Diversification is one of the most important and fundamental tools that a value investor can use to their advantage. For investors that do not have the time to actively manage their investments, it is probably best for them to simply buy into ETF or index funds that track the S&P 500 and the bond market. Their allocation into these funds should be based on their risk tolerance and expected return based on their appetite for risk.
For investors that are interested in managing their own portfolios, diversifying is a great way to reduce risk and raise the return on a portfolio. When we start building a portfolio, we need to keep in mind a couple of things. The first is our risk tolerance. Limiting our exposure to risk will allow us to preserve our capital. Capital preservation is one of the foundations to building wealth. The next step is to think through the purpose of our portfolio. Are we going to invest for a long or short term period (retirement or next year)? Are we trying to simply grow the portfolio’s value or do we want our portfolio to generate income? How does the portfolio increase our net worth? Its always important to think about how we want out portfolio to serve us in particular, and to be realistic in our expectations. Next we need to add assets to our portfolio, and these assets must be targeted in accordance with the purpose of our portfolio.
At this point, the task of building a portfolio is very daunting. Different assets have very different characteristics, and very different returns. We would now need to weed out the investments that would add value to us compared to the ones that wouldn’t. In order to do this, we would use a very simple investment tool, and that’s the net present value of an asset.
Net Present Value (NPV) is simply the difference between the present value of the cash inflows of an asset and the present value of its cash outflows. We discount the assets cash flows since the value of money in the future is less than its value today because of inflation. The discount rate that we use is the expected return of the asset. If we don’t know an asset’s expected return, we could use the expected return of another asset with a similar level of risk. NPV is used by many businesses when determining which projects to invest in and by investors to decide which investments should be pursued.
Assets that have positive NPV are those that add value to us. Assets with negative NPV should be disregarded. NPV is pretty flexible, and can be used by investors that invest primarily in growth stocks that do not pay dividends. I personally would rather invest in companies that pay dividends, and I think it would be very difficult to truly guess the future selling price of the growth company when calculating NPV. Calculating the future sale price of any asset is difficult, but receiving dividends allows me to regain and reinvest capital into more income producing assets.
The overall idea is to add assets that meet our objectives and add value. For this example, I’ll use a stock in my portfolio to show how it works. This is simply a simple analysis and shouldn’t be taken as investment advice or the only way to value companies. This is just a primer as well as a way to weed out assets that do not bring us value. Let’s look at Realty Income, ticker symbol O.
Realty Income owns, manages and leases commercial real estate. A portion of the income generated through its long term lease agreements with commercial tenants is paid to its shareholders in the form of dividends every month. You can buy a share of O for about $45 dollars today, and since intraday trading fluctuates rapidly, we’ll use $45 as the price you’d pay as a cash outflow. We will then discount the cash flows of the future dividends over a five year period. I usually like to hold my investments for a longer period of time as well as add to the portfolio monthly, but that’s beyond the scope of this article. We don’t know what the future dividends of O will be, but they have been increasing at a compound annual growth rate (CAGR) of about 5% for the past 20 years. We’ll use this years dividend of $2.194 and increase it each year by 2.5% to be a little bit more conservative in our estimates. We get 2.194 for 2014, 2.249 for 2015, 2.305 for 2016, 2.362 for 2017 and 2.421 for 2018. Our last step is trying to figure out the price we would be able to sell O in 2018. Prices of stocks fluctuate for many different reasons, some have nothing to do with the performance of the company. Let’s be a little optimistic and say that O is going to return 4% annually from its price today of $45, which leaves us with a 2018 price of $54.74, nearing its 2013 high. We would then use a discount rate of 9% which is about the average return of the overall market. I'm using the average overall return of the market, instead of the return of a REIT index, because we do have more options to invest in than other REITs. We can always just buy the S&P 500 index. When we calculate the NPV for this 5 year period, we actually get -3.428. This would tell us that at a price of $45, O is a little overvalued and wouldn’t be worth pursuing as an investment opportunity. I could always adjust my assumptions in order to justify my pick in O, or to make its NPV positive, but I’ll simply say my outlook is over a 20 year investing period. For anyone investing for 5 years of less, O may not be the right addition to your portfolio.
Disclosure: I am long O