The Holy Grail in Asset Management: Producing Alpha

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment horizon

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

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

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

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

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

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

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

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

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

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

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

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

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