Return on Equity, Episode II (ROE-EP2): A company’s organic growth rate

ROE can also be used to gauge a company’s organic growth rate. This means how fast the company can grow without relying on external factors like M&A, gahmen support, tax relief, Toto winfall, father mother sponsorship or anything else other than its own profits.

Remember that Net Profit, though a volatile no. due to multiple manipulation from sales, to operating costs, to interest and tax, does measure the profit that should go to shareholders if the accounting is done with integrity. And Net Profit is actually added to Shareholders’ Equity at the end of the year.

So Return on Equity or ROE which is

Net Profit / Shareholders’ Equity

tells you how the growth rate of shareholders’ equity has been, in the past 1 year. Now if past ROE is a good gauge for future ROE, we can then assume that next year’s Shareholder Equity will grow exactly by its ROE right? Savvy huh! This is the critical part, usually, high ROE will not last into the future bcos things always mean revert. But if you tracked this particular Co. which had ROE of 20% for the past 20 yrs, then maybe you can quite safely assume next year it will be 20% as well. Btw, ROE of 15-20% is sort of a long term average that things mean revert to. If the Co. has like ROE of 50%, then probably it will mean revert to 20% after some time.

Ok, analogy time. Say Co. X has a ROE of 20% for the past 20 yrs and shareholders’ equity of $100 at the end of Year 20. Since ROE has been 20% for donkey years, we can assume that it is also 20% in Year 21. And Voila, it IS 20% and Co. X earns $20 in net profit. Assuming the Co. X pays no dividend, this $20 is then added back to shareholders’ equity at the end of Year 21 and so Co. X shareholders’ equity becomes $120. In Year 22, Co X again earns 20% of $120 in net profit which will again be added back to its shareholders’ equity and become $144. Shiok huh!

So as you can see, ROE measures the growth rate of the company’s shareholders’ equity if the company does not distribute out net profits as dividends. (If it does, the growth rate simply becomes ROE x (1 – payout ratio), where payout ratio is between 0-100%.)

So when a company has an ROE of 20% and can maintain that, it means that the company can grow its equity base organically by 20% every year (i.e. without relying on M&A etc). Sounds attractive right? This is another reason why people look at ROE so much.

PS: Shareholders’ equity can grow by 20% per year doesn’t mean that stock price will also grow by 20% per year, There is difference between performance of the company and the performance of the stock!

See also ROE Part I

Return on Equity, Episode I (ROE-EP1): Beating the Cost of Equity

That's a cool title! Agree? Anyways, this is probably the last important financial ratio that I have not touched on. You are wondering just how many financial ratios did Wall Street come up with right? Well this is different, this is the famous ROE and its equally famous Du Pont decomposition, chim huh?

Ok, Return on Equity or ROE measure the return that can be earned by the portion of shareholders’ money in the company. Mathematically, it is defined as

Net Profit / Shareholders’ Equity

This is totally different from earnings yield so pls don’t get confused. ROE has to do with the financial performance of the company while earnings yield deals with the performance of the stock. Over the long run (i.e. very long lah, like 20 yrs or more), both should converge, but fundamentally they measure different things.

So why is ROE important? Bcos it measures the profitability of the company with respect to shareholders’ funding. Equity capital comes at a cost (just like debt) and a company with a low ROE runs the risk that it cannot earn its cost of capital (equity in this case) and this means that the company is in deep shit.

As an analogy, say Investor T decides to invest in this Company S and T demands a 8% return over the long run. If you are asking why 8%, don’t ask bcos it introduces a lot of chim stuff like CAPM and more Nobel Laureates which will make it quite complicated. So let us save that for another post.

So T wants 8% but say this S is actually quite crappy and can only do 5% return. This means that T is not adequately compensated for investing in S bcos S is a in a risky business and T might as well have put the money in a bank or perhaps invest in a structured product tied to the growth rate of ministers’ pay which could have given T 8% return or more. So that’s bad news for S bcos equity funds will pull out and S may have to cease operations. So in order for S not to cease operating, it must has a ROE at least as high as its cost of equity.

In other words, a company should earn its cost of equity in order to justify its existence to shareholders. The higher the ROE, the easier for the company to earn its cost of equity and the better the company is as an investment. This concept can be expanded to the cost of capital of the company, where we bring in the cost of debt together with the cost of equity. So a company has to earn a return more than its cost of capital to justify its existence to both shareholders and debtholders.

There are other ways to look at ROE and we shall examine them in later posts.

Price Earnings Ratio and Earnings Yield (Again!)

One way of using Price Earnings Ratio (PER) is to look at its inverse: Earnings Yield. This has been discussed in a previous post, but I would like to emphasize the importance of Earnings Yield, hence the PER strikes back. Do not under-estimate the power of PER… Ok ok, let’s move on.

Earnings yield is the inverse of Price Earnings, meaning when I say I will only buy stocks with PER of 18x and below, I am actually saying I will only buy stocks with earnings yield of 5.6% and above. Or stocks that will give me 5.6% return over the long run. (1/18 is 0.056 or 5.6%, this is what I meant by the inverse)

Consider the China market now. Its PER is over 40x. This means that the Chinese farmers and the Chinese students are willing to buy stocks that will actually only give them 2.5% return (1/40 is 0.025 or 2.5%). They might as well put their money in fixed deposit in Singapore! The other time when the PER of a market reached 40x was during the dot com bubble. Of course, with bubbles, you can never know when it will break, so 40x can go even higher, to 100x. And with China, it may be possible bcos there are maybe another 800mn farmers and students waiting to open brokerage accounts. This is the perfect Greater Fool Game, if you are those who like to play this game.

Earnings yield can also be incorporated with the risk-free rate to calculate the equity risk premium, i.e. the excess return to investors who are willing to risk their money to get better return, hence a risk premium. Remember higher risk, higher return. For STI, the earnings yield currently is roughly 5% while the risk free rate is roughly 3%, so investors are being compensated an additional 2%, the equity risk premium, for investing in risky equities or stocks. That’s actually quite low by historical standards. Equity risk premium should be around 3-5% on average.

For the case of our lovely China, the risk-free rate is now roughly 3% while the market earnings yield is 2.5%. This means that the equity risk premium is actually negative! 2.5% minus 3% gives -0.5%. You are being penalized to invest in risky equities. This is higher risk lower return! What an ingenious break-through!

However, I must stress that a lot of this stuff is academic talk and offers little help in the real world, China’s equity risk premium can go to -3% for all you know, meaning the stock market can still double from current levels.

But earnings yield is a very handy concept to use when you want to gauge the potential return that you will get from your investment (if you hold for the long term). Next time you want to buy a stock with PER 30x, ask yourself, am I ok with this stock giving me a mere 3.3% return over the long term? I would advise you to go open fixed deposit!

The Holy Grail in Asset Management: Producing Alpha

Producing Alpha is also known as Beating the Market in Layman’s Language. We shall talk about Alpha and Beta later on.

There are actually 2 games that are being played in town. The absolute return game that most retail investors and hedge funds play and the relative return game that most monkeys on Wall Street play.

The absolute return game has simple rules, bring me 20% return per annum. That’s the target. For retail guys, if you can do that and can sustain that performance for 20yrs (i.e. earn 20%pa for 20yrs), good for you, your track record is among the best in the world, probably you are a multi-millionaire now and you should really think about doing some philanthropy.

It is actually quite difficult to have negative return in the absolute return game if your investment horizon is longer than 10yrs. But we hear of so many folks losing their pants in stocks and investments. Why? Bcos most pple buy the hottest stocks in the markets, usually paying peak prices and of course after the fad, the stocks nosedive. Same for property speculators who bought 500sqf condos at $2000 psf during 98 and their successors buying 500sqf condos at $3000 psf today. (Actually even if you bought at these peak levels, if you could hold it out long enough, you would not have lost your principal.)

The relative game is a funny game. The rules state that you win when you earn a return that is better than the market return. If the market return 10% this year, you must bring in at least 10.1%. Conversely, if the market return is -10%, even if you lost -9.9% of your money, you have beaten the market and hence become a Big Swinging Dick (i.e. a hero lah), but in reality you have lost money. Btw the market return is usually proxied by an index like STI or Hang Seng or Nikkei etc.

In investment lingo, the excess return earned over market return is called Alpha. (whereas market return is called Beta). On Wall Street, Alpha is like the Holy Grail of Investing. Everybody is looking for it. Some knows where it is but they will never share with others their secrets. Some thinks that it doesn’t exist.

Tons of monkeys play this relative game of Alpha hunting and ironically 90% of them lose out to the market over the long run. In one particular year, some monkeys can beat the market flat, they earn 20-30% on top of market return but the next year, they become shit, and remain like shit for the next 5 years. Seems like to Holy Grail does not exist after all.

But yet we always hear of people who can do it. They can produce Alpha (earn excess return over the market), not just 1 year or 2 years but 10-20 years. People like Warren Buffett, Peter Lynch, fund houses like Pimco, Citadel etc. Is it possible that the Holy Grail actually exists?

Well, one theory says NO. These Alpha producers are just part of the statistics. If you conduct an experiment for 1,000 monkeys to flip coins, and the winners are the monkeys who can flip the most no. of heads. After 1 round, there will be 500 monkeys who managed to flip heads, that’s probability and statistics. By the same logic, after 8 rounds, there is bound to be 2 or 3 monkeys that actually flipped 8 consecutive heads. Are they skilled coin-flipping monkeys or just part of the statistics? So if we think of the stock market as the coin-flipping experiment, Warrren Buffett, Peter Lynch, Jim Rogers, Pimco and the whole lot of Alpha producers may just be part of the statistics. Actually nobody ever beats the market.

I would like to believe that true Alpha producers do exist. They are the outliers because of the effort they put into sharpening their thinking, enhancing their investment process and improving their rigorous analysis. They belong to the top 10% (of all market participants who beat the market) because they earned it. We have seen this in schools, in income distribution, in sports etc. The best of the best are there bcos they earned it. For the top investors 8%pa return is not good enough and they strive for more. Just as for top students, a pass is not enough. They want straight A's. And top income earners strive to earn the next million. They don’t just lament about how come their salary increment is only 5% this year. They constantly seek to improve themselves and come out with ways to earn more money.

Yes, if you want to beat the market, you need to work harder than the market. (And some luck help, of course). But for those who are not so diligent, the good news is the market return is 8%pa on average. You earn this 8% simply by buying indices. That’s probably the closest to get a free lunch, ever.

Back to basics: Price to X, where X equals earnings, sales, cashflow etc

A lot of first-time readers to this blog has feedback that a lot of issues discussed here are too complicated and difficult to understand. I must stress that it is always easier to start reading from my earlier posts and then build on from there as your understanding of the concepts improve.

Nevertheless, to make it easier for new value investors wannabies, I will re-visit old topics to help illustrate the concepts (paiseh to the old-timers here, I will try to add new insights into these re-visit posts as well)

So the topic to revisit today is Price to X, where X equals earnings, sales or cashflow etc. In the earlier post, we talked about the most famous one of them all, Price Earnings Ratio or PER. Today let’s try to further understand this ratio and also try to examine the other siblings.

The price of the stock, as we know, is meaningless. SIA is $18, SMRT is $1.9, SGX is $8. It tells you it cost $18,000 to buy 1 lot of SIA but that’s as helpful as telling you that a property in Istanbul cost 200 million Lira. You have no idea whether it’s expensive or cheap right? (Unless you are a Turkish property agent who specializes in Istanbul and know the SGD Lira exchange rate.)

Everything needs to put into perspective. In the stock market, the convention is to divide the stock price by something else. This something else can be sales, earnings, cashflow etc. This is analogical to the psf used in property. Price is divided by floor size so that a common basis for comparison can be established.

So for the case of the Price Earnings Ratio or PER, Price is divided by the Earnings Per Share or EPS of the company. The lower the PER, the cheaper the stock. (same for property, the lower the psf, the cheaper.) Historically PER ranges from 10x to 40x for whole markets and 2x to 1000x or more for individual stocks. My rule of thumb is if the stock’s PER more than 18x, I think is too expensive for me and I won’t buy the stock if even has the most wonderful growth story.

In the heydays of the dot com boom, most companies don’t have earnings so the Price to Sales ratio was invented to gauge whether the dot com company is cheap or not. Analysts got so ingenious that someone even came up with Price to Eyeballs ratio i.e. Price of stock divided by no. of eyeballs viewing the website. Like that also can!

Of course after Enron and other multi-billion fraud cases, people started to realize actually earnings may not be reliable bcos co.s can always cook their books. So they look at Price to Cashflow, bcos co.s can make up earnings but cashflow is presumably harder to manipulate. Or so they thought!

Investment horizon

Studies have shown that it is quite pointless to time the market if you have a long investment horizon. Btw investment horizon is simply the time when you start putting your money into some stocks or other investments until the time when you sell or divest them.

For simplicity sake, we would just focus on investing in stock markets, and not so much of investing in one stock, or other asset classes.

From 1950 to 2000, if you invest in a stock index (e.g. the S&P500) and your investment horizon is only 1 yr, i.e. you buy in any particular year and sell 1 yr later, your returns can fluctuate from -50% to +25%.

This means that if you are damn bloody good at market timing and started investing in at the bottom of the cycle, (e.g. 1998 to 1999), then your return can be 25%, in 1 yr. And if you are damn suay, and started at the peak of the cycle (1996 b4 Asian Financial Crisis), your return can be as bad as -50%, whoa that's why so many pple get burnt by stocks huh.

Going by the same logic,
If you invest for 5 yrs, your returns fluctuate from -3% to +23%.
If you invest for 10 yrs, your returns fluctuate from +1% to +19%.
If you invest for 25 yrs, your returns fluctuate from +8% to +17%.
If you take the average of all these returns, it is roughly 10%.
In fact average return for S&P500 over an 80 yr period is 10%pa.

As you can see, the risk or volatility of return decrease when the time period gets longer. Even if you had invested at the peak in the stock markets, you will at least get 8%pa for the investment horizon of 25yrs.

Of course if you hold your investment even longer, return converges to 10% (don't ask me how long hor, beyond 25yrs is the realm of academia, and it doesn't really make much sense in on our 3min MTV cultured Earth).

The common man concept of investment is hold for 2-3mths, make a profit and run. I really don't know how to define this? Some call it trading, some call it speculation or gambling, some call themselves chartist whatever. In my humble opinion, if you do this 100 times, most likely you will lose money on 50 trades. If you are damn good, you lose money on 48 trades. But you can cut loss fast on the 48 losing trades while you let your profits run on your 52 winning trades. If you can do this, you can still be a Big Swinging Dick, and probably can earn 10mn with a capital of 10k in 3yrs. And you can start writing books and give talks on how you actually did it, and challenge Adam and Clement to see who has a better track record!

If you like to hold your investments for 2-3yrs, it is still not good enough. Bcos if you invest your money in a down mkt, then you will probably not see light and get very frustrated. Maybe a lot of pple that we know belong here bcos we started investing in 2000, the peak of the biggest bubble in the history of mankind where a few trillion dollars worth of wealth is lost in 1 yr. So if you lost some money here, don't be demoralized, what you lose is a fraction of a fraction of a fraction of a few trillion dollars. We are talking about wealth with 12 zeros here.

If you hold your investments for 10yrs, I would say you are getting close to be a true value investor. Esp if thoughts are given to which markets to buy, which specific stocks to buy. There is still a chance that you will earn only 1%pa for 10yrs, if you invested in the absolute peak of the mother of all stock market bubbles, then you are damn sway and I suggest you go seek enlightenment and become a monk and forget about making money. But by and large, most of us can earn around 8%-12% on our total portfolio after 10yrs bcos that's the return for stock markets in general.

So after all this crap, I guess the moral of the story here is,

1) Long investment horizon you have, go for buy-and-hold and you will earn a decent return over the invested period, hopefully at least 10yrs, the longer the better.

2) You can try to time the market and succeed, you will be able to retire in 3 yrs but chances of that happening is quite remote and you might as well construct an impressive 3mth investment track record then start doing $5000 courses to teach pple how to invest, that way you earn more, faster!

On Technical Analysis or TA

One of the books recommended on this blog has this interesting story about technical analysis or TA. A professor ask a class of students to play a game. They are all given each a pencil, paper and a coin. They are to draw a stock chart with stock price at $1 starting from Day 1. Every toss of a coin represents how the stock will do for that day, and if it lands on head, the stock price goes up 3%, if it lands on tail, the stock price goes down 3%. And from there, they can plot the stock charts for 100 days (i.e. 100 tosses).

Guess what the resulting charts look like?

They look exactly like actual stock charts with famous patterns like head and shoulders (btw this is not a shampoo brand hor, this is a technical signal in stock charts), double tops, double bottoms, flag formation, cup formation etc.

Why is this so?

According to the professor, in the short run (short run means anything less than 10 yrs hor) stock prices move on positive and negative news, and news flow as such are random, like tossing a coin. Hence by looking at how the stock has moved in the past cannot help you predict what it will do in the future. On every new day, the stock has 50% chance of going up and 50% chance of going down, (like tossing a coin), depending on whether good or bad news will come out on that day. So how can you try to determine which way it will go by seeing what coin toss you have done in the past 10 or 20 days?

Then why is there all those studies about technical analysis, head and shoulders, double tops etc? To give them the benefit of the doubt. I think these things work a bit. They probably work 52% of the time and fail you 48% of the time. Btw these are quite good statistics bcos if you go casino it becomes more like 80:20, meaning 80% chance you will lose.

The main reasons why TA work are probably:

1) self fulfilling prophecy: people think that they work and then strive to make it happen, eg when you see a double bottom, you and 10,000 other TAcians buy the stock, of course it goes up.

2) human/investment crowd psychology does not change: this is the basis for TA as explained by TA textbooks, support and resistance levels are formed bcos investor crowd psychology dictates these levels until the next driver pushes the stocks to another paradigm.

But having said that, we must understand that stock markets are complex systems and hence TA can only help you win 52% of the time. There are times that TA can drive the stock prices, and there are times other information like macro outlook, earnings announcement, sentiments etc drive the stocks.

TA is only marginally useful in predicting short run stock peformance and not useful at all in predicting long term stock performance. On the other hand, value investing has zero use in predicting short run stock performance but gives you a little bit of an edge in predicting long term stock performance (probably 54% or so). The good thing about value investing is if you have done work homework, even if you are wrong, you will not lose your shirt.

See also Securitizing Taxis

Balance Sheet and Asset Allocation of a Singaporean Family

Before we go into the asset allocation , let’s take a look at the balance sheet of the Singaporean family. BTW I made all the no.s up and it is not based on any official statistics and no scientific/accounting methodology has been used to come up with the no.s. So please take them with a bucket of salt ok?

Anyways here it is:

Balance sheet of a typical Singaporean family
Assets
Cash & CPF $25,000
Stocks $25,000
Car $45,000
Other assets $5,000
HDB $400,000

Liabilities
Mortgage $350,000
Car Loan $50,000

Shareholders Equity $100,000

Thanks to the real estate recovery in the last 1 year, the typical household now sees some positive equity (as compared to past 10yrs of negative equity for a lot of Singaporean households)

So if we take a look at just the asset part we come to realize that a typical asset allocation/portfolio mix of a Singaporean family is about as interesting as watching a big snake poo-poo. i.e. not interesting at all lah! Anyway, in percentage terms, this would be

5% cash
5% stocks
10% in totally worthless depreciable assets like 1 x Automobile, 2 x Plasma TV and 32,000 credit card points exchangeable for 1 x 60GB white silly looking music player which is also worthless. (btw all these are under Other assets).
and
80% real estate (HDB flat)

If we apply what we have learnt about Modern Portfolio Theory, diversification and Markowitz, the Singaporean household is really quite undiversified and the fortunes of the household is basically determine by how much this little red dot is worth in the eyes of the world.

Fortunately our Government (with a capital G one, don’t pray pray) realizes this (maybe 10 yrs ago) and has planned to make the little red dot the favourite spot for foreigners to come and work and/or invest in our real estate. In concrete terms, 2 important policies made it all successful.
1) The 2 x Integrated Resort (IR) projects
2) The decision to grow our population from 4mn to 6mn pple
And as they say, the rest is history.

So what does it mean for the Singaporean family that is trying to push its asset allocation closer to the efficient frontier? Well if you believe in the almighty of our beloved Government, you can buy more real estate, hopefully somewhere overlooking Marina Bay and Sentosa. If your bet is right, forget about efficient frontier and the rest of the crap, you can start writing your own blog about how you made it and how this blog sucks.

If you believe in Markowitz and diversification, then it’s better to think of how to diversify the portfolio from real estate. Alas, this is not easy bcos RE will probably make up a huge chunk of your asset portfolio and you can only either save a lot more money to invest in stocks or other asset classes, or sell your property and downgrade. I admit both are not very realistic lah. But it’s important to keep this in mind though. And when you have the means to diversify, you should do it.

See also Efficient Market Hypothesis

Asset Allocation

As a seasoned value investor (for those who have been following this blog, hopefully you have become one), asset allocation is a must-know.

Remember we talked about portfolio theory, Markowitz, efficient frontier and the kind of crap. Umm well, actually not that crappy, got win Nobel Prize one, don't pray pray ok. For those blur, read this post. Now in order to earn a return that is on the efficient frontier, meaning the portfolio is so efficient whatever you put in goes straight into your bank account x 10% and then gets immediate giroed to pay your credit card bills.

No, to earn a return on the efficient frontier means that this return can be earned with the least risk possible. Say if you target 10% return, but your portfolio risk is 25% while the risk of a portfolio on the efficient frontier is only 15%, then you loogie big time, bcos your portfolio is not efficient at all and you should really go put some oil on your money to make it run smoothly or something.

So how do we make our portfolio efficient? The answer lies in asset allocation. Asset allocation simply means determining how much to put in different asset classes such that the risk and return will be optimal, i.e. the portfolio is on the efficient frontier.

Back in the good old days when we have only 3 asset classes, the classic answer is 50% stocks, 40% bonds and 10% cash or some similar variation, say 60% stocks, 30% bonds and 10% cash etc. But today, we have 10,000 asset classes, so things are not so simple anymore. An efficient portfolio probably looks like this

40% stocks
10% bonds
10% hedge funds
10% real estate
5% private equity/venture capital
5% commodities
5% gold
5% cash

For a more scientific asset allocation, go google for Havard Endowment’s asset allocation, and you can see how the pros do it. If you want to be better then on top of the above mentioned asset classes, maybe you should consider adding

1% art and antique
1% wine and coke bottles
1% watches and diamond rings
1% krisflyer miles
1% adopted chinese brilliant kids
1% securitized future cashflow from this blog

Ok that’s just for fun hor, don’t follow blindly. The point that is being illustrated here is that current wisdom advocates finding more asset classes that are uncorrelated and then putting some portion of your portfolio in them. (This post has more info). The truth is for the retail investor, finding exposure to asset classes other than equities, bonds and real estate is actually not that easy. Most hedge funds and private equity funds will not accept retail money. But I always believe that when there is a will, there is a way. If you think you really want a well diversified portfolio then you will find ways to do it. Next post of a typical asset allocation for a Singaporean household, watch this space!

See also Efficient Market Hypothesis

Forward PER

PER may be a simple concept but its application can actually be quite complicated. For those who need some refresher course on the PER, it is the Price Earnings Ratio of a stock. It tries to determine the cheapness of the stock by dividing the stock price by its earnings per share (or EPS). For more info, read this post.

Now the issue here, which have never really been discussed in detail in this blog all thanks to this blogger who conveniently left it out, is which EPS should we use to calculate PER? Is it the latest historical EPS announced by the co.? Or what?

The answer is the expected EPS in 1 yr's time (not announced by the co. yet, i.e. it is not in the annual report). The resultant PER is also called the forward PER. The reason is very simple. The stock market always look forward, not backward. It is the culmulation of the expectations of all the players in the market. Hence when using the expected EPS of the stock in 1 yr's time to calculated PER, we roughly get a good sense of the market's expectation of the value of the stock.

BTW, this expected EPS (also called the consensus EPS) is usually the average of all the sell-side analysts EPS estimates for the next year and this no. can be easily pulled off bloomberg or other financial information providers. Now of course you may argue, sell-side is good-for-nothing and their estimates are usually wrong. Then naturally you can do your own homework and come out with your own expected EPS in 1 yr's time and use that to calculate the stock's forward PER. Well that won't be too hard right?

Also, you may ask why 1 yr? Why not 2 yr or 10 yr? Well actually you can use any year you want, if you can forecast correctly the EPS of the stock in 10 yr's time. You should use that. For some business, you can, and you should. But when you are looking at a stock for the first time, it would be easier to get the consensus EPS estimate and get a rough sense of the stock's forward PER. As a rough gauge, I would consider anything less than PER 18x as cheap and I would not buy any stocks that is trading at more than PER 18x.

See also Price to book ratio