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.

Enterprise Value and Free Cash Flow II

This is a continuation of the last post talking about EV and FCF.

A company generates cashflow based on its day-to-day operations. Eg. SIA selling air tickets with fuel surcharges 2x actual ticket prices. The millions of ticket sales generate cash. Of course SIA needs to pay the pilots, the stewardesses, the fuel, landing charges etc. After netting the expenses, it should still have cash left. Some co.s don't, if you own some of these, good luck! Anyways, this no. is called Cashflow from Operations.

Next, SIA needs to spend some of this cashflow on equipment to maintain its operations. Like buying new planes, pilot training programs, 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.

Over the course of many many years (like 10 yrs or more), a good co. will generate significant Free Cash Flow and has the capacity to even grow this amt over time. Now finally, things are getting interesting right? These are co.s that value investors look out for. Usually, I would look at that past 10-15yrs of FCF and take an average amt to use that to calculate EV/FCF. I am assuming that the company can generate this average FCF in the future for many many years.

Let's look at SIA. Over the past 10 years, SIA has 5 yrs of positive FCF and 5 yrs of negative FCF. Cumulatively, it generated a miserable S$175mn of FCF. Our ministers' salaries over 10 years would have generated as much. This is what the most profitable airline in the world can manage. Moral of the story: Don't ever buy an airline!

Combining the two things, you get EV/FCF which is just a measure of the cheapness of the company. The lower the better, like the PE ratio. If this ratio gives 5x, it means that theoretically, you get back your money in 5 yrs. Usually it doesn't get cheaper than that. EV/FCF ranges from 5-15x usually.

Again, back to SIA, the EV is S$8.8bn based on current stock price of S$11+. Calculating EV/FCF give 8800/175 = 50.3x. If you buy SIA today, the free cashflow generated should be able to cover your purchase in about 50 yrs. That's great isn't it? Maybe just in time to cash out and pay for the funeral expenses!