Fifth Capital Management

Fifth Capital Management

Wednesday, April 9, 2014

Warning: If your Financial Adviser Diversifies to Reduce Risk, You're in Trouble!

What you are about to read may enlighten you. Or, if you are a savvy investor, what follows may re-enforce what you already know. However, if you strongly believe that diversifying is a way to reduce risk and practice the often-repeated phrase, “don’t put all your eggs into one basket”, then – not to be rude but – you may not want to continue beyond this sentence.

Well, you are still here. That is good, especially if you are under the influence of the “diversify to reduce risk” way of thinking. It’s sacrosanct to many in the investment industry and my statements below are iconoclastic. They go against the widely held belief that diversifying reduces risk and will, frankly, piss off many people.

However, knowing that you are continuing to read this shows that you want to discover a different perspective on diversification. It shows you care about your money, your future, and your loved ones futures.

You will learn why many financial advisers choose diversification as their main investment strategy along with two very important reasons why diversifying can increase investment risk.

Learning why diversification is not the ideal risk reduction method may prevent you from having below average returns, or in some instances, it may even protect you from massive financial losses. And I don’t want that to happen to you! So, please read on…

1. First Reason as to Why Diversification Can ‘INCREASE’ Investment Risk…

So, what is the first way that diversification can increase investment risk? In short the answer is: diversification is spreading money around with the hope that, in the end, money will be made. Diversification, more than likely, is due to a lack of knowledge and confidence in what to invest in properly. Without proper due diligence into what is bought in the diversification purchase and an awareness of impactful industry and economic developments, diversifying is the equivalent to throwing wild, unfocused and untimed punches in a fist-fight as opposed to covering up, bobbing, weaving, and feinting to test your opponent’s skills and wait for an opening where you will then direct a 100% calculated strike at the jaw line, scoring a knock-out. The former will drain your energy (and if you’re in poor shape, bankrupt it), and open you up to being hit or outright pummeled. Conversely, the latter puts you in a position to see an opportunity after closely observing your adversary. By studying what you’re going up against mindfully, you gain an understanding of how your opponent operates (Mr. Market) and can therefore capitalize on weaknesses and opportunities. 

Leaving this metaphor and jumping into the investment arena, analyzing investment choices closely, understanding how they move, and knowing what the influential factors are before investing in them gives you a much better chance of either avoiding a financial loss or scoring a massive gain, (i.e. a knockout, with just one investment.)

Diversifying without a lot of attention to influential details is a dangerous way to use investment money. You cannot diversify away risk because risk can’t be eliminated. Risk can only be exchanged, transferred or hedged.

Unfortunately, you may not have the time to devote to not only researching investment opportunities but also developing the analytical and business knowledge necessary to make prudent investment choices. If this is you, don’t feel bad. Surprisingly, many financial advisers (FA’s) suffer from lack of time as well.

Many FA’s are charged with bringing in new clients to help their investment firms gain wallet share. This is their main responsibility rather than making certain the money under their watch is in the most secure and best-positioned investments. This is not due to an inability to discern the best investment decision but rather due to simply not having enough time to gain the proper "know-how". They are under pressure to bring in new clients and retain the old ones. Choosing the best investments for his or her clients is not the priority. To save time, they diversify. However, as one investor stated, Diversification is protection against ignorance. It makes little sense if you know what you are doing”. That investor is Warren Buffett.

This lack of understanding can reduce the FA’s confidence to justify purchasing a specific security in a targeted asset class, such as in software technology. In this scenario, the FA relies on third party investment products and/or picks a diversified mutual fund or ETF to do the actual investing work. They distribute the investment money into a number of highly diversified vehicles to spread-out the risk. It also clearly illustrates that the FA lacks his or her own investment ideas.

If you have entrusted a financial adviser to invest your money, I urge you to learn how this person invests. If the FA is like the masses of others in the financial services world, third party diversification products is the number one way to invest.

This should concern you - Why? Because you gave your hard earned money to a financial adviser who’s main responsibility is to get your money into the coffers of his or her firm – not to make certain that your money is going into the best possible investment opportunity. The financial adviser is under pressure to produce. He or she usually has to meet sales targets to get as much money from people as fast as possible into his or her investment firm. Once the money is had, it is then put into investment products that are created and even managed by third parties – people that don’t work for the financial adviser’s firm.

So, you gave your money to your FA who then basically put it into an investment that was created by someone completely unrelated to the FA’s firm. Your FA basically outsourced your money!

Ideally, you want your FA to work at a firm that has its own investment ideas and investment products. You want your FA and the people in its firm to be diligently analyzing stock fundamentals, determining their intrinsic value, looking at technical indicators, and deciding if it is time to buy or sell.

You want your FA’s main responsibility and mindset to be to put your money in the best investment opportunities, rather than to get as many clients and money into the firm. To illustrate, this financial adviser follows say, a NASDAQ tech stock and is able to recognize its intraday, daily, weekly, and quarterly trading pattern as well as understand how its price is affected by micro and macro economic and industry specific events. This close analysis gives a much better probability to enter into an investment at the right time and know when it’s the right time to exit. Again, you want the focus of your financial adviser to be on getting the best return for the client – i.e. YOU – rather than on getting more clients. Does this sound selfish? Well, if your money is at risk, I encourage you to be very selfish and protective.

Also, you want your financial adviser to eat what they cook. That is to say, your financial adviser should be placing his or her money in the same investments that your capital is allocated to. It’s a very good test to learn if the financial adviser trusts his or her own investment advice. If the FA does not have his or her funds in the investments that you bought into, I have to ask: why would you invest in something that your adviser isn’t completely confident about?

This year, volatility in both the stock market and bond market is expected to continue. The damaging effects of the risk on/risk off trading environment sparked by the Fed's tapering will continue to leave investors on edge.  So its important to have an exit plan and be nimble in executing it.

The time-crunched FA will likely go with placing capital in a broad, lumbering, less understood diversified portfolio. It’s really the difference between a thoroughly researched and well-timed investment strategy and a spread out investment wager especially when the overall 2014 securities’ market environment is not brought into the investment decision process. This leads me to my next point.

2. The Second Reason as to Why Diversification Can INCREASE Investment Risk.

The second reason why diversifying can increase investment risk, especially when handled by that time-crunched financial adviser mentioned above, is thinking that diversification will protect against a massive loss if the overall economy and/or stock market tanks. This may minimize a loss. However, there will still be a loss. Its extent will depend on just how “well” diversified the investments are, of course, but that really equates to shuffling the chairs around on the deck of the Titanic. Everything will go down!

The “multiple egg basket” way of thinking pushes the belief that if you drop one basket, you won’t go hungry. However, there is deception with this because investment risk cannot be eliminated 100%. It can only be exchanged, transferred or hedged. With diversification, you are not limiting risk. You are exchanging it.

However, if one is closely in tune with the national and international economies and stock markets, along with what drives the behavior of specific securities, then these major downside market moves will most likely be seen in advance. From this vantage point, it’s easy to not only take defensive action, (i.e. exit susceptible investments, but also engage in offensive action via shorting the market, and/or stock(s), or hedging against potential drawdowns). However, the latter approach takes a lot of time and effort to pay attention to the global variables that influence placed-money that expects a return. And, in today’s investment environment, particularly the electronically traded one, being well informed and agile can certainly mean the difference between losing money and making money.

So, what I want you to learn from this brief investment note is: diversification is not the best risk reduction method available. And if diversification is done in place of careful analysis, then increased investment risk is the most likely outcome.

No forecasts can be guaranteed.

The views expressed are those of Fifth Capital Management and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

6 Steps to Choosing a Career

Monday, February 10, 2014

5 Steps to Value Intangible Assets

Let’s assume that Widget Corp., is a small company with stable residual income growth of 3% annually. Upon meeting with the CFO he provides you with the following figures: 

• Current Assets are $5,000,000 and current liabilities are $2,500,000. 

• Book value of fixed assets is $7,000,000, which is $1,000,000 less than fair value. 

• Free cash flow to the firm for the most recent 12 months is $900,000. 

• Required returns on working capital, fixed assets and intangibles are: 3.0%, 6.0% and 10.5%, respectively. 

• Weighted average cost of capital is 11.5%. 

As the analyst, you proceed in using the excess earnings method (EMM) to calculate the value of Widget’s intangible assets. The EEM estimates the earnings remaining after the required return on working capital and fixed assets is calculated and deducted. The EEM then capitalizes the residual earnings to obtain and estimate the value of the intangible assets. Here’s how it works: 

1. Determine the value of working capital and the fair value of fixed assets. Working capital equals: CA – CL = $2,500,000. The fair value of fixed assets is: $8,000,000. 

2. Estimate normalized earnings. Based on the information given, we can use FCFF of $900,000. 

3. Calculate the required returns on working capital and fixed assets from normalized earnings: $900,000 x 3% = $27,000 and $8,000,000 x 6% = $480,000, respectively. 

4. Estimate residual income by subtracting the required returns on working capital and fixed assets from normalized earnings: $900,000 - $27,000 - $480,000 = $393,000. 

5. Value the intangible assets by capitalizing the excess earnings using a growing perpetuity formula. The excess earnings are multiplied by the residual income growth rate to determine normalized earnings for the next period. Then, the next period earnings are capitalized by the required return for intangibles assets less the residual income growth rate. 

Here’s the calculation: 

$393,000(1+0.03) / (11.5% - 3%) = $4,762,235 (value of Intangibles)

Steps to calculate NPV of Venture Capital Investments

6 Steps to Choosing a Career

When it comes time to choosing a career path, many people often find themselves at a fork in the road. With so many options and decisions to make, the emotional side often clouds the realistic expectations of what lies ahead. In this brief tutorial, I will offer an outline that has worked consistently over the years to the benefit of those who’ve used it. I have personally used the formula with great success and today I’m going to share it with all: 

Step 1:

It’s hard to hit a target you can’t see. So, start with a vision of where you want to be in 5 years. What type of lifestyle do you envision living then? Be realistic! This is key because not all careers will allow you to live according to your dreams. Plus, a period of 5 years is measurable and most people can look ahead 5 years. If you can picture where you want to live, the type of car you want to be driving and the lifestyle in general you envision living, then you’re on track to making the following steps a lot easier. But it all starts with where you want to be in 5 years. You will surely arrive somewhere, the question is where?

Step 2:

How much money would it take to live the lifestyle that you’ve envisioned? Only you know that answer. For some it may be $50,000 a year while for others it may be $150,000. Whatever the figure is, write it down and be realistic!

Step 3:

How much could I potentially earn from my chosen profession in 5 years time? If you don’t have a clue then you’re headed for trouble. How can you position yourself in the market to maximize your potential? If you’re going to school to major in minors then you might want to start thinking about making ‘mid-course’ corrections to position yourself for the earnings power needed to command good pay. Remember, wages will make you a living; profits will make you a fortune. 

Step 4:

Find five people in varying capacities within your target profession and ask them a list of well-designed questions to help you gain knowledge about the profession. For example, if you plan to major in law, then realize that under the law umbrella there are many niches that one can specialize in. The same holds true for other professions. You may not be fit for being a trader, but could you do better as an analyst? But, how would you know unless you interviewed someone in practice? Only then will you understand the pros and cons of each niche. This is crucial in helping you chart the best path to take. And, after concluding your interviews, you may decide that not everything that shines is gold. This can save you countless hours in pursuit of a career that’s empty and meaningless.

Step 5: 

Quantify your education cost relative to your potential earnings power. Are you majoring in debt? The money invested in your education can be thought of as its “book value.” Now, to quantify this, you want the calculation to be accurate so you need to account for wages that were foregone during your time at school – assuming you didn’t work during college.

This step does not account for the important “non-economic” benefits of an education and focuses only on its economic value. 

To begin, you must first take an estimate of the potential earnings you can receive over your lifetime. Then subtract from that figure an estimate of what you would have earned had you lacked a college education. The difference will give you what’s called an “Excess earnings figure.” The ‘excess earnings figure’ must then be discounted, at an appropriate discount rate, back to graduation day. The result will equal the “Intrinsic economic value of your education.”

There are some people who will find that the ‘book value’ of their education exceeds its “Intrinsic economic value,” which means that you essentially overpaid for your education. On the flip-side, if your ‘intrinsic economic value’ far exceeds its ‘book value,’ then the result would prove that capital was spent wisely.

For example: Assume you enter college right out of high school. After 4 years, at age 22, you are ready to enter the work force. Assuming you love your job, you may end-up working 45 years until age 67. Let’s pretend your weighted average salary over the course of 45 years was $120,000 p/year. That translates to $5.4M in earnings over a lifetime. Now, let’s assume that the average weighed pay for a non-college grad over the same period was $40,000 p/year. The ‘excess earnings’ for a college grad would be $3.6M. Now, if you feel that the cost of your college education should yield you at least a 10% return on investment, then you can use 10% as your discount rate. The result would an “intrinsic economic value” of $49,389. This figure must then be compared to the cost of your education, plus the cost of your lost wages during the time you were in school.

For example: Assume the cost of a Bachelors degree is $35,000 p/year. Let’s say there’s 4 years till graduation. During those same 4 years, you could’ve worked and made an equivalent sum. The combined book value of your education is therefore $280,000 vs. $49,389 in ‘intrinsic economic value.’ 

The formula should be used as a template so you can plug-in your own numbers to customize the results. (The numbers above were used only for illustration purposes). 

Step 6:

Make a decision! The proceeding 5 steps are designed to help you make better career choices. We all know a variety of ways to make a living. What’s even more fascinating is figuring out ways to make a fortune. You have no idea how many people I’ve meet who’ve put the cart before the horse only to later find out that they hated their chosen profession. Sure, there many decisions involved when choosing one’s career. But at the end of the day it’s all about the “NET”. How much can you possibly earn to live a lifestyle consistent with you dreams? I hope the steps I’ve outlined will serve to guide and bring you closer in the direction of your dreams.

Warning: if your financial adviser....

Steps to calculate the NPV of Venture Capital Investments

Let’s pretend you’re approached by a group of tech-savvy guys who have just completed product development, organized their operations, and now need additional capital to begin production and sales. The company’s management is asking you to consider a $4.5 million investment. How would you proceed? How do you determine if the investment merits your time and money? 

When you start putting pencil to paper you estimate that the company will be ready for IPO in 3 years, which would permit you to exit the investment with $31 million. 

Feeling the excitement of this newfound opportunity you begin to estimate the probability of success in each of the next 3 years: 60%, 75% and 90%, respectively. 

If investments with similar risk profiles require a 23% discount rate, how would you calculate the expected net present value of the investment? 

Here are the steps: 
The initial investment is $4.5 million. The probability of success after three years is: (.60)(.75)(.90) = 40.5%. Therefore, the probability of failure is: 1- .405 = 59.5%. 

The NPV of success can therefore be calculated as follows: 

NPVsuccess = Terminal Value/(1+r)t – Initial Investment 

--------- - $4.5 = $12.16 million 
(1.23)3*  *(raised to 3) 

Keep in mind that if the project fails the $4.5 million is lost. 

The expected overall NPV can then be calculated as follow: 

E(NPV) = [NPVsuccess x P(Success)] + [NPVfailure x P(Failure)] 

= $12.16(.405) - $4.5(.595) = $2.25 million 

This step would then be combined with any due diligence needed to further evaluate the project. The figures used above are only for illustration purposes and should not be relied on for investment decisions. The process and formula can be used to evaluate a variety of projects requiring an NPV decision.

5 Steps to Value Intangible Assets