Why Quant may work?

In the previous post, we discussed how to construct a quant portfolio. Now let's try to understand why some thinks that it can work (ie it can outperform the market).

Well first, we must get the right factors though. If you screen for something like stocks that has hit 52 weeks high, or stocks with highest volume, or other funny factors, good luck. You have got the GIGO (Garbage in Garbage out) model. The model is only as good as the inputs.

What people usually believes as good inputs are like Low PER, Low PBR, High ROE, High cashflow, High OP margin, High EPS growth etc.

So there are roughly 400 stocks traded in Singapore and you only buy the top 50 with the lowest PER and highest ROE. What this means is that you are buying stocks that are cheap relative to all others and have the highest return potential relative to all others. And you do this every 6 mths, weeding out those that falls off the top 50 and adding new winners in. Theoretically, you SHOULD outperform the market.

But you don't. Murphy Law's works huh.

Well a few reasons. First of all, the data used are either historical or poor estimates. For PER, usually we get the 1-yr forward PER, which is basically the sum of estimates of all the analysts out there. And we know analysts are, well, like private bankers, GFN right? (GFN: Good-for-nothing). As for ROE, usually that's a historical no. so ROE may have changed, or dropped to below those of other stocks.

Second, to beat the market is a zero-sum game. You need to beat most of the other participants in the markets. This means you need to move faster than most other participants. Now when do you think these quant models were first used? Do you think you are one of the early birds using these models? The answer is NO btw. So investors have used this model since the last Ice Age, and here we are re-inventing the wheel and expecting to beat the market. That's not quite possible right?

But there is still hope.

The markets today, as with our world, has gotten very short-sighted. Thanks to MTV and instant noodles. Most people seek instant gratification. They are not interested in growing apple trees and waiting to eat apples years later. They are not interested in stocks that will only payback after 10 yrs.

So as we all know, the markets are unpredictable in the short term but follows earnings growth in the long run. The quant models, if used over long periods of time, should beat the market (esp if the rebalancing period is also stretched, so you don't get killed by transaction costs) bcos most other participants won't wait that long.

Quant Portfolio Construction

One of the more scientific ways to invest is to actually create a quant portfolio and simply rebalance it periodically. Sounds very chim huh? But it's actually quite straightforward. But unfortunately, it is not exactly suitable for retail investors unless

1. You have tons of money
2. You have tons and tons of money

Well, but it's still quite useful to know how quant works, so don't yawn. And don't click the "x" at the top right corner.

Quant is simply the short-form for Quantitative and it is named as such because it uses mathematical models to drive investment decisions. Quant can be very successful because it reduces emotional influences (screw Mr Market man!) and can generate as well if not better an investment performance as fundamental analysis or other types of investment analysis. (Woah that's a statement huh?)

As a very simplistic introduction, we introduce a 2-step quant portfolio construction process here.

1. Use criteria or factors like PER, PBR, ROE, EV/EBITDA to screen out a list of stocks and buy the top 30-50 stocks.

2. Rebalance the portfolio after the pre-determined period like 6 mths or 1 year etc. (ie repeat Step 1 after 6 mths or 1 year.)

Ok, analogy time, say we want to create a 50 stock portfolio and rebalance it every 6mths and we want to use 2 factors, Low PER and High ROE.

For retail, Poems have quite a good screen in its system so can just utilize that. If not, can ask those good-for-nothing Citibank/UOB privilege sweet-young-bankers to generate these screens. Of course, that's like trying to strike Toto, bcos chances are, they ARE good-for-nothing.

Anyways, so you get this list of stocks, and just simply buy the top 30-50 names on it depending on how many stocks you want to hold. But it has to be at least 30 names in order to smooth out the idiosycracies of individual stocks. So now we know why you need lots of money, to buy that 30-50 stocks.

So that's Step 1. And after 6 mths, simply do the screen again, and buy the top 30-50 names. Of course, if the same stock appeared on the first list. You don't sell off what you hold and buy back the same stock lah. Unless you are trying to please your good-for-nothing Citibank/UOB privilege sweet-young-bankers or something.

So simple as that, if you can do this based on some winning factors (that's the catch huh!). Chances are you can make some money. May or may not beat the market average (to do that, the odds are slightly better than finding a good-for-something sweet-young-banker), but you should not have negative return if you invest over the long run (ie 20 yrs or more).

See also Investment Horizon

Facts about the Singapore Market

Hope this serves as a list of good-to-know for people investing in Singapore. These no.s can be used as some kind of benchmark when analyzing co.s and some are really quite interesting! Here is goes:

There are roughly 700 listed co.s in Singapore but only 50 in the STI index. In terms of market cap size, 6 co.s make up roughly 50% of the STI index.

11 co.s have more than SGD 10bn in market cap.
88 co.s have between SGD 1-10bn in market cap.
Slightly less than 300 co.s have between SGD 0.1-1bn in market cap.
The smallest listed entity had 6mn in market cap.
The co. probably paid more than 6mn to brokers, auditors and SGX. Hehe!

The whole of Singapore stock market cap is roughly SGD 600bn.
This is roughly 1% of the world’s market cap which is roughly SGD 70trn (or USD 40trn). This is also 3x our GDP which is roughly SGD 200bn. Rough, roughly, roughlier... The world is filled with uncertainty!

Only 5 co.s generate more than SGD 10bn in sales.
These 5 co.s are: 1 electronics company, 1 airline, 1 telco, 1 shipping co. and 1 distributor for cars.

Only 50 plus co.s generate more than SGD 1bn in sales.
The smallest 8 listed co.s in Singapore generate less than SGD 1mn in sales. (Pathetic right?)
Makes one wonder whether we should ask some of our ministers to list themselves on the stock exchange since they could generate more than that.

Only 5 co.s generate more than SGD 1bn in operating profits (or OP). So much so for Singapore Inc huh? Btw, 1 Integrated Resort will probably generate only SGD 150mn in OP.
Only 2 of the top 5 sales co.s are in the top 5 OP generators.
3 of these co.s are banks.

55 co.s generate SGD 100mn-1bn in OP (IR goes here!).
Slightly less than 200 co.s generate between SGD 10-100mn in OP.
Slightly more than 200 co.s generate between SGD 0-10mn in OP.
Which leaves slightly more than 100 loss-making co.s that are listed in Singapore.
This means 1 out of 7 co.s listed in Singapore are loss making!

About 150 co.s have more than 10% Return on Capital or ROA.
The average Return on Capital is 0.5%.
You have 20% chance of picking a winner, if you picked a loser, you might as well put that money under your pillow. Stock-picking is a dangerous game.

About 150 co.s have more than 5% Earnings Yield
(or a PER of less than 20x).
The average Earnings Yield is 4.2% or PER of 24x.
This means: even if you picked the winner, chances are it's already in the price. i.e. dating a chio babe at an expensive price.

About 60 co.s meet the above 2 criteria which is:
ROA greater than 10%
Earnings Yield greater than 5%.
If you buy all these 60 co.s today, you probably have a 12% chance of outperforming the STI on a 1-year investment horizon. Stock-picking is a bit better than Toto or 4D.

Other financial ratios of the Singapore stock market include:
Average Dividend Yield is 3%
Average Price to Book is 3.5x
Average Debt to Equity is 0.6x
Average ROE is 9.5%

These no.s are quite different from those listed on conventional sources probably bcos I included the a lot of kuching kurau names which have ridiculous ratios like ROE of -200% and Dividend Yield of 100% etc (no time to clean them mah, I can’t just blog whole day, can I?).

Anyways, hope these info help next time you need to analyse something. In investment, knowledge is power!

Scenario Analysis or Sensitivity Analysis

This is another no-brainer concept that is given a cool and sophisticated name so that financial advisers and analysts can brag about their knowledge in investment.

For those first-timer to this blog, pls read the relevant posts that are linked here in order to understand what I am trying to say. Most likely this post will overwhelm you if you read it without the background knowledge.

Essentially what you do in scenario or sensitivity analysis is that you try to stress-test your assumptions and see if they work when the state of the world has change.

I guess the easy example here is SIA. In a previous post, I mentioned that SIA earned $1 EPS in 2005 and given that it is trading at $17, this means that its PER is 17x, or an earnings yield of 6% (i.e. you expect SIA to earn you 6% for every dollar you invest.)

Now we need to test how robust is the EPS of $1 (or the earnings yield of 6%), i.e. we want to know if SIA can actually deliver an EPS of $1 when the world has changed. Usually we will set up 3 scenarios.

1) The base case is where the state of the world is as today, goldilocks, not too hot not too cold. In this case, we assume that SIA will continue to deliver the EPS of $1. Hence its PER is 17x and its earnings yield is 6%.

2) Then we have the nightmare scenario where the world goes into recession, i.e. Sept 11 again or some war breaks out. Obviously we have to assume EPS drops to some very low level, maybe $0.10.

3) And finally we have the blue sky scenario where the world prosper and SIA lives happily ever after and EPS becomes an astronomical no, like $10.

After that, if you like doing math, you can acsribe probabilities to each of the state and calculated the expected EPS of SIA. For me, I am just interested in the nightmare scenario. I want to know if it happens, is SIA still cheap. Obviously, if the nightmare scenario comes true, SIA can only earn me 10c for every $17 of the stock, I might as well buy Singapore T-bills. Hence I will not buy SIA.

The fun part here is how to ascribe an EPS to the nightmare and blue sky scenario. What is the appropriate no.? Is 10c low enough for the nightmare scenario? In which case PER goes to 170x and earnings yield become 0.6%? Or is it 1c, then PER goes to 1700x. Woah, that’s better than Google at its peak (PER 400x or so I think).

I would say the success rate of this kind of analysis only gets better with experience. It also depends on your view of the world and your emotional state and personality. A conservative investor will think that EPS goes to zero and hence will not buy SIA, bcos he thinks SIA will simply drop like a rock if another catastrophe strikes. A greedy and bullish investor who have only seen bright and sunny days will think that SIA will fly no matter what happens. And he will say SIA is still very cheap at PER of 17x.

See also SWOT analysis
and Investment philosophy and process

Discounted Cash Flow or DCF

Discounted Cash Flow or DCF is the most complicated way to value a stock and also probably quite useless to most people. Well, not if you are good at math or if you are called Buffett or Graham or Dodd. Buffett uses very simplified DCF to try to value stocks and is probably quite good at it, given how much he has earned (umm, in case you don't know, it's about 1/3 of what the whole of Singapore earns). Too bad he doesn't blog.

Well I guess I would just try to describe the concept of DCF, bcos the math will simply freak out a lot of people. But having said that, it's probably A level or 1st year university math so if you really want to know, can google it and try to figure it out.

Ok the concept is basically adding up all the cashflow over the life of the firm and try to determine how much it is today.

Perhaps it is easier to use an example:

Firm A will generate $1 of cashflow over the next 50 yrs, what is its value (or intrinsic value) today?

Well the simple answer is simply $1 x 50 = $50 (QED).

Ok, but how can be so simple?

Now we must understand that $1 next year is not the same as $1 today. And $1 two years out is also different. The difference is due to interest.

So $1 next year is actually equal to $0.97 today bcos if we put $0.97 in the bank today, it will earn 3% interest and become $1 next year. And $1 two years out is roughly $0.93 today bcos if we put $0.93 into the bank today, it will earn 3% interest in 1 yr, and both the interest and principal after Year 1 will earn another 3% interest, which brings the total to $1 two years from now.

So once we calculated the present value of all those future $1 (50 of them), we add them all up and we get the intrinsic value of the firm. For the above example, the answer is $25.7.

If you are wondering how to get $25.7, key this "=PV(3%,50,1,0)" in Excel and it will spit out the answer. Need more help, pls email me.

Well, not so hard after all I guess. But the questions below will make you realize what makes it hard.

First, how the hell do we know if Firm A can actually earn $1 every year for the next 50 yrs? And what will the interest rate be in 50 yrs time? And why only 50 yrs, shouldn't a company exist longer than that?

So that's the hard part, for every input, there is some uncertainty. With DCF, you can have infinite no. of inputs, and that's uncertainty times infinity. How fun. Personally I prefer to stick with PER and EPS estimates.

See also Intrinsic Value Part 2
and Definition: Value Investing

Company cheatsheet and stuff - not to be missed!

According to Philip Fisher, one of Buffett's teachers (besides Ben Graham), you cannot never compile a cheatsheet for a company. You have to constantly sniff out info on the company, keep talking to anybody and everybody, from suppliers to customers to employees etc. So analysing a company probably takes like two gozillion years and Frodo have completed the Mt Doom trip like 15 times.

In our world of MTV and instant gratification. Nobody has time for this crap right? So yours truly here has compiled a the ultimate cheatsheet to look at when you first lay your eyes on a company.

I must stress that this cheatsheet is not exhaustive. There are probably another 1,001 things that you should look at. But it should be a good way to start. Also remember than the time you spent researching a company is inversely proportional to the risk that you will lose money. i.e. more research less risk.

But then again who has time to wait for Frodo to go Mt Doom 15x considering we don't even have time to make babies. So I have also kindly calculate the optimal time to spend research a co.

This would be roughly 30 hrs for beginners and 10 hrs for more lao jiao people. But after analysing, this does not mean that you should buy or sell the stock immediately. You should wait for a good time to enter or exit. Investing needs patience, so watch less MTV.

Anyway, to save you from more bull shit, here's the list.

Company specific factors
Mkt cap greater than S$100mn
Operating Profit greater than S$10mn
OPM greater than 10%
Dividend yield greater than 4%
D/E Ratio less than 1x
Growth greater than 5%
ROE greater than 15%
ROA greater than 5%
(Usually these factors can be put into a screening tool to screen out companies that meet these criterias, but I have not found a free screening tool yet... if anyone can find one, pls inform me ok?)

Qualitative factors
Industry climate and firm's position
Strengths and weaknesses of the firm
Major risks for the firm

Valuations
PER less than 18x
PBR less than 4x
EV/EBITDA less than 10x
(These can be put into the screening tool as well)

There are a few things to take note. Even if a firm fails to meet 1 or 2 criteria, it doesn't mean that the stock is lousy. If there are good reasons, it is still a buy. If you try to find a stock that meets everything, probably there won't be any. That's why the each criteria is actually not too strict to begin with. Also, qualitative info matters, that's why it pays to read annual reports, research reports and business news.

See also Investment Philosophy
and Investment Process