Saturday, September 30, 2006

Investing in a professional-managed fund

When putting money in a professional managed fund, it is important to gain an understanding into how the people behind it operate and behave. Professional managed funds includes Insurance companies, Institutions, Pension Funds, Mutual Funds or any funds that are managed by professional money managers.

As these funds are usually Other-people-money, it is wise to understand how they operate. People do not usually take as much diligence in guarding other people asset more than their own.

In the fund industry, often if not all the time, money managers follow the herd mentality. Money managers are always rated relative to how the index does. Even if a stock is extremely overvalued, for instance, Amazon during the dot-com boom at USD400 per share, many funds are buying into the stock then. If a fund manager blanched at paying $400 for a profitless bookseller, and as a result his fund returned only 15% return when all the rest who bought the stock return 20%, he could expect to lose investors, at least part of his bonus, and possibly his job. On the other hand, if he took a gamble on Amazon, along with everyone else, he would be safe. Even if the whole internet sector blew up, and he lost, say, 15% of his client’s money, he would not be blamed as long as his benchmark index lost 15% or more.

So if you are a professional portfolio manager, the best way to keep your head down is to invest with the herd. More than ever, money managers are judged and rewarded based on their relative performance – how well they did when compared to a benchmark index or to their peers. For them, the greatest risk is not losing money; the greatest risk is missing the upside if the market continued to go up.

A prudent individual investor would not eat relative performance. What matter to him is absolute performance – the dollar value of his portfolio in 5 or 10 or 15 years.

The risk for money managers is more on career risk than investment risk. What counts is the past 6 month performance. Even if they lose 15% of the client’s money when the benchmark index loses 18%, they are the seen as the star performer of the industry.

Friday, September 29, 2006

Creative accounting

In recent times, honesty has eroded. It was once pretty easy to tell the good guys from the bad. Back in the 60s, virtually all of America's most-admired firms avoided deception. And most investors at that period knew who was playing game.

Now, many major corporations still play things straight, however a significant and growing number of executives have come to the view that it's fine to manipulate earnings to satisfy what they believe are Wall Street's desires. In fact, many think this kind of action is their duty with the intention of so-called "maximizing shareholder's value."

These managers too commonly start with the assumption that their jobs is to encourage the highest stock price possible - something which I adamantly disagree. To achieve this aim, at first, they strive for operational excellence. But when operations don't produce the desired result, unadmirable accounting tricks - alternatively known as creative accounting - take place. This either manufacture the "desired outcome or earnings" or set the stage for them in the future when needed.

Creative accounting is not illegal. As what Michael Kinsley said: "The scandal isn't in what's done that's illegal but rather in what's legal."

Managers rationalize this behaviour oftenly by saying that shareholders will be hurt if their stock is not fully-priced, and they also argue that in using creative accounting, shareholders are getting what they want. Once such an "everyone is doing it" attitude takes place, ethical misgivings vanish.

An instance of a legitimate accounting entry that is highly questionable is one-time expenses such as "restructuring charges", an accounting entry that is often a device for manipulating and misleading real earnings. In some cases, a large chunk of costs that should rightly be attributed to a number of years is dumped into a single quarter or year, usually one that is already fated to disappoint investors. In other cases, the aim is to clean up earnings misrepresentations of the past, and in others, it is to prepare the ground for future misrepresentations. Many times, wreaks like these are often swept under the carpet discreetly under the nose of innocent and ignorant investors. In both cases, the size and timing of these charges are dictated by the cynical proposition that Wall Street will not mind if earnings fall short of $5 per share in a given quarter, just as long as this shortage ensures that quarterly earnings in the future will constantly exceed expectations by 5 cents per share.

In the acquisition arena, restructuring is often an art form. In many cases of leverage buyouts, business is acquired wholly, then brought private, spruce up with condiments, and then take it public again. In this short period, they can turn a dollar into 3 dollars easily when they sell the business back to investors. Acquisitions and mergers are all about rearranging the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings. An instance will illuminate the case. When a business is acquired, the buyer sometimes simultaneously increases its loss reserves, often substantially. This boost may reflect the previous inadequacy of reserves. But such moves set up the possibility of "earnings" flowing into income at some later stage, as reserves are release later when they explain the earlier reserves were overestimated. When deals occur in which liabilities are increased immediately and substantially, simple logic tells us at least one of the virtues have been lacking or the acquirer is setting the framework for future infusion of "earnings."

As pointed out by Warren Buffett on a true story that happened in the 90s: "Here's a true story that illustrates an all-too-common view on corporate America. The CEOs of two large banks, one of them a man who'd made many acquisitions, were involved not long ago in a friendly merger discussion (which in the end didn't produce a deal). The veteran acquirer was expounding on the merits of the possible combination, only to be skeptically interrupted by the other CEO: 'But won't that mean a huge charge,' he asked, 'perhaps as much as $1 billion?' The 'sophisticate' wasted no words: 'We'll make it bigger than that - that's why we're making the deal.'"

So, in a great and honest management, they would rather disappoint you with earnings than with their accounting. Meeting Wall Street earnings forecast does not play much of a factor to them. They will spend more time on work that increases the real earnings of the business than to spend more time attending to investor relationship answering to what Wall Street wants to hear.

Thursday, September 28, 2006

Is Productivity good or bad? (Part 2)

Ultimately, the consequence of a productivity bubble would be unemployment. In a piece published by David Tice’s, Donald Perry used a story to make the point.

“Basically, productivity in the coop increases when chickens lay more eggs per day,” “Early on farmers noted that hens could produce more eggs when confined to a cage, instead of running around searching for food, being chased by cocks or having to evade predators. To understand productivity as it relates to the economy substitute the word ‘chicken’ for ‘worker.’”

However when more eggs are produced, eventually the price of eggs will fall. The egg business at best will tread water. Too many eggs, like too many cell phones or computers, leave the chicken farmer with little power to raise prices. The solution for the farmer is “to send some of the chickens to Campbell’s.” – ending up literally in their soup. The farmer then has fewer chickens to feed, gets the highest average output per chicken, and makes a little extra money in the process.

In the real world, however “human chickens are not sent to Campbell’s,” Perry pointed out, “they get unemployed and buy fewer goods.” And when there are fewer buyers, the excess of eggs becomes even greater. Now obviously, the market corrects itself by “wringing out the excesses.” Ultimately, many egg farmers are going to go out of business. So when you someone touts productivity gains you should be think logically if productivity is after-all a good thing. It could mean “Who will be going out of business next?”

A boon in anything may or may not be due to logical reasons one needs to always ask why. Rising productivity “makes economic sense when production rises faster than ‘hours worked’, but it makes little or no sense when – as in recent years – hours worked fall faster than rising productivity.”

When productivity gains are linked to jobs vanishing, we see no miracle.

Is Productivity good or bad? (Part 1)

Generally, when people talk about “Productivity”, they are referring to the amount of goods and services the nation or economy produces per hour. In recent times, the dues given towards a higher productivity rate has often been overrated. In part, this is due to human nature thinking that anything that is going up must always be beneficial or advantageous. In today world of the “New Economy” – a term coined in the late 90s – the productivity miracle depended to a fair degree, on a blind fate.

In theory, when businesses produce more per worker, they increase profits and raise wages which will in turn allows worker to spend more to drive the economy upwards when they feel richer. Indeed, with the emergence of new technology, it helps spur productivity to yet another level.

When productivity increases, it means there is more supply to cater to the existing demand. Whatever that are produced must be absorbed by the consumers. If productivity increases to a level where demand cannot catch up, there will be a big problem. Businesses will have to reduce their prices to clear stocks.

Many believe spending on new technology gives an edge against their competitors. However, when a technology that is readily available to the market, everyone can buy the same thing. In the end, the only one who benefit is the consumers. If a business intention of capital expenditure is to increase profit, in this case, many in recent times, did not achieve this aim. To the contrary, when business sink billions into technology willy-nilly, more capacity becomes excess capacity and as supply swamps demand, profits plunge. This cannot be any much truer for those who operate in very competitive market. This is precisely what happened in the late 90s when prices of computers plunge – Intel, Dell and so on have been forced to cut prices.

Every now and then, productivity level of the country will be published. In a world where productivity is greatly influence by technology, the figures given is only a very rough gauge at best – often figures are revised due to counting errors. So what are these counting errors? The problem is it is very difficult to assess the value of the new technology. Until it is set to profitable employment, a computer is just a piece of furniture. Like a piano, its utility depends on the individual. He may play “The moonlight Sonata” or simply “Happy Birthday.” So like most on Wall Street, a rosy picture is often painted. The new economists simply estimated the value of technology produced by the new economy by assuming all individuals studied at Juilliard.

Wednesday, September 27, 2006

The Buying Opportunities

Here are 3 ways in which value is higher than price and thus, each of this presents an opportunity for an investor to buy.
  1. When values increases while price stays flat - Many value investors take advantage of this opportunity. For example, General Electric has been creating value while its price have fallen from previous high and stagnated. Eventually when companies continue to create value, the market will give them their due.
  2. Price falls when value stays flat or even increases - Unfortunately, the opportunities are so rare that you have to be there when it happens. In the late 90s and early 2000, Berkshire Hathaway stock price fell by almost half. Why did it fall so drastically? Perhaps many people thought Warren was losing his touch because he is technophobic. Or people thinks Berkshire being a holder of many business is holding some tech stocks too. Berkshire, was however creating value.
  3. Price rises while value rises even higher - This method can be tough for most traditional value investors.

Sunday, September 24, 2006

Managing greed and psychology

In investing, managing greed is as important as managing how you allocate your capital.

Personally, I have my share of greediness which causes me a lower return on my capital. A simple illustration as follows.

A value investor has bought AAA at $2. Before he got it, he had in mind that the stock is worth $4 in time. So after a year, the stock rises to $4. But he did not sell it, the greed behaviour of human had taken over the logical value thoughts. Then the stock went up to $4.5, he still being greedy thinks it'll goes up more. Yes, he was right, it went up to $5, then $5.2, then $6 And he was still holding to it. Then the stock came tumbling down, from $6to $5. Then for a few days, it hovers around $5, he still did not sells, thinking that it's just a market correction, hoping for it to rise. Then again, the market crashes, it went to $4.5, then $4, then finally, $3.5 and here, it bottoms out. He finally sold off at $3.5 and still made a pile but his initial target was not met because of greed.

In another scenario, this is about managing psychology or so-called "lost" profits. In the same case, the investor got AAA at $2 with a target of $4. When it hit $4, he sold it off. Then the stock was driven way up to $8 because of speculative forces. This investor feels he had taken the wrong strategy because of what happened, attributed to lunatic speculation forces. This is an important junction where the investor's initial discipline on his faith in value strategy is finally tested. If he were to hop onto the other lane, he has lost his discipline in the hope of searching for a hopeful result. If he stay on the same lane, whatever future investment he does, he will most always have a certain result. And he may have missed the peak, but more importantly, he missed the wreak that followed.

In investing, it is important to know the pitfall of greed and how psychology affects your feelings. Psychology is to do with feelings, not facts. Facts will correct everything that deviates from it. Feelings are something that causes the result to deviates from the facts.

Value versus Growth and psychology

Before I start, it is of utmost importance to define what is growth. Growth is in fact a component of the value equation - sometimes a plus, sometimes a minus. However in general, most others think that Growth and Value are two different approaches in investing. For those who thinks so, it clearly shows their ignorance and superficial skills to investing, not their sophisication as assumed by them.

In a bull market, everyone seems oblivious to the danger that comes with pursuing stocks that belongs to the "Growth" school of thoughts. Those who can actually makes a pile from such way are those who can exit before the party ends. In the late 90s, funds that pursue the growth strategy, returns were up much more than those funds who pursue the value strategy. For most investor, they do not care if the fund pursues the value or the growth strategy, what they care is they do not want to miss out on the fund that makes the most money, even if it was speculative. In stocks, you can only exit when someone takes your place. So for those who are vested in the Growth stocks, those who really make a pile are those who cash out before the tumble.

The value strategy is always most discredited or disregarded during the bull market - almost out of fashion. Growth investors flip stocks like houses in the Hamptons because they are only interested in short-term results and the illusion of things being under control. This people are like drivers you see on the road weaving in and out of lanes, trying to get ahead as quick as they can. He gets behind you, then in front of you and then he bangs right into a trailer. Then the one who drives steady will turn his head to see what happens and then moves on.

For this, it is appropriate to mention what Pascal once said "All men's miseries come from their inability to sit quiet and alone." Buffett once said "Most success can be attributed to inactivity." But for most humans, people cannot resist the temptation to constantly move. They can't sit still. It takes discipline to appreciate the value way of investing.

Every investment strategy has its own risk. For the value investor, the risk is time. Sometimes, he may have to wait for years before the stock price reflects its value, staying flat for a couple of years.

In the bull market where prices are driven by the growth strategy, it makes sense to be out of the market especially when prices are driven way out of logical senses. If you are playing cards for money, you do not want to play with lunatics for it is impossible to guess what they might do next. As a value investor, during a bull market, it takes a whole lot of discipline to stay out of it while you see the market still ever advancing at a great rate. In the late 90s, it took a couple of years before the bubble finally was pricked, but it was a few years before that when the price is already driven out of senses. Unless you have a magical ball, then it is safe to pump in fresh funds in the bull market.

Those who pursue the growth strategy believes the market will always be ascending. That's why in the bull market, more people are tempted towards the growth strategy, because a bull market will only happens when stock prices has advanced for a few years before that. Psychologically, the longer the market rises, the more people will believe it will go up perpetually. But if you look at history, you know everything runs in cycles. But that's the way psychology works.

For a value investor, the lesson here is;

1) It is important to recognise the game of playing. If the game is not played your way, it's no longer your game and you should stop playing. The worst is for you to join the other side who is apparently winning for the moment. If you can't understand your game well, you can never play it correctly. It's always more important to protect your funds than to make much more because of greed overcoming one.

2) You could never expect to outrun the bull that had taken charge of the market. The only way to be on the same pace is to hop onto its back which is as good as joining those in the growth lane.

In investing, it is like building Rome, it takes years to build it solidly but if you stumble, it takes a day or two for it to fall like a stack of cards.

In most things you do, success does not comes with foolish risk-taking, though risk comes with everything. It is how you manage risk that determines success. Many will say that the more risky it is, the more returns you get, well, it is true to a limited extent. But for something to be successful throughout the lifespan of it operating, being risk-adverse and managing the risk to a minimal level returns the most.

Saturday, September 23, 2006

In fooled by randomness: The hidden role of risk in the market and in life

To gain an advantage in the stock market or investing in general, it is important to understand the experience in life is generally intertwine with the workings and behaviour of an investor.

Imagine an eccentric and bored billionaire who offers you $10 million to play a game of Russian roulette. He gives you a revolver with 6 chambers, a bullet in one of the 6 chambers, and challenges you to hold it to your head and pull the trigger. Chances are 5 in 6 that you'll get away with $10 million; chances are one in six you won't come away at all. That is, there're six possible paths that your story will take - but after the fact, we'll see one one of them. And if you survive, you may be used as a role model by others, including the media. If this roulette player is a mutual fund player, he'll perhaps end up on the cover of a magazine showing "Savvy investor beating the Index."

Of course, if the roulette-betting fool kept on playing, the chances of failing will catch up with him. From the first round of 5 in 6 chances to survive, it reduces to 4 in 5 chances, then 3 in 4, then 2 in 3, then finally, a 50% chance.

So when you look at the stock market's darling we're looking at the survivors from a very large pool of players. Imagine now there're a large pool of 25 -year-olds willing to play the russian roulette, playing on the first day of each year. With each passing year, there'll be less players, eventually after 20 years, we can expect to see a handful of players left. And this remaining few will be extremely rich and celebrated by the media - and a very large cemetary for those who had fallen. Most likely, they'll be thought by others to have the skills and ways around on how to survive in a roulette game.

These group of players would be hailed as winners - the alternative possibilities of what could have happened to them would be ignored and forgotten.

For every game, someone have to wind up in the top percentile. In a game of luck, it is the same and the important fact here is that none of these players can claim to be an expertise in a game of luck. But still, somebody must always be in the top 10, some in the middle, others trip at the first hurdle.

Friday, September 22, 2006

Simple lesson from Warren Buffett

Imagine you are a sprinter, looking for an edge in your race and Adidas has invented a shoe that can shave a second off your 100-metre run. The shoe is at a bargain price of $150. How many race can you win owning to this great technology invention? 5? 10? Or all the race that you enter?

The answer is ZERO, NONE. Yes, you are not reading wrongly. ZERO is screaming. The reason is very simple. All the rest of the runners are wearing the same pair of shoes. You can bet that all others can easily fork out the $150.

So what has this got to do with investing or Mr. Buffett for the matter? Now, we shall look back in history. The Berkshire Hathaway today is a full-fledged holding investment business for all the businesses that they own. Back in the 1960s when Buffett acquires Berkshire, it was then in the fabric mill business. Then the operating business managers at Berkshire would bring to Buffett's table with well-conceived plans for upgrading of processes, machinery and things you name it. These would on paper at least, save the plant a lot of time and cost of production, which means bigger potential profits for the company. But before long, Buffett realized that such capital expenditures were a waste. These advances were also available to the other mill plants out there. So with everyone else being able to generate the same cost and time savings, and passing them to the customers to boost sales, the only beneficiary will be the customers.

By realizing how to best allocate his capital in the best way, Berkshire turns into an investment-driven company and the rest like they say, is history.

The lesson here is multi-proned.

Firstly, never throw good money after bad money. Let's say if you make a bad investment, never throw good (fresh) fund after the bad funds (which is the bad innvestment made).

Secondly, being able to distinguish the things of all th competitors of the business which you are thinking to acquire are doing. If you can tell that the things which your potential targeted business is doing is something which all the rest are doing, then most likely, they are not having any durable competitive edge.

Thirdly, look for business which has a durable competitive edge.

Last but not least, a great business at a fair price is always better than a fair business at a great price.

Tuesday, September 19, 2006

How to get comfortably well to do in life?

The simpliest formula to this is to do what a person loves to do. By doing what you like to do, you are in the top half of the crowd - the other half being those who dislike doing what they do. So when you do what you love to do, naturally, you increases the odds of you doing well. Common sense will tells you the odds are against you if you do something where you are neither here nor there.

Here are quotes from given by the most successful investor, Warren Buffett and one of his associates, Mr Wertheimer, from Iscar.

"Do what you love. Buffett was asked for tips on how to make the first million, but he had no answer. Stef Wertheimer came to his aid, telling the questioner, "Do what you love - do it well and you'll succeed." Buffett agreed. "Stef is right. I enjoy what I'm doing very much. If you do what you really want to do, that's what will get you going."

Another quote from Mr Buffett to those who do not practise the intelligent way of investment and rely on charting or timing the market.

"Be greedy when others are fearful. Be fearful when others are greedy."

Wednesday, September 13, 2006

Real gold, Fool gold

What I am gonna to present is a very primitive form of way to "do up" or enhance the financial statement. I'm not sure if this may be a legal way but definitely, it is not a method that a business which is values integrity will use in any means. This can be used thru the means of structured products.

The idea behind this special and primitive trade is this: Suppose you pay $100 for a pot of gold. Half of the pot is real gold, while the other half is fool's gold. The portion of the real gold is worth $90, while the fool's gold is worth $10. If tomorrow, the two halves are still worth $90 and $10, and you sell the real gold for $90, can you register a profit? The answer must be no, right? If the real gold cost $90 and you sold it for $90, the profit should be ZERO, right?

WRONG, at least in certain markets where you buy such products. Suppose you buy the pot of gold and claim that each half cost "on average" $50. Tomorrow, when you sell the real gold for $90 - BINGO - you have booked a $40 gain. How? The real gold didn't cost you $90; it cost you $50 - "on average", at least as carried on the balance sheet of the business who purchase the pot of gold - and you sold it for $90 and "gain" $40. Of course you didn't make any profit, but by this way, you can register a gain. And for the fool's gold, you can hold it for as long as the business can, and it will be kept in the cabinet under locks. So by holding, you will never register a loss. It will still be at cost. Many management who are only interested in their paychecks can used such methods to meet the Street earnings expectations. Such problems will eventually surface many years down the road - at such point, it'll most likely be someone else problem - when someone new takes over and the skeleton will have to be brought out from the closet.

This is financial alchemy at its very best.

Tuesday, September 12, 2006

Frictional Cost

Here are two figures from 1998 on the Fortune 500 companies for you to consider. When you talk about the Fortune 500 companies, you are really talking about America Inc. because companies in this universe account for about 75% of the value of all publicly traded American businesses.

Fortune 500 profits in 1998 = USD334,335,000,000
Market value on March 15, 1999 = $9,907,223,000,000

In the equity market, investors have a habit of wanting to change chairs, or at least getting advice if they should change. When this happens, it cost real money - big money. This is called frictional costs. It is paid for a wide range of items. It could be for the market maker's spread, the sales loads, the management fees, the commissions, the custodial fees, the wrap fess and even subscription to financial publications. Never brush off these expenses off as irrelevances or unimportance. If you were evaluating a piece of investment in real estate, would you not deduct management costs in deriving your return? So in exactly the same way, equity investors must face up to the frictional costs they bear.

If the frictional expense cost a percent of the deal - which is quite possibly on the low side - investors would have paid USD100 million on frictional cost. This expense makes up about a percent on the Fortune 500 market value in 1999.

Perhaps 1% on the whole deal seems to be minute to pay for on a market value of 9.9 trillion. But if you look at what you are paying in frictional cost in relation to the real profit generated by the 500, you will notice it cost almost 1/3 of the whole pie of profit. So it leaves investors with a real profit of $250 million which is slim pickings on the return of their 9.9 trillion investment.

So it links you back to the very basic but yet ignored and forgotten theory - future returns are always affected by current valuations. Investors must always bear in mind - make it cast it on stones - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Surely, in the interim before the party ends, you and I can sell each other stocks at higher and higher prices till the last fool becomes wise. Let's say the Fortune 500 is just one business and that the people in this room each own a piece of it. In this case, we could sit here and sell each other piece at ever-ascending prices. You personally could outsmart the next fool by buying low and selling high. But no money from the business would leave the game when that happened. You'd simply take out what the next fool had put in. When it is driven so high, the day of judgement will come sooner than later. And when it comes, the real money that talks will be what the business has earned over time, not the money that had transacted between the buyers and the sellers. Investors must also inscribe in the thoughts that the absolute most that the owners of a business can get out of a business in aggregate is what the business earns over time.

Monday, September 11, 2006

Importance of a multi-disciplined facet thinking in Investing

In investing, it is totally important to have an idea of the different disciplines in life to understand how to arrive at a great decision. If you are only trained in economics and you used only the methods taught in economics and try solving each and every problem with economics, I can guarantee you that you will never make a good decision nor solve a problem in the best way. You must read alot to understand the workings of how history affects the psychological make-up of people and how it affects the general economy at large.
Like what Charlie Munger says "To the man with a hammer, everything seems like a nail". You must know the big ideas in the big disciplines and use them routinely and wisely - all of them - not just a few. Most people are trained in just one model - economics or marketing for eg - and try to solve all problems in one way. This is a dumb way of handling problems.

Sunday, September 10, 2006

Derivatives (Part two)

Another problem on derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger some more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off most of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and thus not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from company A to go bad will also affect Company B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In derivatives, it is unlike banking where there is the Central Bank like the Fed to insulate the strong from the troubles of the weak. If the Central Bank does not exists, the failure of weak would sometimes put sudden and unanticipated liquidity demands on strong banks. Thus, in derivatives, there is no regulatory function assigned to the job of preventing the dominoes from toppling. In this business, firms that are fundamentally sound can be troubled simply because of the travails of other firms further down the chain. When a "chain reaction" threat exists within an industry, it pays to minimize links of any kind.

Large amount of risk, particularly, credit risk, have become concentrated in the hands of relatively few derivatives traders, who in addition trade extensively with each other. The troubles on one could quickly affect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties as mentioned, are linked in ways that could caused them to comtemporaneously run into a problem because of a single event. Such linkage which suddenly surfaces, can trigger serious systemic problems

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserves anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM - a firm unknown to the general public and employing a few hundred people - could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swap, contracts that facilitate 100% leverage in various markets, including stocks. For eg, Party A to a contract, usually a bank, puts up all the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date, it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this kind makes a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and othe financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivative contracts. I will find it amazing if any one can understand how much risk the company is undertaking when one is to read all the long footnotes detailing the derivatives activities of a major bank or likewise.

The derivatives genie has long been out of the bottle, and has certainly mulitplied in both variety and number. Until some event that makes their toxicity clear, many market participants will still be dancing at the party intoxicated by the effortless money they had gained. What comes easy, goes easy. Like cinderalla at the ball, no one wants to miss a single beat.

Derivatives is very much like the weapon of mass destruction of the financial world, carrying dangers that, while now latent, are potentially lethal.

Suggested reading - When Genius Failed.

Derivatives (Part one)

To most market participants, warrants provide a so-called cheap alternative to owning the underlying asset of a business. But however, it is one of the many different products that belongs to the family of Deriatives. It is important for market participants to realise the full risk of a deriatives. In fact, derivatives is 99% or more in the form of speculation or gambling.

It should be viewed as time bomb, for both the parties that deal in them and the economic system. Since derivatives covers an extraordinary wide range of financial contracts - some of which is totally so interwined and complicated that even a maths professor needs some thinking-, it is important to understand it in the most basic form. Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rate, stock prices or currency values.

The range of derivatives contracts is only limited by the imagination of man. At Enron, for eg, newsprint and broadband deriatives, due to be settled in many years in the future, were put on the books. Or say, if you want to write a contract to speculate on the number of twins to be born in Singapore in 2020. No problem - at a price, you'll easily find an obliging counterparty.

In deriatives business, it is like hell - easy to enter and almost impossible to exit. Once you write a contract - which may require a huge payment decades later - you are usually stuck with it. Though there are methods by which risk can be laid off to others. But most strategies of that kind still leave you with residual liability.

Another trait of derivatives is reported earnings are oftenly wildly overstated because today's earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors may usually be honest, reflecting on human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market (think about the contract involving twins) and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for the counterparties to use fanciful assumptions. In the twins scenario, for eg, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model may well turn into mark-to-myth.

The valuation problem is far from academic. In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for eg, companies use derivatives and trading activities to report great "earnings" - until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. Mark-to-market then turned out truly to be Mark-to-myth.

You can be assured that marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report "impressive earnings" (or both). The bonus were paid and the CEO profited from his options. Only much later did the shareholders learn that the earnings were nothing but a sham.

To know more about the pitfall of derivatives, I recommend you to read this book "Fiasco" by Frank Partnoy.

Main reason to Berkshire Hathaway success

To many, the main reason to Berkshire Hathaway success can be attributed to both Warren Buffett and Charlie Munger. But the main reason besides their ability to select a durable and wonderful business is the main man directing the play behind each of these businesses. Thus, to be a winner, you must always work with a winner.

Each and every operating managers in Berkshire operating business are a master of their crafts and run their businesses as if they were their own. These are people who enjoys what they do rather and gain satisfaction from seeing that their painting are always-evolving towards the north.

For Warren, the managerial model is Eddie Bennett, who was a batboy. In 1919, at age 19, he begin his work with the Chicago White Sox, who that year went to the World Series. The next year, Eddie switched to the Brooklyn Dodgers, and they too won the World Series. He, however, smelled trouble. Quickly, he joined the Yankees in 1921, and they promptly won their first pennant in history. Now, Eddie had settled in, shrewdly seeing what was coming. In the next 7 years, the Yankees won 5 American League titles.

What does this have to do with management? It's simple - to be a winner, work with winners. In 1927, for example, Eddie received $700 for the 1/8th World Series share voted him by the legendary Yankee team of Ruth and Gehrig. This sum, which Eddie earned by working only 4 days was roughly equal to the full year pay then earned by the batboys who worked with ordinary associates.

Eddie understood that how he lugged bats was unimportant; what counted was instead hooking up with the cream of those on the playing field. At Berkshire, they regularly hand bats to the heaviest hitters in the American business.

Saturday, September 09, 2006

Reason why more IPOs are available in a bull market

Just like any thing you want to sell, a thing can fetch a much higher price when demand is much more than supply. In a run-up to a bull market, everything starts of with fundamentals or at a fair price. What the wise man does in the beginning, fools do in the end. Speculation is always wildest at the end and prices are always highest at the end but the problem is no one knows when will the whistle be blown.

What actually happens in the cases of IPOs is "wealth transfer", often on a massive scale. By shamelessly merchandising these birdless bush or worthless IPOs (see my other post Fundamental evaluation of an investment), promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to their friends and associates). The fact is that a bubble market has created many bubble companies, entities designed more with an eye of making money OFF investors rather than FOR them. Too often, an IPO, not profits, is the primary goal of a company's promoter. At bottom, the "business model" for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.

But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street - a community in which quality control is not prized - will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

Smart investors will not attempt to pick the few winners that will emerge from an ocean of unproven enterprises. No one can claim to be smart enough to do that - the only factor is luck. Instead, we try to apply the theory of "if a bird in hand is worth two birds in the bush" to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formula where a cheeky guy would perhaps say "a gal in a convertible is worth 5 in the phonebook").

Irrational exuberance of investor's expectation

In a bull market, exuberance can run way out of line with reality with the help of the investors irrational expectation on the return of investment. Equity prices can be driven to be valued at several multiples of probable earnings.

Far more irrational are the huge valuations that the market participants are putting on businesses which are almost certain to end up being of modest or no value. Yet investors, mesmerized by rising prices and ignoring all else, piled into such enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the value of stock in certain sectors become decoupled from the values of the business that underlay them.

This surreal scene is accompanied by much loose talk about "value creating". Though in the past, there has been a huge amount of true value being created by new or young businesses - which is few and far between -, however, value is destroy, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.

Investing in unproven yet sexy business

Historically, stock markets behaves differently from usual human behaviour whereby market participants feel happy to buy while price is on the rise while holding back from participating when prices are falling.

This phenomena guides the prices of many unproven but yet sexy business. Ignorant market participants listen to what the investment managers say and drive up the prices of businesses which still have not earned a single cent or not much. The only reason prices are driven up is because of the "growth estimation" that Wall Street presents. Only on Wall Street will charts be plotted on an upward slope.

Enron and Global Crossing are some examples where it ended up totally with nothing for investors. With Enron bankrupcy, there came the introduction of the Sarbane-Oxley rule to govern corporate honesty and disclosure.

Investment versus speculation

Speculation - in which the focus is not on what an asset will produce but rather on what the price will do or what the next fellow will pay for it - is neither illegal or immoral. But it is not a game that will be glamorized or given any importance on my blog. Like the saying goes "We bring nothing to the party, so why should we expect to bring anything home?"

The line seperating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cindarella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they'r likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore the giddy participants all plan to leave just seconds before midnite. There's one problem, though: They'r dancing in a room in which the clocks have no hands.

Fundamental valuation of an investment

The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C .

The oracle was Aesop and his enduring, though somewhat incomplete investment insight was "a bird in hand is worth two in the bush." To flesh out this principle, you must answer 3 questions. How certain are you that there'r indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the long term U.S.bonds.)? If you can answer these 3 questions, you will know the maximum value of the bush - and the max number of birds you now possess that should be offered for it. Don't think in terms of birds, think in dollars.

Aesop's investment axiom, thus expanded and converted to dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the invention of the steam engine, the harnessing of electricity nor the creation of the automobile change the formula one iota - nor will the internet. Just insert the correct and logical numbers, and you can rank the atttractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the price to earnings ratio or to book value, and even growth rate have nothing to do with the valuation except to the extent they provide clues to the amount and the timing of the cash flows into and out of the business. Indeed growth can destroy value if it requires cash inputs in the early years of a project or an enterprise that exceed the discounted value of the cash that those assets can generate in the later years. Market commentators and investment managers will glibly refer to "growth" and "value" styles as contrasting approaches to investment are clearly displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.

Determining the interest rate is the easiest, though plugging in the numbers for the earlier variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Usually, the range can be so wide that no useful conclusion can be reached. Occassionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startling low in relation to value. To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brillance or binding insights.

At the other extreme, there'r many times when the most brillant of investors can't muster a conviction about the birds to emerge, not even when a broad range of estimates is deployed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination or pressure. In cases of this sort, any capital commitment must be labelled as speculative.

Importance of understanding inflation rate

Inflation rate is the general increase in prices year on year. Sometimes, prices can go the other direction which called deflation.

Inflation affects the value of the every dollar. In short, it affects the ability of how much each dollar can buy a certain amount of product yearly.

For instance, if the rate of inflation is 2% and the bank interest is 1%. It means that the value of each dollar deposited today is worth $1.01 next year while inflation will cause the value of a dollar of a product to raise to $1.02. It means you have to spend more to buy the same amount of product.

What a person should logically do is to benchmark their own savings or earnings to increase more than the general increase in inflation. If a person earnings does not beat the inflation, it means they are in fact earning less than the year before even though there is a percent of increase in earnings.

Intrinsic Value versus Book Value

Intrinsic value and book value are not the same thing. Intrinsic value is the best measurement when it comes to a decision on investment.

To gain some insight into the differences between intrinsic and book value, an instance will be in the form of investing in a colleage education. Think of the education cost as its "book value". If this cost is to be accurate, it must include the earnings that were foregone by the student because he chose college rather than a job.

For this exercise, we will do away with the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime working, and then subtract from that figure an estimate of what he would have earned had he lacked an education. That will gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to the graduation day. The dollar result equals the economic intrinsic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth. In other cases, the intrinsic value of an education will far exceeds the book value of the education, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.

Book Value or Net Asset Value

Book value means the current worth of the assets of the business. You may think of it in terms of a cake that is split into 10 portions/shares. Assuming the cake is worth $10. It means each piece is worth a dollar and thus its book value per share is a dollar.

By itself is quite meaningless, though it is a good enough gauge for a decision by you, to invest or not to, though it is not the best way. In essence, a dollar of asset in one business is different from a dollar of asset in another business in terms of earning power. For eg, a dollar of asset in ABC company can earns 20 cents of profit while a dollar of asset in XYZ can earns 15cents of profit. So in fact, the value of a dollar worth of asset is ABC is better cos it can generate more.

Intrinsic Value

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of a stock, bond or business - all of which are investments. It can be defined simply - the discounted value of all the cash that can be taken out of a business during its remaining life.

The calculation of an intrinsic value, though is not simple, it must be taken as an estimate rather than a precise figure, and it is an estimate that must be changed if the interest rate moves or the future forecast of cash flows are revised.