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Why Do Fundamentals Matter?

With a booming market, everyone forgets fundamentals. Someone, the other day, told me that “You don’t need profits to pay bills” when talking about Amazon. If that’s not a sign of euphoria and not understanding how wealth is built, I don’t know what is. The reason fundamentals matter in the long run is that wealth is built on cash flow, profit, and overall returns. Yes, a company can profit but if you’re paying too much for that profit, it’s going to hurt you in the long run because there will be a time when your investment is out of style and everyone will revert back to fundamentals. It happens in every bear market. People flee the exciting fast growing stocks that aren’t doing as well financially to go to companies that generate cash flow and build their balance sheet. Not only in stocks. Real estate as well. The last 15 years have been a boom in real estate, even after a big bust. Real estate is driven by income. I randomly pulled 28 markets that I could think of in this country and looked at their median income growth and their real estate value growth since 1990. The direct correlation from one city to another wasn’t exactly there, but when you looked at all 28 cities as a whole, they were very much in line. Median income growth was 2.32% per year on average and the average real estate growth was 2.6% per year. Not exact, but close. During the recent 15 years of booms in major markets (that were also in my 28 city analysis), we were seeing 15-20% growth per year even though income wasn’t growing NEARLY as much. Then we saw a massive drop in prices and another rebound, so everyone assumes that the past problems were past problems. We shall see. The bottom line is that everything reverts to the mean. We are never exactly fairly valued. We are either overvalued or undervalued in every investment asset. You are either a buyer or seller of assets. It’s that simple. I choose to wait until asset prices get to the point where they are undervalued enough to make me feel that above-average returns will be experienced based on historical averages. Does it require A TON of patience? Absolutely. Is it frustrating at times? 100%. To hear the so-called “experts” tell me that I’m missing it and I don’t understand and “This time is different” has become annoying. But I stick to fundamentals. And at the end of the day, they win out. Fundamentals are the only true way to measure value. You have to find out what truly defines the price of an asset and buy when the asset is selling for below that fundamental point. Is it just one thing? No. But is it a ton of complicated points? Absolutely not. There are a few things that matter when looking at investments and it is the job of a true investor to understand what those are and where they have stood historically (not just over 25 years but over 60+ years). Share this article with a colleague

Black Hills’ SourceGas Acquisition Provides Patient Investors Good Entry Point For Current Income

Summary Black Hills recently announced the acquisition of privately-owned SourceGas. The company is financing most of the acquisition by taking on additional debt. The market is punishing the company for the acquisition. The stock dropped 14% over the two weeks following the announcement. I believe the stock will decline further, but this will provide investors looking for current income a good entry point. On July 12th, Black Hills Corporation (NYSE: BKH ) announced the acquisition of SourceGas Holdings LLC from investment funds managed by Alinda Capital Partners and GE Energy Financial Services. David Butler has a nice article on the acquisition , and I’ve written previously about Black Hills Corporation’s business and dividend growth history. The acquisition increases Black Hills’ coverage in its existing service area in Colorado, Nebraska and Wyoming, and expands the company’s service area into Arkansas. The combined company’s customer base will expand by 55% to more than 1.2 million, and Black Hills claims the purchase will “meaningfully” increase earnings in the first year after closing the acquisition. Unfortunately, the company was not more specific as to how large of an earnings increase it expects. Market Sells Stock on Announcement Despite the benefits of the acquisition, the market did not react well to the news. BKH stock fell 2.4% the day after the acquisition and kept going, losing over 14% over the next two weeks. (See chart 1 below.) I believe the reaction is due to the large amount of debt that Black Hills will take on for this acquisition. While Black Hills has shown the ability to integrate acquisitions into their business, many of the past acquisitions have been less than $100 million. The SourceGas acquisition is twice as large as the $940 million acquisition of five Aquila utilities in July 2008. The bulk of the $1.89 billion cost of SourceGas will be a combination of the assumption of $720 million in SourceGas debt and an additional $450 million-$550 million in debt, which will increase Black Hills’ long-term debt by 80% to $2.76 billion. According to Bloomberg , Fitch Ratings placed Black Hills on credit watch negative due to the “material increase” in debt. Will the New Debt Impact the Dividend? I don’t expect Black Hills to stop growing its dividend. The company has increased dividends for an impressive 44 years and it isn’t likely to break this streak despite the debt burden. However, the increase in debt will limit the available funds for dividend growth. With a 55% increase in its customer base, the company should see an earnings increase from the acquisition, but will likely need to work off at least some of the new debt over time to see the full effects of the earnings growth. Over the last 5 and 10 years, Black Hills has compounded the dividend at a slow 2.4%. From 1998-2014, Black Hills increased its quarterly dividend by less than a penny a share. In 2015, the company increased the quarterly dividend by a larger-than-normal 1.5 cents. It would be difficult for the company to slow the dividend even further, but I believe that is exactly what the company will do. Until Black Hills works off the debt from this acquisition, I expect quarterly dividend growth of no more than half a cent a year. What this means for investors is that Black Hills will remain an investment for people looking for current income and not for dividend growth. Wait for BKH to Hit Support Before Buying A technical analysis of the stock movement shows that BKH was in a downtrend even before the merger announcement; the announcement only accelerated the downtrend. As shown in chart 1 below, the stock had set up a pattern of lower highs and lower lows. While the stock may currently be oversold, there is little support until $33, with stronger support at the prior consolidation around $28-$31. (See chart 2.) I think it’s likely that BKH will move to that support zone, which would give the stock a yield of 4.9%-5.2% (based on a stock price of $30-$33). I would consider selling a put or purchasing BKH outright at those levels. (click to enlarge) Chart 1: BKH was in a downtrend prior to the acquisition announcement. (click to enlarge) Chart 2: After breaking into the low $40s on heavy volume, the next major level of support is in the high $20s-low $30s. Source: Stockcharts.com The Bottom Line: The acquisition of SourceGas sets Black Hills up for future growth, but the debt overhang will limit near-term dividend growth. The market’s (over)reaction will provide investors looking for current income a good entry point as the stock moves to support. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BKH over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: As noted above, I may take a position in BKH in the near future.

Pick A Valid Strategy, Stick With It

I’m not going to argue for any particular strategy here. My main point is this: every valid strategy is going to have some periods of underperformance. Don’t give up on your strategy because of that; you are likely to give up near the point of maximum pain, and miss the great returns in the bull phase of the strategy. Here are three simple bits of advice that I hand out to average people regarding asset allocation: Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote. If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more. You’d be surprised how little you give up in performance from doing so. The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again. Use additional money slated for investing to rebalance the portfolio. Feed your losers. The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed. That is the number one cause of underperformance for average investors. The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve. Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy. Now, about momentum strategies – if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it. Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up. The best time for any strategy typically come after a lot of marginal players give up because losses exceed their pain point. That brings me back to rule #1 above – even for a momentum strategy, maybe it would be nice to have some safe assets on the side to turn down the total level of risk. It would also give you some money to toss into the strategy after the bad times. If you want to try a new strategy, consider doing it when your present strategy has been doing well for a while, and you see new players entering the strategy who think it is magic. No strategy is magic; none work all the time. But if you “harvest” your strategy when it is mature, that would be the time to do it. It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk. But if you do things like that, be disciplined in how you do it. I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn. Greed got the better of them. Markets are perverse. They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic. When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline. Similarly, when people swear off investing in risky assets, markets tend to perform really well. It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged. The markets aren’t rigged. If you are a soldier heading off for war, you have to mentally prepare for it. The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy. We can make investing easier by restricting the choices that you have to make to a few key ones. Index funds. Allocation funds that use index funds that give people a single fund to buy that are continually rebalanced. But you would still have to exercise discipline to avoid fear and greed – and thus my three example rules above. If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns . Most trading that average people do loses money versus buying and holding. As a result, the best thing to do with any strategy is to structure it so that you never take actions out of a sense of regret for past performance. That’s easy to say, but hard to do. I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain. Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic. Pursue that, whether you invest like me or not. Disclosure: None