Tuesday, June 27, 2006

Fear and Greed

This post is updated in 2024.

In simple terms, fear and greed affect investors' decision by impeding their ability to think rationally. A good investor tries to detach emotions from decision making but it is easier said than done.

Imagine you are out drinking one night with your buddies but you promise your wife to be back by 10pm. At 9:55pm, your decision will probably be governed by these two emotions.

  • Fear: You fly home, bcos if you don't, you will have an unhappy wife and therefore an unhappy life for a couple of weeks.
  • Greed: You stay until midnight, and hope that your wife is asleep, next morning you wake up early and fix breakfast for her, so that you can partially unwind the unhappiness of the wife and hope that that your happy-wife-and-happy-life scenario can play out sooner.

Now let's try to see how they actually work to deter investors from making good investment decisions.

Fear: An investor has done his groundwork / due diligence, he is convinced that the stock has sound fundamentals and is relatively cheap. However, the market is in a bearish mode, he fears further downside and decides not to buy, but to wait-and-see. The market rebounds and he lost the good opportunity to buy.

Greed: The stock has done very well and all the good news has been factored in, but the investor thinks that there might be a new investment thesis for the company, e.g. they can continue to grow via M&A. On valuations, the stock is no longer cheap, unless you become super creative in calculating its future intrinsic value. Obviously, greed has taken over the investor, he fails to see that the stock is already very expensive and refuses to sell. The stock tanked after a few weeks.

Of course, fear and greed also helps in the opposite scenarios. For e.g. in the first case, the bear market might continue for 2-3 years, and by waiting, the investor could have bought the stock at an even lower price.

I guess the moral of the story is to be mindful of these emotions, understand that they will affect your decision making and try to implement ways of going around them in your investment process.

One tried and tested method would be looking at valuations, and use valuations to determine your trades i.e. only buy stocks that are cheap, in fact very much cheaper than its intrinsic value.

Monday, June 26, 2006

The three important principles of successful value investing

There are different ways to label these principles but I shall call them Fundamentals, Valuations and Timing. Making a successful investment will demand that all three principles are followed, in my opinion.

Fundamentals refers to the inherent characteristics of the investment or stock, i.e. whether the company is a good company and whether it has good growth prospects.

Valuations refers to the cheapness of the investment, or stock. A company may be have all the positive traits, but if it is not cheap, it is not a good investment.

Timing refers to when to buy (and of less importance) when to sell. Needless to say, buying at the wrong time results in very different performance.

To see how this can work, let's pick a local stock, say, Singtel. Fundamentals for Singtel looks ok, it has not seen red ink for the past 10 years, maintained low debt, and management seems prudent and competent. Within its industry, clearly Singtel is the market leader and regionally subsidiaries are expected to provide reasonable growth.

Looking at Valuations, over the past 10yrs, Singtel has traded within the range of 10x-30x and currently it is trading at PER of 10x. Not overly cheap but definitely not expensive at all.

Now Timing makes all the difference right? If you had bought Singtel when it listed, you would still be losing money. Of course timing is linked to valuations, at its listing, Singtel might not have passed the valuations part of the test (i.e. at listing it was probably too expensive).

The guru does not believe that timing is important. In his view, a good stock should be bought as soon as you identify it, if it goes lower, you should buy even more. Sounds like a strategy for gambling addicts or rogue traders but it's not. Value investors believe in holding investments for the long term, and if you have the holding power, over time, your investments will reach its intrinsic value. Usually after you gave up waiting and sold the stock though.

In a way, low valuations will take care of timing, i.e. low valuations ensure that you have bought the stock at the right time (and price). Also, according to the guru, once you buy a good stock, you should never sell no matter what (this is also called the buy-and-hold-until-you-peng-san strategy).

Sunday, June 25, 2006

How to read financial statements - the very basics

This post is updated in 2023.

A company's financial statements consist of three separate statements that attempt to describe how the company has performed during its fiscal year. The three statements are

1) the balance sheet (BS)
2) the profit and loss statement or the income statement (P&L)
3) the cashflow statement (CF)

The balance sheet lists out what the company owns: its assets, what the company owes to other entities: its debt, and what is left after its assets are subtracted by its debt: the shareholders' equity, or the book value.

The P&L statement starts with sales or revenue and deduct all sorts of cost from revenue until we arrive at net income, which ultimately goes into shareholders' equity on the balance sheet.

The cashflow statement describes how cash has actually been received and deducted from the company, which is usually different from actual profit gained and loss incurred. It links the P&L to what has changed in the balance sheet. One major item that affects cashflow and income differently is depreciation. Depreciation is treated as a cost in the income statement, but it has no actual cashflow impact.

To use a Singaporean household as an example, the BS will list down the household's assets, liabilities and equity. Assets are HDB flat, car, cash savings, surgically enhanced waistline, chin, double eyelids etc. Liabilities are mortgage, renovation loan, study loan, credit card debt, children, mistresses, pets etc, and equity is what is left. Okay, okay, if you didn't get the joke, those in italics are meant to be jokes. We only list what can be valued in dollar terms. If it is too small, don't bother also i.e. you don't put your $2 favourite coffee cup into your asset side of the balance sheet.

Sad to say, a lot of Singaporean households probably have no equity to speak of, because our liabilities (mortgage, car loans) are usually much more than our assets (value of our flat, car etc). Luckily nobody cares that much if you are an individual, but a company cannot have negative equity. We will go into these details in other posts.

Next, we discuss the two other statements:

The P&L statement of the household will be salary on the top (sales for companies though), followed by all the expenses (food, transport, utilities, deduction to NKF, parking fines, Toto etc), until we arrive at net income, which could be added to the balance sheet at the end of the month or year (i.e. any money left after all expenses goes into savings = equity for the household).

Finally, the cashflow statement would be actual cash movement, i.e. salary that was transferred to our bank (cash inflow), how we have spent the cash on food, pirated DVDs, useless souvenirs from tours etc (cash outflow). P&L can differ a lot from Cashflow because there many items that can be expenses but non-cash. The most prominent example has to be depreciation. If you buy a car for you and your wife at $250,000 each using cash, your cashflow this year will be impacted big time (likely negative unless you print money for a living). But P&L wise, you can depreciation the cars over 10 years and therefore, you might still have income at the bottom of your P&L or income statement.

To analyse a company, all three statements are important and it will be very helpful to be well versed in reading them. I will be posting on how to read each statement in the future, watch this space!

See also P&L Statement

Thursday, June 22, 2006

Value vs growth

In investment lingo, one way of classifying stocks is to label them as either value stocks or growth stocks. Some other ways include large cap vs small cap, NC16 vs R21.

Value stocks are what we have been discussing all this while, stocks that trade below their intrinsic value, come from understandable and mundane industries (insurance, utilities, consumer staples), low PER, low PBR, stable earnings streams etc.

At the opposite end of the spectrum are growth stocks. These are stocks with a lot of potential but they may or may not make their mark. They usually have high PER and high PBR, weak earnings, from hot sectors like Tech, Energy, Biotech etc. But they are attractive because their intrinsic value in the future can be 2, 5 or 10 times higher than today's price. Microsoft was a growth stocks in the 80s, early 90s.

Without considering valuations (i.e. let's not think about prices and whether if it's value for money), let's try to look at growth and value stocks in another perspective:

Growth stock = Porsche, sexy and fast, but prone to accidents
Value stock = Volvo, ugly but safe, reliable and down-to-earth

Buffett thinks that classifying stocks as value or growth is not important because they are simply on different sides of the same equation. A true growth stock is essentially a value stock in disguise.

Wednesday, June 21, 2006

Value trap and the cigar butt analogy

This post is updated in 2024.

Value trap is a stock that looks very cheap but the reason it is super cheap is because it is a crappy company and deserves to be that cheap. This company probably trades below its book value (i.e. Price to Book ratio less than 1x) and had poor earnings and near zero cashflow for the past few years. Buffett likes to give the analogy of the cigar butt. Imagine finding a cigar butt that someone just finished smoking, but there is still a last puff left. The cigar comes free but you get one puff, which doesn't make you feel one hell of a good.

To give another example, a value trap is similar to doing shopping at Ikea (no offense to Ikea and Ikea fans, just an analogy, just an analogy...), you get super cheap stuff but their worth is also just that. If you haven't shop at Ikea before, let me give you an idea. You can get kitchen set (with sink, top and bottom shelf etc) for less than S$1,000 which is like dirt cheap because a Prada bag cost as much. But the kitchen set probably lasts a couple dinners before some panels or screws come loose or some other defects present itself. Yet another example would be "you pay peanuts and you get monkeys", sounds familiar?

In essence value trap means that you are paying cheaply for zero quality. A true value investor pays cheaply for some value, not for garbage.

Sunday, June 18, 2006

Circle of Competence

This post is updated in 2024.

This is another concept from the guru himself. Basically it simply means to invest in industries and sectors that you know well, in fact, so well that you can say you are an expert in it. Buffett terms this as the Circle of Competence.

Essentially, this is saying that you should not be a Jack of all trades. If you just researching the Singapore market then just stick to it. Don't try to be a hero and start analyzing global stocks! After all, there are 600 listed companies in Singapore, that is a lot of companies to research on. It would take years to cover all of them.

So the circle of competence is just that: invest only in areas that you are very familiar with. Over time your circle of competence can grow bigger as you gain more knowledge. (Ok you can try Malaysia when you are ready, but definitely not anything more!) However you must also know your limits and try not to invest in areas where you are weak, or very ignorant and may never gain competence. For Buffett, this was technology. That's why he never participated in the IT boom and bust.

For most of us, the circle of competence will usually be related to our work, or observations from our daily lives. If you encounter other companies in your work that impressed you, might want to know how their stock performed. Similarly, if you wear a particular brand of shoes, and like it so much, it might be worthwhile to do some research on the company that produces the shoes.

See also Investment Philosophy and Process

Thursday, June 15, 2006

Definition: Value investing

After numerous mention of value investing, perhaps it would be appropriate to give a proper definition of value investing on this blog.

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

1) The investment can be bought below its intrinsic value
2) The investment must have a margin of safety

Value stocks are generally characterized by low PER, PBR, high dividend, and typically from mundane industries (not high tech or bio related). Pioneers of value investing include Benjamin Graham, David Dodd and Warren Buffett.

Wednesday, June 14, 2006

Securitizing yellow-top taxis and workings of the stock market

This post is update in 2024.

The stock market is, in its original and actual intention, a place for business owners to "borrow money". The difference is that the borrower, instead of paying interest to the lender, agrees to sell a part of his ownership of the business (i.e. his stock) to the lender. The lender can hope to receive dividends from the borrower when the business do well, or sell his ownership to yet another person.

This ability to transfer ownership from one person to another, for better or for worse, leads to the creation of something that humbles even the most intelligent, Nobel Prize-winning monkeys: the stock market.

To make things simpler, let's try to understand the stock market with an analogy. Imaging a yellow-top taxi driver one day decides to sell his ownership of the taxi to 10 other people. (Yellow-top taxi drivers own their taxis, other drivers rent their taxis from companies like ComfortDelgro, SMRT). The 10 new owners can also sell their 10% ownership (i.e. their stock) to other people.

Now imagine another 9 yellow-top taxi drivers do the same, selling 10% of their taxi ownership to 10 people, we have just created a "stock market" for yellow-top taxis with 10 x 10 = 100 investors/traders. Depending on the ability of the different drivers, the stock of some taxis will sell at a higher price than others. Some stocks will fall and some will rise, driven by people's perception of the ability of the different taxi drivers and, well, almost anything else one can think of. People may worry about what Grab and Uber is doing, or will Comfort Delgro just buy all of them out, or the weather forecast in Ang Mo Kio, or increase in taxi prices relative to decrease in air-con temperature in shopping centres etc.

So, how would you choose which taxi stock to buy? Based on the driver's ability? Or analysts' forecast of the number of people taking taxis next week? Or listening to the weather forecast? Or by looking at how the stock have traded in the past hour?

Buying a stock on some positive news hoping to earn a profit in one day or one week completely misses the point. To buy a stock is, in effect, to become the owner of the company (or the taxi). Surely this decision should be based on solid fundamentals of the company (or the driver) and also the stockholder's long-term conviction that the company will continue to perform in the future.

PS: Yellow-top taxis will be completely gone in a few years if not sooner:

Friday, June 09, 2006

Lemmings and herd mentality or herd behaviour

This post in updated in 2024.

Lemmings are small rodents usually found in the Arctic. They breed very quickly and when their population reaches a certain critical mass, they are known to commit "mass suicide" by leaping off the cliff*. This strange behaviour of Lemmings continue to puzzle many scientists but they have found similar behaviour in people living on a small island south of Malaysia. But since there are no cliffs around, these people employ foreign maids and constantly abuse them for pleasure. Some believe that stress incurred by scarcity of food and overcrowding causes Lemmings to behave abnormally.

Most investors in the stock market, according to the guru, behave like Lemmings reaching a critical population mass. They begin to mindlessly follow others, sell when the market is falling like crazy, or buy more when the market is already over the top. This is why markets crashes or goes into bubble mode so often. In investment lingo, this is also known as herd mentality or herd behaviour.

For some people, it may sound stupid to mindlessly follow the crowd, but essentially, we humans like to follow trends, be it going after the latest fashion (Hermes, Rolex, anyone?), business ideas (remember bubble tea from Taiwan?) or hot stock ideas (GameStop, ouch!). Next time you think about jumping on some bandwagon with no concrete positive story, remember the Lemmings, and the cliff just round the corner.

See also Mr Market

*According to wikipedia, it has not been proven that animals can commit suicide. Lemmings jumping off cliffs is part of a migratory process which unfortunately results it many deaths. See link below:

Thursday, June 08, 2006

About the Blogger

This post is updated in 2023.

Thank you for wanting to know more about me. If you made it to this hidden post, you really tried hard enough. Much appreciated. I am Jay Chan. I am this half-hearted blogger, who had been doing this for a while without much success. Check out the following bloggers who have much more to offer:
My interest in investment started in my university days and I have invested in stocks for more than 20 years. Being a typical Blood Type B (i.e. disorganized but passionate), I have not tracked the performance of my stock portfolio and it could be a Herculean task to try to that now since the number of transactions are probably in the hundreds and some of the records are probably gone. 

My long term goal will be to be able to sustain my lifestyle with dividends and for my portfolio return to achieve 8%pa, the original name of the blog. I have also thought deeply about Singapore's education system and our property market and written some posts on these topics.

8% Value Investhink, a new name adopted some years ago, comes from the components: 1) 8%, 2) Value, 3) Invest and 4) Think. It incorporates the philosophies of value investing and critical thinking which I hope can help us navigate well in today's world of short-termism. In 2022, I also created a team and put this platform on 8percentpa.substack.com

I have been asked why the low hurdle at 8%? In reality, to achieve 8%pa over very long time frame like 20 to 30 years is a very tall order. It means increasing the original capital by 10 folds or more. Warren Buffett has failed to beat this criteria as a result of his large portfolio (now a few hundred billion dollars) over the last 20 years.

8% is just a number and today, the relevant objective is to continue writing to help readers apply the concepts of value investing to make good investments and avoid bad ones. This is especially crucial in the Singapore when it comes to property. I hope to help more people avoid overpaying for one of the most important purchases of our lifetimes. The Property label contains some of my views. It is my belief that investing and in the broader context, financial literacy is something that everyone can learn and master. 

This is me.

Friend Me! http://www.facebook.com/8percentpa

Saturday, June 03, 2006

Investment Philosophy and Process

This post is update in 2024.

An investment philosophy is a set of rules or guidelines that you abide to help you navigate through treacherous markets. Just as in life, most of us have moral principles that we abide, for e.g. we do not steal or commit adultery but tell our wives we are working when we go to pubs, we value life and are filial to our parents, we try to help the needy and are loyal to friends etc. In investment, you must also lay down the rules, and learn not to break them. Collectively, this set of rules and principles will be known as your investment philosophy and will serve you well in time to come.

An investment process is the execution. It will determine how you start looking for stock ideas, when to buy them, when to sell, what are the maintenance research that you have to do etc.

The investment philosophy that I subscribe to, is similar to that of the world's greatest investor. I look for

1) Stocks that are cheap, i.e. trading below intrinsic value
2) Margin of Safety: chances of losing money would be minimized
3) Stocks with strong free cashflow

The investment process that I subscribe to, in simple form which hopefully make sense to most readers:

1) Idea generation from stock screens, discussions and observations in daily life
2) Due diligence to study the company in detail and form an idea around entry price and intrinsic value
3) Discuss the idea with like minded investors to look for blind spots
4) Buy and observe the company and stock before putting more money
5) Sell when company is overvalued and deploy money to other ideas

Investment philosophy and process evolves over time and is different for everyone. A day trader will have another set of guidelines and process, but the most important rule is to figure out what works for you and then stick to it and not deviate!