Sunday, August 27, 2006

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Friday, August 25, 2006

Financial ratios

Wall Street thinks that by divided one no. by another, you can normalize things and hence comparison can be made for different co.s. Much as I despise Wall Street, I think that sometimes ratios make sense. E.g. when I divided the dollar value of all the presents I bought for my wife by the no. of times I skip washing dishes, I can determine the efficiency of the presents. It works out to be $12.6 for per dishwashing session. Anyone needs some financial planning on dishwashing?

Anyway, below is a non-exhaustive list of financial ratios and their meanings.

1) Operating Margin (OP/Sales): Efficiency of the firm's operations, this no. range from -90% to +90%, the higher the better.

2) Asset Turnover (Sales/Total Asset): Efficiency of the firm's assets in creating sales, this no. is usually 1.x, the higher the better.

3) Return on Equity (Net Profit/Equity): Rate of return attributed to shareholders, this no. is usually 5-40%, on average around 20%, the higher the better.

4) Return on Asset (Net Profit/Total Asset): Rate of return attributed to the whole firm, this no. is usually 2-30%, the higher the better.

5) Dividend Yield (Dividend per share/Share Price): Rate of return of dividends, this no. is usually 0% to 10%. In Singapore, anything higher than 5% is considered very good.

6) Other ratios that we talked about: PER, PBR, Net debt-to-equity, cash-to-market cap, EV/EBITDA. For most valuations ratios, the lower the better.

7) Another 10,016 ratios that we did not talk about, created by Wall Street analysts. Maybe you can still find 1 or 2 useful ratios in there.

Essentially ratios are quite useful when you want to analyze a company but try not to be a cult leader and read into ratios religiously. By that I mean you try to contemplate if $12.5 per dishwashing session is more efficient that $12.6 per dishwashing session. They are useful but not that useful. They give a sense of how the company is performing, you still need to do more homework after that.

Wednesday, August 16, 2006

Investing cash flow and financing cash flow

Investing cash flow (or CFI) is usually the 2nd portion of the cash flow statement and it measures the money that the firm use for its investment activities. The most important no. here is the capex no. Capex is also known as capital expenditure which what the firm needs to invest in (usually in new equipment, new technology or new offices etc) in order to stay competitive in its business.

This no. however is not labelled as "Capex" in the cash flow statement but usually goes by some obsure label like "Acquisition of New Property, Plant and Equipment". Why is this so? One good reason that I can think of is because auditors love to make life difficult for a lot of people and sell-side analysts, investor relations managers get to keep their jobs by having to explain what "Acquisition of New Property, Plant and Equipment" really is.

Other no.s that goes into investing cash flow will include:
1) Sale of Property, Plant and Equipment (opposite of capex)
2) Purchase and Sale of Investment Securities
3) Acquisition of new subsidiaries or associated companies etc

Financing cash flow (or CFI) is usually the last portion in the cash flow statement and it deals with the financing needs (both equity and debt) of the company. This would usually involve repayment of debt, or increase in borrowing, dividend payment, capital reduction or increase in equity etc. It would be useful to observe how the company is changing its capital structure from this part of the statement. In Singapore, a lot of companies are trying to reduce its equity base (SPH, Singpost etc) in order to make some financial ratios (like ROE) look good and also to return money back to their No.1 shareholder: Temasek Holdings. Of course, minority shareholders will stand to benefit as well, hence while it last, it would not be a bad idea to invest in these stocks.

The Cash Flow Statement

The last of the three financial statements is the cash flow statement. To most people, the cash flow statement is of least importance and perhaps that is why it is always found after the other two. However, it is also where you can find the truth about companies. As academics put it, it is easy to manipulate earnings, costs or even sales but it is much harder for companies to manipulate cash flows.

Cash flow measures the actual inflow and outflow of cash into and out of the firm. Hence while sales can be manipulated (e.g. by recognising sales from the future), a cash outflow is a cash outflow. A company that has a poor cashflow is something to look out for. It is usually an early warning for bigger trouble to come. Avoid at all cost.

The cash flow statement is also further classfied into various sub segments namely
1) The cash flow from operations or operating cash flow (CFO)
2) The cash flow from investments or investing cash flow (CFI)
3) The cash flow from financing or financing cash flow (CFF)
The most important no. to look out for is undoubtedly the operating cash flow. This no. measures the actual cash inflow from the firm's core operations and it should always be a positive number. If it is not, it means the company cannot earn money from its businesses and all alarms should sound and you should sell the stock if you own, and avoid at all cost if you don't.

Risk, Return and the Markowitz Portfolio Theory




Harry M. Markowitz won the 1990 Nobel Prize for telling the world two fundamental truths about investment: "Higher risk, higher return" and "Don't put all your eggs in one basket". Much as I sounded as if he did not deserve the Nobel Prize, I must point out that his findings were mathematically elegant, and the important implications of his modern portfolio theory still hold true in today's investment arena.

To briefly summarize what was his theory all about, we need to assume that markets are efficient. The efficient market hypothesis essentially assumes a lot of things that do not make sense but academics love them anyway. Just to mention a few, efficient market assumes that all investors are rational, zero transaction cost and that information flows freely etc. These we all know are not true all the time (maybe only 70% of the time).

However, that is not the point, the point is once we assume markets are efficient, according to Markowitz the only way we can make more money is to

1) To take more risk (by investing in riskier assets)
2) To diversify (by investing into different asset classes which are not correlated)

This is graphically represented above in what is known as the Efficient Frontier. The Efficient Frontier represents the maximum return that can be achieved at a specific level of risk. If an investor wants to achieve a higher rate of return, she can invest in riskier assets, like equities or venture capital (Higher risk, higher return). This can be easily visualized as shifting from one point (e.g. Bonds) to another point (e.g. Equities) on the right of the same Efficient Frontier. She can also choose to invest in many different kinds of assets (commodities, real estate etc), this will push out the Efficient Frontier (a parallel shift of the whole Efficient Frontier upwards), enabling the investor to reap more return for any given level of risk.

The players

Know yourself, know your enemy and you can fight a hundred battles and win a hundred battles. This timeless quote from Sun Tze holds true for players in the stock market as well. Although a true value investor would not worry about matters other than those that are related to the intrinsic value of the company, one must be mindful of the forces that move stock prices. This would allow us to buy a good company at cheaper prices and also help us determine when to take profits.

As a basic introduction, here is a (non-exhaustive) list of players in major markets

1) Institutional investors (mutual funds, pension funds, etc)
2) Hedge funds (Macro, long-short, long-only, arbitrage, quant)
3) Brokers (Investment banks, traders, investment arm)
4) Retail investors (rookies, day-traders, investors)

Institutional investors continue to be the major class of investors in the world. They usually invest in benchmarks (like STI, S&P or Nikkei) and their investment activities revolve around their benchmarks as well. Hence on average they are the trend-followers rather than the trend-leaders. (Of course there are the top fund managers who can identify trends way before everyone else.)

Perhaps the most important takeaway is that hedge funds have become a major force in the markets. Hedge funds are usually small investment outfits that invest with radical strategies to make a lot of money with leverage. Hence the name "hedge fund" is actually a misnomer. Hedge funds take a lot of risk to produce their desired return. They are responsible for a lot of volatility in stock prices nowadays and they are increasing their asset under management, for better or worse.

Expected earnings vs actual earnings

The stock market moves on expectations, not on its actual performance. If the market expects Firm A to grow its earnings by 20% for the next 5 years, the stock will rally 100% in the next 5 weeks. It does not matter if Firm A can actually grow its earnings 100% after 5 years. Similarly, if the street expects Firm B to miss its forecast, Firm B's stock will not wait for the announcement and then plunge. It will plunge today.

For the lack of a better way to describe this market phenomenon, I used earnings, but it can apply to everything, from favourable regulation changes to M&A rumours. The stock moves on what the collective thinking of all the investors point towards to and not the actual scenario that will eventually play out. If one can understand this, it is easy to see that this phenomenon has two impact:

1) The market may be wrong, but since the actual scenario does not happen immediately, at the meantime, the market is right. Hence the saying "the market is always right".

2) The market may be right, but it will almost always overreact (e.g. factoring 5 yrs of earnings in 5 weeks) and the scenario is played out in a shorter time frame than expected.

In the long run, the market moves towards the actual scenario and the market corrects its past mistakes. Hence value investing, by trying to estimate the intrinsic value of the company, stands the test of time and the idiosyncracies of the market.

Cash and Debt

Perhaps the most important information that can be derived from analysing the balance sheet is whether the company has good financial health. This is determined by how much cash or debt the company holds.

Needless to say, a company that has no debt will be better than one that has. But what is the optimal level of debt? The academic answer will involve corporate finance and things like WACC which I hope to touch on in future, but not now. For a rough gauge, perhaps we can look at two simple ratios.

Net Debt to Equity ratio
Cash to Market Cap ratio
For a company that has debt, we first subtract cash from its debt to get its net debt level. Next we simply divide its net debt by its shareholders' equity. E.g. Firm A has $100 Debt but $20 Cash and $80 Equity. Hence Net Debt to Equity = (100-20)/40 = 1. This means that Firm A employs as much debt as equity to finance its business.

In Singapore, a company with a Net Debt to Equity ratio of 1 or 100% is considered very bad since most listed companies here has no debt. This is especially true for the best companies around.

Now if the company has no debt, then how much cash is enough? The other ratio that people look at is the Cash to Market Cap ratio. This is simply taking cash that the company holds divided by its market capitalization. I would say that a ratio above 20% would be considered very good. This ratio rarely goes above 50% because if it does, essentially you are buying for the company's operations at a 50% discount. To illustrate, imaging that a company has a Cash to Market Cap ratio of 100%. Essentially, you bought the company for free, because its cash would have paid you the amount you forked out, plus you get the company's business which will continue to generate cashflow FOC.

Components of the balance sheet

The balance sheet can be further broken down to is various components. Assets can be broken down into current assets and non-current assets. Liabilities can be broken down into current liabilities and non-current liabilities. These sub-levels will consist of individual components that makes up the basic building blocks of the balance sheet. Below is a list of important items to know:

Assets

- Current Assets
Cash
Marketable securities or short-term investments
Accounts Receivables
Inventory
- Non-current Assets
Fixed Assets (Property, Plant and Equipment (PP&E)
Intangibles
Long-term investments
Liabilities

- Current Liabilities
Accounts payables
Short-term borrowing (short-term debt)
- Non-current Liabilities
Long-term borrowings (long-term debt)
Other long-term liabilities (pension liabilities, deferred tax liabilities etc)
Shareholders' Equity

Paid-in capital
Retained earnings

Why does the balance sheet balance?

The balance sheet balances because that is how it is defined. By definition,

Assets - Liabilities = Shareholders' Equity

Hence on the balance sheet, Assets are shown on the left, Liabilities and Shareholders' Equity are shown on the right. To illustrate, assuming a start-up company borrowed $100 to buy a printer that cost $200 with initial capital of $100. Its balance sheet would look like this:

Assets (printer) $200
Liabilities $100
Equity (or initial capital) $100
Assets $200 - Liabilities $100 = Shareholders' Equity $100

This has to be the case because initial capital and borrowing add up to the value of the asset that the company has for it to run its business. Now assume that after 1 year, the company generates $20 of profits by printing and selling digital pictures. Its balance sheet would look like this:

Assets $220 (Printer $200 + Cash from profits $20)
Liabilities $200
Equity $120
Assets $220 - Liabilities $100 = Shareholders' Equity $120

Again the balance sheet balances because any entry into any parts of the balance sheet would have a corresponding cancelling entry on another part. In this case, Assets increases by $20 and Equity by $20 as well.

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

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

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

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

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

COGS & SG&A

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

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

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

Hence the total cost of the company would be COGS + SG&A, and whatever profits that remain would be the Operating Profit or EBIT.

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

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

1) Sales or Revenue
2) Cost of Goods Sold (COGS)
3) Selling, General and Adminstrative Expenses (SG&A)
4) Operating Income or Operating Profit
5) Recurring Income or Recurring Profit
6) Extraordinary Gain or Loss
7) Profit before Tax
8) Net Profit

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

In recent years (esp so during the dot.com boom), a lot of listed co.s could not even generate a positive operating profit (i.e. their core business was losing money after factoring in the relevant operational cost). Hence analysts invented another no. called EBITDA which stands for Earnings before Interest, Tax, Depreciation and Amortization. This means that if we do not take into account depreciation cost, the co. is making money.

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

Fear and Greed

In simple terms, fear and greed affect investors' decision by impeding their ability to think rationally. A good investor tries to detach emotions from decision making but it is easier said than done. Let's try to see how they actually work to deter investors from making good investment decisions.

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

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

Of course, fear and greed also helps in the opposite scenarios. For e.g. in the first case, the bear market might continue for 2-3 years, and by waiting, the investor could have bought the stock at an even lower price. I guess the moral of the story is to be mindful of these emotions, understand that they will affect your decision making and try to implement ways of going around them in your investment process. One tried and tested method would be looking at valuations, and use valuations to determine your trades i.e. only buy stocks that are cheap, in fact very much cheaper than its intrinsic value.

The three important principles of successful value investing

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

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

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

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

To give an example how this can work, let's pick a local stock, say, Singtel. Fundamentals for Singtel looks ok, it has not made any losses for the past 10 years, it has maintained low debts, and management seems prudent and competent. Within its industry, clearly Singtel has the dominant market share in Singapore, regionally subsidiaries of the Singtel group also seem to be doing well and reasonable growth can be expected.

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

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

The guru, Mr Buffett does not believe that timing is important. In his view, a good stock should be bought as soon as you identify it, if it goes lower, you should buy even more. In a way, low valuations will take care of timing, i.e. low valuations ensure that you have bought the stock at the right time (and price). Also, according to the guru, once you buy a good stock, you should never sell (this is also called the buy-and-hold strategy) no matter what. Unless you need the money for other purposes.

How to read financial statements - the very basics

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

1) the balance sheet
2) the profit and loss statement or the income statment
3) the cashflow statement

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

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

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

To use an household as an example, the balance sheet will list down the household's assets, liabilities and equity. Assets are usually HDB flat, car, furniture, cash savings etc, liabilities are mortgage, renovation loan, study loan, credit card debt etc, and equity is what is left. Sad to say, 70% (my own guess) of Singaporean households probably have no equity to speak of, because our liabilities (mortgage, car loans) are usually much more than our assets (value of our flat, car etc).

The profit and loss statement of the household will be salary on the top (sales for companies though), followed by all the expenses, until we arrive at net income, which could be added to the balance sheet at the end of the month or year (i.e. any money left after all expenses goes into savings = equity for the household). The cashflow statement would be actual cash movement, i.e. salary that was transferred to our bank (cash inflow), how we have spent the cash on food, leisure and mortgage (cash outflow) .

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

Value vs growth

In investment lingo, one way of classifying stocks is to label them as either value stocks or growth stocks. Value stocks are what we have been discussing all this while, stocks that trade below their intrinsic value, come from understandable and mundane industries (insurance, utilities, consumer staples), low PER, low PBR, stable earnings streams etc.

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

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

Value trap and the cigar butt analogy

Value trap is a stock that looks very cheap but the reason it is super cheap is because it is a crappy company and deserves to be that cheap. Buffett likes to give the analogy of the cigar butt. Imagine finding a cigar butt that someone just finished smoking, but there is still a last puff left. The cigar comes free but you get one puff, which doesn't make you feel one hell of a good.

To give another example, a value trap is similar to doing shopping at Ikea, you get super cheap stuff but their worth is also just that. Yet another example would be "you pay peanuts and you get monkeys", sounds familiar?

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

Circle of Competence

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

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

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

Definition: Value investing

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

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

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

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

Securitizing yellow-top taxis and workings of the stock market

The stock market is, in its original and actual intention, a place for business owners to "borrow money". The difference is that the borrower, instead of paying interest to the lender, agrees to sell a part of his ownership of the business (i.e. his stock) to the lender. The lender can hope to receive dividends from the borrower when the business do well, or sell his ownership to yet another person. This ability to transfer ownership from one person to another, for better or for worse, leads to the creation of something that humbles even the most intelligent: the stock market.

To make things simpler, let's try to understand the stock market with an analogy. Imaging a yellow-top taxi driver one day decides to sell his ownership of the taxi to 100 other people. (Yellow-top taxi drivers own their taxis, other drivers rent their taxis from companies like ComfortDelgro, SMRT etc). The 100 new owners can also sell their 1% ownership (i.e. their stock) to other people. Now imagine another 99 yellow-top taxi drivers do the same, selling 1% of their taxis to 100 people, we have just created a "stock market" for yellow-top taxis with 10,000 investors/traders. Depending on the ability of the different drivers, the stock of some taxis will sell at a higher price than others. Some stocks will fall and some will rise, driven by people's perception of the ability of the different taxi drivers and, well, almost anything else one can think of, from no. of new taxis coming on stream to say, the weather.

Now, how would you choose which taxi stock to buy? Based on the driver's ability? Or rumours of another 5 new taxi companies coming to the market? Or looking at weather forecast? Or by looking at how his stock have traded in the past week? Buying a stock hoping to earn a profit in one day or one week completely misses the point. To buy a stock is, in effect, to become the owner of the company (or the taxi). Surely this decision should be based on solid fundamentals of the company (or the driver) and also the stockholder's long-term conviction that the company will continue to perform in the future.

Lemmings and herd mentality or herd behaviour

Lemmings are small rodents usually found in the Arctic. They breed very quickly and when their population reaches a certain critical mass, they are known to commit mass suicide by leaping off the cliff. This strange behaviour of Lemmings continue to puzzle many scientists but some believe that stress incurred by scarcity of food and overcrowding causes Lemmings to behave abnormally.

Most investors in the stock market, according to the guru, behave like Lemmings reaching a critical population mass. They begin to mindlessly follow others, sell when the market is falling like crazy, or buy more when the market is already over the top. This is why markets crashes or goes into bubble mode so often. In investment lingo, this is also known as herd mentality or herd behaviour.

For some people, it may sound stupid to mindlessly follow the crowd, but essentially, we humans like to follow trends, be it going after the latest fashion (Prada bags anyone?), business ideas (remember bubble tea from Taiwan?) or hot stock ideas (CAO, ACCS, ouch!). Next time you think about jumping on some bandwagon with no concrete positive story, remember the Lemmings, and the cliff just round the corner.

Mr. Market

The stock market is difficult to understand. The guru, Warren Buffett, likes to describe the market as a person who is always ready to buy or sell you a business, but the problem with him is that he is very emotional. Buffett calls this person Mr. Market.

On some days when Mr. Market is very happy, he sees everything in an optimistic light and he will sell you a business at a very high price. On other days, he will be depressed and can see only doom and gloom, and will sell you a business at a low price.

You are free to transact with Mr. Market on any day, or not transact at all. He will always come back tomorrow and quote you a different price. Depending on his mood, the prices will be all over the place. You are free to take advantage of him, and buy a good business from him on his down days, or sell him a bad business when he is feeling on the top of the world.

However, you should never be influenced by his mood, i.e. you too, start feeling super happy on days when he is also happy, and buy a lousy business from him at a high price. Millions of individual investors never understood this, so they never take advantage to buy a good business at a cheap price from Mr. Market when he is feeling sad, but instead, only buy from him when he is bright and sunny.

Investment Philosophy and Process

An investment philosophy is a set of rules or guidelines that you abide to help you navigate through treacherous markets (like the recent meltdown). Just as in life, most of us have moral principles that we abide, for e.g. we do not steal or commit adultery, we value life and are fillial to our parents, loyal to friends etc. In investment, you must also lay down the rules, and learn not to break them. Collectively, this set of rules and principles will be known as your investment philosophy and will serve you well in time to come.

An investment process is the execution. It will determine how you start looking for stock ideas, when to buy them, when to sell, what are the maintenance research that you have to do etc.

The investment philosophy that I subscribe to, is similar to that of the world's greatest investor. I look for

1) Stocks that are cheap, i.e. trading below intrinsic value
2) Margin of Safety: chances of losing money are minimized
3) Stocks that pay dividends

The investment process that I subscribe to, though not similar to the guru, hopefully make sense to most people

1) Observations in daily life to come up with stock ideas
2) Wait for a good time to buy (i.e when the stock falls)
3) Know when to exit in both cases where a) things go as expected, b) things did not go as expected

Investment philosophy and process evolves over time and is different for everyone. A day trader will have another set of guidelines and process, but the most important rule is never to deviate from your own philosophy. In life, to stray away may give you temporary satisfaction, but never the peace of mind. In investment, to stray away may give you temporary rewards, but will not help you make money over the long run.

Price to book

Besides the price earnings ratio, another widely use valuation metric is the price to book ratio, or PBR. This is simply price of the stock divided by its book value per share.

The book value of a stock is also called its shareholders' equity which is whatever that is left for shareholders after all its assets are sold and all its liabilities are paid off (shareholders' equity = assets - liabilities)

By right, a stock should never trade below its book value, because this means that we should sell everything the co. has, pay all its debt and distribute what is left back to shareholders, which is more than the stock price on the market. So theoretically, one can arbitrage when a stock trades below its book value.

In reality, stocks do trade below book value for a variety of reasons, and as Warren Buffett learned, buying each and every stock below book value does not guarantee good return.

The Efficient Market Hypothesis (or EMH), its myth and reality

The Efficient Market Hypothesis states that stocks or other investment instruments always trade at their fair value (or intrinsic value) because investors always react rationally to new information entering the market and prices would instantaneously reflect this. Hence it is futile for people to try to beat the market (i.e. try to earn more return than the average market return) through stock-picking or by other means. The only way to earn higher return is through taking more risk.

In everyday life, this is similar to saying it is very hard for you to find money on the ground while shopping along Orchard Road, because chances are someone has already picked it up.

However, if the EMH is true, and nobody could beat the market, how do we explain Warren Buffett, or Peter Lynch? These are people who has beaten the market for not 1-2yrs but 20-30yrs, and they made 20-30% per annum, far higher than the average of 8%.

As with most things in life, I think the truth is somewhere in between. The market IS efficient and it is hard to find undervalued stocks, but there are people who are "six sigma events", like Tiger Woods, Michael Jordan, Mother Theresa, Albert Einstein and Warren Buffett. With effort, practice and knowledge, we can still invest and make money, we may never earn 30% p.a. but 8% p.a. is not unachievable.

Margin of Safety

The margin of safety (probably coined by the guru or his predecessors) is a concept of buying investments that are significantly cheaper than its intrinsic value. The key word here is "significant". We need to buy with a margin of safety to minimize the risk of losing any money.

Going back to my favourite analogy, let's assume that our friend bought the golden tap to re-sell it to another buyer. According to his calculations (see previous entry), which was the same as ours, the golden tap is worth $1060, and he bought it for $1000. So he could have sold the tap to another buyer who is willing to pay $1060 and he earns $60.

However as you can see, this trade does not have a margin of safety. What if the tap is actually worth $900 because our assumptions were wrong? What if gold dropped 10% the next day? If he bought the tap for $500, then the trade would have earned the praise of the guru himself, by having a good margin of safety.

What is the intrinsic value of a golden tap?

The intrinsic value of a stock or an investment is its true or inherent value based on some valuation method and it is usually different from its market value.

Going back to my favourite analogy of the golden tap, I would like to ask this question: what is the intrinsic value of a golden tap? We know that the market value is S$1000, well because someone paid that much for it. But is that its true or intrinsic value? To calculate this, we make a few simple assumptions.

1) The golden tap used 28g or 1 ounce of gold
2) Manufacturing, processing cost is S$100 (10% of S$1000)
3) Price of gold at the time of purchase was US$600 (or S$960) per ounce

Adding up the no.s, we have S$100 + S$960 = S$1060, the intrinsic value of the golden tap according to my valuation method. So, our friend did not overpay for his golden tap.

In our example, intrinsic value = market value, but in reality that is rarely the case, more often than not, market value is greater than intrinsic value. For luxury goods, like a Prada bag, market value is probably 10-20 times more than its intrinsic value, in my opinion. (However, there are different valuation methods to derive at a product's intrinsic value. Perhaps a Prada bag owner's valuation method is something like: $10 cost of leather, $990 ability-to-show-the-world-I-own-a-Prada-bag).

The goal of investing, is to find an investment which has an intrinsic value significantly higher than its market value. This kind of investing is also known as value investing, pioneered by Benjamin Graham and David Dodd and later Warren Buffett, the world's most successful value investor.

Investment cannot make you filthy rich, if your last name isn't Buffett

Considering that investment can only make 5-8% on average in the long run, we cannot expect investment to bring home the bacon, can we? Going back to my first blog, an average Singaporean earns S$2k per month, assuming that she can save S$1k every month, which is very optimistic (i.e. S$60k after 5yrs) and she starts to invest after saving S$60k. She earns 8% of S$60k = S$4.8k per yr, which is S$400 per mth. Well not enough to buy a tap for some, enough to eat, pay off some bills for others. Not exactly a huge amt.

So my point is: investment can give you incremental income, if you invest as well as an average investor on Earth. It cannot make you filthy rich. To invest as well as an average investor, you need to put in a lot of work into analysing the stocks or investments you want to buy. Sometimes it might be better for you to teach tuition to primary school kids and earn as much.

If your last name is Buffett, the story turns out to be quite different. You might have made 30% annual return on your investments for the last 40 years and earned US$30bn, which doesn't necessary count as incremental income. Too bad most of us are Lees, or Tans, or Ngs.

Market capitalization

Market capitalization (a.k.a market cap) is simply the share price x the no. of outstanding shares that the company has issued. It is a measure of the "perceived" value of the company. To paraphase, market cap is what the participants in the stock market thinks how much a company is worth, it may or may not reflect its true value, or the intrinsic value of the firm.

Great company, good stock but not a good buy

One important tenet about investment is to separate a good stock from a good investment. What do I mean by that? A good stock or a good company is one that consistently delivers earnings, capable of making good strategic decisions, always one step ahead of competition and the leader in its field. Essentially the WalMarts, the Googles and the Toyotas of the world. A good company however may not be a good investment, because its "goodness" is already factored in the share price. A good investment is buying a good company at a cheap price. That is, buying WalMart 30 years ago, when nobody has heard of it and when it was trading at a huge discount to its intrinsic value.



As an analogy, take the Dom Perignon champagne. It cost roughly S$200 per bottle. Is it expensive? To answer that we need to know its true or intrinsic value. For consumer products, an easy way is to breakdown its cost components. For the champagne, probably goes like S$50 labour, S$30 processing, S$20 packaging, S$10 logistics, S$10 admin cost (I am arbitrarily putting in no.s here), the rest of it the Dom Perignon's brand, taste, prestige and heritage. When you buy a bottle of Dom Perignon for S$200, you are paying all these, so you probably did not overpay or underpay. In other words it is fairly priced. When you buy a great company like Google, or WalMart, it is the same. Chances are you are not buying them at a bargain price. This is what it means: its "goodness" is already factored into the share price.



So how do we find a stock that is a good investment? That is the question, isn't it? Good investments don't come by easily. One has to dig, to search, often to find that it is not so good after all. But they do exist. At least the guru, Mr Buffett managed to find 12, and that made him a billionaire.

Price to Earnings ratio, P/E ratio, PER

The P/E ratio is simply the price of the stock divided by its earnings per share. It is the most widely used yardstick to value a stock (i.e. to see if the stock is cheap or expensive). In short, P/E is the same as trying to determine the value of a product by dividing its price by its quality. Here the quality of the company is determined by how much money it makes. To give an analogy, Car A and Car B sells for $10,000 and $20,000 respectively, A saves $200 of petrol per year while B saves $500 of petrol per year after driving the same distance. Which is a cheaper car? Answer: Car B, because the Price / Petrol Savings is lower for B ($20,000/$500 = 40) than A ($10,000/$200 = 50). Similarly, a stock with a lower P/E ratio is cheaper stock, because for a certain price, you are getting better quality (i.e. the company generates more earnings). Historically, P/E for major markets have fluctuated from 10 to 40. (40 during the IT bubble). P/E ratios of individual stocks can be as low as 2 or 3. This simple but effective rule has been proven to make money over the long run.

The P/E ratio might be the single most important no. in investment as it gives an investor a quick and fairly accurate sense of how much a company is worth. Over the years, analysts and academics developed other valuation metrics like EV/EBITDA, EVA (with a copyright) PEG ratio etc, but nothing beats the simplicity of P/E. Surprisingly, most retail investors probably never heard about this when they buy their first stock and mainstream business news fail to mention this important ratio most of the time.

How much money do you need in a lifetime?

How much money do you need in a lifetime? Or rather how much money would be enough for one to lead a reasonable life? There is a simple answer, and a difficult one. I calculated the simple one, based on average spending per month, multiplied by, say, 50 yrs, depending on how you spend, it can be anywhere between S$1mn to US$20bn. For me, it is roughly S$3mn (S$5k (monthly expense, including mortgage) x 12 (mths in a yr) x 50 (years) = S$3mn). That's easy, because it is based on my assumptions of what is enough to lead a reasonable life today, undoubtedly, these will change for people in different phase of their lives. So the difficult question is, what constitutes "enough to lead a reasonable life" for everyone. There is no answer, because everyone has different assumptions and the assumptions change over time. For an average Singaporean, with a monthly pay of S$2k, which they spend most of it, that number is close to S$1mn. For Bill Gates, that may be US$20bn.



But is it important to know how much you need in a lifetime? Yes. Knowing one's own spending capacity is probably the most important aspect in personal wealth management. It is both the basis and goal for investment and wealth management. It allows you to understand your financial needs and how you should go about fulfilling those needs.