Traders and Investors

Just like to share my own definition of traders and investors that I thought about recently...

First let's start with Ben Graham's definition of investors and speculators.

Graham first stated that an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return and operations not meeting these requirements are speculative.

So an investor focuses on analysis to look for capital safety and adequate return. This is usually interpreted as fundamental analysis of the company, its business model, its competitive advantage, margins, sales growth and of course, the financials: cash on hand, debt, bankruptcy risk, capex needs etc.

Anything less of such analysis means speculation. A speculator is simply one that doesn't do that kind of rigorous analysis.

Simple right?

For me I think it's about different focuses.

An investor focuses on value.
A trader focuses on price.

An investor is interested in the value of a stock (or any other thing he wants to buy), and he spends an awful lot of time and effort to figure out this value (or intrinsic value). This is analogous to Graham's analysis. Or more accurately rigorous fundamental analysis of business operations and financials. Price serves only to tell him how much he actually has to pay if he were to buy the stock. Needless to say, the lesser the better. Graham and most value investors advocate buying 30-40% (margin of safety) below the stock's intrinsic value.

To an investor, profit is made when the stock price subsequently rises to its value which usually take years.

A trader is interested in the price of a stock and he spends an awful lot of time and effort following how the price has moved. Actual value of a stock basically serves no purpose for the trader.

To a trader, profit is made when the stock rises above his buying price and he sells it to another person willing to buy at a higher price. Usually also known as the Greater Fool.

So, that's that! Just two different philosophies here to make money.

Balance and Reversion

Taoism talks about being in tune with the Universe and consequences of allowing a strong force to overwhelm others. Yes we are talking about the Yin and the Yang. Both forces should balance each other to achieve Balance. A stronger Yin over Yang or vice versa leads to unrest, discomfort and ultimately it calls for a reversion to the mean.

In Graham-speak, this becomes Bond versus Stock. Back in his days where there were only 2 asset classes: Bonds and Stocks, his strategy was to always maintain a portfolio with at least 25% in one asset class and a maximum of 75% in the other. And this is when one asset class in grossly overvalued versus the other. In most cases, it should be a 50:50 split between bonds and stocks.

So as with Taoism, the ideal situation is always an equal split between the bonds and stocks. Both asset classes will be in balance. Bonds give income, stocks give capital appreciation. Bonds counter deflation, stocks counter inflation. Bonds, downside protection, stocks provide upside. Totally in sync with the Universe!

However there are times when a stronger force overwhelms the other. With investment, well usually a stock bubble brings valuation so out of whack that it makes sense to disrupt the balance. In this case, overweight bonds and underweight equity. Ultimately, the Universe must return to its status quo, ie stocks will correct to its appropriate valuations and the investor benefits.

Value investing focuses a lot on the process up till buying the stock. But very little is said about selling. Buffett, the Oracle of Omaha, is famous for saying you never sell a good stock except when you want the money to buy a better one. Graham never specifically said anything about selling as well.

But I guess, by reading between the lines and drawing lessons from Taoism, we should sell when things are out of balance. In the case of stocks, when it’s grossly overvalued. The sad mistake we all make is to rationalize the overvalue-ness to justify why we still hold on to the stock. Like the company has this new product that will be a hit, or the company is going to do M&A, or the company is going to increase dividends etc.

So the next time we want to hold on to a stock that had gotten too expensive, think about the balance of the Universe and why reversion will always occur and it’s time to allow that to happen. Sell the damn stock.

Graham and Lao-Tzu

Not sure if it is just me. Reading some of Graham’s philosophy reminds me of Taoism and Lao-Tzu. Using no-change to combat ten thousand changes, cycles and repetitions, no rules etc. More than a handful of Tao philosophy is actually reflected in Value Investing. Well someone did come out with a book called Tao of Buffett.

Combating ten thousand changes

Graham thinks that it is futile to predict the future. Nobody has been able to do it. So what he does is to assume that what has occurred will continue, with relatively high probability. This has of course been well mastered by Buffett, his prodigy. Hence their preference for brick and mortar businesses that basically face little changes over the years (unlike technology or growth sectors).

This is also exemplified by his preference for 10 year valuations. Which I think is probably one of the most important concepts from the Intelligent Investor. You see, on Wall Street today, most people, when they talk about valuations: ie PER and PBR. They talk about Share Price today divided by the Earnings Per Share next year for the company.

Graham uses an average of 10 years’ worth of EPS in order to determine if the stock is cheap. Basically, he is saying that if the average annual EPS over the next 10 years is the same as the previous 10 years, and if the price is cheap (ie PER of less than 15x), then the stock should be a BUY.

This makes whole lot of sense for someone who really thinks about buying a business for REAL right? Think about it, if you are going to buy that coffeeshop down the road. The owner says the shop will earn $500k next year. So you will pay 15x of $500k for the shop (ie $7.5 mn)? Or would you be more willing to buy from the other owner who showed you his average earnings for the past 10 years, amounting to $300k per year?

For one, the average earnings would usually be lower than next year’s earnings forecast. Especially if the forecast is made by a 23-year-old analyst from the brokerage firm. Or in the coffeeshop case, the owner who wants to cash out.

In any case, nobody ever gets their forecast right? So Graham simply uses the past and assume that the future is going to be like that. Using no-change to combat ten thousand changes. Bu Bian Ying Wan Bian.

More Taoism to come.

Analysing ETFs

It came as a pleasant surprise how SGX had expanded its portfolio of ETFs to 30 from a pathetic 10 when I was looking at it a couple of years ago. Recently, the biggest distributor Lyxor (Soc Gen), announced a further 5 ETFs to be listed. Looking at this trend, one can expect the no. of ETFs to go to 50 in the next 1-2 years, providing retail investors an inexpensive way to diversify and invest globally.

http://www.sgx.com/wps/portal/marketplace/mp-en/products/securities_products/etfs
This link provides a lot of info on the ETFs listed on SGX

At this juncture, I thought it would be good to post something about this investment product which might be one of the most important factor to help one achieve a 8%pa long term rate of return. Here are a few things I thought one should look at.

1. Expense ratio
Needless to say, this is probably the first thing to check. SGX listed ETFs have expense ratios ranging from 0.4-0.9%, which is kind of expensive compared to those in the US (as low as 0.2%) but much cheaper than unit trusts at 1.5% sales charge and 1% management fee. Well Singaporeans always get short-changed, so just live with it.

2. Market maker
Some ETFs listed way back in 2001-2002 has zero trades for the past 8 years without market makers which I think resulted in their failure. Now it's impossible to buy or sell them as there are no buyers or sellers! Even though its a listed product. Then came Lyxor with its market maker (basically some execution party and ensures you can buy or sell the ETF even when there is no counterparty) and viola, ETFs took off and Lyxor now has 50% market share of all ETFs listed in Singapore.

3. Spread
Even though there is a market maker and trades get executed, some times we need to pay attention to the spread. My rule of thumb is that if the spread is more than 1%, then it's a huge transaction cost. It is not something that you can change though. My greatest concern would be that if I hold this ETF for 10 years or more when the whole world has lost interest in it, will the spread balloon? Meaning I can't sell it. I have no answer at this point. Enlightened parties, pls share!

4. Dividends
Some ETFs listed on SGX give dividends, some don't. Personally I prefer dividends, a bird in hand man! Yes academics argue it doesn't matter, it might even be better bcos the dividends get re-invested - you don't get taxed, you get higher compounded return! I don't care, I want income stream and I want it now! Well that's me though.

5. Market Cap
The size of the ETFs determine if its likely that this product will continue to be listed, and I would say go for stuff with like USD 50-100mn in size. If it's too small, there might be a chance that the distributor will delist it. Then it's trouble trouble.

6. Valuations
This would be the single most important factor determining what or when to buy. As with stocks having their PER, PBR etc. ETFs also have their PER and PBR. It is not easy to get those figures (without a Bloomberg) but I think you can try to call their hotline and ask around. My general rule of thumb would be buy at PER 12x and PBR 1.2x. Some ETFs were at this attractive level earlier this year, now they are closer to PER 15x and PBR 1.5x. So wait for them to come down.

7. Components
Ultimately, ETFs are made up of stocks. So it pays to look at what's inside and see if you are comfortable with it. As with most indices, the bulk is actually finance stocks. Like STI is 40% banks maybe 20% Real Estate stocks. Russia used to be the hottest thing in town bcos it was mostly just oil companies. Since what we want is diversification, I would suggest look for ETFs that are more balanced, or buy a few to balance it out yourself.

8. Prospectus
Lastly check out the ETF's prospectus, see if anything is amiss or if there is something bothering you? Give them a call if need be. Usually it's some salesperson that is trained to answer some standard questions but no harm trying and hope they managed to help.

I am also still learning about all these, so knowledable parties pls share what you have learnt. 2009 and 2010 would be a good time to finally put money to work and earn a decent rate of return!

What is Value Investing?

Value Investing is perhaps one of the most important topics in life that is misunderstood by the most people. This is a reflection of our modern society that constantly tries to replace rationality, long term thinking and hard truths with sensations, material gains and get-rich-quick mentality.

It is a sad fact that most people today equate investing with gambling when the segregation can be crystal clear. To quote Benjamin Graham, father of value investing, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return and operations not meeting these requirements are speculative”.

In simple layman terms,

Value investing simply means adopting an investment philosophy to buy something that's worth a dollar with a lot less, like 60c or less.

Here is a modification of the old formal definition that I posted some years back.

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Value investing is a broad definition of a style of investment that follow two basic principles:

1) Buying at a price that is less than its intrinsic value

2) Buying with a margin of safety

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In a nutshell, value investing is simply applying the concept of "shopping during bargain sale" to buying stocks, bonds, properties ie investing. It means paying less for more. Get good value for money. Buy one get two free. Buy a dollar for 60 cents.

The concepts here are not difficult to understand and their applications are also straightforward but as with dieting, what makes sense doesn't mean that it's easy to accomplish. This is because human emotions like greed and fear are constantly playing tricks to blur our rational minds which it what makes value investing tough. Especially when there are prices, charts and patterns, talking heads with irrelevant short term newsflow bombarding us daily.

Over the years, the paradigm of value investing has expanded to encompass many things:

1. Fundamental analysis (FA) needs to be rigorously employed in order to determine the stock's intrinsic value. This plots value investing into the infamous FA vs TA argument. TA stands for technical analysis ie looking at charts and stuff.

2. Buying a stock is like owning a business. Hence long investment horizon becomes norm as business owners don't buy and sell their co.s like oranges. And also undervalued stocks usually take some time to revert to it's intrinsic value.

3. Stocks that have certain characteristics become known as value stocks

a. predictable business operations and stable earnings (easier to calculated its intrinsic value)

b. low PER, PBR, high dividend, high cashflow or other "value" quantitative factors

4. Based on the points raised in Pt 3 above, value stocks typically come from mundane industries like food and staples, utilities and other old economy industries ie no high-tech, alternative energy or bio-venture stuff.

5. It is generally accepted that Benjamin Graham is the father of value investing. Other well-known value investing practitioners include: David Dodd, Irving Kahn, William Ruane, Martin Whitman, Charles de Vaulx, John Templeton, Charlie Munger and Warren Buffett.

Since the concept of buying something that is undervalued is so broad, value investing is sometimes used to refer to investing in special situations like merger arbitrage, discount bonds (e.g. some bonds trading at 50% below par value and pays 10% interest and has little risk of default). However, this blogger thinks that this is a stretch for value investing.

For most people, it should suffice to understand that value investing is about owning a partial stake in a good company by buying its stock at a reasonable price.

How long term should we be?

The investment horizon that is appropriate for our generation is probably 15-20 yrs, in my opinion. This is bcos we usually have some savings after the age of 30-35 for some real investing as we get married, buy house, have kids etc. And if you think about at what age should you enjoy the fruits of your investment, then it's probably 15-20 yrs later. I mean retirement age may go up to 62 but shouldn't we start thinking about enjoying life in our late 40s, early 50s? No point investing for 40 yrs and then get old and immobile and use the fruits of investment to pay for medical bills right?

Also, we shouldn't forget that even though official retirement may become 62 or it might go up to 65, probably it gets harder and harder to stay employed as our generation hits 45 years old. This is a major social reality/issue and it is already biting at a lot of people. Look around, do you see a lot of your colleagues who are in the 50s or 60s? The career life span is shortening. If you are in your 30s like me, we cannot expect to stay employed until 50.

Say if the investment horizon is only 15 yrs, and intrapolating the no.s on my previous post, the returns probably vary around +3% to +18%. ie if you bought at the peak of the market, you can expect to get 3%pa, which is worse off than leaving money in CPF. And worse still, if you had bought in 2007, it is likely that you might take more than 15 years to break even.

In order to mitigate this undesirable outcome, we must definitely employ a sound investment plan or some form of dollar cost averaging which basically means you put aside some money to buy stocks or bonds or funds every month. This should provide a +ve return after 15 years.

To aim higher, ie achieve an ok return like 8%pa, we must pay attention to market cycles in the macroeconomic sense. Don't buy a whole lot of stocks during the peakish periods and look to buy during doldrums (like now). Of course for true Graham/Buffett style value investing, the valuation takes care of this. You won't be buying stocks at the peak bcos the valuations will say No-No. Graham is famous for using his 10 yr valuation to smooth out earnings peak and trough during cycles. He would say BUY only if stocks are trading well below 10 yr valuations. ie Price/Average EPS over 10 yrs is less than 18x. He also have 6 other criteria to follow. Basically, you can't find stocks meeting most criteria in 2006-2007.

In conclusion, to get an ok return on investment (like 8%pa) over a 15 yr investment horizon, we need to know the macroeconomic trends, don't jump into stocks when everyone is also jumping in, focus A LOT on valuations, esp long-term valuation (not 1-2 yr forward EPS) and keep that margin of safety concept in our heads, and we should be ok.

On market timing

This is one topic that always attracts a lot of debate and verbal lashes. Value investors are of the view that it is futile to time the market. Over long period of time, studies have shown that you cannot beat market return after factoring transaction costs. This does not mean one cannot have positive returns. It might be possible to generate positive returns but I have enough evidence to believe that it's quite difficult.

Traders, on the other hand, believe that market timing is part and parcel of "investing". Well what value investors define as investing may be different from what traders define as investing though, but for now let's not delve into this yet. Anyways traders believe that those who don't look at charts and to a certain extent, time the entry and exit are idiots.

Ok, first we should actually define the two different types of market timing that exist.

The first type is looking at daily, weekly, monthly, quarterly or even 1-2 yr charts and try to time the bottom and top. ie buy at the low (as dictated by chart patterns or other signals) then sell at the high. To try to win this game is very similar to playing at the casino. Your chances of winning are usually less than 50%. Nevertheless there are ways to make money even when you are up against the house. The book Fortune's Formula provide some interesting insights. I hope to discuss some interesting stuff from this book in the future but for now, we are not interested in this definition of market timing. You are at a value investing blog, remember?

Ok, the 2nd type of market timing involves 5-7 years macroeconomic trends and stock market cycles. This is the important type of market timing that we shall focus today.

From 1950 to 2000, if you invest in a stock index (in this post we use stats from 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 vary between -50% to +25%.

This means that if you are damn bloody good 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 (like 2007), your return can be as bad as -50% in 1 yr.

However as your investment horizon stretches, the returns tend to vary less and get skewed towards a +ve return.

If your investment horizon is 1 yr, your returns vary from -50% to +25%.
For 5 yrs, your returns vary from -3% to +23%.
For 10 yrs, your returns vary from 0% to +19%.
For 25 yrs, your returns vary from +8% to +17%.
This is true for the time period 1950 to 2000.

The worst 25 yr return rate on record is when you started investing in 1929, your return is actually 0% after 25 yrs. Incidentally, this may be the case if you started in 2007. In order to avoid this pathetic outcome, someone invested in 2007 should keep buying esp in 2009 and 2010.

If you take the average of all these returns, it is roughly 10% which is average return for S&P500 over an 80 yr period. What about the other markets? Sadly most other markets do not deliver as good returns and the S&P. Japan for one, has a 25 year bear market and still counting. However, it's probably safe to say that stock markets have delivered 5-8%pa over the past 20-30 years even after taking into account this crisis.

Ben Graham, the father of value investing, advocates that we should not try to time the market and simply be happy with this 5-8%. Buffett had also mentioned that one of the best investment strategies for the retail investor would be to set aside some money buy an index fund every year and earn this 5-8%. It's simple, saves time, get rid of the emotions and can make you real money for retirement!

Stock vs Spouse

If you are really into value investing, you should, hopefully by now, understand that buying and owning stocks can be akin to marriage. It is not about buying today, selling tomorrow. Or instant gratification. Or short term happiness. It's about long-term commitment, going through thick and thin together, sharing your lives.

Here's the list of comparisons. Enjoy!

Stock and spouse

1. Both are meant to be enduring life-long affairs.

2. Both require a lot of due diligence before committing to achieve happiness.

3. If you have made a good choice, the relationship only gets better over time.

4. You wouldn't admit it's a bad investment until it's too late.

5. If you've got a real gem, you can always show your friends and feel proud.

6. It's always better to start looking early in life. But not too early, teenagers reading this blog, sorry teenage = too early.

7. It's unwise to dismiss potential targets when there are only minor flaws bcos good ones are hard to come by.

8. And really, the super good ones are very hard to come by.

And here's the treat of the day!

Stock vs Spouse

1. A stock doesn't care if you surf net all day and didn't spend quality time with it.

2. A stock won't leave you for another sweet young thing.

3. A stock doesn't care if you look at other stocks.

4. A stock doesn't occupy 70% of your bed and SNORE.

5. A stock always look good in the morning, without make-up or grooming, even after 10 yrs.

6. A stock is never interested in how many stocks you have in the past.

7. You can still buy a stock even if you don't have a car, 2 condos, 3 country club memberships and 5 credit cards, well you do need a few thousand dollars though.

8. A stock doesn't need a diamond ring (with increasing carat) every 24 months.

9. A stock doesn't throw a big tantrum if you forgot the 15th anniversary of the day you two first met.

10. You don't have to visit the stock's Mum, Dad, 3 Aunties 6 Grandmas and 14 Uncles EVERY WEEKEND.

11. A stock will never complain about your cooking or your spending or anything about you for that matter.

12. A stock doesn't care if you make more money that it does.

13. A stock gives you dividends every year, usually you give your wife shopping allowance every week.

14. A stock gives you dividends every year which usually grows even bigger over time. Chances are not high to find a husband who can match that, esp if he is reading this blog.

15. When you decide to part ways with a stock, it doesn't go around bitching about you.

16. When you decide to part ways with a stock, it doesn't claim ownership of 50% of your OTHER ASSETS.

But a stock cannot give you a massage when you need it, a shoulder to cry on, share your joy and laughter, love you and care for you in sickness and in health.

And that's why Spouse still wins.

Wisdom from the Guru

The following is taken from the latest Berkshire Hathaway Chairman's letter.

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In good years and bad, Charlie and I simply focus on four goals:

(1) maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash

(2) widening the “moats” around our operating businesses that give them durable competitive advantages

(3) acquiring and developing new and varied streams of earnings

(4) expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.
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Undoubtedly good advice for retail value investors as well. In this post, I shall add my two cents brief commentary on each of the following points raised from the guru. (The link here: Just in case you are new here and wondering which guru we are talking about.)

1. As individuals, how much cash should we have in hand? There are many rules to live by. Going by portfolio construction, 5-10% in cash. In times like this, some would say 100%. But I would live by Graham's rules of not trying to time markets, ie maintain a fixed proportion in certain asset classes regardless of what happens, and rebalance that ever yr - ie if it becomes 20% bring it back down to 10% or vice versa. However, one other rule that I live by would be 6-12 mths of living expenses. Unemployment rate can hit both the headlines and us! So for me, it would 10% of portfolio or 12 mth living expenses whichever is more.

2. For this, since small time retail investors like us can't really help to enhance the moat of our companies, we should focus on buying co.s ALREADY having a durable competitive advantage. This would be big brands, strong companies. In Singapore, as mentioned in my past posts, probably less than 30 of them around. However, as individuals, we can and should focus on expanding our personal moat: something that we can do exceptionally well, much better than most people. This takes great effort and a hell lot of time, and most people never achieve anything of significance. Well, still need to try though, just be the best that we can be!

3. This came as a surprise. Buffett is not known for diversifying his bets. Anyways, I have always advocated not to put all our eggs in one basket. This, I think is a universal truth. Of course it does not make sense to have 100 bets as well. Probably a dozen of new and varied streams of earnings will earn the praise from the Guru himself!

4. Again as individual investors, we cannot really get to know top management well enough. We can only get to know them from media and from their actions (like whether they suka suka do RIGHTS issue! - which btw is super duper bad for existing shareholders, and not a free treat to buy stocks cheap as most aunties and uncles would like to think). In the context of personal networking, this means to mingle with people with the correct mindset, with honesty and integrity.

Well always refreshing to read letters from the Guru himself. Hopefully Berkshire's stock price can recover soon!

More on margin of safety

A frequently asked question on value investing is this: how can you be so sure that the co's intrinsic value is $100 (or any other no.)?

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 30-40% below your calculated intrinsic value. That is if you calculated that a stock is worth $100, you should be buying only when it hits $60-70.

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%, below your buying price but quite unlikely to tank 80% below your buying price. And chances are after it tanked it will creep back up again, it will not bankrupt you. That's the strength if you have a huge margin of safety.