Motley Fool Money - Office Hours: Valuing ETFs, Investing For Kids, and Creating Dividends

Episode Date: April 30, 2022

Office Hours: Valuing ETFs, Investing For Kids, and Creating Dividends You've got questions? We've got answers! John Rotonti and Robert Brokamp answer audience questions about investing in ETFs, cash management, measuring risk, and more. Got a question for the show? Call our voicemail: 703-254-1445 Bonus resource - https://www.fool.com/investing/2020/07/16/do-you-have-an-investing-checklist.aspx Host: John Rotonti Guest: Robert Brokamp Producer: Ricky Mulvey Engineer: Rick Engdahl, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

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I hear a lot of you guys mention stocks that you bought for your kids, but how do you guys go about buying stocks for your children and at what age or what kind of funds are you using to fill these things out? I'm Chris Hill, and the answer to Rick's question is coming up in a few minutes. It's time for office hours. We're emptying our inbox and checking the voicemail on the Motley Full Money hotline. Today, John Rotanti and Robert Brokamp are teaming up to answer your questions about cash management, measuring risk and investing in ETFs. Hi, Fools. I'm John Rotonte. I'm joined by Robert Brokamp today for office hours on Motley Fool Money. So let's send it over to the first voicemail question.

Hi, my name is Kail Phillips. I'm from Bloomington, Indiana, senior studying finance and real estate at Indiana University. My question pertains to selecting ETS. I know in the show you talk a lot about stock picking and doing reviews on stocks, But when it comes to ETS, what are your best practices for either valuing them or selecting the right ones, given the trends in today's market? Thank you very much. Hi, Kail. Thank you for that question. I'm going to turn this one over to Robert Brokamp.

This is his area of specialty. Robert. So I would say, first of all, it starts with deciding what you want to invest in in terms of an asset class. Are you looking for U.S. stocks, international stocks, large-cap stocks, small-cap stocks, whatever. Start there. Think about what you want to look for. There are plenty of sites that will list just about every ETF that is available in each category. There's ETF.com. There's ETFDB.com. My favorite is probably Morningstar. You go to Morningstar on the website there. You can find a whole area with ETFs. And they also have their favorite ETFs. And the great thing about Morningstar, too, is you can get historical performance and cost information. And what you're really looking for is an ETF that is outperformed probably, you know, 75.

percent at least of similar ETFs over the last three, five, and ten years if the ETF has been around that long. What you do is you enter the ticker into Morningstar, click on the performance tab, and scroll down, and you'll see percentile in category. That basically tells you where it performed relative to similar ETFs. You're looking for a lower number. So if you enter an ETF and you see in the five-year return the number 10 as a percentile in rank, that means it is performed in the top ten. 10% over the last five years. Often you will find that the lower cost ETFs generally have the better performance, but not always. This is the fool known as Peter from Ontario. Recently, I've been looking into shares outstanding and stock buybacks or share buybacks.

And the thing that confuses me is when there's a share buyback, the shares outstanding decrease, the price stays the same. but the market cap should stay the same based on that being the value of the company. What happens during a share buyback to the value slash price of a stock? Hi, Peter. I love the introduction. The fool known as Peter in Ontario. Very foolish question. We appreciate it. So to begin, when a company repurchases its shares or buys back its shares, it doesn't necessarily mean that the share count will decrease. It does not necessarily mean that the shares outstanding will decrease. In a lot of cases, especially earlier stage, fast-growing companies, earlier in their life cycle,

these companies may not yet be generating a lot of earnings or cash flow, and so they pay their employees in stock-based compensation. to do that, they issue new shares. If a company is issuing more shares than it is buying back, then the share count will actually still increase. If a company is simply using buybacks to offset the dilution that comes with stock-based compensation, then the share count will remain pretty flat. It will remain the same. And there's actually a lot of companies that tell you the reason they are repurchasing shares is to offset dilution. They will actually tell you their reason for doing it. But let's assume that a company is buying back more shares than it's issuing.

In that case, the share count would decline. A declining share count in and of itself is not creating shareholder value. Companies create shareholder value if they are buying back their own stock at a discount to the stock's true, fair value. Just like me, myself, or Robert Brokamp, or you, Peter, can go into the market and buy stock when you think it's trading at a discount to its intrinsic value. The company itself can also go into the market, make an open market, make an open market purchase of its own stock, just like you or I can, and they can hopefully do so when it's trading at a discount to its intrinsic value or its fair value based on the fundamentals of the business. Some companies are better at this than others. Some companies just buy a buyback

share sort of on a schedule. Other companies, however, are more opportunistic in their share repurchases. They buy more stock when the stock falls. In other, other words, they buy more stock when it's trading at a discount to its fair value. Warren Buffett has said on several occasions that share buybacks, when done intelligently, are probably the highest return capital allocation a company can make with its cash. If they are being done at price discount to its intrinsic value, that's almost the highest return investment a company can make. What happens is the share. Shares outstanding will decrease.

If the numerator, net income, or free cash flow stays the same or is growing, and shares outstanding decreases, Peter, then the net income per share, also called earnings per share, or the free cash flow per share will grow. And ultimately, as owners of this business, that's what we are after. Long-term growth of free cash flow per share. Free cash flow can grow from growth of top line revenue, which will fall down to growth of free cash flow, but then it can also grow more than that through share repurchases. I hope that answers your question, Peter.

Long story short, not all share repurchases are created equally. It really comes down to the price that the company is paying. My name is Bryant from San Clemente, California. regards to my investment in my Roth IRA account. I've been withholding making any payments or making my actual maximum amount of payment that I can make for 2020 to my Roth IRA due to the current economy and what's going on with the stock market. I was wondering if you guys had any advice and when it would be a good time to actually make my investment in that for 2022. Thank you. for your help. Hi, Bryant. Thank you for that question. This one is Taylor made for Robert Brokamp.

Bro. So, Brian, I would say there are a few things that you might be asking about. If you're asking about whether you should contribute to your Roth IRA or not, because of what's going on in the economy or the stock market, I would say, just go ahead and make the investment. Even if you're nervous about the stock market, because you can put the money in the IRA and then invest it in something like cash or short-term treasuries, you'll get a little bit of interest. and the benefit of having that in the Roth IRA is you won't pay taxes on that interest. Whereas if you kept that money out of the IRA, kept it in a regular bank account, you're going to have to pay taxes on that. So go ahead and put the money in. As for being nervous about the

stock market, I understand that, but we generally believe that if this is money you don't need for the next 5, 10, 20, 30 years, you're going to be happy that you invested today. So if it's a question of whether to invest in the stock market, I understand that. I'm a little nervous myself, but that doesn't change the fact that every time I get paid by the Motley Fool, I still invest my 401k into the stock market. And I'll just add a third thing since you talk about being nervous about the economy. For people who might feel like, well, I may be nervous about my job or something going on. Can I afford to put this cash that I have on the side into the Roth IRA?

because I might need it in case maybe I lose my job or something like that. The great thing about the Roth IRA, and it is unique to the Roth IRA, and that is you can put the contributions in, and then you can take the contributions out tax and penalty-free at any time. The earnings, you have to wait until you're 59.5, but you can take the contributions out. So some people often call the Roth IRA as sort of a backup emergency fund. I've even written articles about that.

So I would think if you have the cash, you want to say for your retirement, your eligible to make the Roth IRA, go ahead and put the money in, and you'll at least get that tax-free growth on any short-term safer investments. Although, as I suggested previously, if this is long-term money, you're probably going to be happy that you invest in the stock market over the long-term. Yeah, bro, I'll just add, for long-term investors, like you said, over the last 42 years through 2021, the stock market was up in 32 of those years, 32 of the last 42 years. And so it really pays to be bullish if you're a long-term investor. You know, that means that the stock market was up in 75% of the years over the past 42 years.

So, yeah, really pays to be bullish. Hey, it's Rick from Texas. I hear a lot of you guys mention about stocks that you bought for your kids. I know you guys have been talking about children comments, but how do you guys go about, you know, buying stock for your children and at what age or what kind of funds are you using to build these things out. Thank you. Hi, Rick from Texas. Thank you for the question. Another one for Bro. Bro is pulling the weight so far in this podcast full. So, bro, take it away. So I would say, first of all, it depends on what you intend to use the money for. So if this

money will be used for college, the two best choices of the 529 and the Cover Dell. The great thing about those, if the money is used for qualified education expenses, and it doesn't necessarily even have to be college. The rules are a little different for each account. But if the money is used for qualified education expenses, it grows tax-free. The benefit of the Coverdell over the 529 is that you can actually invest in individual stocks. With the 529, you usually can only invest in index funds, and you can only make a change once a year. The downside of the Coverdell is the contribution limits are only $2,000 a year. And the contributions can only be made by people, and who make under a certain amount of money, although you can get around that by just gifting

the money to people who have lower income. The good thing is you can do both. You can max out the Coverdell to invest in individual stocks and then invest in the 529. And the contributions limits for the 529 are huge in the hundreds of thousands of dollars. It varies by state, but most people don't have to worry about that. Now, I'll just tell you what I've done for my kids. So we have 529s, but we do have just regular brokerage accounts for our kids because they are minors, or at least they were when we opened the accounts, they had to be custodial accounts.

In most states, that's an Utma account. It might be an Umba, but at most is an Uttma. And the benefit of those is that a portion of any of the income like the dividends is tax-free. The downside of that is once the kids reach the age of majority, and that depends on the state too, the money becomes theirs. So, you know, they will even use it wisely or they will sell all the stocks and go buy a car. And the other downside of that is they are assets of the children. So anything that is an asset held by the children has a bigger effect on reducing financial aid eligibility in college,

as opposed to assets owned by the parent. And Coverdell assets and 529 assets are considered parental assets so they don't have as much of a harmful impact on financial aid eligibility. And then just finally, I'll just say what we did for our kids is they each own some index funds, both U.S. and international, because we believe in index funds in general. But then we got their input. So each kid chose companies that they like, from Apple to Tesla to Target Starbucks and let them have a little bit of input

in the stocks that they chose. What we don't do is talk about the returns with the returns one kid had over the other because we don't want to cause any resentment. So one kind of doesn't know how the other kid is performing, but that's how we've done it here in the Brokeamp household. As far as when, earlier, the better, right? I mean, if possible, day one, right?

The day of the birth. Yes. I mean, certainly when saving for college, for sure, right? That is one of the best things you can do is start as soon as possible. And then, you know, the kids do get to an age where they understand what a company is. You know, I don't know how many times I've told my kids when we go into Starbucks that we're part owners of this company. And the great thing about with no brokerage commissions and being able to, you know,

to buy fractional shares, even a five-year-old who likes watching Disney movies, you can buy a little bit of Disney and then start explaining how now that you are a stockholder, you are a part owner of this company. You're a partner of the company, and you are entitled to a percentage of the future earnings and free cash flow of that business. Just to put some numbers around why starting earlier is more powerful when it comes to compounding really quickly, if you invest $10,000, $1,000, This is just an easy example with math. Obviously, you're going to keep contributing to these accounts.

But if you invest $10,000 just once, and it compounds at 10% per year for 40 years, you end up with $452,000. You invest $10,000 once. It compounds at 10%, which is what the market has done on average over a long period of time. You hold for 40 years, you end up with $452,000. If you also invest that $10,000 once, and it also is what the market is done, you have done, once and it also compounds at 10% per year, but you hold it for 60 years. That's the only difference. You end up with $3 million. And so everything's the same. You just started 20 years earlier.

You now hold for 60 years and you end up with six or seven times more wealth. So I think we're now going to switch over to some questions that came in via email. And to read those emails, I'm going to bring on my hour producer, Ricky. Ricky. Good to see it, John. Good to see it, bro. If you have a question for us, you can call us 703-254-1445. That'll get you to our voicemail.

These podcast questions came into us at Podcasts at Fool.com. The first one coming from Lewis, who is a Quebecois in the Woodlands, Texas question. How do you use or leverage the daily or weekly volume of shares traded information? for particular stock you own or plan on acquiring. I must admit, I seldom pay attention to it. Does it belong more to the realm of momentum analysis? Thank you for your time. That comes from Lewis.

Lewis, this is a good question. I've been investing. I'm just going to speak personally, and then I'll send it over to Robert. For over 20 years, I never looked at average weekly trading volume until I got to the Motley Fool, ever. Not there's anything wrong with it. I just never found a way to work it into my process. Once I got to the Motley Fool and was responsible for making,

for pitching stocks to a service, and now I'm responsible for leading a service and making stock recommendations, I do have to look at it now just to make sure the weekly average trading volume is not so low that, you know, we could really move the market by recommending a stock, you know, like a microcap, like under a billion dollars, No, like under $500 million in market cap and really low trading volume, you know, we probably tried to avoid those types of recommendations because they just don't trade enough.

And so, you know, just buying a few shares could really move the market. Other than that, other than making sure that I'm above that sort of minimum requirement for the service that I lead, Showdown 2022, I still don't look at it. I just haven't found a way to work it into my process. Next question comes from Mike in Petawawa, Ontario, Canada. Question is, I'm a longtime listener, subscriber to Stock Advisor and Rule Breaker investing, and a huge fan of your podcasts. I have a question about cash allocation.

I hear a number of analysts and Tom Gardner routinely speak to growing and holding a cash position for anywhere between 5 and 20% of one's portfolio size. What's not clear to me is how we reconcile this position against an emergency fund, investing at regular intervals, and balancing the percent of a portfolio. cash versus a growing portfolio size? Can you have your analysts speak to how they recommend growing the cash position against these factors? If it helps, for context, my wife and I have roughly a six-month emergency cash fund. But we invest regularly, every payday on Motley-full recommendations. As our portfolios grew in the past two to five years, it became increasingly difficult to

hold a sizable cash position beyond our emergency fund. If I were to hold more cash, it would be at the expense of regular monthly investments. Any insight would be super helpful. This is a great question. I'll start and then and then turn it over to bro. So one, first thing is the six-month emergency cash fund is good. You know, at the Motley Fool, we like to say don't invest any money in the stock market that you may need for at least the next three to five years. And so, you know, that money, we really try to keep that cash, we really try to keep on the sidelines three to five years that you think you could possibly need. As far as how to build up a cash position while at the same time investing on a regular schedule

and following the Motley Fool recommendations, one suggestion may, and bro, I'd like to know what you think about this. One suggestion may be to not reinvest your dividends. And if you're not reinvesting those dividends, then they would just, you know, land in the cash part of your brokerage account. So that's one way, I think, to build up cash while at the same time investing on a regular schedule. What do you think, bro? Yeah, that's absolutely right. And I would say just anecdotally, most of the investing analysts here at the Motley Fool don't

reinvest their dividends. They let them accumulate in cash because that gives them the dry powder to buy more when they feel like it's necessary. I would also say, you know, in his 2012 annual letter, Warren Buffett talked about why Berkshire doesn't pay a dividend. He suggested something that he called his sell-off method, which is basically, instead of having a stock that pays a 1 to 2 percent dividend, you just sell 1 to 2 percent of your holdings and create your own dividend.

So that's one way to do it. And then the other way to think about it, I think, is just rebalancing your portfolio. If a single stock or a single sector has done so well that it is now a new way. a disproportionate part of your portfolio and maybe too much that you're comfortable with, selling some of that is also another way to raise some cash. I love that idea of trimming, bro. You don't have to always sell out of something. You can just trim a position that may have grown to be too large a percentage of your portfolio

and then use those trimmings as a source of funding to buy other stocks that you want to invest in. So, all great ideas. Thank you. Next question comes from Dan in Silverton, Oregon. You mentioned that you pick a discount rate. I think he's talking to you, John. Based on the riskiness of an investment, I understand that a new startup is going to be different from PepsiCo, but what are some ways that you measure riskiness?

Is a company's beta meaningful to you? At the Motley Fool, we don't consider beta a measure of business risk. So beta, by definition, is how much the stock price moves relative to the market. A beta of one means that the stock price moves, you know, in line with the market. If the market goes up, the stock goes up about the same amount. If the market falls, the stock falls by the same amount. That's a beta of one.

A beta of more than one means that when the market goes up, the stock price generally moves up more than the market. And when the market falls, the stock price generally falls more than the market. and then finally a beta less than one means when the market goes up, the stock goes up less than the market. And when the market falls, the stock falls less than the market. So beta is not a measure of business risk. Rather, it's a measure of stock price volatility. And if you're a long-term investor, then stock price volatility can be your friend. stock price volatility, if you're a long-term investor, can allow you to buy low and sell or trim at higher prices like we just talked about.

So what do we consider risk? Risk factors for business and investing in the stock market are a company that has too much debt. Most of the corporate blowups you see will come from too much debt. For me, that is risk factor number one. Number two, weak business models. Number three, product or service irrelevance. Number four, mismanagement. Number five, misaligned incentives. So that's how we think about risk factors for investing. If you want a fuller list, maybe 20 different risks, I bulletpoint them in an article I put on

fool.com called Do You Have an Investing Checklist? All right, that's it. Thank you so much, fools, for the questions through email and voicemail. Robert, thank you for jumping on last minute to help me with some of these financial planning questions. Ricky, thanks for joining us, reading the questions, and hopefully we'll do another of these office hours down the road. Hope so. Thanks, John. Full on, everybody. If you'd like to submit a question for an upcoming episode, the number to leave a voicemail is 703-254.

1445. It's also in the show notes. As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.