Capital Prudence

One gauge for management which is often overlooked is how they manage the firm’s capital. Do they see the firm’s equity and cash on its balance sheet as valuable resources that belong to the shareholders and think twice about doing funny things with them? Well most management will do funny things when given the chance.


We look at 4 aspects of what crappy management will do:

1. Dilution

Most management couldn’t care less about diluting shareholders’ stake bcos they get the much coveted capital to cover up their mistakes. In Singapore, dumb retail investors actually rejoice when management wants to do rights issue: bcos they can get more shares at a cheaper price! The irony!
When management comes cap in hand to shareholders for money, multiple times in a span of a few years, run for the trees! This is one of the most unforgivable management mistakes.

2. Aggressive Capex

Beware of management that always announce huge expansion projects in the name of growth. Especially, when they are done at the top of the cycle. Most of these projects will not recoup its capital fast enough ie ROI is very low, like maybe 3% (ie 33 years to recoup the investment).

A good management should always be prudent with capex, expanding slowing at a regular pace and keeping expansion cost low.

3. M&A

This is a double edge sword. Some management are very good at M&A and can actually help to grow the company through M&A, however the fact is 70% of all M&A fails (ie 1+1 less than 2). If the management is always looking to do M&A, esp in unrelated fields, beware!

4. Cash Hoarding

Some great companies have such beautiful business models that the companies just overflow with cash as time goes by. You see companies with cash to market cap of 30-50% bcos the business just keeps churning money!

The management mistake then becomes how they keep hoarding the cash and not putting it into good use: like giving back to shareholders. Most management would say that they need the cash for expansion ie doing 2 or 3 stated above. Which destroys shareholders’ value.

Buffett sometimes just buy over the whole firm and dictate that whatever cash that is generated goes to the parent co: Berkshire Hathaway. This is the ultimate trick!

On Bad Management

Basically, bad management doesn’t have the shareholders in mind. Or if the bad management is the majority shareholder, they don’t have other shareholders’ interest in mind. Their policy is about “Screw You and I Get My Bonus” or “I Win, You Lose”.

On bad management, CK Tang’s recent saga definitely comes to mind. It’s a long story that probably deserves a book trilogy starting with the great CK Tang himself, who built a solid business based on virtues like good customer service, treating employees well etc. His business approach was a very traditional, fundamental approach that sadly had lost its touch in today’s Singapore.

The poor management began shortly after his death some 10 years ago perhaps. Over the past 10-15 years, CK Tang had been able to deliver annual sales of S$160-220mn sadly without very significant growth. Singapore’s GDP has probably doubled in that span of time.

The story for profits is even worse. Net income was negative for the most part with some years losing as much as S$40-50mn. The company did not pay dividend for the most part of the past 10 years and kept throwing money into wasteful ventures, like new CK Tang outlets in KL, Vivocity etc.

If the story had ended here, we are not in a position to scold management too much. Well, admittedly, the world has changed. Department store was a good concept in the 80s and early 90s. High quality lifestyle products all under one roof and brands fight for space in the stores. But the retail scene had since evolved, with brands like LV, Nike, Jimmy Choo having their own stores. And shopping at dept stores wasn’t trendy anymore. People preferred shopping malls, specialty stores and newer stuff.

CK Tang’s management was of course unable to stop this global change. But what was unforgivable was their attempt to take the company private at ridiculously low prices (well that’s subjective, let’s see my argument first ok?). They attempted thrice. During the first two tries, the minority shareholders screwed them by refusing to let go. On the third try, the no. of shareholders that agreed to sell hit the minimum no. and the co. was taken private. Well most people gave up after 10 years I guess.

The co. was taken private at a price of roughly S$200mn. This is lower than what CK has as its equity of S$220mn. Of course CK Tang paid only S$20-40mn to buy out the remaining 10-20% of shareholders. Official valuation of the land that CK Tang has in Orchard Road was about S$340mn (last done some time back). Based on $1200psf - a value that I think represents fair value for property in Singapore, the property alone is worth S$190mn, ie CK Tang’s management thinks that its department store business is worth nothing and they are paying the minority shareholders $1200psf for their portion of the Orchard Road land. Btw, Orchard Road land is now going for $2000psf or is it $3000? Geez I can’t even keep up with the no.s.

So the land value that CK Tang has on its books could be easily more than half a billion if today’s prices were used, or if the land was redeveloped. Basically, the minority shareholders got taken out at a cheap price.

Of course, CK Tang maintains that there is no plan to redevelop its Orchard Road flagship, they think what they paid the minority shareholders is fair. It would be really interesting to see if they announce plans for redevelopment in the future. Then it would confirm that they were all-out to screw shareholders all along.

In my opinion, CK Tang is a complete dud as a shareholder entity. Even as a consumer, I would think twice shopping at CK Tang after seeing that is how management treats people. It IS a good thing that it’s gonna get delisted and hopefully never file for listing again.

If you don’t know the jewellery...

Buffett lives by a few simple rules throughout his life. He has acquired them over the years and found them to be useful rules to live by. He and his partner Charlie Munger believes in such simple logic. Charlie Munger used to say that there are really just a few big ideas in life. There are no secrets to become rich, or to be successful, or to be whatever you want to be. The so-called secrets are simply ideas/rules that we know so well but we fail to apply them. Or our emotions overrule our logic and deter us from applying them rationally. The simple rules are like these listed below:

1. Early bird catches the worm
2. Live within your means
3. Bang for your buck, value for money, go for bargain
4. Keep things simple stupid
5. Be fearful when others are greedy

So today, we look at a similar one that Buffett came up with: “If you don’t know the jewellery, at least know the jeweller”. The idea behind is really simple. You must know that the management of the company is good and trust them to do the right thing. You may not know whether you are really buying a real gem or a useless piece of rock at the jewellery store, but if you know that the jeweller is honest, wants to help you whole-heartedly, (unfortunately no such retailer exist in Singapore, ALL retailers are out to screw the customer), well then perhaps you can trust him to select a good gem for you.

Buffett doesn’t know everything about businesses. He admits that he doesn’t know nuts about technology. But the good thing is Buffett has perhaps mastered the art of sizing people up. He has been meeting people for over 50 years, for goodness. Well some times he screws up (like maybe Salomon Brothers…), but most of the time, he meets up with people in the top management, gets to know them and if they are up to the mark, he trusts them to make the right decisions for shareholders.

This is perhaps the major reason why he bought BYD, the Chinese battery maker. He probably placed two layers of trust here. Trusting Mid American Energy to know enough about BYD to buy a stake. And trusting BYD’s management as well. Apparently he flew to China to meet the CEO, now the richest man in China, and was very impressed. He definitely know nuts about batteries and technology, so it’s really about knowing the jeweller.

In stock analysis, we always like to look at financial ratios like ROE, operating cash flow, margins, balance sheet strength etc. It’s quite no a brainer once you know a thing or two about financial statement and just divided one no. by another. The insight here is actually thinking about who made those no.s? Ultimately, it’s the people in the business. The top management, middle managers in the company and the company staff.

Company ABC’s average ROE for the past 5 years is 15%, therefore we can expect it to be 15% as well when the economy recovers. Or we can expect it to grow to 20% bcos they have a new product, or perhaps the industry average is 20%, so they should make 20% in time. Well, only if the top management has the leadership, determination and drive to make that happen. People make the numbers. Superior management made the 15% ROE and have the capability to bring it higher. Crappy management cook the books. And there's a lot of crappy management around.

But as small time retail investors, how do we get to know management well enough? Yes it’s difficult. It is true that retail investors may not access management from meeting them, talking to them directly, but we can still judge by their actions, their business plans and get to meet them during AGMs. Sometimes, things get so blatant that any Tom, Dick or Harry investor would stay 500 miles away from stinky management.

It takes a while (like a few years) to gather information about managements of listed companies and also experience to determine if what the management did was good for the shareholders. This means to read beyond what our "high quality" press media reports, decipher the news in the context free of any hidden agenda.

One-off businesses

This is the opposite of recurring revenue businesses. Basically, the company sells a product to a customer and that’s the end of it. There is no need for the customer to buy anything else for the next few years and hence no contact between the customer and the product seller for the next few years.

Most products that most companies make fall under this category: cars, massage chairs, LCD TVs, home sports equipment (like treadmills and stationary bicycles), vacuum cleaners, MLM magnetic beds, well you name it.

There is a stark difference between these one-off products and necessity/staples like shampoo, soap, kitchen paper etc. That is: you don’t buy staples products once and do nothing for the next 3 years. You keep buying them. Of course, there are times that the lines can be blurred.

There are a few major shortfalls with this type of business model:

1. The resellers and distributors have no interest to provide good service and they hope to rip off as much margin as they can from the customer since they won’t see them again for some time.

2. Since repeat sales from the same person is low, the company needs to utilize extensive advertising and marketing to sell their products. (well staples may also require this in order to sell, remember the Dove and the Pantene ads?) And the worse part is, if advertising and marketing expenses are cut, revenue falls.

3. The company is forever chasing volume growth because that is what drives the whole business. Hence the company needs to keep opening new stores or to keep coming out with “differentiate” products that are essentially not so different: like massage chair, followed by leg massage machine, head massage device, eye massage eye-wear etc.

4. It also means that sustainable revenue growth is close to impossible. The revenue stream is highly cyclical, following replacement cycles, general economic trends and/or market sentiments.

The prime example in the Singapore context would be OSIM which, by the way, is quite well managed even though it has a crappy business model. But as Warren Buffett puts it, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

For OSIM, the Free Cash Flow track record shows quite clearly that the management is prudent, at least pertaining to generating free cash flow. The company had delivered on average close to SGD 30mn of free cash flow per year over an average equity base of SGD 260mn over the past few years. Which in my opinion is a very significant feat. You just have to give it to Ron Sim.

However the other woes of the company overwhelm this positive FCF. The major blunder was the M&A of Brookstone, which we shall not discuss as it doesn’t really prove the point here.

Stripping out Brookstone, it was still evident that the quarterly sales fluctuated wildly from roughly S$50mn to S$150mn over the past few years. As mentioned, revenue growth needs to be driven by new products, more ad spending and/or new store sales. All of which need money ie less money for shareholders. It is definitely not easy for this business to actually generate good return on capital.

Unfortunately, as the facts add up, this company had an average dividend yield of meagre 1+% over the past 10 years. Its stock price was $0.16 in 2000, went all the way up to $1.36 and fell dramatically back down to $0.04 at its low and is $0.42 today. An investor would have lost money most of the time if he bought OSIM in the past 10 years. Specifically, he would only had made money if he bought in 2000-01 when it was still below $0.20 or in 2008 near the lows.

Near Monopoly Part 2

To illustrate Pt 4 and 5 of the previous post, we look at a Singapore company: SMRT. As with railroads in other countries, SMRT is a kind of natural monopoly bcos the capital outlay is so intensive, no competitor can come in and build a similar infrastructure just for the sake of competition. Even our beloved Government tried that and failed when they gave the North East line to another operator only to realize it doesn’t work.

So SMRT is in a good position to basically do whatever they want to enjoy supernormal profits.

First, they raise prices like nobody’s business. Well it’s subjected to approval from the LTA but heck, LTA always approves anyways. So the Singaporean passengers comprain and comprain like there’s no tomorrow. Actually in my opinion, it helped bcos SMRT became less aggressive somewhat after seeing the social repercussions. The truth is, Singapore train fares are probably still quite low at 70c for 1 station compared to global average of roughly US$1. So prepare for MORE fare hikes to come.

And after raising fares, the quality of service actually drops. That’s probably the unforgivable action. Trains take more than 10 min to arrive at non-peak hours and they frequently break down with minimal repercussions. Talk about 1st World Service!

Nonetheless, the shareholder benefits. SMRT shareholders have seen net profits grown S$100mn to S$160mn over the past 10 years. Dividends more than doubled from 3c to 7c. If you have bought SMRT at 60c (roughly the IPO price), dividends over the past 10 yrs would have reaped 40c. Not to mention the price today is $1.6.

With increasing population and real estate potential from re-developing its stations, SMRT’s future growth may not slow down unlike some other Singapore monopolies like SPH and Singpost. There is also the wildcard of whether the other future lines (Circle, Downtown etc) will be given to SMRT to manage as well. Again since most of the capex is done by the Government, it's a free lunch for SMRT and its shareholders.

However, it is likely that the company will continue to squeeze the commuters by providing ever declining quality of service and at the same time raising fares whenever the opportunity arises. Hence it is prudent for every commuter to become an SMRT shareholder.

As a shareholder, besides the dividends and capital gain, you can go and eat free food at the AGM and screw the management by asking tough questions. Hopefully they wake up their ideas and start to look at BOTH profits and services.

Near Monopoly

Companies with dominant global share are usually capable of generating supernormal profits. Sadly, in Singapore, such companies are hard to come by and hence this important factor is rarely looked at and discussed.

As Economics 101 would tell us, monopoly or near monopoly creates many conditions that is ideal for the market leader. These includes

1. Huge economies of scale – hence able to produce at a lower cost than most competitors

2. Bargaining power with clients and suppliers – to the extent of pricing out other competitors or ousting them in other ways

3. Advantage in capital outlay – a market leader does not need to spend as much as a competitor when increasing capacity bcos it can always leverage a lot on its existing structure (including distribution, sales and marketing etc)

4. As a result of stifling competition, the market leader now has pricing power. Basically it can price its product or services at any rate and customers will need to accept as there is no alternative

5. Reduction in cost of operations, and hence leading to a reduction in quality. The market leader now can reduce its cost of operations – including perhaps reducing the amount of input material cost or cutting sales force. This leads to reduction in quality of product or service

I guess the whole Singapore society is an apt reflection of monopoly works. Prices are ever rising yet quality of product or service keeps dropping. As consumers, Singaporeans keep suffering. Hence it is important for us to become shareholders as well, and so more or less offset the shit thrown at us as consumers.

*Sigh*, that's life in Singapore. Tomorrow will be better. Or so we hope.

Anyways, as an example to illustrate Pt 1, 2 and 3, we have HP laser printers. HP has a dominant share in the global laser printer market. Around 60% market share. As a result of this, they have huge economies of scale. They can produce laser printers and more importantly, the ink cartridges, at a much lower cost than all other competitors. However there is no need to sell the cartridges at a lower price than competition bcos they enjoy a good brand name. But if they wanted to, they could easier crush all other competitors by selling their cartridges at a much lower price.

Since they are the No.1 leader, they can always demand the best shelf space in electronic stores, or lower distributor margins, or bargain for lower prices with their parts supplier (those who supply the various small components inside the printer).

Of course, they can build new production lines and bring in new capacity at a much lower cost than all others. So how can anyone compete at all? Despite this, the never-give-up Korean superpower Samsung is fighting hard to break HP’s monopoly. We shall see if they have the same success with LCD TVs.

Next post, we look at a Singapore company on Point 4 and 5.

Good Businesses to Own

There are businesses and there are businesses. Some companies just cannot generate good enough returns for shareholders not because management sucks or there’s too much competition. It’s the business model that’s flawed.

Usually, it’s the high capex ie very high investment needed to buy new equipment to compete. It’s so high that all the money made from good times is not enough to pay for the equipment. And these companies need new equipment to compete in the next cycle.

We all know these industries: airlines, semiconductors, shipping, heavy industries etc.

Then there are these wonderful businesses that keep churning out cash without the need to invest a lot. And the best things is people just cannot stop buying their products bcos it’s a necessity or they are tied down by other factors to buy.

One good example is actually tobacco companies. As Warren Buffett puts it: it costs a penny to make, you sell at a dollar or more, and people just keep coming back for more. And you don’t need new investments. Perhaps just 15 tobacco factories can supply enough sticks for the whole global population of smokers (my guess). Well there’s the moral issue of course…

To summarize, here are some factors that good businesses have

1. Recurring revenue stream – usually coming from

- razor and blade model (printers, games, ipod and itunes)
- necessity item (toiletries, food and drinks)
- contract/license agreement (anti-virus, telcos, utilities)
- consumables (medical supplies, office supplies)

2. Low capex needs

3. Competition is not severe - usually due to

- limited no. of competitors
- dominant market share

4. Strong barrier to entry or moat (branding, technological edge, market share)

5. Pricing Power – related to

- level of competition and market share
- position in Porter forces

6. Growth Potential

We shall talk about some of these factors and companies with superb business models in the next few posts

Companies that shouldn't exist

The market is efficient and smart, but only to the point of the average smartness of all its investors. Hence it allows companies that spectacularly generate low or even negative return on capital to exist for very long periods of time.

The No.1 ranking company that achieve this tremendous feat would probably be Chartered Semiconductors, our beloved high tech foundry.

Over the past decade, the company had lost over a billion dollars culmulatively, burnt two billon SGD of cash and generated a spectacular ROE of negative 6%. It has never paid a cash dividend in its entire existence and have asked for money countless times.

Considering that cost of capital is around 6% (see previous post), Chartered failed to even come close. In fact, Chartered helped investors LOSE 6% every year. Yet the market cap of Chartered had been around S$2bn for the good part of the past 10 yrs. (its peak was a whopping S$7bn during the IT bubble and trough a miserable S$300mn during the Lehman shock.) Why would such companies exist in a rational, efficient world?

Well the stock market is just one aspect of the economy I guess. Chartered provides tens of thousands of jobs considering all the peripheral companies that it supports, we cannot just let it go down right? So we did the next best thing, we sold it! And thank goodness, Chartered will be delisted.

Why has a company like Chartered lingered around for so long? Well market participants always had hope and greed and of course Chartered did serve some purpose for punters. Back in the IT bubble, it was so clear that Chartered would be a STAR. It made chips for goodness sake. And chips are what make IT possible. so that was the eternal hope. Even when the company started burning REAL cash for Hungry Ghost festival every year, investors held hope. It's biggest shareholder, Temasek, never gave up. Well until now, that is.

Here lies the new insight I have about efficient markets. Markets are efficient in the short run, ie 1-2 yrs where almost all market participants share similar thought horizon and are able to price stocks very efficiently within this time frame. And markets are efficient in the very long run, ie more than 10 yrs - companies that ultimately shouldn't exist would go, like GM, like some airlines, and perhaps Chartered. And of course, Great companies will rise through the ranks and become behemoths and rule the world, like Walmart, Toyota and Nestle etc.

Cost of Capital

This post is edited in 2016.

We are back to talking about something dry after a long, long hiatus. Ok Cost of Capital.

Basically, capital is not free, it comes at a cost.

Why is there such a cost? Well basically the person providing the capital needs to earn a return. If not, he might as well chuck it under his pillow right?

So the question is how much return does he want?

Well, the lowest return he can get without any risk of his original amt being reduced is 3% or so. That is if he buys government bonds. So the cost of capital cannot go below 3%.

Capital actually comes in two forms: debt and equity. Let's talk about the cost of debt first, bcos it's easier.

Debt
Say you want to start a company today and need money, so you go to a bank and ask for a SME loan. Depending on the nature of your business, your bargaining ability, the desperation of the loan officer, your interest on the loan should be around 6-10%, which is pretty high. Well that's bcos it's SME, may go any time one. So the bank needs some buffer. If a big Fortune 500 firm issues a bond, they can probably get US$100mn with interest rate of 4+% or so.

So the cost of debt is just that: 4% to maybe 6% for most large cap companies. In 2016, with negative interest rate dominating a lot of sovereign bonds, the long term cost of debt has come down to 2-6% for corporates.

Equity
Traditionally it has been thought that cost of equity should be higher than debt bcos the equity provider gets to participate in the upside (when the profit grows, stock price rises) but the debt owner will always only receive the fixed interest. So cost of equity will at least be 6% or more. In the 1950s or maybe 60s, academics tackled this question in a big way and came out with a huge model called the CAPM model. This is huge and Nobel prizes are given and economists became gods. For those interested, you can go wiki it or something.

Basically the idea is that cost of equity can be expressed in an equation like

Cost of equity = risk free rate + equity risk premium

The equity risk premium part can be further broken down into super complicated stuff like beta and expected market return which are too mind-boggling for our purposes here so it suffice to say that this equity risk premium should be a no. to compensate equity investors for the risk they take and make the total cost of equity higher than cost of debt.

Historically, cost of equity is about 8-10% for most large cap companies.

So the equity risk premium is about 5-7% (bcos risk free rate, which is usually long term government bond yield is about 3%)

Combining the two, you get something called the WACC (for weighted average cost of capital), and this is the cost of capital for a company. This no. usually ranges from 6-8% judging by the no.s given above.

It is said that companies should earn more than its cost of capital to justify its existence. So meaning the co. should have a return on capital of at least 6-8%. Capital meaning debt + equity, or roughly speaking total asset of the company (not exactly the same thing but close). If the co. has no debt, it means that the return on equity (the famous ROE), should jolly well be above 8-10%, ie above the cost of equity.

If a company cannot generate this return, then investors should really pull out all the funds and invest in others that can. However, in real life, that is not always the case, as we shall explore in the next post.

What's Right with Buy-and-Hold?

So Buy-and-Hold has its flaws, but the alternative, which is trading is not much better. Empirically, trading has not help generated wealth. But before we come to some conclusion, let's look at the usual Pros with regard to Buy-and-Hold.

Pros

1. Missing out the 10 biggest days in positive movement

Studies have shown that if you subtract the returns of the 10 biggest positive gain days in the past 20 yrs, your long term average annual return drops something like from 8%pa to 4%pa. This is major bcos suddenly you might as well go and buy 30 Yr Singapore Govt bonds and that could have given you close to 4%pa, without all the risks associated with stock market. Since we cannot predict which days will be the biggest positive gain days in advance, value investors argue that we should always buy and hold to reap the full benefits.

2. Transaction cost

This has come down over the years but still constitute 0.5% or more to most retail investors. Considering in Singapore where the minimal brokerage cost is S$20 per trade, you need to do a S$8,000 trade so that you can get the buy and sell costs to be 0.5% of your trade. Sadly it can only go as low as 0.25% bcos after that, the brokers charge based on the size of your trade. So let's work with 0.5%. Most retail investors would probably do more than 1 buy-sell trade per year, let's say they do 2. We know that average annual market return is 8% and two trade incur transaction costs of 1%. Congrats, you just gave your brokers a 12% commission. Every year. So Buy-and-Hold pls, save the transaction cost.

3. Dividends

Globally dividend yield usually ranges from 2-4% and in extreme times, you see dividend yield of a market going to 6-7%, like the STI in 2008. Albeit it's a lagging yield bcos the data is always late to factor in a drop in dividend going forward. Anyhow, the point is, dividend is a huge part of return. Since we all know that average market return for investment is only 8%, dividends can constitute 25-50% of this market return. It does make sense to focus a lot on dividend stocks. And needless to say, to get dividends, you can't just trade, you need to buy-and-hold.

4. Missing out the full growth

This will be the most compelling argument. Trust me.

If you have bought a Great Company, not just Good but Great with a capital G, then there is never a right time to sell bcos the company simply grows exponentially and overwhelms everything! Some of Berkshire's companies would illustrate this very well. I will just highlight See's Candy and Coke. Buffett bought over the whole of See's Candy for USD 25mn in 1972. Today See's generate pre-tax earnings of over USD 1bn, if See's is a listed co. the market cap would be close to USD 20bn. So that's close to a 1,000 fold return. Mind you, that's 100,000% return. If you sold for 100% profit in 1973, you just made the biggest mistake of your life.

Coke tells the same story. Berkshire bought 8% of Coke for USD 1bn in 1988, today the same stake is worth USD 10bn and Coke's pre-tax earnings is USD 7bn, of which Berkshire is entitled USD 600mn (on paper). In another 10 yrs, the profits entitled to Berkshire would be more than what Berkshire paid for and this current ten bagger will become a 20 bagger or even more. So is there ever a right time to sell Coke?

Sadly, most retail investors never get to enjoy this kind of thrill bcos a 20% profit in 2 weeks is already better than sex.

Conclusion

Again in investing, there are no hard and fast rules, most of the time buy-and-hold makes sense, but there are times that they do not, some times you can take some profit here and there during those periods. However, to trade in and out every few weeks or days and try to beat buy-and-hold is a tall order. Much taller than most people would like to think so. Not to mention the effort needed to do those weekly trades! So run through the pros and cons again, when you are tempted to trade!

What's Wrong with Buy-and-Hold?

This is another topic that has been debated left-right-centre since... Geez, Adam and Eve I guess. Let's just go through the usual pros and cons. I will start with the Cons.

Cons

1. Doesn't help to make money

This has been highlighted various times in the papers. Someone who bought an index, say the S&P500 and held for the past 10 years would have made zero return. In some markets, you could have bought-and-hold for the last 20 years and still lost money. The best example being Japan. Buy-and-hold at any point over the past 20 years would have made negative return! So to hell with Buy-and-Hold right?

2. What about locking in profits?

If a stock has risen 100%, and knowing that stocks on average gives only 8%pa, this stock has already given you roughly 10 yrs worth of return, isn't it a good idea to lock in the profits? Especially if the stock intrinsic value is not going to grow by that much over time - meaning that it's grossly overvalued. We should sell when things are grossly overvalued, right?

3. There is no time.

Buy-and-hold takes a long time to give you a good return ie average market return of 8%pa. However, time is a luxury that not everyone has, especially if you are 40 and above. You need a substantial retirement nest egg in 15 yrs assuming you retire at 55. Although retirement age is 62, most people don't get to stay employed until that age unless you are a civil servant, or self-employed. And increasingly, the career lifespan is shortening, look around you, do you see a lot of your colleagues in their 50s? So how do you buy-and-hold in 10 or 15 years? Incidentally, if you bought the STI index in Dec 99 at 2,600 points, you just managed to claw back your capital as the STI today is, well, at 2,600 points! 0%pa after 10 years, that's great isn't it?

So Buy-and-Hold sucks, what should we do?

Well you trade. You buy the STI when it was at 1,200 in Sep 2000, Hold until Sep 2007 and sell at the peak of more than 3,000. Buy back when it dropped to a low at 1,500 in Jan 2009 and sell now at 2,600. You would have make 500% gain over the past 10 yrs, that's roughly 50%pa.

Haha, well this can only be done on hindsight. Most traders lose their pants trading bcos their emotions get to them. Even if they bought at 1,200, they would have sold when it reached 2,000. Then hastily buy more when it reaches 3,000 and then got stuck when it collapsed, etc. Well you know the story, don't you.

Trading works when you have a good trading system and you adhere to it. 100%. If you do that, you can probably make an average return of 4-6%pa after transaction cost. Of course, legendary traders make a lot more than a meagre 4-6%pa. So we should strive to be like them! Then value investors will bring out Warren Buffett, who made 24%pa for 50 yrs and grew USD 1mn to USD 60 BILLON. So better argue based on average returns, not the legends' rate of returns.

In reality, most retail traders lose money trading. We are not even talking about market return of 8%pa here. Next post, we look at what's right with Buy-and-Hold.

The ultimate bet

This post is related to the last one regarding probabilities and payoff and how we should bet.

We often hear about people betting their life savings of $100k on the next property of say $500k, hoping for that 20% rise before TOP and make $100k return (with a capital base of $100k). Lets see how this works in that matrix thingy we used in the previous post:

Let's give the benefit of doubt and say this guy has 70% chance of making $100k, he has read the property market well, the cycle is turning, the stars are aligned. However, again in life, since nothing is 100% one, we have to think that he also has a 30% downside whereby he will lose $250k (ppty of $500k goes down by $100k, mortgage $130k, legal fees $20k all add up to $250k)

Probability payoff
0.3 -250k -75k
0.7 100k 70k
Expected return -5k

Now we see that the expected return is negative. Even if we tweak the no.s here and there, which I did, the expected return is not high. You can probably get to expected return of $80k - which is good if you use $100k as the base. But in reality the base is $500k, bcos the guy borrowed $400k from the bank. So you risked a life of perpetual debt for $80k, is it worth it?

In real life, and not just paper math, if the 30% probability becomes reality, this guy is stuck with a $500k 30-yr mortgage on a house worth significantly lesser, he may have cashflow problem and need to sell out some time in the next 30 yrs, or declare bankruptcy. As we know it, his life is over. Well at least financially that is. He will never achieved the much coveted financial freedom, a nice cosy retirement nest egg and the kind of crap Robert Kiyosaki likes to preach.

Anothe way to look at it, we can think of such bets as extreme as this Russian Roulette game:

1 shot of out six has a real bullet.

If you win, you get paid $5mn, enough for a lifetime. (Well at least for me, I dunno about you though)

If you lose you die.

Odds are in your favour: ok let's make it even better, we have a revolver that can house 20 shots.
So only 1 in 20 chance you will die.

19 in 20 chance you never have to worry about money in life.

Will you play?

Betting when the downside is something we cannot afford to happen is not a good way to bet. Think about this when you are faced with such choices.

Probability and Payout

This is something that relates to the Kelly Formula but at a much more simplistic level.

Basically, it all started when some friend of mine had the idea that if we are 80% sure of a 10% upside, we should be punting big on this event?

Eg. we heard a rumour that the CEO of TSMC saying he wants to buy Chartered for $2.20 (Today closing price $2.00) from the secretary of the CEO of TSMC and he will announce it tomorrow. How should you bet?

Mathmatically, this event can be illustrated with the matrix below.

Probability Payout
0.8 10 8%
0.2 -20 -4%
Expected return 4%

In the first scenario, there is a 80% chance you earn 10% and in the 2nd one 20% chance you lose 20% bcos say for some reason, he did not announce it the day after, or something unexpected happens. In life, nothing is 100%, even if you are the TSMC CEO yourself, you cannot say for sure if you can make the announcement as planned. You might get murdered, or something else etc, Anyways, as such is the case, the expected return is actually about 4%, which is, well, lower than market return of about 5-8%pa.

My initial thought is that we cannot punt this kind of event to help us make big bucks. Given the inherent unreliability of a rumour, the low expected return, it is not exactly a good way to maximize wealth. Of course we can always tweak those probability and payoff to get a good expected return, but using logic and rationality, it is difficult to get a good expected return of more than 15%.

In value investing, I think the matrix looks like this:

Probability Payout
0.4 -30 -12%
0.6 50 30%
Expected return 18%

There is a 40% chance you will lose 30% of your money, but a 60% you make 50% (remember margin of safety and other safeguard put in place?) Your expected return is 18%. If you make enough of these during a lifetime - you are a clear winner.

The caveats here are:

1) your analysis must be quite accurate, ie the intrinsic value is really 50% higher than current price

2) the timeline here is long, it may take 3 years to realized this 18%, which means 6%pa

You might think this is just bcos I am promoting value investing. But if you play around with the probability and payoff you can still get 10+% payout on average, which would translate to only 2-3%pa but still it's positive number.

Back to the TSMC case, you can argue that the 4% when translate to annual return becomes 1200%pa. Spectacular! However the logic would be that you won't get to hear a rumour about a takeover 300 days a year... So looking at the absolute expected return no. regardless of the timeline becomes important. And if you play around with the probability and payoff for this, you do get negative numbers.

So with this in mind, hopefully you can do this simple exercise with your next stock buying and practise more value investing rather than punting!

Best Of The Best

This is an updated list of stocks screened out by some value factors, like less than 2 yrs of negative free cash flow over the past 10 years, high dividend over the past 10 years etc.

Sorry I have no clue as to how to make the image bigger, so pls click on it to see the whole damn table.

The ratios you see are also 10 year average ratios, hence they will look different from what you get in most places. This is adhering to what Ben Graham taught. Looking at the performance of the company over a long time frame to smooth out any economic cycle, boom and bust that the co. went through, and most importantly bring down the no.s especially if the company had had spectacular growth in the last 1-2 yrs.

My personal top pick is Cerebos Pacific, Brand's Chicken Essence rules man! More on this next time.

And finally, disclaimers, buying stocks listed here won't guarantee that you will make money. If really these stocks here can make anybody rich, I won't be blogging here my dear!

Anyways, do take a look and see if you agree these are the best of the best listed on SGX!

More Payback in Years

In line with the previous post, here are more scenarios how payback in years can change drastically with the vagaries of modern life

Bought a water stock – 33 yrs
The CEO got married – 99 yrs
To a scientist nominated for the Nobel Prize for water purification – 12 yrs
They divorced – 33 yrs

Bought a condom stock – 35 yrs
Satellite failure stopped the broadcasting of global sports channels for 2 weeks – 16 yrs
False alarm, satellite’s working! – 33 yrs
Korean melodrama satellite fails – 8 yrs
Global power failure caused by Al Qaeda – 2 yrs

Bought a telco stock – 18 yrs
The co. announced that an ex-CEO of a mining co. will take over as CEO – 180 yrs
The new CEO divested poor performing subsidiaries and incurred losses of USD 4bn – 625 yrs
The new CEO got fired – 18 yrs
The subsidiaries recovered – 68 yrs
The telco co. decided to invest in the subsidiaries again – 255 yrs

Here's the bonus for this week!
List of most anticipated IPOs and their relevant payback years

Twitter IPO – 50 seconds
Facebook IPO – 2 hrs
Facebook acquires MySpace – 120 yrs
Twitter acquires Facebook + Myspace – 2,718,28 1,828,4 59,045, 235,360 seconds

Iridium Satellite Phone Returns! IPO – 125 yrs
Lehman Brotherhood Restructured IPO – 214 yrs
Revenge of the Fallen: Mega-Electron General Motors IPO – 369 yrs

Shanghai Stock Exchange US$100bn IPO – 88 yrs
Bird Nest Stadium IPO at $18 – 188 yrs
Jackie Chan Franchise IPO – 288 yrs

Temasek Holdings IPO, CEO Singa the Lion – 440 yrs
Wimbledon Tennis IPO, CEO Aggassi – 1,066 yrs
Tour de France IPO, CEO Lance Armstrong – 1,789 yrs
Terracotta Army Exhibition IPO, CEO Zhang Ziyi – 6,000 yrs

Jurassic Park Ride IPO, CEO T-Rex – 65mn yrs
Google Earth IPO at $3141.59265 – 4.3bn yrs
STAR WARS Franchise IPO, CEO Chewbacca – 13.5bn yrs

Price Earnings and Payback in Years

Another way to think about the all powderful Price Earnings Ratio is to think of it as Payback in Years. Ok, here's the expraination:

Price Earnings = Price / Earnings

Say if a stock earns 5c per share and you are paying $1 for it, how many years would it take for you to get back your $1?

Assuming that it will earn 5c every year forever, the answer is 20 years right?

And how did we get 20 yrs? Well $1/5c gives you 20.
Which, in case you fail to notice, is the formula for Price Earnings Ratio.

So lower PE means faster payback in years.

Some people talk about it's alright to buy a stock with PE of 40x bcos it's the dream stock, spectacular growth for the next 20 years!

40x is cheap! Let's put in more no.s to this scenario and see what we get:

EPS for 2007 20c
EPS for 2008 40c
EPS for 2009 60c
EPS for 2010 80c

Price in 2009 $32

This stock is, well... trading at 40x PER for 2010 at $32. In order to get a decent payback in years (roughly 15 yrs), the stock needs an average EPS of $2.4 for the next 15 years.

This means that the EPS needs to triple in the next 3 years, grow a bit more and finally stabilize at $2.6 so that the average can hit $2.4!

Even if it somehow managed to perform this spectacular feat, what you have paid for at $32 merely justifies it. You did not get any upside or discount. There is no margin of safety in this investment. So think really hard when you are asked to buy a stock with 40x PER.

Anyways, in line with the points system found in Men are from Mars, Women are from Venus, here is a list of scenarios and the estimated payback years:

Analysed a blue chip for 3 mths & bought it in a bear market - 12 yrs
Analyzed a blue chip for 3 days & bought it in a bull market - 26 yrs
Bought a blue chip without any analysis whatsoever - 33 yrs
Bought a blue chip, heeding advise from a friend - 52 yrs
Bought a blue chip anticipating a RIGHTS ISSUE - 89 yrs

Bought the highest traded stock on SGX after it dipped 10% - 48 yrs
Bought the highest traded stock on SGX after it rose 15% - 60 yrs
Bought a stock that rallied 30% after some good news - 76 yrs
Bought a stock that rallied 30% after some good news, in a bull market - 182 yrs

Bought a stock not covered by any analysts - 27 yrs
Bought a stock rated SELL by an analyst from a broker house - 42 yrs
Bought a stock rated BUY by an analyst from a broker house - 84 yrs
Bought a stock rated Strong Conviction BUY by an analyst from a broker house - 205 yrs

Bought an S-chip at IPO - 51 yrs
Bought an S-chip at IPO, heeding advise from a friend - 90 yrs
Bought an S-chip at IPO, heeding advice from a taxi driver - 122 yrs

Bought a stock Warren Buffett bought, at a lower price - 14 yrs
Bought a stock recommended on this blog - 21 yrs
Bought a stock recommended by a value manager on CNBC - 29 yrs
Bought a stock recommended by a magazine - 48 yrs
Bought a stock recommended by a broker - 128 yrs
Bought a stock recommended by two different brokers - 199 yrs
Bought a stock recommended by a self-professed stock guru, advertising "How To Make 1 Million in 2 week" on Straits Times - 256 yrs

Cheers!

Traders and Investors

Just like to share my own definition of traders and investors that I thought about recently...

First let's start with Ben Graham's definition of investors and speculators.

Graham first stated that an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return and operations not meeting these requirements are speculative.

So an investor focuses on analysis to look for capital safety and adequate return. This is usually interpreted as fundamental analysis of the company, its business model, its competitive advantage, margins, sales growth and of course, the financials: cash on hand, debt, bankruptcy risk, capex needs etc.

Anything less of such analysis means speculation. A speculator is simply one that doesn't do that kind of rigorous analysis.

Simple right?

For me I think it's about different focuses.

An investor focuses on value.
A trader focuses on price.

An investor is interested in the value of a stock (or any other thing he wants to buy), and he spends an awful lot of time and effort to figure out this value (or intrinsic value). This is analogous to Graham's analysis. Or more accurately rigorous fundamental analysis of business operations and financials. Price serves only to tell him how much he actually has to pay if he were to buy the stock. Needless to say, the lesser the better. Graham and most value investors advocate buying 30-40% (margin of safety) below the stock's intrinsic value.

To an investor, profit is made when the stock price subsequently rises to its value which usually take years.

A trader is interested in the price of a stock and he spends an awful lot of time and effort following how the price has moved. Actual value of a stock basically serves no purpose for the trader.

To a trader, profit is made when the stock rises above his buying price and he sells it to another person willing to buy at a higher price. Usually also known as the Greater Fool.

So, that's that! Just two different philosophies here to make money.

Balance and Reversion

Taoism talks about being in tune with the Universe and consequences of allowing a strong force to overwhelm others. Yes we are talking about the Yin and the Yang. Both forces should balance each other to achieve Balance. A stronger Yin over Yang or vice versa leads to unrest, discomfort and ultimately it calls for a reversion to the mean.

In Graham-speak, this becomes Bond versus Stock. Back in his days where there were only 2 asset classes: Bonds and Stocks, his strategy was to always maintain a portfolio with at least 25% in one asset class and a maximum of 75% in the other. And this is when one asset class in grossly overvalued versus the other. In most cases, it should be a 50:50 split between bonds and stocks.

So as with Taoism, the ideal situation is always an equal split between the bonds and stocks. Both asset classes will be in balance. Bonds give income, stocks give capital appreciation. Bonds counter deflation, stocks counter inflation. Bonds, downside protection, stocks provide upside. Totally in sync with the Universe!

However there are times when a stronger force overwhelms the other. With investment, well usually a stock bubble brings valuation so out of whack that it makes sense to disrupt the balance. In this case, overweight bonds and underweight equity. Ultimately, the Universe must return to its status quo, ie stocks will correct to its appropriate valuations and the investor benefits.

Value investing focuses a lot on the process up till buying the stock. But very little is said about selling. Buffett, the Oracle of Omaha, is famous for saying you never sell a good stock except when you want the money to buy a better one. Graham never specifically said anything about selling as well.

But I guess, by reading between the lines and drawing lessons from Taoism, we should sell when things are out of balance. In the case of stocks, when it’s grossly overvalued. The sad mistake we all make is to rationalize the overvalue-ness to justify why we still hold on to the stock. Like the company has this new product that will be a hit, or the company is going to do M&A, or the company is going to increase dividends etc.

So the next time we want to hold on to a stock that had gotten too expensive, think about the balance of the Universe and why reversion will always occur and it’s time to allow that to happen. Sell the damn stock.

Graham and Lao-Tzu

Not sure if it is just me. Reading some of Graham’s philosophy reminds me of Taoism and Lao-Tzu. Using no-change to combat ten thousand changes, cycles and repetitions, no rules etc. More than a handful of Tao philosophy is actually reflected in Value Investing. Well someone did come out with a book called Tao of Buffett.

Combating ten thousand changes

Graham thinks that it is futile to predict the future. Nobody has been able to do it. So what he does is to assume that what has occurred will continue, with relatively high probability. This has of course been well mastered by Buffett, his prodigy. Hence their preference for brick and mortar businesses that basically face little changes over the years (unlike technology or growth sectors).

This is also exemplified by his preference for 10 year valuations. Which I think is probably one of the most important concepts from the Intelligent Investor. You see, on Wall Street today, most people, when they talk about valuations: ie PER and PBR. They talk about Share Price today divided by the Earnings Per Share next year for the company.

Graham uses an average of 10 years’ worth of EPS in order to determine if the stock is cheap. Basically, he is saying that if the average annual EPS over the next 10 years is the same as the previous 10 years, and if the price is cheap (ie PER of less than 15x), then the stock should be a BUY.

This makes whole lot of sense for someone who really thinks about buying a business for REAL right? Think about it, if you are going to buy that coffeeshop down the road. The owner says the shop will earn $500k next year. So you will pay 15x of $500k for the shop (ie $7.5 mn)? Or would you be more willing to buy from the other owner who showed you his average earnings for the past 10 years, amounting to $300k per year?

For one, the average earnings would usually be lower than next year’s earnings forecast. Especially if the forecast is made by a 23-year-old analyst from the brokerage firm. Or in the coffeeshop case, the owner who wants to cash out.

In any case, nobody ever gets their forecast right? So Graham simply uses the past and assume that the future is going to be like that. Using no-change to combat ten thousand changes. Bu Bian Ying Wan Bian.

More Taoism to come.

Analysing ETFs

It came as a pleasant surprise how SGX had expanded its portfolio of ETFs to 30 from a pathetic 10 when I was looking at it a couple of years ago. Recently, the biggest distributor Lyxor (Soc Gen), announced a further 5 ETFs to be listed. Looking at this trend, one can expect the no. of ETFs to go to 50 in the next 1-2 years, providing retail investors an inexpensive way to diversify and invest globally.

http://www.sgx.com/wps/portal/marketplace/mp-en/products/securities_products/etfs
This link provides a lot of info on the ETFs listed on SGX

At this juncture, I thought it would be good to post something about this investment product which might be one of the most important factor to help one achieve a 8%pa long term rate of return. Here are a few things I thought one should look at.

1. Expense ratio
Needless to say, this is probably the first thing to check. SGX listed ETFs have expense ratios ranging from 0.4-0.9%, which is kind of expensive compared to those in the US (as low as 0.2%) but much cheaper than unit trusts at 1.5% sales charge and 1% management fee. Well Singaporeans always get short-changed, so just live with it.

2. Market maker
Some ETFs listed way back in 2001-2002 has zero trades for the past 8 years without market makers which I think resulted in their failure. Now it's impossible to buy or sell them as there are no buyers or sellers! Even though its a listed product. Then came Lyxor with its market maker (basically some execution party and ensures you can buy or sell the ETF even when there is no counterparty) and viola, ETFs took off and Lyxor now has 50% market share of all ETFs listed in Singapore.

3. Spread
Even though there is a market maker and trades get executed, some times we need to pay attention to the spread. My rule of thumb is that if the spread is more than 1%, then it's a huge transaction cost. It is not something that you can change though. My greatest concern would be that if I hold this ETF for 10 years or more when the whole world has lost interest in it, will the spread balloon? Meaning I can't sell it. I have no answer at this point. Enlightened parties, pls share!

4. Dividends
Some ETFs listed on SGX give dividends, some don't. Personally I prefer dividends, a bird in hand man! Yes academics argue it doesn't matter, it might even be better bcos the dividends get re-invested - you don't get taxed, you get higher compounded return! I don't care, I want income stream and I want it now! Well that's me though.

5. Market Cap
The size of the ETFs determine if its likely that this product will continue to be listed, and I would say go for stuff with like USD 50-100mn in size. If it's too small, there might be a chance that the distributor will delist it. Then it's trouble trouble.

6. Valuations
This would be the single most important factor determining what or when to buy. As with stocks having their PER, PBR etc. ETFs also have their PER and PBR. It is not easy to get those figures (without a Bloomberg) but I think you can try to call their hotline and ask around. My general rule of thumb would be buy at PER 12x and PBR 1.2x. Some ETFs were at this attractive level earlier this year, now they are closer to PER 15x and PBR 1.5x. So wait for them to come down.

7. Components
Ultimately, ETFs are made up of stocks. So it pays to look at what's inside and see if you are comfortable with it. As with most indices, the bulk is actually finance stocks. Like STI is 40% banks maybe 20% Real Estate stocks. Russia used to be the hottest thing in town bcos it was mostly just oil companies. Since what we want is diversification, I would suggest look for ETFs that are more balanced, or buy a few to balance it out yourself.

8. Prospectus
Lastly check out the ETF's prospectus, see if anything is amiss or if there is something bothering you? Give them a call if need be. Usually it's some salesperson that is trained to answer some standard questions but no harm trying and hope they managed to help.

I am also still learning about all these, so knowledable parties pls share what you have learnt. 2009 and 2010 would be a good time to finally put money to work and earn a decent rate of return!

What is Value Investing?

Value Investing is perhaps one of the most important topics in life that is misunderstood by the most people. This is a reflection of our modern society that constantly tries to replace rationality, long term thinking and hard truths with sensations, material gains and get-rich-quick mentality.

It is a sad fact that most people today equate investing with gambling when the segregation can be crystal clear. To quote Benjamin Graham, father of value investing, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return and operations not meeting these requirements are speculative”.

In simple layman terms,

Value investing simply means adopting an investment philosophy to buy something that's worth a dollar with a lot less, like 60c or less.

Here is a modification of the old formal definition that I posted some years back.

----------------------------------------------------------------

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

1) Buying at a price that is less than its intrinsic value

2) Buying with a margin of safety

----------------------------------------------------------------

In a nutshell, value investing is simply applying the concept of "shopping during bargain sale" to buying stocks, bonds, properties ie investing. It means paying less for more. Get good value for money. Buy one get two free. Buy a dollar for 60 cents.

The concepts here are not difficult to understand and their applications are also straightforward but as with dieting, what makes sense doesn't mean that it's easy to accomplish. This is because human emotions like greed and fear are constantly playing tricks to blur our rational minds which it what makes value investing tough. Especially when there are prices, charts and patterns, talking heads with irrelevant short term newsflow bombarding us daily.

Over the years, the paradigm of value investing has expanded to encompass many things:

1. Fundamental analysis (FA) needs to be rigorously employed in order to determine the stock's intrinsic value. This plots value investing into the infamous FA vs TA argument. TA stands for technical analysis ie looking at charts and stuff.

2. Buying a stock is like owning a business. Hence long investment horizon becomes norm as business owners don't buy and sell their co.s like oranges. And also undervalued stocks usually take some time to revert to it's intrinsic value.

3. Stocks that have certain characteristics become known as value stocks

a. predictable business operations and stable earnings (easier to calculated its intrinsic value)

b. low PER, PBR, high dividend, high cashflow or other "value" quantitative factors

4. Based on the points raised in Pt 3 above, value stocks typically come from mundane industries like food and staples, utilities and other old economy industries ie no high-tech, alternative energy or bio-venture stuff.

5. It is generally accepted that Benjamin Graham is the father of value investing. Other well-known value investing practitioners include: David Dodd, Irving Kahn, William Ruane, Martin Whitman, Charles de Vaulx, John Templeton, Charlie Munger and Warren Buffett.

Since the concept of buying something that is undervalued is so broad, value investing is sometimes used to refer to investing in special situations like merger arbitrage, discount bonds (e.g. some bonds trading at 50% below par value and pays 10% interest and has little risk of default). However, this blogger thinks that this is a stretch for value investing.

For most people, it should suffice to understand that value investing is about owning a partial stake in a good company by buying its stock at a reasonable price.

How long term should we be?

The investment horizon that is appropriate for our generation is probably 15-20 yrs, in my opinion. This is bcos we usually have some savings after the age of 30-35 for some real investing as we get married, buy house, have kids etc. And if you think about at what age should you enjoy the fruits of your investment, then it's probably 15-20 yrs later. I mean retirement age may go up to 62 but shouldn't we start thinking about enjoying life in our late 40s, early 50s? No point investing for 40 yrs and then get old and immobile and use the fruits of investment to pay for medical bills right?

Also, we shouldn't forget that even though official retirement may become 62 or it might go up to 65, probably it gets harder and harder to stay employed as our generation hits 45 years old. This is a major social reality/issue and it is already biting at a lot of people. Look around, do you see a lot of your colleagues who are in the 50s or 60s? The career life span is shortening. If you are in your 30s like me, we cannot expect to stay employed until 50.

Say if the investment horizon is only 15 yrs, and intrapolating the no.s on my previous post, the returns probably vary around +3% to +18%. ie if you bought at the peak of the market, you can expect to get 3%pa, which is worse off than leaving money in CPF. And worse still, if you had bought in 2007, it is likely that you might take more than 15 years to break even.

In order to mitigate this undesirable outcome, we must definitely employ a sound investment plan or some form of dollar cost averaging which basically means you put aside some money to buy stocks or bonds or funds every month. This should provide a +ve return after 15 years.

To aim higher, ie achieve an ok return like 8%pa, we must pay attention to market cycles in the macroeconomic sense. Don't buy a whole lot of stocks during the peakish periods and look to buy during doldrums (like now). Of course for true Graham/Buffett style value investing, the valuation takes care of this. You won't be buying stocks at the peak bcos the valuations will say No-No. Graham is famous for using his 10 yr valuation to smooth out earnings peak and trough during cycles. He would say BUY only if stocks are trading well below 10 yr valuations. ie Price/Average EPS over 10 yrs is less than 18x. He also have 6 other criteria to follow. Basically, you can't find stocks meeting most criteria in 2006-2007.

In conclusion, to get an ok return on investment (like 8%pa) over a 15 yr investment horizon, we need to know the macroeconomic trends, don't jump into stocks when everyone is also jumping in, focus A LOT on valuations, esp long-term valuation (not 1-2 yr forward EPS) and keep that margin of safety concept in our heads, and we should be ok.

On market timing

This is one topic that always attracts a lot of debate and verbal lashes. Value investors are of the view that it is futile to time the market. Over long period of time, studies have shown that you cannot beat market return after factoring transaction costs. This does not mean one cannot have positive returns. It might be possible to generate positive returns but I have enough evidence to believe that it's quite difficult.

Traders, on the other hand, believe that market timing is part and parcel of "investing". Well what value investors define as investing may be different from what traders define as investing though, but for now let's not delve into this yet. Anyways traders believe that those who don't look at charts and to a certain extent, time the entry and exit are idiots.

Ok, first we should actually define the two different types of market timing that exist.

The first type is looking at daily, weekly, monthly, quarterly or even 1-2 yr charts and try to time the bottom and top. ie buy at the low (as dictated by chart patterns or other signals) then sell at the high. To try to win this game is very similar to playing at the casino. Your chances of winning are usually less than 50%. Nevertheless there are ways to make money even when you are up against the house. The book Fortune's Formula provide some interesting insights. I hope to discuss some interesting stuff from this book in the future but for now, we are not interested in this definition of market timing. You are at a value investing blog, remember?

Ok, the 2nd type of market timing involves 5-7 years macroeconomic trends and stock market cycles. This is the important type of market timing that we shall focus today.

From 1950 to 2000, if you invest in a stock index (in this post we use stats from 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 vary between -50% to +25%.

This means that if you are damn bloody good 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 (like 2007), your return can be as bad as -50% in 1 yr.

However as your investment horizon stretches, the returns tend to vary less and get skewed towards a +ve return.

If your investment horizon is 1 yr, your returns vary from -50% to +25%.
For 5 yrs, your returns vary from -3% to +23%.
For 10 yrs, your returns vary from 0% to +19%.
For 25 yrs, your returns vary from +8% to +17%.
This is true for the time period 1950 to 2000.

The worst 25 yr return rate on record is when you started investing in 1929, your return is actually 0% after 25 yrs. Incidentally, this may be the case if you started in 2007. In order to avoid this pathetic outcome, someone invested in 2007 should keep buying esp in 2009 and 2010.

If you take the average of all these returns, it is roughly 10% which is average return for S&P500 over an 80 yr period. What about the other markets? Sadly most other markets do not deliver as good returns and the S&P. Japan for one, has a 25 year bear market and still counting. However, it's probably safe to say that stock markets have delivered 5-8%pa over the past 20-30 years even after taking into account this crisis.

Ben Graham, the father of value investing, advocates that we should not try to time the market and simply be happy with this 5-8%. Buffett had also mentioned that one of the best investment strategies for the retail investor would be to set aside some money buy an index fund every year and earn this 5-8%. It's simple, saves time, get rid of the emotions and can make you real money for retirement!

Stock vs Spouse

If you are really into value investing, you should, hopefully by now, understand that buying and owning stocks can be akin to marriage. It is not about buying today, selling tomorrow. Or instant gratification. Or short term happiness. It's about long-term commitment, going through thick and thin together, sharing your lives.

Here's the list of comparisons. Enjoy!

Stock and spouse

1. Both are meant to be enduring life-long affairs.

2. Both require a lot of due diligence before committing to achieve happiness.

3. If you have made a good choice, the relationship only gets better over time.

4. You wouldn't admit it's a bad investment until it's too late.

5. If you've got a real gem, you can always show your friends and feel proud.

6. It's always better to start looking early in life. But not too early, teenagers reading this blog, sorry teenage = too early.

7. It's unwise to dismiss potential targets when there are only minor flaws bcos good ones are hard to come by.

8. And really, the super good ones are very hard to come by.

And here's the treat of the day!

Stock vs Spouse

1. A stock doesn't care if you surf net all day and didn't spend quality time with it.

2. A stock won't leave you for another sweet young thing.

3. A stock doesn't care if you look at other stocks.

4. A stock doesn't occupy 70% of your bed and SNORE.

5. A stock always look good in the morning, without make-up or grooming, even after 10 yrs.

6. A stock is never interested in how many stocks you have in the past.

7. You can still buy a stock even if you don't have a car, 2 condos, 3 country club memberships and 5 credit cards, well you do need a few thousand dollars though.

8. A stock doesn't need a diamond ring (with increasing carat) every 24 months.

9. A stock doesn't throw a big tantrum if you forgot the 15th anniversary of the day you two first met.

10. You don't have to visit the stock's Mum, Dad, 3 Aunties 6 Grandmas and 14 Uncles EVERY WEEKEND.

11. A stock will never complain about your cooking or your spending or anything about you for that matter.

12. A stock doesn't care if you make more money that it does.

13. A stock gives you dividends every year, usually you give your wife shopping allowance every week.

14. A stock gives you dividends every year which usually grows even bigger over time. Chances are not high to find a husband who can match that, esp if he is reading this blog.

15. When you decide to part ways with a stock, it doesn't go around bitching about you.

16. When you decide to part ways with a stock, it doesn't claim ownership of 50% of your OTHER ASSETS.

But a stock cannot give you a massage when you need it, a shoulder to cry on, share your joy and laughter, love you and care for you in sickness and in health.

And that's why Spouse still wins.

Wisdom from the Guru

The following is taken from the latest Berkshire Hathaway Chairman's letter.

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In good years and bad, Charlie and I simply focus on four goals:

(1) maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash

(2) widening the “moats” around our operating businesses that give them durable competitive advantages

(3) acquiring and developing new and varied streams of earnings

(4) expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.
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Undoubtedly good advice for retail value investors as well. In this post, I shall add my two cents brief commentary on each of the following points raised from the guru. (The link here: Just in case you are new here and wondering which guru we are talking about.)

1. As individuals, how much cash should we have in hand? There are many rules to live by. Going by portfolio construction, 5-10% in cash. In times like this, some would say 100%. But I would live by Graham's rules of not trying to time markets, ie maintain a fixed proportion in certain asset classes regardless of what happens, and rebalance that ever yr - ie if it becomes 20% bring it back down to 10% or vice versa. However, one other rule that I live by would be 6-12 mths of living expenses. Unemployment rate can hit both the headlines and us! So for me, it would 10% of portfolio or 12 mth living expenses whichever is more.

2. For this, since small time retail investors like us can't really help to enhance the moat of our companies, we should focus on buying co.s ALREADY having a durable competitive advantage. This would be big brands, strong companies. In Singapore, as mentioned in my past posts, probably less than 30 of them around. However, as individuals, we can and should focus on expanding our personal moat: something that we can do exceptionally well, much better than most people. This takes great effort and a hell lot of time, and most people never achieve anything of significance. Well, still need to try though, just be the best that we can be!

3. This came as a surprise. Buffett is not known for diversifying his bets. Anyways, I have always advocated not to put all our eggs in one basket. This, I think is a universal truth. Of course it does not make sense to have 100 bets as well. Probably a dozen of new and varied streams of earnings will earn the praise from the Guru himself!

4. Again as individual investors, we cannot really get to know top management well enough. We can only get to know them from media and from their actions (like whether they suka suka do RIGHTS issue! - which btw is super duper bad for existing shareholders, and not a free treat to buy stocks cheap as most aunties and uncles would like to think). In the context of personal networking, this means to mingle with people with the correct mindset, with honesty and integrity.

Well always refreshing to read letters from the Guru himself. Hopefully Berkshire's stock price can recover soon!

More on margin of safety

A frequently asked question on value investing is this: how can you be so sure that the co's intrinsic value is $100 (or any other no.)?

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 30-40% below your calculated intrinsic value. That is if you calculated that a stock is worth $100, you should be buying only when it hits $60-70.

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%, below your buying price but quite unlikely to tank 80% below your buying price. And chances are after it tanked it will creep back up again, it will not bankrupt you. That's the strength if you have a huge margin of safety.

Getting Whipsawed!

Whipsaw is a wonderful description of a trade. Specifically you buy some stock, it goes down 20% and you sold out, intending to preserve whatever capital you have left. And the next thing you know, the stock goes up 100%! Shiok right!

Actually the fear of getting whipsawed is so great that it causes a lot of investors to make silly mistakes. But if you think about it, even if you really get whipsawed, it's not a big deal except for the psychological factor. Say you cut loss at 10% and the stock subsequently rallied, so you would have lost just 10%. But if you did not cut loss and stock continues to decline, you will eventually lose maybe 50-60%.

Let's for argument sake, make the example a bit more mathematical. Say you bought a stock at $10 and it plunges to $8. There is a 50% chance that it may rebound 50% to $12 and 50% chance that it plunges another 50% to $4.

So you have two choices now:

Choice 1: If you cut loss, you lose $2

Choice 2: You wait out the storm,
If you get lucky, you make $2, as the stock rise back to $12
If you are damn suay and the stock continue to plunge to $4, you lose $6

Let's assume it's 50:50 between the $2 and -$6, your expected return of not cutting loss is $-2 (0.5*2+0.5*-6), which doesn't make you better off than if you had cut loss. Actually it's probably 70-80% chance that it will go down. Logically thinking stock at $10 which had gone down to $8 should continue to decline bcos something had gone wrong in the first place. So unless a new positive catalyst appears, the stock will not rally.

However the fear of getting whipsawed is so great that it blurs the rational mind. If the stock did rebound and go back to $12, most pple would rather kill themselves than to admit that they only lost $2. This fear of getting whipsawed makes us hold on to our losses longer than we should.

Gambler's Ruin Takeaways

Well actually, Gambler's Ruin has more to do with speculating than investing. Nevertheless I think we can learn a few things from Gambler's Ruin.

Btw Kelly's Formula is

% of money = odds of winning - (odds of losing / payout)

Eg. You think Stock A that have a 60% chance of going up 80%
Then % of money = 0.6 - (0.4 / 0.8) = 0.1

ie you should be putting at most 10% of your money in this stock
But take note that ALL the inputs are arbitrary, the odds, the payout.
The formula output is only as good as the inputs.

Ok here are the takeaways:

1. If you simply buy a fixed dollar amt, like $1,000 for every stock you will go broke as time passes, even if the odds are fair. And you will go broke even faster, esp if the odds are against you. (As far as investing is concerned, in most cases, the odds ARE against you).

2. Even if the odds are in your favour, betting the same absolute amt doesn't make sense, you need to apply Kelly's Formula or its variations to optimize returns. This means that you should always decide how much money to invest based on a % of your total amt of money and not an absolute amt. And this % should be decided by the Kelly's Formula or some modifications (half Kelly etc) of it.

3. Building on the previous point, one of the most popular implementation is actually the much talked about rebalancing method used by institutions and shrewd indvidual investors. Say you have 60% in stocks, 30% bonds and 10% cash. You should rebalance your portfolio whenever the ratios are out of whack. Like maybe stocks go up to 70% during boom time, so bring it down back to 60%. This makes sure you buy low and sell high and at the same time mitigate Gambler's Ruin.

Ben Graham, father of value investing, advocates always maintaining a ratio of 50:50 in stocks and bonds (with possible digression to 25:75 or 75:25). In the same line of thought, when the ratios are out, say stocks go from 50% to 80%, then you should bring it back down by selling. This ensures that you buy when it is low and sell when it is high.

Gambler's Ruin

Here is a tip for this Chinese New Year gambling.

The concept of Gambler's Ruin was mentioned in a very insightful book called Fortune's Formula which I thought deserve more scruntiny, both from gambling and investing point of view.

The story goes as follows. Imagine you have some money and you decide to bet a fixed amount in a game where your probability of winning is 50%. Say you have $100, you want to bet $1 on "Big" and "Small" (and in this case, there is no "House Win" like double sixes. Bcos if there is "House Win", your winning probability would be less than 50% which we do not want in this story yet).

So what is the probability that you will lose all your money after some time?

Well it's 100%!

This is intuitively illogical bcos the odds are 50% right? Why should one lose everything? Well the caveat here is "after some time" which is as good as saying "playing forever". If you play forever, you are bound to lose everything, which can be shown mathematically and that's what we are gonna do in this post. If you decide to stop after winning a certain amt of money, then good for you, it's possible that you achieve your goal and leave the casino with some money.

The mathematical proof of why you can expect to lose everything if you play for a long time (or rather forever) goes as follows:

The probability of either losing your money or doubling your money is 0.5. Consider these mutually exclusive cases:

Case 1: Probability of losing all your money after X1 no. of bets = 0.5
Case 2: After X1 no. of bets, you have doubled your money (0.5), but you continue to play for another X2 bets, so probability of later losing everything again = 0.5*0.5 = 0.25
Case 3: After X1 + X2 no. of bets, you double your money yet again, lucky you! (0.5*0.5), but you continue to play another X3 bets, and the probability of later losing everything = 0.5*0.5*0.5 = 0.125

The no. of cases go on and you add up all the probability that you will go broke = 0.5+0.25+0.125+... = 1

So, as long as you bet the same absolute amt, even in an even odds game, you WILL lose everything in the end.

This link allows you to simulate exactly what will happen and I tried it and recorded down that it takes about 20,000 games to go broke if you have $100 and the odds are 50% (which is quite a lot, but still the math is against you). If the house odds just goes up by 5% (ie your probability of winning is 45%), you lose everything in less than 1,000 games.

So what to do? Well the book says that you should follow this formula called Kelly's Formula to decide how much to bet (which is a % of your money rather than a fixed absolute amount). In this case, the formula actually says don't bet though...

So don't keep betting $1 during the usual CNY Big/Small game. Vary your bet size according to Kelly's Formula!

Random Thoughts on Various Investment Topics

In this post I would like to share my thoughts on my stance on various matters in investing like whether EMH works or not, TA is bullshit or not etc. So let's start!

Value concepts: I subscribe to most value investing concepts like margin of safety, circle of competence, buy things on sale, value-for-money etc. Most of these are very common-sensical and I don't think there is a need to argue with that. If you have no idea what are these, start reading this blog from the first post back in early 2006.

EMH is bullshit: One thing that I do not agree with other value investors would perhaps be the lack of respect for efficient markets. I think that markets are efficient and it's not easy to beat them. The market is the confluence of everybody's viewpoints and this collective wisdom is actually, usually right, at that point in time. However the market also has an investment horizon that is the average of its participants' horizon, which is usually not very long, abt 1 yr I think. This is probably the only reason why value investors get to have an edge, bcos we look at co.s with solid fundamentals that should outlast market's short-termism over time. Still, I don't think it's easy to get much higher than average return of 8%pa.

Chart reading: I used to think that chart reading is pretty much bullshit bcos if you look at past tosses of coins, can you use that to predict the outcome of your next toss? No. But that is what TA is trying to do. However, prices are not like coins and do have some memory so it might predict future prices. But my guess is its predictive power is probably 2-3 days. So, not that useful. The reason why TA can still work is probably self-fulfilling prophecy at work. Lots of participants playing the game with TA and hence prices do bounce off support levels. I did a simple simulation on the comment section of the last post. Basically, it's possible to make positive return using TA but again, you may not beat market returns. Nonetheless, there are pple who can beat the market using TA and I salute them.

Trading rules: I think this is a useful tool but it works only if you fit it to your temperment, style and investment horizon. E.g. cut loss at -10%. Some can be religious and do it everytime. Some cannot, and see -10% become -50% and curse and swear. According to the value doctrine, you should buy MORE when it drops bcos it just got cheaper right? Well it can go even cheaper, like 2008 and 2009 or even 2010. And your initial analysis must be right. ie things have not changed. If things have changed, the stock is no longer at the original intrinsic value that you calculated, then really must cut. Take profit rule sucks I think. If you sell anything with a 20-30% profit, how are you ever going to make the big buck?

Diversification: Again, this is probably where I differ from the guru (ie Buffett). I think this makes a lot of sense. Diversification is said to be the only free lunch in investing. Of course one major shortcoming is that you must have enough capital. Some textbook says around 30 different investments and they must be relatively uncorrelated lah. This is hard, bcos in today's world, everything just follows everything else. Nevertheless, don't put all your eggs in one basket. Yes we have limited time, money etc. You research on this stock so much and buy 1 lot and see it go up 200%. WTF right? But which is more painful, entire savings become zero or missing out 200%? Beware of the Black Swan!

Well, as most would have realized, I don't subscribe to everything on the value investing doctrine. But I think the core of successful investing has to be Graham/Buffett value philosophy. And now is the time to take action as the fire sale is going on!

Free Cash Flow and Dividend Stocks

As we enter the new year, this is the bonus post that hopefully can make us rich in time to come!

Short Name Industry Subgroup Dividend Yield
SINGAP SHIPPING Transport-Marine 10.53
SIA ENGINEERING Commercial Services 10.05
MOBILEONE LTD Cellular Telecom 9.864
SINGAP AIRPORT T Airport Develop/Maint 9.859
DEL MONTE PAC LT Food-Canned 9.586
SINGAP REINSURAN Reinsurance 9.154
SINGAP PRESS HGS Publishing-Newspapers 8.599
CEREBOS PACIFIC Food-Misc/Diversified 8.503
SINGAPORE POST Transport-Services 8.17
SINGAPORE FOOD Food-Misc/Diversified 7.684
SINGAPORE EXCH Finance-Other Services 7.49
HAW PAR CORP Diversified Operations 6.964
SINGAPURA FINANC Finance-Mtge Loan/Banker 6.667
UNITED O/S INSUR Property/Casualty Ins 6.55
HONG LEONG FINAN Finance-Other Services 6.341
PARKWAY HLDGS Medical-Hospitals 5.804
GREAT EAST HOLD Life/Health Insurance 5.791
SING INV FIN Diversified Finan Serv 5.714
CHUAN HUP HLDGS Transport-Marine 5.263
UNITED OVERSEAS Commer Banks Non-US 5.208
RAFFLES EDUCATIO Schools 5.13
APB BREWERIES Brewery 3.168

This is a list of stocks that have never had a single year of negative free cash flow for the past 8 years and hence I would deem that they should be able to pay dividends for the foreseeable future.

As a surprise, high dividend yield is not selected as a criteria for this list but 15 out of 23 stocks have a dividend yield of more than 6% which I think as high considering that with their strong FCF generative ability, the co.s have less probability of cutting their dividends and what you see is likely to be what you can get as dividends. But don’t be too hopeful, co. mgmt can play the conservative card and decide to keep cash and not pay you.

Incidentally, out of the 700 stocks listed on SGX, only 30 stocks had never had a year of negative FCF and in my opinion, these should be part of the truly investable stocks on SGX.

This drives another point that I have made before. Most stocks on SGX are crap and it is not worth spending time investigating and investing in them.

This does not mean that this list represents ALL the investable stocks on SGX. Or that stocks that don’t make it to this list equals crap. Certainly not! It also does not mean that every stock on this list will turn out to be 5-10 baggers in the future. If this happens, I would require a 25% share of your future profits. But probably, I should have made so much money that I wouldn’t be blogging here. Right?

The list is generated with no regard to the qualitative aspect of the various co.s, like mgmt capabilities, co’s past actions, true source of their cashflow, shareholder friendliness etc. I would advise you to do a lot more work on each of these co.s if you are seriously thinking of putting money into them. Names that I would avoid now would be Parkway: seems like that they might run into cashflow problems with their huge expansions. Others would be Singapura Finance, Raffles Education. Singapura Finance: totally don't know what they do. Raffles Education: wary of what they are doing...

It is unlikely that 80% or even 60% of the stocks on this list will turn out to be spectacular investments. Looking at the 10 year performance to date for this list of stocks, a handful of them have actually declined 50% in the past 10 yrs, making them serious lemons!

Well, that’s investing. Something like finding your life partner. You never get 100% of what you want: e.g. no chores, no quarrels, honeymoon every day, guy’s nights out with no curfew, no anniversary Carat upgrade request but Omega watch present every year, yeah dream on... Hopefully, we get some of what we want, and live with some of what we don't want. And things don't turn out too bad.

My hope would be that this list gives similar results.