DCA: When the market down, BUY MORE!

Value investors rejoice when the markets go into correction mode. Bcos that means they can pick up good businesses at bargain prices. Logically and intuitively, this makes perfect sense, but somehow our ape-evolved brains are not wired to think that way.

When the markets have rallied for some time and it goes down, we panic. When they subsequently rebound, we curse and swear that why didn't we buy more during the correction. And when the markets go into correction mode for 3 years, we get totally not interested in the markets. Many don't ever return to invest, even though it's the best chance they got against inflation.

So some have come up with a method to counter this flaw and help us invest wiser. It's called Dollar Cost Averaging or DCA for short. It simply means that you put the same amt of money to buy stocks/UT/index funds etc at fixed time periods.

The logic is that although you lose money when the markets go down, bcos you put the same amt again after it has declined, you buy more of the stock/UT/index fund, and over time, since all markets will rise, you will earn the market average return of 8-10%.

However, one must be wary that it's also detrimental if you cut it too thinly ie if you DCA every mth, you end up paying a lot of commission bcos sometimes for UT there is a sales charge for every transaction, and for stocks the bid-ask or the $20 transaction cost kills you. This is what brokers will recommend bcos it generates more commission dollars, so beware!

I have 2 recommendation to improve on DCA that I hope will help most pple.

1) This is just reiteration. Don't cut it too thinly, ie maybe at least once a year and buy more at one go, like maybe roughly $10k at one go. Imagine if you DCA every mth at $1k. You pay 2% sales charge, or you pay $20 on transaction at the brokerage, which is also 2%, you are giving the return away, investment earn only 8%pa on average. So it has to be a huge amt to offset these costs. At $10k, the $20 becomes 0.2% + some bid-ask which ends up maybe like 0.8% or something. Alas, for UT or funds that charge 2%, too bad, $10k you still pay 2%. So avoid funds with huge sales charge.

2) Buy more when the markets are down. Instead of DCA-ing the same amt. You can buy more when markets are down ie. in 2000 you really DCA a minimum amt, 2001 you increase your DCA to 120%, 2002 to 140% of original, 2003 another increment etc. Of course, on hindsight, that's easy. We knew what happened already. How about now? Do you increase your DCA amt next year if the markets are down? Chances are if it goes down in 2008 it's gonna go down in 2009 as well right? But I guess one simply has to strengthen the will to increase DCA when the markets are down and lighten up when the markets are rally. That way, it will enhance return and help you hit 8-10%pa over the long run.

More on inflation

In the last post, we talked about how inflation will hurt us badly. Today we shall discuss some countermeasures.

So inflation is a major issue if you think hard about it. All your savings goes down the drain and you are back to square one. You think you save S$1mn for your retirement and that should be enough. But hey 30 yrs from now, S$1mn cannot even buy HDB, Bcos the value of S$1mn in 2038 is worth only S$300,000 in 2008 and basically you might even have lost money even though you saved like mad for the past 30 yrs. What the heck! What should we do?

Actually there is nothing much we can do, except to invest in stocks and real estate properties. Historically these are the only two asset classes that can keep up with inflation. With stocks, you are buying pieces of companies and good companies will create value for their shareholders, inflation or not. The same goes for real estate.

There are some other unconventional methods to beat inflation completely original from this blogger so just read for fun and implement at your own risk!

1) You can increase your debt! Inflation helps debtors bcos the money they owe also decline in value, so if you borrow tons of money before inflation kicks in, next time you only need to pay back less than what you borrowed in real terms. But you must not put them in your bank and earn fixed D bcos then your fixed D also decline in value and you suck thumb. So you must borrow money and spend them asap, like buying Prada bags and Ferragamo shoes and satisfy your immediate desires! So maybe not much help to build your retirement nest.

2) Buy stuff that will retain its value over time, this means buying things like limited edition Rolex watches, silver, gold, white gold, platinum jewellery or other maybe pure gold bars. (Not diamonds btw, if the real supply of diamonds are released into the global markets, 1 carat diamond is worth as much as 1g of sand, the perceived high value of diamonds can be regarded as the biggest marketing gimmick in our times. Sorry girls, diamonds are worthless, contrary to what you think).

So back to the original solution: nothing beats buying stocks and properties to combat inflation, so keep your savings in these asset classes. The rest of the asset classes like cash, bonds, other currencies sadly will not help much.

The return of inflation

Most of us never really lived through periods of high inflation, thanks to very effective central banks throughout the 80s until today. But with recent rise in commodity prices translating to higher food prices, higher raw material prices, higher property prices, higher taxi fare, higher this, that and everything else, inflation may be coming back to haunt us. And believe me it's gonna be scary.

It is generally accepted that mild inflation is actually good for the economy bcos it helps increase wages, improve productivity, encourage employment and keeps the economy churning along and all is well. But usually this means inflation of 2-3% per yr or something. And if wages increase by 5% per yr then it is a real increase over inflation and everybody is happy!

However, this time round, the world, and hence Singapore (or maybe more Singapore) may be going into a period of not-so-mild inflation. This means inflation of maybe 5-10% per yr. Although not as bad as hyperinfation, this has very drastic consequences for value investors, or rather, everybody.

A bit of digression here. Hyperinflation refers to inflation getting totally out of whack and hence the value of the currency of the sovereign entity goes down the drain. This means that in people's eyes, the currency has no value and becomes as good as banana money (read further down to know more abt this) or simply worthless paper. The worst case of hyperinflation is of course Germany in the 1920s when the inflation rate was 10^27 times.

For those who fail to comprehend the significance of this, it means that $1 today get reduced to 1/1,000,000,000,000,000, 000,000,000,000 of its value. To put it in another way, even if you are a gozillionaire in Deutsche Mark, ie you have 1 million billion trillion Mark, all you have becomes $1 at the end of the day.

Basically your money is worth even less that the paper used to manufacture the note.

In Singapore, of course, we have our infamous case of the banana money issued by the Japanese military during WWII. Luckily or unluckily $1 of banana money becomes only 1/1,000 of its value by the end of Japanese occupation.

Well all these seems a bit far-fetched and probably we will not see such dramatic times again. So back to the real story, if inflation hits us at 5-10% per yr what happens? Well let's work with 8%pa (I like my blog name you see). This means that your money loses 8% of its value every year. Basically in 6 yrs, every dollar you save becomes 50c. Even if you invest wisely and earn 8%pa return, it only means that your $1 stays at its original purchasing power.

In reality $1 you invest becomes $1.08 after 1 yr but your Kopi-O also jump from $1 to $1.08 so effectively your investment did not help you build up your wealth.

Lemmings falling off the Cliff!

Lemmings are small rodents usually found in the Arctic. They breed very quickly and when their population reaches a certain critical mass, they are known to commit mass suicide by leaping off the cliff. (Although according to Wikipedia, it is proven that this was not the usual behaviour of lemmings but rather something propaganded by media to create sensational news.)

Anyways this strange behaviour of Lemmings excited many social scientists bcos they have found similar behaviour in people living on a small island south of Malaysia. But since there are no cliffs around, these people employ foreign maids and constantly abuse them for pleasure. Some experts believe that overcrowding and the pursue of status and material wealth leads to such inexplicable symptoms.

Ok let's move on to something related to stocks.

As you would have guess, in financial markets, participants exhibit Lemmings' strange behaviour as well by mindlessly following others' irrational actions. In most aspects of normal life, most people behave rationally when looking to buy a car, a fridge, whatever. They collect information, talk to others, get viewpoints but ultimately come up with a decision that is usually rational.

However when it comes to stocks, somehow, independent analysis becomes a taboo. People like to follow what others are doing. When the market is shouting buy, buy, BUY into the peak, they simply react like Lemmings, rushing ahead regardless and then when they see the Cliff, they happily jump over it, just like all the other Lemmings ahead of them who jumped. (Of course participants won't literally see a Cliff until they fell off it as the market tanked.)

Strange huh?

I think this has got to do with greed (and not overcrowding or pursue of status though). For the general public, they seldom come in contact with stocks, investments in their daily lives but in times of bubbles, unscrupulous bankers, brokers, agents will start calling them up and sell them dumb products at the peak of markets. And they get sucked in bcos of the dumb freebies and all. I guess it's also human nature to get easily persuaded by friends (selling insurance policies) or sweet young bankers (selling some dumb structured pdts). So it's difficult to really fault the general public.

Well I guess the lesson learnt from the Lemmings is this: always think on your feet and dont blindly follow the front Lemming (or the sweet young banker leading you) down the cliff. (Which makes me think about the condo called The Cliff, so those staying there are Lemmings of the property market?)

Defensive stocks

In different markets, different sexy terms come into play. I guess the latest infatuation on Wall Street in recent months has been "defensive stocks". Defensive stocks usually refer to stocks that will see stable profits even during times of trouble, ie like the past few months lah. These would be stocks in industry sectors like: consumer staples ie your food, beverage, razor blades etc. The thinking is that people need to eat, drink and shave no matter what right? Stock market down means everybody goes without food? Unlikely, so these are defensive stocks.

The other sectors are like pharma (your diabetic patient needs his pills regardless of stock market woes), utilities (eh, obvious I hope, we need electricity even during bear markets) etc. So you get the idea, things that we can't do without even during an economic downturn.

So what are things that we do without during the downturn? Well it actually differs for different entities on this planets. For example, Ah Beng who made money punting property and bought himself two Ferraris will still drive his Ferraris and buy Prada bags for his Ah Lians even though his latest punt has gone wrong and he has a $4mn mortgage but his condo at Sentosa is worth probably <$1mn and his monthly salary is $5k. So to him, Ferraris and Prada bags are still things that HE cannot do without even during a slowdown. But for most people and for the stock market, consumer non-staples (like car, furniture, luxury products, massage chairs, high tech goods etc) usually see profit decline.

Also most of the darling sectors that rallied during 2003-07 bull market ie oil exploration, shipping, property etc. One reason would be bcos credit is drying up and most of these sectors require a lot of credit financing to grow their profits. Of course, some experts may beg to differ, these sectors are in a secular boom and some silly sub-prime trouble is not going to derail their "sexy" story. Well... this blog is big enough for differing biews, so share your thoughts if you have some. The other type of defensive names would be stocks that pay high dividend, has huge amts of cash on their balance sheet, or stocks that generate huge cashflow regardless of business cycles

Hurray! Buffett is World Richest!

This is a time for the world's value investors to rejoice. Our hero, Warren Buffett has become the world's richest man, overtaking Bill Gates, Founder of Unpopular Vista and Insecure Windows and Carlos Slim, Monopoly Tyrant oops Tycoon of Mexico. Of course, Lady Luck has got a lot to do with this, here are a few facts to support the thesis:

1) Microsoft has eaten full full and got nothing better to do, so decided to launch a bid for Yahoo! which aggrevated a lot of investors bcos it's quite a stupid move given that Yahoo! is like yesterday's darling (ie like Demi Moore or Alicia Silverstone, does anybody remember them anyways?). Hence Bill Gates lost like 20% of his net worth in a couple of days and got relegated to No.2. Or was it No.3?

2) Thanks to the sub-prime crisis, investors are desperately looking for safe haven to park their money to hide away from the storm, and where's a better to place than to hide with the Guru? So Berkshire stock rallied like nobody's business and our hero became No.1.

So that's that, fellow value investors buck up and follow your idol and the road to riches will be short ride.

Er, wait a minute, although this blogger believes that value investing is a good way to help you grow your wealth, there are a few things that Buffett can do while most of us cannot. So the road ahead is always not that short I'm afraid. The philosophy is important, but it may not reach the same destination depending on the execution. Here's a few tricks that Buffett can use but we cannot:

1) Buffett can buy over whole co.s and ask mgmt to pay out excess cash to Berkshire. This is a very powerful tool as we all know that mgmt simply cannot be trusted to handle shareholders' money. We have seen so many examples of good co.s generating good cashflow only to see it squandered away on useless ventures. I think the most aped example would be Microsoft. Bill Gates must be cursing Steve Ballmer to death now for doing the Yahoo? deal. Shareholders are so much better off if Microsoft just generate cash and return them to shareholders.

Well this trick is something that you and I cannot do. But it is a good philosophy to bear in mind and remember to apply this, if it is ever applicable in our lives. I guess one example would be property. If you are holding a property that can generate rental yield of 15%. I guess you should never sell this property unless it's like a super real estate bubble in which your property will fetch as much price as the whole of Bintan or something. Except for that scenario, you should never sell something that gives you 15% yield bcos in 6 yrs you get back your principal and the ppty will continue to generate 15% per yr for as long as you own the property!

2) Buffett's investment actions follow the self-fulfilling prophecy. There are websites, blogs, analysts, TV programs, cell groups following Buffett's every investment moves and hence whenever Berkshire makes a move, a lot of people will simply charge and buy with the Sage of Omaha. So is it a wonder why whatever Berkshire buys always goes up? Of course, this is also due to Berkshire's brand name. ie whenever Berkshire buys something, it is a stamp of recognition that the stock or investment is undervalued and money is to be made.

In other words, at a certain stage when a famous investor or fund manager becomes so successful, his success will simply feed onto itself bcos a lot mindless followers will simply support him and validate his investment decisions. Again this is something that we cannot do, yet. You see, this blog will become a sensation in time and start recommending stocks which will then send its own army of mindless followers to buy and the early birds here will reap the rewards. Haha fat dream right?

Well hope is a good thing, and all good things never die. (taken fr Shawshank Redemption by Stephen King) So keep hoping!

Shareholders' Equity

The balance sheet is basically an elaborated display of a simple equation.

Assets - Liabiilities = Shareholders' Equity or simply Equity

What this means is that whatever assets that a company owns, subtracting whatever the company owes, gives you what's left for shareholders. This is also known as the book value of the company.

Shareholders' Equity is usually at the bottom right of the balance sheet (Assets on the left side, Liabilities on the top right) and is usually broken down into the following sub components:

Common stock
Paid in capital
Retained Earnings
Preferred stock
Treasury stock
Others: there are actually a lot more complicated stuff but I will just lump it under others and we will talk about that on another day.

Common stock and paid in capital are usually thought of as the original capital of the company. Common stock is the no. of outstanding shares multiplied by its par value which is usually some arbitrary no. like $1 and paid in capital is usually the proceeds received during IPO or subsequent secondary equity financing.

Retained earnings would be the impt sub-segment to know. Needless to say, retained earnings comes from net profit (from the P&L statement). So what this means is that retained earnings should be as big as possible. If you see a company that has an original capital of say $1mn but retained earnings is like $80mn or some big no. then you know this co. has created tons of value for shareholders. And conversely, if paid in capital is bigger than retained earnings, either this firm is still very young, or it has continously raised new money from shareholders ie old shareholders keep getting their stake diluted and the business model's sustainability is questionable

Preferred stock is basically a stock pays dividend forever and is usually not a big sub-segment. Thus it pays to find out why a co. might have a huge preferred stock capital.

Treasury stock is a negative entry (ie the $ amt here is negative not positive) in shareholders' equity and it arises only when a company does share buybacks. This is a good sign bcos it signifies that the company has its shareholders in mind and is using share buyback as a way to return capital to its shareholders.

Step-By-Step Company Analysis

This is an expansion of a previous post on how to do a detailed company analysis.

Company CheatSheet

The zero-th step for company analysis is actually a quantitative stock screen. Poems have a good system to come up with a list of stocks. As for what criteria to use, the post mentioned above has a list which I would recommend pple to use. The screen should include both company specific financial ratios and valuations.

So you put in the criteria, the the system churns out a list of companies. Then you can select any co. that has a nice sounding name or maybe it is in a good industry and study it. It will probably take you 3-4 days (if you have a full-time job and can only spare limited family time to do this ECA) to read the annual report and broker's reports try to understand its business.

Ratios: when doing the screen, you would have included a few financial ratios, but the trick is to actually look at all other ratios, if something bothers you, ie this co's interest coverage ratio or asset turnover is too low. Then perhaps its not wise to invest in the stock.

Next is to focus of qualitative stuff. Some things that I would look for are:
1) Whether the company is in the right regional markets / right industry ie places where there is still a lot of growth, less competition and co. has pricing power.

2) Market share of its products, it is better to be either No.1 or No.2 in its field bcos anything else, it has no pricing power nor the competitive edge over its competitors. Of course, all industries are different, sometimes, the market is such that there is no mkt leader and can never have one.

3) Its business moat / competitive advantage / barrier to entry of its business, the company needs to have that edge where no one can ever get close to them. For Toyota the edge is its manufacturing capabilities, it can make a cheap, reliable and fuel efficient car targeting the mass affluent, and no one else can do that. But the European cars fight with another edge: branding and image. Think Porsche, Ferrari, Lamborgini.

4) Its management, their compensation scheme and their past actions. Has the mgmt been friendly towards shareholders? Have they issued options or other means to dilute shareholders' stake indiscriminately? Any directors resigned?

5) Clarity of its annual report. Sometimes, the annual report of the company can be very flashy but it does not tell you the impt things. ie. the company is trying to hide. It then pays to avoid these co.s.

Of course, the list goes on and on. And as you gain experience as an investor, you refine your thinking, and know what to look out for: the warning signs, the best practices, the business moats and whether the businesses are sustainable.

There are really so many things that you should look out for and even after that it pays to let things cool for a while, re-visit the company after some time, or after when the stock has fallen a lot. Especially in the Ra-Ra markets of 2006-2007.

So when I have decided that this is a company that I should own, I will wait for a good time to buy. When valuation gets cheap enough. Usually I only look at PER. So if the sustainable forward PER is cheap enough, I will buy. This is the most important step as a wrong entry price will decide if this stock is a 10 bagger or just a 1.5 bagger (after 10yrs).

It's not easy but it's rewarding when you get it right.

Mr Market and the ice-cream machine

Global stock markets are technically in a bearish mode, defined as falling 20% below the previous peak. The other well-known technical indicator is 2 consecutive quarters of negative GDP growth equals recession. Guess most pple know this one right?

In this kind of market, it is natural that most participants feel very down. Especially those who don't have a clue about stocks, trading, investing and entered the markets hoping to make a quick buck bcos their friends/colleagues did just that. Or maybe they heard stories of how pple made quick bucks buying COSCO, hold it for a few weeks and made a couple thousand dollars.

Well, now the stories become how pple loss 50% of their portfolio in one month and in absolute terms translate to $15,000-$30,000. They are in so much pain that they cannot eat, cannot sleep, don't want to hear anyone mention sto.., sorry you are not allowed to finish the word. Ok, if you know any of these people, ask them to come here and this blogger shall play Uncle Agony today.

Buffett and his predecessors like to use this term Mr. Market to describe the stock market. For more info on Mr. Market, click the hyperlink. Well the point I want to make here is that Mr. Market, or rather the stock market is like the Hokkien auction coordinator. He keeps shouting prices day in day out. And the prices are dictated by his emotions and they are usually not rational ie. they do not reflect the true value of the stocks.

For now, let's digress a bit. Let's say you bought this ice-cream machine that makes you fantastic vanilla ice-cream that you can sell for $5 per ice-cream, for many many yrs. Then someone comes over today and tells you, "Hey your ice-cream machine is only worth 50 cent, sell me now!", what do you do? Of course you ignore this mad guy right? Then suddenly next day he appears and again tells you, "Hey your ice-cream machine is worth $10,000, sell me now!" In fact, he will come everyday and quote you a price. So should you go happy like a bird when he says it's $10,000 today, and go appetiteless, sleepless, depressed when he says it's 50 cents tomorrow?

Well if you didn't know what you have bought and couldn't care less and the only thing in your mind when you bought it is that you think you can sell it few weeks later at a 15% profit, then, you should be appetiteless, sleepless, depressed bcos now you can only sell it at 50% lower than the price you pay.

But the good news is, if you hold on to it long enough (like 20 years), it's got a good chance that it may cross your buying price. Bcos the average return for stocks is 5-10% per year, so even if it dropped 50% this month, in a worst case scenario, say if the stock only goes up for 5% per year for the next 20 years, it will rise by 100% and reach your buying price. Meanwhile you can decide if you should be appetiteless, sleepless, depressed for the next 20 years. So that's consolation from Uncle Agony. Doesn't help much I guess, hehe.

But if you took pain to calculate how much your ice-cream machine is worth. And took pain to do research, to wait for a good price to buy the machine. Even if conditions are bad today and you can only sell your machine for less than its true worth, you know it's ok. Bcos you know some day, its value will be recognized.

Of course, humans cannot escape from emotions. Even the most experienced value investors feel the pain when their stocks decline 50%. However it is the philosophy that is important here. When the market is shouting that you are wrong, your stock is worth 50 cents, it doesn't mean that you have to be depressed. Re-look into your analysis and see if there is any truth. Usually there isn't, so be resolute and ignore the noise. It is your ice-cream machine, your stock, you don't need someone to tell you how much it's worth. It make take years to prove your point, that's investment, that's the stock market. You have to live with that in order to play this game.

Free Cash Flow Yield or FCF

One advanced but quite useful financial ratio that has not been discussed on this blog is the Free Cash Flow Yield. This no. tries to determine how much return can an investor expect after the company has made its money and invested what it needs for future operations. It also gives an indication of how much the dividend yield could be.

This ratio is not called an advanced ratio for nothing. For those who think investment is easy, well sorry, you have to read maybe 5-6 posts on this blog in order just to understand this one. I have added the links on all the keywords. Anyways, here's the basic.

A company generates cashflow based on its day-to-day operations. Eg. a hawker selling bar chor mee gets money fr his customers. This no. is called Cashflow from Operations.

Next, he needs to spend some of this cashflow on equipment to maintain its operations (bowls, knives, noodle cutting machine etc.) This no. is called Capex which is the short-form for capital expenditure.

When you deduct Capex from Cashflow from Operations, you get a no. called the Free Cash Flow. Basically, that's what's left that can be distributed to shareholders or to pay down debt. If the company has no debt, it's basically money that can be paid to the shareholders.

Next we try to compared Free Cash Flow or FCF with the stock price. So you divide FCF by no. of shares. You get the Free Cash Flow per share. This is similar to dividing Net Profit by the no. of shares to get the EPS.

And finally, you divide the FCF per share by the stock price to get the FCF yield. This is similar to EPS divided by stock price to get the earnings yield, the inverse of the all-famous PE ratio. So we all know, the higher the earnings yield, the better, bcos it means more return of investors. Similarly the higher the FCF yield means more money back to investors.

Empirically FCF yield of 5-8% would indicate that the co. is quite good in terms of managing its cashflow and capex. If you get lucky you may find co.s with 10-12% FCF yield. What this means is that this business keeps churning out cash and yet you need not invest in a lot of new stuff to keep it going. This is the kind of businesses that value investors like. See's Candy would be an example that Buffett would place here. In Singapore, I think Vicom would be a good example. No. of cars keep increasing, but not much new investment needed to check more cars.

Sadly, I would guess that 30-40% of all listed co.s would have a negative free cash flow yield, bcos most businesses require a lot of capex just to keep going. The prime example would be semiconductor and/or tech businesses. Every few yrs, technology advances and companies just have to keep investing just to stay competitive. 6" wafers to 8" then to 12". Everytime to inch size changes, all the eqmt have to change. Is it a wonder why Chartered cannot make money?

So that's FCF yield, a good indicator of whether the co. is good or bad at generating cashflow for investors. But it's quite troublesome to calculate this and usually stock screens don't have this ratio easily available although it's on Bloomberg.