How to determine if the trend is your friend


I was on the hunt for some interesting insights in to the current market and using momentum or contrarian strategies for clients .  Lawrence Lam of Lumenary Investment Management writes in this guest blog that it not always a case of either or but a combination.

At a recent lunch with another fund manager I found myself engaged in a discussion about the state of the current market.

‘From your perspective, are you seeing many good opportunities?’ I asked.

‘I’m seeing good companies, but prices are toppy,’ he said, wincing before continuing. ‘More than I’d like to pay. But we’ve recently deployed more anyway.’ He shrugged his shoulders, ‘Momentum in the market is strong – the fed is decreasing rates. Despite the high prices, we wouldn’t want to miss this momentum.’

I nodded as we both acknowledged this unique investment environment. Decreasing rates, high stock valuations, yet stock prices that have continued to climb steadily.

Walking back to my office I reflected. ‘Is now a good time to be a momentum investor? Or is it time to go against the herd?’

Harness the power of momentum or be a contrarian?

 It’s a dichotomy faced by all investors, but it isn’t a binary decision. Your portfolio can be made up of both momentum and contrarian investments. So the question becomes: how can we determine the optimal proportion of holdings between momentum and contrarian?

Are you seeing the full picture?

Momentum investors have much to gain if the wave of popularity is caught early. However, be the last one to the party and you will be left with all the cleaning up. The real question is: how much more of the wave is left to catch? The solution to this contradiction can be found by understanding the long-term context.

The ratio of a company’s stock price-to-intrinsic value tells us how much the market is willing to pay for the company. It’s a useful measurement of sentiment at one point in time. There’s a clear link between sentiment (the stock price) versus fundamental value (intrinsic value).

But it doesn’t give us the full picture. To understand this contradiction, we need to see how sentiment for the stock has changed over a significant period of time – over entire market cycles. Extend the ratio of stock price-to-intrinsic value over a 15 year horizon and you’ll now gain a multi-dimensional view of just how manic-depressive Mr Market is.

As an example, here is the change in sentiment for the founder-led aerospace electronics company HEICO Corporation.

 

During the GFC, Mr Market was very pessimistic. He was only willing to pay 1.8x the intrinsic value of HEICO. But alas Mr Market is as fickle as they come. More recently, he has been very bullish. He’s willing to pay 4.8x intrinsic value. A large proportion of the returns have been driven solely by the company’s increasing popularity with investors.

Now we have a better view of the context. Understanding the stock price and intrinsic value over a long time period equips us to answer the following question…

 

Is the party getting started or is it about to end?

There’s an interesting observation about parties. When do they end?

Answer? They end when the alcohol runs out. Rarely do they end immediately though. Good times roll on for a while longer before the sudden realisation hits the sobering crowd.

So when is the worst time to join a party?

As you’re pondering the answer, here is another view of HEICO to illustrate the point.

 

Although the intrinsic value of HEICO’s business has consistently increased over time, the increase in it’s price has far outpaced the fundamental growth of the company. HEICO is a solid and growing company, but its impressive performance has been driven primarily by sentiment and price, rather than actual business value. The price-to-intrinsic value ratio shows this.

Risk is heightened when a company’s stock price outpaces its intrinsic value for significant periods of time. As crazy as Mr Market is, one thing is certain – his enthusiasm and pessimism never last forever. The gravitational pull of a company’s fundamental value is unrelenting.

The best time to join a party is when there’s plenty of alcohol and not too many people. But tread carefully when there crowd is pumping and booze is running low. Whilst the fun may continue for a while longer yet, the risk of an abrupt ending is heightened.

A ‘reasonable’ price

Pure momentum investing focuses predominantly on the historical price movement and pays little attention to actual fundamental value. But if you want to understand if a trend is justified, the fundamentals are critical.

Armed with this insight, we can make a judgement call on what a ‘reasonable’ price would be and whether we should join the party. Some sectors run hot. Today, technology is a classic example. But a strong trend shouldn’t be a deterrent. Prices may seem exorbitant, but in the context of the company’s historical sentiment, sometimes the high price is worth paying. What may seem expensive on an absolute basis may be reasonable in the context of history. For example, the price-to-intrinsic value of Facebook was high on an absolute basis in late 2018, but was reasonable when compared to its history. It has proven to be a good entry point so far.

But there’s more for enterprising investors – the picture is still not yet complete.

A deeper level of analysis

Competition

You may have noticed my focus on individual company analysis rather than broad-based economic generalisations. We are buying slices of companies after all. Whilst we can understand the sentiment in our target company, it is also important to have context across other comparable companies. The same price-to-intrinsic value historical ratio across a few companies will give us a sense of sentiment across the sector. We’ll be able to see if there are any other reasonably priced companies.

Potential growth

So far the focus has been on gaining historical context. Sometimes the momentum is justified if there are tangible growth prospects. In other words, intrinsic value is expected to grow significantly with price. In those situations, the trend may be your friend. For those that heard me speak at the AIA National Conference, I outlined my framework to assess the potential growth of a company.

Intrinsic value

Speculators focus on stock price movements only. Investors focus on the underlying true worth of a company.

As Warren Buffett says “Price is what you pay, value is what you get”.

The fundamentals of a company’s value is reflected in its Intrinsic value. Importantly, in determining a company’s intrinsic value, I’ve stripped out accounting distortions that may hide a company’s true worth.

Closing remarks

Is the trend your friend?

If the fundamentals of a company are sound and the price is reasonable in the context of its history and other competitors, then the trend may indeed be an ally. Ride the wave and enjoy the party.

Price and intrinsic value may deviate for many years but price will eventually move towards intrinsic value over the long-term. Seeing the full picture is key to capturing sensible opportunities. In every party, everyone sobers eventually.

Happy compounding.

Note:

Stocks mentioned have been used as examples only. They are not recommendations to buy or sell.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

 

The SMSF Coach is in no way connected to Lawrence Lam of Lumenary Investment Management and we do not receive referral fees or commissions of any sort from them. This is purely general advice and market commentary from a trusted source and you should seek personalised financial advice before making any investment decision.

Looking for an adviser that will keep you up to date and provide guidance and tips like in this blog? Then why now contact me at our Castle Hill or Windsor office in Northwest Sydney to arrange a one on one consultation. Just click the Schedule Now button up on the left to find the appointment options. Do it! Make 2019 the year to get organised or it will be 2029 before you know it.

Please consider passing on this article to family or friends. Pay it forward!

Liam Shorte B.Bus SSA™ AFP

Financial Planner & SMSF Specialist Advisor™

SMSF Specialist Adviser 

 Follow SMSFCoach on Twitter Liam Shorte on Linkedin NextGen Wealth on Facebook   

Verante Financial Planning

Tel: 02 98941844, Mobile: 0413 936 299

PO Box 6002 BHBC, Baulkham Hills NSW 2153

5/15 Terminus St. Castle Hill NSW 2154

Corporate Authorised Representative of Viridian Select Pty Ltd ABN 41 621 447 345, AFSL 51572

This information has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation and needs. This website provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

 

Why you should make loans to your children not gift them money


I am always on the look out for interesting tips for clients and while this may not necessarily be SMSF related, many of my readers are also wish to help their children with money for house deposits, education funds or other ad-hoc expenses .  I read the blogs from Dr. Brett Davies at Legal Consolidated regularly and found them very informative and excellent guidance so, with his permission, I am “paying it forward” again!

In his blog Parents making loans to children he discusses why smart parents use loan agreements to protect the family wealth. Here is the detailed article and video he prepared.

Parents making loans to children

Sad parents

Mum and dad give their daughter, Joanne $400,000 to buy a house. She then marries Ken. Ten years later Joanne and Ken divorce. The house is still worth $400,000. It is the only asset of the marriage. The Family Court awards $200,000 to Ken. The Family Court is not interested that the money was a gift from Joanne’s mum and dad. Instead, loans to children are safer.

Smart parents

Mum and dad lend $400,000 to their daughter, Joanne. Joanne signs a legally prepared Loan Agreement built on Legal Consolidated’s website. Joanne purchases a house with the money. She marries Ken. Ten years later they divorce. The house is still worth $400,000. It is the only asset. The Family Court is shown the Loan Agreement. The Family Court orders that Ken gets nothing. This is because the assets of the marriage are nil.

To protect your loan build a legally prepared Loan Agreement – on a law firm’s website. Homemade loan agreements may not work. They carry less weight with the Family Court and Bankruptcy Court. Why take the risk?

But I love my children

There is nothing wrong with helping our children financially. It could be for their first car, grandchildren school fees, a holiday or a property. Today it is becoming more popular to help out our children with a home deposit, but simply giving away the money has real risks. It is important to protect the money in case:

  1. they divorce
  2. go bankrupt

  3. suffer from drugs
  4. suffer a mental condition
  5. stop loving you – ‘King Lear’ offers his daughters his Kingdom for the return of their love, but after they promptly abandon him
  6. you run out of money yourself, in your old age

loans to children

 

Documenting loans to children

Never ‘give’ your children money. Always ‘lend’ them money ‘payable on demand’. Get it back if something goes wrong. Treat yourself like you are a bank, and your children are taking out a loan.

Creating a loan agreement not only protects your own interests but also benefits the child as you can decide in the future to forgive the loan while you are alive or in your Will.

With loans to children, never rely on a verbal agreement. Press the Build button and build a Loan Agreement on our website. We are Australia’s only law firm website providing legal documents online. It puts everything in writing with rules about the loan.

Any tax issues?

There are no tax issues. The interest rate for the loan is ‘as advised by the Lender’. Therefore, while the interest rate is zero you have no income tax issues. If the child separates you can increase the interest rate to draw more money out of the failed relationship. There is less money for the Family Court to give to your ex-in-law.

A loan isn’t always for property and the grandchildren’s school fees. You can also fund the children’s Superannuation fund. Speak to your Financial Planner and Accountant.

At different times, it is common to benefit one child over another with money. If you benefit one child over another then it is adjusted automatically at the time of your death. Say you lend one child $500k and the other child $300k then that is adjusted at your death. So it is all fair again.

When making loans to children:

  1. talk with all your children together about the loans
  2. never gift children money – only loan them money (this protects both you and them).
  • don’t rely on home-made loans or IOUs – build a Loan Agreement

  •  

    loan agreement legal consolidated brett davies lawyers

    Can I just do a Loan Agreement on the back of an envelope?

    In the movies, IOUs are often handwritten on a piece of paper. Sometimes instead of a Loan Agreement, someone does a ‘minute’. Both approaches fail. In Rowntree v FCT [2018] FCA 182 shows the additional care required to document even simple related-party transactions, such as loans. In this case, the taxpayer, a practising NSW lawyer, claimed he borrowed over $4m from his group of private companies. The Court said:

    ‘Mr Rowntree has not deliberately chosen to ignore the law. His evidence presented to the Tribunal suggests that he genuinely believed that there were arguments to support his view that a loan was in existence.’

    He failed. Only a legally prepared Loan Agreement satisfies the ATO, Bankruptcy Courts and Family Court.

    Cheeky son refuses to pay Dad back

    In Berghan v Berghan [2017] QCA 236 the son borrows money from his Queensland aged father. The son refuses to pay it back.

    The son, in the first court case, successfully argues that the monies were given to him as a gift.  However, the Court of Appeal held that the amounts were loans.

    Portrait of an ungrateful childchild loan agreement

    The son’s company suffers financial stress.  The son gets $98k from this Dad. The boy continues to borrow more money from dad.

    Later, the son borrows his father’s credit card. The boy clocks up another $13k of debt.

    The First court case

    His Honour said that Dad failed to prove a legal binding agreement. There was no paperwork. There was no written loan agreement.  It was a gift.

    The Judge said:

    • The son promised to look after his Dad in old age. But that was just a moral obligation.
    • Dad is making the payments to the son, for the benefit of the company, was simply discharging his parental obligations. This is because their daughter was an employee at the son’s company.  The money was therefore of a charitable nature. Dad was protecting the son’s company so his daughter would keep her job.
    • Dad allowed his boy to use the credit card when the boy was injured and impecunious.  These circumstances are charitable.

    Good sense prevails in the Appeal

    The Court of Appeal had a better sense:

    • The lengthy period it took Dad to make a demand for the money does not count against his assertion that a breach of contract existed. The Court held post-contractual conduct is not taken into account when interpreting the terms of a contract.
    • The motive Dad had in transferring his son the money, be it “charitable” or otherwise, was not relevant.

    The Court set aside the decision of the District Court.  The Court said that the monies were paid with an understanding that they would be repaid. This was an “inescapable conclusion”. The transactions were a contract of loan. The Court gave judgement in favour of Dad of $286,000 including interest.

    This is another example of elder abuse. The decision shows the perils of not signing a loan agreement. Going to Court – twice in this instance – was expensive and exhausting for the aging father.

    What happens if your child has a partner and buys a home?

    What if your child has a partner? The loan agreement may change depending on whose name the home is purchased under. Best that your child signs the Loan Agreement and buys the home just in their name. This binds your child alone, and the partner has no say in the matter. What if the partner objects? It is important to stay firm and explain it is ‘to protect your interests, it is nothing personal’. This protects yourself and your child, if the relationship with the partner does not end up ‘happily ever after’.

    What happens if the home is purchased in both your child and their partner’s name? Then both your child and their partner sign the Loan Agreement. Our Loan Agreements allows the loan to be lodged as a caveat. Or our Loan Agreement can be registered as a second mortgage – but the bank is notified. So caveats are more common.

    Visit Parents making loans to children  to start the process or seek legal advice form your own Solicitor.

    We are in no way connected to Legal Consolidated, we do not receive referral fees or commissions of any sort from them. This is purely general advice from a trusted source and you should seek legal advice form them or your own solicitor before making any decision.

    Looking for an adviser that will keep you up to date and provide guidance and tips like in this blog? Then why now contact me at our Castle Hill or Windsor office in Northwest Sydney to arrange a one on one consultation. Just click the Schedule Now button up on the left to find the appointment options. Do it! Make 2019 the year to get organised or it will be 2029 before you know it.

    Please consider passing on this article to family or friends. Pay it forward!

    Liam Shorte B.Bus SSA™ AFP

    Financial Planner & SMSF Specialist Advisor™

    SMSF Specialist Adviser 

     Follow SMSFCoach on Twitter Liam Shorte on Linkedin NextGen Wealth on Facebook   

    Verante Financial Planning

    Tel: 02 98941844, Mobile: 0413 936 299

    PO Box 6002 BHBC, Baulkham Hills NSW 2153

    5/15 Terminus St. Castle Hill NSW 2154

    Corporate Authorised Representative of Viridian Select Pty Ltd ABN 41 621 447 345, AFSL 51572

    This information has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation and needs. This website provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

     

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