Brokers, analysts, advisors, investment bankers, private bankers etc cannot be trusted

Why do brokers provide research service to their clients? Brokers, or analysts (from sell-side brokers), or investment bankers or private bankers for the matter, thrives on activity. Activity is their friend, and is what drives their profits. For every trade that you make, they will take a cut, regardless of whether you are buying or selling.

Now bearing this in mind, does it make sense for research analysts, working for brokerage firms to make a BUY recommendation and do nothing for the next 5 to 10 years? So, in a sense, research analysts from sell-side can only make short-term calls, to generate churning. They may not realize it, they may genuinely want to analyze companies and give their client good advice, but the system is in place for them to generate churning.

In the markets, to make short-term calls is like throwing a coin and then trying to guess whether it is heads or tails. Research estimates that investment professionals are right 40-50% of the time. The best guys are right 60% of the time. Trusting an analyst to make a correct short-term call is as good as trusting a monkey to throw a dart on chart to determine a stock's target price.

Having said that, brokers are good for information and flows, so use them for that. As far as they want to project an image that they are on our side, we must remember that their interests and ours are not aligned. We must be careful not to let them suck away precious returns in the form of transaction costs.

See also Securitizing yellow-top taxis

and Fear and greed

COGS & SG&A

In finance, acronyms are everywhere. Analysts love acronyms as much as women love the hardest rock on Earth and Michael loves to rock every 25 minutes.

Sorry, or was it Michael learns to rock? But since he is learning to rock, perhaps we can assume he loves to rock as well. But that's not the point, the point is we are going to introduce two more acronyms to make you learn to rock as well.

The Cost of Goods Sold (COGS) refers to the direct input costs that is incurred by the company. This would include raw material cost, labour cost, energy cost, depreciation cost etc. For most types of industry, raw material cost or input cost will be the main focus in COGS. For manufacturing co.s raw material cost can be anywhere between 40-80% of COGS.

One important measure of profitability comes in the form of Gross Profit which is Sales - COGS. It measures the direct profitability of the company after all the input costs are deducted. For certain type of industry (e.g. retail), Gross Profit is as important as Operating Profit.

Selling, General and Adminstrative (SG&A) refers to the indirect costs incurred when doing business. As the name suggests, these costs would usually be sales, marketing, adminstrative, logistics (could be classfied under COGS as well though). A cost-conscious company is one that keeps its SG&A low. As a percentage of sales, SG&A varies from 10-40%.

Hence the total cost of the company would be COGS + SG&A, and whatever profits that remain would be the Operating Profit or EBIT (oh another acronym!). If a company has very low COGS + SG&A, it means that its OP margin is very high (40% or higher rocks!) and it is probably piling up cash and you should definitely dig further.

See also P&L statement

and How to read financial statements

The profit and loss (P & L) statement or income statement

The Profit and Loss Statement is the second instalment of the three financial statements in annual reports and is the most frequently looked at. It describes how the company has done over the past period in terms of sales and profits on paper. The P & L begins with Sales or Revenue at the top and is followed by all sorts of costs until we arrive at net profit. The following is usually how the P & L is arranged:

1) Sales or Revenue
2) Cost of Goods Sold (COGS)
3) Selling, General and Adminstrative Expenses (SG&A)
4) Operating Income or Operating Profit

5) Interest Expense or Income
6) Recurring Income or Recurring Profit
7) Extraordinary Gain or Loss
8) Profit before Tax
9) Net Profit

The most important no. to look at is 4) Operating Profit (or EBIT: Earnings before interest and tax). This no. is basically the profit that the firm has booked after it has subtracted all relevant costs that are incurred in doing its business. Below operating profit, no.s are subjected to very serious manipulation and hence become seriously unreliable. (That doesn't mean that the operating profit cannot be manipulated though, in fact, everything from Sales to Net Profit can be manipulated, that is why integrity of management is so important.)

In recent years (esp so during the dot.com boom), a lot of listed co.s could not even generate a positive OP (i.e. their core business was losing money after factoring in all relevant operational costs). Hence analysts invented another no. called EBITDA which stands for Earnings before whatever it takes to make it a positive number. Well actually it's "Earnings before Interest, Tax, Depreciation and Amortization". It means that if we do not take into account depreciation cost, the co. may be making money.

To put it in another light, say you bought an ice-cream machine that cost $200, you use it to make ice-cream selling for $1 and you declare that you made $200 after selling 200 ice-creams. The cost of the ice-cream machine? Doesn't matter, as long as EBITDA is concerned. Depreciation cost for the ice-cream machine is not a cost under the definition of EBITDA.

See also COGS and SG&A

and How to read financial statements

Fear and Greed

This post is updated in 2024.

In simple terms, fear and greed affect investors' decision by impeding their ability to think rationally. A good investor tries to detach emotions from decision making but it is easier said than done.

Imagine you are out drinking one night with your buddies but you promise your wife to be back by 10pm. At 9:55pm, your decision will probably be governed by these two emotions.

• Fear: You fly home, bcos if you don't, you will have an unhappy wife and therefore an unhappy life for a couple of weeks.
• Greed: You stay until midnight, and hope that your wife is asleep, next morning you wake up early and fix breakfast for her, so that you can partially unwind the unhappiness of the wife and hope that that your happy-wife-and-happy-life scenario can play out sooner.

Now let's try to see how they actually work to deter investors from making good investment decisions.

Fear: An investor has done his groundwork / due diligence, he is convinced that the stock has sound fundamentals and is relatively cheap. However, the market is in a bearish mode, he fears further downside and decides not to buy, but to wait-and-see. The market rebounds and he lost the good opportunity to buy.

Greed: The stock has done very well and all the good news has been factored in, but the investor thinks that there might be a new investment thesis for the company, e.g. they can continue to grow via M&A. On valuations, the stock is no longer cheap, unless you become super creative in calculating its future intrinsic value. Obviously, greed has taken over the investor, he fails to see that the stock is already very expensive and refuses to sell. The stock tanked after a few weeks.

Of course, fear and greed also helps in the opposite scenarios. For e.g. in the first case, the bear market might continue for 2-3 years, and by waiting, the investor could have bought the stock at an even lower price.

I guess the moral of the story is to be mindful of these emotions, understand that they will affect your decision making and try to implement ways of going around them in your investment process.

One tried and tested method would be looking at valuations, and use valuations to determine your trades i.e. only buy stocks that are cheap, in fact very much cheaper than its intrinsic value.

See also Great company, good stock but not a good buy

and How much money do you need in a lifetime?

The three important principles of successful value investing

There are different ways to label these principles but I shall call them Fundamentals, Valuations and Timing. Making a successful investment will demand that all three principles are followed, in my opinion.

Fundamentals refers to the inherent characteristics of the investment or stock, i.e. whether the company is a good company and whether it has good growth prospects.

Valuations refers to the cheapness of the investment, or stock. A company may be have all the positive traits, but if it is not cheap, it is not a good investment.

Timing refers to when to buy (and of less importance) when to sell. Needless to say, buying at the wrong time results in very different performance.

To see how this can work, let's pick a local stock, say, Singtel. Fundamentals for Singtel looks ok, it has not seen red ink for the past 10 years, maintained low debt, and management seems prudent and competent. Within its industry, clearly Singtel is the market leader and regionally subsidiaries are expected to provide reasonable growth.

Looking at Valuations, over the past 10yrs, Singtel has traded within the range of 10x-30x and currently it is trading at PER of 10x. Not overly cheap but definitely not expensive at all.

Now Timing makes all the difference right? If you had bought Singtel when it listed, you would still be losing money. Of course timing is linked to valuations, at its listing, Singtel might not have passed the valuations part of the test (i.e. at listing it was probably too expensive).

The guru does not believe that timing is important. In his view, a good stock should be bought as soon as you identify it, if it goes lower, you should buy even more. Sounds like a strategy for gambling addicts or rogue traders but it's not. Value investors believe in holding investments for the long term, and if you have the holding power, over time, your investments will reach its intrinsic value. Usually after you gave up waiting and sold the stock though.

In a way, low valuations will take care of timing, i.e. low valuations ensure that you have bought the stock at the right time (and price). Also, according to the guru, once you buy a good stock, you should never sell no matter what (this is also called the buy-and-hold-until-you-peng-san strategy).

See Investing Philosophy and Process

and Fear and Greed

How to read financial statements - the very basics

This post is updated in 2023.

A company's financial statements consist of three separate statements that attempt to describe how the company has performed during its fiscal year. The three statements are

1) the balance sheet (BS)

2) the profit and loss statement or the income statement (P&L)

3) the cashflow statement (CF)

The balance sheet lists out what the company owns: its assets, what the company owes to other entities: its debt, and what is left after its assets are subtracted by its debt: the shareholders' equity, or the book value.

The P&L statement starts with sales or revenue and deduct all sorts of cost from revenue until we arrive at net income, which ultimately goes into shareholders' equity on the balance sheet.

The cashflow statement describes how cash has actually been received and deducted from the company, which is usually different from actual profit gained and loss incurred. It links the P&L to what has changed in the balance sheet. One major item that affects cashflow and income differently is depreciation. Depreciation is treated as a cost in the income statement, but it has no actual cashflow impact.

To use a Singaporean household as an example, the BS will list down the household's assets, liabilities and equity. Assets are HDB flat, car, cash savings, surgically enhanced waistline, chin, double eyelids etc. Liabilities are mortgage, renovation loan, study loan, credit card debt, children, mistresses, pets etc, and equity is what is left. Okay, okay, if you didn't get the joke, those in italics are meant to be jokes. We only list what can be valued in dollar terms. If it is too small, don't bother also i.e. you don't put your $2 favourite coffee cup into your asset side of the balance sheet.

Sad to say, a lot of Singaporean households probably have no equity to speak of, because our liabilities (mortgage, car loans) are usually much more than our assets (value of our flat, car etc). Luckily nobody cares that much if you are an individual, but a company cannot have negative equity. We will go into these details in other posts.

Next, we discuss the two other statements:

The P&L statement of the household will be salary on the top (sales for companies though), followed by all the expenses (food, transport, utilities, deduction to NKF, parking fines, Toto etc), until we arrive at net income, which could be added to the balance sheet at the end of the month or year (i.e. any money left after all expenses goes into savings = equity for the household).

Finally, the cashflow statement would be actual cash movement, i.e. salary that was transferred to our bank (cash inflow), how we have spent the cash on food, pirated DVDs, useless souvenirs from tours etc (cash outflow). P&L can differ a lot from Cashflow because there many items that can be expenses but non-cash. The most prominent example has to be depreciation. If you buy a car for you and your wife at $250,000 each using cash, your cashflow this year will be impacted big time (likely negative unless you print money for a living). But P&L wise, you can depreciation the cars over 10 years and therefore, you might still have income at the bottom of your P&L or income statement.

To analyse a company, all three statements are important and it will be very helpful to be well versed in reading them. I will be posting on how to read each statement in the future, watch this space!

See also P&L Statement

and BS statement

Value vs growth

In investment lingo, one way of classifying stocks is to label them as either value stocks or growth stocks. Some other ways include large cap vs small cap, NC16 vs R21.

Value stocks are what we have been discussing all this while, stocks that trade below their intrinsic value, come from understandable and mundane industries (insurance, utilities, consumer staples), low PER, low PBR, stable earnings streams etc.

At the opposite end of the spectrum are growth stocks. These are stocks with a lot of potential but they may or may not make their mark. They usually have high PER and high PBR, weak earnings, from hot sectors like Tech, Energy, Biotech etc. But they are attractive because their intrinsic value in the future can be 2, 5 or 10 times higher than today's price. Microsoft was a growth stocks in the 80s, early 90s.

Without considering valuations (i.e. let's not think about prices and whether if it's value for money), let's try to look at growth and value stocks in another perspective:

Growth stock = Porsche, sexy and fast, but prone to accidents

Value stock = Volvo, ugly but safe, reliable and down-to-earth

Buffett thinks that classifying stocks as value or growth is not important because they are simply on different sides of the same equation. A true growth stock is essentially a value stock in disguise.

See also Definition: Value investing

and Value Trap

Value trap and the cigar butt analogy

This post is updated in 2024.

Value trap is a stock that looks very cheap but the reason it is super cheap is because it is a crappy company and deserves to be that cheap. This company probably trades below its book value (i.e. Price to Book ratio less than 1x) and had poor earnings and near zero cashflow for the past few years. Buffett likes to give the analogy of the cigar butt. Imagine finding a cigar butt that someone just finished smoking, but there is still a last puff left. The cigar comes free but you get one puff, which doesn't make you feel one hell of a good.

To give another example, a value trap is similar to doing shopping at Ikea (no offense to Ikea and Ikea fans, just an analogy, just an analogy...), you get super cheap stuff but their worth is also just that. If you haven't shop at Ikea before, let me give you an idea. You can get kitchen set (with sink, top and bottom shelf etc) for less than S$1,000 which is like dirt cheap because a Prada bag cost as much. But the kitchen set probably lasts a couple dinners before some panels or screws come loose or some other defects present itself. Yet another example would be "you pay peanuts and you get monkeys", sounds familiar?

In essence value trap means that you are paying cheaply for zero quality. A true value investor pays cheaply for some value, not for garbage.

See also Definition: Value investing

and Intrinsic value

Circle of Competence

This post is updated in 2024.

This is another concept from the guru himself. Basically it simply means to invest in industries and sectors that you know well, in fact, so well that you can say you are an expert in it. Buffett terms this as the Circle of Competence.

Essentially, this is saying that you should not be a Jack of all trades. If you just researching the Singapore market then just stick to it. Don't try to be a hero and start analyzing global stocks! After all, there are 600 listed companies in Singapore, that is a lot of companies to research on. It would take years to cover all of them.

So the circle of competence is just that: invest only in areas that you are very familiar with. Over time your circle of competence can grow bigger as you gain more knowledge. (Ok you can try Malaysia when you are ready, but definitely not anything more!) However you must also know your limits and try not to invest in areas where you are weak, or very ignorant and may never gain competence. For Buffett, this was technology. That's why he never participated in the IT boom and bust.

For most of us, the circle of competence will usually be related to our work, or observations from our daily lives. If you encounter other companies in your work that impressed you, might want to know how their stock performed. Similarly, if you wear a particular brand of shoes, and like it so much, it might be worthwhile to do some research on the company that produces the shoes.

See also Investment Philosophy and Process

and Three principles of value investing

Definition: Value investing

After numerous mention of value investing, perhaps it would be appropriate to give a proper definition of value investing on this blog.

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

1) The investment can be bought below its intrinsic value
2) The investment must have a margin of safety

Value stocks are generally characterized by low PER, PBR, high dividend, and typically from mundane industries (not high tech or bio related). Pioneers of value investing include Benjamin Graham, David Dodd and Warren Buffett.

See also Value vs Growth

and Value trap