Thursday, October 23, 2008

What could have happened?

The past few weeks actually went passed normally for most people NOT reading this blog. Common folks getting on with their daily lives, occasionally watching the news and see indices around the world fall 25% in one week, goes WOW and moved on. About 10,000 pple were digusted bcos they got conned to buy some Lehman mini-bonds. But actually that's quite far from what could have actually hit them worse. Oblivious to them and partly to me as well is the probability of a financial meltdown that could have happened. We always talked about it. But this has only happened a couple of times in history, usually localized in 1 or 2 countries (this round think Iceland, and maybe Korea) and only once on a global basis: the Great Depression.

When the first bailout plan failed to pass, it was said that we were close to the financial meltdown, systemic breakdown, start of the depression, beginning of the end, whatever you call it. But then global authorities took pain to alter the state of things, and here we are. *Phew* What a relief! And we can continue to just talk about financial meltdown without really going through it.

Well, what could actually happen?

Since I have never lived through one, I can merely speculate. And I assume most readers wouldn't have experienced one as well, so let's just ponder through the following scenarios and try to empathize.

1. Global stock markets collapse 90-95% from its previous high. This means STI will fall to 300. Yes, the no. of Spartans fighting 10,000 mini-bond investors no I believe it's Persians. Dow falls to 2,000 and Hang Seng 2,500. It will take roughly 25 yrs to surpass the previous peaks. As of now, global markets are roughly 50-70% from previous highs, though we averted the Great Depression scenario, we are not quite well off either. It will probably still take 8-10 years to surpass the previous peak made in 2007. But nevertheless, count ourselves lucky.

2. Many banks will fail, and I mean maybe like 40% of all the banks in the world or something. Globally, almost 10,000 banks failed during the Great Depression, bank runs were ubiquitous. Most people basically lost all their deposits bcos if everyone went to their banks to withdraw their savings at the same time, the bank definitely cannot pay up - which constitutes a bank run. This is scary if you think about it. Entire savings gone! The global authorities knew this and have put a stop by guaranteeing all deposits. Singapore did that too recently. In Iceland, they were a bit too late, so what they did was restricting everyone from withdrawing any money from the banks! Even foreigners who deposited in their foreign branches. Imagine your Maybank account getting frozen! But then, that's probably the right thing, bcos bank runs were one of the main reasons that led to the Great Depression. Ultimately the global financial system is built on confidence, without that, banks cannot exist, credit lines cannot exist, business cannot function, global economy cannot grow. We have ensured that credit lines will exist. Bank runs cannot occur. So this is good.

3. This time round, if things did go wrong, although we probably won't see 10,000 bank failures, some will still go. More of Northern Rock, IndyMac etc. When banks fail, corporations that rely on banks for credit to do their business cannot survive, there will be worldwide bankruptcies. My guesstimate is 40% of all listed companies going bankrupt. 80% of SMEs will fold. It will be a disaster on Richter Scale 10. Financial tsunami is an understatement. Nothing will be too big to fail. In fact bankruptcies become daily affairs. Workers will be just waiting for their turn, waiting for their co.s to go belly up.

4. With bankruptcies we have unemployment. During the Great Depression, unemployment hits 25% in the US. Today, it will probably hit 20% globally and maybe 33% in Singapore. So 1 in 3 people you know will be unemployed. Most likely you will also be unemployed. Most people will go broke. Their mortgages will be greater than the prices of their homes. And they have no money to pay. Govt may pass laws to stop banks for seizing these pples' properties bcos if they did, then we will see millions of homeless pple.

5. Those lucky ones with a job see salary cuts of 50-70%. Average household income falls drastically, consumption and prices follow. This time round, commodities are falling like autumn leaves already. Ultimately, goods and services prices will also fall 50-70%, but this comes at no relief bcos 30% of households have no income, those with income has only half of what it was. People cannot spend and hence less spending, less production, less jobs and the vicious cycle continues. So the Gahmen is right. Price increase is actually GOOD! ERP up GOOD! MRT fare up GOOD!

6. Global GDP falls 40% to USD 25trn or so and Singapore GDP halves to USD 60bn. Our reserves of USD 100bn come into play to help Singapore, probably to finance some sort of massive fiscal spending like reclaiming land to link all the islands surrounding Singapore, including Tekong, Jurong Island, Sentosa and building 100km bridges to Kusu Island and Bintan. Still it will take 5-10 years for GDPs to return to previous levels.

In short, it's Armageddon. So aren't we glad we averted this outcome and can blog about it?

Thursday, October 16, 2008

Value investing versus technical trading

Some time back there have been some debate on other blogs about whether value investing works better, or technical trading works better or turtle style works better or whatever. It is very logical to think that technicians detest value investors and vice versa. Bcos their investment philosophy is completely different.

One buys stocks that are mundane, cheap, stable earnings based on fundamental analysis. One buys based on short term newsflow, charts, momentum etc. It is very tempting to think that these different investors fight a lot. Like Cats versus Dogs, Chu vs Han kingdom, Man U vs Liverpool etc.

To summarize the styles a bit, they probably look like the following:

Champion style: Buy low sell high - sure win one!
Short selling: Sell high buy low - sure win too!
Value investing: Buy low, sell lower
Technical trading: Buy high target sell higher but usually sell low

Ok, just a joke. This is not your Wikipedia definition of the different styles. And also styles do not dictate whether you can win in this game. No matter which style you use, more than 80% of all investors underperform the markets and most retail investors don't even have positive gain to talk about.

At this point, I would like to draw an analogy to pop music.

There are many styles a pop artist can follow:
A-Mei: strong voice, dance a lot, bold and catchy tunes
Yanzi: R&B music, sweet young thing look
Morning Girls: Act cute, kiddy songs etc

There are basic guidelines to be trained to perform in different styles. Eg. For A-Mei style, vocal singing training, dance training, music and song writing training and probably a lot of real life experience in pub performing etc. For Morning Girls, no need vocals or song writing, just act cute.

Styles do not dictate whether you can sell double platinum albums. Some styles have better chances, some don't. Artists from different styles do not necessary hate one another and fight all the time. They respect one another's talent and attempt to bring better music to their audience, if anything. (Well sometimes they do fight, but not a whole lot :)

Value investing is just a style. One that some people believe and I believe has a better chance to make money. Just a slight advantage. But you can make it big with other styles too. Bernard Baruch is a multi-millionaire trader. Jim Rogers, George Soros bet on global macro trends. Jesse Livermore reads the tape. Peter Lynch, value and growth at reasonable price.

There are a few guidelines/basics on how to do value investing, eg. buy with margin of safety, don't time the market, look for co.s with stable earnings etc. However it doesn't mean that if you know all these, you will make money. In fact if you follow them strictly by the textbook, it is not going to work.

It is the same with technical trading, global macro betting, turtle style, tape reading etc. There are the basics, you learn them. Doesn't mean that you follow them strictly, you will make money. It takes a lot of effort, time, and usually luck as well for all styles.

And it doesn't help anyone to criticize other's style. Some people are good at certain styles. Some are good at others. More than 80% of all investors fail to beat market returns, regardless of which style they use. All styles can make money if you develop the flair, find out what ticks.

Ultimately investing to make money is an art, and in this aspect, investors are also like pop artists, most will falter, some spent their lives singing only in pubs, a small % can make a decent living as an artist and only a handful sells double platinum albums. If we put in decent amount of effort in developing a good investment philosophy and style, I would like to believe that we will be rewarded. May not beat the market, but it should be a positive return and add good incremental cashflow to our household income.

Wednesday, October 08, 2008

Focus on cashflow and not capital gain

When people say they do investing, there is a tendency for most people to focus on the capital gain that each investment will bring in. Eg. Ah Beng buys SGX at $3, today is $6, so his perceived capital gain is 100% and he is happy like a bird. Or Ah Gou buys a property at District 10 for $1mn in 2006 and today it is valued at $2mn, his capital gain is again 100% and he goes and buy a Ferrari. This is very natural and it's got to do with our primitive wiring and we cannot easily re-wire our brains.

However as long as we don't sell and lock in whatever gains, there is no cashflow coming into our pockets. And in most cases, it is actually not to our advantage to lock in the gains. Take the example of Ah Gou's house, if he sells, he gets his $2mn but the a similar house in District 10 will now cost $3mn. So he has to downgrade. And for Ah Beng, he sells and lock in his gain, but now he needs to find something else than to park his money, and in this market, it is difficult to find things that are safe.

Furthermore, price that Mr Market dictates has nothing to do with the true value or the intrinsic value of the asset. ie Mr Market may say that SGX can sell for $6, but it is really worth $6? And so did Ah Beng really double his money? Again the Mr Property Market says Ah Gou's house can sell for $2mn but is it really worth $2mn? If we cannot be sure, then why do we always look at our portfolio value at the end of the month and go smiling when Mr Market says your portfolio is up 10% this mth or down 20% next mth?

So instead of looking at the at the absolute price of the asset as dictated by Mr Market, perhaps the better way to look at investment is the real cashflow that it can generate for us. For stocks, since most people go for capital gain, there may be very little cashflow to talk about. Unless you keep buying and selling stocks and make sure some cash in generated every year or every quarter. However that means you need to be very good at market timing and studies have shown that most people sucked at market timing. So at some point in time, one should think about how to extract stable cashflow out of the portfolio regularly in order to enjoy some of the fruits. I mean no point holding on to stock certificates until you are dead right?

Assuming that your portfolio have grown substantially large over many years, one way would be to slowly sell some shares (assuming that they are infinitely divisible) as one approaches retirement so that cashflow can be generated and support a meaningful lifestyle. Another more realistic way would be to have a good % of dividend stocks that will generate some cashflow even if you don't sell any holdings.

Warren Buffett probably knows this better than anybody and that is probably what he has been doing this for 50 years. I estimated that Berkshire's stable of companies can generate USD 6-8bn of cash every year on an asset size (not original capital amt!) of roughly 220bn, so that's a 4% cash yield, on current asset size. Of course he can buy 100% of the company and demand all cash generated to go to him. That's not quite possible for us lah.

Nevertheless, at some point in time, when we are closing on retirement, we need to focus on how much cash the portfolio can generate every year. And personally I don't think it is wrong to practise that now, even though we may be 20-30 yrs away from retirement. I would be quite happy if my portfolio can have a cash yield of 2-3%pa for a start.

As for property, needless to say, the focus should be on how much rental the property can fetch, instead of thinking whether you can sell this property for $1,100psf after you bought it for $1,000psf. As a rule of thumb, I think we should only buy properties that can generate a sustainable rental yield of 5% over long period of time.

The focus on capital gain also means that we have to constantly buy and sell in order to lock in profits and find new buys. Now value investors do not like to play this game of buying and selling too frequently. It does not fit their investment philosophy and it serves only to make brokers happy. So they focus on cashflow. When thinking about the next investment, ask whether the investment can generate you good cashflow yield over a long time horizon, not whether you can sell at a 10% profit in 1 mth's time.