Analysing ETFs

It came as a pleasant surprise how SGX had expanded its portfolio of ETFs to 30 from a pathetic 10 when I was looking at it a couple of years ago. Recently, the biggest distributor Lyxor (Soc Gen), announced a further 5 ETFs to be listed. Looking at this trend, one can expect the no. of ETFs to go to 50 in the next 1-2 years, providing retail investors an inexpensive way to diversify and invest globally.

http://www.sgx.com/wps/portal/marketplace/mp-en/products/securities_products/etfs
This link provides a lot of info on the ETFs listed on SGX

At this juncture, I thought it would be good to post something about this investment product which might be one of the most important factor to help one achieve a 8%pa long term rate of return. Here are a few things I thought one should look at.

1. Expense ratio
Needless to say, this is probably the first thing to check. SGX listed ETFs have expense ratios ranging from 0.4-0.9%, which is kind of expensive compared to those in the US (as low as 0.2%) but much cheaper than unit trusts at 1.5% sales charge and 1% management fee. Well Singaporeans always get short-changed, so just live with it.

2. Market maker
Some ETFs listed way back in 2001-2002 has zero trades for the past 8 years without market makers which I think resulted in their failure. Now it's impossible to buy or sell them as there are no buyers or sellers! Even though its a listed product. Then came Lyxor with its market maker (basically some execution party and ensures you can buy or sell the ETF even when there is no counterparty) and viola, ETFs took off and Lyxor now has 50% market share of all ETFs listed in Singapore.

3. Spread
Even though there is a market maker and trades get executed, some times we need to pay attention to the spread. My rule of thumb is that if the spread is more than 1%, then it's a huge transaction cost. It is not something that you can change though. My greatest concern would be that if I hold this ETF for 10 years or more when the whole world has lost interest in it, will the spread balloon? Meaning I can't sell it. I have no answer at this point. Enlightened parties, pls share!

4. Dividends
Some ETFs listed on SGX give dividends, some don't. Personally I prefer dividends, a bird in hand man! Yes academics argue it doesn't matter, it might even be better bcos the dividends get re-invested - you don't get taxed, you get higher compounded return! I don't care, I want income stream and I want it now! Well that's me though.

5. Market Cap
The size of the ETFs determine if its likely that this product will continue to be listed, and I would say go for stuff with like USD 50-100mn in size. If it's too small, there might be a chance that the distributor will delist it. Then it's trouble trouble.

6. Valuations
This would be the single most important factor determining what or when to buy. As with stocks having their PER, PBR etc. ETFs also have their PER and PBR. It is not easy to get those figures (without a Bloomberg) but I think you can try to call their hotline and ask around. My general rule of thumb would be buy at PER 12x and PBR 1.2x. Some ETFs were at this attractive level earlier this year, now they are closer to PER 15x and PBR 1.5x. So wait for them to come down.

7. Components
Ultimately, ETFs are made up of stocks. So it pays to look at what's inside and see if you are comfortable with it. As with most indices, the bulk is actually finance stocks. Like STI is 40% banks maybe 20% Real Estate stocks. Russia used to be the hottest thing in town bcos it was mostly just oil companies. Since what we want is diversification, I would suggest look for ETFs that are more balanced, or buy a few to balance it out yourself.

8. Prospectus
Lastly check out the ETF's prospectus, see if anything is amiss or if there is something bothering you? Give them a call if need be. Usually it's some salesperson that is trained to answer some standard questions but no harm trying and hope they managed to help.

I am also still learning about all these, so knowledable parties pls share what you have learnt. 2009 and 2010 would be a good time to finally put money to work and earn a decent rate of return!

What is Value Investing?

Value Investing is perhaps one of the most important topics in life that is misunderstood by the most people. This is a reflection of our modern society that constantly tries to replace rationality, long term thinking and hard truths with sensations, material gains and get-rich-quick mentality.

It is a sad fact that most people today equate investing with gambling when the segregation can be crystal clear. To quote Benjamin Graham, father of value investing, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return and operations not meeting these requirements are speculative”.

In simple layman terms,

Value investing simply means adopting an investment philosophy to buy something that's worth a dollar with a lot less, like 60c or less.

Here is a modification of the old formal definition that I posted some years back.

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

1) Buying at a price that is less than its intrinsic value

2) Buying with a margin of safety

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In a nutshell, value investing is simply applying the concept of "shopping during bargain sale" to buying stocks, bonds, properties ie investing. It means paying less for more. Get good value for money. Buy one get two free. Buy a dollar for 60 cents.

The concepts here are not difficult to understand and their applications are also straightforward but as with dieting, what makes sense doesn't mean that it's easy to accomplish. This is because human emotions like greed and fear are constantly playing tricks to blur our rational minds which it what makes value investing tough. Especially when there are prices, charts and patterns, talking heads with irrelevant short term newsflow bombarding us daily.

Over the years, the paradigm of value investing has expanded to encompass many things:

1. Fundamental analysis (FA) needs to be rigorously employed in order to determine the stock's intrinsic value. This plots value investing into the infamous FA vs TA argument. TA stands for technical analysis ie looking at charts and stuff.

2. Buying a stock is like owning a business. Hence long investment horizon becomes norm as business owners don't buy and sell their co.s like oranges. And also undervalued stocks usually take some time to revert to it's intrinsic value.

3. Stocks that have certain characteristics become known as value stocks

a. predictable business operations and stable earnings (easier to calculated its intrinsic value)

b. low PER, PBR, high dividend, high cashflow or other "value" quantitative factors

4. Based on the points raised in Pt 3 above, value stocks typically come from mundane industries like food and staples, utilities and other old economy industries ie no high-tech, alternative energy or bio-venture stuff.

5. It is generally accepted that Benjamin Graham is the father of value investing. Other well-known value investing practitioners include: David Dodd, Irving Kahn, William Ruane, Martin Whitman, Charles de Vaulx, John Templeton, Charlie Munger and Warren Buffett.

Since the concept of buying something that is undervalued is so broad, value investing is sometimes used to refer to investing in special situations like merger arbitrage, discount bonds (e.g. some bonds trading at 50% below par value and pays 10% interest and has little risk of default). However, this blogger thinks that this is a stretch for value investing.

For most people, it should suffice to understand that value investing is about owning a partial stake in a good company by buying its stock at a reasonable price.

How long term should we be?

The investment horizon that is appropriate for our generation is probably 15-20 yrs, in my opinion. This is bcos we usually have some savings after the age of 30-35 for some real investing as we get married, buy house, have kids etc. And if you think about at what age should you enjoy the fruits of your investment, then it's probably 15-20 yrs later. I mean retirement age may go up to 62 but shouldn't we start thinking about enjoying life in our late 40s, early 50s? No point investing for 40 yrs and then get old and immobile and use the fruits of investment to pay for medical bills right?

Also, we shouldn't forget that even though official retirement may become 62 or it might go up to 65, probably it gets harder and harder to stay employed as our generation hits 45 years old. This is a major social reality/issue and it is already biting at a lot of people. Look around, do you see a lot of your colleagues who are in the 50s or 60s? The career life span is shortening. If you are in your 30s like me, we cannot expect to stay employed until 50.

Say if the investment horizon is only 15 yrs, and intrapolating the no.s on my previous post, the returns probably vary around +3% to +18%. ie if you bought at the peak of the market, you can expect to get 3%pa, which is worse off than leaving money in CPF. And worse still, if you had bought in 2007, it is likely that you might take more than 15 years to break even.

In order to mitigate this undesirable outcome, we must definitely employ a sound investment plan or some form of dollar cost averaging which basically means you put aside some money to buy stocks or bonds or funds every month. This should provide a +ve return after 15 years.

To aim higher, ie achieve an ok return like 8%pa, we must pay attention to market cycles in the macroeconomic sense. Don't buy a whole lot of stocks during the peakish periods and look to buy during doldrums (like now). Of course for true Graham/Buffett style value investing, the valuation takes care of this. You won't be buying stocks at the peak bcos the valuations will say No-No. Graham is famous for using his 10 yr valuation to smooth out earnings peak and trough during cycles. He would say BUY only if stocks are trading well below 10 yr valuations. ie Price/Average EPS over 10 yrs is less than 18x. He also have 6 other criteria to follow. Basically, you can't find stocks meeting most criteria in 2006-2007.

In conclusion, to get an ok return on investment (like 8%pa) over a 15 yr investment horizon, we need to know the macroeconomic trends, don't jump into stocks when everyone is also jumping in, focus A LOT on valuations, esp long-term valuation (not 1-2 yr forward EPS) and keep that margin of safety concept in our heads, and we should be ok.

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!