The Acme of Value Investing

I have been thinking about this for a while. Some time back, Warren Buffett started buying over mum-and-pop businesses that have grown tremendously over a long span of time from its original owners. These owners have painstakingly built their empires over the years, they are now old, they want to cash out some of the future earnings of their business, so they go to Buffett. But how do they determine price? Buffett being Buffett, is not going to undercut them by paying them just 10x earnings. But he definitely will not overpay as well.

In the stock market, Mr Market determines the price, which some times go crazy and the owners of businesses (ie shareholders) have no choice but to sell at basement prices. Buffett takes this opportunity to buy from these willing sellers. Well, in the first place, some of these market participants never regarded themselves as the owners of the firms which they hold stocks. They are in for the quick gamble. So Buffett gladly profits from their fear.

However, in private transactions, Buffett knows these sellers. Some of them are his friends in Omaha. He is not going to shortchange them. So the logical conclusion is that Buffett pays a reasonable price for these businesses he buys, Maybe 18x earnings. We can think of it as the sellers get 18 years of future cashflow from their business. Thereafter, the profits will be what Berkshire shareholders stand to gain from. There is bread from everybody. Nobody gets shortchanged.

To put it graphically, value investing is often viewed as buying an asset below its intrinsic value with a margin of safety (ie buy when purple line is below green line). Since Mr Market eventually prices asset correctly (albeit after a long time and only for a short while), money is to be made when value investors buy stocks way below intrinsic value and wait for it to rise back to intrinsic value.

However what Buffett does with buying good franchises would be buying an asset at its intrinsic value, at that point in time. And since it is a good franchise, its intrinsic value rises over time and way out into the future, Berkshire shareholders benefit from the exponential growth in intrinsic value. This is perhaps why he keeps talking about buying a strong franchise at a reasonable price, rather than buying a mediocre firm at bargain prices.

In every transaction, we are taught that usually there is a buyer and a seller, and there is a winner and a loser. Yet in Buffett's position, it is possible to have a transaction and yet benefits both the buyer and the seller. In my opinion, this would qualify as the acme of value investing.

The Truth Shall Prevail

Value investing is based on an inherent fundamental assumption: that someday, an asset's true value (or intrinsic value) would be realized. Hence buying a stock when it is trading significantly below intrinsic value would yield good return bcos they eventually trade back to its intrinsic value (albeit after a long time and only for a short while). But what happens if the stock never reverts to its intrinsic value? Is that likely? Well I don't have a good answer to that, but let's explore this topic a bit more broadly first.

Analogous to this the concept that a stock eventually reverts to its intrinsic value are similar logics like: the truth shall prevail, good will triumph over evil, hardwork eventually gets rewarded etc. I would think that these tenets should hold most of the time, if not all the time. The issue in the real world is that it can take generations for them to come true. Think Khmer Rogue, North Korea. Think about why some incompetent managers can stay in the firm for years. Or why some evil deeds never get punished (50% of murder cases are unsolved). Well the stock market is efficient, but the reality may not be as efficient.

Khmer Rogue did get its retribution after killing 6 million Cambodians 30 years later, and one or two ex generals are getting trial. One may say that this is too little too late. But Cambodia is finally thriving now with its Angkor Wat and a few hundred other Tomb Raider ruins. But our beloved tyrant in Pyonyang is still enjoying his tyranny. It's been about 20 years of hardship perhaps for the North Koreans? Well I hope I can see some resolution in my lifetime.

Of course, bad managers, they manage to stay afloat for some time but eventually they are either being force to retire or they themselves choose to retire after creating maybe 20 years of negative goodwill amongst colleagues. Yes the damage is done. But what I think could happen is that these people accumulate so much negative goodwill during their lifetime, even though they can be rich and living a luxurious life after retirement or termination, they are not happy. And they die not happy.

As for murder cases, again we can only hope that goodness finally prevail whenever the murderer reflects that he lived a meaningless life, caused only harm and pain to the world and dies a lonely death with nobody to mourn for him, eventually.

The fortunate thing about markets would be that many many participants are judging the stocks, everyday. Hence prices revert to value relatively quicker (but still a good 3-5 years). However there are cases that prices never revert back to value, then shit happens, like the company got taken private at a cheap price (very likely in Singapore). But overall, I would say maybe 70-80% of the time, prices will revert back to intrinsic value over a period of 3-5 years or sometimes a bit longer.

In the case of bad tyrants and bad managers, I guess the problem lies with too few judges. For bad tyrants, virtually nobody can judge them until things get so bad that the people revolt (usually 50 years or more? If we look at the history of China). Or in today's context, global leaders may force a regime change. For bad managers, well perhaps a few bosses on top judging them but not a whole lot efficient. Hence, in my opinion, universal truths can take a long time to prevail. In the worst case, a hundred years.

What is the solution to this?

In the stock market, it would be some diversification, buying enough value stocks so that even if one or two stocks never returns to its intrinsic value, the portfolio should be ok. And that is perhaps why good value fund managers tend to be able to beat the market more often than other managers.

In reality, my current thinking would call for dis-association. Or simply escape from such situations, bcos we cannot live a hundred years to wait for things to revert. I always wondered why North Koreans can endure such shit for 20 years. Shouldn't 90% of the population be gone by now? Indeed I estimated that 0.5% of the population escapes the country every year. But the conclusion I arrived at is that people weigh the risk of dying while escaping vs risk of dying in North Korea and choose the latter. Aside from the great famine in 1993-95, most people have enough food to eat so as they won't die, they have a shelter over their heads, medical is taken care of somewhat. And they adapt. However population growth for the country is near zero or may even be negative. Needless to say, economic growth is also near zero. Well that's North Korea.

As for situations closer to our reality, like in the cases of your bosses happening to be real jerks, pls quit your jobs asap. That is the first step, the 2nd step would be to help the world by revealing their evil deeds such that justice can prevail faster.

How To Live Longer

This would probably be my first non-investment related post. Well, it’s sort of related bcos in order to reap the full benefits of value investing, time is a terribly important component. So by living longer, your investments can compound for an extended period of time and you get richer! Remember Warren Buffett only got famous around 1980s when he was already 60 plus. Then finally attend icon status after the dot com bubble burst, when he was closer to 80 years old!

Btw, much of what’s below is lifted out from some CLSA report. Much as I dislike having non-original content, this list is too good not to be shared around.

Anyways, here is real deal:

A researcher called Dan Buettner spent a lifetime studying people living in what he called Blue Zones where the population life expectancies are much higher than average. Here are the things that he found out:

1. Exposure to sunlight: his studies showed that people living in places with a lot of sun tend to live longer, like Hawaii, Okinawa, Mauritius whereas people in Norway, Siberia are not so lucky.

2. A little alcohol every day. But not too much. I think this is quite well-known.

3. Big breakfast. Not too sure why is it so impt, but I guess all those diet programs emphasizing less food during dinner do ring a bell here.

4. Eat more vegetables. Not exactly zero meat, but more vege definitely do our bodies more good than bad.

5. Eat a lot of tofu. This is the only food that can slow aging somewhat. There are 99 processes that age human beings and no one pill, food or treatment can reverse all of these processes. Tofu comes up top though.

6. Have a social circle. With a group of close friends or relatives looking for one another definitely helps to improve life expectancy I guess. And this is not about your 501 Facebook friends, but real buddies and kakis that you really like to hang out with forever.

7. Choose your friends well too. No point if your best friends are thugs or serial-killers I guess. Even obese friends are not so good.

8. Get married. Married people significantly outlive singles. But not sure about those who are married multiple times though.

9. Sleep 7 hours a night. Not too much though. 10 hours apparently doesn’t help. But 4 hours is the other extreme. Napoleon died at 52.

10. Have a purpose in life. Retiring is not a good idea, statistically the year you retire is one out of the two years in life that people are most likely to die. The other being the year you are born!

11. Be optimistic.

What not to do:

1. Exercise too vigorously – like going for marathon every week. Moving naturally is good enough.

2. Smoking – Takes 8-10 years of life away.

3. Diet programs – doesn’t work. What is needed are long term changes to eating habits, eat more veges and less in total.

I always believed in the Grand Theory of Balance. Basically, do everything in moderation. For each of these points, you cannot overdo or underdo. Like alcohol, sleep etc. So to live longer is then really about living life in moderation.

Wealth, innovation, hardwork and others

This post serves as clarifying some economics concepts for myself also. It has to do with wealth and how it links to being rich and famous and getting adored by the masses.

Imagine that the world has only 2 pple: 1 farmer and 1 fisherman. The farmer harvests some rice every day and the fisherman catches some fishes. The farmer will sell some rice to the fisherman and vice versa. So the money supply in this world has maybe like $4, $2 with the farmer which he gets from selling 2 kg of rice and $2 for the fisherman who sells 2 kg of fish.

So the question is how can either of them get richer?

This is quite easy to answer, say the farmer is the aspire-to-be-rich kind, so he contemplates to be richer than his other companion on this lonely Earth. Well, what can he do? He can raise prices.

Say previously he sold 1kg of his rice for $1 to the fisherman. Now he can sell $2 for 1kg. Then he will be earning twice as much! How wonderful. But then since there is only one other person on this lonely planet, i.e. the fisherman, he will raise prices too unless he is stupid or something.

Then we get into a situation called inflation. Nothing really changed just that things got more expensive. It doesn't mean that if you have more dollar notes, you are richer.

So how does the farmer REALLY gets richer than his companion?

1) He can work harder than his companion, he harvests more rice and sell more to his companion. But since his companion may not be as hardworking, i.e. the fisherman only catches the same amt as previously, he will not be able to sell more fish to get more money to buy more rice.

The farmer's wealth in this world is restricted by the total money supply of $4 so the farmer get "richer" by way of having more free time since he can store up his harvest and wait for the fisherman to have more money to buy from him.

Or he can sell more rice on credit to the fisherman and now he gets more dollars in his safe deposit box while the fisherman has some debt.

2) He can cross pollinate the rice grains and sell a new grain of rice which is more delicious and charge his companion more for each kg. The fisherman "naturally" has to understand the quality difference and is willing to pay more for delicious rice. But again bcos the fisherman may not fish better quality fishes, he is again limited in his capacity to spend and the farmer gains by having more free time or getting money on credit again.

So in other words, the farmer get richer than the fisherman either by working harder, by thinking harder (innovate a new grain of rice) or by luck. Well, the farmer can get lucky and somehow the rice mutate by themselves into a better grain and he then sells it more expensive to the fisherman.

Well there is a fourth way, but it delves into immorality like by cheating the fisherman, telling him the rice is a kind of new grain but in fact it is not. Sadly, a significant proportion of rich people actually amass wealth through this fourth method.

So how can both of them get rich?

It can only be through improvement in efficiency (or technology advancement) for both of them. Say both the farmer and fisherman somehow managed to harvest and fish much more in the same time versus previously, they can then sell to each other in higher volume and get more dollars from each other (i.e. an overall increase in wealth).

If you think of these issues in our world today. Usually most people get rich by through their own hardwork or innovation or luck (or some through deceit), and they managed to amass wealth ahead of the population. But bcos the population is not as advanced as these rich people are, the poor simply gets left behind, becoming poorer in a relative sense. In our 2 pple world, the money supply is restricted bcos there is only 2 pple so the rich farmer can only get more free time or earn money on credit. But in the real world, the rich amass fortunes from 6bn other poor pple. So they get a lot of dollar bills - which are credit to buy services from the society.

The true accomplishment would be the raise the bar for all pple so that everyone gets richer. But this is a feat that is difficult to achieve. Why would the rich raise the bar for everyone so that they become poorer in the relative sense? But for those that do that, we gotta take our hats off to them.

More On Financial Freedom

This is a continuation of a previous post on financial freedom.

So it seems that financial freedom helps to achieve the 3 important things that we want in life: Time, Money and Happiness. This is achieved by trading away 10 to 30 years of doing some job. Someone capable can do it in 10, for most of us, it's 30 years, my dear. Or to put it in percentage terms, if we lived to an average of 80 years old, the solution then is to trade 10-40% of your life to achieve financial freedom. And if considering that we start thinking about this at age 20, then the denominator is not 80 but 60, and the solution becomes to trade 20-50% of your life to achieve financial freedom.

I would think that a better solution would actually be looking at this issue more holistically. Specifically, changing the way we look at the Job part of the matrix. To most people, a Job is solely income generation, Job – brings home the Money, takes away the Time, and that’s that. People talk about work-life balance. Work is work, Life is life. Outside work is our true Life. Work and Life cannot mix.

Actually, Work is 10 hours out of 16 hours that we are awake. Work is Life!

In Maslov’s famous hierarchy, the top echelon is some big word which is also very much coveted. I will try to spell it: Self Actuallyrealizingmoneyisnonotion or something. Let’s just put it down as Purpose.

If you think about it then, the true intention of financial freedom is to actually have the Time to do our Purposes in life, without having to worry about Money.

This Purpose can be as simple as witnessing your kids growing up, or creating art, or doing charity etc. So the ultimate motive of financial freedom should then be trying to replace Job with Purpose.

Then you have a beautiful matrix where you have a Purpose in life, you have Time, Money and also Happiness.

Of course, this is ideal talk. I can hear readers yelling Get Real! Wake Up! Most Purposes need Money, not bring in Money. That is true.

Nevertheless, as a start, I think we should try to find our own Purposes in our Jobs. If you totally hate your job, cannot find a good reason to go to work everyday you wake up. Please. Change your job. Life is short. Eat dessert first.

Well it’s quite difficult to pull your Job to your Purpose in life if your job is to clean toilets or to entertain some HNWI’s dog. (HNWI: High Net Worth Idiots) I cannot imagine anybody who thinks his Purpose in life is to make toilet bowls in Singapore’s Kopitiams sparkle like a 24 carat diamond or become an idiot's dog's best friend.

Let’s put it this way. Most of us don’t know our Purpose in life. Some lucky fellow might. He woke up on his 15th birthday and decided he should be a doctor and save lives. For the rest of us, we go to school and get psycho-ed to study Engineering and ended up being a HR manager. Some find that helping people adjust to their jobs might not be too bad, and grew to embrace their jobs as HR managers. Their Jobs became their Purposes.

Well, for others, not so lucky. What they really wanted: is to be a rock star. And here they are stuck as a HR manager. Ok, for such cases, being financially free also cannot help. Pai-seh. Please go and join Singapore Idol.

I guess what I want to say is: Think about how you can embrace your Job as your Purpose, if that cannot be done no matter what, change your job and work towards what you really want. Saving enough or through shrewd investing to get passive income enough to support your lifestyle? It is a gimmick. The truth is, it usually takes more than a quarter to half a lifetime to achieve that.

All things come in packages in life. There are some things you like about your wife, and some things you don’t, but you married her anyways. So similarly, there are some things you don’t like about your job. And surely there must be some things you like about your job. From there, we can try to work to find our Purposes.

Financial freedom means you need not worry about money. But when you can have all the money, all the time in the world then what? If you don’t know your Purpose, how do you find Happiness with your abundant Time and Money?

Financial freedom is then, not about the money. It is a term cooked up to make us think we need more money but in fact, what we need is to find a Purpose that can help us balance the Time, Money and Happiness.

On Financial Freedom

Just some thoughts on this term “financial freedom” that has become a much coveted goal in life popularized by Robert Kiyosaki in Rich Dad Poor Dad. Btw apparently Kiyosaki was never as rich as he proclaimed. He got rich after selling his book. Well, some of his ideas are refreshing though.

What is the definition of financial freedom?

I guess to most people, it would be having enough money in your bank to last a lifetime living the same quality of life and thus having the freedom to choose not to work for money.

In the first ever post on this blog, we worked out this amount is probably slightly more than half a million dollars for a conservative guy and $3mn for someone more aspiring. And this amount is highly unreachable with normal jobs since annual salary is about $30,000 to $40,000 on average in developed countries. (Well actually it’s doable given enough time: like 30 years, as we shall see but that defeats the purpose I guess :)

Hence there is a need for passive income (another term from Kiyosaki) to help fund monthly expenditures. However passive income can only come from a few sources:

1. Dividends from stocks

2. Interest from fixed income instruments (bonds, T-bills etc)

3. Rental income from property

4. Pension or annuity payout

5. Cash flow from businesses (which you don’t have to run it)

6. Royalties from books, songs etc

7. Others: sponsorships, fees etc

So, in order to fund an annual expenditure of say $25,000 (roughly 80% of Singapore’s average income), well say the income yield is 5-8% (an arbitrary average yield if you invest in some or all of the 1-7 above), you need a portfolio of $300,000-500,000. So theoretically, if you save enough and put your money to work wisely, you could become financially free in about 20-30 years. Hell, it’s still gonna take a long time!

(Obviously this amount comes up to be much smaller than what was stated in the first ever post bcos one no. simply calculates lifetime expenses (including mortgage and other liabilities) while the other no. is about how to sustain a certain expenditure with returns from a portfolio.)

Of course, if your monthly household expenditure is $3,000, this works out to be $36,000 per year, it should then then take you about 40 years to save up to a portfolio that could generate $36,000 per year assuming that you save 25% of your income and your savings are invested to achieve a return of 8%. Shiok huh? 40 years to financial freedom!

Well some capable souls might be able to shorten to 10 plus years which is not bad, bcos he or she would be 40+, still young!

Let’s delve into this a bit deeper. Why do people want so much to be financially free?

Well I guess according to the definition above, so that they don’t have to worry about money and bills, and can spend their time somewhere else instead of working like having time to engage full-time in a hobby, to play with kids, do volunteer work etc.

I guess this would be the goal for most who proclaims that their goal is to attain financial freedom.

To put it in another way: the crux of this financial freedom problem seemed to be represented in this matrix

We want Time, Money and Happiness. Job gives Money but takes away Time and maybe Happiness: so how?

Most people’s solution is to trade 10+ (if possible) or 20-30 years of time, do a Job that gives Money, and after getting enough money, quit job and get Time, Money and Happiness.

At this point, we should also note that Time and Money does not generate Happiness. So even after you have achieved financial freedom. It does not guarantee Happiness - which I would think would be the ultimate goal in life. So something is missing here.

Now the question is really then: is trading 10 plus years of life, or for others 20-30 years a good solution to achieve the coveted financial freedom or rather what most people actually want?

Concerns on ETFs

I love ETFs. They allow retail investors to invest in indices with low costs, liquidity, give dividends and even have a helpline that you can call everyday to ask about the ETF you bought. What else can we ask for? However, due to time constraint and limited resources, I haven't been able to research and answer some thorny questions on them. If anybody reading this have answers, pls do comment and share the knowledge.

1. Forex risk

Most ETFs on the SGX are listed in USD and as we know, the USD is being dragged to hell as Fed prints money like there is no tomorrow to save the economy. Albeit this process will take many many years. However, if our ETF is in USD, wouldn't that mean that we are being screwed? My answer would be no. Bcos the USD is just a medium to reflect the underlying securities. What matters is the underlying intrinsic value of the securities, not the medium. Take oil for example, it is also in USD. But the underlying value of oil will continue to grow because there is not much left. So USD goes down by 20%, doesn't mean oil price will go down by 20%. Am I right?

2. Counterparty risks

What if the issuer of the ETF goes down? Like Lehman. What would happen to the ETF? My understanding is that since the ETF would be held by CDP and we do own the underlying stocks with the ETF, it can be liquidated and the money goes back to us. But is that good enough? How about if the issuer decides to close the ETF bcos it's no longer popular, or whatever other reasons they might have, are they obligated to give us money back at a fair value? Say the NAV of the ETF, of which the NAV is thoroughly calculated to reflect the real NAV of the index?

3. Swap based ETFs

Some ETFs do not actually own the underlying stocks of the index they are suppose to represent but a completely different basket of stocks and the return of that basket is swapped for the return of the index. This goes for most Lyxor ETFs. So when we buy the Lyxor China ETF, we actually own a lot of European stocks, whose returns are being swapped for the return of the Hang Seng China Index. So what are the risks involved here? One obvious one would be again counterparty risk. If the swap counterparty cannot honour the agreement, then ultimately we get screwed. Say the European stocks collapsed 20% while HSCEI was up 20%. The counterparty cannot deliver, the ETF holders might get short-changed. What about other risks? I don't have all answers though.

Here are just 3 issues, but I think there are many others that we have not thought about. If anybody has any answers, pls do share, thanks!

The 7 Levels of Market Participants

This was inspired by the 7 Levels of Photographers by Ken Rockwell, which was perhaps inspired by religion. Well, in any case, here are 7 Levels of market participants, with One being the lowest and Seven being divine. Enjoy!

Level One: The Tippee

The Tippee is someone who receives a tip or some advice and wants to make a quick buck out of greed. This level of market participants usually never had a brokerage account and decided that they should make a some money from the stock market bcos everybody else is doing it. They are inevitably tipped to enter the market by friends who give bad advice at the peak of the bull market and are inevitably burnt and vow never to return. Only to do so during the next bullish peak, again tipped by another friend. In normal times, they live their quiet lives in reality, having full-time jobs and enjoying themselves like other normal folks. This level includes grandmas opening a brokerage account for the first time in their lives, taxi drivers, housewives, first time unit trust buyers, retirees and primary school kids.

Level Two: The Amateur

The amateur is a market participant who decided that he/she should dabble in the markets and learn about the intricacies of the world of investing. They are usually bold, eager to learn but lacking in knowledge and information. The amateur spends time after school or work to read up and learn more. The amateur has the potential to reach the higher levels of market participant if he/she has the determination to pursue their goals to the fullest, devoting time to learn the tricks of the trade. This level usually includes high school students or undergrads, young working professionals, semi-retired, rational investors.

Level Three: The Tradee

The Tradee is a term that I invented meaning someone who gets traded by the market, ie being played by the market. Most tradees aspire to be hotshot traders earning $10k per month but lack the knowledge or the will to pursue their goal to the fullest. Most of them never attain the status of a trader (next level). Well if they did some rational thinking, they would realize even the hottest shottest traders don't earn $10k per month unless their capital base is like close to $1mn. And if you already have $1mn, why bother trading? Tradees also don't have a robust trading system and the emotional stronghold to withstand the markets. Amateur can become tradees quite easily hence this level also includes a lot of young working professionals, semi-retirees, undergrads, housewives etc.

Level Four: The Trader

Okay a small no. of tradees do evolve into traders. These guys make the cut by adhering to their robust trading systems and rules. They definitely have their emotions under control as well. Usually they have put in a lot of effort as tradees, learnt their lessons and have proven themselves. They quit their full-time jobs to trade, making good money (unlikely to be $10k per month maybe $4-5k). They do not blog, they don't argue in forums as to whether traders are better or value investors are better. They spend their time analyzing and thinking. This level usually includes mid career professionals, ex-army officers, ex-investment bankers, PhD students and civil servants.

Level Five: The Manipulator

Now we get to the interesting stuff. Manipulators are the big boys. Much like Gordon Gekko. Their investment philosophy is buy high, sell higher. They keep asking, where's my edge over the market. Things they do are in grey zones like buying ahead of earnings downgrade by analyst. They had lunch with the analyst and he hinted. They also engage in activist moves. Like accumulating a lot of Company ABC stock, then announcing some plan to restructure the company, to be led by a restructuring guru, who is their buddy. Technically, it is all still legal, but grey. These people would include big names like ex-remisiers, high net worth stock operators, hedge fund managers, ex-prop traders etc

Level Six: The Value Investor

Ok this is the level we are familiar with. We buy value. Stocks that trade at a margin of safety below their intrinsic value. Usually mundane companies with a history of stable earnings. We spend a lot of time reading annual reports, looking at financials and if possible talking to industry people, analysts, company management etc. These level can include a whole spectrum of people including working professionals, undergrads, old-timers, fund managers, retirees and bloggers.

Level Seven: The Legend

This is the pinnacle. This are people who have seen it all, been there and done that in the world of investing. Usually they have a knack for finding value but they also have a nose for a good trade, has good macro economics background and are very smart and very diligent. They would buy value stocks only when they see a catalyst for the value to unlock. This is unlike dumb value investors who would just wait and wait. They would also go for high probability trades - like shorting Korean Won or Thai Baht after analyzing and knowing that their central banks cannot defend the currencies. They have surpassed all levels and reached the pinnacle whereby their investment philosophy is no philosophy. Using the formless to combat form. Legends are investors with names that people from all walks of life would know of, like movie stars, famous scientists and world leaders.

A Two Iteration Monte Carlo Simulation on Trading

This is something that I have posted in a comment some time back. I thought I would just expand it for discussion and see if it makes sense.

First let’s work through some assumptions and no.s and see what’s the expected return for trading.

1. The capital base is $100,000
2. $10,000 is utilized per trade
3. 10 trades is done in 1 year
4. Take profit at 20%
5. Cut loss at -10%
6. Winning rate 60%
7. Transaction cost $20

Based on these:

a. The 6 winning trades will bring in $12,000.
b. The 4 losing trades take away $4,000.
c. Transaction cost is $400.
d. Total winnings: $3800
e. Return 3.8% - Yeah that's life for a trader, my darling. Why don't you put the money in CPF and earn the same return?

Ok, there are a lot of assumptions, some might be skewed to put traders down. After all, this is a value investing blog. :) What if we tweak them around? Say the capital base is just $20,000 – then the return becomes 20%! However the rationale would then be it won’t be possible to realize 10 trades in 1 yrs with just $20,000.

Anyways let’s do a more aggressive one

1. The capital base is $50,000
2. $10,000 is utilized per trade
3. 10 trades is done in 1 year
4. Take profit at 15% (rationale being that the time horizon is now shortened)
5. Cut loss at -10%
6. Winning rate 60%
7. Transaction cost $20

Based on these

a. 6 winning trades will bring in $9,000
b. 4 losing trades take away $4,000
c. Transaction cost $400
d. Total winnings: $4,600
e. Return 9.2%

Ok that’s better than market return, but that’s probably also a high hurdle. To do 10 trades with $50k in 1 yr, reach trade can only go for 6 mths.

I think the appropriate scientific experiment we should do is a Monte Carlo simulation of 1,000 iterations to see what’s the true expected return. But my guess is it’s actually going to be less than market return (of 8% or so). Yes, actually if you do it correctly, a trader should earn positive return, not negative ones. And in all those books, it always says academic studies show that trading cannot beat market return after factoring in transaction costs.

Well this also implicitly means, if you get your transaction costs low enough, you might beat market return and becoming a Big Swinging Dick.

Ok, daydreaming over. Trading is hard. My sense is, it is actually much harder than value investing. If you do it right, you might just make average return. Most people don't do it right in the first few years. Think about the time and effort that is needed to execute these trades during the year. Basically it’s a full time job in itself. Not forgetting that it's gonna be one helluva emotional rollercoaster ride every day!

Well, that’s why I stick with value investing.

Management compensation

Needless to say, if the management team is paying themselves too well, pls avoid the company. Most annual reports of Singapore co.s these days have a section on management payout. I make it a point to find out how much they are paid.

Just some rough no.s (since I can’t really remember all the figures), the CEO pay package is usually about $1mn for a few hundred million revenue firm. For smaller co.s, it is about $500k or so. Of course, as we all know, the record is a whopping S$20mn.

What is a good sum to pay a CEO? And how to actually determine the formula for the payout? Well I don’t have a good answer, but what I do think is wrong is to base it off revenue. Bcos a firm could have high revenue but zero profits to shareholders. It is also wrong for it to be mechanical, like based on formulas. So maybe a basic package and then bonus to be based off a comination of factors like net profit growth, impact of past decisions and qualitative appraisal by stakeholders of the firm.

Well there is also the social pay scale to consider, in our crazy world where a 23 yr old analyst could be paid S$100k a year, surely we cannot expect CEOs to be paid like S$150k a year right? So actually there is a floor for CEO’s pay. Since senior managers in big firms get around $200-300k so it is not unusual for CEOs to be getting around $500k at least.

Most of the time, when reading the annual reports, you won’t find anything strange until it gets out in the news. Usually the annual report just says that top management is being paid in a range of S$1-5mn, which is reasonable, considering what we have discussed.

Strange things happen once in a while and astute investors’ warning bells should sound and put companies that pay their CEOs or top management too well on the blacklist.

The infamous case of Sing Power comes into mind. I cannot recall the whole story but apparently the compensation package for the top management exceeded the net profits of the firm or something. This was bcos is was based on some arcane formulation and the management argued that it was ok. My foot!

Noble group made the news paying 11 directors $30+mn in 2008. Not sure if this is a lot or not. Net profit was a record $500mn or so. So maybe it’s reasonable. After all, only 5% of net profits right? But I checked out their dividend payment – it was also $30+mn. Hmmm...

Of course we always have our favourite CEO who was paid $20mn – highest paid CEO ever in the history of Singapore in a year when his firm profits was down 50%. Again the formula excuse was used to justify this absurdity.

The lowest paid CEO in a Fortune 500 firm, by the way, is our favourite hero from Omaha. He pays himself US$100k annually.