The power of compound interest

When asked what is mankind's most wonderful invention, Einstein's answer was "compound interest". Guess most people wouldn't want to argue with Einstein, unless you think you can win a Nobel Prize too. But what's so good about compound interest?

For those lao jiao value investors, sorry for writing this simple post which you all would already know and swear by it.

Ok, for those value investors wannabies, this post is gonna change your life. So get ready.

If you buy $10,000 of Singapore govt T-bills (i.e. govt bonds or Treasury bills) today, it earns you 3% interest, bcos of compound interest, it will become roughly $24,000 in 30yrs. Without compound interest, it's just $19,000. That's 55% difference (14 divided 9). If you put it in the bank, it earns 0.025% and becomes $10,700 in 30yrs. You might have as well put it under your pillow.

Now imagine if you can save $10,000 every year to buy T-bills for the next 30 yrs, and they give 3% interest. Do you know how much it will become?

It will be close to $500,000.

If you save $20,000 every year and buy T-bills for the next 30 yrs, you get close to $1,000,000. If you invest and get 5% instead of 3%, you get close to 1.5mn, if you invest as well as an average investor on Earth, i.e. you earn 8%pa, you get $2.5mn. If you invest as well as our hero, Warren Buffett, you get 24%pa and you get *drumrolls* $65mn. That puts you in the top 30 richest Singaporean list.

This is the power of compound interest.

You don't have to do a lot, save enough, earn a good rate of return, and just wait. You will be a millionaire in 30 yrs. Now that seems quite easy right?

So why we don't see millionaires all over Singapore? Well actually they ARE all over Singapore but too bad we are not one of them. There are a few reasons:

1) Discipline: Most pple, after working long and hard for one month will grab their paycheck and spend it on some gadget or some luxury bag worth $7 selling for $700 to reward themselves, including this blogger here. Who has time to think about saving for 30 yrs?

2) Diligence: Putting the money you saved in fixed deposit is not enough. Only when there is some campaign, you get 3% but usually it's only 0-1%. So you have to put them in T-bills and rollover every few months. That's difficult. Imagine spending your precious weekends in banks to rollover these stuff. Now we have POEMs, so pls go open an account today. But still, it's a hassle.

3) Time: Now compound interest works best when the time period is long enough. Warren Buffett took 50 yrs, for the illustration above, you need 30 yrs. Most pple can only have some savings after major cash outflows like wedding, buying a house, having kids etc. So even if you start at 25, you will only become a millionaire at 55.

So that's why it seems easy but it's not. But there people who does this and got there. Their parents started for them when they were like 10 yrs old, and when they are 40, they become millionaires. Well, don't blame your parents, just make sure you try your best to help your children! Hehe.

Marketable and Investment Securities

Marketable and Investment Securities is probably one of the most neglected rows in the balance sheet after the "others" column. I mean most people look at cash, shareholder's equity, assets. If they have any more free time, they look at debt, accounts payables and receivables and inventory. Who has got time to figure out marketable and investment securities?

Well in most cases, even if you don't figure them out, it doesn't really matter. That's why most people don't look at them. They only matter when the daughter (or son) becomes more important than the parent. Now what the hell does that mean?

Marketable and Investment Securities refer to stock holdings of the company. Marketable simply means the company has no intention in holding them for the long-term and would sell them when it's appropriate. Investment securities are usually holdings of subsidiaries or affiliate co.s and the parent company has no intention of selling them.

Now bcos of accounting rules, these holdings may be accounted for at cost (i.e. at prices when the parent acquired them) or at market value 1 yr ago (i.e. when the book closed last yr). In some cases, the market value of these holdings may have grwon to be quite significant, e.g. 50% of the parent's market cap or more. Such cases would arise when the stock market enters a rally trend, or circumstances like acquisition offer or simply bcos the subsidiary grew so much faster than the parent.

So essentially when you buy the stock, you get a lot of "freebies" that comes along in its balance sheet. And investors love this kind of stuff. One good example would be Yamaha Corp, the musical instruments maker.

Yamaha Corp owns 20% of Yamaha Motors, the motorcycle maker. And Yamaha Motors market cap is now a few times more than that of Yamaha Corp, its parent co. bcos of its cheap and quality motorcycles are selling like hotcakes all over the world. So when you buy Yamaha Corp, you are actually buying its musical instrument business, plus a huge freebie: shares in Yamaha Motors.

However, this value may or may not be unlocked bcos Yamaha Corp may want to hold on to its shares of Yamaha Motors, instead of selling it and returning the cash back to shareholders. In that case, you can only suck thumb.

See also Cash and Debt

How much money do you need - Part 2

This is the sequel to my first post on this blog. There is actually another way to think about how much money you would need in a lifetime and it's quite logical (well at least to me...).

Assuming that you would be working 2/3 of the time in your entire life, you should be saving at least 1/3 of your pay. The key word here is AT LEAST. Bcos we must not forget inflation.

Now say if you are currently 30 yrs old, you earn $3000 per mth, you expect to retire at 60 and live until 75, i.e. you work 30 yrs out of 45 yrs of your life (2/3) and have no income for the last 15 yrs (1/3 of 45). You should be saving at least 1/3 of your pay i.e. $1000 in order to maintain your current lifestyle until the day you go to heaven (or wherever you want to go that won't need money from Earth... hehe).

Why is this so? Bcos the 1/3 that you save for 30 yrs (which amts to $1000 x 12 x 30 = $360,000) will be just enough to cover you for the next 15 yrs when you don't work at all ($360,000 /(15 x 12) = $2000 = the amt you are spending now every mth). That is assuming no inflation.

Hence similarly if you want to retire at 50 and die at 70 (which means you work 20 yrs and don't work 20 yrs) you would need to save at least 50% of your pay. Which probably means 90% of Singaporean cannot retire at 50 and die at 70, bcos if they want to retire at 50 they must die, say at 55 in order not to rely on their children or the state or any other entity to support them. How fun.

So what happens when we take inflation into account? Well it simply means you have to save more, or make your money work harder (i.e. invest lor). If inflation is 3%, then for every dollar you save, it must earn 3% every year until you retire. If you believe in this blog which says investment earns 8%, then all is well.

If you intend to cover inflation by saving more, it gets tricky bcos inflation goes on yearly but you only save the same amt every month. This means that for Year 1 you will need to save 3% x 30 (yrs) = 90% more and Year 2 you need to save 3% x 29 (yrs) = 87% more and so on (i.e. Year 1 you need to save $1900 per mth, Year 2 you need to save $1870 per mth and so on).

But you only earn $3000 per mth remember? How to save $1900? It cannot be done, so the answer is you should spend less, much lesser than the original $2000 per mth. As a rule of thumb, I think saving 50% of your salary should be quite ok. Which then means a lot of pple in Singapore are probably not ok... Count on me Singapore, count on me to go broke before 50!

See also Investment cannot make you filthy rich

Discounted Cash Flow or DCF

Discounted Cash Flow or DCF is the most complicated way to value a stock and also probably quite useless to most people. Well, not if you are good at math or if you are called Buffett or Graham or Dodd. Buffett uses very simplified DCF to try to value stocks and is probably quite good at it, given how much he has earned (umm, in case you don't know, it's about 1/3 of what the whole of Singapore earns). Too bad he doesn't blog.

Well I guess I would just try to describe the concept of DCF, bcos the math will simply freak out a lot of people. But having said that, it's probably A level or 1st year university math so if you really want to know, can google it and try to figure it out.

Ok the concept is basically adding up all the cashflow over the life of the firm and try to determine how much it is today.

Perhaps it is easier to use an example:

Firm A will generate $1 of cashflow over the next 50 yrs, what is its value (or intrinsic value) today?

Well the simple answer is simply $1 x 50 = $50 (QED).

Ok, but how can be so simple?

Now we must understand that $1 next year is not the same as $1 today. And $1 two years out is also different. The difference is due to interest.

So $1 next year is actually equal to $0.97 today bcos if we put $0.97 in the bank today, it will earn 3% interest and become $1 next year. And $1 two years out is roughly $0.93 today bcos if we put $0.93 into the bank today, it will earn 3% interest in 1 yr, and both the interest and principal after Year 1 will earn another 3% interest, which brings the total to $1 two years from now.

So once we calculated the present value of all those future $1 (50 of them), we add them all up and we get the intrinsic value of the firm. For the above example, the answer is $25.7.

If you are wondering how to get $25.7, key this "=PV(3%,50,1,0)" in Excel and it will spit out the answer. Need more help, pls email me.

Well, not so hard after all I guess. But the questions below will make you realize what makes it hard.

First, how the hell do we know if Firm A can actually earn $1 every year for the next 50 yrs? And what will the interest rate be in 50 yrs time? And why only 50 yrs, shouldn't a company exist longer than that?

So that's the hard part, for every input, there is some uncertainty. With DCF, you can have infinite no. of inputs, and that's uncertainty times infinity. How fun. Personally I prefer to stick with PER and EPS estimates.

See also Intrinsic Value Part 2
and Definition: Value Investing

Industry Life Cycle

According to Buddhism, there are four phases in Life: Birth, Aging, Sickness and Death. The funny thing is, business schools teach a similar theory about industries.

This is the what makes investment interesting I guess. It is not just about making money. It encompasses knowledge from different fields like philosophy, religion, social science, accounting, economics, finance etc. Which means you have to know a lot before you can invest and make money. Investment is about knowledge. Investment is also about your style, your view of the world and about your ability to stomach losses and conquer your greed.

Okay, back to the main topic, so similar to Buddhism, industries follow a four phase life cycle:

1) Infancy: Few players, growth rate: 10-20% e.g. Fuel Cell
2) Growth: Many players, growth rate: 50-400% e.g. LCD TV
3) Mature: Ogliopoly, growth rate: 5% e.g. Oil majors like Shell
4) Decline: Ogliopoly, growth rate: -5 to 0% e.g. Photo film

Industries can be broken down into these four phases and depending on which phase an industry or company is in, we can see some characteristics pertaining to that phase and frame our expectations accordingly.

1) Infancy: This phase marks the beginning of a new industry, technologies are only recently discovered and business models are still evolving. Growth is limited due to limited demand and lack of funding and interest. Usually marks the 1st 5-10 yrs of a new industry.

2) Growth: At a certain point, an infant industry hits an inflexion point and starts to grow spectacularly. Competitors also start to enter the industry causing prices to come down. But declining prices lead to even stronger demand for products. Stock market starts to get very interested at this stage. Growth phase usually marks the next 10-30 yrs of strong growth.

3) Mature: A growth industry will eventually mature when penetration rate reaches a certain level and/or demand runs out. Growth rate declines to single digits. Weak players exit the business as they cannot compete at low prices and low sales volume. Industry usually consolidates to a few strong players.

4) Declining: This is similar to death in Buddhism life cycle. The industry cannot continue to exist as there is no longer any demand for its products.

It is important to note that these are theories. They do not work perfectly in the real world. Some industries go from Infancy and straight to Decline (e.g. MD players?). Some enjoy growth for 40-50 yrs (autos: is it still growth or mature?). Some industries reach mature stage in 3 yrs (Internet auctions, online stores?). Some industry simply cannot fit into any phase (e.g. consulting?).

Once we understand which phase an industry or company is in, we can better size up its growth potential, investment return and other big picture aspects.

See also Porter's 5 Forces
and Secular Trends

Dividend yield

For a list of dividend stocks (as of Jan 2009), see Free Cash Flow and Dividend Stocks.

Dividend yield is the stock dividend per share (DPS) divided by its share price. E.g. if Company A gives 10c dividend in 1 yr and its share price is $1, then its dividend yield is 10%.

Alas, as we can guess, it is very unlikely that a stock will be able to sustain a 10% dividend yield for long periods. The simple reason being that if it does payout 10% handsomely forever, why would the original owners list the company? They might as well keep it private and keep the 10%. There are times when the market collapse and dividend yield hits 10% but it is unlikely to remain cheap for long as the stock would rebound quickly. But if you do find one in the current market, let us know! So that we can all buy. Huat Ah!

Globally market dividend yield ranges from 2-4%, but some individual companies do give much higher yield (usually that also mean the company has not much growth prospect). In Singapore the average dividend yield is also around 3-4%, which is not much higher than fixed deposit rate, but actually quite ok by global standards.

Personally I think dividend is very important because it may be the only form of incremental income for a value investor (who prefers to buy and hold stocks). If a company does not pay dividend, there is no way to get cash out of your investment except by selling the shares. But if you would like to hold the shares because you think the company will continue to grow, what can you do? Value investors also need cash to buy groceries right? Not much use holding on to stock certificates until you are one leg into the coffin, isn't it?

Also, by paying dividend, the company shows that it has its shareholders in mind. Excess capital is always returned to shareholders if it cannot be put into better use. Of course, a growth co. needs ALL the money to invest and grow, and they don't pay dividend. Investors sometimes take that excuse, but usually also taken for a ride. However some growth company do grow big and when they are ready, they pay dividend as well, e.g. Microsoft.

However, Berkshire Hathaway has never paid dividend since Singapore got independent because its owner-manager, our hero Warren Buffett, thinks that he can use put the money into better use. And he has done that.

Since most if not all companies are not like Berkshire, we should expect them to return investors some of the money the firm has earned.

See also Company cheatsheet
and Earnings yield

Industry Food Chain

This reminds me of primary school days, when the small fish eats plankton and the big fish eats the small fish and all the crap right? Well with production and business, it's almost the same.

Industry food chain refers to the process by which raw material is being passed through different manufacturers as semi-finished products and finally being made into end-products for the consumer. The most famous one is the semiconductor food chain. But since this food chain is far too complicated, even for sell-side semiconductor analysts, I shall use another relative simple one.

Honey -> Bee -> Bird -> Human

Ok, ok, before you click the "x" at the top-right corner,

Wafer suppliers -> Foundry -> Chip makers -> Consumer electronics

Well that's the simple semiconductor food chain, but what makes the actual chain so complicated is that at every level, there are equipment suppliers and fabless design houses and testing equipment makers and OEM manufacturers so the whole thing turns into a huge spider-web which is good for putting around your workstation to impress sweet young secretaries.

Ok, but what's so useful about learning this? The short answer is Bottleneck. By understanding the food chain we can find out where is bottleneck. i.e. the point in the food chain when there is less capacity than demand, or where there is limited no. of players and hence they have the bargaining power over everyone else. (See Porter 5 Forces.)

Take the example of the hard-disk drive (HDD) industry. HDD is part of the huge spider web within the IT/semiconductor food chain. If we take a closer look at its food chain specifically, it is something like

Materials (Magnets, metal screws, glass discs)
-> Components (recording heads, motors, connectors)
-> Hard-disk drive makers (Seagate, Western Digital etc)
-> Consumer electronics (PC, Ipod, HDD-DVD recorder etc)

There are currently only 5 or 6 players globally in the assembler space. Seagate being the market leader with 40% share, followed by Western Digital and some Japanese and Korean players. However there are countless material suppliers, component makers, as well as consumer electronics players.

2 years ago when Ipod became the No.1 item on everyone's wishlist and when Flash memory was still too expensive, HDD was in super short supply. A bottleneck formed at the assembler space gave HDD assemblers huge bargaining power over its suppliers and customers.

As we can expect, HDD assemblers' stock prices shot through the roof together with Apple and those who have bought these assemblers laughed their way to the bank. Well that is if they sold, today flash memory is rapidly replacing HDD and we all know what is happening now.

See also SWOT analysis
and Secular trends

Porter 5 forces

Michael Porter, elder brother of Harry Potter, wrote and published a book in 1980 called Competitive Strategy that helped frameworked how we should look at an industry and the forces that interact with the various companies in the same industry. Ok, just kidding hor, Michael Porter is a real academic while Harry Potter is a wizard in a bestselling septology i.e. a story with seven episodes!

Well what Mr Porter said was somewhat common sense but they will nevertheless teach it in business school and set 1 exam question on this per semester. Anyways, the canonical Porter's five forces are

1) Existing competitive rivalry between industry players
2) Threat of new market entrants
3) Bargaining power of buyers
4) Power of suppliers
5) Threat of substitute products (including technology change)

An industry leader/formidable player should be able to tackle all the forces with ease. As an example, let's look at the aircraft makers: Airbus and Boeing.

1) Rivalry between these two players: yes they are somewhat bitter rivals, but on the whole, because there are only two players, price competition is quite limited, and profitability remains high.

2) New market entrants? Not likely, since they are the leaders with all the experience, no airline will think of getting planes from new entrants. Well maybe African airlines buying cheap Russian planes, but overall, not a big threat.

3) With over 100 airlines, basically the airlines don't have any bargaining power. Boeing and Airbus set the price, airlines just accept. If they don't there will be 99 airlines waiting to buy anyway.

4) Suppliers, well depending on the parts, suppliers can be quite powderful. Especially high-end stuff like engines etc. Hence they (Boeing and Airbus) may lose out here.

5) Substitute? Er like flying cars? Or high-speed broomsticks? Well sorry this is not Hogwarts, so in short, no threat from substitutes.

So Boeing and Airbus are in a good position, of the 5 forces, they have the upper-hand in 4 of them. Of course, this is just one aspect to look at one industry. Will be introducing more!

See also SWOT analysis
and Secular trends

Company cheatsheet and stuff - not to be missed!

According to Philip Fisher, one of Buffett's teachers (besides Ben Graham), you cannot never compile a cheatsheet for a company. You have to constantly sniff out info on the company, keep talking to anybody and everybody, from suppliers to customers to employees etc. So analysing a company probably takes like two gozillion years and Frodo have completed the Mt Doom trip like 15 times.

In our world of MTV and instant gratification. Nobody has time for this crap right? So yours truly here has compiled a the ultimate cheatsheet to look at when you first lay your eyes on a company.

I must stress that this cheatsheet is not exhaustive. There are probably another 1,001 things that you should look at. But it should be a good way to start. Also remember than the time you spent researching a company is inversely proportional to the risk that you will lose money. i.e. more research less risk.

But then again who has time to wait for Frodo to go Mt Doom 15x considering we don't even have time to make babies. So I have also kindly calculate the optimal time to spend research a co.

This would be roughly 30 hrs for beginners and 10 hrs for more lao jiao people. But after analysing, this does not mean that you should buy or sell the stock immediately. You should wait for a good time to enter or exit. Investing needs patience, so watch less MTV.

Anyway, to save you from more bull shit, here's the list.

Company specific factors
Mkt cap greater than S$100mn
Operating Profit greater than S$10mn
OPM greater than 10%
Dividend yield greater than 4%
D/E Ratio less than 1x
Growth greater than 5%
ROE greater than 15%
ROA greater than 5%
(Usually these factors can be put into a screening tool to screen out companies that meet these criterias, but I have not found a free screening tool yet... if anyone can find one, pls inform me ok?)

Qualitative factors
Industry climate and firm's position
Strengths and weaknesses of the firm
Major risks for the firm

Valuations
PER less than 18x
PBR less than 4x
EV/EBITDA less than 10x
(These can be put into the screening tool as well)

There are a few things to take note. Even if a firm fails to meet 1 or 2 criteria, it doesn't mean that the stock is lousy. If there are good reasons, it is still a buy. If you try to find a stock that meets everything, probably there won't be any. That's why the each criteria is actually not too strict to begin with. Also, qualitative info matters, that's why it pays to read annual reports, research reports and business news.

See also Investment Philosophy
and Investment Process

Investment Process

An investment process is a SOP (yucks I hate to use this acronym!) that you follow when you want to invest in a stock. For the sake of many non-Singaporean guys and Singaporean gals who have never bother to find out what their boyfriends did in the most unproductive 2.5 yrs of their lives. SOP stands for Standard Operating Procedure: a set of strict execution procedure to follow, during NS.

Anyways, SOP for investing is pretty simple, for me. You should modify your own investment process to suit your style. Investing is as much about your personal style as making money. Your investment process should help to drive your investment philosophy. The process I follow is summarized below

1) Screening
2) Fundamental analysis
3) Valuation
4) Technical
5) Monitor

Screening is the most tedious part of the whole process. Usually it takes a long time to come up with stock ideas if you do not have the relevant tools. Professional fund managers use screening tools to "screen" stocks that fulfill certain criteria. This would be like low PER, high earnings growth, high ROE etc.

Fundamental analysis is what a main part of this blog has been talking about. Things like financial statements analysis, financial ratios, SWOT analysis, intrinsic value etc. The company that you want to invest in must first pass the screening, and then you look in-depth into the company. This is the part when you see the company under the microscope. Scrutinize everything.

If everything looks ok up till now, look at valuations from all angles, PER, PBR, EV/EBITDA etc. A good company must be cheap. If it is expensive, there is no value to be gained by buying. See this post.

Technicals: buy when the timing is right. The general market is on a positive trend, but not too bullish. No analysts are looking to downgrade the stock. i.e. most of them have SELL or NEUTRAL ratings. Charts look ok. Overall sentiment is good but not overly optimistic. Of course, true value investors do not look at this because over time, prices correct themselves and move towards its intrinsic value. But a stock can still drop 10% 2 days after you bought them. If you don't like to stomach this kind of shock, better take a look at technicals.

And finally, when you have bought a stock. Monitor it. Not by looking at its daily price. But by looking at its business. Make sure they are making money, doing the right thing. If things are not going as expected. Sell.

Investing in a stock should be viewed very much like buying an house or a car. The more homework you do, the less likely get conned or lose money.

See also Financial Ratios
and Brokers cannot be trusted