Friday, January 26, 2007

Wisdoms from Charlie and Warren

A question often posed to Warren Buffett and Charlie Munger is “How do you learned to be a great investor? Warren says to the extent that “no one can get smart without reading a lot.” Charlie says “you have to understand your own nature” and “I don’t know any wise man who doesn’t read a lot.”

What Warren says can be easily grasped. Knowledge more often than not comes from book. Great investors are not born with all the necessary information and ideas with them. They may be born with certain characteristics that enable them to pick up things faster than others but it boils down to finding the right knowledge to apply them. Between me and you, we certainly do not have a high likelihood of learning a great deal from each other. The only way to speed up the process of learning which in turn helps the process of becoming smarter is read a lot. However, the world consists of endless books giving you endless ideas and options. So it is important to pick out the best and right ideas from the vast sea of knowledge are just as important. It is similar to investing where you have to pick out the winners from the rest.

As to Charlie’s idea, he said “Each person has to play the game, given his own set of utility considerations and in a way that takes into account his own psychology. If losses are going to make you miserable – and some losses are inevitable – you might be wise to utilize a very conservative pattern of investment and saving all your life. So you have to adapt a strategy to you own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.”

Then Charlie also says you have to gather information. “I think both Warren and I learn more from the great business magazine than we do anywhere else. It’s such an easy, and shorthand way of getting a vast variety of business experience to rifle through issue after issue covering a great variety of businesses.

He went on to say “And if you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom about investing. I don’t think you can get to be a really broad-range investor without doing a massive amount of reading. I don’t think any one book can do it for you.”

Charlie also believes that reading should not be random. You must know what books or ideas that you want by zooming in on a particular book that provides the underlying idea that you are trying to acquire. He says “You’ve to have some idea of why you’re looking for the information.” He too says, “Don’t read annual reports the way Francis Bacon said you do science – which, by the way, is not the way to do science – where you just collect endless data and then only later do you try to make sense out of it. You’ve to start with some ideas about reality. And then you have to look to see whether what you’re seeing fits in with proven basic concepts.”

“Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.”

Charlie maintains that the ability to answers such questions explains why some people are more successful and others are not. On the other hands, he says “If it isn’t a little difficult, everybody would be rich.” By the way rich is relative because if everyone is a millionaire, then what is rich? To me, knowledge is being rich and wealthy and the ability to sustain the success or goal that you have in mind.

Eggs and basket: How do you distribute the eggs?

Conventional business schools wisdom states risk can be reined by diversifying your funds. Most business schools just simply reward difficult and complex behavior more than simple behavior, in all cases, simple behavior and idea are superior to complex ones. The saying "never put all eggs in one basket" is an advice I strongly disagree with. In stating this opinion of risk in relation to diversification, the definition of risk, using dictionary terms, is "the possibility of loss or injury."
So what causes loss and injury? The main cause behind it is not having a lot of baskets. Rather it is to know what you are doing and how well you understand the basket. The only reason why you can no longer put more eggs in a basket is when the basket is filled to the brim.
For example, let's say there’re 3 baskets, all with different strength and make of different material. One is made of steel, one with rattan, and one with paper. Each basket has a similar volume capacity which can accommodate 30 eggs each. If you have 30 eggs, which basket would you put in? Raise your hands if you will put everything in the one made of steel. Raise your hands if you will put some in steel, some in rattan. Obviously, you know what the answer will be. I rest my case if all of you will put your eggs in the steel basket. If any of you will put 25 eggs in steel, 5 eggs in some other basket. I would be much interested to know the reason behind your decision.
Now, if you have 40 eggs, which basket would you chose and how many eggs will go into each basket which you chose? For me, I will put 30 eggs in the steel one and 10 eggs in the rattan basket. Again, it is a no-brainer.
If you use this same concept and apply it to life or investment, most of you will be able to get a better result in everything you do.
Unless the person who is making a decision on how many eggs go into which basket do not have an idea on the nature of the material of the basket, then he or she will have a problem of how many eggs will go into which basket. So if he does not know the kind of material of the basket, the logical decision will be to place 10 eggs in each of the 3 baskets. Then when the bottom of the paper basket gives way first, he will know the impact of his decision.
When you think further, this example of eggs distribution is similar to what Warren says for investment, firstly, to protect your principle. To achieve this objective, you must know what you are doing and to do it well, diversification is not a method that will assist the process of doing well. It just shows that diversification is for people who don't know what they are doing.
So if you know what you are doing, it makes no sense to diversify. Diversification only serves as a protection against ignorance. But if you are ignorant, isn't it better to stay out of investment altogether rather than to risk your principle? And even if you want to invest by diversification, it just simply means you are just trying to play safe to ensure that nothing bad will happen to you relative to how the market performs. So you can still be losing when the market goes downhill. It is just relative measurement to the general investors’ results that you are not the odd one out. There's nothing wrong with that. It's a perfectly sound approach for anyone who doesn't know what to do but it just isn't a good reason to do anything if you do not put in some effort towards understanding the nature of what something can do for you.
So if you have capital which is too little to buy up the business which you want to own - think in terms of the eggs distribution example - it is crazy to diversify the capital into a few businesses. It just lowers your returns. If you have 10 eggs to put into any of the 3 baskets again, it is crazy to put 7 in the steel and 3 in the rattan or paper one.
Clearly, by putting all the 10 eggs in the steel basket, it ties up with Warren's advice of "Risk can be greatly reduced by concentrating in only a few holdings."
Anyway, I hope the eggs and baskets example cast some light in to the much twisted conventional thinking on risk can be reduced by diversification. Yes, it can be but only if you do not know what you are facing with. If you have an idea of what you are doing, why chose an option with the strength of rattan over an option which is much stronger with the strength of steel?

Monday, January 22, 2007

Words of wisdom that works in life and in business

One of the reasons why many people fail to stand on the better side of things or fail to find a balance in their life is because many have not yet paid a really heavy price in what they select.

For example, in many people working life, a majority of us will never find a job which thoroughly suits us or at the minimal, be able to find a job which we can find joy in and look forward to going to 24/7. Some people are able to take it more in their stride. Some are less tolerant towards enduring a difficult time. For most people, they delay their making a really meaningful decision until much later in life which is often too late. For most people, they just job-hop hoping to find a better job when another ship sails alongside and jump over. But as usual, most of those who jump often jump onto another ship which is just as worst although at first, it doesn’t appears so. For many who stick to not solving a fundamental problem which they will perpetually face especially something as essential as having satisfaction in a job (let’s face the fact, we tend to face work more than we face any other event other than sleep), the problem will tend to escalate as time goes by. So what happens, a balloon or bubble is only so elastic, it can’t take more pressure than it is designed for. Very much like engineering, an aircraft is designed to fly at up to certain operating parameters, if it is flown at above the operating parameters over a period of time, it will surely break and disintegrate at somewhere and sometime in point. You do not know when but it will fail with a very high likelihood.

Same as in human to human relationship, when the basics do not fit mutually, it tends to lead to a little crack at first. Well, most people will just shrug their shoulders and ignore the initial crack. Then as the crack widens, they tend to pay a little more attention to try to fix it. Some cracks can be fixed. Some are just structural or innate damage which means it is a defect which is inherent. But many, when faced with inherent damage, they are faced with a dilemma – a very tough dilemma. When mixed with emotions, it usually gets thing jumbled up and confused. So they decide to stick together for reasons only known to them. Well, if the problem is an inherent one, usually, it will just widen a little bit slowly as time goes on. Problems may not appear today, or tomorrow. It will appear somewhere down the road depending on many factors. So it may reach a day sometime later in life when the couple are tied down with 2 kids, and a house to maintain, and then come a point where the crack just give way forcing open the floodgate.

Similarly, in investing, very common mistake is to lead yourself on which Warren always points out, “The easiest person to fool is often oneself.” One of the reasons why many fail to realize the way to make sustainable gain from investing is never through what I call “play by the ear” investing. It means listening to what the general public says you should invest in. Yes, in a strong bull market, even if you got a very silly and high price, a speculator will still gain as long as the crazy bull charges forward – at least on paper. Well, if the speculator does not cash out, he will not see real gain when the tide turns. Then when the tide turns, they pay a very heavy price and fail to find a balance in how they invest. And then, these people who are burnt may quit the game and a new bunch of speculators may enter the game and the cycle keeps rotating. It will be the same old ride - the only difference is with a different set of players.

Just very much like a regular gambler, they may just wager a little every week. Maybe some week they wager $50, some week they wager $100. As time goes by, some gambler gets more drawn into the game and up their stake. At first, it doesn’t really affect them or people close to them. But as time goes by, especially if the stake also follows in a similar direction, it may just blow up one day when they find themselves affixed to an addiction which may lead to the event of wagering off everything they have.

All these examples are often so real but also often, people do not pay much heed to or just shrug it off. Accidents often can be avoided if proper care are given. In many mishaps, it is usually a series of events that led up to the final blow-up. A chain of events where one misstep unfolds another misstep. But too often, all events prior to the grand blowout are covered by people who believed the next gamble would cover their last disaster - and who couldn't admit they were wrong or in a rampant state of self-delusion.
As Charlie says, “History is a bad teacher, and students are a lousy bunch of learners.” Until people pay a really heavy price, they will realize that past actions represent real consequences some time down the road, albeit a little too late to look for another clear piece of road if it comes too late.

Saturday, January 20, 2007


In continuation from the topics of yesterday, we gather that one of the most important limitation of the accounting system is it is just a very rough estimation, whereby its output is as good as the inputs which in turn is dependent on how aggressive or conservative the person estimating the accounts is.
One of the subset of accounting that is very important to determining the outcome of the Income Statement is Depreciation. Depreciation is a very straight-forward component of the accounting system where it shows how clear-cut that accounting is in fact just a system of estimation, and not a precise system.
For any new car owner, they will know that once the new car is driven off the dealer's lot, the car will lose a value of anything between 10% to 30% of its original cost, in generally accepted accounting principles (GAAP), it is called depreciation. Well, in some cases, they're not actually totally in the nature of depreciation, it lies more towards the nature of devaluation. Like in this example, the very next day even if you do not drive the new car for a single mile and you want to sell it, straight away you lose a certain percentage, is that a depreciation or devaluation? So what is the difference? Depreciation is associated with wear and tear. So for a car that is as good as new which is not driven, how can it be classified as depreciation for the value that is lost? That is devaluation, a loss of value due to its relative attractiveness.
To continue on the car example, suppose you own a taxi company that consist only one taxi. Your biggest expense would be purchasing that taxi, so what is the best way to account for this expense? You could simply expense it all in a single year which will cause some very absurb scenario. For example, in the first year, if the taxi cost $30K with a scrap value of $5K at the end of the useful period, and you account all the depreciation in the first year, and also on average you can earn about 20% yearly on what you spend on the taxi, you will see a very absurb loss of $19K. And in the subsequent year, you will see a profit of about $6K till the taxi is scrapped. This manner of expensing the cost will cause wild fluctuation which distorts the actual picture from the start to the end.
What GAAP tries to do is match sales and expenses in the same time period. It does this by requiring all companies to make a few estimates on capital assets: the useful life of the asset, the salvage rate, and the depreciation rate. This way, an estimated expense can be matched with the sales the asset generates.
There are many different types of depreciation. The vast majority of companies use the straight-line depreciation method. This method, for example in the taxi company, the taxi costs $30K, it is estimated to be able to last for 10 years with a scrap or salvage value of $5K at the end of the 10 years. If we take the difference between the taxi's cost and the salvage cost, we get a total depreciation cost of $25K. Because it is estimated to last for 10 years, the annual depreciation cost is $2.5K.
So if we use the straight-line depreciation method to account for the taxi company income, it will show a better reflection of the profit that is made from year to year. In the first year to the last year assuming the return is 20% of the taxi cost, it will make a profit of $3.5K yearly for the 10 years.
And now if you compare the two methods of depreciation, clearly, you can see that the first method is a very bad reflection of any of the given year profitability although both method will give a total profit of $19K for the 10 year period of the taxi operating life span.
Also, depreciation is a tool that can be exploited. In a hypothetical example, in the low-cost airline industry, Aircock, expensive planes will make up the bulk of the company's asset, so the depreciation expense is critical to the income statement. If we go into the company financials and look under "accounting for long-lived assets," we can gather that Aircock thinks its aircraft and engines will last for between 18 to 20 years with a residue value of 15%.
Frankly, other that being a normal traveller, I'm no expert in aviation, so I can't gather much from only one airline. So in another low-cost airline, Tiga Air, in one of the footnotes stated under its "summary of significant accounting policies," it says that its aircraft will last between 20 to 22 years with a residue value of 20%.
Between the two above airlines, Tiga Air, has a slightly more aggressive accounting system, but not too much that causes a concern.
So here is another airline, Jet Black, it states its aircraft will last for between 27 to 30 years with a residue value of 25%.
So what now if you compare Jet Black with Tiga Air or Aircock? Any normal investor will probably not get into such details usually, but they would be lucky if some very cautious investor will raise the red flag. The accounting practice is much too aggressive compared to Tiga and Aircock. Although for the residue value of Jet Black of 25% seems only 5% more than Tiga Air, that is only on the surface because how could it be the residue value of a 27 to 30 year old plane be more than the residue value of planes which are 20 to 22 years ones (Tiga Air planes) or 18 to 20 years ones (Aircock).
In conclusion, depreciation expenses are meant to estimate how much "wear and tear" expense should be matched against yearly sales based on how much was paid on the asset, how much the company thinks the asset might sell for when they scrap it, and how long the company thinks the asset will last. Ultimately, you should take a look at what assumptions a company is making, go to the footnotes. That's where the story is told. If you see things that you cannot understand or are made to look complicated, it is most likely that the person telling the story does not want you to understand. So why does someone not want you to understand? It could be more than meets the eye.

Deferred tax liabilities

As noted earlier, deferred taxes exist because of the difference in accounting methods for shareholder income (what the company tells the shareholder) and taxable income (what the company tells the taxman).
In deferred tax liabilities, let's use an example here. If Popeye was always asking for his spinach today in exchange for payment the next week, he is actually getting the benefit upfront while delaying his payment for as long as he can. Like Popeye, businesses want to do the same thing with their taxes. The longer they can defer taxes, the longer they have use of that cash, which means they can use it to make more money - free money without incurring interest.
When companies delay their tax payments, they create deferred tax liabilities accounts (DTL) to reflect future tax obligations. The most common reason for DTL is depreciation. When a business buys property, plant and equipment (PPE), it makes assumptions or estimations that either depreciate this PPE slowly or quickly. To the shareholders, the business will want to impress them with higher income and thus, depreciate it slowly. For the taxman, the company accelerates depreciation which lowers income and tax payments.
In theory, the amount of DTL will reverse over time when the company will eventually have to pay up. As a result of all these, the company books DTL to reflect future tax obligations.
To throw a little confusion into the mix to challenge what is theoretically taught, DTL can be permanent where the situation will not reverse. For example, many companies are growing and continually adding PPE, and the depreciation method remaining the same.
Fairly asset-intensive companies like Kroger, Wal-Mart generally have to build more stores in order to increase revenues. Thus, PPEs of retailers like these increase over time, and the difference in speed between shareholder and taxable depreciation methods tends not to reverse.
In some cases of DTLs, not only does it tends not to reverse but it will never reverse. For example, at Berkshire Hathaway, they are sitting on some very pretty, fat and hefty future capital gain taxes, all thanks to their astute investment selection. Of these astute investments, one of it is Coca Cola which cost them $1.3 billion. Today, it is worth $9.6 billion. The capital gain of $8.3 billion is taxable at 35% if they were to sell today. And if we assume that they would and upon the sale, they would have to set up a deferred tax liability to reflect Berkshire's potential future tax liability. They will have to set aside $2.9 billion. However, because Berkshire may never sell (as you know, their favourite holding period is forever), the DTL on these long-term holdings occupy some sort of netherworld between the nature of an equity (what Berkshire owns) and the nature of a liability (what Berkshire owes).
So, when figuring out DTL, try to understand the source of the difference in shareholder and taxable income, and if the difference is valid. In BH case, obviously, DTL related to permanent equity holdings are unlikely to reverse, so investors can take comfort knowing that they won't get stuck with a huge tax bill anytime as long as the right man is in charge there.

Thursday, January 18, 2007

Deferred Tax Assets

Accounting is one of the most amazing, interesting and ungodly smartest invention of the modern world especially towards the contribution of how it advanced capitalism. Having said that, it is also extremely important to know its limitations, particularly on how things are accounted for. As you may be aware, accounting is just an estimated, not a precise system. For example, the most basic difference is in depreciation, SIA may have a 10 years depreciation policy while Qantas may have a 15 years policy, the way this difference will work out will be all-important to the bottomline with all other things being equal. Thus, there are some areas in the financial statements an investor should train himself or herself to look out for, which will ultimately reduce many unhappy incidents (and of course increases your chances of getting the right pick) which he or she would have otherwise encountered if they had not taken note of.
One area of the balance sheet which can be both frustrating and obscure is known as the deferred tax items. Everyone would have an idea what role "accounts receivable" and "property plant and equipment" play in the balance sheet. But Deferred Tax items? As the name suggests, it is some sort of an asset which a business will receive in the future. But what role does it plays? Let's take a closer look.
Deferred taxes exist because the accounting for the shareholder's income (what the company tells you) and taxable income (what the company tells the tax man) are different. You may ask why. Let's say you're on a date with an attractive person of the opposite sex, and this person politely asks you your disposable income. You employ a brilliant accountant who was able to make your income look like it was $0, thus exempting you from paying any taxes. Would you thus triumphantly declare to your date that you made all of zero dollars in taxable income last year? So, if you put that picture on to the business world, it is similar. Companies paint as dreary a picture as they can to the tax man in order to reduce or tax payments, but to someone they're trying to impress (shareholders), they'll probably show a rosier picture. Here, the large part has nothing much to do with how good you are towards understanding finance, it is more on how you understand human behaviour - of which Charlie Munger advocates as all-important if you want to succeed in anything.
In deferred taxes, there're two parts - Deferred tax assets and Deferred tax liabilities. We shall start with the fairly easier to understand part: Deferred Tax Assets. Think of deferred as delayed, or somewhat in the future. We know what taxes are, and we know that assets are a positive thing. In other words, deferred tax asset (DTA) is a future tax benefit. A DTA is created when shareholder income (what the company tells you) falls short of the taxable income (what IRAS sees). A DTA is somewhat the same as a Prepayment or prepaid tax.
Deferred tax assets can result from Warranties, restructuring charges, net operating losses, and unrealized security losses. For example in Restructuring charges, USG is a prime recent example, they're poised to receive a tax credit of USD1.8 billion some time this year due to their emergence and settlement from Chapter 11. Another example will be in Warrenties, Courts and Best Connection sell ton of electronics that come with multi-year in-house warranties. Every year, these companies have to estimate on their future warranty expenses based on how many returns they think they'll get. The company tells you - the shareholder - these estimates, and expenses them on that year financial statements, thus decreasing shareholder income which in turn decreases shareholder taxes. However, IRAS says that warranty expenses cannot be recognized until the actual event takes place, and as a result, shareholder income is lower than taxable income. Thus, until such warranty expenses take place when the item is return, would Courts or Best has to report higher income (and thus pay higher taxes) to IRAS. This results in a deferred tax asset account simply because Courts or Best has prepaid these warranty taxes and will receive a future benefit (lower taxes) when the warranty event actually occurs.
As highlighted at the outset, accounting is just an estimate and many times, A does not equals to B and thus you need to insert C into the formula to make it A+C = B. Here B is to be Deferred Tax Asset intially estimated or expected. A is the actual Deferred Tax asset that will be received and if A falls short of B, how do you account for that? You need to create an account called "Allowance" which in this case is C. So A+C = B.
In other words, if a company does not think it will receive the full benefit of a DTA (B), it can offset this with a valuation allowance in order to be more conservative. For example, a company losing tons of money will have lots of NOLs (net operating losses) in the form of DTAs. These NOLs can be used to offset future income, which lowers taxes. But, if a company can't reasonably expect to make a future profit, then it'll never reap the benefit of those NOLs, and a valuation allowance must be set up to reflect this.
Here, a word of caution, in today world of creative accounting, you should keep a watchful eye on valuation allowance. The fact is since Valuation Allowance is an estimation by the management standard where they can be either conservation (reserve too much) or aggressive (reserve too litttle), this is a very subjective matter that can lead to manipulation of the company's earnings. For example, if a company has a $100 million valuation allowance to offset $100 million in DTAs, and in a particular year, the management realizes that they're going to miss earnings by $10 million, it can make a slightly more aggressive assumptions to release $10 million in its valuation allowance to make up for the expected shortfall, this release from Valuation allowance will flow to net income and thus, allows the company to meet earnings forecast by whoever.

Calculating intrinsic value for business with earnings partly reinvested and partly redistributed as dividend

This is in response to a fellow value investor, Jojo, who asked if it is better to take into consideration of dividend payout in calculating the intrinsic value. Again, I agree with her view if the business you are evaluating does have a dividend policy. I mean whether you calculate your intrinsic value by either way - that is 1) the company does not give out dividend and reinvest every penny or 2) the company gives out part dividend and reinvest the rest - the basics in calculating the intrinsic value are the same. The difference is you get a more accurate outcome if you can manage to make an intelligent guess that will be close to what will happen in the future.

Before going further, what I did before was just a very very rough estimation, just a general guideline. And I am glad you pointed out about how dividend can affect the outcome of the intrinsic value which I totally agree. I gave it some thoughts earlier but did not go further than having the thoughts. Now that you pointed out, here is what I did and the outcome is like what you say, it is definitely very different if all earnings are reinvested.

If we put the exact same principle of intrinsic value - which states that intrinsic value is a value which is all the cash and earnings, irregardless of it given out as dividend or retain in the business, that an investor will receive in the future, discounted at an appropriate interest rate back to today - to use, the basic notion is still the same.

In the same example as given earlier in Walgreen, there will be two parts to the intrinsic value if I calculate the intrinsic value based on the business having a dividend policy.

The first part is the intrinsic value of the capital gain for the timeframe that an investor has, for my case, it is 20 years. This capital gain has accounted for all distribution of dividend that are paid out, that means calculation here is based on earnings that are reinvested.

The second part is the intrinsic value of all the dividend that an investor would receive, discounted back to today.

Here is how it is calculated. The variables needed are: 1) 2006 book value is $9.92, 2) ROE is 19% and 3) dividend policy is estimated at 15% payout of earnings.

In 2007, the business will earn $1.88 ($9.92 x 19%) per share. Out of this $1.88, the dividend given out will be $0.28 per share. Therefore, at fiscal ended 2007, the book value will result as $11.52 ($9.92+$1.18-$0.28) per share. So to estimate the intrinsic value for 20 years, all you need to do is the repeat the process for another 19 times.

After you have repeated that process up to the 20th year, you will get a book value of about $198.11. The intrinsic value for this gain in book value between this 20 year investment timeframe will have to be deducted with the earnings you would otherwise have earned in an alternative risk-free investment like bonds. So the earnings from the reinvested capital which results in the growth of the book value from $9.92 to $198.11 is $188.19. Then you have to deduct this earnings from reinvested capital from the earnings from bonds of $74.42. This results in an intrinsic value of a future amount of $113.77. And then you have to discount it at an appropriate interest rate (5.25%) back to today value, which results in an intrinsic value of $40.88 at today value for the gain in reinvested capital.

And also, you will have a list of all the yearly dividend that are given out yearly - $0.28 in 2007, $0.33 in 2008....$0.94 in 2015...and $4.86 in 2026. Remember all these future dividend cash outflow to an investor is at a future value. Again you must discount it back at 5.25%. The dividend received in fiscal ended 2007 of $0.28 is worth about $0.27 today. The dividend received ended in 2008 of $0.33 is worth about $0.30 today. In 2015, the dividend of $0.94 is worth $0.59 today. In 2026, the dividend of $4.86 is worth $1.75 today. So now you have to add up all these future cash dividend flow for all the 20 year you would expect to receive, it results in a total intrinsic value of $16.02 for all these 20 years of dividend cash flow.

So what is the intrinsic value of the business? You have to add both the intrinsic value of the reinvested capital of $40.88 and the intrinsic value of all the dividend cash flow of $16.02. It gives you a total of $56.91.

So at the price I bought which is $41, that equates to paying 72% of all the future 20 years of cash flows. In other words for every present value of dollar for the next 20 years of cash flow, I am getting a 28% discount for each dollar at today value for the future.

Monday, January 08, 2007

Why is a dollar worth of A is different from a dollar worth of B?

Is a dollar of asset worth in A the same as a dollar of asset worth in B? In all businesses, asset classes and investment types, the ability for each of the different asset of generating future value worth of earnings varies, even though on paper both are carried at equivalent worth.
In traditional Benjamin Graham's method, one of the principles is to buy a business at less than a dollar worth which is carried on paper. That is, for every dollar worth of asset, you must not pay more than a dollar in order to have a margin of safety. However, many times, this principle can be very misleading in the sense that many such deals could be a "cigarette-butt" kind of business. Imagine if you pick up a cigarette smoked almost to the tilt by the sidewalk, you can perhaps take a last puff out of it and nothing more. It may appears cheap but it will not last. And that's pretty much it.
Let's assume A to be government bond and B to be a stock equity or a private business available for sale. In a government bond, if you invest a dollar, it is represented on paper as a dollar. In other words, the price-to-book ratio in bonds is 1.
Whereas in stock equity or a private business, it is not neccessarily so. Sometimes, the stock price is worth less than what is carried on paper, sometimes, it is more, and some other times, it is equal.
From the above, we can deduce that a dollar carried on paper is just an arbitrary figure and gives no meaningful deduction as to what the dollar can generate in terms of output in the future.
The next question to ask is what is the actual value of a dollar worth in each different asset class that you should pay for. In other words, what ratio an investor should pay in relation to what a dollar of asset is carried on paper.
For example, if you have a dollar to invest in either bond or a business, which will be the better option? To determine the better option, another fact is a dollar invested in bond is carried on paper as a dollar. While a dollar invested in the business is carried on paper as 25 cents.
In this example, if you follow strictly on Graham's theory, you'll never pay each dollar for every 25cents worth of assets. But here, Graham missed an extremely vital point in which every asset is very different in nature. For example, a residential or commercial property asset that is worth $1M is very different from a million worth of Coca Cola's plant and equipment. A more clearcut example is if you buy a dollar worth of Louis Vuitton handbag, immediately, even if you do not use it and want to resell on the market, it'll be worth at $0.70.
Thus, for a pure Grahamite, between investing in bond or in the business, the obvious choice is to go into bonds. So let's fast forward to 20 years later to see the result between these two asset classes.
In bonds, for every dollar invested will be worth $2.78 at the end of a 20-year period at an interest rate of 5.25%. On the other hand, in the business, a dollar paid for every 25cents worth of the business asset will grow to be worth $8.11 worth of assets at the end of the 20 years, assuming the return on equity of the business is 19%.
Hence, what is clear here is the 25cents worth of asset today is worth far more than the dollar worth in bond. So paying a dollar for every 25cents in the business is a far superior investment than to pay a dollar for every dollar of bond.
And if we discount both values of the business and the bond at the end of the 20 year back to the present value of today at an inflation rate of 2.2%, the present value of the business is worth $5.13 and the bond is worth $1.76, respectively.

Saturday, January 06, 2007

Riches and Price versus Wealth and Value

Like Warren, most of us will find the best way to own a business is owning parts of it through the stock market. Over time, if you end up being smart at the investment game, you can use the earnings of your business to acquire more ownership in the same business or in other business, and eventually, the whole business. Actually, investing in a business to build wealth may be easier than starting and managing your own business. That’s been the Warren Buffett strategy.

With the approaching Chinese New Year, maybe it is a good time to think deeply about the difference between being rich and being wealthy, and price and value. Being rich is having money, which can be temporary in nature and is often brief. Riches are about excess and indulgence. Ask yourself how long you would be able to feel the happiness and desire after you bought a piece of dress, pants, shoes, watch or even a luxurious car which you have been eyeing for some time. Whereas being wealthy is having knowledge, doing what you enjoy, learning about things you like, expanding your knowledge and horizon of views on life, personal relationship success, a sense of humor, and a basic foundation of principles. Price is what you pay and whereas value is what you get. For example, you may pay a high price for something whereby you cannot extract any value more than the price out of it.

So the focus to life success should be on the principles of becoming wealthy: firstly, to acquire knowledge, to have a desire to keep learning so that your interest can be sustained because if you stop learning, naturally interest will deteriorates too. Then with knowledge, you are in fact accumulating wealth over time and with the right principles, you can pass it on to the future generation like what Warren, Bill, Andrew, Benjamin Graham and many others did, for the good of society. It does not matter if you adopt some or all of these wealth principles, most importantly, one must be able to make sense out of it. Warren said it best, “Money will not change how healthy you are or how many people you love.” Money may decide who gets what opportunity but over time, you measure success by knowing who loves you and what makes them love you, and the process of getting there rather than the proceeds.

He still lives in the same house since 1958, still eat the same food and have the same drink he had all along. According to him, a man is rich to what he has, and a man is wealthy according to who he is. So true wealth is not in how much he’s worth but rather his character and values on how he sees the world. There’s no quick get-rich scheme or sure-to-get-rich scheme in this world. Instead, a better approach is a get-rich-slow program which has been tried and tested with the wealthy principles as earlier pointed out. And this involves patience, focus, lots of hard work, an unyielding endurance, and application of these principles, and all this are controllable by a person. A lady once asked at Berkshire annual meeting: “Mr. Buffett, I only have one B share,” And he interrupted and said, “That’s ok, lady. Between you and me we own half the company. What’s your question?”

So from this, it kind of gives an insight into how he views things. With the extraordinary wealth and timeless principles, Warren has a platform and the opportunity to teach and advance investment and life education. He takes you from outside of riches and price to the inside of wealth and value. If one can distinguish the meaning behind the difference of "Riches and Wealth", and "Price and Value." It is one of the highway to a better quality of life.

How would you design the world?

One of the many benefits of the internet is the ability to view the speeches and gleaning the thoughts of some of the world’s greatest thinkers in history. Some of the best are people like Warren Buffett, Bill Gates, Charlie Munger, Charles Darwin, Andrew Carnegie, and so on. I consider Warren Buffett as the most rounded thinker of all time for the reason of how he view wealth, how the world is constructed, how human reacts which enables him to understand almost fully how the world works which in turn brings him to where he is. Besides having a certain intelligence, he is able to grasp the psychological side of the world in such a way that when combine with the conventional method of success or wealth building, the mixture compounds the success of what he set out to do. He is one person who mix investing lessons with life lessons and the following are what I stumbled upon all the while from him.

Let’s just assume it was 24 hours before you were born, and a genie came to you, and he said, “Warren, you look very promising, and I have a big problem. I’ve got to design the world in which you are going to live in. I have decided it is too tough and I shall allow you to design it. So now you have 24 hours to think of how to design. You figure out what the social rules should be, the economic rules and the government rules, and you and your kids and their kinds will all live under those rules.

Oh now, you’d be thinking, “Oh man, I can design anything? There must be a catch.” The genie says, “Yes, there’s a catch. You don’t know if you are going to be born black or white or yellow, rich or poor, male or female, able-bodied or disabled, bright or retarded, born in a first or third-world nation. All you know is you are going to take one ball out of a gigantic barrel consisting of 5.8 billion balls. You’re going to participate in the ovarian lottery draw which will decide where you’ll be born, black or white, rich or poor, smart or retarded. And that is going to be the most important thing in your life, because that is going to control whether you are born here (in a first-world nation) or in Afghanistan or whether you are born with an IQ of 130 or an IQ of 70. It is going to determine a whole lot. So what type of world are you going to design before you draw your ball among the lot?

So before you draw the lot, it is good to look at the social questions, because not knowing which ball you are going to get, you are going to want to design a system that is going to provide lots of goods and services, because you want people, on balance and on the whole, to live well. So now what kind of world would you design besides the obvious things like everyone gets an afternoon nap and coke for free? It is better to design a world where everyone has a fair shake at success. You may not require that everyone has the exact same skills, but an ideal world would have everyone starting off on a level playing field. For example, you’d perhaps create a world where every child has a home and a caring adult or two who will watch over the child and let him or her know that someone cares, or a world where they is an equal chance for a basic education.

Unfortunately, the world we live in is not ideal. There are children throughout the world – in the thousands – who don’t have a home, who don't have an adult looking out for them, who don't get a sniff at an education. They may be in an institution where they have enough to eat and a bed in which to sleep for those so-called luckier ones among this unlucky lot, but that’s pretty much it.

Fortunately, however, there are people like Warren Buffett, Bill Gates and in the past, Andrew Carnegie who truly see through the meaning of wealth by distributing most of what they have back to society. In Andrew words, “Huge fortune that flows in large part from society shall in large part be returned to society.” In Warren words, “I want to give my kids enough so that they could feel that they could do anything, but not so much that they could do nothing.” “it makes sense for high compounder to take care philanthropy needs.” Then if you look at those many others who passed down their fortunes generation after generation, the money withheld does not help either the family themselves or the world at large. Many families are torn apart or many individual got slackened to the point of being a slouch, having no objective in life because they do not value the meaning of achieving and contributing.

The following two quotations from 1995 and 1988, respectively, highlight Warren Buffett's thoughts on his wealth and why he long planned to reallocate it:

"I personally think that society is responsible for a very significant percentage of what I've earned. If you stick me down in the middle of Bangladesh or Peru or someplace, you find out how much this talent (his investment skill) is going to produce in the wrong kind of soil... I work in a market system that happens to reward what I do very well - disproportionately well. Mike Tyson, too. If you can knock a guy out in 10 seconds and earn $10 million for it, this world will pay a lot for that. If you can bat .360, this world will pay a lot for that. If you're a marvelous teacher, this world won't pay a lot for it. If you are a terrific nurse, this world will not pay a lot for it. Now, am I going to try to come up with some comparable worth system that somehow (re)distributes that? No, I don't think you can do that. But I do think that when you're treated enormously well by this market system, where in effect the market system showers the ability to buy goods and services on you because of some peculiar talent - maybe your adenoids are a certain way, so you can sing and everybody will pay you enormous sums to be on television or whatever -I think society has a big claim on that."

"I don't have a problem with guilt about money. The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing. I don't do that though. I don't use very many of those claim checks. There's nothing material I want very much. And I'm going to give virtually all of those claim checks to charity when my wife and I die."

The idea of people like Warren is to leave the world a better place when they are gone, by living below their means and giving back their money to society.

Friday, January 05, 2007

Warren Buffett exact words on Intrinsic Value

This is Warren Buffett answer to a question posed on what is intrinsic value is about.

He remarked, "Intrinsic Value is the figure you would come up with if you knew what all the earnings from a business would be between now and what would eventually be disappeared - I mean between now and judgement day. And it's a measure of the cash a business would be able to distribute, whether one year from now or 10 years from now or 50 years from now, discounted back at an appropriate interest rate and that relates to the long term government rate and now some business are terribly certain.....some business are incredibly different to predict, we try to stick to business which are easy to predict."

And he went on to describe that though what he always stick to are always what he understood, he too acknowledged the fact that what he did not understand may also be a better or superior investment than what he would invest in all those which he understood. But then he will not invest in something which he does not understand even though it may be a better investment because he cannot read the game but there are always others who can. So here is a very important insight which he pointed out, always stick to your competency.

Thursday, January 04, 2007

Business economics of a newsprint in today's world

People will always want to be entertained and informed. However people just have two eyeballs, and they have only 24 hours in a day. Fifty or 60 years ago, media for most people consisted of the local movie theater, radio, and the local newspaper. Now people have a variety of ways of being informed faster (if not necessarily better), and have more entertainment options, too. But no one has figured out a way to increase the time available to watch entertainment.

In the nature of any business, whenever more competitors enter a business, the economics of that business tends to deteriorate. Newspapers are still highly profitable, but returns are falling. The size of the audience for network TV is declining. For years, cable TV was thought to operate in its own world, but that’s changing. Few businesses get better with more competitors – if you can find one, sell everything and buy this sort of business.

The outlook for newspapers is not great. In the TV business, a license from the government was essentially the right to a stream of royalty. There were basically three highways to people’s eyeballs, and companies like P&G, Ford, Gillette, and GM would pay a significant amount of money to be get on those highways and advertise their products to a mass audience. But as the ways to get in front of people’s eyeballs increases, the value of those highways goes down.

World Book used to sell 300,000 sets per year in the mid-1980s, each for $600. Then the Internet came along; it didn’t require printing or shipping, and people became less willing to pay for World Book sets. It doesn’t mean that it’s not worth $600. But competition has eroded returns.

So if you were looking at newspaper publishers as possible investments, what would you use as a margin of safety?

What multiple should you use for a company that earns $100 million per year whose earnings are falling by 5% per year rather than rising by 5% per year? Newspapers face the prospect of seeing their earnings erode indefinitely. It’s unlikely that at most papers, circulation or ad pages will be larger in five years than they are now. That’s even true in cities that are growing.

But most owners don’t yet see this protracted decline for what it is. The multiples on newspaper stocks are unattractively high. They are not cheap enough to compensate for the companies’ earnings power. Sometimes there’s a perception lag between the actual erosion of a business and how that erosion is seen by investors. Certain newspaper executives are going out and investing on other newspapers. It’s hard to make money buying a business that’s in permanent decline. If anything, the decline is accelerating. Newspaper readers are heading into the cemetery, while newspaper non-readers are just getting out of college. In other words, as the older population dies out, the younger population does not take over the readership of the newsprints. The old virtuous circle, where big readership draws a lot of ads, which in turn draw more readers, has broken down.

Charlie and Warren think newspapers are indispensable. Warren read four a day. Charlie reads five. They couldn’t live without them. But a lot of people can now. This used to be the ultimate bulletproof franchise. It’s not anymore.

Charlie used to think that GM was a bulletproof franchise. Now he’d put GM and newspapers in the “Too Hard” pile. If something is too hard to do, they look for something that isn’t too hard. What could be more obvious?

It may be that no one has followed the newspaper business as closely as they have for as long as they have—50 years or more. It’s been interesting to watch newspaper owners and investors resist seeing what’s going on right in front of them. It used to be you couldn’t make a mistake managing a newspaper. It took no management skill—like TV stations. Your nephew could run one.

Monday, January 01, 2007

Corporate Governance: Corporate directors accountability and level of independency

As published on Straits Times on Jan 01, 2007 about the question of how independent a corporate director can be. This subject has always been on the lips of both Warren Buffett and Charlie Munger but not many investors or governing authority really pay any heed to or have been doing anything much to remedy the question of the independency and impartiality of a corporate director, especially the independent director. The following is an interview with Charlie Munger on his thoughts recently with L.A. Times.
How did CEO compensation get so out of whack?
Some of the worst sinners are compensation consultants. I have always said that prostitution would be a step up for these people. "Whose bread I eat, whose song I sing."It isn't that the CEOs are such terrible people. It's that the system, with its envy-driven compensation mania, has developed to a place where it brings out the absolute worst in good people.
What about corporate directors? There's been a move to pay them more and try to make them more accountable. Would that help?
Paying directors more is going to make the compensation excesses harder to fix. The more you pay directors, the more the directors are going to want to pay the CEO. Putting more duties on the directors and giving them more money is like trying to extinguish a fire by pouring gasoline on it.If I were running the world, I would not allow directors to be paid at all. I would make directors be exemplars and serve just as they serve on the boards of Harvard and Yale.
What about putting limits on how much a CEO can be paid?
Congress tried to do that in 1993 by passing a prohibition on pay of more than $1 million. You can see how effective that was. I think you can assume that any law will be promptly evaded.I don't see blanket limits as a good idea, because it's not the dollar amount that's a problem. No one is the least mad when Tiger Woods earns $18 million. They figure he's earned it. What makes CEO pay so difficult is that only a few of the people who are earning these huge amounts are actually worth it. Everyone else figures they have to keep up or recognize that their guy isn't as good. Who wants the recognition that the company down the street has a remarkable CEO, but we have a mediocre klutz? I like the idea of high pay for people who are really worth it. The problem is that most of them are not. Every mediocre employee who rises through the ranks to become CEO thinks he should retire rich. It's crazy.
What is the solution?
The reason this has grown to such an extreme degree is that it is so hard to do something about it. It's like autocatalysis in chemistry — it's a reaction that just feeds on itself and keeps ballooning and ballooning. If more executive compensation issues required shareholder approval, I think that might dampen some of the excess. That has been suggested, and there is a lot of discussion around that subject. But there are also a lot of malcontented nuts in the world, and you wouldn't want the malcontents to get too much power. I don't know. Just because something is a serious problem doesn't mean that you can fix it. There's an element of tragedy in this because some very good people are acting in some very bad ways.But things are seldom so bad that you couldn't make them worse by a dumb intervention.
You don't seem to have much hope that things will change.
There's always hope. But frequently, when things are very excessive, the correction is very painful. Korea had cowboy capitalism, with low fiduciary standards, and things got worse and worse. They had to go through a total collapse and a huge scandal, but it's now largely fixed.I would like to see CEOs act as exemplars. I would like them to realize that they are setting an example when they are setting their own pay. But CEOs are very pompous and they assume they are right about everything. Saying that to them would be a total waste of breath. I don't want to spend my life nattering against my friends' pay. But if you think there's an easy solution, you don't understand the problem too well.We have had an enormous improvement in the garden variety of corporate fraud in America, in pretending to earn money that you did not. But the next level of reform will be much harder. In my opinion, not enough executives have gone to jail.