Thursday, August 30, 2007

View on long term investing

The major reason why investors lose money is: 1) they view stock market as some sort of magic expecting a dollar invested today to be worth two tomorrow (too short an horizon); 2) by paying the wrong price; 3) at times by paying the wrong price, there’s still a chance for recovery if the business economics will improve with time but then investors do not have the patience and sell themselves out early.

Investors of such practice simply are watching and following the wrong indicator of performance that tells the truth – they are just watching the price ticker. As if in watching a basketball game, the action is on the game floor, not on the scoreboard. It is what the players that are doing on the court that influence what will be shown on the scoreboard.

And then as if one is able to outscore every other player on the board, one tries to outmaneuver the other by trying to catch both the top and the bottom by pressing and squeezing harder than the one next door. These players are just influenced by trying to predict when the next storm is going to come. As a storm approaches, they try to run for cover totally but then a storm does not unroot all tress. Trees which are well deeply rooted are never in the long run destroyed by any storms. Thus, let us look a little in the history of stock which may give a little insight into what may happen in the future and thus improve the chances of investing success.

Firstly, investing is an act of faith. By investing a dollar today, we are entrusting to the steward in a corporation in the faith or at least with the hope that their endeavors will generate a rate of return that more than commensurate our investments. In this commitment of faith, we are committing our investment in the long term success of the corporation or economy at large and that the world’s financial markets will continue to march forward.

Any attempt to try to time, rather than price the market is an act of speculation. This action of timing is more to do with human psychology rather than wisdom. Market participants’ faith in investing has waxed and waned, kindled by bull markets and chilled by bear markets that happened from time to time, but over time the market has always remained intact. The market has survived the Great Depression, two world wars, the rise and fall of communism, two oil shocks, the assassination of a U.S. president, time of high inflation, shocks in commodity prices, among many others. In recent years (since 1982 though), our faith has been enhanced by the bull market in stocks and has accelerated, without much ado – perhaps only in early 2000s – until now.

In the event of both bull, many just can only see all things which are rosy and unfortunately, the reverse applies in the bear market as well where many just cannot see anything rosy except doomsday. Excessive behaviors always lead an investor to either bringing himself to be in a very risky position where he might make a lot but the price to be paid for the risk to be undertaken simply does not commensurate the price with the risk. On the other hand, in a frenzy market downturn, an investor may simply just head for any exit as long as he sees one where again, he will not consider the price he is selling commensurate with the value that he is foregoing.

Might some unforeseeable or unpredictable shock trigger another depression so severe that it would destroy our faith in the promise of investing? Possibility is always there. Excessive confidence in a smooth and rising sea can only blind us to the risk of storms. History is littered with episodes in which the enthusiasm of investors has driven equity prices to and beyond the point at which they are swept into the vortex of speculation, ultimately leading to unexpected losses. There is definitely little certainty in investing, at least for the short run. As long term investors, however, we must be aware of the past and cannot afford to let the ruinous possibilities frighten us away from the markets. For without risk, there is no return.

Here is a story about Chance. Chance is someone who knows about risk in all seasons because he is a gardener. His story contains an inspirational message to long term investors. The seasons of his garden are akin to the cycles of the economy and the financial markets. We can emulate his faith that their patterns of the past is an indication that may define their course in the future.

Chance is a gardener who works for a rich man in his mansion. He lives in a solitary world bereft of contact with the outside world. One day, the rich man dies, Chance wanders out on his first foray into the world. He is hit by the limousine of a powerful advisor to the president. When he is rushed to the advisor’s estate for medical care, he identifies himself only as “Chance the gardener.” In the confusion, his name is wrongly interpreted as “Chauncey Gardiner.”

When the President visits the advisor, the recuperating Chance sits in on the meeting. The economy is slumping; blue chip corporations are under duress and the stock market is collapsing. Unexpectedly, Chance is asked for his advice:

“In a garden,” he said, “growth has its season. There are spring and summer, but there are also fall and winter. And then spring and summer again. As long as the roots are not severed, all is well and all will be well.”

The president seems quietly pleased and delighted with the insightful thoughts of Chance. The president said: “I must admit, Mr. Gardiner, that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time. Many of us forget that nature and society as one. Like nature, our economic system remains, in the long run, stable and rational and that’s why we must not fear to be at its mercy. We welcome the inevitable seasons of nature, yet we are upset by the seasons of our economy. How foolish of us.”

This story may be fictional. But like Chance, I see the history of our economy to be similar. The economy has passed the test of any past disasters and remains as healthy and stable in the long run. No doubt, it is marked by seasons of growth, sluggishness and decline but its roots have remained intact and strong. Despite changing seasons, our economy has persisted in an upward course, rebounding from the blackest of calamities.

Just for some historical figures. The average annual nominal return for three different time periods are: 1) 1802 to 1870 is 7.1%; 2) 1871 to 1925 is 7.2%; 3) 1926 to 1977 is 10.6%. After accounting for inflation, the net real return is 7%, 6.6% and 7.2% for the same periods respectively.

For an eye opener, an initial $10,000 investment in stocks from 1802 on, with all dividends reinvested will result in a terminal value of $5.6 billion in real dollars. Yet more staggering result if the same $10,000 is invested in bonds rather than stocks, it will result in $8 million. Well, that is not the worst, the worst is to invest in lands or properties.

Well, of course, none of us can expect to live near to two centuries, much less one. But having 50 years of investing time period is certainly within the reach of most people and 50 years is certainly a long time period where many different seasons will come and then go and come again. And with the story of Chance, having a strategy like his will certainly be great for most investors, at least for those who don’t know what they are doing.

Saturday, August 25, 2007

What is investing?

The strategy for sustainable investing remains little change since the dawn of Wall Street. Purchasing marketable stocks is akin to purchasing and evaluating businesses in its entirety. We should want a business that is one to be a) we can understand; b) with favorable long-term prospects and economics; c) operated by honest and competent people; d) available at an attractive price.

Maybe you will ask how does one decide on an attractive price. In answering this question, most analysts feel they must choose between two approaches which they thought to be customarily opposite in nature. The two approaches are “growth” and “value.” However, many investment professionals view any mixing of the two approaches as a form of intellectual cross-dressing.

However, Mr. Warren Buffett, thinks the two approaches are joined at the hip: He remarked, “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”

Then the term value investing is kind of redundant. If investing is not for seeking more value, then what else could it be for? At any time, by consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – must be labeled as speculation.

Whether the term value investing is appropriate or not, it is widely used. Typically it implies the purchase of stocks having attributes such as a low ratio of price to book value, a low price to earnings ratio, or a high dividend yield. Such characteristics, unfortunately, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is thus truly practicing on the principle of obtaining value in his investments. On the other hand, the opposite characteristics – a high price to book ratio, a high price to earnings ratio and a low dividend yield – are in no way inconsistent with a value purchase.

On the same note, business growth, per se, reveals little about value. It’s true that growth often has a positive impact on value, sometimes one of extraordinary proportions. But such a conclusion is far from certain. For example, in the past, investors have regularly poured money into the airline industry to finance profitless growth. For these investors, it would have been better if the Wright brothers did not even invent the airplane. The more the industry has grown, the worst the disaster for owners.

Investors can benefit from growth only when the business in point can invest at incremental returns that are enticing. That is to say for each dollar used to finance the growth, each of such dollar must creates over a dollar of long-term market value. In the case of a low-return business needing incremental funds, growth will hurt investors.

Written over 60 years ago, John Burr Williams, set forth in his book, The Theory of Investment Value, the equation of value, which is condensed here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.” Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity “coupons.”

An investor should buy the investment shown to be the cheapest by the discounted cash-flow calculation regardless of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates or return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. The first type of business is, unfortunately, very hard to find. Most high-return businesses tend to need relatively little capital. Shareholders of such business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Thought the mathematical calculations required to evaluate equities are not difficult, an analyst can easily go wrong in estimating future “coupons.” There’re two ways to mitigate the problem. First, try to stick to businesses that we think we can understand. To me, that means they must be relatively simple and stable in character. If a business is complex or subject to constant change, I’m just simply not smart enough to predict the business future and ultimately, the future cash flow. Ironically, this shortcoming should not bother you. In fact, it is a strength rather than weakness. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistake.

Second, and as important, one must insist on a margin of safety in their purchase price. If one calculate the value of a common stock to be only slight higher or lower than its price, one should be disinterested in buying. This principle of margin of safety brought to us by Ben Graham is the cornerstone to investment success.

Sunday, August 19, 2007

List of villians in the investment community

1) The conglomerate movement, “with all its fancy rhetoric about synergism and leverage.”

2) Accountants who played footsie with stock-promoting managements by certifying earnings that weren’t earnings at all.

3) “Modern” corporate treasurers who looked upon their company pension funds as new-found profit centers and pressured their investment advisers into speculating with them.

4) Investment advisers who massacred clients’ portfolios because they were trying to make good on the over-promises that they had made to attract the business.

5) Investment managers who brought and churned the worst collection of new issues and other junk, and the underwriters who made fortunes bringing them out.

6) Elements of the financial press which promoted into new investment geniuses a group of neophytes who didn’t even have the first requisite for managing their own money, much less other people’s money, and a lack for sense of responsibility.

7) The securities salesmen who peddle the items with the best stories – or the biggest markups – even though such issues were totally unsuited to the customers’ needs.

8) The sanctimonious partners of major investment houses who wrung their hands over all these shameless happenings while they deployed an army of untrained salesmen to forage even less trained investors.

9) Mutual fund managers who tried to become millionaires overnight by using every gimmick imaginable to manufacture their own paper performance.

10) Portfolio managers who collected bonanza incentives of the “heads I win, tails you lose” kind, which made them fortunes in the bull market but turned the portfolios they managed into disasters in the bear market.

11) Security analysts who forgot about their professional ethics to become storytellers and let their institutions be taken in by a whole parade of confidence men.

Thursday, August 09, 2007

Who does better collectively? Active or Passive investors?

Who does better, the active investor or the passive investor? William Sharpe, a Nobel Prize winner, divides the world of investors in “active” and “passive” investors. A passive investor is one who is sensible enough to realize you can’t beat the market. The passive investor who thus knowing his limitation would logically put all his money into a market portfolio of every stock in existence (roughly, an “index fund”).

An active investor is one who suffers from the delusion (if you know what you are doing, it is not a delusion) that he can beat the market. The active investor puts his money into anything except a market portfolio. By Sharpe’s terms, an active investor need not trade “actively.” A retiree who has two shares of Johnson & Johnson in the bottom of his drawer counts as an active investor. He is operating on the assumption that JNJ is a better stock to own than a total market index fund. Active investors include anyone who tries to pick “good” stocks and shun “bad” ones, or who hires someone else to do that by putting money into an actively managed mutual fund or investment partnership.

Who does better was Sharpe’s query: the active investors or the passive ones? Collectively, the world’s investors own 100 percent of all the world’s stocks. In other words, the average return of all the world’s investors – before factoring in management expenses, brokerage fees and taxes – has to be identical to the average return of the stock market as a whole. It can’t be otherwise.

Even more clearly, the average return of just the passive investors is equal to the average stock market return since all passive investors invest in the market index which matches the return of the whole market.

By subtracting the return of the passive investors from the aggregate, this leaves the return of the active investors. Since the passive investors have exactly the same return as the whole, it follows that the active investors, as a group, must also have the same average return as the whole market. This leads to a surprising conclusion. Collectively (not individually), active investors must do no better or worst (before taxes and fees) than the passive investors.

Some active investors do better than others, as we all know. Every active investor hopes to do better than the others. One thing is for sure: Everyone can’t do “better than average.”

Active investing is thus a zero-sum game. The only way for one active investor to do better than average is for another active investor to do worst than average. You can’t wriggle out of this conclusion by imagining that the active investor’s profits come at the expense of those wimpy passive investors who settle for average return. The average return of the passive investors is exactly the same as that of the active investors, for the reason highlighted earlier.

Now factor in expenses. The passive investors have little or no brokerage fees, management fees, or capital gain taxes (they rarely have to sell). The expenses of the active traders vary. For most parts, active investors will be paying a percent or two in fees and more in commissions and taxes. (Hedge fund investors pay much more in fees when the fund does well.) This is something like 2 percent on capital per year and must be deducted from the return.

Two percent is no small cake. In the twentieth century, the average stock market return was something like 5 percent more than the risk-free rate. Yet an active investor has to earn about two percentage points more than average just to keep up with the passive investors.

Do some active investors achieve that? Absolutely. Then do these active investors who have achieved that are also able to sustain what they are doing? Again, a resounding yes. They’re the smart or lucky few – more smart than lucky – who fall at the upper end of the spectrum of returns. The majority of active investors do not achieve that break-even point. Most people who think they can beat the market do worst than the market (worst yet, some deceive themselves by counting the wins but not the losses – ask how many gamblers who always proclaim a win when they strike a lottery). This is an irrefutable conclusion. Sharpe said, and it is not based on fancy economic theorizing. It simply follows from the laws of arithmetic.

Tuesday, August 07, 2007

When those who didn't care meet those who didn't think

What happens when the one who doesn't care meets the one who doesn’t think? It is a recipe for mischief and ultimately disaster in the field of investment.

In investment, who is the one who doesn’t care and who is the one who doesn’t think is clearly distinguishable. As Warren Bufett remarked, “First, many on Wall Street – a community which quality control is not prized – will sell investors anything they will buy. Generally, many market participants will not think what they will buy. A public opinion poll will usually replace thoughts for them which is the first step towards disaster. Obviously, no single event works per se can cause destruction to the world of investment. It’s usually a chain of events that lead to it. And we will try to unravel some of the critical events and key players that lead to it.

And of course, simply by following a contrarian approach is just as foolish as a follow-the-crowd strategy. Just because a stock or business is unpopular does not make it an intelligent purchase. What’s required is thinking rather than polling. In reality, unfortunately, Bertrand Russell’s observation about life in general applies with an uncanny truth in the financial world: “Most men would rather die than think. Many do.”

Originally, bonds that were initially investment-grade and downgraded were termed as “fallen-angels.” But yet again, Wall Street is full of illusionists.

Then, in the 1980s, a new kind of bastardized fallen angel burst onto the investment scene – “Junk bonds” that were far below investment grade when issued. As the decade passed, new offerings of manufactured junks became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name and obviously it was started promoted by those who didn’t care to those who didn’t think. In 1990 – even before the recession dealt its blows – the financial sky became dark with the bodies of failing corporations.

The preacher of debt assured us that this collapse wouldn’t happen: Huge debt, we were told, would cause operating managers to focus their efforts as never before (remember when you were a student, it is so easy to come up with dozens of positive reason for doing something but then most of it are illusions), much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. With such attention given, a very alert driver will be produced. But another certain consequence would be a deadly – and unnecessary – accident if the car hit even the tiniest pothole. The roads of business are riddled with potholes; a plan that required dodging them all is a plan for disaster.

In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: “Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” The failure of investors to heed this simple message caused them staggering losses as the 1990s began.

At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. Many businesses, good or bad, then bought with a mountain of debts could not service the interest with the gross income. Many of the bonds that financed the purchase were sold to the eventual failing savings and loan associations. And guess again who pick up the tabs for this folly? Again, it is the taxpayer.

When these disservices were done, however, dagger-selling investment bankers or rather promotees pointed to the “scholarly” research of academics, which reported that over the years the higher the interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds.

But, there was a flaw in the salesmen’s logic – one that a first-year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues.

The universes were of course unlike in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked towards that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing ones.

Wall Street cared little for such distinctions. As usual, the Street’s enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn’t care to those who didn’t think – and there was no shortage of either.

Monday, August 06, 2007

The origins of EBITDA and its implications

Ever wonder how did the term EBITDA – Earnings before Interest, Taxes, Depreciation and Amortization – come about? This goes back to more than half a century back with the beginning of Zero-Coupon bonds.

The first zero-coupon bonds – the famous Series E U.S Saving Bonds – were sold during World War II. No one then called the Series E a zero-coupon bond then, a term probably not invented yet. But that’s precisely how Series E functions.

These bonds came in denomination as small as $18.75. That amount purchased a $25 obligation of the U.S. government due in 10 years, terms that gave the buyer a compounded annual return of 2.9%. At the time, it was an attractive rate. That means the buyer would pay $18.75 for every $25 bond that the government issued. There’ll not be any yearly or semi-yearly interest given. Only at the end of 10 years, would the buyer get his $25. In effect, a zero-coupon bond requires no current interest payments from debt obligators, the investor receives his yield by purchasing the security at a significant discount from the maturity value. The effective interest rate is determined by the original issue price, the maturity value, and the period between issuance and maturity.

However, Saving Bonds are only issued to individuals and are unavailable in large denominations. One problem with a normal bond is that even though it pays a given interest rate – say 10% - the holder cannot be assured that a compounded 10% return will be realized. For that rate to materialize, each annual coupon must be reinvested at 10% as it is received. If the current interest rate is, say, 7% when these coupons come due, the holder will be unable to compound his money over the life of the bond at the advertised rate. For pension funds or other investors with long-term liabilities, “reinvestment risk” of this type can be a serious problem. And thus, Saving Bonds of Series E type can solve it. What big players needed was huge quantity of “Savings Bond Equivalent.”

Enter some ingenious – in the early 1980s – in this case, and you guess it, some investment bankers again. They created the instrument desired by “stripping” the semi-annual coupons from the standard Government issues. Each coupon, once detached, takes on the essential character of a Savings Bond since it represents a single sum due sometime in the future. For example, if you strip the 40 semi-annual coupons from a U.S. Government bond due in 20 years, you will have 40 zero-coupon bonds, with maturity ranging from 6 months to 20 years, each of which can then be bundled with other coupons of like maturity and marketed. If current interest rate is 10%, then a 20-year issue will sell for 14.20% of each dollar of bond. The purchaser of any given maturity is thus guaranteed a compounded rate of 10% for his entire holding period. As the years went by, stripping of government bonds is done on a large scale as it is well suited to the big buyers’ needs.

But all too often on Wall Street, what the wise men do in the beginning, fools do in the end. In the late 1980s, zero-coupon bonds and their functional equivalent, pay-in-kind (PIK) bonds have been issued in abundance by ever-junkier credits. (PIK bonds distribute additional PIK bonds semi-annually as interest instead of paying cash.) To these issuers, zero or PIK bonds offer one overwhelming advantage: It is impossible to default on a promise to pay nothing.

This principle at work – that you need not default for a long time if you solemnly promise to pay nothing for a long time – has not been lost on promoters and investment bankers seeking to finance ever-shakier deals. But its acceptance by lenders took a while. When the leveraged buy-out craze began in the mid 1980s, purchasers could borrow only on a reasonably sound basis, in which conservatively-estimated free cash flow was adequate to cover both interest and modest reductions in debt.

In the late 1980s, as the adrenalin of deal-makers surged, businesses began to be purchased at prices so high that all free cash flow had to be allocated to the payment of interest. That left nothing for the pay down of debt. Debt now became something to be refinanced rather than repaid.

Soon borrowers found even the new, lax standards intolerably binding. To induce lenders to finance even sillier deals, they introduced an abomination, EBITDA, as a test of a company’s ability to pay interest. Using this yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay.

Such an attitude surely is delusional. Capital expenditures that roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs. Even a high school dropout knows that to finance a car he must have income that covers not only interest and operating expenses, but also realistically calculated depreciation. He would be laughed out of the bank if he started talking about EBITDA.

Capital outlays at a business can be skipped, of course, in any given month, just as human can skip a day or two of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-stop feeding program will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. But of course, as businessmen, you should relish having competitors who are unable to fund capital expenditures.

You might think that waving away a major expense such as depreciation in an attempt to make a terrible deal look like a good one hits the limits of Wall Street’s ingenuity. If so, you haven’t read enough on the behavior of Wall Street. Promoters needed to find a way to justify even pricier acquisitions. Otherwise, they risked losing deals to other promoters who are more “imaginative.”

Promoters and their investment bankers proclaimed that EBITDA should now be measured against cash interest only, which meant that interest accruing on zero-coupon or PIK bonds could be ignored when the financial feasibility of a transaction was being assessed. This approach not only relegated depreciation expense to the let’s-ignore-it corner, but gave similar treatment to what was usually a significant portion of interest expense. To their shame, many professional investment managers went along with this shenanigans, though they usually were careful to do so with only clients’ money, not their own. Calling these managers “professionals” is actually too kind, they should be designated “promotees.”)

Under this new standard, a business earning, say, $100 million pre-tax and having debt on which $90 million of interest must be paid currently, might use zero-coupon or PIK issue to incur another $60 million of annual interest that would accrue and compound but not come due for some years. The rate for these issues would typically be very high, which means that the situation in year 2 might be $90 million cash interest plus $69 million accrued interest, and so on as the compounding proceeds. Such high-rate reborrowing schemes, which in the early 80s were confined, soon became models of modern finance at virtually all major investment banking houses.

Investment bankers show their humorous side when they make these offerings: They dispense income and balance sheet projections extending five or more years into the future for companies they barely had heard of a few months earlier.

Ken Galbraith, an influential Keynesian economist, in this witty and insightful bestseller, The Great Crash, coined a new economic term, “the bezzle,” defined as the current amount of undiscovered embezzlement. This financial creature has a magical quality: The embezzlers are richer by the amount of the bezzle, while the embezzlees do not yet feel poorer.

Professor Galbraith astutely pointed out that this sum should be added to the National Wealth so that we might know the Psychic National Wealth. Logically, a society that wanted to feel enormously prosperous would both encourage its citizens to embezzle and try not to detect the crime. By this means, “wealth” would balloon though not an ounce of productive work had been done.

The contemptuous nonsense of the bezzle is dwarfed by the real world nonsense of the zero-coupon bond. With zeros, one party to a contract can experience “income” without his opposite experiencing the pain of “expenditure.” In the earlier example, a company capable of earning only $100 million dollars annually – and therefore capable of paying only that much in interest – magically creates “earnings” for bondholders of $150 million. As long as major investors are willing to don their Peter Pan wings and repeated say “I believe,” there’s no limit as to how much “income” can be created by the zero-coupon bond.

Wall Street understandably welcomed this invention. Here, finally, was an instrument that would allow the Street to make deals at prices no longer limited by actual earning power. The result, obviously, would be more transactions: Silly prices will always attract sellers. But as intelligent investors watching from a distance, the more unprudent the market is, the more prudence you should exercise your own doings.

The zero-coupon or PIK bond possesses one additional attraction for the promoter and investment banker, which is the time eclipsing between folly and failure can be stretched out. This is no small benefit. If the period before all costs must be faced is long, promoters can create a string of foolish deals – and take in lots of fees – before any chicken come home to roost from their earlier ventures.

But, in the end, alchemy, whether it is metallurgical or financial, fails. A base business can not be transformed into a golden business by tricks of accounting or capital structure. You can smoke your way through but you can not gain knowledge. The man claiming to be a financial alchemist may become rich. But naïve investors rather than business achievements will usually be the source of his wealth.

Whatever their weaknesses, many zero-coupons or PIK bonds will not default. No financial instruments are evil per se; it’s just that some variations have far more potential for mischief than others.

The blue ribbon for mischief-creating should go to the zero-coupon issuer who is unable to make its interest payments on a current basis. An advice ought to be heeded is: whenever an investment banker or rather promoter starts talking about EBITDA or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures – shut your wallet tight. Turn the tables by suggesting the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures

The comments here about investment bankers may seem harsh but I believe that they should perform a gatekeeping role, just as auditors rightfully should but, guarding investors against the promoter’s propensity to indulge in excess. Promoters, after all, have throughout time exercised the same judgment and restraint in accepting money that alcoholics have exercised in accepting liquor. At the least, the banker’s conduct should rise to that of a responsible bartender who, when necessary, refuses the profit from the next drink to avoid sending a drunkard out on the highway. Unfortunately, many on Wall Street have found bartender morality to be an intolerably restrictive standard. Once, those who travel the low road on Wall Street encounter heavy traffic, everything comes to a standstill.

One distressing note: You may think the cost of zero-coupon folly will only be borne by the direct participants but that is far from the truth. Many pension funds, institutional investors were heavy buyers of such bonds, using cash. Straining to show splendid earnings, these buyers recorded – but did not receive – ultra-high interest income on these issues. Many of such funds got into big problems. Had their loans to shaky credits worked, the owners of the funds would have pocketed the profits. In many cases in which the loans will fail, the taxpayer will pick up the bill.

Saturday, August 04, 2007

GAAP accounting

To start, I shall offer a disclaimer: Despite the shortcomings of generally accepted accounting principles (GAAP), it would be a tough job to devise a better set of rules. The limitations of the existing set, however, need not be hindering: Managements are free to treat GAAP statements as a beginning rather than an end to their obligation to inform owners and creditors – and indeed they should for it is their morale duty. After all, any manager of a subsidiary company would find himself in hot water if he reported barebones GAAP numbers that omitted key information needed by his boss, the parent corporation CEO. Why, then, should the CEO of the parent company himself withhold information vitally useful to his bosses – the shareholder-owners of the corporation?

What needs to be reported is data – whether GAAP, non-GAAP or extra-GAAP – that helps financially-literate readers answer three important questions: 1) Approximately how much is this company worth? 2) What is the likelihood that it can meet its future obligations (whether to owners or creditors)? and 3) How good a job are its managers doing, given the hand they have been dealt?

In most cases, answers to one or more of the three questions are somewhere between difficult and impossible to glean from the minimum GAAP presentation. The business world is simply too complex for a single set of rules to effectively describe economic reality in a wide variety of businesses, especially conglomerates.

Twisting the problem yet further is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to be overcome. Too often their accountants willingly assist them – “How much,” says the client, “is two plus two?” Replies the ever cooperative accountant, “What number did you have in mind?” Even honest and well-intentioned managements sometimes stretch GAAP a bit in order to present figures they think will more appropriately describe their performance. Both the smoothing of earnings and the “big bath” quarter are “white lie” techniques employed otherwise by upright managements.

Then there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP as the gospel truth. So these charlatans interpret the rules “imaginatively” and record business transactions in ways that technically comply with GAAP but actually display an economic illusion to the world.

As long as investors – including supposedly sophisticated institutions – place fancy valuations to reported “earnings” that march steadily upwards, you can be sure that some managers and promoters will exploit GAAP to produce such numbers, no matter what the truth may be. Over the years, there were many accounting-based frauds of staggering size. Few of the perpetrators have been punished. Many have not even been censured. It has been far easier to steal large sums of money with a point of the pen than small sums with the point of a gun.

An interesting accounting irony lies in the treatment of controlled companies and those of minority holdings such as marketable securities. For controlled entities, all the earnings the subsidiary declares will flow to the parent’s income statement. The reverse is true for marketable securities where a business holds a minority stake. Only dividend declared by the marketable stock will be reflected in the business income statement. Thus, all other retained earnings will not be shown. However, accounting rules provide that the carrying value of these minority holdings of marketable stocks must be recorded on the balance sheet at current market prices. The result: GAAP accounting allows business to reflect in their net worth the up-to-date underlying values of the businesses they partially own, but does not allow businesses reflect their underlying earnings in their income statement.

The reverse is true for controlled entities. Here, businesses are allow to show full earnings in their income statement but never change the asset values on their balance sheet, no matter how much the value of a business might have increased since it was purchased.

Therefore, the mental approach to such accounting schizophrenia is to ignore GAAP figures and to focus sorely on the future earning power of both controlled and non-controlled businesses. Using this approach, we are able to establish our own ideas of business value better, and keeping these independent from both the accounting values shown on the books for controlled companies and the values placed by a sometimes foolish market on the partially-owned companies. It is this business value that investors should hope to increase at a reasonable rate in the years ahead. After all, what a stock price should represent is buying for all the future earnings of a business at a safe margin.

Mindset when buying into businesses or marketable securities

Let’s look at some of the common behavior of market participants in common stocks again. During this year, the stock market was an area of much excitement. You are, of course, aware of the small-scale roller coaster ride that produced the recent withdrawal of the market. The STI advanced from about 2800 at the start of the year to a high of almost 3700 recently, and withdrawing back to almost 3400 just this week. Mr. Market was on an euphoric mood until early this month and then experienced a sudden, small seizure.

We have “professional” investors, those who manage many billions, to thank for most of this mini turmoil. Instead of focusing on what business will do in the years ahead, many prestigious money managers focus on what they expect other money managers to do in the days ahead. For them, stocks are just tokens in a game.

An extreme attitude of what their attitude leads to is “portfolio insurance,” a money-management strategy that some private investors, including perhaps some leading investment “professionals,” embraced. This strategy – which is simply an exotically-labeled version of the small investor’s stop-loss order dictates that ever increasing portions of a stock portfolio, or their index-future equivalents, be sold as prices decline. The strategy says nothing else matters: A downward tick of a given magnitude will automatically trigger a sell order.

If you’ve thought that investment advisors were hired to invest, you may be bewildered by this technique. After buying a piece of land, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your property to whatever bidder was available at 10:31 on some morning just because at 10:30 a similar property sold for less than it would have brought on the previous day?

Moves like that, however, are what portfolio insurance or stop-loss order tells a fund, or market participant to make when it owns a portion of enterprises such as Capital Land or SGX. The less these companies are valued, the more vigorously they should be sold, says this approach. As a “logical” corollary, the approach commands the market participant to repurchase these companies once their prices have rebounded significantly. Considering such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberration fashion?

Many commentators, however, have also drawn an incorrect conclusion upon observing such events: They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. You’d be glad if you are a small investor or even big to hear the following conclusion. The commentators’ conclusion is dead wrong. Such markets are ideal for any investor – small or big – so long as he sticks to his investing knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment choices. He can only be hurt by such volatility if he is forced, by either financial or psychological factors, to sell at untoward times.

Mr. Market will perpetually offer the true investor opportunities – you can be sure of that – and when he does, we should be willing to participate.

Wednesday, August 01, 2007

Mindset when buying into businesses or marketable securities

I’m writing on the approach into buying into common stocks, and to some extent, the approach to buying a controlling stake in an entity. When buying into marketable security, the approach to the transaction is as if we are buying into a private business. We must look into the economic prospects of the business, the people in charge running it, and the price we must pay. We do not mind if the transaction is made at any time as long as the price is attractive. Indeed, we must be willing to hold a stock indefinitely as long as we expect the business to satisfactorily increase its economic value. When investing, we should view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, or not even as security analysts.

This approach makes an active trading market useful since it periodically presents investors with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of the trading in the securities market should not in any way bother investors any more than does the lack of daily quotations of that security. Eventually, an investor’s economic fate is determined by the economic fate of the security they hold.

Ben Graham long ago described the mental attitude toward market fluctuation that I personally truly believe to be the most conducive to sustained investment success. He said that you should imagine market quotations as coming from a remarkably accommodative and manic-depressive fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market will appear daily and name you a price at which he will either buy your interest or sell you his. The option to buy, sell or ignore him is entirely up to you.

Even though the business that the two of you own may have stable economic characteristics, Mr. Market quotations will be anything but. For, sad to say, the poor guy has incurable emotional problems. At times, when he feels euphoric and can see only the favorable factors affecting the business, he names a very high price to buy out your interest because he fears that you will snap up his interest and rob him of imminent gains. At other times, when he is depressive and can see nothing but trouble ahead for both the business and the world, he will name a very low price since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation today is uninteresting to you, he will be back tomorrow with a new one. Transactions are strictly at your discretion. Under these conditions, the more manic-depressive he is, the better for you.

But, like Cinderella at a ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is in his pocketbook that you will find useful, not his wisdom. If he shows up one fine day in a particularly foolish mood, you are free to either ignore him or to take advantage of him. But it will be disastrous if you fall under his influence. Indeed, if you are uncertain that you understand and can value your business far better than Mr. Market (which unfortunately majority of the market participants are), you don’t belong in the game. As they say in poker, “If you’ve been in the game for half an hour, and you don’t know who the patsy is, you’re the patsy.”

Ben’s Mr. Market metaphor may seem out-of-fashion in today’s investment world, especially in a particularly hot market. Professional and academics alike talk of efficient markets, dynamic hedging, diversification, trend investing, whatever you call it. Their interest in such talks is understandable since techniques covered by mystery clearly have value to the seller of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”?

In my opinion, investment success – not fly-by-night success – will not be produced by arcane formulas, computer programs, charts, or signal flashed by the price behavior of stocks and markets. Rather an investor will succeed only by combining good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. It is the second part that is way harder than the first. In order to stay insulated, it is highly useful to keep Ben’s Mr. Market fable firmly cast in mind.

Following Ben’s teaching, we should allow the common stocks guide us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while (the duration can drag for years), but eventually it will confirm it. As Ben said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” The speed at which a business’s success is recognized is not that important as long as the business’s economic value is increasing at a satisfactory rate. In fact, delayed recognized can be an advantage: It simply gives us more time and chance to buy more of a good thing at a bargain price. If you are a shopper, would you rather have Great Singapore Sale lasting one month or half a year?

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts indicate it would. In such case, we should sell our holdings – that means by selling, we’re getting more than a dollar of any future dollar from the business cash flow. Some other times, we should sell a security that is fairly valued or even undervalued because funds are needed for a still more undervalued security or one we believe we understand better.

However, it needs to be stressed that we need not sell holding just because they have appreciated or because we have held them for a long time. One maxim of Wall Street I find foolish is “one can’t go broke by taking a profit.” As long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business, we should be contented to hold any such security indefinitely.

In some other extreme situations which I firmly believe, if a business is managed by an extraordinary manager who both has the business savvy and honesty, I’ll not in any circumstances consider selling the holdings even in an extreme overvalue situation. Call me bonkers if you will. This is more slanted towards personal value rather than economic gains. Thus, a determination to hold or to have a stock or a wholly owned business, obviously involves a mixture of personal and financial considerations. To some, this stand seems very eccentric. But then David Ogilvy said, “Develop your eccentricities when you are young. That way, when you are old, people won’t think you are going ‘ga-ga’.” To many on Wall Street, both companies and stocks are treated only as raw material for trading. But then, it is understandable why they do that and it is totally alright, just that, the way I think it should be done is a much better and superior and humane method.

Whichever attitude investors chose to follow, the adopted attitude should fit their personality and the way they want to live their lives. Winston Churchill once said, “You shape your buildings at first and then your buildings shape you.” I know the way in which I wish to be shaped and for this reason, I would rather achieve a return of X while associating with people whom I firmly like, strongly admire rather than to realize 110% of X by exchanging these relationships for uninteresting, self-centered or unpleasant ones.

We know how management consultants prescribe companies on how many people should report to any one executive, but it hardly makes any sense. When you have able managers of high character running a business about which he is passionate, you can have a dozen or even more reporting to you and still have time for an afternoon nap. But if you have even one inept manager reporting to you who is deceitful, inept, and uninteresting, you will find yourself with more than you can handle. By associating with only people you like and admire, it not only enhances your chances of a good result but also ensures an extraordinarily good time which no material things in the world can buy. On the other hand, working with people who makes your stomach churns seems much like marrying for money – probably a bad idea under any circumstances, but if you are already rich, it is absolute madness.

In all cases, we should try buying into businesses with favorable long-term economics. The prudent and modest investor is to find businesses at a bargain price. Successful investors like Warren Buffett, and Charlie Munger have found making silk purses out of silk is the best that they can do; with sow’s ears, they fail.

For market participants who are not convinced by this method, you would find solace that even Warren Buffett required 20 years to recognize how important it is to buy good businesses. In the prior period, he too searched for “bargains” and had the misfortune to find some. The punishment was an education in the economics of short term farm manufacturers, third-rate department stores, and textile manufacturers.

Owning marketable securities though have numerous disadvantages compared to controlled entity. But sometimes, it is offset by a huge advantage: Occasionally, the stock market offers the chance to buy non-controlling pieces of an extraordinary business at truly ridiculous price – dramatically below those commanded in negotiated transaction that transfer control (think LBO, or even the recent News Corp offer for Dow Jones, although most are offered overvalued).