Thursday, June 28, 2007

General thoughts of market

True value investors see the stock market as a giant yard sale, at times there’s a fire garage sales going on, at times, the market is so fully or overly priced with the exception of one or two available at a humble discount. Prior to late last year, there were occasionally a few penny stocks on SGX that happen to be overlooked treasures. By today, even the last one that is extremely undervalued (based on the Graham method of valuation) a month back is gone – that was Lion Asia Pac, about a month back it was available at 17 cents and cash alone was covering its share price, yes, you heard that right. But such dusty diamonds are hardly, if even available today, are a lot harder to find now. It seems to be a generally fully-priced, or even overly, world out there. Perhaps this is because of the world is awash with cash. This is partly because of the low return rates otherwise provided by the banks. With the market as buoyant as it is right now, it turns out to be on the surface a no-brainer that putting money in the stock market would beat the return otherwise held in the bank. But with too much cash chasing too few assets, all stocks, good or bad, are pushed to a yet higher level without consideration for the risk involved.

With stock market prices going up, and yet even more cash available, the additional liquidity brings additional buyers, and some of the excess flows to other investment type of assets like properties, arts, and even ships and aeroplanes.

But fortunately, the world is connected and since the stock market is a giant yard, it covers the whole world of public companies. In the U.S., there are specifically a few large-cap, high quality companies that a value investor can gain an edge – like McDonald, Wal-Mart, P&G, Johnson & Johnson.

In addition, of all the big companies in the whole world, the most misunderstood and probably mispriced one is likely to be Berkshire Hathaway. Because of its large, complex, multi-businesses of which many has no synergy, offers no earnings guidance, has little Wall Street following, and once a year, you get to come to Omaha and get in line with everyone else to gain the same advantage by listening to the business progress, it seems hard to thus put a value to its business especially with no “professional” help from Wall Street.

Although many Wall Street analysts find it tough to put a value to its stock, the Berkshire’s annual report apparently makes that task simple and transparent enough. Each group of her business and some individually, are given with the essential information to put a decent valuation to each individual group of business.

If the world has run out of any undervalued stock, and even if Berkshire is fully-priced, or slightly over-priced, I would trust it into Berkshire as it is the safest stock that is sure to appreciate as time goes by with its quality stable of equities and businesses.

Saturday, June 23, 2007

Dividend Policy

When it comes to dividend policy, it is seldom explained on the logic. A company will say, “Our goal is to pay out 40% of earnings and to increase dividends at a rate at least equal to the rise in the CPI” and that’s it. There’s no explanation or analysis as to why that particular dividend policy is best for the owners of the business. Yet, allocation of capital is crucial to the business and investment management. Thus, it is important for both owners and managers to think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses, particularly those that have high asset to profit ratios, inflation causes some or all of the reported earnings to become unreal. The unreal portion – otherwise known as “restricted” – cannot be distributed as dividends if the business is to retain its economic position. Were these earnings to be distributed, the business would lose ground in one or more of the following areas: 1) its long-term competitive position, 2) its ability to maintain its unit volume of sales, 3) its financial strength. No matter how conservative its payout ratio, a business that consistently distributes restricted earnings is destined for oblivion unless equity capital is injected.

Restricted earnings are seldom valueless to owners, however, they must be heavily discounted. In effect, it is conscripted by the business, regardless how poor its economic potential. This retention-no-matter-how-unattractive-the-return situation is reflected in many so-called undervalued stocks that are selling well below its book value. For instance, A is selling for as low as one third its book value because of its economic reality. Every time, a dollar of earnings retained for reinvestment in the business, that dollar is transformed into only 25 cents of market value. But despite this gold-turn-into-lead process, most earnings were reinvested in the business rather than paid to owners. But this is inevitable as long as the business wants to survive in the industry.

Now, let’s turn our attention to the much more valuable unrestricted portion of the earnings. These earnings may, with equal probability, be retained or distributed. Management should chose the course that makes the greater sense for the owners of the business.

This principle is not universally or commonly accepted and practiced. For a variety of reasons managers like to withhold unrestricted earnings from shareholders. This may be to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, to enhance the value of his share options, etc. But in the view of the shareholders, there’s only one valid reason for retention. Unrestricted earnings should be retained only when there’s a reasonable prospect that for every dollar retained by the business, at least one dollar of market value must be created for the owners. This will only happen only if the capital retained produces incremental earnings equal to or more than those generally available to shareholders.

To illustrate, let’s assume an investor owns a risk-free 10% perpetual bond with one very unique feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e. a perpetual life and coupons offering the same cash or reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting his cash should instead take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.

If, however, if interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were zero. The opposite course – reinvestment of the coupon – would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they’ll be available at a large discount.

An analysis similar to that made by the hypothetical bondholder is appropriate for owners in thinking about whether a company’s unrestricted earnings should be retained or distributed. Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond example, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them to paid to you if low returns are the likely outcome of reinvestment.

Many corporate managers reason very much along these lines in determining whether their subsidiaries should distribute earnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level are often a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.

Following this approach, the CEO of a conglomerate will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO will accept no lesser behavior and will have no problem following through on this in his parent-subsidiary relationship. But if his own long-term record with incremental capital is 5% and the market rates are 15%, he’s likely to impose a dividend policy on the shareholders of the parent company that simply follows some historical or industry-wide payout pattern. Moreover, he’ll expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But ironically, he will seldom supply his owners with a similar analysis pertaining to the parent company.

When judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total increment capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of its excess cash in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns beings earned by the portion of earnings incrementally invested in the core business. The situation is similar to a basketball game: even if 11 of the 12 players are hopeless scorers, the team’s best scorer will be respectable because of the dominating skills of the star player.

Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. But most times, they don’t.

In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners’ interest in the exceptional business while sparing them participation in sub-par businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held responsible for those allocation decisions, regardless of how profitable the overall enterprise is.

Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, thus, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distribution earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.

We know excellent businesses throw off a lot of excess cash and somehow this excess cash must either be put to good use or to distribute back to owners. By distributing to owners, there’re two ways – by dividend or stock repurchase. However, what is more important is how management put the excess cash to good use through purchase of new businesses.

To illustrate, Conglomerate A owns many subsidiaries of which B is one of those. In 2006, B earned $72 million pre-tax compared to $8 million pre-tax when A acquired B 15 years ago. While an increase from $8 million to $72 million sounds terrific – and usually is – one should not automatically quantify that to be the case. You must firstly ensure that earnings in the base year were not severely depressed. If they were instead substantial in relation to capital employed, an even more critical issue must be examined: how much additional capital was required to produce the additional earnings. If a dollar of additional capital produces a dollar of earnings, it is no great feat – putting in a saving account will produce the same desired result.

In our case, B did exceptional well in both respects. First, the earnings 15 years back were excellent compared in relation to capital then employed in the business – earning $8 million on $40 million of tangible assets. Second, although annual earnings are now $64 million greater, the business requires only $40 million more in invested capital to operate than was the case then.

The dramatic growth in earning power of B, accompanied by their minor need for incremental nominal capital, illustrates clearly the power of the economic goodwill during an inflationary period (a phenomenon as detailed in the article before this). The financial characteristics of B have allowed A to use a very large portion of the earnings B generate elsewhere – acquiring C, D and so on. If an average business requires $8 million to generate an additional $1 million in pre-tax earnings, that business would, therefore, have needed over $550 million in additional capital from its owners in order to achieve an earnings performance commensurate to our fictitious business B.

When returns on capital are ordinary, an earn-more-by-putting-up-more strategy is no great managerial feat. You can get the same result personally while operating from your rocking chair – just triple your principle in a savings account and you tripled your earnings. If you know the facts, you would have held back praises for such actions. Yet, when CEOs retire, praises were often heaped for even those who quadrupled earnings in such companies during their reign – with no one examining whether this gain was attributable to many years of retained earnings and the working of compound interest.

If the company consistently earned a superior return on capital throughout the period, or if capital employed only doubled while earnings quadrupled during the CEO’s reign, the praise may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be restrained. A savings account in which interest at 8% would quadrupled in earnings in 18 years (of course, savings account isn’t 8% now).

The power of this simple math is often ignored by companies to the detrimental of their shareholders. Many corporate compensation plans reward managers handsomely for earnings increases produced sorely, or in large part, by retained earnings (earnings withheld from owners). For instance, 10-year, fixed-priced stock options are granted routinely, often by companies whose dividends are only a small percentage of earnings.

An illustration will show the inequities possible under such circumstances. Let’s suppose you had a $100,000 savings account earning 8% interest and “managed” by a trustee who could decide each year what portion of the interest you were to be paid in cash. Interest not paid would be “retained” and added to the savings account to compound. And let’s suppose that your trustee, in his superior wisdom, set the “pay-out ratio” at one quarter of the annual earnings.

Under these terms, your account would be worth $179,084 at the end of ten years. Additionally, your annual earnings would have increased about 70% from $8,000 to $13,515 under this “inspired” management. And, at last, your “dividends” would have increased commensurately, rising regularly from $2,000 in the first year to $3,378 in the tenth year. Each year, when your manager prepared his annual report to you, all of the charts would have had lines marching skyward.

Now to add more fun, let’s push the scenario one notch further and give your trustee-manager a ten-year fixed-priced option on part of your “business” (i.e. your savings account) based on its fair value in the first year. With such an option, your manager would reap a substantial profit at your expense – simply by withholding most of your earnings. If he was both a Machiavellian and a bit of a mathematician, he might just cut the payout ratio totally once he was firmly entrenched.

This scenario is not as far fetched as you might think. Many stock options in the corporate world simply have worked in the exact same way. They have gained in value simply by withholding earnings and not because it did well with the capital in its hands. If granting stock options as a way of compensation to its executives is a way of wresting shareholder’s funds, it will be even more unthinkable for those businesses where its managers grant options that was still regularly adding or obtaining additional capital for the business.

You would hardly see anywhere in the business world where ten-year options are granted to outsiders – ten-months are in fact very rare. The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period. Managers regularly engineer ten-year, fixed-priced options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value, and second, ignore the carrying cost of capital. As such, these managers end up profiting much as they would have had they had an option on that savings account that was automatically building up in value.

Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. Ironically, managers who are really exceptional to shareholders almost always get far less than they should. But when the result is equitable, it is accidental. Once granted, the option is blind to individual performance. Because it is irrevocable and unconditional (as long as the manager remains in the company), the sluggard receives rewards from his options precisely as does the star.

Ironically, the oratory about options frequently describes it to be desirable because they put managers and owners in the same financial situation. In reality, the situations are far apart. In terms of capital costs, owners have bore the burden of it whereas the holder of a fixed-priced option bears no capital costs at all. An option holder has no downside risk while the owners have to weigh the upside potential against the downside risk. In fact, the business project in which you would wish to have an option is frequently the project in which you would reject ownership – you’ll be happy to accept a TOTO ticket as a gift but you’ll never buy one.

Despite the shortcomings of options, it can be appropriate under certain circumstances. The earlier criticism on it relates to its indiscriminate use and, in this connection, there are a couple of points that need to be highlighted.

First, stock options are inevitably tied to the overall corporation performance. Thus, it should logically be awarded only to those managers with overall responsibility that causes the eventual result within their scope. The Michael Jordan of a team should expect, and also deserve, a big payoff for his performance – even if he plays for a mediocre team. While the side-kicks should get rewards that fit their performance even if he plays for a perennial winning team. Only those with overall responsibility for the team should have their rewards tied to its results.

Second, options must be structured carefully. There should be a carrying-cost factor built into it. Equally important, they should be priced realistically. Managers unfailingly point out how unrealistic market prices can be as an index of real value when they are faced with offers for their companies. But why, then, should these same depressed prices be the valuations at which managers sell portions of their businesses to themselves? Owners are generally not well served by the sale of part of their business at a bargain price – whether the sale is to outsiders or insiders. Thus, options should be priced at true business value.

In the whole wide world, only one corporation has never distributed any earnings to its owners except on one occasion. You would have guessed it – Berkshire Hathaway. Let’s turn to Berkshire and examine how these dividend principles apply to it. Historically, Berkshire has earned well over market rates on retained earnings, in other words, creating over a dollar of market value for each dollar retained – rarely (and I mean extremely rarely) has a corporation met this goal, not to mention that Berkshire is the only one for such a long time retain all its earnings and yet been able to do so. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.

In fact, if significant distributions were given in its early years, it would have been disastrous. Before the current mode of Berkshire Hathaway, it is operated under three entities: Berkshire Hathaway Inc, Diversified Retailing Company, and Blue Chip Stamps (all now merged). Blue Chip paid a small dividend, and the other two none. If, instead, the companies had paid out their entire earnings, it is most certain that there would be no earnings today, and perhaps running out of capital. The three companies each originally made their money from a single business: 1) Textiles at Berkshire, 2) department stores at DRC, 3) trading stamps at BCS. These cornerstone businesses then have, respectively, 1) survived but earned almost nothing, 2) shriveled in size while incurring large losses, and 3) shrunk in sales volume to about 5% its size at the time of their entry by 1984. Only by committing available funds to much better businesses were Berkshire able to overcome these origins.

The incentive-compensation system at Berkshire rewards key managers for meeting targets in their own turf. If, for example, See’s does well, that does not produce incentive compensation at the Buffalo News or vice versa. Neither does Berkshire looks at the price of Berkshire stock when they award bonus checks. It is in Berkshire that they believe good unit performance should be rewarded regardless of the overall performance of its parent – Berkshire in this case. If See’s makes $100 million in profit, See’s manager will be awarded based on the $100 million performance even if Berkshire makes a loss in that year. Similarly, average performance should earn no special rewards even if Berkshire share soar through the roof. Performance is therefore defined based on the underlying economic performance of the business – in cases where manager’s performance is due to any tailwinds not of their own making, applause should be withheld, or in other cases, if managers manage to arrest unavoidable headwinds, applause must be given.

Saturday, June 16, 2007

Book Value, Intrinsic Value and Business Valuation

Let’s distinguish the difference between Book Value and Intrinsic Value. Book Value is the amount that has been pumped into a venture because whatever amount that has been invested is being recorded on the book – even if it at an overpaid price. What has been invested in a business does not guarantee what can be generated out of the business. But to make a profitable deal, what counts is what can be generated out from what has been fed into it. In this case, Intrinsic Value is the measurement of what can eventually be taken out from the business. Simply put, Book Value as a measurement or proxy for the relative attractiveness of a business or its intrinsic value is meaningless.

In reality, the value between the two is often different, sometimes vastly so. In the event than intrinsic value exceeds the book value, whoever that invested in the business got his money worth. Since intrinsic value is a calculation based on the sum of all the business cash flows during its remaining life, it pays for investors to act only on businesses which are certain to produce a steady and predictable cash flow, and at the same time, the business must not be easily vulnerable to new or current competition.

You can gain an insight into the difference between Book Value and Intrinsic Value by comparing the current earning power of an undergraduate and a blue-collar worker. The undergraduate may be earning $1000 monthly on a part-time job while the blue-collar worker is earning $2000 monthly. If the earning is treated as the Book Value, then is it a true indication of the intrinsic value of them? Obviously, the intrinsic value of the undergraduate is much higher than what his book value today suggests when he graduates.

Now, let’s do an example based on a fictitious business offer as if it is available to you as a whole. Assuming there’re two businesses making chewing gum, Wrigleys and China Gum, up for sale. Each possesses vastly different business economics and competitive advantages. Wrigleys is available at a price tag of $50 million and China Gum is available for $36 million. Each of them earns $4 million. In other words, the PE ratio is 12.5 for Wrigleys and 9 for China Gum, which will you chose? I bet most of you’d chose China Gum since it costs $14 million lesser while earning the same profit, and also, it takes a shorter time to recoup the capital invested.

Now, let’s throw in some more important information. Wrigleys’ net tangible asset is $16 million and China Gum is $36 million. This works out at a return of 25% on net tangible assets for Wrigleys and 11% for China Gum. Now, we do know a little bit more why did Wrigleys commands a premium of $34 million over its tangible assets. China Gum while making the same profit may well thus be sold for the value of its net tangible assets because the business possesses little or no economic goodwill. But then, if you pay $50 million for Wrigleys, then effectively, an investor return on the business is 8%, of which $34 million will be recorded in the balance sheet as Goodwill, and $16 million as tangible assets.

So, in this case, is it still worthwhile to buy Wrigleys over China Gum? The answer is a resounding “Yes” even if both businesses are expected to have flat unit volume as long as you anticipate a world of continuous inflation. To understand why, we must understand the workings of inflation and that it is inevitable over time.

What happens in an inflationary world? It simply means prices in the future will be higher than today for the same service or product rendered. In the long run, inflation is nothing but a certainty and it is inevitable. Imagine the impact that a doubling of price level will have on both businesses. Both would need to double their earnings to $8 million to keep themselves even with inflation. This would seem easy: just sell the same number of units at double the earlier price and assuming profit margins remain unchanged, profit must then double.

But more importantly, to bring that about, both businesses would have to double their nominal investment in net tangible assets, given that that is the kind of economic requirement that inflation usually imposes on businesses, good or bad. And all this inflation-required investments will produce no improvement in the rate of return. The reason for this investment is the survival of the business, not the prosperity of the owner.

Remember that Wrigleys had net tangible assets of $16 million. Thus, because of the inflation, they had to commit an additional $16 million to fund the capital needs. China Gum, however, had a burden over twice as large by investing an additional of $36 million in capital.

After the dust had settled, China Gum now earning $8 million annually might well be worth the value of its tangible assets, or $72 million. This means its owners would have only garnered a dollar worth of nominal value for every new dollar invested.

However, Wrigleys, also earning $8 million might well be worth $100 million (as it logically would be) on the same basis as it was originally available. So it would have gained $50 million in nominal value while its owners just put up $16 million in additional capital – over $3 of nominal value gained for every dollar invested.

Because of inflation, both businesses were forced to put up additional capital just to stay even with inflation for real profits. However, in this case, China Gum although doubling their earnings did not get any real growth in earnings because it is eaten up by inflation – they were having the same purchasing power when they earn $8 million as when they were earning $4 million. But it is different for Wrigleys, the owners got more than a dollar worth of value for each dollar invested in times of inflation. Simply, Wrigleys was beating the rate of inflation.

Any business that requires some form of tangible assets to operate (and almost all do) is hurt by inflation. Thus, businesses needing the least or little in the way of tangible assets simply are hurt the least.

The reality of this has been difficult for many people to appreciate. For years, tradition wisdom held that assets are the best protection for inflation. Thus, businesses laden with natural resources, plant and equipments, or any other tangible assets, are thought to be the best protection against inflation. But unfortunately, it doesn’t work that way. Sad to say some traditions are “long on tradition, short on wisdom.” Inflation is best protected by the earning power of the asset, not the book value. Asset-heavy businesses tend to earn low rate of return – to the point that barely provide enough capital to fund the inflationary needs of the business, with nothing left for real growth, for distribution to owners, or for acquisition of new businesses.

During the inflationary years, a disproportionate number of great businesses fortunes were built up by operations that combined intangibles or goodwill with lasting economic value with relatively small requirements for tangible assets. In such cases, earnings have spiraled upwards in nominal dollars with little in the way of additional capital, and these nominal dollars have largely been used to acquire new businesses or repurchase outstanding shares. In times of inflation, Goodwill is the gift that keeps giving.

But that statement is only valid to true economic goodwill. Spurious accounting goodwill is another matter and there’re plenty around. When a management purchases a business at a silly price, the same accounting treatment is observed. Because Goodwill cannot go anywhere else, the silliness ends up in the Goodwill account. Due to the lack of managerial discipline and business-savvy, the account was created and it is treated as an asset as if the acquisition had been a sensible one. But for any past silliness, the future pays for it. When someone try to reach for the silliness, the Goodwill just melts away and then to bring the acquisition closer to what is intrinsically worth, an impairment of Goodwill will have to be taken to make up for the past accounting shenanigans.

In taking silliness of such business deal to the forefront, imagine you are an undergraduate, would you merge your earnings, although you’re not earning a single cent today, with a plumber who earns $2000 monthly on a 50/50 basis so as to get $1000 monthly? If you merge, after you graduate, and if you command $3000 monthly, you’d then have to combine your pay with the plumber’s pay, and you’d get only $2500 because of the decision you took to merge. You think this is ridiculous, isn’t it? But that’s what has been happening in the business world where management simply is that silly – well, I can’t say they are that silly, maybe they’ve got their personal agenda to enrich themselves rather than to look after the shareholder’s value.

And the plumber said with a parting shot to the undergraduate when they merged: “Promise never to do a deal this dumb in the future.”

Friday, June 08, 2007

Investing Experience

I’m gonna to talk something which is a little detrimental to my advantage because this will increase the circle of competition in the correct method of investing. But on the whole, nature as it is, even with the facts of life staring with undisputable truth, it is hardly taken with due respect.

For the regulars on my blog, you’ll probably know that I only purchase undervalued marketable equities, regardless of the view of the general market. Most of the time, I’m swimming upstream in most of my decisions in investments. Along the swim upwards, there’re many bystanders who keep yelling “hey dude, you’re in the wrong direction.”

As at that point, if the stock price is an accurate indicator of value, I admit I’m in the wrong direction. Having said that, I realized early in my proper investing road, I’m lucky to pick up the correct concepts through the best investing teacher in history, Benjamin Graham. He said, “In the short run, stock market is a voting machine. In the long run, stock market is a weighing machine.” What is important to me is the long run, therefore, as long as I invest at a fair price – it’d be much better if undervalued – I do not care if the price I invested at would go 10%, 20% or even 30% lower than at the price I got at. I realized the stock market is like a big gambling house – although it shouldn’t be treated as one in the first place. Maybe someone should put a bouncer at the front end to screen potential gamblers from entering. But then without these gamblers, the opportunity for prices to get out of whack (in both directions) from its intrinsic value will be seriously remote. With millions of market participants, it is impossible to know what the next fool or genius will buy or sell their stocks at. Not that I don’t feel pain when I see prices going even lower than the price I considered already undervalued. I too at times rant within that I could have gotten at a better price but ultimately what counts is not tomorrow, neither does it counts a year later unless you’re only keen to show results by making the numbers. What counts will be the progress of the business at the undervalued price an investor pays for in 10 years, 20 years or even for an investor’s lifetime.

But such long-term view will seriously reduce the number of potential businesses an investor can deploy their money in. When you can find one, you should pump as much resources in that business that meets the two criteria. Furthermore, if the stock price goes down yet further, ironically, in the measurement of risk by Wall Street, risk has increased. Hello, risk has increased because stock price plunged? Volatility as a measurement of risk is total nonsense. Risk should be measured by how much you understand the business long-term competitive advantage, the price you are paying at and ultimately the present value of all future cash flows the company will produce. For me as with all true-blue intelligent investors, a yet-further depressed price only serves as an opportunity to increase your stake in a fabulous business.

Thus far, for some of the purchases I made, I feel I’m actually profiting from the eventual class of entering shareholders who took my place. For example, Stamford Land, I bought the share at 29 cents in December 2005. At that time, the price was undervalued because investors did not care about the huge gain of property gain SL will record in the subsequent fiscal year. What happened, was profit then surged by 60% if I remember correctly. SL ended at a recent high of 65 cents. At that price, people were expecting a bumper dividend but they ignored a fundamental reality that any dividend is dependent on the business cash flow capability. I sold out at a much lower price because I do not expect to catch both the bottom or should I expect to catch the top. Then finally, SL issued their 06/07 report and 3 cents dividend was given. Coupled with the high price placed on its share, investors were naturally disappointed and it went to 55 cents (although still not a terrible plunge). The lesson here is an inferior class of investors ultimately entered the business compared to the superior class of investors who bought at an undervalued price. So what really happened was the superior class profited from an inferior class of investors. The higher the price you enter in, the higher your risk. So it totally debunks the concept of volatility as a risk.

I’ll end here for now. There’ll be a part two on some other investing thoughts on the difference between book value and intrinsic value.

Sunday, June 03, 2007

Misconceptions on Investing

Misconceptions come in all shapes and sizes. I swear when I ask my friend what’s the capital of Australia, many of them would reply Sydney or Melbourne. But the capital is Canberra. Similarly, in investing there are many misconstrued notions which I shall try to address here as far as I could.

Investing misconceptions are like that: The untruth is always packaged as truth even in the face of logic. I think the best way to deal with it is to continuously attack and disprove the misconceptions.

1) “Wow, that stock’s cheap at 20 cents.”

The whole concept of price per share should be done away with. The popularization of differentiating stocks into “blue-chips” and “penny stocks” are doing many ignorant investors a great disfavor. This is as if to classify stocks as in fashion into “Chanel” and “G2000.” Here the saying describes such behavior in the best light, “One who knows the price of everything but the value of nothing.”

The fact that SC Global is trading at $5.50 per share and Thai Beverage is trading at 28 cents per share does not mean that one is cheap and the other is expensive.

A share of stock can be pictured as a piece of the cake. The fact that I’ve five cherries on my slice and you have two doesn’t mean my slice is superior to yours. What is important is how big the cake is, and what ratio or percentage your slice comprises in relation to the cake.

What should investors then focus on? A company’s market capitalization is the price per share multiplied by the number of shares outstanding. The enterprise value is the market cap plus net debt. Investing in marketable securities must be treated as if one is examining to buy a private business as a whole. If you were to buy SC Global, despite its “sky-high” per share price, you’d only pay $870 million (the market cap) for the whole business. Compared to Thai Beverage, which is nearly 8 times as costly at $7 billion market cap.

The gist in how to think about prices in investing is to think price in terms of value that you’ll eventually get out of it.

2) “I want to buy at the bottom and sell out at the top.”

I’m at times as guilty as anybody of trying to time the bottom as well as the top. I get upset when a stock drops immediately after I buy and goes up immediately after I sell. One can go on a tantrum and complain loudly about how this always happens.

The truth is it’s very foolish to think one can catch the bottom or top on a regular basis. The stock market is a gigantic auction where millions of people participate in, buying or selling every day. When I buy or sell a stock, I’m selling or buying to or from one of those millions. It’d be impossible to predict what those millions of other people are going to do the second after I execute my trade.

Then what should investors focus on? I believe that investor’s performance can be enhanced immensely once they realize the futility of trying to time a top or a bottom. It’ll stop foolish thinking, and promotes thinking such as “What is the best estimate for the intrinsic value of the stock?”

It is important to recognize two super-contagious emotions which will affect an individual investing record if they are not kept in check: Fear and Greed. These two emotions will remain forever in the investing community and will swing from one end to the other at different time in point. The timing of these emotions will be equally unpredictable, both as to the duration as well as the degree. Therefore, one should never try to anticipate the arrival or departure of either emotion. The goal of an investor should simply attempt to be modest when looking at how to profit from the folly of the others: “To be fearful when others are greedy and to be greedy when others are fearful.”

As this is written, little fear is visible in a few quarters in the stock market – the high valuation awarded to China stocks, Singapore property sectors, and to a certain extent, the risk undertaken by loaners to borrowers to finance property. We have seen in the past how foolish lenders can be in extending loans to borrowers without proper risk/reward probability taken into consideration.

There’s nothing more exhilarating than to participate in a bull market in which the rewards to the investors are effortless. Unfortunately, if the stock performance becomes uncoupled with the business underlying economics, the rewards simply melts away when it is reached for. Simply, stocks can’t outperform the businesses indefinitely. When called upon, the stock performance will either enhance or contract closer to the underlying business value, based on the past valuation by the market.

Moreover, because of transaction cost, which can be hefty for those with “professional” helpers, stockholders as a whole and over the long term must inevitably underperform the company they own. If STI businesses as a whole earn 12% on equity annually, investors as a whole must end up earning significantly less. Bull market can obscure mathematical laws, but they cannot repeal them.

3) “Great company, great investment.”

When it comes to investment, two things counts, the length of time you hold it and the price you pay. An investment in a great business by paying a dear price is no great investment. By paying a dear price, one is actually paying for business earnings of well-many years down the road. Eventually, a business will need a period of time to play catch-up for a high-price-paid-today stock.

4) “Falling in love for a hot stock.”

It is hard to resist a sexy lady’s advances for a date at any time. The problem is the trouble always begins much later when the things that really counts begin take its shape. After all, who could resist a temptation when it promises one all the goodies? Except that the goodies last for a short period. Similarly in stocks, investors get suck into a full-blown romance and fall in love with a stock’s story. Emotion will cloud their judgment when it comes to assessing valuations, and its growth and economical prospects.

Enron is a classic example. A company operated by con artists at the very top who are disguised as angels in selling the company to investors. Investors are being pursued by Enron, just very much like a guy who does nothing but get ask for a hot date with a hot chick. The problem is everything beneath the beautiful surface is nothing but a can of worms.