Monday, October 29, 2007

Asking a Best Denki salesman whether you need a LCD TV

If you walk into Best Denki or Harvey Norman and ask the salesman whether you need a $3,000 LCD TV, what do you think he will say? He will immediately recommend you the $8,000 50 inch Samsung High Definition LCD TV, and give you 1,001 reasons why you NEED that TV. Right?

I guess the message here is that the salesman cannot tell you whether you NEED a LCD TV. His job is to sell you the TV NOT to determine if you need one.

But our world is a strange place. In so many areas of our lives, esp those related to finance, we ask the salesman whether we NEED something and we expect them to have our interest at heart and tell us the answers. Think about the following questions.

Is it logical to ask the insurance agent what kind of insurance is suitable for you?
Is it logical to ask your broker or his analysts which stock to buy?
Is it logical to ask your private banker how you should manage your wealth?
Is it logical to ask an investment banker whether your co. should do M&A?

In most to these cases, the salesperson, middleman thrives on activity. This is bcos he takes a cut or commission on the transactions that take place. So it is NOT in his interest that he recommend you the best thing. Bcos it will not generate future activity. He needs activity to earn his keep.

The insurance agent wants to revisit you every yr so that he can sell you another policy even though he sold you one last year that would have taken care of your lifetime need. And he will only sell you a life policy or an investment link one even though a term policy makes more sense for you. Bcos the commission on those pdts are much higher.

The analysts change their ratings every 3 mths bcos that's their job. Their job is not to identify the long term winner. Their job is to churn and create lots of buy and sell orders. So it is not in their interest to help investors identify the real 10 baggers (stocks that will rise 10 folds). Even if there are genuine analysts out there who believe they should help investors, the system is in place to discourage them. That's life dear.

Similarly the private bankers cannot help you grow your wealth. Their job is to sell you investment products and earn their keeps. They need to sell new products every yr to hit their annual targets. So naturally they will recommend you to buy this, sell that and buy back what you sold etc year in year out. Even though investments can only generate good return by investing for the LONG TERM.

As for companies, when they reach a stage where organic growth becomes difficult, they seek to do M&As. But the investment bankers they consult to do M&A are at best, well, not much better than the Best Denki salesman. They cannot help to identify which good co.s to buy. Their job is to make deal, not to help the CEOs find bargain M&A. That's why most M&A fails (though they look good on paper).

So how? I am still searching for an answer, but by talking to people who have gone down the same path sometimes help, esp those that have more experience in life and have succeeded (ie. not a bloke lah, but getting advice fr a bloke may still be better than getting advice fr private bankers). People who have bought so many insurance policies and finally know what is really good. People who have talked to so many private bankers and finally know not talking may be the best. And of course, when you have the answers, contributing your answers to this blog will help too!

Thursday, October 11, 2007

More Margin of Safety

A frequently asked question on value investing and how to calculate intrinsic value is this: how can you be so sure that the co's intrinsic value is this and at this price it is a good investment?

For those not so sure what the hell is going on, read these first
Value Investing
Intrinsic Value
Good Investment

Well, the truth is, you are never sure, you can spend 20 days calculating the intrinsic value of the company and become so sure that the stock is undervalued. So you buy and the stock tank 20%. Shiok huh?

Intrinsic value goes hand in hand with margin of safety. Bcos you can never be sure whether you really got the intrinsic value right, you need to have a margin of safety. ie you will only buy the stock if the current price is way, way, WAY below your calculated intrinsic value. As a rule of thumb, I recommend 40-50% below your calculated intrinsic value.

Buffett used the example of building a bridge. If you know that the maximum weight of vehicles that will cross the bridge is 10 tons (based on historical statistics), will you build a bridge that will support 10 tons or a bridge that will support 30 tons?

That is margin of safety.

Ben Graham, the grandfather of value investing once said this: if you need to surmise value investing into only 3 words, it would be "margin of safety". It is THAT important.

Unfortunately, most investors don't really have this concept in mind. Even those who are very experienced. I guess it's not easy partly bcos have a strict margin of safety rule forces you to pass on many investment ideas even if they are quite good. And when you see them rally 100% after you decided NOT to buy them, wah shiok right? Now every wall you see has a purpose. For you to bang your head hard on it! Haha!

But having a margin of safety will make very sure that you will not lose your shirt. Even if you are damn wrong on your intrinsic value, you may lose a bit of money, the stock may tank 20%, but it won't tank like 80% and chances are after it tank 20% it will creep back up again, it will not bankrupt you. That's the strength if you have a huge margin of safety.