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.

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