Friday, May 23, 2014

Fallacies of ETFs

This post is updated in 2016.

I have posted a long time ago that investing in ETFs could be one of the easy ways to make money. The theory was simple. Since 80-90% of all investors never beat the index, then why should we even try? We should just buy the index. That was simply buying ETFs. Since ETFs replicate the indices and are traded just like any stocks. We can easily buy them using one of the brokers like Poems or Kim Eng or whatever.

We stand to enjoy market growth (8-10% per year) and we need not worry too much about losing our shirts.

Well, the story didn't turn out that way. As I have mentioned before, every investing decision only has a 60% chance of getting it right. At best. There is no such thing as a sure win... far from it. Investing is just a bit better than playing roulette, betting red or black whatever. Of course, roulette is actually only about 40+% of winning since the zeros and double zeros somehow appear more often than they should. So 60% is as good as it gets.

Back to ETFs, what looked like a good way to invest turned out to be wrong. Even Buffett got that wrong. He did advise laypeople to just buy ETFs if value investing is just way too tough.

Why did ETFs fail?

Well, the following would be my own reasons:

1. There are only one or two ETFs that generated good returns over time.

The famous ETF that we should buy is the one that replicates the S&P500. All the other thousands of ETFs out there just don't generate good return over time. Why? Because ultimately ETFs are just putting different stocks together. If you put enough crap together, you will still just get crap. Worse still, the crap overwhelms the true good gems or firms and you do not benefit by investing in such ETFs.

Even for ETFs that replicate market indices like those of the Hang Seng, or Nikkei, or China's A share or India's Sensex. The construct of most indices by definition includes a lot of crap such as financial entities, domestic firms and moatless businesses. Hence by investing in them, we might be able to generate a positive return over a very long time frame (like 20-30 years) but the return would just be mediocre (like low single digit). 

The reason why the S&P500 have historically been a good performer is probably because it represents the success of capitalism hitherto and the dominance of the US economy across the hundreds of stocks. Also, the index itself is actively managed by a committee. There are professionals debating which stock should be taken out and which stock should be added in. The careful selection ensures that the 500 companies are the real global dominant leaders with superb businesses like Colgate, 3M and Johnson & Johnson etc. By investing in this special ETF, you are buying pieces of great businesses. 

Over a good long term investment horizon, the indices of other key economies such as DAX of Germany, FTSE of UK and Hang Seng of HK/China had also performed well, representing the success of these regions/countries. Alas, for most of the other ETFs, especially those that were cut to finely like tech ETF or oil and gas ETF or renewables ETF etc, the returns are just too crappy. Even our own STI index. The longest dated chart from 1999 showed it started at 2000 and after 15 long years it's now at 3000. Yes 50% return but over 15 years just means that it's a paltry 3% return per year.

FSSTI over 15 years

2. ETF came with too much hidden costs.

After investing in ETFs over a few years, I have come to fully appreciate some of these hidden costs associated with ETFs. I must admit I have not understood these fallacies holistically and some of my claims here have to be further verified. They are just hunches that I believe could be true. 

Now the few problems with ETFs are: forex, dividends and liquidity. How forex is being mitigated in ETFs is not completely clear to me but my experience with the banks tells me that forex is a big way that banks can cream off the customers ie us. Ultimately ETFs are products pushed by the banks and I would think that ETF investors are also taken for a ride.

A few ETFs pay dividends which is all good and proper. But sadly, the majority of ETFs don't pay a single penny even when the underlying indices have good dividend yields. For instance, the Brazilian stocks that make up most Brazilian indices now pays 3-4% dividend but most Brazil ETFs do not pay anything to retail investors! Again, I see this as another way of ripping off investors.

And finally the last problem with liquidity is real and visible. ETFs traded on SGX are very thinly traded and the spreads could be very wide like 2-4% or more. Some are not even tradable since there are no market makers ie if there is no one on the other side of the trade, you cannot buy or sell the ETF.

So in short, while ETFs work on theory it just doesn't work in reality. That reminds me of Yogi!

"In theory, there is no difference between theory and practice. In practice, there is." - Yogi Berra

My experience with ETFs tells us that we make single digit return at best and probably barely breakeven if we enter at the wrong times. We stand to have a good chance of generating good return only when we buy the S&P500, which is the exception rather than the rule.

In the end, the best way to invest is to find great companies with great businesses and buy them at reasonable prices.

Tuesday, May 06, 2014

2014 High Dividend Stocks in Singapore

The annual dividend list is out!

This year's list produces only 18 names despite tweaking the factors multiple times. It goes to shows that the market continues to be expensive and it is hard to get as many gems as before. Again, we see the usual suspects: Elec & Eltek, CSE, Transpac, Boustead etc. 

2014 High Dividend Stocks in Singapore

As with previous years' lists, I used just a couple factors: ROE, Dividend Yield, Free Cashflow Yield and Operating Margin. The top 3 names gave amazing dividends. It should be one-off and unlikely to be sustainable. If CSE Global gave another 50% dividend this year, the stock price would go to zero

Some of these names have appeared many times since the list started in 2009. This is actually not a good thing. Yes, a long term investor would have earned the dividends over the years, some are quite good like 5-6%. Elec & Eltek now gives 11%! But other than the dividends, it provided little capital appreciation, which is likely to be the case going forward as well. Elec & Eltek, while the stock fluctuated between $1 to $5 over the past 20 years, the long term chart essentially showed that the intrinsic value of the company did not grow. So buying this stock was more like buying a risky bond that gives c.5% yield. 

This year's list didn't really have a lot of good candidates. SIA Engineering and SATS are still there. I would just reiterate that these two could be considered as the few true blue chips in Singapore.

One of my favourite names last year dropped out: Sembcorp Marine. Well it didn't do very well in the last 12 months, a time frame too short to determine anything though. Then again, this proved my annual message that this list is just a starting point. The heavy-lifting starts after you see this screen. After you decided to drill down on a name. You have to dig out the annual reports, read and re-read, talk to people, do some number crunching and then wait for the right price. Hard, hard work!

Okay, so what happened to Sembcorp Marine? Well, the firm cut its dividend, had some troubles at their shipyard and the business model is facing pressure both from competition and from its clients. However I remain confident that our stars (the other being Keppel) in this niche oil exploration industry will continue to shine. We have the expertise, experience and the endurance to compete. Building on these strengths we have a few competitive advantages including state-of-the-art repair shipyards for the biggest ships, possibly the only ones in the world. We are still very good at cost control and management. So we will survive! 

Majulah Singapura!

Having said that, the lesson learnt from buying Sembcorp Marine was this: no margin of safety. As Charlie Munger puts it. It is not simple. We can know all the right philosophy but to execute is a different matter. Smokers know they should not smoke and fat people know they should not eat fries but they can't help it. Similarly, to buy with sufficient margin of safety is not easy to achieve. Esp when the stock gave 5% yield, the business looked sound and solid and everyone said Buy! On hindsight, Sembcorp Marine would look like a safer buy at $3.50. I would be averaging down at that price.

As I have blogged about in "5 Things You Need to Know about Investing", the success rate for even the best investors is 60%. There will be 4 stocks that will lose money for every 10 that you buy. So no need to feel upset about losing money in a few stocks here and there. In the end, it's the portfolio that counts. And if you buy enough dividend names, over time the dividends will offset all the losses.

It is not unimaginable to live off dividends someday. Starting with $100,000, a dividend portfolio that gives 5% and grows 5% per year will become a $500,000 portfolio giving you $25,000 in dividends in about 33 years. So start early

Again here is the past lists: