAP was a bad deal, and you can learn how to be a good investor by learning from this situation and selling your SNAP.

How do you value an investment, something that you are thinking about putting your own savings into?  What factors or variables do you need to know to determine a valuation?  This is the first of at least a two-part (and possibly more) blog post on valuation methodologies.  I hope to show you what the “textbook” methodologies are and how to make sense of them, and then to discuss what works in today’s market and what doesn’t work, and why.

Constant Dividend Growth Model

The most basic valuation equation is called the Constant Dividend Growth Model, which is as follows:

Value = Dividend/(Rate of Return – Growth)

Thus, you need to know the company’s or the investment’s dividend (for the next year) and the dividend’s projected growth rate, as well as the rate of return that you want to earn on this investment.  Does that mean you should look up a company’s dividend and use that as the numerator in the equation?  No, it doesn’t.  “Dividend” in this equation means all of the cash flow generated in the next year by this company or this investment.  Think about if you are looking at buying a 4 unit apartment building.  Let’s say you think you can get $1,000/month for those units, and that you think you can raise rents 2% per year.  In this case, your Revenues would be $1,000 times 4 times 12 months, or $48,000 per year.  However, you have to pay some operating expenses to achieve those rents, such as property management fee, property taxes, insurance, and repairs.  Do not include interest on a loan – that is a different category of expense.  Those operating expenses typically add up to 40% of revenues, so that your cash flow, or “Dividend”, to be used in the numerator of the equation, would be as follows:

Revenues:                                          $48,000
Expenses (40%):                                (19,200)
Cash Flow:                                         $28,800

So, $28,800 is your “Dividend” for the purposes of this equation.  Now let’s say you want to make 8% on this investment.  That means your denominator is 8 – (.6)2, or 6.8%.  Remember, if you think your rents will go up 2%, so will your expenses, and if you pocket 60% of your income, your true growth rate is 60% of 2%, or 1.2%.  That means you would pay $28,800 divided by .068, which is $423,529 for this entire 4 unit apartment project.

Why am I using an apartment building as an example?  Because the finance textbook says you should use the same equation if you buy a stock, and I think a 4 unit apartment building is easier to identify with than is an investment in a stock.  Remember:  When you buy stock in a company, that means you own that fractional percentage of the company.  It’s yours!  Same as when you buy 100% of an apartment building.  It’s yours!

Is it Practical?

Is the Constant Dividend Growth Model a practical way to go about figuring out what price you should pay for a stock?  No, it is not.  Why not?  Because, as an individual investor, purchasing a 100 or a 1,000 share lot of or interest in a company, you are not at all in control of all of the cash flow or even of your fractional percentage of cash flow from the company that you own.  The company’s management is in charge of determining how much cash flow the company will keep and how much it will distribute to the shareholders.  This is something called the Dividend Payout Ratio: the percentage of a company’s cash flow that gets paid out to its shareholders.  Currently the Dividend Payout Ratio for the S&P 500 is approximately 40%.  That means on average that S&P 500 (i.e. large) companies pay out 40% of the cash flow they earn to their shareholders and keep the other 60% and re-invest it back into the company, presumably to try to increase future cash flows.  You are a shareholder, but when it comes to deciding how to allocate cash flows, you are along for the ride.  Don’t like how management allocates its cash flows?  Talk to other shareholders and convince them to fire or vote out management.  Is that an easy thing to do?  No, it is very difficult.

Another reason the equation is not practical is because it is very difficult to determine what a company’s actual cash flow is.  This is because of accounting rules.  Things like depreciation, amortization, capital expenditures, and even taxes are governed by accounting rules that make it very difficult for the average investor who is not a CPA or finance professional to decipher.  This is one reason why you need the Stock Analyst.  It is partly the Stock Analyst’s job to calculate a company’s cash flow and to make a call up or down as to whether that cash flow is sustainable or not.

IMO

As with most equations or theories from academe, the Constant Dividend Growth Model is a good rule of thumb but not very practical, especially for the typical individual investor, because of the lack of control over the cash flows and opaque accounting rules.  Use it when you make a simple investment and you will control all of it.  Don’t rely on it if you are a minority shareholder.

Next posts will include discussion of a cousin of the Constant Dividend Growth Model called the Discounted Cash Flow Model, as well as a discussion of one prominent investor who does use these models, and why he is able to be successful using them.  I bet you can guess who that prominent investor is.

I have just been handed my next blog topic.  My wife and I have been trying to purchase a Long Term Care (LTC) insurance policy, and we have just been denied.  While we each take medications and each has had medical issues in the past, we both consider ourselves healthy.  I ride my road bike 40 miles per week or more and do some exercise most every day.  Before she hurt her shoulder, my wife swam, and she still enjoys her walks.  Neither of us is fast, but we are active.  Nevertheless, we have been told that we are Uninsurable.  We are both over 55 (but not yet 60!), so not ready to go into the Home just yet.  That’s a tough verdict to take.

Protect Your Assets

During my CFP® training, it was stressed that a client with some assets worth protecting and the ability and willingness to pay should purchase LTC insurance.  It is a form of Risk Transfer – the insurance company takes over the risk of potentially paying for your time in the nursing home, or for in-home care.  Costs are going Up!  Nursing (or assisted living) situations are quoted in terms of Cost Per Day, while in-home care is usually quoted as cost per hour.  Here in Orange County, California, a nursing home can easily cost $400/day, which is $12,000/month.  In-home care can easily cost $25/hour for a nurse, and maybe somewhat less for a qualified caregiver who is not a nurse.  If you don’t have insurance, then it is all out-of-pocket, after tax cost.  Do that math!  You save and scrimp your whole life so that you can retire in peace, only to have to spend it all on a caregiver or perhaps on a home.  Medicaid?  You do not want to go to a Medicaid home. In my opinion, care is poor, and the homes are there to just make you safe until you pass away, and to avoid lawsuits.  Don’t believe me?  Go and visit someone who is in a Medicaid facility, and ask yourself if that is what you want for your own future.  If you have any assets, you want to go to a Home of your choosing, or you want a home caregiver so you can stay in your own home until that is no longer possible.  And you want to do this without having to spend all of your money, so that your heirs might get something.  That’s why you buy LTC insurance.  Your choice:  Spend some money now (in the form of premiums) to buy coverage now, or spend a lot more later, once you need care or are in the Home.  Or really roll the dice and hope you will die not needing care – unlikely in this age of life-extending medicine.  Those are your choices – not really a rosy future as you get old.

Tough To Buy Insurance

Our case is certainly a one-off situation, but I think it may be consistent with the way the insurance market and economy are moving now.  The national news has been focused on health insurance, and how in many counties and states there are a dwindling number of insurers willing to write health coverage for individuals not associated with a company or group.  I think our situation shows that the case is the same for LTC insurance.  It is becoming more and more difficult to buy insurance.  I don’t think of my wife and me as high-risk purchasers.  Like I mentioned, we work hard and we live healthy, active lives, albeit with some (totally legal) chemical assistance.  Have you had a similar experience?  With LTC insurance or maybe with life insurance?  Please let me know – maybe it will help prove my notion that the entire insurance market of all types is tough now.

Full Disclosure

I have had sleep issues for most of my life, and I take medication to help me and I use a mouthguard to inhibit snoring.  It’s not pleasant not to sleep well, but I manage and plan my life accordingly.  During one of my doctor visits to discuss my sleep issues, possibly as part of a questionnaire, I mentioned that I sometimes have loss of memory associated with my insomnia.  Who wouldn’t?  Seems like a natural thing, especially as one gets older.  Well, according to my insurance agent, any mention of memory loss will almost always result in Denial of Coverage.  The agent says I could dispute the result and try to prove that I don’t have “memory loss”, which I don’t, but it will take a lot of my time and will be costly, and highly unlikely to succeed.  So did I sink my own ship by disclosing casually something that is natural?  Is there anyone out there who doesn’t have memory loss to some degree?  It sounds to me like the insurance company was looking for a reason to deny us.  It’s like if you get in a minor fender-bender car accident – do you report it to your insurance company, or do you just pay for the repair out-of-pocket so that your insurance premium doesn’t go up?

IMO

I still think LTC insurance is a good idea, but if you have had any health issues and you are on any continuing medications such as for high cholesterol or blood pressure, it may already be too late.  It is best, and may be only possible, to purchase LTC insurance while you are young and in tremendous shape.  Insurance companies like to insure situations where there is very little or no risk.  My wife and I are not that.  Act early, before you are even thinking about your needs as an old, sick person, because the window closes quickly.  For any LTC insurance agent, or any financial planner who lives on commissions generated by placing insurance policies:  Your business is rapidly changing, and not for the better.

I recently watched an episode of Flip or Flop?  The beautiful Tarek and Christina bought a broken-down house in coastal Palos Verdes, California, gutted it, and put it back on the market for sale at what would be a handsome profit.  Everybody who has plied a hammer or a screwdriver (not to mention a nail gun or a power saw) has at least thought about trying their hand at a house renovation and selling it to make money.  Tarek and Christina have turned everyone’s dream into a hit TV show.  During the episode I watched, Tarek and Christina did some things extremely wrong, but they did some things right, as well.  Here’s my take on each:

Wrong!

Cost Overruns:  They bought the house and started the project with a general budget in mind.  However, as is the case in 99.9% of home renovations, things cost more than they thought.  In this episode, for instance, they decided part way through to convert one of the bedrooms into a bathroom – and a very high-end bathroom at that.  Some finish pieces, including a pantry door that didn’t exactly work correctly, were added at the spur of the moment.   The best renovators follow the following playbook:  1) Know what you are going to do to renovate prior to buying the house;  2) Know how much it costs to do those renovations;  and 3) Do what you planned to do, and no more.  Ideally, the renovator will know what they want to sell the house for as well as what their renovation costs are and what their profit is before making an offer on the house, as the cost of the house is the “plug number” to make the rest of the equation work.  In this regard, they work backward.  Creating a renovation budget and sticking to it is essential especially when the for sale housing market is weak, or if the house is in an inferior location because there is no strong market to bail you out when you have overruns.

Time:  Tarek and Christina’s renovation took more than 6 months to complete.  Granted, it was a down-to-the-studs project, but 6 months plus is a long renovation.  The most cost-effective renovations take place lickety-split.  In real estate, time is money.  If they financed their purchase with a mortgage, then they pay more interest to the bank the longer the project goes on.  If they paid cash for the home (the more likely situation in this case), then the cost is Opportunity Cost: what they otherwise could have done with the money they sunk into this house.  If they had planned to rent renovated property, then they are losing rental income the longer the renovation goes on.

Right!

Location:  Their cost overruns and the time it took them to complete their renovation are mitigated by the high-end location of the property.  It is, after all, Palos Verdes, beautiful coastal Southern California.  At one point during the episode, Christina remarks that she knows she is overspending on this renovation and making changes they hadn’t planned on, but that Palos Verdes is a high-end market and that the market will support this level of renovation.  They understand their ultimate resale market and so they spend accordingly.  This isn’t always the case in real estate.  A lot of markets are really difficult.  Most people have heard the old saw:  The three most important things in real estate are location, location, and location.  It proved to be true in this episode of Flip or Flop?  (I don’t like it when the title of a book or a TV episode ends with a question mark!)

Know Your Contractors:  Tarek and Christina knew their general contractor very well.  Moreover, the GC knew his business very well.  He had a quick answer for each How Much Will This Cost question.  Of course, this was a TV show.  As a renovator, if you are not doing all of the renovations yourself (i.e., most renovators), you have to have a good relationship with and a very high level of trust in your contractor or contractors.  The contractors need to stay dedicated to the job.  Maybe you share some of the profits with the contractor?  Not a bad way to incentivize them.  The contractor will make or break the project and can bail you out if you hit a snag.

IMO

House renovations, if done correctly (that is a really big If!!), can be an excellent source of income or profits.  It can be done at any stage during someone’s life.  In fact, it is an excellent retirement activity for someone who is handy, or has a good eye, and can stick to a budget.  It is not physically strenuous (unless you are doing the work yourself, which is not advised), you can work as you please, and it keeps you mentally occupied.  The barriers to entry are minimal – mostly what you need is capital and some experience with buying and selling real estate.  Having Home Depot or Lowe’s nearby makes it easy to access the stuff you need to do the renovation.  The trick is picking the correct location and sticking to the pre-determined budget.

P.S.:  There have been volumes of books as well as seminar programs devoted to the subject of flipping real estate.  All of these really boil down to what I have written here in this blog post.  Then again, you get what you pay for, so, by all means, do further research if you are thinking about doing a house flip project.  Or just contact me.

Quick:  Whose profile is on a US Quarter?  That’s right – George Washington, the First President, the Father of Our Country.  My daughter just turned 25 years old – a quarter of a century.  She requested a cake that looked like a McDonald’s Quarter Pounder.  We contacted a local bakery and they made a great cake for her.  The “hamburger” part was chocolate cake, and the two “buns” were vanilla cake.  They even added frosting lettuce, tomatoes, cheese and pickles!  Here is a photo of it:

Quarterly Earnings

As I write this, it is quarterly earnings season and week.  Many of the big companies – Alphabet/Google, Facebook, Amazon – report 2nd quarter earnings this week.  GOOGL’s earnings were strong but maybe not what The Street was looking for.  Facebook’s earnings exceeded The Street’s expectations.  Amazon beat on Operating Cash Flow and Net Sales but still didn’t make a big profit.  Same old story for Amazon, but that’s good – see below!

The Street

When I (or someone on CNBC for that matter) mention The Street, what do I mean?  Mostly I mean analysts that cover the respective companies.  Analysts are usually (but not always) employed by the big brokerage firms.  Their job is to analyze corporate-provided financial data and to make projections of future sales, net income, and cash flow, as well as to label the company as a Buy, Hold or Sell, and to make a price target projection for the stock.  Since corporate financial reporting is becoming more opaque, and because companies are more and more limited as to what they can directly disclose and when they can disclose it (see: Sarbanes-Oxeley), being a Wall Street stock analyst is a very difficult job.  In addition to their own internal corporate accountability standards, analysts are graded each year by various financial publications including Barron’s.

Mainstream Media

Think of the Wall Street analyst brigade as the Mainstream Media of Wall Street.  Collectively they are the filter between corporate raw reporting and its consumption by the investing public.  Analysts report and then provide a “take” on the information companies dump out there.  Above all else, analysts want consistency.  They do not want to be surprised.  The best companies at the reportage game foster strong relationships with the analysts that cover them.  If the company/analyst relationship is adversarial, the company is sunk.  Surprises include both to the downside and to the upside, although of course upside surprises are more quickly forgiven.  Surprises mean the analyst looks bad.  Company performs well and works collaboratively with the analysts, and analyst rewards company with positive recommendations and a Buy rating.  That’s the way the game is played.

Too Much Emphasis?

In the past, there has been criticism by some in the financial media that there is too much emphasis on quarterly earnings in US markets.  If they have to focus too much on quarterly results, the argument goes, companies will be less able to execute long term strategies for growth.  Sometimes companies have to re-invest their earnings back into the company to the detriment of quarterly earnings.  Capital Expenditures and/or Research and Development costs may or may not have to be expensed, which affects quarterly earnings.  Japan, the criticism went, will win the day in the long term because their markets are more long-term focused and Japanese companies are therefore able to invest in products and technologies that will take a long time to develop but will own the future.  How has that criticism worked out?  Since The Bottom in March 2009, Nikkei (Japan) 225 Stock Index Future has risen from the high 7000’s (say 7800) its current value of 20040, which is an increase of about 157%.  Not bad!  The S&P 500 Index Future, at the same time, has risen from about 720 to 2471, which is an increase of 243%.  Much better!  At least since 2009, the US market, with its emphasis on quarterly earnings, has significantly outperformed.  So, one could say the criticism doesn’t hold weight.

Amazon

What about the criticism within the US itself that the emphasis on quarterly results prevents companies from investing in the future?  I give you the example of Amazon, which just reported its quarterly earnings this week.  Amazon has been around for 20 years as a public company, and to this day its emphasis is on Operating Cash Flow and Net Sales, and not on Earnings Per Share.  Amazon now does turn a profit, but that is a recent development.  Amazon has played the game correctly with its analysts.  Amazon has co-opted its analysts on its strategy that it will re-invest its cash flow back into its business, in an effort to grow its business and to dominate in all of its businesses.  Who would have guessed that the company that started out as mainly a book seller would become one of the world’s largest cloud computing providers through Amazon Web Services?  Amazon has been able to accomplish this because it satisfied its analysts (and, of course, the investing public) and got them all to accept that they would grow but maybe not earn any actual accounting profits.  A masterful job!

IMO

Markets enforce discipline on companies the way governments or other entities or institutions cannot.  Markets can be brutal – perform, or you’re out!  Quarterly earnings mean even more, closer discipline.  Only the strongest of the strong companies make it through the gauntlet of quarterly earnings and the level of information sharing needed to co-opt the analysts and the investing public.  No laggards allowed.  That’s one reason why the US markets are the most efficient, and the US economy is the most successful in the world.