Monday, December 31, 2007

To Cut or Not To Cut

In Value Investing, you NEVER cut losses. If you have analysed the company and have determined that it is a good buy, and you bought it. If it goes down, you should be buying MORE of the stock. Since it is cheaper now. Well, that's provided everything is still the same since the time you did your analysis.

But for most novice investors, including this blogger, our analysis is usually flawed. There is probably something that we missed. Remember the market is not stupid. In fact we all know the saying don't we, "The market is always right." If you bought a stock, and it falls 20-30%, chances are something is wrong with the company, at least in the next few mths (well the market is very short-term focused also). And it pays to redo your analysis.

Well if you are willing to wait out the storm (which may take years), then all is well, it may go down 20-30%, but eventually it will come back, and it will surpass your cost price, in time. If you are a true blue value investor, and you think the co. fundamentals have not change when you decided to buy it back then, and if you got the GUTS, then BUY MORE of it.

For those not so true blue value investors, well you may want to follow some trading rules, ie to cut loss at a certain level. Some recommend 10%, some 15% below the price you bought, depending on how much pain you can endure. Hehe. But remember the tighter the cut loss level, the easier it gets triggered and the easier you get whipsawed. Btw whipsaw means you sell after the stock tanked 15% and then it goes to rally 100% and you go and bang your head on every wall you see.

Cutting loss is actually also rational in some ways bcos you can buy more of the stock at a cheaper price. If the stock is now $10 and you used $1000 to buy 100 shares. It drops to $5. And you use another $1000 to buy 200 shares. So you have 300 shares.

But if you cut loss when it drops to $8. You get back $800. It drops to $5 and you use the original $800 plus another $1200 you get to buy 400 shares! In both cases, you spend $2000 but if you cut loss and buy back at a lower price, you get more shares!

Having said that, it is not easy to cut loss bcos of the psychological factor. This is well studied in behaviour finance. People tend to hold on to their losses far longer than they should. And they take profits too early. Bcos if they cut loss, they have to admit they were wrong, realized their mistakes. But if they simply hold on, it's not realized, there is still HOPE that it will turn around. Vice versa, for profits, once they locked in, they would have proven a point, they got it right. And the right to brag about it later on. So pple always take profit too fast. It is in the wiring of our ape evolved minds. A seasoned investor tries to overcome this malfunction and makes the money.

Saturday, December 22, 2007

Of estimates and consensus thinking

I attended an investment session where the instructor asked the class (of around 20 pple) to estimate the size of Thailand vs Singapore. Was it 50x bigger? Or 100x bigger? Or 500x or what?

He wanted to prove a point. The true answer will lie in the range of everybody's estimate. Bcos someone was bound to get it right. Well his point was quite valid, in the end, the answer did lie within the range of everyone's estimate.

But what was more striking to me was that most estimates are wrong and some VERY WRONG. For those dying to know how big is Thailand vs Singapore, well it's actually 73x. The closest estimate was 50x. And only one guy got that close. Some had it 10,000x. My estimate was 400x.

This made me think very deeply about the nature of estimates. And more specifically, estimates of future earnings of listed companies. We know that the sell-side or brokers have their army of analysts to forecast listed companies' earnings for next yr, or 2 yrs out. Maybe, just maybe the analysts' estimates on a listed company's EPS that we, and most investors rely on, might usually be wrong as well. And it's logical that they should be wrong. Bcos estimates, by virtue that they are estimates, are usually wrong!

Of course, you may argue that analysts have access to information since they get to talk to industry people, competitors, company management etc. Well the analogy with Thailand vs Singapore may not be quite right today, since we have Google and Wikipedia.

But imagine if it were the Stone Age and the class was given 1 yr to walk Thailand and Singapore and come up with an estimate, how likely is it for the class to get it right? Probably as likely as the analysts to get next yr's EPS right, right? Which implies that estimates based on some info but INCOMPLETE info is not much help and that's the way it should be.

So consensus thinking and crowd thinking, by logically extending the argument, can actually be usually wrong. This can be quite scary bcos most of us (well some of us) usually follow others' action thinking that they did their homework so we are safe. E.g. I will go for a stall with a respectable queue in front of the shop at an unfamiliar hawker centre. As for financial markets, there is this thinking that even if we are wrong, so would most others and so it shouldn't be that bad.

Now based on the recent poll, I guess most pple would agree that Singtel is a bad investment since most pple thought that Singtel gave back 0% return since IPO. But guess what, the actual answer is more than 44% return since IPO, which is at least 3%pa based on the price of Singtel when the poll started (around S$3.60). Bcos Singtel gave back lots of dividend and capital back to shareholders during the 15 years it was listed. Since then, Singtel reached a new high of S$4.00 or so. That's another 10%. So again, most people are wrong. Ok you may argue 3%pa is not very attractive, esp after putting your money there for 15 yrs. Well its better than fixed D, and the point here is actually estimates are usually wrong, just a reminder.

Also it's a mere 15 years since Singtel IPOed. Statistically, it's not really that significant yet. Yes in order to be of statistically significant, the track record has to be 18 yrs or more! If you hold on to Singtel for the next 3 yrs or more, maybe the annual return will converge 8%pa or something.

So I guess the moral of the story here is this: Don't trust what most people do, they are usually wrong. Do your own homework and come up with the logical conclusion. Or you can visit this blog (which tries to post accurate logical conclusion on most stuff) more often.

Sunday, December 09, 2007

The Efficient Market Revisited

There has been a lot of debate since the 1950s whether markets are efficient or not. Btw, if you are asking what the heck is an Efficient Market, you can read this posts first.

Label: Modern Portfolio Theory

Ok Efficient Market. Essentially, some academics came out with this theory that nobody can earn a superior return than the market return (ie average investment return) over an extended period of time bcos markets are damn bloody efficient. ie if there is an inefficiency (or a discrepancy between price and value), eg a stock is worth $5 but is only trading at $3, people will simply keep buying the stock until it is fairly valued. So no matter how hard you try, you can only earn the average index/market return if you invest in stocks/bonds whatever, which is about 8%pa.

As with academics, they made it complicated. So they came up with three forms of Efficient Market which I have forgotten what they are. But the message is nobody can beat the market whether you use fundamental analysis, or technicals or whatever intelligent tools you can come up with. So even if you managed to spot one inefficiency, you are just lucky and you won't be able to do it over and over again. The academics dare you to prove them wrong man! They really do! And sadly I think they are winning. Not 100% but quite close.

Having said that, actually there is a flaw in the EMH, or Efficient Market Hypothesis. The flaw is that the markets are not efficient to begin with. It becomes efficient bcos the market participants are constantly taking out the inefficiencies. Imagine 1 million investors/speculators in the market and everyone just managed to spot 1 price/value discrepancy, then the market will be quite efficient already right?

So the markets become efficient bcos there are lots of participants taking out the inefficiencies all the time. The thing is that most participants can probably pick out 1 or 2 inefficiencies during a certain time frame but not a hell lot over long periods. Hence in general, markets are quite efficient to any one person.

But what if they are those who can consistently spot inefficiencies and earn the difference between price and value? Does that mean that the market is not efficient? In my opinion, the markets are still efficient it's just that this group of people have superior tools to enable them to pick out more inefficiencies than others. Of course for those still blur blur one, we are talking about value investors.

One reason why value investors can do this is bcos of their investment philosophy and investment horizon. Most pple nowadays go for instant reward, taking quick profits. They are not interested in owning businesses, waiting for its value to grow over time. They want profits NOW. Hence although a lot of people may know about value investing, they either

1) don't believe it works; they just don't believe in the owning business thingy
2) may not want to practise it bcos it takes too long to see the fruits
3) they think they are practicing value investing but they still buy and sell stocks like oranges or mobile phones or cars

So those Superinvestors for Graham and Doddsville patiently buy businesses while the world revolves around trading stocks like oranges or mobile phones or cars and Voila! They beat the major indices flat with their 30 yr track record of 25-40%pa. But sad to say, there are probably only a handful of these people and they don't really have a strong statistical argument against the Almightly Efficient Market.

Conclusion: The markets are not 100% efficient but they are efficient enough such that you don't get a free lunch if you don't work hard enough for it. Work hard = read books / annual reports, do a lot of macro, industry, company analysis etc.

Monday, November 26, 2007

Barriers to Entry

To determine whether a company has a business moat ie whether it can defend its turf when competitors come in, we look at what is called Barriers to Entry, one of Porter's 5 Forces. I have identified a few common barriers but I must point out that the list is not exhaustive. Other barriers exist and it takes experience and knowledge to identify them. Again, investing is about life-long learning and hard-work. It is not about get-rich-quick.

Market share
This is the most basic edge a company can have over its competitors. When a company is the No.1 or No.2 in its field, it is simply much more difficult for the laggards or any newcomers to try enter their market. Esp if there are only 2 or 3 big players in the market. This is bcos standards are set and relationships have already been established, and the laggards and newcomers don't have the resources or time to beat the leaders.

Technological edge
This edge can be manifested in several ways. It can be simply authentic technological capabilities, like Toyota with its hybrid technology which it was the first to developed and remain the leader today. Or it can be superior manufacturing technology which allows the company to make stuff cheaper yet have similar or better quality. Like Samsung's LCD TVs.

High initial investment cost
Some businesses require very high start-up cost and this naturally deters competition. Oil/mineral exploration, wafer fabs, a telco network etc. It is simply not business that any Tom, Dick, Harry can start. Sometimes, it can only be started by the government. So when a business can earn a good return and its in one of these high start-up cost sectors, hmm, maybe it can be interesting.

This is one of the best barriers a company can ever build. Buffett prides his See's Candy, commenting how people will always buy See's Candy even when it keep raising prices. Great brands like Coca Cola, Louis Vuitton, Rolex and our beloved Ipod are simply immune to competition. No matter what the competitors do, people will still buy Coke to drink, LV bags, Rolex watches and the Ipod over Creative Mp3 players.

This is the most tricky barrier. Sometimes it works very well for the company in question, but sometimes it simply screw things up. The investor has to become a political analyst to get this one right. Eg. oil fields in Indonesia and Russia. Although major co.s like Shell etc negotiated for rights to sell the oil in these fields some years ago with the respective govts, the contracts were void since oil prices shot through the roof. In the case of Russia, the rights were forced to be sold back to Russian co.s. Suck thumb right? Some value investors stay away from highly regulated sectors altogether.

So, as mentioned, there are other barriers and it takes time and experience to identify them. But when you know the company has got a good business moat, earns a good return, and reward shareholders, then go for it. In Singapore, some co.s that comes to mind would be your mass transport stocks, newspaper, telcos etc.

Saturday, November 17, 2007

Index Investing vs Stock Picking

Our guru, Warren Buffett doesn't really like the idea of buying indices bcos it is not really investing per se. He thinks most pple stand a better chance if they follow simple investment rules like those governing Value Investing. But not everyone can be like him.

Another reason why some prefer stock picking is: index fund investing simply takes all the fun out of investing. It is like skipping the appetizer, the soup, the main course and going straight to the dessert. Investment is about pitting your wits against the market right? What's the point of just parking some money in some indices that move only 1% each day?

Well for most folks who really have no time to read up and study but yet want to say they are doing investments, it would be better for them to go buy index funds rather than spend the money on some structured pdts or unit trusts recommended by ignorant / totally unethical bankers that will probably give them poorer or even negative returns.

But for those reading this blog, well, we are different right? We are here to learn to pick stocks and beat the index. Sad to tell you the truth, chances of that happening is roughly 10%. This is a very well documented result and there is even a book that argues if you give darts to some monkeys and they simply throw the darts on some newspaper with all the stock quotes to "pick stocks", the resulting portfolio will do as well as the average fund manager's portfolio.

Nevertheless, the valiant shall not be discouraged. There is Value Investing and there are those Superinvestors fr Graham and Doddsville that made it right? Why not me? Well there are probably tens of millions of golfers around the world, why are we not like Tiger, Vijay or Phil? It takes years of hardwork to be good at anything. Value investing and/or stock picking is no exception.

But having said all that, stock picking is simply too fun to give up for many, including this blogger. Bcos even when you get just one stock right, it's more than enough satisfaction even though you may get another 10 stocks wrong hehe! It is like having kids, I guess. You lose sleep for 10 nights, there are the wailings, the worries when the baby is sick, worries when the baby is too fat, too thin etc. But in the end, that one smile is all it takes to make those sleepless nights and worries worthwhile. Emotional dividend yield 1000%, hehe!

So back to stock picking, although the chances of picking the 10 bagger is pretty slim, we can enhance our chances by sticking to the right investment philosophy. Well the tried and tested method that worked is of course *drumrolls* value investing lah. But it doesn't mean you studied all the literature about value investing then you will make money. Ah Beng knows the golf strokes and theory, but can he beat Tiger? Value investing just increase your chances. Of course, other investment philosophy may work too. After all it's a free market and there are pple who made millions out of day trading.

Maybe the trick is to have a certain % of your portfolio in indices and the rest in stock picking. That way you get to enjoy the best of both worlds. The index part of the portfolio will ensure you earn a good average return of 8-10% and the stock picking gives you the kick you want. So work hard, Tiger is not as high up as you think!

Saturday, November 10, 2007

And how to tackle private bankers?

The private banking industry is booming in Asia and more so in Singapore. Hence we see banks like Citi, UBS, HSBC hiring bankers by the truckloads. They hope that their legions of private bankers will be able to capture AUM (Asset Under Management) and then they can churn their clients to collect lots of fees. Btw, that won't be the official stance, the official stance would be to help HNWIs (high net worth individuals), manage their wealth, do tax planning, investments etc. Sadly, 99% of them (my own guess) will fail to do their jobs.

Traditionally the private banking industry has done good segmentation and actually the name, "private banker" is only reserved for those in the highest hierachy, ie bankers that serve the richest clients, the UNHWI (ultra high net worth individuals, whoa, that's a cool acronym right? Go tell your wife/gf that you will become a UNHWI someday, hehe).

But now, everyone wants to call themselves private bankers, so even those behind the counters whose jobs are to con aunties and uncles into buying some crazy pdts by offering them free umbrellas call themselves private bankers.

Anyways, the job of the private banker is to help clients manage their wealth. But their commission is based on two criteria. 1. How much money they can con their clients to put with the bank. 2. How many pdts they can con their clients to buy.

The second criteria is what makes it most unethical bcos they must continuously sell clients new pdts in order to hit their tgts. ie like maybe 10 pdts per mth or something. And next mth, it's another 10 pdts. So they have to ask the client to buy pdt A today, sell pdt A next mth, then buy pdt B and sell B next mth and buy back pdt A etc. But we know that investments can only generate good return over the long run right? Btw long run means 10 to 20 yrs hor. If you buy and sell stuff mth in mth out, you are just generating comission for the banker, which is what they want and will not help you build your retirement nest egg.

So what is the best way to tackle the private bankers and the best way to do investment? The short answer is you don't have to talk to private bankers.

For most people, the best way to invest would be to buy index funds that have the lowest fees. Index funds are funds that try to mimick the performance of an index, like the STI, Hang Seng, Nikkei, S&P500 etc. They don't employ fund managers who claim that they can beat the benchmark, they just buy whatever is inside the index and hence most of these funds have no sales charges and minimal mgmt fees.

In Singapore, MAS has made some regulations on unit trusts/funds that cap the sales charge at 3% or something. That's actually still too high bcos investment on average only give you 8% per annum. So you pay on 3% on your first year of performance, you are left with 5%, that's a mere 2% better than fixed D! Imagine buying a PC and you need to pay the salesman 20-30% ie $200-300 of commission! On top of them, you pay 1% mgmt fee every year, usually for fund managers that will underperform the benchmark. So my own personal policy is to refrain from buying unit trusts whenever possible. But sometimes, unit trust can help you gain access to some sub-sectors that are not easily investable, eg. environment/green stocks or energy stocks etc.

Look for index funds that have 0% sales charge and probably 0.5-0.8% mgmt fee per year. Lower fees mean higher return back to you. One of the biggest index fund seller in the world is the Vanguard Group. It may be hard to get their pdts in Singapore though. That's when you get the help of the private banker, ask them to source all the index funds available. If they are any good in the first place, they can help you. My guess is: it's more difficult than striking lottery.

After you buy the fund, just leave it there. Don't be bothered by the daily or weekly or even monthly fluctuations, over the long run, all indices will go up, if history is any accurate, you will earn 8-10% per annum, ie you double your money every 6 to 8 yrs. When you have more money to spare, you should just buy more of the same. Of course, you can exercise some judgement and buy indices of growing economies, like China, India etc. Or diversify globally, ie. have some of these hot economies, but also of US and Europe and Singapore.

That is the simple truth about investment, just buy index funds, and you will do ok. Disappointed huh, why so much hype around financial advisers and private bankers right?

But what about stock picking? Next post!

Saturday, November 03, 2007

So how to tackle the insurance agents?

I thought maybe I should provide some (even though still imperfect) answers to my questions in the last post.

On insurance, if the agent cannot help you then who can? For my own journey, I talked to other agents, then I talked to friends, and find out more from the net and newspaper and talked to experienced folks to try to get to the truth.

At first I thought surely there would be some good agents out there. After all, some agents do earn big bucks by selling insurance right? Sooo, I called up pple, asked for appointments, but soon realized that they were all the same. They are TRAINED to sell you the useless stuff, and TRAINED to "taiji away" the difficult questions.

Whenever I asked about term insurance, they would say,

"Oh, but they only cover you until 60 you know?"
"But after 60, my kids are grown up, I don't need too much insurance." I say.
Then they change topic, "But if you buy this life plan, it's like a savings plan, you still get your money back, plus 3-4% per year."
"But meanwhile I pay $2,000 per yr for the next 20 yrs to earn 3-4%? And get covered for $50,000?"
"$50,000 coverage will grow to $50,512 over time! Ok what about this investment link product, it is very good blah blah blah"
What the heck...

I even got one agent who claimed to have advised millionaires on how to buy insurance and still give me stupid recommendations. So in the end, I gave up. I started talking to friends and read up. And here are some conclusions that I gathered.

Use less than 10% of your annual salary on insurance, I recommend 5%. But agents will quote you 20%, saying its MAS regulation. I find it hard to believe. I don't spend 20% of my annual salary on ANYTHING, not even mortgage! 20% on insurance? WTF!

But for 5% you have to try to maximize coverage, it has to be at least 5 times your annual salary to be meaningful. So this is tough job for 99.999% of all insurance agents. Try to find one who can do that, someone young, willing to work hard and help you. My experience: no agent can, so you gotta do it yourself. And that is to buy SAFRA insurance, one of the cheapest around.

Don't get swayed by the agents. They try to bend your rules, like 5% is not enough! Or you cannot see it that way, bcos this 20% will go to your savings blah blah. They should follow your rules, not the other way.

Don't buy investment linked products, usually you overpay for commission and stuff. If you want to do investment, do it separately.

Agents like to blackmail emotionally. Like if you die, your family how? Your kids so young how? And they will say, "I know one friend, cancer, no insurance, pay $200,000 etc". Stop them. I KNOW it's a disaster to die without insurance. But tell me the facts. The premium, the coverage etc. And Get me the cheap value-for-money policy, damn it!

So the ideal scenario, if your annual household income is say $60,000, spend $3,000 on insurance, buy minimal life (you need life policy to get term), say $20,000 and get lots of term, say $250,000. So you spend $3,000 to get insured for $270,000. That's probably an ok deal.

Not sure if most rational people are doing this. Pls comment ok!

Monday, October 29, 2007

Asking a Best Denki salesman whether you need a LCD TV

If you walk into Best Denki or Harvey Norman and ask the salesman whether you need a $3,000 LCD TV, what do you think he will say? He will immediately recommend you the $8,000 50 inch Samsung High Definition LCD TV, and give you 1,001 reasons why you NEED that TV. Right?

I guess the message here is that the salesman cannot tell you whether you NEED a LCD TV. His job is to sell you the TV NOT to determine if you need one.

But our world is a strange place. In so many areas of our lives, esp those related to finance, we ask the salesman whether we NEED something and we expect them to have our interest at heart and tell us the answers. Think about the following questions.

Is it logical to ask the insurance agent what kind of insurance is suitable for you?
Is it logical to ask your broker or his analysts which stock to buy?
Is it logical to ask your private banker how you should manage your wealth?
Is it logical to ask an investment banker whether your co. should do M&A?

In most to these cases, the salesperson, middleman thrives on activity. This is bcos he takes a cut or commission on the transactions that take place. So it is NOT in his interest that he recommend you the best thing. Bcos it will not generate future activity. He needs activity to earn his keep.

The insurance agent wants to revisit you every yr so that he can sell you another policy even though he sold you one last year that would have taken care of your lifetime need. And he will only sell you a life policy or an investment link one even though a term policy makes more sense for you. Bcos the commission on those pdts are much higher.

The analysts change their ratings every 3 mths bcos that's their job. Their job is not to identify the long term winner. Their job is to churn and create lots of buy and sell orders. So it is not in their interest to help investors identify the real 10 baggers (stocks that will rise 10 folds). Even if there are genuine analysts out there who believe they should help investors, the system is in place to discourage them. That's life dear.

Similarly the private bankers cannot help you grow your wealth. Their job is to sell you investment products and earn their keeps. They need to sell new products every yr to hit their annual targets. So naturally they will recommend you to buy this, sell that and buy back what you sold etc year in year out. Even though investments can only generate good return by investing for the LONG TERM.

As for companies, when they reach a stage where organic growth becomes difficult, they seek to do M&As. But the investment bankers they consult to do M&A are at best, well, not much better than the Best Denki salesman. They cannot help to identify which good co.s to buy. Their job is to make deal, not to help the CEOs find bargain M&A. That's why most M&A fails (though they look good on paper).

So how? I am still searching for an answer, but by talking to people who have gone down the same path sometimes help, esp those that have more experience in life and have succeeded (ie. not a bloke lah, but getting advice fr a bloke may still be better than getting advice fr private bankers). People who have bought so many insurance policies and finally know what is really good. People who have talked to so many private bankers and finally know not talking may be the best. And of course, when you have the answers, contributing your answers to this blog will help too!

Thursday, October 11, 2007

More Margin of Safety

A frequently asked question on value investing and how to calculate intrinsic value is this: how can you be so sure that the co's intrinsic value is this and at this price it is a good investment?

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 40-50% below your calculated intrinsic value.

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%, but it won't tank like 80% and chances are after it tank 20% it will creep back up again, it will not bankrupt you. That's the strength if you have a huge margin of safety.

Monday, September 24, 2007

Why Quant may work?

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

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

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

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

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

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

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

But there is still hope.

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

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

Sunday, September 16, 2007

Quant Portfolio Construction

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

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

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

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

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

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

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

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

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

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

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

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

See also Investment Horizon

Monday, September 10, 2007

The Razor-and-Blade Model

In this post, I would like to introduce a familiar business model (for most value investors) that can help most investors in their analysis of companies. It is also a model that entrepreneurs should seriously adopt when they want to start their own businesses. It is a very basic model that can help generate good recurring income and is probably a sign that the company will be in the business for a long, long time and not those fly-by-night bubble tea shops where you see them today but not tomorrow.

This business model is known as the razor-and-blade model. Well for the uninitiated, this is the model where you sell the low profit margin razor at a cheap price and then earn back the money by selling the blades at a high margin.

Though mundane as it may sound, this model has proven itself time and again that it can generate stable cashflow and earn a good margin. Unfortunately, as the guru used to say, it’s hard to teach a new dog old tricks. So a lot of businesses don’t employ this model.

This model plays on the human mindset by enticing people to buy something, usually having the impression that it should be expensive at a low price. Then after “locking-in” the customer, the co. sells him consumable products at a higher margin. However, our ape-evolved minds cannot relate that instantly and we still think we are getting a good deal.

For example, we buy a mobile phone at S$199 thinking that it’s quite value-for-money given a lot of sophisticated stuff goes inside this cool piece of plastic and electronics (So the phone is the razor here). However, we then need to buy the blades (talk-time) that cost us $30-50 a month! And worse still, we are lock-in for 2 years! So is it really value-for-money if you think of the whole package? Hmmm…

Sounds like it’s a bit unscrupulous? Feel like you are being treated unfairly? But hey, that’s life, folks. Become a shareholder of the company then and screw the management during AGM! That’s why I own Singtel! Haha!

Anyways, besides the telcos, today we see various businesses employing this simple model, including our favourite Ipod (selling you the Ipod/razor, then the songs/blades), Canon printers, Playstation and Nintendo games, anti-virus softwares etc. But at the macro level, not a hell lot of businesses are doing this. Well of course, sometimes the nature of the business does not allow the adoption of the model, like the retail business. Which also implies that maybe that’s why retail businesses cannot earn a hell lot of money. Sadly when Singaporeans say they want to be entrepreneurs, most people think of retail businesses like restaurants, bubble tea (*gosh*) and clothings etc. My guess is only 1 in 20 retail shops will actually "succeed" ie earn as much as a full-time job after adjusting for time and effort put in.

The razor-and-blade model also manifests itself in different versions but the crux remains at its ability to generate recurring income stream. This is best exemplify by Dell, which recently announced that it wants to provide IT services to its clients instead of simply selling them the box (ie the PC lah). So in this case, the PC is the razor and the servicing contract is the blade. So Michael Dell really got some Liao one ok? Don’t pray pray!

Maintenance contract is actually a very good razor because it usually last for 2-3 yrs and hence securing the stable cashflow from the client for that time period, like the telcos (btw telcos is short-form for telecommunications companies like Singtel, Starhub hor). And with minimum extra capex or cash outflow, you actually get this money rolling in.

So next time when you see a business with a razor-and-blade model, remember to give it some credit bcos chances are it will still be earning money even when the crunch comes, unlike a lot of other businesses which will probably go into red. Especially those hot sectors nowadays, like RE related construction where majority of co.s involved don’t really have a business moat and are rising simply bcos it’s high tide now.

Thursday, August 30, 2007

Investment, Golf and Hardwork!

Let's try to relate investment with a sports like say Golf. To put some things in comparison, we have

Golf Set = Bloomberg, Excel Spreadsheet, Brokers' charting tools
Golf Swing Techniques = Fundamentals, Valuation, Technical analysis
To win the game of Golf = a lot of hardwork and luck
To beat the Market = a lot of hardwork and luck

When you first start at golf, you will suck big time. You probably bought a golf set that cost S$299 and try out on the driving ranges. In investment, this is like engaging your local broker and their cock-up systems with their technical charts and then dabbling into your first purchase.

Then you realize that you need to put in more time and effort to actually play golf meaningfully and this is when you start to engage instructors to improve your swing, you read up golf books and practice a lot. In investment, this is where you also try to learn from other investors, attend sessions, read books, buy some software and really get your hands dirty with all the financial statements and valuation analysis. Or charts and RSI and MACD for the technicians.

So after a few years of practice, you are ready to compete with other golfers. Say there is a competition for all the world's golfers from beginners like yourself to pros like Tiger, where do you think you will stand? Will you beat say 50% of all the golfers? Or 80%? Or 99%? Similarly in investment, after a few years of doing some real company analysis and trading, can you earn average market return of 8-10%pa? Or the best returns of around 25-40%pa (over the long run ie. 10yrs or more)?

The success rate of being able to beating the average will correlate with the amount of hardwork you put in to either golf or investment.

What determines why Tiger beats the average? Most golfers know the swings and techniques like Tiger does. (Most investors know all about fundamental and technical analysis). Most golfers use the same tools (golf sets) like Callaway/Mizuno/TaylorMade golf sets. (Most investors use the same Excel/Bloomberg/Brokers' charting tools.)

Tiger beats the average golfer through a lot of hardwork and beats the best of the best golfers through luck. Some might argue talent is impt but studies have shown that talent may help but ultimately it's hardwork.

I think a lot of pple know Tiger started golf at the age of 3, and trained hard everyday to win his first championship at 18. That's 15yrs of hardwork btw. But he did not stop there, he continued to work hard to perfect his swing so that he can better himself. So if you are not training that hard, is it a wonder why you cannot beat him?

Don't believe? Read this article.

But at the pros level, Tiger, Vijay, Phil etc, everybody is training as hard as everyone else. So in the end, whoever wins the championship is probably a matter of luck.

So in investment, if you are spending 1-2hrs a day reading some annual reports, doing simple brainstorming about how the world will change tomorrow and how your investment will do, can you beat the market average of 8-10%pa? Of course the market is made up of some aunties and uncles, some novices, some semi-pros, and also pple like Buffett, Lynch, Soros, Jim Rogers, Peter Lim who spent their lives thinking about how the world will change and are very good at it. If you work hard enough, probably there is a chance to beat the average even though you cannot beat the best of the best.

As a side note, passively investing in indices will give you 8-10%pa which is quite good and this is actually one of those rare free lunches in life. Minimal effort for earning an average return!

If you do put in a lot of hardwork, so much so that you think you are in the league of the best investors globally including Buffett, Lynch, Soros, Jim Rogers, Peter Lim etc, then you can only beat these pple if you have luck. Studies have shown that only 10% of all investors can actually beat the average return of 8-10%. So it's a lot of hardwork to be in this top 10%. And to stay there, give a big smile to Lady Luck and hopefully she smiles back!

Tuesday, August 21, 2007

Which EPS to use? (for calculating PER)

We are back to my favourite topic on PER (Lao Jiao value investors are yawning right?). But I think I need to clarify one issue on PER (which stands for Price Earnings Ratio) which I KIVed for some time. For the un-initiated on PER, pls refer to this post.

Ok in short, PER is simply stock price divided by its earnings per share and it measures the cheapness of a stock. The stock price does not tell you anything about whether the stock is cheap or not!

Now to determine Price is easy, this is the all impt Price that you get from TVs, Yahoo, Your broker's system. Singtel is $3.30, SMRT is $1.75, even grandmas know this.

But EPS? Where to find this? And which year's EPS should we use?

For the sake of newbies, we go back to Finance 101. EPS is actually the net profit for the company for the year, divided by its no. of outstanding shares. These no.s are usually inside the company's annual report.

However, things published in annual reports are dated, ie. We can only get last yr's EPS. In the stock market, nobody likes to look at the past. The market is always forward looking. So we need to know next yr's EPS.

This next yr's EPS is usually an average of all the analysts' estimates which are usually not available for most folks but are easily accessible from financial service providers like Bloomberg, Reuters and Thomson One.

As convention, the PER that is usually quoted is the 1-yr forward PER (ie. Next yr's PER using analysts' estimates of 1-yr forward EPS). But for growth stocks, ie. the company is growing its profits really fast, then the 1-yr forward PER is usually too ex. Then you need to look at 3-yr forward or even 5-yr forward PER so that it gets reasonably cheap.

But it's always very dangerous to use such futuristic PER bcos the probability of error will be very very big. You may think that you are buying a 10x 5-yr forward PER stock but if the company fails to grow in its 3rd and 4th year, then Ha Base, 10x become 30x PER and the stock plunge 60%!

As for value investors (or rather any prudent investors), we should be determining what is the long-term sustainable EPS and hence what is the PER of the stock today.

There is no magic formula here to help you predict the long-term sustainable EPS. For the professional investment analysts, they talk the company's management, study their markets, do some research and analysis and try to come up with a sustainable EPS, and still usually get them wrong. So for the simple folks, what's the chance that you can get it right? Not much higher than winning Toto.

Nevertheless, that doesn't mean that you shouldn't try though. Bcos when you can get an estimate for this EPS, and apply a margin of safety, if the stock is still reasonably cheap after that, then probably it's safe to buy. But with investment, nothing is for certain, so you may still be wrong. Well at least, you learn from your mistakes.

Wednesday, August 15, 2007

Emotions, Emotions, Emotions

Market participants, or rather human beings, are really suckers when it comes to investing in the markets. In almost all kinds of transaction, people look to buy cheap and sell expensive. When you buy a fridge, you look to buy it during some sale or discount. When you sell your car, you ask for S$5,000 above COE valuation.

But when it comes to the market, people look to buy when the prices are high, the higher the better, like now. And when prices nosedive for 2-3yrs, people become totally not interested, like in 2003.

This is the result of two powderful emotions at work: Fear and Greed.

Fear is a much forgotten emotion nowadays except during 1-2 weeks when the markets stumble a bit (like last week). During 2000-02, when the markets entered a full-fledged bear cycle, it was a sight for sorrow. Finance stories made headlines like only when the editors need to choose whether it's "Dead Kitten on Toa Payoh Road" or "NOL stock price made new low". IPOs that came out almost always nosedive. Soon pple got so disappointed, nobody participated anymore, which made it worse. There was a general fear of the stock market bcos many pple got burnt.

As the bleeding continues, fear spreads even further. At gatherings, none of your friends, colleagues, acquaintances talk about stocks, or investment anymore. It simply hurt too much. If you said your job was an investment analyst, they go “Oh ok.” And move on to another topic. You can smell the fear of words like “stock” or “investment”.

Only value investors were very active. They were buying up all the cheap and good stuff, like during the Great Singapore Sale! But somehow, most pple really become suckers during those times. i.e. they fail to buy when it’s cheap.

In today’s market, Gordon Gekko’s good friend has taken over. Well, Gordon Gekko is the guy who quoted, “Greed is Good” in that hit movie and then won an Oscar! I heard he is coming back for a sequel to the 1987 blockbuster Wall Street.

So greed has taken over today’s market. The guys who got burnt in 2000? Well most of them shunned the markets until maybe yesterday, then decided to join the party bcos everybody around them is talking about it. But entrance tickets are not cheap now. What about the grandmas? Maybe they will join tomorrow.

Of course, there are also lots of newbies who have not seen the bloodshed the last round. And they have the all important role of Ra-Ra-ing this whole party. Haven’t we all heard how that young punk made a ton of money buying some stock and bought himself a Ferrari? So greed is all around now but maybe we have not seen it grown full blown just yet.

During these times, it’s always hard for the value investors. Some wished that they had bought more during the good old days of 2003. Some are thinking whether to sell now, but if the market keeps going up, then they lose out again. So as you can see, Greed spares no one, not even value investors. The same goes for Fear by the way.

It is an art to be able to judge the greed barometer of the market and decide if the peak is reached (vice versa: to judge if the market has reached maximum fear which will mark the bottom of the bear market). If you can do this, you are on your way to great success. But most old timers would advise against that. Hence they advocate the good old buy-and-hold strategy. As they say, it is futile to try to time the market.

As for me, I suspect the market hasn’t reach maximum bullishness just yet, so there may still be some upside from here. Forward PER of the STI is still ok at 15-16x, but it’s hard to buy anything now. The margin of safety is not there anymore. In this game, it’s only worthwhile to buy during the Great Singapore Sale. But somehow, most pple buy AFTER the Great “GST” price hike (of 200%). GST here stands for: the Great stock market Surge of 200% rally Tax!

PS: STI in 2003 was 1200, it rallied roughly 200% to 3600 today!

See also: Fear and Greed

Thursday, August 02, 2007

Global industries and product market sizes and their implications

This is the 3rd installment of facts and figures around the world. (Don't we just love trilogies!) Not so useful for a lot of people, even value investors. Value investors just need to know enough about the companies they invest in order to do well. But hopefully, information here can help to widen your circle of competence.

We shall talk about a few industries and markets here: Steel, Automobile, PC, TV, Game console, Mobile phone.

The global steel industry is an estimated USD 600bn industry with global annual shipment of 1.2bn ton of steel. The No.1 leader in this industry is Mittal Steel with close to 10% market share. Interestingly, our hero, Warren Buffett has a stake in POSCO, a Korean Steel co. which is also one of the lowest cost producers of steel in the world.

To a layman looking at this 1.2bn ton for the first time, this may be just another no. and may not seem impressive at all so let’s translate this to something more powderful. 1.2bn ton of steel translates to 200kg of NEW steel being produced and used every yr for every person on Earth. This means enough steel to make 1 washing machine + 1 fridge + 1 aircon + 1 full set of stainless steel cutlery and 1 Ipod for every person on Earth EVERY YEAR! And this amt has been going up since humans walked this Earth (well it went up a lot more during the last 100 yrs as compared to the past 1000 yrs.)

Btw, consumption of all kinds of natural resources have only gone in one direction since, well, humans walked this Earth, and that is up. Environment fanatics talk about recycling and conservation but the way I see it: it’s a lost cause. Primarily bcos recycling comes at a price and it’s too high. Eg. it cost USD300-400 to produce 1 ton of steel and the truth is scrap steel (i.e. recycled steel) cost almost as much too! Anyways, that’s a topic for another day.

Ok, next. The global automobile industry is an estimated USD 2trn industry (Woah that’s huge! Remember global GDP is only 40trn!) with annual shipment of 70mn cars. Needless to say, the Japanese dominates this industry. 1 in 3 cars on global roads now are Japanese cars and Toyota now produces close to 10mn cars every year ie 1 in 7 cars is a Toyota. With China joining in the 5C’s race, we can expect even more cars and seems like the Japanese will win hands down bcos they are cheap and reliable, just what the masses want.

Fortunately or unfortunately, the rest of the industries/markets are all tech-related and most value investors hate tech bcos tech has never really created much value. No tech product ever stood the test of time, remember Polaroid? Or Walkman? Discman? SegaSaturn? So we may not see these products mention here 20yrs from now.

Anyways, the global PC market is USD 250bn market with annual shipment of 250mn units. This 250mn is an interesting no. bcos the global TV market is an estimated 220mn unit shipment. Hence it probably suggests the maximum ceiling for household products is around 200-300mn global unit shipment per year. This means that when analyzing the next killer household application, this may be a good no. to use as the maximum ceiling for unit shipment. Incidentally, the no. of households in the developed world is roughly 300mn as well.

The global game console market is a small one with a market size of USD 8bn and annual shipment of roughly 30mn units. Of course, if you include the revenue of the software (ie, the games), this market is already bigger than Hollywood. Most pple like to look at the market over its lifecycle though which is roughly cumulative shipment of 150mn units over 5-6yrs. During the last cycle, PlayStation 2 made by Sony shipped an incredible 120mn units over 5 yrs. But this time round, it’s Nintendo stealing the limelight with its Wii console. If you are not familiar with Wii, go google it up and be amazed! Sadly the PlayStation 3 has shipped only a miserable few million consoles to date.

The global mobile phone market is a USD 200bn market with annual shipment of 1bn mobile phones. If you are missing the impact of this, it’s 1,000,000,000 mobile phones! This means that 1 in 6 people globally buys a mobile phone every yr! If you take out the children and the old folks and those in not-so-privileged countries, we can even say that EVERYONE buys a mobile phone EVERY YEAR! If you think Ipod is big, think again! Ipod shipped a mere 100mn units over 4-5 yrs!

The mobile phone is definitely the most impactful killer application in the history of humankind although it may be at the tail-end of its growth. Wish you had bought a Finnish co. with a funny name some 15yrs ago huh!

So what’s the use of knowing all this? Well actually not very useful. It helps you to think about your co. (i.e. the co. you are investing in or planning to invest) in the global scheme of things. What is the market that your co. is competing in. How big is the market? Does your co. have a huge share of the market? These questions and more. With these no.s at the back of your mind, hopefully it will make the analysis easier. Doesn’t mean that you can make money though!

Thursday, July 26, 2007

More Facts, this time Global Facts, don’t pray pray!

In this post, we shall examine two macro statistics, GDP and Population.

The Global GDP is USD 41trn while Singapore’s GDP is USD 120bn i.e. we make up 0.29% of global GDP, which is quite insignificant. So actually, calling Singapore a little red dot is already a compliment. So don’t be so yah-yah okay?

US, the world’s biggest economy contributes to roughly 25% of global GDP, while Europe makes up about 20%. Japan is No.3 at 11% and China is slightly less than 5%.

However, in terms of PPP which stands for purchasing power parity, a chim term which I shall explain later, China is already No.2 at 19% of global GDP, Japan at No.3 at 9% and India is No.4 at 8%. Developing countries or the new buzz word: Emerging Countries now make up close to 50% of global GDP in terms of PPP and growing fast! Maybe Singapore should call herself an emerging country, bcos that’s the in-thing now siah!

PPP tries to measure GDP by taking away the effects of exchange rate in goods and services. In layman terms, one Big Mac in US will have the same impact on GDP as one Big Mac in China. Whereas, in the conventional method of measuring GDP, the Big Mac in US will impact GDP 3-4x more than the same Big Mac in China. So PPP actually gives a better picture of how world GDP is structured.

So that’s global GDP, btw it’s growing at roughly 4% (for the past 5yrs), developed nations are growing at 2% and Asia at 7%. Singapore has been growing at 8-10% for the past 40 yrs and we might do 11% this year. This is actually quite amazing, so maybe we can afford to be a bit yah-yah. But it always pays to be humble though. Who likes a yah-yah person even when he is in a position to be yah-yah?

The other macro statistic that you should know by hard in order to call yourself a seasoned investor is population statistic.

Well if you have no clue, better memorize this list now!

Global population 6.4bn pple
China 1.3bn pple
India 1bn pple
Europe 900mn pple (this is tricky, bcos depends on how you define Europe, this no. will change)
US 300mn pple
Indonesia 220mn pple
Brazil 180mn pple
Russia 140mn pple
Japan 130mn pple
Singapore 4mn pple

Needless to say, demographics drive long-term trends. Why did the global economy grow so strongly in the past 100 yrs? A large part of it is probably bcos the human population exploded. In 1900, there was only 1.6bn pple in the world but now we have 6.4bn pple. That’s roughly 3% annualized growth rate. And we all heard about the baby boomers. It was this generation that brought about a few big trends in the past few decades, like the rise of automobiles, the mutual fund (i.e. unit trust) boom in the US etc. So bottomline, population matters! Why do you think our Gahmen keeps talking about not enough babies? Now they know relying on Singaporean babies is not enough, so can only import more pple here.

Anyways, going forward, the world population is expected to grow only 1.1% per year and will peak out in 2050 when the global population reaches 10bn pple. Will the global GDP still grow at 4%? And more importantly, will equities give you 10% return per yr? Food for thought huh.

Interestingly, here is a forecast of top 10 populous nations in 2050
India 1.6bn pple
China 1.4bn pple
Europe 825mn pple
US 395mn pple
Pakistan 305mn pple
Indonesia 285mn pple
Nigeria 258mn pple
Brazil 253mn pple
Bangladesh 243mn pple

This is why the whole world is so bullish on China and India. Though China is now in the limelight with strong GDP growth and a large population base, India is the dark horse (no pun intended!) that will win the race. India is the fastest growing population on Earth and will become the most populous country in time.

It is fortunate that Singapore has links to both countries and can definitely find a niche to play in the world theatre of tomorrow, be it integrated resorts, a private banking hub or something else.

For those interested to play the India story, I recommend Singtel (btw this is probably my first stock recommendation on this blog, so don’t bet your house on it). Singtel’s stake in Bharti will be worth more than Singtel itself in time to come. So buy it now while it’s cheap (PER 15x).

See also Secular Trends

Thursday, July 12, 2007

Facts about the Singapore Market

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Saturday, July 07, 2007

Return on Equity, Episode III (ROE-EP3): Du Pont Decomposition

Return on Equity can be broken down into three different parts. This famous decomposition is known as the Du Pont Decomposition. Does it have to do with the chemical giant Du Pont? Probably yes, but for those interested, you can go Google and Wiki it up, now we are at the climax of the trilogy, so let’s move on. Recall that:

ROE = Net Profit / Shareholders’ Equity

This can be broken down into

ROE = Net Profit / Sales x Sales / Asset x Asset / Equity

Mathematically, this makes no sense as Sales and Asset are all cancelled out, why include them in the first place? Engineers cannot understand this. But when we break down ROE into these three elements, ROE can be re-written as

ROE = Net margin x Asset Turnover x Leverage

There are still a few twists and turns to the climax of this trilogy but to cut the story short it simply means that ROE is impacted by these 3 things

1) Net margin (which is Net Profit / Sales)
2) Asset Turnover (which is Sales / Assets)
3) Leverage (which is Asset / Equity)

In order to increase the company’s ROE, we just need to improve either one of the 3 things mentioned above.

We can reduce cost, hence even if sales remains the same, net margin goes up, ROE goes up. We can increase asset turnover, i.e. by making our existing asset work harder to generate more sales. Or we can increase debt.

Now (1) and (3) are easy. For (1) you just fire a whole bunch of people, make the rest work harder, or hire 10,000 cheap workers from emerging countries to replace those you fired. For (3), it is even easier, just borrow more. By borrowing, you increase the liabilities that your co incurs thereby increasing your asset base (usually as an increase in cash) which can translate into more sales and profits if those cash or assets are used correctly and hence ROE goes up.

To improve ROE by improving (2) i.e. increasing Asset Turnover is one hell of a job. I have got a post on that. Read this! Basically, when you see a company with high ROE, it pays to see how this high ROE came about. If it is due to high debt, then maybe it’s a Decepticon! So beware, there is more than meets the eye!

If it is due to either (1) or (2) then, probably it’s still ok. But if you see a company’s ROE improve over the years and it’s due to only (2), increase in Asset Turnover, then give the management some respect. It’s a job well done! And it is time to load the truck with stocks of this company!

Saturday, June 23, 2007

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

Wednesday, June 13, 2007

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.

Sunday, June 03, 2007

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!

Monday, May 28, 2007

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.

Wednesday, May 23, 2007

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!

Friday, May 11, 2007

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!

Saturday, April 28, 2007

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

Monday, April 23, 2007

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
Cash & CPF $25,000
Stocks $25,000
Car $45,000
Other assets $5,000
HDB $400,000

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).
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

Thursday, April 19, 2007

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