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.