On the morning of March 12, 2005 I had the blessing of making the acquaintance of Evan, a retired Detective with a knack for mentoring others about the stock market. I had no intention of learning anything new about the market that morning.   In fact, I was driving out east to purchase a Snow Blower Evan listed for sale on craigslist.org  

It's funny, I had read several books on the market. I had worked in financial institutions. Yet, despite the years spent reading and working, I learned far more valuable information on the morning I bought a used 2 stroke Toro snow blower from Evan than I ever expected.

Evan explained to me how he got involved in REITS. I had heard the term before, but I never really gave it much thought.  Evan also explained to me what he looks for before making a purchase. Although Evan is not a professional investor, his detective training and conservative approach to investing really piqued my interest. I began taking notes after he invited me inside to explain his system.  What I am sharing with you here is the overview of what he was kind enough to tell me.

First, Evan explained REITS.   A REIT is a company that buys, develops, manages and sells real estate assets. REITs allow participants to invest in a professionally-managed portfolio of real estate properties. REITs qualify as pass-through entities, companies who are able distribute the majority of income cash flows to investors without taxation at the corporate level (providing that certain conditions are met). As pass-through entities, whose main function is to pass profits on to investors, a REIT's business activities are generally restricted to generation of property rental income. Another major advantage of REIT investment is its liquidity (ease of liquidation of assets into cash), as compared to traditional private real estate ownership which are not very easy to liquidate. One reason for the liquid nature of REIT investments is that its shares are primarily traded on major exchanges, making it easier to buy and sell REIT assets/shares than to buy and sell properties in private markets.

I did some additional research and learned that the origins of the real estate investment trust, or REIT (pronounced "reet") date back to the 1880s. At that time, investors could avoid double taxation because trusts were not taxed at the corporate level if income was distributed to beneficiaries. This tax advantage, however, was reversed in the 1930s, and all passive investments were taxed first at the corporate level and later taxed as a part of individual incomes. Unlike stock and bond investment companies, REITs were unable to secure legislation to overturn the 1930 decision until 30 years later. Following WWII, the demand for real estate funds skyrocketed and President Eisenhower signed the 1960 real estate investment trust tax provision which reestablished the special tax considerations qualifying REITs as pass through entities (thus eliminating the double taxation). This law has remained relatively intact with minor improvements since its inception. REIT investment increased throughout the 1980s with the elimination of certain real estate tax shelters. Investments in real estate provided investors with income and appreciation.

The Tax Reform Act of 1986 allowed REITs to manage their properties directly, and in 1993 REIT investment barriers to pension funds were eliminated. This trend of reforms continued to increase the interest in and value of REIT investment. Today, there are over 300 publicly traded REITs operating in the United States their assets total over $300 billion. Approximately two-thirds of these trade on the national stock exchanges. In order for a corporation to qualify as a REIT and gain the advantages of being a pass-through entity free from taxation at the corporate level, it must comply with the following Internal Revenue Code provisions:

• Structured as Corporation, business trust, or similar association
• Managed by a board of directors or trustees
• Shares need to be fully transferable
• Minimum of 100 shareholders
• Pays dividends of at least 90 percent of REIT's taxable income
• No more than 50 percent of the shares can be held by five or fewer individuals during the last half of each taxable year
• At least 75 percent of total investment assets must be in real estate
• Derive at least 75 percent of gross income from rents or mortgage interest
• Have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries

 

For more info on REITS visit: REITS 101 Investopedia on REITS

Now that we have a better idea about REITS, let me share with you the rules Evan told me about basic conservative investing.

Evan's rules:

 1) Buy nothing new. That's right, you might miss out on the latest and greatest fad and you might kick yourself for being the biggest schmuck in the world, yet this is the best way not to get suckered by the claims pertaining to new cell phone devices, new gold mining methods, or some Nigerian Businessman that needs your checking account for political purposes. Basically, none of these have a track record, so you want nothing to do with it.

2) If it doesn't pay dividends, it's not worth buying.

3) You want to see reasonable earnings per share

4) Diversify, (Don't put all your money in one market sector). REITS might look nice, but don't put everything in them.

5) No wild P/E (see below for definition and explanation of P/E)

6) Pull the max chart and look for splits.

7)If P/E and E/PS are good, if the stock pays dividends, if it has a history of splits and a solid market capitalization, pull the max chart and place a ruler across it's current price horizontally. If the majority of the activity is taking place above the present date on your horizonal line, the stock might be showing a good buy sign for you to get in at a low. After all, history does tend to repeat itself.

The beauty of splits working with dividends is apparent to anyone who bought 1000 shares of Citicorp before 1987.

CITIGROUP INC (NYSE) Ticker (C) Last Trade: 47.79 Trade Time: Mar 11 Change: 0.36 (0.75%) Prev Close: 48.15 Open: 48.15 Bid: N/A Ask: N/A 1y Target Est: 57.03 Day's Range: 47.47 - 48.25 52wk Range: 42.10 - 52.88 Volume: 11,987,300 Avg Vol (3m): 13,134,136

 

Market Cap: 248.25B

P/E (ttm): 14.66

EPS (ttm): 3.26

Div & Yield: 1.76 (3.68%)

At that time, 1000 shares would have cost $11,000.00. at $11/share If the person who made that investment did nothing at all and just held it with the splits (noted by the triangles on the chart below)

Top 10 Critical Failings Of EBITDA 1. EBITDA ignores changes in working capital and overstates cash flow in periods of working capital growth. 2. It can be a misleading measure of liquidity (quick access to cash). 3. It doesn’t consider the amount of required reinvestment—especially for companies with short-lived assets, whether it’s cable equipment or trucks. 4. It says nothing about the quality of earnings. 5. It’s an inadequate stand-alone measure for a company’s acquisition multiples. 6. It ignores distinctions in the quality of cash flow resulting from differing accounting policies — not all revenues are cash. 7. It’s not a common denominator for cross-border accounting conventions. 8. It offers limited protection when used in indenture covenants. 9. It can drift from the realm of reality. 10. It’s not well-suited for the analysis of many industries because it ignores their unique attributes

 You can see the stock split 8 times:

1) 1000 shares become 2000 shares

2) 2000 shares become 4000 shares

3) 4000 shares become 8000 shares

4) 8000 shares become 16000 shares

5) 16000 shares become 32000 shares

6) 32000 shares become 64000 shares

7) 64000 shares become 128000 shares

8) 128000 shares become 256000 shares

If the stock remained at $11 during the splits, the value now would be $11 * 256,000 which = $2,816,000.00   So the wise investor of 11K turned that into 2 million? Nope, much more actually, because as you can see from the chart, the price went up to over 40. But we will use 40 for our illustration. 40 * 256,000 = $10,240,000 Not bad, huh? Yet there is an extra bone! They also pay Dividends of 3.68% (A dividend is the portion of a company's earnings distributed to shareholders, generally on a quarterly basis, paid in cash or additional shares of the company's stock.) Evan suggested using Dividends to purchase more of the same stock as this permits dollar cost averaging to help you over time and most brokerages won't charge for this.

(Dollar cost averaging is a technique designed to reduce market risk through the systematic purchase of securities at predetermined intervals and set amounts.)

P/E is shorthand for the ratio of a company's share price to its per-share earnings. For example, a P/E ratio of 10 means that the company has $1 of annual, per-share earnings for every $10 in share price. Earnings by definition are after all taxes etc. A company's P/E ratio is computed by dividing the current market price of one share of a company's stock by that company's per-share earnings. A company's per-share earnings are simply the company's after-tax profit divided by number of outstanding shares. For example, a company that earned $5M last year, with a million shares outstanding, had earnings per share of $5. If that company's stock currently sells for $50/share, it has a P/E of 10. Stated differently, at this price, investors are willing to pay $10 for every $1 of last year's earnings. Advertisement P/Es are traditionally computed with trailing earnings (earnings from the past 12 months, called a trailing P/E) but are sometimes computed with leading earnings (earnings projected for the upcoming 12-month period, called a leading P/E). Some analysts will exclude one-time gains or losses from a quarterly earnings report when computing this figure, others will include it. Adding to the confusion is the possibility of a late earnings report from a company; computation of a trailing P/E based on incomplete data is rather tricky. (I'm being polite; it's misleading, but that doesn't stop the brokerage houses from reporting something.) Even worse, some methods use so-called negative earnings (i.e., losses) to compute a negative P/E, while other methods define the P/E of a loss-making company to be zero. The many ways to compute a P/E may lead to wide variation in the reporting of a figure such as the "P/E for the S&P whatever." Worst of all, it's usually next to impossible to discover the method used to generate a particular P/E figure, chart, or report. Like other indicators, P/E is best viewed over time, looking for a trend. A company with a steadily increasing P/E is being viewed by the investment community as becoming more and more speculative. And of course a company's P/E ratio changes every day as the stock price fluctuates. The price/earnings ratio is commonly used as a tool for determining the value the market has placed on a common stock. A lot can be said about this little number, but in short, companies expected to grow and have higher earnings in the future should have a higher P/E than companies in decline. For example, if Amgen has a lot of products in the pipeline, I wouldn't mind paying a large multiple of its current earnings to buy the stock. It will have a large P/E. I am expecting it to grow quickly. PE is a much better comparison of the value of a stock than the price. A $10 stock with a PE of 40 is much more "expensive" than a $100 stock with a PE of 6. You are paying more for the $10 stock's future earnings stream. The $10 stock is probably a small company with an exciting product with few competitors. The $100 stock is probably pretty staid - maybe a buggy whip manufacturer. It's difficult to say whether a particular P/E is high or low, but there are a number of factors you should consider. First, a common rule of thumb for evaluating a company's share price is that a company's P/E ratio should be comparable to that company's growth rate. If the ratio is much higher, then the stock price is high compared to history; if much lower, then the stock price is low compared to history. Second, it's useful to look at the forward and historical earnings growth rate. For example, if a company has been growing at 10% per year over the past five years but has a P/E ratio of 75, then conventional wisdom would say that the shares are expensive. Third, it's important to consider the P/E ratio for the industry sector. For example, consumer products companies will probably have very different P/E ratios than internet service providers. Finally, a stock could have a high trailing-year P/E ratio, but if the earnings rise, at the end of the year it will have a low P/E after the new earnings report is released. Thus a stock with a low P/E ratio can accurately be said to be cheap only if the future-earnings P/E is low. If the trailing P/E is low, investors may be running from the stock and driving its price down, which only makes the stock look cheap.

Earnings Per Share EPS

The portion of a company's profit allocated to each outstanding share of common stock. Calculated as:

 

Companies usually use a weighted average number of shares outstanding over the reporting term. This is the single most popular variable in dictating a share's price. EPS indicates the profitability of a company. The diluted EPS means that the outstanding shares include any convertibles or warrants outstanding.
 

EPS manipulation might be the second oldest profession, but there is a relatively easy way for investors to protect themselves. This article will show you how to evaluate the quality of any kind of EPS, whether it's GAAP, pro forma, or otherwise.   Overview The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of Alice in Wonderland. Instead of Tweedle-dee and Tweedle-dum we have pro forma EPS and EBITDA. And, despite rumors to the contrary, the whisper number--the Cheshire Cat of Wall Street--continues to exist as guidance. To be fair, this situation cannot be totally blamed on management. Wall Street deserves as much blame due to its myopic focus on the near-term and knee-jerk reactions to one-cent “misses.” A forecast is always only a guess--nothing more, nothing less--but Wall Street often forgets this. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions. EPS Quality “High quality” EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated). I use the word “relatively” because while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done. A low-quality EPS number does not accurately portray what the company earned. GAAP EPS (earnings reported according to generally accepted accounting principals) may meet the letter of the law but may not truly reflect the earnings of the company. Sometimes GAAP requirements may be to blame for this discrepancy; other times it is due to choices made by management. In either case, a reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. How to Evaluate the Quality of EPS The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with the SEC. To determine earnings quality, I rely on operating cash flow. The company can show a positive earnings on the income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected. “Cash is king” is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long. Want proof? Just look at how many of the dotcom wonders survived! If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS, earnings are of a high quality because the company is generating more cash than is reported on the income statement. Reported (GAAP) earnings, therefore, understate the profitability of the company. If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what I feel are the “true” (cash) operating results. An Example Let's say that Behemoth Software (“BS” for short) reported that its GAAP EPS was $1.00. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock. However, if BS's operating cash flow per share were a negative $0.50, it would indicate that the company really lost $0.50 of cash per share versus the reported $1.00. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The $0.50 negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement. If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was $0.50 more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment. Trends Are Also Important Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends. It is possible that an entire industry may generate negative operating cash flow due to cyclical causes. Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth. Evaluating trends will also help you spot the worst case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. The appearance of growing GAAP EPS even thought the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP by analyzing the trend in debt levels, times interest earned, days sales outstanding, and inventory turnover. The Bottom Line Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. Luckily, it is relatively easy for investors to evaluate the situation.