What's Wrong with Buy-and-Hold?

This is another topic that has been debated left-right-centre since... Geez, Adam and Eve I guess. Let's just go through the usual pros and cons. I will start with the Cons.

Cons

1. Doesn't help to make money

This has been highlighted various times in the papers. Someone who bought an index, say the S&P500 and held for the past 10 years would have made zero return. In some markets, you could have bought-and-hold for the last 20 years and still lost money. The best example being Japan. Buy-and-hold at any point over the past 20 years would have made negative return! So to hell with Buy-and-Hold right?

2. What about locking in profits?

If a stock has risen 100%, and knowing that stocks on average gives only 8%pa, this stock has already given you roughly 10 yrs worth of return, isn't it a good idea to lock in the profits? Especially if the stock intrinsic value is not going to grow by that much over time - meaning that it's grossly overvalued. We should sell when things are grossly overvalued, right?

3. There is no time.

Buy-and-hold takes a long time to give you a good return ie average market return of 8%pa. However, time is a luxury that not everyone has, especially if you are 40 and above. You need a substantial retirement nest egg in 15 yrs assuming you retire at 55. Although retirement age is 62, most people don't get to stay employed until that age unless you are a civil servant, or self-employed. And increasingly, the career lifespan is shortening, look around you, do you see a lot of your colleagues in their 50s? So how do you buy-and-hold in 10 or 15 years? Incidentally, if you bought the STI index in Dec 99 at 2,600 points, you just managed to claw back your capital as the STI today is, well, at 2,600 points! 0%pa after 10 years, that's great isn't it?

So Buy-and-Hold sucks, what should we do?

Well you trade. You buy the STI when it was at 1,200 in Sep 2000, Hold until Sep 2007 and sell at the peak of more than 3,000. Buy back when it dropped to a low at 1,500 in Jan 2009 and sell now at 2,600. You would have make 500% gain over the past 10 yrs, that's roughly 50%pa.

Haha, well this can only be done on hindsight. Most traders lose their pants trading bcos their emotions get to them. Even if they bought at 1,200, they would have sold when it reached 2,000. Then hastily buy more when it reaches 3,000 and then got stuck when it collapsed, etc. Well you know the story, don't you.

Trading works when you have a good trading system and you adhere to it. 100%. If you do that, you can probably make an average return of 4-6%pa after transaction cost. Of course, legendary traders make a lot more than a meagre 4-6%pa. So we should strive to be like them! Then value investors will bring out Warren Buffett, who made 24%pa for 50 yrs and grew USD 1mn to USD 60 BILLON. So better argue based on average returns, not the legends' rate of returns.

In reality, most retail traders lose money trading. We are not even talking about market return of 8%pa here. Next post, we look at what's right with Buy-and-Hold.

The ultimate bet

This post is related to the last one regarding probabilities and payoff and how we should bet.

We often hear about people betting their life savings of $100k on the next property of say $500k, hoping for that 20% rise before TOP and make $100k return (with a capital base of $100k). Lets see how this works in that matrix thingy we used in the previous post:

Let's give the benefit of doubt and say this guy has 70% chance of making $100k, he has read the property market well, the cycle is turning, the stars are aligned. However, again in life, since nothing is 100% one, we have to think that he also has a 30% downside whereby he will lose $250k (ppty of $500k goes down by $100k, mortgage $130k, legal fees $20k all add up to $250k)

Probability payoff
0.3 -250k -75k
0.7 100k 70k
Expected return -5k

Now we see that the expected return is negative. Even if we tweak the no.s here and there, which I did, the expected return is not high. You can probably get to expected return of $80k - which is good if you use $100k as the base. But in reality the base is $500k, bcos the guy borrowed $400k from the bank. So you risked a life of perpetual debt for $80k, is it worth it?

In real life, and not just paper math, if the 30% probability becomes reality, this guy is stuck with a $500k 30-yr mortgage on a house worth significantly lesser, he may have cashflow problem and need to sell out some time in the next 30 yrs, or declare bankruptcy. As we know it, his life is over. Well at least financially that is. He will never achieved the much coveted financial freedom, a nice cosy retirement nest egg and the kind of crap Robert Kiyosaki likes to preach.

Anothe way to look at it, we can think of such bets as extreme as this Russian Roulette game:

1 shot of out six has a real bullet.

If you win, you get paid $5mn, enough for a lifetime. (Well at least for me, I dunno about you though)

If you lose you die.

Odds are in your favour: ok let's make it even better, we have a revolver that can house 20 shots.
So only 1 in 20 chance you will die.

19 in 20 chance you never have to worry about money in life.

Will you play?

Betting when the downside is something we cannot afford to happen is not a good way to bet. Think about this when you are faced with such choices.

Probability and Payout

This is something that relates to the Kelly Formula but at a much more simplistic level.

Basically, it all started when some friend of mine had the idea that if we are 80% sure of a 10% upside, we should be punting big on this event?

Eg. we heard a rumour that the CEO of TSMC saying he wants to buy Chartered for $2.20 (Today closing price $2.00) from the secretary of the CEO of TSMC and he will announce it tomorrow. How should you bet?

Mathmatically, this event can be illustrated with the matrix below.

Probability Payout
0.8 10 8%
0.2 -20 -4%
Expected return 4%

In the first scenario, there is a 80% chance you earn 10% and in the 2nd one 20% chance you lose 20% bcos say for some reason, he did not announce it the day after, or something unexpected happens. In life, nothing is 100%, even if you are the TSMC CEO yourself, you cannot say for sure if you can make the announcement as planned. You might get murdered, or something else etc, Anyways, as such is the case, the expected return is actually about 4%, which is, well, lower than market return of about 5-8%pa.

My initial thought is that we cannot punt this kind of event to help us make big bucks. Given the inherent unreliability of a rumour, the low expected return, it is not exactly a good way to maximize wealth. Of course we can always tweak those probability and payoff to get a good expected return, but using logic and rationality, it is difficult to get a good expected return of more than 15%.

In value investing, I think the matrix looks like this:

Probability Payout
0.4 -30 -12%
0.6 50 30%
Expected return 18%

There is a 40% chance you will lose 30% of your money, but a 60% you make 50% (remember margin of safety and other safeguard put in place?) Your expected return is 18%. If you make enough of these during a lifetime - you are a clear winner.

The caveats here are:

1) your analysis must be quite accurate, ie the intrinsic value is really 50% higher than current price

2) the timeline here is long, it may take 3 years to realized this 18%, which means 6%pa

You might think this is just bcos I am promoting value investing. But if you play around with the probability and payoff you can still get 10+% payout on average, which would translate to only 2-3%pa but still it's positive number.

Back to the TSMC case, you can argue that the 4% when translate to annual return becomes 1200%pa. Spectacular! However the logic would be that you won't get to hear a rumour about a takeover 300 days a year... So looking at the absolute expected return no. regardless of the timeline becomes important. And if you play around with the probability and payoff for this, you do get negative numbers.

So with this in mind, hopefully you can do this simple exercise with your next stock buying and practise more value investing rather than punting!

Best Of The Best

This is an updated list of stocks screened out by some value factors, like less than 2 yrs of negative free cash flow over the past 10 years, high dividend over the past 10 years etc.

Sorry I have no clue as to how to make the image bigger, so pls click on it to see the whole damn table.

The ratios you see are also 10 year average ratios, hence they will look different from what you get in most places. This is adhering to what Ben Graham taught. Looking at the performance of the company over a long time frame to smooth out any economic cycle, boom and bust that the co. went through, and most importantly bring down the no.s especially if the company had had spectacular growth in the last 1-2 yrs.

My personal top pick is Cerebos Pacific, Brand's Chicken Essence rules man! More on this next time.

And finally, disclaimers, buying stocks listed here won't guarantee that you will make money. If really these stocks here can make anybody rich, I won't be blogging here my dear!

Anyways, do take a look and see if you agree these are the best of the best listed on SGX!

More Payback in Years

In line with the previous post, here are more scenarios how payback in years can change drastically with the vagaries of modern life

Bought a water stock – 33 yrs
The CEO got married – 99 yrs
To a scientist nominated for the Nobel Prize for water purification – 12 yrs
They divorced – 33 yrs

Bought a condom stock – 35 yrs
Satellite failure stopped the broadcasting of global sports channels for 2 weeks – 16 yrs
False alarm, satellite’s working! – 33 yrs
Korean melodrama satellite fails – 8 yrs
Global power failure caused by Al Qaeda – 2 yrs

Bought a telco stock – 18 yrs
The co. announced that an ex-CEO of a mining co. will take over as CEO – 180 yrs
The new CEO divested poor performing subsidiaries and incurred losses of USD 4bn – 625 yrs
The new CEO got fired – 18 yrs
The subsidiaries recovered – 68 yrs
The telco co. decided to invest in the subsidiaries again – 255 yrs

Here's the bonus for this week!
List of most anticipated IPOs and their relevant payback years

Twitter IPO – 50 seconds
Facebook IPO – 2 hrs
Facebook acquires MySpace – 120 yrs
Twitter acquires Facebook + Myspace – 2,718,28 1,828,4 59,045, 235,360 seconds

Iridium Satellite Phone Returns! IPO – 125 yrs
Lehman Brotherhood Restructured IPO – 214 yrs
Revenge of the Fallen: Mega-Electron General Motors IPO – 369 yrs

Shanghai Stock Exchange US$100bn IPO – 88 yrs
Bird Nest Stadium IPO at $18 – 188 yrs
Jackie Chan Franchise IPO – 288 yrs

Temasek Holdings IPO, CEO Singa the Lion – 440 yrs
Wimbledon Tennis IPO, CEO Aggassi – 1,066 yrs
Tour de France IPO, CEO Lance Armstrong – 1,789 yrs
Terracotta Army Exhibition IPO, CEO Zhang Ziyi – 6,000 yrs

Jurassic Park Ride IPO, CEO T-Rex – 65mn yrs
Google Earth IPO at $3141.59265 – 4.3bn yrs
STAR WARS Franchise IPO, CEO Chewbacca – 13.5bn yrs

Price Earnings and Payback in Years

Another way to think about the all powderful Price Earnings Ratio is to think of it as Payback in Years. Ok, here's the expraination:

Price Earnings = Price / Earnings

Say if a stock earns 5c per share and you are paying $1 for it, how many years would it take for you to get back your $1?

Assuming that it will earn 5c every year forever, the answer is 20 years right?

And how did we get 20 yrs? Well $1/5c gives you 20.
Which, in case you fail to notice, is the formula for Price Earnings Ratio.

So lower PE means faster payback in years.

Some people talk about it's alright to buy a stock with PE of 40x bcos it's the dream stock, spectacular growth for the next 20 years!

40x is cheap! Let's put in more no.s to this scenario and see what we get:

EPS for 2007 20c
EPS for 2008 40c
EPS for 2009 60c
EPS for 2010 80c

Price in 2009 $32

This stock is, well... trading at 40x PER for 2010 at $32. In order to get a decent payback in years (roughly 15 yrs), the stock needs an average EPS of $2.4 for the next 15 years.

This means that the EPS needs to triple in the next 3 years, grow a bit more and finally stabilize at $2.6 so that the average can hit $2.4!

Even if it somehow managed to perform this spectacular feat, what you have paid for at $32 merely justifies it. You did not get any upside or discount. There is no margin of safety in this investment. So think really hard when you are asked to buy a stock with 40x PER.

Anyways, in line with the points system found in Men are from Mars, Women are from Venus, here is a list of scenarios and the estimated payback years:

Analysed a blue chip for 3 mths & bought it in a bear market - 12 yrs
Analyzed a blue chip for 3 days & bought it in a bull market - 26 yrs
Bought a blue chip without any analysis whatsoever - 33 yrs
Bought a blue chip, heeding advise from a friend - 52 yrs
Bought a blue chip anticipating a RIGHTS ISSUE - 89 yrs

Bought the highest traded stock on SGX after it dipped 10% - 48 yrs
Bought the highest traded stock on SGX after it rose 15% - 60 yrs
Bought a stock that rallied 30% after some good news - 76 yrs
Bought a stock that rallied 30% after some good news, in a bull market - 182 yrs

Bought a stock not covered by any analysts - 27 yrs
Bought a stock rated SELL by an analyst from a broker house - 42 yrs
Bought a stock rated BUY by an analyst from a broker house - 84 yrs
Bought a stock rated Strong Conviction BUY by an analyst from a broker house - 205 yrs

Bought an S-chip at IPO - 51 yrs
Bought an S-chip at IPO, heeding advise from a friend - 90 yrs
Bought an S-chip at IPO, heeding advice from a taxi driver - 122 yrs

Bought a stock Warren Buffett bought, at a lower price - 14 yrs
Bought a stock recommended on this blog - 21 yrs
Bought a stock recommended by a value manager on CNBC - 29 yrs
Bought a stock recommended by a magazine - 48 yrs
Bought a stock recommended by a broker - 128 yrs
Bought a stock recommended by two different brokers - 199 yrs
Bought a stock recommended by a self-professed stock guru, advertising "How To Make 1 Million in 2 week" on Straits Times - 256 yrs

Cheers!

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!