Pepsico

The stock market had a pretty good run since last September 2010. As the index goes up, opportunities in value proposition comes down. But there are some areas where the valuation is very compelling, and quite frankly, hidden in plain sight. Within the consumer staples space, there're a number of compelling valuations - Pepsico, P&G, Reckitt Benckiser, Anheuser Busch InBev, and Molson Coors for examples, and even Coca Cola though less compelling than the rest.

However, not many people are going to revved about it and say owning these consumer staples plays will outperform the market. Let me refer back to the previous note on risk - on a risk-adjusted basis, these looks like good excellent value in my opinion. This is, however, not for short term play or traders. Holding these companies would require a long term horizon where we expect to hold them indefinitely until better opportunities become available or we think we made a mistake. Moreover, such higher-quality businesses would not require as high a potential rate of return as a lower-grade security. Reason is we endeavor to evaluate equities just like a bond buyer would look at bonds - we don't go for the highest return without consideration on a risk-adjusted basis. If we will, we will only buy when the risk/premium is correct: like how it was during Mar 2009, you could buy any of the surviving banks at ridiculous valuation and and they were generally perceived by the market as very risky as the price tumbled, but the exact opposite actually happened, the more it fell, the less risk it presented, thus, the risk/premium for a class of stock that was then perceived as extremely risky was in fact priced for great future return in a low-risk manner at the extreme.

In today's market, certain consumer staples are selling not much more expensive than industrials or basic materials which are more cyclical in nature than consumer staples - in some cases, cheaper. Example, Emerson Electric, Boeing, United Technologies, Honeywell, 3M, all sell almost at par or over Pepsico valuation. The consumer businesses we are interested in make disposable products with very little economic sensitivity. In this economic environment, companies manufacturing industrial or consumer goods that have long lives - like autos, tractors, machineries, appliances or any durables - is an area of concern because their replacement decision can be easily delayed. The five consumer staples companies are basically higher quality businesses with market-leading positions in their principal products; well-recognized brand names; a barrier to entry; with long product cycles but short customer-repurchase cycles; and with relatively low capital requirements that allow the business to generate high cash returns on tangible assets while growing.

Personally, I own all the five companies (in addition, I own Coca Cola but Coke is not as cheap as it was last year so I don't recommend it at this time). Particularly, I would focus discussing on Pepsico in this note, PEP constitutes the largest of my position (close to 30% of my managed portfolio).

I started with a small position (less than 7%) back in Oct 2010 and added intermittently. With the recent retreat, my position was increased by another 50% because I think it is unfairly punished - at $64, it is selling for no more than 14.5x 2011 adjusted earnings for a business that has a long term potential growth of 9-11%. People often ask what is the market missing and what unique insight you bring. I bring no unique insight. It is as if you must be so astute, and have some very complex thesis or story that no one else sees in order to identify an undervalue proposition. Some times, it doesn't. The fact of the matter is there are times when quality businesses are undervalued and we just have to be alert and smart enough to recognize those moments and chose to own them. In 1988, when Buffett started buying Coca Cola, what special insights does he brings besides knowing that KO was selling at 12-14x earnings. That is all there is. Most times the market understands, sometimes it doesn't - that's why in most years, KO sells for 17 to 22x earnings while in a few others, 12 to 15x or 60x when it doesn't.

Pepsico is somewhat distinct from Coca-Cola in that Pepsico is a partial beverage and partial snack foods business. On the beverage front, Pepsi owns its namesake carbonated soft drink (CSD) brands, Mountain Dew, Gatorade and others. On the snack food business, the primary divisions are Frito-Lay and Quaker Foods. Pepsico is the dominant player in the snack food arena. If you walk down the chips aisle of a grocery store, it is hard not to find a bag that's a Pepsico brand. Sure, there're niche players but Frito-Lay has some of the highest market share of any major product in the grocery store. In fact, Pepsico's fortunes are much more driven by snack foods, rather than beverage. They are the powerhouse in snacks just like Coca Cola in CSD. Frito-Lay accounts for about half of Pepsico business and its margin and return on assets are far better than its beverage business.

What's the expected returns if we buy shares today at $64? On a forward basis, we estimate PEP to earn a normalized $4.42. They should be able to keep about 80% of that (from 1994 to 2010, they had kept between 79-135% of normalized earnings). So free cash flow would be around $3.53 per share. That's a 5.5% free cash yield. On top of this, Pepsi should deliver an annual volume growth of 1.5-3%, primarily from increase snack-food sales and international expansion. Add in some pricing of 2%, largely to compensate for inflation, the expected annual return is 9-10.5%. Compared to S&P, S&P500 is estimated to earn $95 for 2011, of which you keep maybe 50% as free cash flow. At 1300 on the index, the resulting FCF of $52 gives you a 3.7% free cash yield. Add on 3% inflation and 1.5% for organic growth, the average investor is potentially looking at 8.2% annual return from the market. In my opinion, Pepsico is a higher-quality business with lower risk than the average S&P 500 company, it should trade at a premium to the market rather than a discount. When an excellent company like this trades at a decent annual rate of return and with that kind of discount to the market, it's a very attractive risk-adjusted buy.

One thing when you focus on the forward rate of return is it keeps you centered on the fundamentals of the business, its economics and its cash flows. Thus, we are not counting on others to pay us a higher multiple or trying to figure out what the future P/E or cash-flow multiple should be - if they will, all the better. For example, in five years time, PEP should deliver at least $6.8 per share in adjusted earnings. If P/E multiples remains the same as today of 14.5, stock price will be $98.6 - an annual compounded return of 9% excluding dividend. Obviously, if the market values the multiples more by then, the annual compounded would be more than 9%. But we don't need to rely on that in order to make money. All we need is just to focus on the fundamentals. Owning a solid business with a 9-10% real return while lying in wait for better opportunities to emerge seems to me a pretty sound approach to making money.

Selected actual historical performance of Pepsico provided:

Table 1

Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
Non-GAAP EPS	4.14	3.71	3.67	3.38	3.00	2.66	2.32	2.07	1.96
Trailing 10-yrs annual compound growth	9.55%	9.84%	11.54%	11.29%	10.54%	8.92%	6.73%	6.62%
Trailing 5-yrs annual compound growth	6.61%	6.87%	9.67%	10.28%	8.92%	9.85%	9.81%	10.92%	11.06%
Dividend	1.89	1.78	1.65	1.43	1.16	1.01	0.85	0.63	0.6
Payout as a % of non-GAAP eps	45.70%	47.88%	44.90%	42.20%	38.64%	37.99%	36.70%	30.42%	30.39%

Continued table 1

Year	2001	2000	1999	1998	1997	1996	1995	1994
Non-GAAP EPS	1.66	1.45	1.23	1.16	1.10	1.13	1.21	1.09
Trailing 10-yrs annual compound growth
Trailing 5-yrs annual compound growth	8.57%	5.09%	0.42%	1.22%	2.37%
Dividend	0.58	0.56	0.54	0.52	0.49	0.45	0.39	0.35
Payout as a % of non-GAAP eps	34.60%	38.27%	43.38%	44.45%	44.47%	39.34%	32.30%	32.09%

Table 2

Stock price in USD
Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
High	68.11	64.48	79.79	79	65.99	60.34	55.71	48.88	53.5
Low	58.75	43.78	49.74	61.89	56	51.34	45.3	36.24	34
Year-end closing price	65.33	60.8	54.77	75.9	62.55	59.08	52.2	46.62	42.22
Annual compound growth since low of 1994 to end of respective year	9.20%	9.31%	9.20%	12.48%	11.83%	12.34%	12.26%	12.29%	12.50%

Continued table 2

Stock price in USD
Year	2001	2000	1999	1998	1997	1996	1995	1994
High	50.46	49.94	42.56	44.81	41.31	35.88	29.38	20.56
Low	40.25	29.69	30.12	27.56	28.62	27.25	16.94	14.63
Year-end closing price	48.69	49.56	35.25	40.88	36.25	29.25	27.94	18.13
Annual compound growth since low of 1994 to end of respective year	16.22%	19.05%	15.79%	22.82%	25.47%	25.99%

Table 3

Stock price in SGD
Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
High	89.26	89.57	114.18	114.08	104.26	101.56	95	84.3	96.84
Low	83.52	65.54	72.22	94.95	90.97	84.53	76.98	62.87	60.36
Year-end closing price	84.11	85.33	78.82	109.39	95.93	98.32	85.28	79.29	73.32
Annual compounded growth since low of 1994 to end of respective year	8.17%	8.80%	8.84%	12.09%	11.94%	13.23%	13.05%	13.61%	14.24%

Continued table 3

Stock price in SGD Year 2001 2000 1999 1998 1997 1996 1995 1994 High 92.38 86.73 71.51 71.43 63.46 50.72 41.6 33.03 Low 71.76 50.76 51.1 48.04 40.31 38.81 24.79 22.13 Year-end closing price 90.13 85.81 58.73 67.88 60.74 40.94 39.52 26.48 Annual compounded growth since low of 1994 to end of respective year 19.19% 21.36% 17.66% 25.13% 28.71% 22.76%

Table 4

PE based on non-GAAP eps
Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
High	16.47	17.39	21.71	23.39	21.98	22.69	24.06	23.61	27.32
Low	14.21	11.81	13.54	18.33	18.65	19.31	19.56	17.5	17.36
Year-end closing price	15.8	16.4	14.9	22.48	20.83	22.22	22.54	22.51	21.56

Continued table 4

PE based on non-GAAP eps
Year	2001	2000	1999	1998	1997	1996	1995	1994
High	30.36	34.44	34.51	38.67	37.49	31.72	24.33	18.85
Low	24.22	20.47	24.42	23.79	25.97	24.09	14.03	13.41
Year-end closing price	29.3	34.18	28.58	35.28	32.9	25.86	23.14	16.62

Observations:

1. Non-gaap eps compounded at a rate of about 9% from 1994 to 2010, from $1.09 to $4.14, on US dollar basis.
2. Today, stock price is priced about 14.5x 2011 eps. In July 1994, PEP was priced 13.5x (a little better than now) at its low for the year. Had an investor bought at its low of $14.63 (in July 1994), he would have compounded at at rate of between 9.2% to 25.99% on USD basis, depending on his holding period. Had he held till 2010, he would have achieved 9.2% compounded return (ex div) for 17 years, or at end of 1996 knowing the rate of return is unsustainable, he would have sold and achieved a compounded rate of 25.99% for 3 years and waited for better chances (all figures on US dollar basis).
3. Let's say the investor is a Singaporean, he would have paid SGD22.13 in July 1994, and compounded at a rate of between 8.17% to 28.71%. If he held till end 2010 for 17 years, he would have achieved a compounded rate of 8.17%. If he sold at end of 1997, he would have compounded at 28.71% for 4 years of work. All are exclusive of dividends.
4. In addition to above gain, for an investor who bought in 1994, and not sold PEP stock before 6 Oct 1997, he would be entitled to 0.1 Yum! Brands stock for every PEP stock he held. And if he had held on to the YUM stock to 2010, the 0.1 YUM stock is worth about USD4.9. That means, the PEP stock which he bought in 1994 low, would have been worth USD65.33 (PEP stock) + USD5.2 (YUM stock) = US$70.53

If an investor buys today and holds for the long run as in 15 to 20 years, he'd likely get decent return. In between, the stock can go about anywhere (maybe if lucky enough again, you could get a 20% compounded return in any of the years in between the very long term. Then when you find the pendulum is at the extreme, you could always sell and wait. The pendulum is hardly at its happy medium. Otherwise, even if the stock don't misbehave, you still will likely get 9-10% return which isn't all that bad, or if I am wrong, 6-8% (on US dollar basis).

Now, what're the alternatives in July 1994 for a Singaporean investor? We know a Singporean PEP investor would have make 3.8x (excluding YUM stock) from his initial outlay of SGD22.13. Here're a few alternatives:

1. OCBC: July 1994 @ $3.5, Dec 2010 @ $9.88, return of 2.82x
2. UOB: July 94 $7.54, Dec 2010 @ $18.2, return of 2.42x
3. DBS: July 94 $7.66, Dec 2010 $14.32, return of 1.87x
4. Haw Par: July 94 $2.98, Dec 2010 $6.13, return of 2.05x
5. APB: July 94 $8.1, Dec 2010 $19.6, return of 2.42x
6. NOL: Jul 94 $1.93, Dec 2010 $2.18, return of 1.13x
7. F&N: Jul 94 $2.66, Dec 2010 $6.41, return of 2.41x
8. Singtel: Jul 94 $3, Dec 2010 $3.05, flat return

(All prices obtained from Reuters interactive stock chart)

It's hard to find an outlier but not that there's none. There's one - Sembcorp Marine that sold for $0.86 in July 1994, and ended at $5.37 in Dec 2010, giving a return of 6.25x - double even the best return among the 8 examples. The problem is the stock was flat, fluctuating between $0.50 to $0.8, for the next 10 years. Share prices hardly go no where for a decade for no reason. The reasons for a flat return could be numerous: 1) business could be ill-managed, or 2) lack of decent business economics or growth, or 3) simply priced too aggressively where future gains have been priced into the current price, or 4) others. So that meant the investor who bought in 1994 had bought at the highest price point during the next 10 years. Then from 2005 onwards, the stock simply just spiked up. So why the surge? I don't know the exact cause because I don't follow SembCorp but if I have to guess, it was either the stock was too unloved where people have forgotten about and then woke up to reality, or there was a very major structural change to its business economics where it enjoys a high growth rate.

And where does it Pepsico stands? With PEP return of 3.8x (on SGD basis) from 1994 to 2010 (17 years, that is a long run), it will be ranked top among the 8 examples. But if you include Sembcorp, PEP would come in second place but I personally think Sembcorp, at that time, would not be an easy investment decision that could be made with strong conviction.

Sure, among the 8 examples, there may be some that were simply too expensive and thus became a disadvantage and created an anchor to future stock price gain because when it is expensive, investors are simply bringing future gain into the present. For example, Singtel was listed in Nov 1993 at $3.5 or something. That was priced at 45x earnings. So instead of acting as a tailwind to advance the stock price, it acted as an anchor when compared to PEP which at that time (July 1994) was priced at a low PE. Had Singtel been priced reasonably in July 94, say at 12x earnings, it would be available at $0.93 instead of $3 to $3.5. And it would have delivered a return of 3.27x by end of 2010, topping all the 8 SG examples. Had it been priced at 10x pe, it'd end up with 3.9x return, topping PEP. But history is not so. So what does all these tell us? That fundamentals and multiples matters more than anything else.

But I have to say even PEP at today low P/E would not provide spectacular return, somewhere in the region between 9-11%, excluding forex losses, which is almost a sure thing for the long horizon. It's hard to tell how hard SGD will depreciate against USD for the next decade or two since that is the time horizon I am proposing to hold. Currency don't fall in a straight line - up next year, up again the year after, down the next and so on. Is it possible that SGD will depreciate at the rate of the past 2 years? It could but unlikely in my opinion. Let's take a look at history. Below shows the average rate of decline for the currency pair of SGD/USD since 1960.

	1960	1965	1970	1975	1980	1985
Average annual rate of decline to 2010	-1.5925%	-1.7642%	-1.9771%	-1.5528%	-1.4770%	-1.8615%
Continued

	1990	1995	2000	2005
Average annual rate of decline to 2010	-1.3932%	-0.3040%	-2.1982%	-3.4310%

From 1960 to 2010, a period of 51 years, USD has depreciated by 66% against SGD, at an average of rate of -1.59% annually. If you noticed, the fx from 1960 to 1970 was flat. SGD was initially pegged to Sterling Pounds till the early 1970s and then pegged to the US dollar for a short period of time. It was only from 1973 onwards, that SGD was unpegged. That probably explains why SGD against USD was almost flat from 1960 to 1972, going from 3.06 to 2.8, respectively, before plunging to 2.45 in the year after it was unpegged in 1973. So taking 1960 to 1973 numbers would likely distort the real picture of the long term average rate of decline. It's better to look at numbers from 1975 onwards. From 1975 to 2010, a period of 36 years, the average rate of decline is 1.55% annually. 1980 to 2010 is 1.477%. And so forth.

The period of 2005 to 2010 is either an outlier or the new normal rate of decline. Let's say it's the new normal rate of decline (but things can always be worse, there's no such thing as a worst-case short of total loss), taking into account that US economy is not as vibrant and healthy as it was in the 1980s to 1990s. So if the new normal is an average decline of 3.4-3.5%, then it did take away about 3.8% from the 9% of PEP growth, ending up with yearly return of 5.2%. So where does 5.2% real return brings you in 17 years? You will have 2.36x of your principle (excluding dividend), which is about the same performance had you purchase UOB, F&N or APB in 1994 and held for the next 17 years.

Another table for additional info which shows the SGD/USD rate of decline in the respective 10-year period:

For the period	1971 to 1980	1981 to 1990	1991 to 2000	2001 to 2010
Average annual rate of decline	-3.4783%	-1.5210%	-0.0220%	-2.7910%

However, none of the above reflects the worst rate of decline in a 10-year period since 1960. The worst 10-year period average rate of decline was 1986 to 1995 at -4.2%. If for the next 17 years, the average rate of decline is 4.2%, then it did chop roughly 4.5% off the top of 9%, giving a real return of 4.5%, which will exactly double your principle in 17 years. Is that the worst case? Of course not because worst case means total loss and many things (including externalities) or assumption can go wrong, it is just a matter of likelihood and if you have thought through it logically, clearly and deep enough.

The Most Important Things to successful investing via the Howard Marks' Way (Part 1)

*The principles behind this note are drawn from Howard Marks thinking. What I learnt and think deeply from all of Mark's principles is his thoughts on risk. I've to be honest that I've not paid as much attention or thought of risk so much as to generating return.

"What has been will be again, what has been done will be done again; there is nothing new under the sun." (Ecclesiastes 1:9-14 NIV)

I came across the following portfolio:

On the outlook, it looks like a decent performance over the last decade. But in investing, luck can be mistaken as skill. A lucky idiot can be mistaken as a successful investor. So could the above portfolio be skill or luck? Was the return achieved with the correct risk control in mind? Whatever it is, I hope to design my portfolio for a safer, more consistent return that can last for a full investing career, rather than to chase for return that is incommensurate with risk which can come back to bite you on a dime.

Beating the market can be far from synonymous with superior investing. So the question lies in exactly what is successful investing and how to construct a risk-adjusted portfolio that can perform consistently over a full investing career.

KEYS TO SUCCESSFUL INVESTING
Successful investing is to beat the market and to beat the market, you've to be above average, i.e., in the top half of the crowd. Anyone can be average just by investing in an index fund. How can you achieve superior return? Either you need good luck or superior insight. But counting on luck doesn't enhance your chance of success. So you'd better concentrate on insight.

To be above average, you have to find an edge where the crowd don't have. You must think of something they haven't thought of, or have thought of but is restricted to act on, see things they miss or bring insights they don't possess. In short, you have to act and behave differently – i.e., be a contrarian. However, being a contrarian doesn't guarantee success. The key is you have to be more right than others.

To achieve a consistent above-average result, you need superior insight, intuition, a sense of value and awareness of psychology. All consistent successful investors have something in common – second-level thinking. First level thinkers say, “The economic outlook sucks because of lower-than-expected growth and higher-than expected inflation” Second-level thinkers say, “The outlook stinks but everyone else is selling in a panic; let's buy!”

Superior performance comes only from correct non-consensus forecasts, but non-consensus forecasts are hard to make, hard to make correctly and hard to act on. But doing so correctly will lead to superior investment results but that's not easy. And investing is not supposed to be easy. In short, second-level thinkers must be different from and better than first-level thinkers.

An accurate estimate of intrinsic value (IV) is the indispensable starting point for reliable successful investing. Without it, any hope for consistent success as an investor is just that: HOPE.

FUNDAMENTAL OR TECHNICAL INVESTING
Investing can be divided into two basic schools: 1) those based on analysis of the company's attributes, known as “fundamentals,” and 2) those based on the study of the price behavior of the securities themselves, known as “technicals.” In short, an investor is faced with two choices: first, gauge the security's underlying intrinsic value, or, second, make an investing decision purely on expectations regarding future price movements.

Technical or momentum investing might allow you to participate in a bull market that continues upward, but there're a lot of drawbacks. For one, if something cannot go on forever, it will stop. Trees don't grow to the sky. Neither does much things go to zero. What happens to momentum investors then? Without a strong core, they'd likely yield to emotions which will cause them to sell when they should be buying, or buy when they they should be selling. They capitulate to emotions than to facts, causing them pain both emotionally and in the pocketbook.

Another main flaw of momentum investing is the investor considers themselves successful if they bought a stock at $10 and sold at $11, bought it back the next week at $20 and sold at $21, and then bought it another week later at $39 and sold at $40. If you can't see the flaw in this where the trader made $3 in a stock that appreciated by $30, you're like the guy in the casino where after a few rounds, and if have not figured out who the patsy is, it's the guy.

VALUE OR GROWTH INVESTING
Now on fundamental investing, there're two approaches: 1) value investing and 2) growth investing. In value investing, the goal is to quantify the company's current value and buy its securities when they can do so cheaply with a margin of safety – i.e, value investors buy when the current price is low relative to the current value. Growth investing is to identify companies with bright futures. By definition, that means there's less emphasis on the company's current value and attributes, and more on its potential – i.e, growth investors buy securities when they believe the value will grow fast enough in the future to produce substantial return. So, the choice isn't really between value or growth, but rather between value today or value tomorrow.

All investing involves coming to a conjecture about the future, be it growth or value. For value investing practitioners, it's easy to say value investing allows them to avoid conjecture about the future and that growth investing consists only of conjecture about the future, but that's not exactly right. After all, establishing the current value of a business requires an opinion regarding its future. Even a net-net investment can be doomed if the company's assets are wasted unwisely on expensive acquisitions or money-losing operations. So, it is better to regard growth investing as having a conviction about the future, whereas value investing emphasizes current-day attributes but cannot escape dealing with the future.

There's no question that's it's harder to see the future than the present. Thus, the batting average for growth investors are lower, but the payoff for doing it well is higher, naturally.

The difference in upside potential between growth and value is growth is more dramatic while value is more consistent. So value is the better approach in my opinion. Consistency trumps drama.

INTRINSIC VALUE
How do you produce a successful investing result consistently? Remember, it starts with an accurate estimate of intrinsic value. Without an accurate estimate, you'll be as likely to overpay as to underpay. If you overpay, what can you count on to bail you out? Either, it takes a surprising improvement in value, or a strong market, or an even less discriminating buyer (what we used to call a “greater fool”) to bail you out. An accurate intrinsic value will not only result in success but also serves as a protection from investing risk.

In investing, we wish the stock will tick up the moment we buy them and thus proving ourselves right immediately. But a stock falling the next day or month, or even a year thus, does not prove we are wrong. In investing, being correct about a security isn't synonymous with being proved correct right away. It's hard to consistently do the right thing as an investor. But it's even harder or impossible to consistently do the right thing at the right time. The most we value investors can improve our chances for success is to be right about an asset's value and buy it when it's available for less. Thus, a firmly held view on value can help you to cope with this disconnect (where buying today doesn't mean you're going to start making money tomorrow).

As an example, you found something that is worth $100 and have a chance to buy it for $60. Chances to buy well below actual or intrinsic value don't come along everyday and you should welcome it. So you buy it and feel you've gotten a great deal. But seldom the security price will move up on the next tick the moment you buy it. Chances are you'll often find that you've bought in the midst of a decline that continues. Pretty soon you'll be looking at paper losses. But one of the greatest investing adages reminds us, “Being too far ahead of your time is indistinguishable from being wrong.” So now that the security that is worth $100 is selling for $40 instead of $60, what do you do? In normal course of life, people want less of something when price goes up and more of something when price goes down. It makes perfect sense. But not in the world of investing. In investing, many people tend to fall further in love with the thing they've bought as its price rises because they feel validated, and they hate it when price falls, and then they begin to doubt their decision to buy. This psychology effect makes it very difficult to hold or even to buy more at lower prices, especially if the decline proves to be extensive. (Think about March 2009, securities were all at multi-years low, how many of us really bite when we should have?)

Now, if you like it at $60, you should like it even more at $40, and much more so at $30 and $20. But it's not that easy psychologically. We, humans, will wonder, “Maybe it isn't me who's right. Maybe it's the market.” The danger is maximized when they start to think, “It's down so much. I'd better get out before it goes to zero.” That's the kind of thinking that makes bottoms and causes people to capitulate and sell there.

The thing that can prevent you from capitulating at the wrong time is to have a strongly held sense of value and an accurate estimate of intrinsic value. Without which, investors who have no knowledge or concern for profits, dividends, sense of value, understanding of the business prospect and attributes, simply cannot be counted on to have the resolve to do the right thing at the right time. With most of everyone around them buying and making money, they cannot know when a stock is too high and therefore resist joining in. And with a market in free fall, they also cannot possibly have the confidence and knowledge needed to hold or buy at severely depressed price. So to be consistently successful in investing, you need an accurate opinion on valuation. Not only accurate, but also strongly held because a loosely held opinion will be of limited help when you need it the most. However, you must be aware that an inaccurate opinion on valuation, strongly held, is far worse. This shows how hard it is to get it all right. Investment is not supposed to be easy, especially superior investing. In a declining market, you need to have an accurate non-consensus estimation on value, and hold that view strongly enough to be able to hang on and buy even as the declining prices suggest you are wrong, and of course, you've to be correct on your estimation of value. Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis worked out. There's no deal better than buying from someone who has to sell regardless of price during a crash. To cater for errors, you need a margin of safety. You either have to be more conservative with valuation or buy a security at a larger discount to the intrinsic value.

Charlie Munger is known to advocate: “It's better to buy a great business at a fair price than to buy a fair business at a great price.” But the caveat is the price paid. Investment success doesn't comes from buying good things – Facebook is a good thing but is the price good? – but from buying things well. So price is the starting point in achieving investing success. History has demonstrated time and again that no asset is so good that it cannot become a bad investment if bought at too high a price. And there're few assets so bad that they cannot be a good investment if bought cheaply enough. In other words, there's no such thing as a good or bad investment regardless of price. An investment that is well bought is half sold. All is needed is to figure out the value, price to pay and the of course, the opportunity to act. If the opportunity is not there, there is no point to chase for one. Opportunity in market comes about naturally and not because you want it, it is not created out of an individual's needs or doing. So to chase for an “opportunity” which isn't there just for the sake of getting what you want is close to suicidal in investing success.

In the day-to-day pricing of a security, there're two considerations: First, the value of the security and second, the price-to-value relationship of the security. The key to ascertaining value (or the earnings) is skilled financial analysis – this is the easier part. While the key to understanding price-to-value relationship or the outlook for it lies largely in insight into other investors' state of mind or psychology. When people are fearful, they assign a low price-to-value to the security, and vice versa if they are intoxicated. Investor psychology is like a pendulum that can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals. The more people likes an investment now, the higher the value of the current price-to-value relationship, and vice versa. Future price-to-value relationship movements (increase or decrease in P/E) will thus be determined by whether the security will come to be liked by more people or less people in the future. If you boil it down, investing is like a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already baked into the price, and no or few new buyers are left likely to emerge (i.e, all the greater fools have been used up).

It is surely hard to know exactly when the market will peak (bubble does not announces its arrival or ring the bell before it departs) but it is not difficult to know where we stand in the market pendulum. In a typical bubble, buyers do not worry about whether a stock is priced too high because they are sure someone else would be willing to pay them more for it. “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time or become even more overpriced. Those who have initially resisted buying may eventually question their wisdom, then capitulate and buy when they see seemingly easy massive profits everyone else is enjoying. Unfortunately, the greater fool theory works only until it doesn't. Eventually, valuation comes into play, and those who are holding the bag will pay the price. Market will self correct itself without anyone knowing the exact timing.

The problem in bubbles is that a security that is attractive will morph into “attractive at any price.” How often have we heard people saying,”I know it's not cheap but I think it'll keep going up because of excess liquidity and many people are willing to pay more at any price.” How I wish I could sell my car or house to you at any price! Buying or holding on that basis is simply playing with chance and blinkmanship, but that's what makes bubbles. During a bubble, investors become complacent and disregard any notion of value and fairness of price, and are infatuated with market momentum on the upswing, and greed takes over (ok, maybe not totally greed but envy because most investors are alpha types who cannot stand missing out what others are seemingly enjoying and look like a loser). Thus, just when an investor needs prudence the most, they forsake it and chase for return by bearing above-market-risk-adjusted return.

As we have seen, an investment approach that is based strongly on solid value is the most dependable. In contrast, to count on others to give you a profit or bail you out regardless of value (to rely on an ever-expanding bubble) is probably the least.

Just like there're many ways to skin a cat, there're also a few possible routes to investment profit:

1. Benefiting from a rise in the asset's underlying intrinsic value. But the caveat is that increases in value are hard to estimate accurately. Further, the potential for increase is usually factored into the asset's price. So unless your view is superior and different from the consensus, it's likely you're already paying for the potential improvement – i.e. hard to get any alpha return.
2. Use leverage. The problem here is that using leverage doesn't make a security a better investment or increase the probability of gains. What it does is just magnifies whatever gains or losses that may materialize. Moreover, it introduces the risk of ruin if a portfolio fails to satisfy a contractual value test and lenders can demand their money back at a time when prices and illiquidity are at its worst. Over the years, leverage has been associated with high returns, but also with the most spectacular meltdowns and crashes.
3. To sell for more than your asset's worth. Everyone hopes to sell his assets to a buyer who is willing to overpay. But certainly, to hope for a less discriminating buyer cannot be counted on. Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable.
4. Buying something for less than its value. This is the most dependable way to make money consistently in my opinion. Buying at a discount from intrinsic value and having the asset's price move to its fair value doesn't require luck; it just needs market participants to wake up to reality.

Of all the possible routes, buying cheap is the most reliable. But even buying cheap isn't sure to work. You can be wrong on the intrinsic value. Or events can come along that reduce the business value. Or deterioration in markets can make something sell even further below its value. Trying to buying cheap isn't foolproof but it's the best chance to investing success.

UNDERSTANDING RISK AND HOW TO INTELLIGENTLY BEAR IT
Successful investing requires us to buy below value and to have an opinion on value. Thus, to have an opinion, we are dealing with the future. And because it involves the future which none of us can know for certain, risk is inevitable. Dealing with risk is the essential element in investing.

There're three steps to risk. The first step consists of understanding risk. The second step is to recognize it when it's high. The final step which is the most critical is controlling it. We know that the riskier the asset, the higher the return but riskier investments absolutely cannot be counted on reliably to deliver higher return. Why not? Because if riskier investment can reliably produced higher returns, they wouldn't be riskier.

What is risk? First, risk is covert. Risk can only be seen on hindsight, that is, after the fact if events happen in a certain way. But it doesn't mean that if things don't turn up in a certain way, risk is not there. Almost remember, risk is stealth. The risk of an investment cannot be measured in retrospect any more than it can be measured beforehand. Let's say you makes an investment that works out as expected, does that mean it wasn't risky? Maybe you bought something for $100 and sold it a year later at $300. Was it risky? Who knows? Maybe it exposed you to great potential uncertainties that did not materialize. Thus, its real riskiness may have been very high though events did not turn out to be that way. Or say the same investment produced a loss instead, does it mean it was risky? If you think about it, the answer is simple: The fact that something – in this case, a loss happened does not mean it was bound to happen, and the fact that something did not happen mean it was not likely to happen. Nassim Taleb, in his book, Fooled by Randomness, talks about the “alternative histories” that could have unfolded but didn't. Even after the investment is sold out, it's impossible to tell how much risk it entailed. The fact that an investment makes money does not mean it was not risky, and vice versa. Did the investor do a good job assessing the risk entailed? It's hard to answer. Something that is probable does not mean it will happen and something that is improbable does not mean it will not happen. History has proven time and time again that probable things fail to happen and improbable things happen all the time. That's something you need to take into account about investment risk.

How do investors measure risk? First, it is nothing but a matter of opinion. Second, the standard for quantifying risk is nonexistent. Some people will think the risk high and others low. Some will state risk as the probability of not making money, and others as the probability of losing a fraction of their money. If you herd all the investors involved in a room and show their cards, they'd never agree on a single number or method representing an investment's riskiness. Third, risk is deceptive, covert and stealthy. When you boil it all down, risk is subjective, hidden and unquantifiable. For simplicity, we shall define risk as the probability of loss which hopefully, we can agree on.

So where does that leaves us? We certainly cannot ignore risk. If risk of loss cannot be measured or even observed, how can it be dealt with? Skillful investors can get a sense of risk present in a given situation. They make judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value. Other things will enter into their thoughts, but most will be subsumed under these two.

Risk of loss does not necessarily come from weak fundamentals. A fundamentally weak asset – a cigar-butt company's stock, a speculative-grade bond, or a building located in the wrong part of a town – can make for a very successful investment if bought at a low-enough price. There's no asset that is so good that will become a successful investment regardless of price, neither, are there many assets that are so bad that cannot produce a successful investment if bought at a low-enough price.

Risk is ubiquitous regardless of economic conditions. It is present even without weakness in the macro-environment. Risk is most dangerous when we let our guard down, when we become too arrogant, or fail to understand and allow for risk. And then a small adverse development in the environment can be enough to wreak havoc.

Mostly, risk comes from investors' psychology that's too positive and thus drives up prices. They expect high returns from things that have been doing well lately, and thus, buy more. The investments may deliver on people's expectations for a while, but they certainly entail a higher risk. In theory, high return is associated with high risk because the former exists to compensate for the latter. Thus, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher return. The market has to set things up to look like that'll be the case, if it did not, no one would make risky investments. But it can't always work that way because if it does, it wouldn't be risky at all. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they're worth. In the same way, overpaying means both low prospective return and high risk.

Bargain securities are by nature dull, ignored, beaten-down, and possibly tarnished but are often the ones value investors favor for high returns. Their returns during bull markets are rarely at the top, but their performance is generally excellent on average, more consistent than that of “hot” stocks and characterized by low variability, low fundamental risk and smaller losses when market do badly. Much of the time, the greatest risk in these unloved bargains is in the possibility of underperforming in heated bull markets. That's something the risk-conscious value investor is willing to live with. During a bull market, it is more than enough to keep even with it or perform slightly below it. But in a bear market or crash, the risk-conscious investor will beat the market, often by a large margin. That's when on average the risk-conscious investor will outperform the market over a full investing career.

In the world of investing, one can live for years on a great coup or a long running bull market. But does that proved one's success? During a booming market, the best results often go to those who take the most risk. Were they really so smart and have the insight to anticipate good times, or just aggressive individuals who were bailed out by the positive events? Simply put, how often in our business are people right for the wrong reasons? These are the people Nassim Taleb refers as “lucky idiots,” and until the tide goes out, it's definitely hard to tell them from skilled investors.

Here's the key to understanding risk: it's subject largely to a matter of opinion. It's also hard to measure even after the fact. Many future scenarios are possible but only one future scenario will occur. The future that happens may either be beneficial or harmful to your portfolio, and may be attributable to your foresight, prudence or luck. The performance of your portfolio under the one scenario that unfolds says nothing about how it will perform under the many other “alternative scenarios (or histories)” that were possible. Consider the various scenarios below:

1. Portfolio A is set up to withstand 99% of all scenarios but succumb because it's the remaining 1% that materializes. Based on the outcome, it may appear to have been risky, whereas the investor might have been quite cautious.
2. Portfolio B may be constructed so that it'll do very well in half the scenarios and very poorly in the remaining half. If the favorable scenario materializes and the portfolio propers, onlookers may conclude it was a low-risk portfolio.
3. Portfolio C is structured entirely to be contingent on one single oddball scenario, but if the scenario occurs, wild aggression can be mistaken for foresight and even conservatism.

The above scenarios alone show return alone – and especially return over short periods of time – say very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured. Certainly, it cannot be gauged on the basis of what “everybody” says at a moment in time. However, risk can be judged by sophisticated, experienced second-level thinkers.

Great investing requires both generating returns and controlling risks. And recognizing risk is the prerequisite for controlling it. Dealing with risk starts with recognizing it. Recognizing risk inevitably starts with understanding when investors are paying too little attention to it, being too optimistic and paying too much for a given asset as a result. Value investors think that high risk will lead to low prospective return, both stemming primarily from high prices. Thus, an essential component of dealing successfully with risk is the awareness of the relationship between price and value – whether for a single security or the entire market.

In the upward-sloping capital market line, the increase in potential return represents compensation for bearing incremental risk. Investors should not plan on getting added return without bearing incremental risk unless they can generate “alpha.” For added return, they should demand risk premiums. But at some point in the swing of the pendulum, investors forget that truth and embrace risk taking to excess. The fact is, risk tolerance is detrimental to successful investor. When people are not afraid of risk, they'll accept risk without being compensated for doing so.

A prime element in risk creation is the belief that risk is low, or even nonexistent. That belief drives up prices and leads to the embrace of risky actions despite the prospect of returns is low. Investors bid up assets, essentially, accelerating into present appreciation that would otherwise have occurred in the future, and thus lowering prospective returns. The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum's swing, the belief that risk is low and the investment in question is sure to produce profits intoxicates the herd and causes its believers to forget caution, prudence, worry and fear of loss, and instead obsess about the risk of loss opportunity.

In every bubble that ever existed, its believers inevitably thinks “this time is different,” and worst still, think they can exit in time before the door closes and will not be the last one holding the bag. Unfortunately, under every bubble lies a pin, and during the bubble party, there's no clock that tells the time is ending for the party. Bubble participants have demonstrated that what will be will be again, and what will be done will be done again. There's nothing new under the sun.

Worry and its relatives, distrust, skepticism, questionings, fear, and risk aversion, are essential elements in a safe financial and investing system. Lack of these will lead to a lack of discipline and succumb to imprudence for the sake of chasing return without proper consideration. Adequate risk premiums will only come when investors are sufficiently risk-averse.

The market is not a static arena. It is responsive and dynamic, shaped by investor's own behavior. The herd is wrong about risk as often it is about return. Investment risk resides most where it is least perceived. When everyone believes something is risky, their unwillingness to buy often reduces its price to the point where it is not risky at all. Over-pessimism can make a security the least risky thing since all optimism has been driven out of its price – all bad news has been baked in and often overly so. Conversely, when everyone believes something is of low or no risk, it is usually bid up to the point where it's enormously risky. No one fear for risk and demand for risk premium, and thus, no reward for risk bearing. This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something is risky. But high quality assets can be risky and low quality assets can be safe. It's just a matter of the price paid for them.

At the core, it's the investor job to intelligently bear risk for profit. Doing it well is what separates the best from the rest. Outstanding investors are distinguished at least as much for their ability to control risk as they are for generating return.

A great job on risk control is unobservable and thus lowly recognized in the mainstream media and public. High absolute return is much more recognizable and titillating than superior risk-adjusted performance. That's why it's them who get their pictures in the news. Because it's difficult to gauge risk and risk-adjusted performance (even after the fact), and the importance of managing risk is widely under-appreciated, investors rarely gain credit and recognition for having done a great job in this respect. But, great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk.

Risk is covert, invisible, and unobservable. What is observable is loss, and loss generally happens only when risk collides with negative events. Homes in California may or may not have construction flaws that would have collapsed during earthquakes. We do not know until an earthquake occur. The fact that the environment was not negative does not mean it could not have been. Thus, the fact that the environment was not negative does not mean risk control is undesirable. The important thing here is that risk may have been present even though losses did not occur. So, the absence of loss does not necessary mean the portfolio was constructed safely. Risk control can be present in good times, but it is unobservable because it's not tested. You do not buy an insurance only after the fact. Risk control is like buying a house insurance: It's invisible in good times but still essential, since good times can so easily turn into bad times.

How do you enjoy the full gain (or just a little below it) in a up-market while simultaneously being positioned to achieve superior performance in down markets? You need to capture the up-market gain while bearing below-market risk and that is not an easy task. But an inefficient market can allow a skilled investor to achieve the same return as the benchmark while taking less risk, and this is a great accomplishment even though you did not beat the market. It is important that you recognize that not all the time it is worth to chase the market and beat it, especially in heady times. In heady times, it's a great achievement if you can even keep up with it by bearing below-market risk.

Because there're more good years than bad years in the market, and because it takes bad years to show the value of risk control in smaller-than-market losses, the cost of risk control – in the form of foregone returns – can seem excessive. Risk-conscious investors are like the prudent homeowners who carry insurance and feel good about having protection in place even when there's no fire. While risk control is inevitable, it is neither wise or unwise per se. It can be done well or poorly, and at the right time or the wrong time. Think about how most investors become more prudent and risk averse in a crash when they should have more risk tolerance and vice versa in an up-market.

Extreme volatility and loss occur infrequently. And as time passes without that happening, it appears more and more it will not happen, and that risk assumptions were too conservative - just like a frog that is boiled slowly to death. Thus, it lures investors away from their prudence, relax their rules and increase leverage. And all too often, this is done just before risk finally rear its head. Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver which has hundreds, if not thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of bullet, under a numbing sense of security. Second, unlike a well-defined game of Russian roulette, where the risk are visible to anyone capable of multiplying or dividing by six, one does not observe the chamber of reality. One is thus capable of unwittingly playing Russian roulette – and calling it by some alternative “low-risk” game.

Can we avoid risk altogether? No. So how conservative should we be? If you think about the high-risk game which the financial institutions played from 2004 to 2007, it is easy to say they should have made more conservative assumptions now that it is after the fact. If we say they should be more conservative, then by how much? You cannot run a business on the basis of worse-case scenario. And “worst-case scenario” is a misnomer: there's no such thing, short of a total loss. If every portfolio was to run such that it is able to withstand the scale of decline that we witnessed in 2008, it's possible no leverage would ever be used. What do you do about that? There's no easy answer. However, risk control is the best route to risk avoidance. On the other hand, risk avoidance is likely to lead to return avoidance as well. We shouldn't run from risk. We should welcome it but only at the right time, in the right instances, and most importantly, at the right price. It's by bearing risk when we're well paid to do so – and especially by taking risk toward which others are most averse to – that we can add value either to your clients or your personal portfolio.

The road to long-term investment success lies in risk control more than through aggressiveness. Aggression at the wrong time can make you look like a hero for as long the good time lasts and generally is associated more with rashness than intelligence. Skillful risk control is the hallmark of the superior investor. Over a full career, most investors' results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. This last statement alone gives an important insight: Investing, like tennis, can be a loser's game. In tennis, there's the game played by professionals who win by going for aces and volleys. Then there's the other game played by amateurs: let your opponent commits all the mistakes by going for volleys and aces, while you keep your stroke just enough to go over the net – that is, commit less mistakes than your opponents.

Additional info on Haw Par

Haw Par's stake in UOB may have increased from the previously reported 62.88 million shares during FY2010 by roughly 3.2%. Why? Because the actual "investment income received" as indicated in the cash flow from operation showed $6.282m during 2010, a huge reduction from $43.575m in the prior year.

The difference of $37.293m is almost equal to the portion of dividend that is due to her UOB's stake (62.88m shares X $0.60 dividend = $37.728). So instead of receiving the UOB's dividend in cash, Haw Par may have opted to receive it in scripts. Thus, Haw Par's stake in UOB may have ended as at 31 Dec 2010 with 62.88m shares x 1.032 = 64.89 million shares.

Moreover, it makes more sense to receive the dividend in scripts because 1) UOB is fairly inexpensive; 2) Haw Par will drown in cash if they are to keep receiving it without a good option to redeploy it; 3) it relieves the pressure of deploying cash for the sake of deploying it and end up with below-par investments; 4) the existing cash pile of $110m is more than enough to cover over 2 years of current dividend rate, excluding cash that will come in for the next 2 years from normal operations and other dividend other than UOB. Of course, the downside are for dividend seeking investors, there's less chance for an increase in dividend yield.

All in all, Haw Par seems to have made some sensible choices that position the company for better future value.

UPDATE (9 Apr 2011): We are now certain Haw Par owns more UOB shares than the previous FY, approximately 65m shares in total on estimation. Why? Note 14 on HP's annual report states "During the financial year, approximately $38,628,000 (2009: $Nil) of additions were non-cash and

obtained in lieu of dividends." All are related to UOB because out of the 3 major holdings, only UOB offers dividend in scripts.

Haw Par

Could Haw Par stock be a ten dollar note available for sale at $6? Book value as at end 2010 is roughly $9.8 while stock is selling at $6. For seasoned investor, we know the pitfall just by simply investing based on discount to book value, no matter how huge the gap is. Let's start valuing instead by dissecting Haw Par. There are basically two parts to Haw Par core business: 1) Operating businesses including property rental and sale of healthcare consumer products (mainly Tiger Balm's line of products); 2) Equity investments.

Market value of Haw Par = 197.9m shares x $6 = $1187.4m

The company owns 4% of UOB (62.88m shares), 41.4288m shares of UOL, 67.558m shares of UIC and 277.9m shares of Hua Han biopharmaceutical which is listed on HKSE.

Market value of listed equities

1) UOB - 62.88m shares x $18.3 = $1150.7m

2) UOL - 41.4288m x $4.5 = $186.4m

3) UIC - 67.558 x $2.8 = $189.2m

4) Hua Han - 277.9m x HK$2.4 = HK$667m or SG$109m

Total market value of listed equities = $1635.4m

Based on this, the business is already discounted at a rate of 27%.

Not cheap enough? Here's some more icing - the company owns no debt except tax both current and deferred but for deferred, it probably isn't payable till its investment properties are sold but those are held for rental yield; then, it holds another $110m of cash. Add on this cash, the business is selling at a discount of 32%.

In fact, the whole of Haw Par just selling at slightly above the value of UOB shares that the company owns. So, as in investor, at $6, you simply pays for the UOB stake, and are getting the rest - UOB, UIC, Hua Han, cash in bank & investment properties + the tiger balm business which generates $79m in sales yearly - for free.

Another method of valuation I use is based on earnings of both the operating business and the proportional share of earnings of its equity investments.

1) Operating business - Operating earnings excluding dividend from investments come up to about $36.5m. At a tax rate of 17%, net profit = $30.3m.

2) Proportion share of earnings from equity investments:

a) UOB - EPS $1.6 x 62.88m shares = $100.6m

b) UOL - EPS $0.55 x 41.4288m = $22.8m

c) UIC - EPS $0.172 x 67.558 = $11.6m

d) Hua Han - EPS HK$0.146 x 277.9m = HK$40.6m or SG$6.6m

*UOL and UIC eps are excluding fair value gain/loss on investment properties.

Total earnings from operating business + earnings from equity investments on a look-through basis = $141.6m

On this basis, at $6 a pop, PE is less than 9.

Other considerations? Surely, there are. Are the equities that the company holds really valuable or undervalued for the matter? To be sure, it looks reasonable for the most parts, in particular, UOB - priced roughly 11x earnings.

What's the prospect of UOB? As long as Singapore and the region grows, UOB will grows too as assets in the region grows. Banks is simply just the money grid that helps to allocate and distribute capital from those who have them but don't need them to those that need them but don't have them. Not long ago, Singapore government hope to increase the nation average salary by 30% on a real term in 10 years time or something. This looks like one factor that looks favorable for banks to grow its asset base. Total assets was $214b at end 2010. ROA of 1.2% will produce $1.65 in eps. In 2001, UOB total assets was $114b. In 1992, was $28b. Part of it was due to merger like with OUB and most part to organic growth.

Need further proof? Here are some. Singapore GDP measured at current price was $84.7b and $304b in 1992 and 2010, respectively. A growth of 259%. UOB share price grew from $4.5 to $18.3 in the same period. A growth of 300%. Almost mirroring the country rate of growth.

Forest Labs & Wal-Mart

Forest Laboratories

FDA's advisory panel voted 10-5 against approving the drug, Daxas, and the share skidded by over 13%, closing at $28.25 for the week. FDA generally follows the panel's advice but is not bound to the panel's decision. The fate of Daxas, a once-a-week pill for chronic obstructive pulmonary disease, is key to Forest as it rebuilds its portfolio ahead of the Apr 2012 patent expiration of its top-selling drug, Lexapro, which contributes almost 60% to its revenue. Daxas is developed by Nycomed, a private Swiss company, but Forest holds the right to sell in the USA. Analysts' estimate for Daxas' peak sales of anything from $500m to $2.1b. Lexapro's sales is $2.3b.

Forest second top-seller is Namenda, which generates sales of $1.1b, with an annual growth rate of 15% recently. The drug patent is poised to expire in Apr 2015. In the last 2 years, 2 new drugs were launched - 1) Bystolic, launched in Jan 2008, recorded sales of $125.9m for the first 9 months of 2010 financial year, 2) Savella, launched Apr 2009, recorded sales of $15.4m in the recent 3rd quarter ended 31 Dec 2009.

Aside from the patent expiration challenge the company faces, the numbers look pretty decent:

1) Market cap - 305m shares x $28.25 = $8.6b

2) Cash & equivalents - $3.874b

3) Net profit - $0.768b

4) Free cash flow - $1b

Excluding cash & equivalent, the company is valued at 4.7 times FCF or 6 times earnings - less than half of Pfizer valuation, which its top-seller, Lipitor, with $12b in sales is expiring.

Wal-Mart Stores

Based on forward PE, WMT is selling at a slight discount to other fellow retailers. WMT is estimated to earn $3.98 a share, and at $55, PE is 13.8. Target, TJX, Family Dollar, Costco Warehouse, BJ Warehouse, are selling at PE of about 15, with Costco the highest at over 20.

Thomson Reuters reported same-store sales - an important metric that compares sales for stores that are open at least a year - for the month of March 2010 hit a record high of 9.1% for retailers. TJX posted 12% growth, BJ Warehouse up 10.6%, Target up 10.3%, Costco up 10%, and Family Dollar up 11%. Wal-Mart does not report monthly same-store sales.

Walmart share price had lagged most of her fellow retailers the past year, though it is up 10%.

Basic information on DJIA

Total earnings for calender year 2008/9 = $253.5b

Total earnings for calender year 2009//10 = $205b

Market cap/PE at 2009 low based on 2009/10 earnings = $2.175 trillion / PE 10.6

Market cap at 2009 high based on 2009/10

earnings = $3.774 trillion / PE 18.4

Market cap as at 02 March 2010 = $3.5 trillion / PE 17.1

Out of the 30 companies, 2 companies made a loss during 2009/10. Excluding these 2 companies, PE, as at 02 March 2010, would be 16.

More details as follow.

A look at Dean Foods

Over the past two days, DF stock price plunged almost 20% because its Q4 earnings came in below estimates, lower-than-expected earnings forecast and faces headwind on higher cost of dairy milk.

DF has an annual sales of about $11.1B. Of which $8B goes to cost of sales, $2.5B goes to operating expenses, and $0.25B goes to interest expense. Leaving about $0.35b to both stockowners and Uncle Sam - of which tax rate is 35%.

In 2009, DF earned $1.38 a share or $240m. With an outstanding share count of 183 million, the company is valued at $2.65b. Free cash flow for 09 was $391m.

Now DF looks cheap compared to many of her competitors, who easily are valued from 13 to 16 times its earnings or even higher based on FCF. This could be because DF is a low, if not the lowest, margin food business. DF is also highly leveraged at 5.77 times of shareholder's equity. To operate the whole business, $7.8 billion in total is needed. Of which, $4.2b is interest-bearing debt, $1.37b from shareowners, and the rest from trade debtors and others.

The question is the sustainability at such highly-levered rate. The cash flow certainly can service the interest payment and pay down debts. We know that all business are structured differently - some with more equity, and some with more debts - but in the end, all are financed through different sources which are different in seniority. Now, lets assume DF is debt-free, i.e, DF must convert the $4.2B into equity. Then the market value increase from $2.65b to$6.85b ($2.65B + $4.2B). Then, DF need not have to pay a dime of interest expense which will save them $250m a year, or $163m after-tax. In total, DF would earns $403m ($240m + $163m), which prices DF at a PE valuation of 17 ($6.85b / $403m).

I know the above seems confusing. In summary, stock holders put up $1.37b in equity to get a return of $240m after tax, while, debt-holders put up $4.2b to get a return of $250m before tax.

So a debt-less structure would be less advantageous to the current stockowners. Therefore, it would be better that DF structure the business where it is financed more by debts than by equity holders, where equity holders will get more of the share of the pie, and debt-holders less.

In conclusion, DF is relatively cheap, but not without reasons and risks. The main risk is DF must meet certain financial covenants on her financial debts. If DF fails to meet such covenants in the event of really adverse economic conditions, share price would plunge because the company may be forced to restructured the financing structure of the business by converting debt to equity at a price that is totally disadvantageous to current common shareowners. But at $14.5 - moreover at a 52-week low - it is worth to take a look. I wouldn't say this is a good long-term holding but certainly a holding that would get a reasonable return within a reasonable time frame.

I am also looking at the defence contractors sector - players like Raytheon, Northrop Grumman, Lockheed Martin, General Dynamics, L-3 Communications. Will share more on this when I am through.

10,000 Hours of Practice

Many investors are impressed by Warren Buffett's ability to make an investment decision in 5 minutes. In a recent town hall meeting at Columbia University, a student asked which particular information does Buffett looks at to make an investment decision in 5 minutes. Buffett answered: "Well, it is basically 50 years of preparation and 5 minutes of investment decision."

And his answer struck me and brought me back to a chapter that I read in the book Outliers by Malcolm Gladwell. In the book lies the ingredients for success. One of the ingredients is clocking 10,000 hours of practice just to attain a skill such that it functions as how your arms and legs do for you.

When we look at outliers like Bill Gates, Tiger Woods, or Roger Federer, it is so easy to assume they had it easy because they are cruising their way through competition and life. But the question is how did they get to where they are. All of them, in fact, devoted more than 10,000 hours of practice just to get the correct stroke, or basics, perfect. How many of us have the will and patience to do the same thing over and over again just to get a single subject perfect? And yet we envy them and think they had it easy, though it is undoubtable they have the innate talent for what they do. So even for the best in class need to put in tons of time and effort to get it right. How about the rest of us, the ordinary folks? All the more we should put in more time to get it right, even we can never get to the level of the outliers, but at least, we would end up in the top 10 or 20 percentile - to get an advantage over the others who don't devote time and effort who have the same innate capability.

Take for example, Berkshire's investment in the Coca Cola Co in 1988. Buffett has been a Cola drinker all his life - though he was a Pepsi drinker earlier in his life. He had been evaluating Coke all his life ever since he started buying 6-pack cans of coke and broke it up to sell for a dime each. For 50 years, he did not own a share of Coke - a period where he knows hell lots about what is tipping the advantage towards Coke's economic future. For instance, the advent of refrigeration caused a surge in Coke's sales volume in the 1960s. Beginning 1980s, with the opening up and growth of the Asian economies, Coke is bound to have a bigger share of the beverage market (international sales made up more than 50% of its operating profit today). It was only in 1988 that a sudden down shift in Coke's share price that Berkshire made a huge investment in Coke without much further evaluation because he knew all the factors that drove Coke's business and profit at the back of his hand with 50 years of knowledge. So that is basically the effect of "50 years of preparation and 5 minutes of investing decision."

Lack of patience is well evidenced when a young shareholder asked Charlie Munger how to follow in his footsteps to becoming rich. Munger responded: "We get these questions a lot from the enterprising young. It's a very intelligent question. You look at some old guy who's rich and you ask, 'How can I become like you, except faster?' Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day, at the end of the day - if you live long enough - most people get what they deserve."

In short, success is about continuous learning even after you get it right. The more you know, the less time you need to make a decision because you would have known most, if not all of the unnecessary information you would have looked at when you started and eliminate those from the decision process. Again, Munger pointed out that 10% of freight carries 90% of the weight. So to get to the level of making a decision in 5 minutes, we need to know which are the 10% of the freight and to arrive there, we need patience, and continuous practice and learning. In Munger's terms, building a latticework of mental models. So when someone tells you a short cut, there's no short cut. If it sounds too easy and good, it is most likely too good to be true.

Steve Jobs: How to live before you die

Daily Journal Corp. - A Goog Buy?

Daily Journal Corp (Stock code DJCO) seems to be selling very cheaply whether valued by itself or compared to other print businesses. What I find that really interests me is not the core print business but rather the equity portfolio which is on the books.

DJCO is an obscure and extremely small-cap stock. But behind it lies a one of the best investment managers as its largest owner and director - Mr. Charlie T. Munger. DJCO's core business is news prints and publications and are sold to more niche markets, like targeting in the area of law.

Some numbers at a glance. Market cap is $85 to $86 million. Earnings was about $8 million for the year ended Sep 2009. Free cash flow is about the same as reported earnings. Current assets = $72.5m, total liabilities = $31.1m. Of the $72.5m in current assets, $62.1m is cash, treasuries and marketable securities. And out of $62.1m, $54.1 is marketable securities ($47.9m is stock and rest is bonds).

The company, after deducting all liabilities and assuming all noncurrent assets of $10.15m is worthless, the net assets is still worth $41.4m ($72.5m - $31.1m). In other words, at the current market cap, the core business of the company is valued at less than 6 times its earnings ($85m - $41.4m / $8m profit).

As mentioned, what is interesting is the stock portfolio worth $47.9m as at end Sep 2009. The whole of 2008, DJCO actually did not own any stocks, most were invested in Treasuries worth of about $20m. During the period Jan 2009 to Mar 2009, DJCO sold the treasuries and bought mostly into stocks and some into bonds. The cost of stocks were $15.5m and bonds $4.9m. In a period of 6 months, the value has more than doubled from $20.4m to $54.1m. I don't think they achieved this due to luck but rather most likely due to the foresight of Mr. Munger that he recognized that the market is totally irrational at the time. For example, banks, even Wells Fargo, were selling for ONE time its pretax preprovision for credit losses income. That is how ridiculous it was in early Mar 2009.

However, DJCO does not disclose the stock they hold. But whatever they hold, I am highly certain it will be worth many times more the longer they hold to it. On top, investors get a rather cheap print business that is still holding out fine, though maybe a slowing and dying business in time to come.

Buffett Personal Wealth and Wells Fargo

Too Big To Fail is surely the best investigative business book since Barbarian at the Gates or The Smartest Guy in the Room. Andrew Sorkin gave many new details and juicy insights into the events leading up to and during the crisis last Fall. One of which was the implied personal fortune of Warren Buffett.

On page 508, Buffett quoted, "I will be willing to personally buy $100 million of stock in this public offering (a Buffett's idea which subsequently led to the eventual PPIP)," which, he explained, "constitutes about 20 percent of my net worth outside of my Berkshire holdings." We can infer that he has a personal fortune of $500 million outside of his fortune in Berkshire.

And during last fall, his by-now famous co-op, Buy America: I am, revealed Buffett bought stocks for his personal account. One of which is Wells Fargo. He owns a personal stake of 2,240,000 shares which he most likely accumulated at a cost of about $56 to $60 million last fall. This constitutes about 12% of his personal fortune.

Disclosure: I own Wells Fargo.

A review of my current and past holdings

This is the first time I'm reviewing the decisions I made for my investments - both current and past holdings. There're mistakes I made (like I should have sat rather than to jump) and things I learnt (eg., investments are like gardening, some flowers take a longer time to bloom than others).

• Wells Fargo (current holding)

Banking sector, generally, in the States were selling at historical lows early this March. Wells Fargo hit a low of $7.8 - in effect, the whole company was available for $33 billion (based on the outstanding shares at that time). Wells potentially earns $40 billion in pre-tax pre-provision earnings. That priced the whole company at less than 1 time its earnings before tax and provision for credit losses.

Now, banking stocks have recovered somewhat - about 3 times from the sector's lows in March 09. Wells is selling at over $27. Even with the recovery, the sector is still selling at a low valuation historically. Wells, for one, is valued among the lowest of the banking stocks available. At $27, it is priced at no more than 3.2 times of pretax preprovision income. With every passing week, it's another week towards hitting the bottom, which means recovery. When the economy turns and earnings normalize, assuming Wells earns $40 billion in pretax preprovision, and 30% of it is catered for credit losses, and after a tax of 35%, it leaves roughly $18 billion available to shareholders. That translates to about $3.8 per share and if a multiple of 12 is applied, the stock can sell for $45.

Why is Wells priced so low? Probably because of the uncertainty on the extent of credit losses from the Wachovia's loan portfolio. The other worry is the rising rate of Wells Fargo's nonperforming loans. At this time, the market is likely to be a couple of quarters away from seeing a peak in nonperforming loans. Once nonperforming loans peak, banks, including Wells Fargo, will need to provide less for credit losses. If we look at Wells Fargo earnings before tax and credit losses - $40 billion - this equates to 5% of its loan portfolio. In order for Wells Fargo to sustain a loss, its nonperforming loan would have to hit 5% of its total loan portfolio. End of 3Q09, nonperforming loans stand at $21B (2.63% of the loan portfolio). So nonperforming loans would have to about double before eating into shareholder's equity.

What are the risks? If nonperforming loans continue to grow at a faster pace than in the past for the next few quarters, then Wells may have to raise capital which in turns dilute shareholders. However, if nonperforming loans grow at a much slower pace than in the last few quarters before peaking, the likelihood is the share price would shoot up quite dramatically.

• American Express (current holding)

A much misunderstood stock early this year when it was priced at less than $20, bottoming out at about $9. Amex, unlike Visa or Mastercard, offers credit to its customer rather than just offering a system for payment. However, interest income from its lending operation only accounts for less than 15% of total revenue. Majority of Amex's revenue comes from discount revenue - slightly more than 50%.

In recent years, Amex may have over-expanded credit businesses to less than desired customers, leading to an increase in loans. When the economy tanked last year, so did Amex share price because investors became worried of the credit losses Amex may face.

All told, Amex pretax preprovision earnings is about $8.5 to $9.5 billion, which means it covers more than 10% of its total loans and accounts receivable ($78 billion at end of 2008).

At the low sub-$10 a share, the company was priced at less than $12 billion (1.36 times its pretax prevision earnings). Amex is now $40 a share or $47.5B (5.57 times its pretax prevision earnings).

In normal times, Amex is priced 7 to 8 times its pretax preprovision earnings. So if this holds in the future, the upside is another 34% or more.

• Kraft Food (current holding)

This is a simpler investment to analyze. At $27, Kraft is selling for less than 14 times its earning power (EPS of estimated $1.97 for Y2009). Moreover, Kraft aims for a 7 to 9% growth in EPS yearly, and for a 15% operating income margin (compared to 12% in the past).

Kraft pays a dividend of $1.16 (4.4% yield). With operating cash flow of over $4 billion a year, and after lessing out dividend of $1.7 billion and capital expenditure of $1.2 billion, it leaves net cash of over $1 billion in the company's coffer.

Moreover, Kraft has lagged the stock market in 2009. With the Dow Jones gaining 17% so far this year, Kraft is about flat. Chances are Kraft would outperform the general index some time in the future, especially with the potential positives that the management has set Kraft up for.

• Berkshire Hathaway (current holding)

Berkshire has been a laggard this year. But all good deals are happening to Berkshire. Many people believed that Berkshire always get better deals because of who they are. But the truth is many couldn't get deals like Berkshire because they did not have the lending capacity or cash like Berkshire had during the time of crisis. When all others are pulling back, Berkshire was the only one that was willing to lend to credit-worthy companies and then of course, with lesser lenders, Berkshire was able to dictate for better terms.

The past year alone, Berkshire had extended over $22 billion in various types of investment securities to 10 different companies - Goldman Sachs, Wrigley, Dow Chemical, GE, USG, Swiss Reinsurance, Harley Davidson, Sealed Air, Tiffany, and Vulcan Materials. All securities came with a basic 8.5% to 15% yield. Some of the securities come with warrants, like Goldman Sachs, which is now in the money by over $2.5B just for the warrants alone. Swiss Reinsurance is another which can be converted some time in the future, which if it is today, it is in the money by over $2B (for a principal of $3.3B).

This month, Berkshire did their biggest investment to date, acquiring Burlington Northern Santa Fe at a valuation of $34B. However, it is by no means cheap. It was bought at an earnings multiple of 17 to 18 based on 2008 earnings. But Buffett called it an "all-in" bet on the future of America's economy. If America does well in the future, Burlington will do likewise. It is invested with a very long term view of 10, 20 or 50 years. By then, Warren wouldn't be around but he is positioning Berkshire for the future which he has been building Berkshire towards this end both in terms of culture, and the mix of businesses.

That is a very brief overview of Berkshire. Now to the details of Berkshire's value. Based on Berkshire's 3Q09 shareholder's equity, the share price is valued at less than 1.3 times its book value. A ratio that has not been seen since probably for a decade or more. But simply to base an investment decision on this ratio is an easy way out, probably not sufficient for an investor to understand the value of Berkshire.

Berkshire, primarily, can be broken down into 4 major categories of business - insurance; manufacturing, services & retailing; utilities & energy and; financial & financial products.

The headline net earning on the income statement can swing wildly from year to year or quarter to quarter because of the impact of the put option derivatives underwritten on 4 major global indexes (S&P 500, FTSE 100, Euro Stoxx 50 & Nikkei 225). So in order to understand the normal earnings, the gain/loss from such derivatives should be excluded.

The ultimate gains or losses on these contracts will not be known for many years but it is important to understand the mechanics of it because derivatives that are written without discipline are "weapons of mass destruction." The notional value of these equity put options is $37.1 billion. The first contract comes due Jun 2018. Any losses will only be paid on the due date. Meanwhile the value of these contracts are mark to market and any losses will be recorded as a liability. As of 3Q09, the liability recorded for these contracts was $8.1B. Meanwhile, Berkshire received a premium of $4.9B, which they have invested. These two items - the liability and the premium - means Berkshire had so far reported a mark-to-market loss of $3.2B (compared to a mark-to-market loss of $5.1B at end 2008, showing how volatile marking to market gain or losses can be).

To illustrate how Berkshire can lose on these contracts, say, Berkshire had sold a $37.1B (the notional value) 15 year put option on the S&P 500 index when that index is at 1300. If the value of S&P 500 is at 1170 - down 10% - on the day of the maturity (15 years later), Berkshire would pay $3.71B. For Berkshire to lose $37.1B, S&P 500 would have to go to zero. In the meantime, Berkshire had been paid $4.9B as premium to write the put contract and free for Berkshire to invest. As you can see, even if the index is 10% less than the day the contract was written (which is 15 years later), Berkshire would still not have lost a dime, in fact, a gain of $1.19B, not including any other gain Berkshire had realized from the $4.9B they had put to work.

The derivatives subject is a bit of a diversion. Now, let's get back to valuing the 4 different categories of Berkshire's main business, excluding impact of derivatives.

Insurance operations:

In Y2008, insurance earned $5.3B, of which $1.8B comes for underwriting gain and $3.5B from investment income. Valuing the insurance business would depends on which approach you use. There're a few.

• If you apply a straight 15 times multiple to its earnings, you get a valuation of about $80 billion.
• If you based it on its net worth (or book value), the insurance book value is probably about $75 billion and applying a 1.5 times book value, you get a valuation of about $113B.
• Another way is to value underwriting and investment income separately. Underwriting gain does not really gets its earnings from the book value or investment assets, though the capacity or amount that can be underwritten depends on the net worth or equity in the business. So if you apply a multiple of 12 to the $1.8B in underwriting gain, you get a value of $22B. Then since investment income is derived directly from investment assets, we can simply just based the value of the investment income side on the net book value which is roughly about $75B and if you apply a 1.5 times to the book value, it is worth $113B. In total, the insurance business is worth about $135B.

Depending on which valuation method, the insurance business is worth between $80B to $135B.

Manufacturing, Service & retailing:

This motley collection of businesses earned $2.3B in 2008. The various businesses in this group can be as different as night and day from each other. For simplicity sake, we will apply a multiple of 15 to its earnings which give a value of $34B.

Utilities & energy:

In 2008, this sector earned about $1.2B after one-off items. By applying a multiple of 15, it is worth up to $18B, of which Berkshire owns 87.4% (diluted) interest. So Berkshire's interest in MidAmerican is about $15.7B.

Financial & financial products

This sector earned roughly about half a billion in 2008. By applying a factor of 10 to the earnings, it is worth in the range of $5B, more or less.

Conclusion: Berkshire, when we add up the individual valuations, it is worth between $135B to $190B (difference lies in how you value the insurance business).

This is getting too long. I will try to write more on some other investments that I still hold or had held in the past.

Berkshire Hathaway's 15 Biggest Stock Holdings - Slideshows - CNBC.com

Berkshire Hathaway's 15 Biggest Stock Holdings - Slideshows - CNBC.com

Food for thoughts on investing in undervalued companies

Again, I had a rather long break. And I'm back. One of the cornerstone to successful investing is to buy undervalued businesses. But is it enough? I'd argue it ain't. One other aspect is to have good management that really thinks and acts in the right manner on the behalf of the shareholders, whom the management ultimately have a fiduciary responsibility to.

Sometime in July 09, IMS Health was selling at $12 - click here for more details in a previous post. At $12, the whole company was selling for $2.2 billion. A value that substantially undervalues the company in relation to its future earnings potential. This week, a consortium led by TPG offered $4 billion (or $22 a share) to buy out IMS. The offer was accepted by IMS management. David Carlucci, IMS Chairman and CEO, said: "This transaction enables our shareholders to realize substantial value from their investment in IMS with an immediate cash premium." But is it really so?

Yes, it is but with a caveat. It only offer substantial immediate value for those shareholders who had bought at $12 or so during the period in July but not for the other shareholders. In effect, the management had sold out on the majority of its shareholders. During the period between Oct 08 to before the offer, its share was traded in the range of about $10 to $18 (mostly at $12). Only shareholders who had invested during this period had benefitted but not fully - substantial value is left on the table.

Prior to Oct 08, its share traded at above $22. At that price, it too was undervalued in relation to what a full price would be. At $22, the whole company sells for $4B, with a free cash flow of over $350 million. The company is holding up well through the crisis and business prospects appear sound, though revenue had declined. Expanding global pharmaceuticals market, as expected by IMS, to grow at a compound rate of 4 to 7% to about $1 trillion in 2013. So what value, if any, does TPG and its partner bring to the table. Indeed, much value is left behind.

In my view, the management had failed in its fiduciary responsibility to its shareholders. Even for investor who bought at $12, they may have less cause for celebration because the management failed to do their best to get a full value of what the company is really worth. One reason the management is eager to sell could be because of the generous slice of equity in the deal they can get.

So in essence, even if an investor manage to find an undervalued company (imagine you had bought IMS at $22 which is an undervalued price), they may not get rewarded because of a mediocre management.

On the other hand, it is always better to invest in a company that is not only undervalued, but comes with a decent management (think of Berkshire, YUM Brands, Amex, Wells Fargo) who takes care and thinks for their shareholders whom they represent. However, if an opportunity comes where a company is undervalued but its management is mediocre, it's best to buy only at a substantially undervalued price, for IMS case, it did be at $12 or so, not $22 - though both prices are undervalued. Any value investor who had bought before Oct 08 at $22 would perhaps rethink about the whole concept of buying into a company that is run by people who do not think for the people they represent.