Wednesday, March 28, 2007

Discounted cash flow analysis

I consider myself a value investor. To me, all that means is that I am price and value conscious. The price on the ticker matters little to me as long as it is of good value. The bottom line is I refuse to pay more than an investment is worth.

If I am not going to pay too much, then I have to make an estimate of an investment’s value. There are different ways to calculate value – you have probably seen many of them. But today I want to focus on the discounted cash flow analysis.

Why the Cash Flow Statement the most important of the financial statements? The most important is its intent is very clear – either it generates cash or it doesn’t and it is not subject to many varying accounting interpretation. In other words, it is the least susceptible to fraudulent practice compared to the Income Statement or Balance Sheet. Since accounting is nothing but just an estimate, its outcome is as good as its input. And input in accounting relies a lot on assumption, for instance, the useful life of a company’s asset.

Compare to the Income Statement, its outcome is subject to many different interpretations. For instance, a business can use “mark-to-market” accounting to boost its earnings. A business which signed a 10-year contract worth $10 million can account all its earnings in one-single fiscal year while the business will only receive its earnings as the work is carried out through the ten years, intermittently.

John Burr Williams developed the idea in the 1950’s, and Warren Buffett has embraced and evangelized it in the years since. Despite its power and simplicity, there are areas we need to tread carefully. Used properly, DCF can be a great buddy; used foolishly, DCF can be our worst enemy. So let’s look at DCF carefully, because I don’t want you to pay too much for an investment.

Here's what we're up against

First, we need the equation. Be prepared. You may already know it, but I'll present it here for reference:

Value = Sum[Cash Flow(t)/(1+k)^t] from t = 1 to infinity

We'll call this the long form. All you need to do is predict all of the future cash flows and discount them back to the present at the rate of k. K is the risk-free interest rate while t is the number of years which could be eternity. What could be easier? For simplicity, we'll define "cash flow" as cash flow from operations minus capital expenditures.

Pitfall No. 1: We don't know jack

I know that sounds harsh, but it's the truth. We cannot consistently predict the cash flows and their growth rates with any accuracy; the business environment is far too dynamic – that’s why buying businesses you understand is of utmost importance. Of course, we should try to make the best estimates we can. And that means being careful about our assumptions and predictions because we don't want to have the pitfalls of the equation work against us.

Merck has been getting the attention of many value investors 2 years back. The Vioxx problems and the court ruling about early patent expirations have caused lots of uncertainty, knocking down the stock price. Using our definition, Merck earned $7 billion in cash flow in 2004. Should that be the starting point? No. Do we know the cash flow reduction from the two issues stated above? I read one report that said the Vioxx lawsuit could cost $4 billion to $30 billion. No precision there. Will two people using the same information predict the same value? Not likely.

The equation is not for calculating precise answers, like in physics and engineering. The better the judgment, the better the estimate.

Pitfall No. 2: Stay away from critical mass situations

There is a simplified form of this equation, assuming constant growth and a constant discount rate.

Value = Cash Flow(t = 0)*(1+g)/(k-g) where

g = growth
k = discount rate
t = 0 is the cash flow from the previous year

One reason we cannot rely on the equation for precise answers is that there is a point of critical mass. In 1946, scientist Louis Slotin died from radiation poisoning after he accidentally let two half-spheres of beryllium-coated plutonium touch during an experiment. When the two halves touched, they reached the critical mass required to sustain a nuclear reaction.

The equation above is valid only if the discount rate is greater than the growth rate (k > g). If k is less than or equal to g, the equation is undefined. Our critical mass pitfall comes when g starts to get close to k. As this happens, value starts to get really big, really fast.

For illustration, let's look at Google. My gut tells me that Google is overvalued. But my gut and a quarter won't get me a cup of Starbucks coffee. From 2004 financial statements, we know everything in the upper half of the table. We don't know the growth rate. So let's assume a discount rate and solve for growth.

Note: Dollar values in millions.

The results tell us that cash flow needs to grow at 23.4% per year from now until infinity to achieve a 25% annual return. So in year 19, Google will have to generate $35.7 billion in cash. For comparison, Microsoft generated $13.5 billion of cash in its 19th year as a publicly traded company. That's a lofty goal. Does it mean that Google is overvalued? I don't think we can say from this equation. The validity of the answer breaks down because we are too close to the critical mass point, where k equals g.
Pitfall No. 3: Money for nothing.

So if the simplified form of the equation is breaking down, what about using the long form? We can break the equation into parts: a fast-growth part and a slower-growth part. Let's assume that Google can grow cash flow at 100% per year for the next five years and at a slower rate after that. Again, let's use a discount rate of 25%. I know you are wondering how I can have a growth rate higher than the discount rate. In the long form of the equation, there's nothing that says we can't. But let's think carefully about what that means.

Essentially, it means that we are getting money for nothing. It implies that the cash flows are more valuable simply because they are growing. It also implies that our investment has infinite value and that we are guaranteed a return no matter what price we pay. We both know those are foolish notions.

At the Berkshire Hathaway annual meeting, Warren Buffett referred to this as the St. Petersburg Paradox, based on a paper by David Durand. No investment has infinite value. So we have to be very careful using g > k for extended periods of time.
Should we throw DCF out the window?

An emphatic no! We just need to use it smartly. Here's what I recommend:
1. Be conservative.Aggressive analyses can lead to inflated values and cause you to pay too much. Pay too much, just like incurring high transaction costs, and you get lower returns. It is similar to how management adopting an aggressive accounting method.

2. Think about your assumptions and gather contrasting viewpoints.Poor assumptions based on viewpoints that are the same as yours can lead to aggressive analysis. And we know where that can lead.

3. Use a margin of safety.Sorry. Despite the fact that you are conservative doesn't mean your answers are more accurate. Have the courage to pay significantly less than your estimate of value. Your family will thank you down the road.

How to be a shrewd investor?

“Nowadays, people know the price of everything and the value of nothing.” – Oscar Wilde, The Picture of Dorian Gray.

Oscar wasn’t even an investor or participant in the stock market. He wasn’t even living the age of stock market. He was a playwright who died in 1900. Nonetheless, his famous quote illustrates the difference between price and value.

All of us are able to distinguish the difference when we behave as consumers. For instance, we wouldn’t pay $10,000 for a vehicle’s CEO with 7 years to go when a new 10-year CEO is going for $12,000. In fact, we’d be downright suspicious of any car salesman trying to pull that one over on us.

As consumers, we want to get the most for our hard-earned money, and we don’t want to overpay for the products we buy. However, we don’t always think the same way when picking stocks.

Then again, valuing a stock is slightly more difficult than looking up a car’s fair value. Maybe that’s why novice investors can turn to false indicators of value – that is the share price on the ticker – and interpret it as value, due to convenience or otherwise.

The thing is, share price alone tells us very little, in fact nothing, about the actual value of a stock. For instance, Singapore Food which trades at $0.86 per share could be a much better value than Capital Land which trades at $7.80 a stub.

To value a stock properly, we need to look at the company’s financial statements – particularly the cash flow statement. If you are either too lazy and do not bother to learn how to interpret the basics of a financial statements, it is highly suggested you do not invest – not even a single cent. Warren Buffett said: “If you bring nothing to the party, you shouldn’t expect to bring any thing home.”

Why the cash flow statement? Cash flow shows us how well the company manages its cash – If its cash is generated through normal operation, loans or otherwise. And cash, after all, is what we eventually want in return from our investments. As Scott Glasser, co-manager of the Legg Mason Partners Appreciation fund, puts it: “Shareholders don’t get earnings. They get cash.”
Moreover, companies with positive earnings could be burning through their cash, which could be a sign of inefficiency. Some businesses could have posted positive earnings over the past 12 months but have not actually produced any free cash flow.

In some other cases, which could be false, the earnings are a fraud – like how Enron did. Before Enron got busted, they were posting earnings of more than a billion. However, they were perpetually negative in free cash flow.

Ideally, you’d like to see a company generating enough free cash flow to either reinvest in the business, repurchase outstanding stocks, or return to shareholders in the form of dividends. Long-term winners such as Procter & Gamble and Johnson & Johnson for instance, have consistently generated enough cash to pay dividends every year since the 19th century.
Once we know how much extra cash a company is generating, we can estimate how much cash it will down the road. Using the discounted cash flow model, we can then decide how much those future cash flows are worth in today’s dollars. If the sum of those values is higher than the stock’s current price, the stock might be undervalued and worth buying.

This is one of the methods that many value investors use to select stocks for their portfolio. And many of them have had a lot of success with it.

Looking at stocks in terms of value and not simply price is a simple way to help improve your returns in the long-term. It’s worked for guys like Buffett, Templeton, Graham, Schloss, Browne and many more. By integrating their framework into your framework, it can work for you too.

Tuesday, March 27, 2007

Why I like Warren Buffett

Is there anyone anywhere who has more nicknames than Warren Buffett or who has more books written about him in investment? Vanity fair calls him the Forest Gump of finance.

He’s been dubbed the “Oracle of Omaha, Omaha’s plain dealer, the corn-fed capitalist, St. Warren and the financial world’s Will Rogers,” says Janet Lowe in the introduction to her book “Warren Buffett speaks: Wit and Wisdom from the World’s Greatest Investor.”

Needless to say, I like and admire Warren Buffett.

He’s as much of an enigma as he is a financial genius. Despite his immense wealth, he is famous for living an unpretentious and frugal lifestyle. He still lives in the same house he bought in 1958 for $31.500. His annual salary is $100,000, tiny by any standards of senior executive of corporation of all types.

He was born August 30, 1930, in Omaha, Nebraska. He attended grade school there, junior high and high school in Washington after his father was elected to Congress. He dropped out of the University of Pennsylvania’s Wharton School and finished his degree at the University of Nebraska. Here’s the mother of all disaster in the modern history of university enlistment. He was rejected by Harvard’s graduate school and was accepted at Columbia where he met and was mentored by Benjamin Graham, the investment fundamentalist, alongside with future value investor like Walter Schloss and Irving Kahn. This could be the luckiest mistake Harvard can commit by doing the world a great favor by rejecting him.

Buffett’s current company Berkshire Hathaway is an investment holding company where stock has traded for as little as $7.50 in 1965 to as much as $115,000 per share recently.

The investment world doesn’t necessarily hang on every word from the mouth of Warren but it does listen. Here are a few excerpts of Mr. Buffett’s wits and wisdom: “Rule No.1: Never lose money. Rule No.2: Never forget Rule 1.

He often uses the advice of Ben Graham and quotes from Ben’s books, “The Intelligent Investor.” I consider there to be three fundamental ideas, ideas that if they are really ground into your intellectual framework, I don’t see any other way but to do reasonably well in investing. None of them are complicated and take supreme mathematical talent of anything or the sort.

Ben said, “You should look at stocks as small pieces of the business. (Market) Fluctuations are your friend rather than your enemy – profit from folly rather than participate in it – the three most important words ‘Margin of Safety.’”

Those ideas, whether 50 years ago, presently or 100 years later, as long as capitalism prevails, will be regarded as the three cornerstones of sound investing.

I love the “profit from folly” idea. Most people panic when the market drops or when the stock they bought at which is already cheap drops yet further. If you are paying 40 cents for a dollar and tomorrow someone is selling the dollar yet lower at 30 cents, it doesn’t make the value bought today lower. The pros hang in there. They invest on the downturn. They make money when others are losing, buying into their inefficiency, by insisting on having a “margin of safety.”

Buffett’s and Ben’s advice is to ignore the market moods. Ben said, “The market is there to serve you. Not to instruct you.” Warren said, “The market is there only as a reference point to see if anybody is offering to do anything foolish. When we invest in stock, we invest in businesses.”

”If we find a company we like, the level of the market will not impact our decisions. We will decide company by company. We spend essentially no time thinking about macroeconomics factors….We simply try to focus on businesses that we think we understand and where we like the price and management. ”For some reason, people like their cues from price action rather than from values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up.”
From this brief glimpse at a few of Mr. Buffett’s statements I get a clearer understanding of why he is the self-made “Billionaire from Nebraska.”

Notable Quote: “It’s an old principle. You don’t have to make it back the way you lost it.” — Warren Buffett.

Monday, March 26, 2007

Who says investing the old-fashioned way doesn't work today?

Many have debunked the original way of value investing brought about by the late, Benjamin Graham. His original thinking on investing as thought by today world is as good as being in the grave, buried 10-foot under with the originator.

This is to disprove the notion that the old-fashioned way of investing is ineffective today. We don’t care what industry a business is in – it can be in electronics, manufacturing, finance, hotels, properties and so on – as long as it is cheap. The result from this is not a random exercise. All the stocks are hand-picked prior to what the price is today, with no hindsight involved. The exercise here is in no way similar to how the corporate world handled the recent debacle of backdating in stock options.

The following table shows stocks which are picked according to either one or a combination of the Benjamin Graham’s principles: 1) Significant margin of safety to Net Asset Value which in this exercise of which stocks selling at 25% or more discount to NAV, 2) Low Price-to-Earnings ratio which in this case if there is a lack of discount to NAV, a high return on equity is required, 3) or a combination of both. In this table, a many of these businesses are not even earning decent return on equity but yet, it proves that the theory of Ben is correct even today: That the stock price will sooner or later raised closer to its eventual asset value, given time.

Stock Brought Price PE NAV then Today or sold Price % gain

Kingboard $0.26 (Dec 05) 6 $0.45 $0.41 58%
Stamford Land $0.285 (Dec 05) 12 $0.48 $0.41 44%
Amtek $0.49 (May 06) 6 $0.66 $0.685 40%
Ossia $0.135 (Oct 06) 5 $0.215 $0.195 44%
Metro $0.68 (Dec 05) 2 $0.965 $0.85 25%
Swing Media $0.08 (Jun 06) 6 $0.21 $0.12 50%
Matex $0.10 (Oct 06) 12 $0.25 $0.13 (Mar 06) 30%
Electrotech $0.435 (Nov 06) 5 $0.46 $0.54 24%
QAF $0.45 (Nov 06) 9 $0.74 $0.535 19%
AEM $0.135 (Jan 06) 5.6 $0.20 $0.22 63%
MITECH $0.13 (Feb 06) 4 $0.17 $0.20 54%
Media Asia $0.14 (Mar 06) 6.6 $0.265 $0.255 82%
TT Intl $0.13 (Mar 06) 6.6 $0.244 $0.26 100%
Sinobest $0.08 (Aug 06) 4.1 $0.28 $0.12 50%
Hiap Moh $0.33 (Feb 06) 8 $0.89 $0.54 64%
Kian Ho $0.17 (Feb 06) 5.2 $0.29 $0.285 68%
Kian Ann $0.17 (Feb 06) 6.6 $0.315 $0.23 35%
Tai Sin $0.135 (Feb 06) 6.4 $0.20 $0.305 226%
China Transcom $0.08 (Nov 06) 3 $0.245 $0.16 100%
Asia Dekor $0.11 (Jan 06) 7.3 $0.155 $0.13 18%
Elite KSB $0.06 (Jan 06) 6 $0.12 $0.24 400%
Spindex $0.18 (Jan 06) 8 $0.36 $0.24 33%
San Teh $0.335 (Jan 06) - $0.89 $0.50 49%
IFS $0.625 (Dec 05) 12 $1.10 $1.07 71%
2nd Chance $0.205 (Dec 05) 5.8 $0.29 $0.37 80%
Willa Array $0.11 (Dec 05) 6 $0.19 $0.16 45%

Of course, for all those stocks in this table, the price bought-in was not the lowest, for example, Amtek, it went down to 43 cents. Most people will fluster and perhaps sold it and regret later. Here it is important to think in this manner in order to maintain discipline and ultimately to make profit: If you know the price today is selling for $1 and it is worth $1.2 in a year time, what difference does it makes even if within this one year it plunge to 70cents?
This table presents some lemons if you were to hold till today but then most of these, you could have made a profit if you know when to sell. For example, United Food, it went to about 30cents in Apr 06.
Stock Brought Price PE NAV then Today or sold Price % gain

Unifood $0.235 (Dec 05) 6.8 $0.39 $0.175 -26%
Lion Asiapac $0.19 (Jan 06) 4.7 $0.39 $0.16 -16%
Southern Pack $0.14 (Jan 06) 9 $0.20 $0.15 7%
KXD $0.07 (Oct 06) 5 $0.15 $0.07 -
Tsit Wing $0.30 (Jun 06) 8 $0.24 0.275 -5%
Radiance $0.125 (Jan 06) 5.5 $0.21 $0.125 -

All the above bought-in price were based on either a very low P/E or a significant discount to NAV and usually as a result, the prices paid are usually, if not all, at its past 52-weeks all-time low. The following are some stocks as of today which are in similar position to those in the first table.

Potentials Stocks

Stock Today Price

Unifood $0.175
Surface Mount $0.32
Singfood $0.88
Fu Yu $0.275
Lion A.Pac $0.16
IDT $0.40
GP Bat $1.28
GP Ind $0.49

To conclude, one thing is very clear here, the chance of winning, even if you do not get to buy each and every cheap stock, far outweighs the chance of losing. Out of the 32 stocks, only 6 businesses were lemons. But if you know when to sell as I said in the case of Unifood, it is one less lemon. By the way, I got tired typing out much more winners in such a scenario using the method of the old-fashioned method of investing.

Sunday, March 25, 2007

Sam Walton's 10-Rules to running a successful operation

These are 10 rules given by Sam Walton, the founder of Wal-Mart to running a successful business that had worked for him during his lifetime.

On this list, there are a few which are needless to list. One of it is “work hard.” If you do not have that already, or you’re not willing to do it, you probably won’t be going far enough to need his list anyway.

Read it, step back and take some time to evaluate which rules work, which doesn’t for you. As Sam puts it, “They are some rules that worked for me. But I always prided myself on breaking everybody else rules, and I always favored the mavericks who challenged my rules.” Pay attention to rule 10, and if you interpret it correctly – as it applies to you – it could mean simply: Break all the rules.

Rule 1: COMMIT to your business. Believe in it more than anyone else. Sam overcame every single one of his personal shortcomings by the sheer passion he brought to his work. He noted: “I don’t know if you’re born with this kind of passion, or if you can learn it. But I do know you need it.” If you love your work, you’ll be out there everyday trying to do it the best you possibly can, and pretty soon everybody around will catch the passion from you – like a fever.

Rule 2: SHARE your profits with all your associates, and treat them as partners. In turn, they will treat you as a partner, and together you will all perform beyond your wildest expectations. Remain a corporation and retain control if you like, but behave as a servant leader in a partnership. Encourage your associates to hold a stake in the company. Offer discounted stock, and grant them stock for their retirement. It is the single best thing Wal-Mart ever did.

Rule 3: MOTIVATE your partners. Money and ownership alone aren’t enough. Constantly, day by day, think of new and more interesting ways to motivate and challenge your partners. Set high goals, encourage competition, and then keep score. Make bets with outrageous payoffs. If things get stale, cross-pollinate; have managers switch jobs with one another to stay challenged. Keep everybody guessing as to what your next trick is going to be. Don’t be too predictable.

Rule 4: COMMUNICATE everything you possibly can to your partners. The more they know, the more they’ll understand. The more they understand, the more they’ll care. Once they care, there’s no stopping them. If you don’t trust your associates to know what’s going on, they’ll know you don’t really consider them as partners. Information is power, and the gain you get from empowering your associates more than offsets the risk of informing your competitors.

Rule 5: APPRECIATE everything your associates do for the business. A paycheck and a stock option will buy one kind of loyalty. But all of us like to be told how much somebody appreciates what we do for them. We like to hear it often, and especially when we have done something we’re really proud of. Nothing else can quite substitute for a few well-chosen, well-timed, sincere words of praise. They’re absolutely free – and worth a fortune.

Rule 6: CELEBRATE your successes. Find some humor in your failures. Don’t take yourself so seriously. Loosen up, and everybody around you will loosen up. Have fun. Show enthusiasm always. When all else fails, put on a costume and sing a silly song. Then make everybody else sing with you. All of this is more important, and more fun, than you think and it really fools the competition.

Rule 7: LISTEN to everyone in your company. And figure out ways to get them talking. The folks on the front lines – the one who actually talk to the customer – are the only ones who really know what’s going on out there. You’d better find out what they know. To push responsibility down in your organization, and to force good ideas to bubble up within it, you must listen to what your associates are trying to tell you.

Rule 8: EXCEED your customers’ expectations. If you do, they’ll come back over and over. Give them what they want – and a little more. Let them know you appreciate them. Make good on all your mistakes, and don’t make excuses – apologize. Stand behind everything you do. The two most important words Sam ever wrote were on that first Wal-Mart sign: “Satisfaction Guaranteed.” They’re still up there, and they have made all the difference.

Rule 9: CONTROL your expenses better than your competition. This is where you can always find the competitive advantage. For twenty-five years running – long before Wal-Mart was known as the nation’s largest retailer – Wal-Mart ranked number one in their industry for the lowest ratio of expenses to sales. You can make a lot of different mistakes and still recover if you run an efficient operation. Or you can be brilliant and still go out of business if you’re too inefficient. It is important therefore when you negotiate for cost of your business, you’d make sure you do not pay for a price where you buy into other people inefficiency.

Rule 10: SWIM upstream. Go the other way. Ignore the conventional wisdom. If everybody is doing it one way, there’s a good chance you can find your niche by going in exactly the opposite direction. But be prepared for a lot of folks to wave you down and tell you you’re headed the wrong way. Sam reckoned in all his years, what he heard more often than anything was: a town of less than 50,000 population cannot support a discount store for very long.

Now personally for me, I disagree with Mr. Walton on setting a high goal. Instead I subscribe more to the idea of Mr. Buffett in looking for 1-foot hurdle to step over rather than a 7-feet hurdle to jump over. All of these are some very pretty ordinary rules, some would say even simplistic. The hard part, the real challenge, is to believe in it, have the discipline to follow through, and to constantly figure out ways to execute them. You can’t simply keep doing what works one time, because everything around you is always changing. To succeed, you have to stay out in front of that change.

Thursday, March 22, 2007

Turning the house advantage to yours

In gambling, as in investing, a statistical advantage is what separates a winner from a patsy. And those in the business of casino never allow this basic knowledge out of their sight. Counting cards, if done correctly, gives a blackjack gambler a 1% advantage. Sound small though, but it’s enough to give a precious few a full-time profession.

Now imagine that you could get a couple of percentage advantage in investing. You could too make investing a full-time career. Few folks seriously consider becoming full-time investors, but in a way, that’s what many will inevitably do in retirement, forced or otherwise. And even if clocking out isn’t on your radar at the moment, investing is at least a side job for you, a way to earn a little more money. Otherwise, you wouldn’t be reading till this far for this article.

So gaining a couple percentage of advantage could translate eventually into a full-time investment career, you may think it sounds naïve or interesting? Well, there are a few ways to turn the advantage into your favor from the house. This results from taking advantage from market-trashing actions. So where do market-trashing results from?

For a long time, up through today in some dwindling corners, the Efficient Market Theory exercised great influence in the academic community. It holds that no one can systematically outperform the market’s returns since all information relevant to the value of the stock is instantly reflected in that stock’s price. One of the linchpins of the theory is that the participants in the market are always knowledgeable, dispassionate, rational players acting in their own interest. Because there’s so much evidence that not all investors are particularly rational, least of all knowledgeable, what has gained more influence latterly are various theories of behavioral finance.

I was reading through a presentation that noted value investor, Arnold Van Den Berg, made last spring to his clients. One part of it describes the four irrational states of sellers that you’re looking to buy from. Because no matter what form of efficient market you believe in, there’s no arguing on one point – whenever there’s a buyer of a stock, there’s a concurrent seller. And one of them is ultimately going to be proved right, and the other wrong. The more that emotion is driving the seller, the better you’ll do. So here are the emotional states you should look for in a seller.

1) Apathy: When a stock has gone nowhere for years, often sellers just don’t really care whether they own it anymore. Van Den Berg gave the example of Coca-Cola, a stock which has done nothing for its shareholders for 8 years or more. Microsoft is another company plenty of shareholders just don’t care if they own anymore, after watching the company perform well but the stock go nowhere.

2) Disgust: When shareholders lose money, or a stock has gone sideway for a long time, shareholders just want to get rid of it. The stock has disappointed you, the company’s earnings have declined, so has its sales, and you’re just disgusted with it. That is truly a deep psychological state.

3) Fear/panic: While disgust is nice, fear and panic are even better. It causes already irrational behavior even more irrational. Some classic examples of stocks getting very cheap are Merck, and Johnson & Johnson when the 1993 Hillary Clinton-led health-care plan came out. Those with their heads with them cleaned up in the wake of that panic sell-off. These companies appear to meet most of the classic value investors’ metrics today as well, though more because of apathy.

4) Anger: The forth and the best sate to find in a seller is anger. Van Den Berg claims that when his clients call him up angry over his placement of a stock in their accounts, he has his best results. He has gone back and measured that the “angry stocks” have returned 25% to his clients over his investing career. He cites Wal-Mart as the quintessential angry stock today. And I guess that Altria has to rank as one of the class in this category as well.

Van Den Berg has applied the dispassionate pursuit of great value opportunities to the phenomenal benefit of his clients. Not surprisingly, given the advantage underlying value investing, people who use behavioral states of mind are beating the market, continuously.

Sunday, March 18, 2007

One of the clearest signal

For most people, I'd bet you would prefer to spend time with your family and friends, doing almost anything else, rather than to actively manage your investments or working in your regualr job. Yet if you do not take care of your money, it'll never grow to the point where it can truly allow you to focus on far more important personal things which matter to you.
It's a tough predicament, really. If you spend too much time with your money, you'll miss out on enjoying the things that it can provide, including quality time with your family and missing out on the growing up years of your kids. On the other hand, if you ignore your finances, you won't have the money and time to spend on those things that will allow you to dictate on things which are important to you. What is clear here is balance is the key, and striking the right balance will let you have both the money and the time to enjoy things which are important to you. With that said, most of you would think that is a dream but who wouldn't? But it can be a reality if you seek for the treasure which are buried a little more than a foot beneath.
As you may be aware, the most optimum strategy of investment for an individual is for a business to retain all its earnings and reinvest in the business provided that the business can generate a return better than what is being returned to the shareholders. Having said that, there's only one business which I know in the world wide world that does it this way, that is Berkshire Hathaway. And the result of this is its book value grew from $19 in 1965 to $59,377 in 2005. Although clearly, this is an extreme case of an optimum investment result, the next best case scenario is how efficient a business is able to return its shareholders any excess capital. There are two ways, firstly, is through cash dividends and second, through stock repurchase. Giving through dividends is a direct method where the shareholders are able to feel its impact right away. The second way is an indirect method where it takes some time or a lag in period before an investor can feel the impact.
The extent of how these two methods are employed will also demostrate one clear fact, that is the financial strength and outlook of the business. One of the best measures of how a company is performing is through "free cash flow" (defined as cash remaining after capital expenditures required to support the growth of the business). Its virtue is its simplicity and clarity which means you either generate cash or you don't and it is not subject to many varying interpretations or accounting changes, in the words of Ralph Larsen (former Chairman and CEO of Johnson and Johnson). In saying this, I shall give one extreme example. Enron, the business that went bust in late 2001, is a prime case of how one can tell straight from the face that Cash Flow Statement demostrates what Ralph said is absolutely correct, simple and clear where the business generate cash or not. On Enron's Profit and Loss statement, year after year, their profit was on an upward slope, culmulating at more than a billion of profit in the year before they went bust. One key policy which helps Enron to show this profit is how they adopt a certain accounting policy. Enron used "Mark-to-Market" accounting treatment for its revenue. What this essentially means is if you have a contract that provides for $100B of revenue for the next 20 years, you can actually use a lot of assumptions to calculation how much profit you can achieve for the next 20 years and book the profits you assumed on the latest financial year. Of course, for a 20 year contract with $100B of revenue, you will not have the money flowing in all in one shot on the year you sign. It will come as and when the job is perform. On the other hand, Enron's cash flow statement is perpetually shown with a negative operational cash flow, which means the business consumes more capital than it is able to generate. But at that time, many were blindly when they were at a party and most were willing to look at the other end until someone shouted "Fire." In short, what this means in Enron's case is the profit shown is paper profits without real cash coming in through the door.
So if you have a strong and excellent balance sheet, it can be demostrated through a constant share repurchase program (as demostrated by Home Depot, Radian Group, Johnson and Johnson, amongst others in recent times) and a constantly increasing cash dividend scheme which is increasing year on year. More importantly, an excellent financial position will provide an enormous flexibility to invest in growing a business and to seek out and act upon new opportunities which of course is one of a much hidden significant competitive advantage one can have. Coupled with that, it brings with it much lesser pressure compared to someone else who have to leverage in order to invest. Imagine if you have the excess cash to invest in a business which is bound to be profitable, you will not face the pressure of having to settle your borrowings for the interest. On the other hand, if you borrow to invest in a business, before you count the eggs, you have to make sure that there're enough eggs to return to the lender and if it is a mediocre business, you will bound to be pressured and when pressure comes along, the natural tendency for a person is they tend to make more mistakes than when they are calm.
Here we shall focus on how a dividend-focus investing strategy can be made attractive. Companies that pay dividends to their owners do so for two key reasons. The first is to directly reward them for the financial risks they have taken by investing in the company. The second which is slightly more subtle but is even more important is to signal the likely future for the business.
By paying attention to the signals that dividends send, you can greatly simplify your investing research. Some questions about the company's dividends can help you cut through the clutter is: 1) Are they sustainable, 2) Are they growing reasonably?
A company's dividend policy can tells you volume about what the business really expects for its future. Because of the bad press and extremely negative market reaction to a dividend cut, companies don't like to cut that payment if it's at all possible. On the flip side, the magnitude of a dividend increase can really reveal how confident a company's management is in its business plan. After all, since nobody wants the bad press of cutting a dividend, a company will typically only raise its payment if it's pretty certain it can make the higher payout.
As a result, you can often determine better the real truth about a business from its dividend practices than from virtually any other statement or financial report. That's the signalling power of a strong dividend policy.
Although dividends are probably the most maligned and ignored part of the average investment strategy, more often than not, a dividend policy represents a tiny fragment of an investor's stake in a business. Given the wild gyrations in stock prices these days, the total value of a year's worth of dividends can be added or taken away from a company's share price in less than a week. It's thus sometimes a pity dividends are treated with so little respect. Dividends often seems too small to be useful, yet somehow still can manage to cause all sorts of headaches during tax time. But believe it or not, those low little payments, if used to their full potential, can help you build serious wealth. Here's an example.
Howard, in 1985, invested about $15,000 in Johnson and Johnson. His first year dividends in 1985 was about $497. Now after 21 years of dividend increases and a few stock splits, he received $9,894 in dividends for the year of 2006.
That $9,894 in annual dividend payment comes from an initial investment of $15,000. As long as Johnson and Johnson maintains its annual dividend policy and increase in dividends yearly, in about another 5 years time, he will get an annual dividend of $15,000 yearly.
While Johnson and Johnson has been an exceptional company for Howard to own, it's not unique among companies that pay and regularly raise its dividends. In fact, solid dividend-paying companies don't tend to keep their payments static. As businesses grow and mature, stockholders can expect to share in the success of the companies they own.
Here are 3 more examples. If you invested in Harley Davidson in 1989 at about $1.02, the full year dividend in 2005 was $0.625. If you had invested in Coca Cola in 1983 at $2.15, you get $1.12 in dividend in 2005. If you had invested in Wal-Mart in 1983 at $0.58, you will get $0.60 of dividend in 2005.
One of the easiest way for shareholders to get their slice of a company's ever growing pie is through dividends. Tbe larger the company's profits, the larger the dividend payments it can afford to make. In fact, well-run dividend-paying companies oftern clearly signal their expected growth by upping their dividends in anticipation of rising profits. If you hold on to a strong company that treats its shareholders well, the long-run income growth can give you some absolutely phenomenal total returns.
Having said all these, the key lesson from Howard's story, however, is the time it took to unfold. His tremendous long-run success was largely due to the fact that he had the PATIENCE to do nothing while the company continued to pay him ever-increasing amounts of cash. Doesn't this sounds like some of Warren Buffett's earlier purchase? I think it sounds so much like See's Candies, and Nebraska Furniture Mart where by now, the year profit more than pays for Warren's initial investment. If you want a shot at following in his footsteps, you too need to learn the value of such patience when you hold a great business.
Johnson and Johnson isn't the only one that provides Howard with such gains as clearly seen in the other three examples as given. Had you bought any of these businesses in those days, by now, you would be receiving at least half of your initial investment back to you - every year from now till the business disintegrate permanently. What's more amazing is you get to keep the shares that generated that income, giving you the potential for even more in the future.
As Howard's success has shown, it's a great way to invest (not a great way to fly, which by the way, I think they may be the best in their industry but it does't qualify them to be a great business with great economic strength). All you need to do is make your initial purchase of the right businesses. Then sit back and cash the checks as and when it comes in, letting your companies do the work for you. How difficult can that be?

How to screw up your life?

Enter a bookstore or library, and you'll likely find lots of books with titles such as How to Lose Weight, How to Win Friends and Influence People, How to Read a Book, How to Improve Your Marriage, How to Make Money in Stocks, How to Raise a Puppy, and so on. There's lots of advice available on how to enrich your life. Thinking about this recently, I realized that there's a gaping hole in this area: a dearth of books on how to screw up your life.

Now you may be thinking to yourself, “Well, who would want to live a less comfortable life?” Believe it or not, I’ve an example. You may or may not have heard of Simone Weil. She was an upper-class French intellectual and activist who, feeling too privileged, chose to work in factories, lived on a tiny income, gave much of her money away, ate much less than most people, and often slept on the floor, even when there was a bed available. Many may think she is bonkers to do that. But actually, she’s rather inspiring despite her peculiarities.

However, I’ll concede that most of us, including myself, do not want to make our lives any worst off. Despite that, though, we often do things that will indeed screw our lives up. Here are some “nos-nos” which one ought to look out for so that you can stop committing them if they apply to you.

1) Racking up credit card debt. Credit card debt is reverse-investing. Whereas you might earn 10% or so in a stock or fund in a year, credit card issuers are perhaps earning 20% (or more!) on you in a year. Instead of a little money in, it's a lot of money -- out. Fortunately, you can dig yourself out if you recognize the danger within early.

2) Not investing. I can see how it happens. You figure that things will somehow work out well in the end. You think there’s always the government Social Security like CPF, after all. But will it be around when you need it? Even now, according to the CPF system, at the retirement age, you cannot draw out all the cash in the ordinary account, you will only be given a certain monthly allowance based on your balance. Will that be enough to sustain me? I think not. Can I count on a pension to help out? Nope. That's why I'm saving and investing as much as I reasonably can. And starting as early in life assist greatly in the formula of compounding.

3) Delaying your investing in earnest. Each year that goes by without your investing for the future can have a big effect on your nest egg. That's because your most powerful dollars are the ones you invest first, because they have the longest time to grow. Fortunately, it's rarely too late -- or too early -- to start.

4) Having unrealistic expectations unless you have the right fundamentals. Even if you have the right fundamentals, expectations on returns must also tie up with what is reasonable with the kind of fundamentals. If you are a growth player, the historical return is about 8%, if you are a value player, it is about 11%, and if you are a basket-investor in indices, it produces roughly 8% as well. That is the benchmark. The S&P 500 advanced 24% in 2003, but if you think you'll see that kind of result every few years, think again. The market's long-term historical average is around 6 to 8%, and in many years, it will deliver low-single-digit returns or even occasional negative returns. Still, over the long haul, it should do well.

5) Not being patient. Real wealth for most of us grows over decades, not days or even single years. If a company is growing steadily, if it has competitive advantages, and if her financial statements are strong, then don't worry if its stock has stagnated. The stock will catch up to its true value, eventually.

6) Following the herd mentality. One of the sustainable ways to long term success in investing is to recognize the folly of others. Buy when others are fearful and sell when others are greedy.

7) Trying to predict the behavior of others. Here the wisdom of Warren Buffett speaks clearly: “The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.” A market downturn is in fact an opportunity to increase ownership of great businesses. It is silly to head for the door when things get cheaper. Investing is the only field where such foolishness happens where on the whole, investors sell when things are cheaper instead of buying when things are cheaper.

8) Using the “Gin-rummy “behavior in investing. It is detrimental for investors to try to slot in and out trying to profit by jumping from flower to flower. It is impossible to do reasonably well if one try to flip-flop in and out of every individual business which are hot at a certain point in time.

9) Getting too weighed in by the general prospect of the current economical state. Years ago, no one could have foreseen the huge expansion of the Vietnam War. In the 1990s, no one could have expected the invasion of Kuwait by Iraq. Who could have predicted the oil shock in the 70s, the resignation of a president, a one-day drop of 508 points in the Dow, or the fluctuation of the treasury bill yields between 2.8% to 17.4%? But surprise, none of these blockbuster events made the slightest dent in the basic fundamentals of Benjamin Graham fine investment principles. A different set of major shocks will sure to happen but none of these should cause an investor to fluster and try to predict nor profit from them.

10) Being irrational. Nothing sedates rationality like large doses of effortless money which happens in a bull speculative market. The line separating investment and speculation is never bright and clear for most people, especially after the market participants have enjoyed recent triumphs. After such a heady experience of this kind, normally sensible people drift into behavior similar to that of Cinderella at the ball. They know overstaying the party – that is continuing to speculate hoping there will be some other fools to come by paying a higher price – will bring nothing but pumpkins and mice. Unfortunately, in this party, there is no clock on the wall.

11) Inability to differentiate price from value, or book value from intrinsic value. Price is meaningless in the measurement of value. Each dollar worth of asset is different from another dollar worth of a different asset. Every asset’s ability to generate revenue or profit varies. Therefore, the book value is an inaccurate measurement towards intrinsic value which makes book value meaningless.

12) Failure to control your temperament. In investing, more than anything else, intellect is secondary to having the right temperament. What has gotten many people – including many geniuses – into trouble have been the failure to control the urges that got them into trouble. In life, you don’t have to swing your bat at every ball that comes by. Only swing at the few fat balls which you understand and bet big when such balls are thrown by. The problem with many is the inability to sit around doing nothing when doing nothing at many times proved much better than to do something. I wish someone could have written the rule in investing stating: “As motion increases, returns decrease.”

Just a little time spent reading and learning about financial matters can make your future years far, far more comfortable. Solutions might not even be as complicated as you fear. Consider, for example, target-date mutual funds, which are rising in popularity. Each is designed around a specific retirement date, and its investments are chosen with that date in mind. The Vanguard 2025 (VTTVX) fund is for those who plan to retire in 2025. It recently had 79% of its assets in stocks and 21% in bonds, whereas its Vanguard 2045 (VTIVX) counterpart had 90% in stocks and 10% in bonds. See what's going on? The fund takes care of shifting your assets as you get older -- it adds more bonds in later years.

If you'd like to learn more about how to set yourself up for as cushy a retirement, it is important to recognize the foolish of others and why are certain things structured in a certain way. If you cannot make sense of things like how the Vanguard funds are structured, it is best to stay out.

Friday, March 16, 2007

Alternative investment strategy

Earlier, I recommended the best investment strategy is to go for value. Another investment strategy is much better than to invest in either the growth strategy or the plain-vanilla indices. That is even if you buy stocks at a very high valuation and if you hold it for a very long time, you can do better than either one of the other lesser strategies. But there is a catch here. This strategy is to only buy businesses which are the best in their class and has the most secured advantage whereby anyone who is given a billion dollar cannot hope to create much of a dent to the business. And the timeline for this strategy is almost for eternity.

Businesses which qualify under this strategy includes but not limited to are McDonalds, Wrigley, Pepsi, Coca Cola, Wal-Mart, Johnson & Johnson, P&G, Walgreens and the likes.

If you have bought Johnson & Johnson in 1992 at $13 with valuations of 37 times earnings, at the price today, the compounded return is 12%. For P&G in 2001, if you got at $33, the return is 13%. At Wal-Mart, at $11.50 in 1991, the return is 11%. At Walgreens, at $18.50 in 1998, it is 12%. At Dollar General which is lately being sought to be brought out by KKR, in 1994 at $4.30 for earnings of 24 times, before KKR offer, the return is 12%, after KKR offer, the return stands at 14%.

One thing is clear here, this strategy of buying the best businesses can give better return than growth or indices. But it is still not the best yet. The best strategy is to buy the best business when the price is at a cheap valuation – meaning when investors do not value the earnings of the business by as many times.

The best investment strategy

When I say I’m a value investor, people often look at me as though I’m crazy. I just know how to stack the odds in my favor and bet really big when the odds are totally in my favor. In value investing, it is the easiest and most simple trick around – to whack big when prices are low and wait for it to rise. As to how long I’ll wait, I’ll wait indefinitely. And I thoroughly believe that everyone should include value stocks as a significant part of their investment portfolio.

Value usually doesn’t lead to quick returns and that’s why patience is a virtue here. But over the long term, it blows all other strategies away by a huge margin, and it does so with less volatility and personal stress if one is the kind of person who worries about their net-worth by looking at the price tickers every other day. Think of it in this way. If you invest $1000 and you are sure the investment is worth $1200 in a year time, what difference does it makes between now to a year later even if the investment drops below $1000? If you can control this evil of yours where the daily price ticker means nothing to you, you are a true value investor. It is no coincidence that Warren Buffett is both the best-known value investor and the world’s second-richest person. So following Benjamin Graham’s strategy is the best way in investing. Besides Buffett, direct-disciples of Ben includes Walter Scholoss who over a 28 year period averages a 21% compounded return, Tom Knapp & Ed Anderson who formed the framed investment firm Tweedy Browne which averages 20% return, Bill Ruane, & Charles Brande.

The results can be clearly distinguished in a study by Ibbotson Associates comparing the performance of value stocks, growth stocks, and the S&P 500 from 1968 to 2002. The returns from S&P 500, growth stocks, and value stocks averaged 6.5%, 8%, and 11% respectively. An initial investment of $1000 will be worth $8471, $13,520 and $34,630 in 2002.

Investors focused on value finished with twice as much cash as the growthies, and four times as much as the plain-vanilla indexers. That’s the difference between corn beef and steak.

Bearing in mind the study mechanically divided the market into value and growth categories - meaning that each category included both great stocks and complete garbage. Suppose that instead of just buying them all, you focused only on the best and the cheapest. Avoid the worst performers and focus on the best.

That’s what here’s attempting to do which is looking for businesses with the following traits.
Solid financials
Strong competitive position
At least 30% undervalued.
We don't care what sector the stock is – it can range from tech companies to banking although it is best to avoid all tech stocks.. In addition, buying value stock does not mean growth is excluded. In fact, growth is just part of the value equation – growth and value are joined at the hips. So most of what I buy got significant future growth potential. As long as it is cheap, I love to buy.

Such picks can really outperform. Take, for example, IBM in 1993, when upheaval in IBM's hardware business pushed the stock down to multidecade lows. The reports of IBM's death proved premature, and investors from that time are now sitting on returns greater than 600%.
Buffett used a similar strategy with his purchases of Coca-Cola beginning in 1988 at a dividend-adjusted price of around $4. He's since made a 10-bagger on that investment.
These aren't isolated examples. Such opportunities come up again and again to investors who are both patient and alert. I'm thinking of USG in 2000, Walgreen in Sep 2006, and Wal-Mart in 1997, and Altria and General Dynamics in the spring of 2003.

Opportunities like these are out there right now, so make sure you look for them. With the recent upheaval caused by the concern in Sub-prime loans, a good number of other stocks are still trading at what I consider bargain levels, especially for one in particular.