My personal tribute and gratitude to Mr. Warren E. Buffett

The following letter is something I wrote in July this year and sent to Mr. Buffett. I would like to share the experience that I went thru with all the people whom I hope will be able to gain some positive effect out of this to inspire their dreams and life for the better. Part of what I am doing is to document down my entire journey from the day of how I got started in doing what I like to do, and hopefully to the day when I am immobolize or have lost my ability to do this correctly and logically. And also hopefully, I will be able to document the things that I have both done correctly and incorrectly for others to either replicate the correct things or to learn and not to repeat past mistakes done by fools.

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Dear Mr. Warren Edward Buffett,

I am writing to express my gratitude and honor for you. Though I have not met you or know you personally, I would still like to show my gratefulness to you for your remarkable intelligence, knowledge and thoughts which you so readily share with the public all the time. I have always been interested in the field of investing since a long time back but it was only during last October that I managed to stumble upon a sensible and logical philosophy towards investing. Prior to last October, I do not have even a tiny bit of an inkling on it, it was all pure speculation on what you may label as "wanting a last dance at the ball with Cinderalla." A large part of it can be attributed to your influence that totally shaped my outlook towards life in general for the better.

What had got me started seriously can also be attributed to a dear friend of mine, CH (who is also a huge ardent follower of yours and owns Berkshire B share). As a respect, I have copied him in this email and I would appreciate that you will copy him if you reply. He handed me a book - The Making of an American Capitalist - which totally blew me away after reading it. During which, I discovered the grandfather of Investing, Mr. Benjamin Graham who is both your personal friend as well as teacher. I bought his books - "The Intelligent Investor" and "The Interpretation of the Financial Statements" - for which any to-be investor should read before embarking on the path of investing. In terms of value, these books are totally invaluable and I bought it at what intelligent investors will regard it as "rock-bottom value". What could take me a lifetime to learn (if it even may happens), it took me a few months to grasp the idea of rock-solid investing fundamentals which involves a mix of having the right mentality, psychology, discipline, patience, reasonable level of IQ, logic and a fairly decent mathematical skills. It works like how a duck takes to water. It's like "BAM, everything falls right into place, makes sense and wired up in one fell swoop!" To borrow a line from you "No, I hadn't changed my diet or anything. The only new ingredient was Ben's ideas. Quite simply, a few hours spent at the feet of the master proved far more valuable to me than had ten years of supposedly original thinking. My debt to him is incalculatable." My debt is incalculatable towards you as well as to Ben, and your long-time partner and alter-ego Charles Thomas Munger for having the best minds and thoughts towards defining a proper way to the field of investment and often, such principles are also practical for other aspects outside of investing.

To quote a few lessons I learnt from you, I think the most important concept is the principle of defining one "Circle of Competency" whereby its size is not very important, knowing its boundaries is however vital. I agree that it is always more important to define things which one do not know rather than things one already know. And this is, in my view, not an easy principle to embrace immediately for most individuals due to the human nature of modesty. It is never easy for one to acknowledge one's shortcoming. By recognizing this, it actually makes one realize it is easier to improve. More often than not, by nature, trumpeting routs modesty because it simply boosts one's ego. The easiest person to fool is most often oneself. Another thing I learnt is the "perverse nature of human to like to make easy things difficult." I have taken 28 years to recognize the notion of such simple but yet much neglected principles. I'm glad by the stroke of luck that these simple principles are pointed out by you, Ben and Charlie. Also, I was reading Berkshire's year 2000 annual report, in it, I discovered the Aesop's investment axiom if "a bird in hand is worth two birds in the bush." And "BAM", there it goes, it totally makes sense on the principle of valuation.

The world, now and the future, is so fortunate to have an opportunity to learn from the best minds and people in investing which give a hope to shaping the world in a better way. What you, Ben and Charlie have achieved will definitely benefit the future generation with the legacy (which is the knowledge) that will be left behind.

What further impresses me is the rareness of a mega-rich person who will donate a major part of his fortune for the good and future of the society. I too agree with Andrew Carnegie that "Huge fortune which flows in large part from society should in large part be returned to society" and your thoughts of not creating a "dynastic fortune" to be passed down generation after generation which will tilt the already imbalance society even more. Children born in mega-rich family in effect have an advantage over an average kid with all the opportunities laid out on the table by their parents. Many a times, having a "too good and comfortable" life will often lead to complacency and instead of helping the children, it ruins the children's future. Usually, when the fat gets fatter, they get lazier and slower to a point they become inert. However, having said that, I too agree with you that "a very rich person should leave his children enough to do anything but not enough to do nothing."

It is rare to have a very successful person to be the second-richest man in the world. It is even rarer to have the second richest person to share his knowledge so candidly. And it is practically impossible to have a person with the preceding two factors to be remarkably generous for the good of the society. Therefore, I hail you for having the grace to share your astute knowledge and wealth with the general society at large, and also for having the enlightenment to see beyond the love for money and many other material things that many average human beings cannot see and feel.

Lastly, I realized how much you enjoy working with wonderful people who relish doing what they like. This is all-important because only by doing what we enjoy, we enhance our odds to excel in it and live a more fulfulling life. I discovered people like Katharine Graham, Philip Fisher, Tony Nicely, Tom Murphy, Ajit Jain and so on. If there is a chance, I would like to get an insight into the thoughts of these wonderful individuals. So far, I have read "Personal History" by Kay, "Common stocks, uncommon profits" by Philip and "Damn right" a book on Charlie Munger. All the others, I'm unsure if they have any writings, but if they do, I will definitely read up more on them. I believe these remarkable individuals can rub positive effects on others.

I am still learning day after day, stocking up on my knowledge. I find it satisfying to look at a painting where I can add on slight adjustments to it daily. Personally, it is the journey of learning and improving that is more satisfying and enjoyable than the end result itself. I hope to go for Berkshire Hathaway annual meeting one day, hopefully, to pay my utmost regards to you in person. By the way, I do not hold any Berkshire shares at this moment, but I hope to own some at the price that I view to be fair, hopefully in the near future.

If it was not because of the sensible principles and ideas which you, Ben and Charlie have provided, I would not have been wired up to allocate my funds in more effective and better way. You taught me to be humble, candid, acknowledge my shortcomings and define where my strengths and weaknesses lay and far more a lot. Therefore, once again, I thank you for all the knowledge you have provided through your past writings, speeches, interviews given, articles and yearly annual reports. This is the least I can do to pay my tribute to one of the most remarkable, wonderful and beautiful person in the world.

Yours Sincerely,
BC
Singapore

PS: I took a hell lot of time to write this and effort. I do not hold much hope that you will reply me but I hope you will at least read this. Actually, I applied what I learnt to this, by putting more effort, I am trying to improve my odds, hoping this will be something interesting for you to read and perhaps reply.

Understanding a business model

As most investors will proclaim, they understand the business that they own. The idea behind understanding is really very deep and diverse. Just how deep an investor understands, it is essential to always ask "Why."

Some investor confuses short term with long term interest in understanding a business. Most important in understanding a business is to be able to tell its performance in the the long road down the lane. No doubt, everyone hope to earn more profit in the short term. But when the short term and long term interest conflict, the long term interest must takes precedence at short term pain.

Knowing the competitive edge of a business has, is of utmost importance. When that is determined, the next most important question is to ask "How durable is this edge?." These are all long term goals that a business must answer. When the long term competitive edge of a business improves as a result of some painful or unnoticeable actions, that is "widening the moat." And doing so is essential if you want to have the kind of business a decade or more from now.

If management plays the short-term game in order to meet the short-term earnings targets as dictated by none other than Wall Street, bad decisions can be expected when a promise to make the numbers turn to making up the numbers. Consequently, the moat gets thiner, customer service and brand strength deteriorates. Then when this happens, no amount of subsequent brillance will overcome the damage that has been inflicted.

So in understanding a business, "an ounce of prevention is worth more than a pound of cure." should be the way to understanding it.

Executive Compensation and Corporate Governance

All too often, management proclaim that their interest are aligned with shareholders' interest. However, what is proclaimed is often not followed by actions. If the compensation of an executive does not match the performance of the business, then the talk on shareholders' interest is nothing but paying lip's service.

Many times, executive compensation is ridiculously out of line with performance. This will be hard to change given that the deck is stacked against investors when it comes to the CEO's pay. The result is that a mediocre or worst CEO all too often receives gobs of money from an ill-designed compensation arrangement. How did this happen? The answer lies in those inside the boardroom and the so-called consultant and directors who are appointed. These are the ones who have no trouble perceiving who "buttered their bread." As one compensation consultant commented: "There're two classes of clients you don't want to offend - actual and potential."

An instance of how a CEO can receive a bundle while not matching his performance. Take, for eg, ten-year, fixed-price options. If Mr. Futile, CEO of Stagnant Corp, receives a bundle of these, enough to give him a 1% stake in the company, his interest is thus clear. He should skip giving out dividends completely and instead use all of the earnings to repurchase stock. Let's assume he lives up to the business name. In each of the 10 years, after the option grant, the business earns $1B on $10B of net worth, which comes to $10 per share on a 100M shares outstanding then initially. He eschews dividends and regularly uses all earnings to buy back shares. If the stock constantly sells at 10 times earnings, it will have appreciated 158% by the end of the option period. That's because repurchases would reduce the number of shares to 38.7M by end of the 10 years, and earnings per share would thereby increase to $25.8. Simply by withholding earnings from shareholders, he gets very rich while the business remains stagnant since the start of the grant. Astonishingly, he could still have benefited $100M even if Stagnant Corp earnings declined by 20% during the period. He would not have done a splendid job for anyone else besides himself and those executives enjoying the same kind of grant. By simply deploying earnings he withhold from investors into disappointing projects and acquisition (incl of those repurchases), he got extremely rich which they do not deserve. In fact, this mode of compensation on fixed-priced options is a transfer of wealth from one to another with the size of the pie unchanged.

CEOs understand this simple math and know that every dime paid out in dividends reduces the value of all outstanding fixed-price options. Although many preach capital comes at a cost internally, they somehow forgot to preach that fixed-priced options give them capital that is more than free. It's child's play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. However, options of such kind - options tracking the performance of the business performance - are never issued. Indeed, such options with strike prices that are adjusted for retained earnings seems foreign to compensations "experts." Even if a CEO manages a blopper that ultimately costs him his job, it will still gives him a bountiful payday. Indeed, he can earn more in that single day while cleaning out his desk than any average worker earns in a lifetime of cleaning toilets. Today, the rule has kind of changed to "Nothing succeeds like failure." Huge severence payments, lavish perks and outsized paychecks for ho-hum performance often occur because of compensation committees have become slaves to comparative data. The drill is simple: A few directors - not chosen by chance - are bombarded before a board meeting with pay statistics that always ratchet upwards. When comparitives data are used, all too often, everyone want the same treatment. Just like a kid saying: "But Mom, all the other kids have one."

The next question is to logically ask what can be done to align the options more in the interest towards the shareholders as well as not taking everything away from the CEO. Options should not be totally restricted in any way, in fact, a CEO may well receive much of his pay via options, albely in a logically-structure one. This is in respect to 1) an appropriate strike price, 2) an escalation in price that reflects the retention of earnings, and 3) a ban on his quickly disposing of any shares purchased through options. Arrangements that motivate managers must be cheered, whether in cash bonus or options but it must be appropriately and logically structured to benefits both ends. And if a company is truly receiving value for the options it issues, there is no reason why recording their cost should cut down on its use. The simple fact is that CEO knows if their options are rationally expensed, they know their stock would sell at a lower price if realistic accounting were employed, in other words, they will reap less when they offload in the open market.

So how did all this happens? Accountability and stewardship withered in the last decade, becoming qualities deemed of little significance by those caught up in the Great Bubble. As stock prices rise, the behavorial norms went down. It should be noted that most CEOs, man and woman, are people you would be happy to have as spouses or next-door neighbours. However, too many of these people have in recent time behaved badly while holding office - making up the numbers and drawing obscene pay for mediocre performance. These otherwise decent people simply follow the saying: "I was Snow White but I drifted."

Then when able but greedy managers overreach and try to dip too deeply into the shareholders' pockets, directors must slap their hands. But in reality, too few hands are slapped. So why has directors failed so miserably? It is not due to inadequate laws but rather in what is called "boardroom atmosphere." In a boardroom, it is almost impossible to raise question of whether a CEO should be replaced. Moreover, his inside staff and outside advisors are present and unanimously support his decision. Then it is understandable how paychecks got out of hand. When management hires people, or when companies bargain with a vendor, the intensity of interest is equal on both sides. One's gain is the other's loss and the money involved has real meaning to both. However, in executive compensation, the people deciding are those who sit on the board and compensation committee. A CEO may always regard the difference b/w getting options for 100K or 500K as monumental but to a comp committee, the difference may seem unimportant because neither grant will have an impact on reported earnings if options are not expense.

Then more recently, this malfunctioning system cries for "independent" directors. But what really motivates independency has been largely ignored. If independency comes at a price to appoint it, it defeats the purpose. There are two all-important responsibilites for these directors (independent or not) and the entire board is to firstly, to appoint an able and honest manager and then to compensate that manager in a fair way. It is definitely true that it is desirable to have directors who think and act independently but they must also entail three essential qualities - business-savvy, interested and shareholder-orientated. But, often, these people, though decent and intelligent, simply did not know or chose not to be interester about business or care enough about shareholders to question foolish acquisitions or over-the-top compensation.

Many times, however pathetic a management performance had been, directors had routinely rehired and approved the compensation of the managers. If there is real independency between the board, the directors and the management, there may be a better road towards awarding compensation that is more aligned to both the real performance generated and to the interest of the owners. If there is some form of a link existing between these groups where their personal interest is involved, owners will perpetually be paying more than they should to the managers which does not match the performance.

In essence, management of businesses who grant themselves a gob of fixed-price options, mostly likely owners' interest does not align with management interest. On surface, at the end of the period when they cash in on their options, both sides seems to have earned. But, in truth, the management return on their investment is insanely faster than those investors who has held their shares since year when the options were granted. For owners, capital comes at a cost, for such management, it comes much more than free.

How to minimize investment returns?

Long ago, Sir Isaac Newton gave mankind three laws of motion, which were the work of genius. But his talents did not extend to investing - having lost a fortune in the South Sea Bubble. Reflecting later, he said, "I can calculate the movement of the stars, but not the madness of men." Had he not be traumatized by this event, he may well has gone on to discover the fourth law of motion - In the investment field, returns decrease as motion increases.

In investing, as a whole, the more movements there are, the less the returns will be. You may mentally argue your returns can be higher than another person. Yes, it is true but if measured as a whole for all investors combined, it will be otherwise. By buying and selling in a clever way or perhaps attributed to luck, investor A may take more than his share of the pie at the expense of investor B. Surely, all investors feel richer when stocks soar. But an owner can only exit by having someone take his place. If someone sells high, another must buy high. For investor as a whole, there will not be any magic that will enable them to extract wealth from their companies beyond that created by the companies themselves. The most that owners can earn in aggregate between now and Judgement Day is what their businesses in aggregate can earn. For those who can earn a return more than what the business in aggregate produces, they are in fact gaining at the expense of those who underperform this aggregate. There is no way the value of a subset of a product can exceeds the value of the product, we will run into a big math problem which is unsolvable if it happens. An analogy will be something that someone told Mr Buffett: "There're more lawyers than people in New York."

With this simple logic where no one can extract any cent more than what the total a business can earns during its lifespan, it pays to value a business at the very most in aggregate what a business can churns out during the life span. But this "very most" value strategy will only works if you stay inactive throughout the life span of the business. When you trade - that is by always buying and selling - frictional cost will be incurred. So when you pay commission to the intermediaries, you will have reduced the profit received from the aggregate profit that the business produces because the commission will have to be paid and it comes from this aggregate that is churned out. In reality, a smart investor will value the business to be the aggregate value churn out by the business by substracting the frictional cost from this aggregate.

Having said the above, owners who buys through an intermediary can only expect to earn less than what their businesses earn because of "frictional" costs. In other words, in stock investing, it is wrong to assume that all the profits a business produces will go to the investors' pocket, part of it (a pretty substantial ratio) goes into the pocket of those who facilitate the trade. Often, such costs are ignored or neglected by the investors. The most atrocious idea is for investors is to think that return can be more than what a business can actually produce.

Thoughts on investing and current market (Part 3)

Another thing to note, when you see an influx of funds by people who do not usually talk about stocks, it is the time when the euphoria really begins. When there is an excess of money to buy stocks, there is no other way but up for stock prices. The reason is very simple. If you understand how the mutual fund industry works, all they want is new funds. For instance, like the local banks where they promote lots of different funds. If next year, out of the blue, everyone in Singapore wants to invest in a fund, they bring into the market with a lot of money. Where is the money going to go to? Sit idle? Goes to buying bond and earning its interest? Hell, no way, fund managers must find a way to invest the newly acquired funds for the customers. So when the supply of the stock is the same, all the fund managers will be fighting for a slice of the limited cakes. Thus, price of equity goes upwards. Now you may ask the reason they still buy when price is overdriven. Simple, they can’t afford not to. They are on losing ground whichever side they stand on. So for them, they’ll have to join what all others are doing. So when they fall they go down together, and they won’t look as bad. In some way, it’s in the fund manager interest to follow the herd, even if he thinks the herd is wrong. In the worst case scenario, he will go up in flames along with everyone else. And no one will fault him. Alternatively, if he dares to think outside the box, and do what he believes is the best long-term interest for his clients, he takes the chance of being “wrong and alone.” In the mutual fund industry, time is not the friend of the fund manager. In a market that focuses on the moment, the last 6 months is all that matters. So to speak, clients will not give money managers a chance to prove their case with time even if in future, the performance will be better than the others. Secondly, when investors invest, they expect their money to be in stock, not in liquid, if it is in liquid, the investor will withdraw the money and find someone else. This amounts to losing a business. Here, shall mention another Warren’s message – “The stock market is a no-call strike game. You don’t have to swing at everything – you can wait for your pitch. The problem when you are a fund manager is that your fans (investors who put money with you) keep yelling, “Swing, you bum.”

Thus far, the mutual fund only allows 4 paths for its managers to walk. 1) You can be right and with the crowd – which is fine. 2) You can be right and alone – and then you are a hero. 3) You are wrong and with the crowd, which isn’t actually so bad. When everyone is down, it doesn’t hurt (the fund manager career either because you’ll be ranked together with everyone) to be down. 4) Or you can be wrong and alone and then you’ll look like an idiot. The last option is the ignominious fate that a career-conscious fund manager strives to avoid at all cost even by knowingly buying stocks at a high price that is stack against the odds. So for most money managers, they do what the whole of Wall Street does best – by playing to the gallery; playing to how the fans and crowd dictates them to play. Wall Street does what they does best – being the best salesman. When you assume the role of a salesman, all they care about are sales – investor’s interest counts for nothing. On Wall Street – a community where quality control is not prized – will sell investors anything that they will buy.

Not that all mutual funds operates in this typical manner, but those who do not are too few and far between. It takes a hero to divert from where everyone else is moving. The strange thing with people is they do not mind falling together no matter how hard the pain is. But if anybody who has the intention to put his money in the care of a fund manager, the model example of this caretaker must at minimal be of the same standard as Jean-Marie Eveillard and Charles de Vaulx of First Eagle Fund. They were the heroes in the late 90s when most mutual funds are supporting the equity market while they are out in a huge way. What they say is impressive with action “At least we lost half of our shareholders - rather than losing half of our shareholder’s money.” “We only appeal to defensive investors, people who are worried about losing money than they are eager to make as much money as possible because we are not aggressive investors.”

Then as a value investor, it is also important to know the every basic of what can test your faith in the idea of intelligent investing. When everyone else is doing better than you in a bull market, naturally most people will feel down. Not because they are earning more, but because almost everyone is abandoning the creditability of a great idea. Like what Eveillard mentioned “I don’t mind seeing professional investors I respect doing better than me. To see people I did not respect doing better than me – this is totally discouraging.” When you encounter this, this is when it tests your discipline in your method of investing. To make money out of something you do not believe in is not really fun first of all, then it puts you in a very precarious position. Another Warren’s quote “I would rather be certain of a good result than to be hopeful of a great one.” Do something that is certain, not hopeful. The journey does not ends tomorrow, the day after, a year later or 20 years later, it ends the day you are immobilize. So, for something to last that long, you must have a solid foundation and idea to do it right. You can have a revolver with a bullet in 6 chambers pointing to your head, and then you shoot it yearly. The more you shoot with each time, your chances of survivor lessens. Assuming you survive the first 4 years, when it comes to the 5th year, you only stand a 50% chance of survivor. That is because it is something you have no means to predict in the safest way. But if you chose to do that, you must know when to give up. Being greedy will definitely harm you. It is important to know the level of greed moves in opposite direction of odds and sanity. So when you get greedy, odds and sanity decreases. In life, it is like a poker game where you must know when to give up even if you have a much-loved hand. Life is also a series of opportunity cost. Whatever you give up, you gain in something else.


If the present valuation is the same as in the late 90s, it is surely overpriced now. For most people, they think stocks are ever-ascending, on paper, at least, it shows. But in reality, the real people who gain are those who took their winnings home before the party ends. The vast majority historically holds on – as they are told by the press, the brokers, the gurus. For those who cash out, they may have missed the peak but they missed the wreak that follows suit.

The only so-called setback when you go against the crowd is you are almost alone. The crowd may provide you warm because you are inside the herd. But one of the few greatest advantage is time is your friend while it is the foe of those who does not practice value investing.

To summarize all the above, you can glean from it that investing is really one of the most diverse subject on earth, if not the most. It encompasses human psychology, basic arithmetic skills, discipline, patience, general knowledge, economics, and much more. For those who think investing is just about figures, then it is same as the principle of the man with the hammer who deals with everything like a nail – just hammer it in. Well, the problem with hammering all nails in is you have a problem of pulling the nail out when it is hammered at the wrong place.

Thoughts on investing and current market (Part 2)

Actually, I find 1990 valuation very similar to now. When we compare prices, we must cut it down to a basis where it is comparable. If you just look at the stock price purely, for example McDonald’s, it costs USD7.4 in 1990 and USD31.53 in 2006. How do you compare? You have not counted inflation and all other factors. So are you not going to buy just because it costs so much more compared to 1990? That’s total bonkers. Look at the valuation, the price proves valuations are almost the same both in 1990 and 2006. In 1990, it was a time when commodities surged in price too. But I do not know if the level was the same as 2006, it could be the same but don’t just look at the numbers alone, you must be able to bring it back to a basis where it is the same. At that time, things were at the middle of the bull-run – where the run started in 1982 after a flat market for the earlier 17 years – the bull-run lasted till year 2000 where valuations get totally out of controlled. For some businesses like Coke and Pepsico, the bull started running at its fastest pace starting from 1995, it was valued at 15 to 20 times book value and 28 to 63 times earnings. That is so much pressure to put on for future profits to go way up. The thing to learn here for investors is any future gains are always dependent on current valuations.

During the late 90s, investors are valuing the whole market earnings to be much more valuable than the assets combined. For instance, if you expect a 12% annual gain in stock, but the yearly earnings of the business increases only 7%, in the long run, stock prices will adjust this discrepancy bringing back down the annual expectation of 12% to below the actual increase in business earnings. The iron rule here is that the value of an asset, whatever its character, cannot over the long run moves faster than its earnings do. Another thing I yet to check out is if stock prices are growing faster than the GDP. If it does, it makes no sense to invest at all. Someone once told Warren there’re more lawyers than people in New York. Is it possible or logical? It’s an idea that can be possible where people buy into but it is not logical to happen, those who buy the idea are left with a useless piece of idea in time. That’s the same with people who think that profits can be larger than GDP. When you begin to expect the growth component to forever outpace that of the aggregate, you get into problems in math. If GDP is set to grow at about 5 to 7%, it is illogical for the investors as a whole to expect an average of 12% return yearly on stocks. In the short run, on paper, they may be proven right. But in reality, like what happen in 2000, if you do not take home you winnings, you will be proven wrong in the long run.

At today pricing, if there’s a crash, it is just a slight turbulence, and it is not due to the valuation of the stock. The only weighing factor on this is the core prices of commodities being speculated to such madness. In fact, I think it is better for a crash of such nature to happen, i.e. for commodity prices to come way down. No doubt stocks will follow suit but it won’t be a big fall. It will fall but rise again.

Unless, you have a crystal ball on when the market will crash and so on, I always think it is best to buy on value you can reason out and be fair even if it falls through. Here is a few of Warren ideas. Firstly – “If you are an investor, you’re looking on what the asset is going to do, if you are a speculator, you’re commonly focusing on what the price of the object is going to do.” – to which I’m adding, they are timing what the next fool is going to do. If you are going to play game with a lunatic for money, you can’t reasonably guess the madman next move even with the best math model thrown in. Secondly, “If you understood the business perfectly, and the future of the business, you would need very little in the way of a margin of safety.” Thirdly but not least, “We’ve long felt that the only value of stock forecasters is to make fortune-tellers look good…short-term market forecasts are poison and should be kept locked up in a safe place.”

All of these ideas are to be taken and reasoned out together, not just by using one and then based a decision on that single idea alone. Don’t try to be like the man with a hammer where everything looks like a nail. So when you think of everything that is happening coupled with today valuation of this group of businesses, we are not seeing an overly driven market, at least for this core group that is taken. I did not have the opportunity yet to dig into numbers in the early 70s, I’m pretty sure the valuation then was almost same as late 90s. At that time, Warren was totally out of the market because he was out of sync. Here’s an idea he explained in 1969 – “I’m out of steps with present conditions. When the game is no longer played your way, it is only human to say the approach is all wrong, bound to lead to trouble, and so on. On one point, I’m clear. I’ll not abandon a previous approach whose logic I understand - although I find it difficult to apply - even though it may means foregoing large and apparently easy profits to embrace an approach I don’t fully understand, have not practiced successfully, and which possibly could lead to substantial permanent loss of capital.”

Although at the moment, the market as a whole is not rock-bottom cheap, it is also not a totally irrational speculative market. To give an idea on what has happened in the past market bottoms, the PE of stocks was 10 and the dividend yield was 5%. It happened in 1942, 1949, 1974, 1980 and 1982. As of now, we are not close to that yet but though if you are a buy and hold investor in a great company at a fair price, all these really doesn’t matter to you although no doubt you can earn more when you get something at rock-bottom.

Thoughts on investing and current market (Part 1)

This is a little data I collated and deductions are based on these. Like many, a hard-landing or sudden melt-down is highly worried and on the agenda of many businesses and economy. Of all, Buffett finds it a whole lot harder to find great buys the past few years, starting since the last crash in 2000. However, a point to note is he did not particularly points out the market is overvalued at present, unlike in the late 90s, he expressed his concerns through Fortune.

To start with, I do not think the market is at the wildest stage of speculation for stocks – though in commodities it may be – based on the few huge and big-name businesses that I’m going to present to you. The core set of business consists of Costco, Home Depot, Walmart, Tesco, Harley Davidson, Coca Cola, Pepsico, McDonald’s and Anheuser Busch (parent of Budweiser). To note, I am taking this group to represent the whole index like S&P, DJIA, and such. It may not be true that the whole index is at the same value. To be sure, it is better to find it out.

In 1999 and 2000, the average PE for this group was 37.1 and 35.4 respectively. The Price-to-book ratio in 1999 and 2000 averaged 8.7 times and 8.2 times book value. In 2006, the PE average 17.6 times earnings while the PB is 4.5 times book. The PE of 17.6 is surely not by definition cheap, it is just that slightly more expensive than what is average. Over the years, S&P has traded at 14-15 times earnings in the past. That doesn’t mean it will always be so. We are probably in the middle of a secular bear market that started since 2000.

What do all these numbers tell you? It shows as a whole, the market is valuing the business much lesser than what was experienced in a super-bull market. In fact, I shall bring you back further to the valuations in 1990 and 1995. If you recall, in 1990, there was a slight hiccup due to the Iraq war on Kuwait, dampening sentiments for a little while, but still, it does not affects much on fair valuation. In fact, part of what I am trying to present is a lot of people unduly gets over-worried on how the general economy as a whole will affects the individual business even if the business is valued at a fair price or valuation. No doubt that if all other businesses as a whole form together gets overvalue, it gives a higher chance for the market as a whole to crash. But this group which is part of the whole – being valued sensibly – will no doubt experience some adverse impact in the most minimal way but will recover just as fast to normal. So when you buy a business, you should not look at what the whole economy is being valued and value the business in the same way. The business can be fairly priced while the market or index as a whole is highly speculated. Warren once mentioned “The key to investing is not assessing how much an industry is going to affect the society, or how much it will grows, but rather determining the competitive advantage of any given company and above all, the durability of the competitive edge.” Likewise, if the price of the business is right, one should not let how the total value of the whole economy affects you much. Though you are right that if I am to buy today for a great business at a fair price of USD100 per share and if tomorrow, the market crashes, definitely, my share will goes down by some too. But it won’t tumble. It just goes down and recovers just much faster than anyone else. It is just like experiencing midair turbulence and the plane gains altitude again. When you have a competitive edge, it is also important to know the boundary of this circle of edge, many times, people do not recognize the boundary, thinking it is limitless.

A classic example of a durable competitive edge is to think about Coca Cola. If you are given a choice to buy between Coca Cola for 60 cents or China Cola for 50 cents, which will you buy? The answer you give will go a long way in determining the durability of the product. If you answer coke, well, it is logically the answer of many others. Even at 20% more costly than its rival, they have the edge. Another scenario is the alternative name of Coca Cola, which is Coke. That is a hell of an advantage over their closest rival, Pepsi Cola – although Pepsi won the taste test. So if you are not a Pepsi fanatic, when you want to order a Cola, you would most like to say “Coke” – correct me if I am wrong – the simple word of Coke goes a long way in extending this competitive edge over their rivals. This is also a classic example of how branding creates a competitive edge. It should be studied in detail by anyone who wants to be in the Advertising and Promotion industry.

Finest investors on the Dean of Wall Street Benjamin Graham

This may have nothing much to do with direct knowledge of investing but for the lucky few who got to study the logic behind Benjamin Graham's ideas, it is one event that can change their life forever. Here's are some tributes on Ben from Wall Street finest.

"One of the luckiest events in my life was when I met Ben Graham...." - Warren E. Buffett, Berkshire Hathaway

"Like that other genius Edison, Graham created light where there was none." - Bill Ruane, Sequoia Fund

"Graham's teachings gave me a lifetime investment philosophy...." - Charles Brandes, Brandes Investment Partners

"When Benjamin Graham lived, I believe he was undervalued by investors..." - Walter J. Schloss

"No intelligent investor should fail to read and understand the works of Benjamin Graham." - John Bogle, Founder of Vanguard Group

Investing in a professional-managed fund

When putting money in a professional managed fund, it is important to gain an understanding into how the people behind it operate and behave. Professional managed funds includes Insurance companies, Institutions, Pension Funds, Mutual Funds or any funds that are managed by professional money managers.

As these funds are usually Other-people-money, it is wise to understand how they operate. People do not usually take as much diligence in guarding other people asset more than their own.

In the fund industry, often if not all the time, money managers follow the herd mentality. Money managers are always rated relative to how the index does. Even if a stock is extremely overvalued, for instance, Amazon during the dot-com boom at USD400 per share, many funds are buying into the stock then. If a fund manager blanched at paying $400 for a profitless bookseller, and as a result his fund returned only 15% return when all the rest who bought the stock return 20%, he could expect to lose investors, at least part of his bonus, and possibly his job. On the other hand, if he took a gamble on Amazon, along with everyone else, he would be safe. Even if the whole internet sector blew up, and he lost, say, 15% of his client’s money, he would not be blamed as long as his benchmark index lost 15% or more.

So if you are a professional portfolio manager, the best way to keep your head down is to invest with the herd. More than ever, money managers are judged and rewarded based on their relative performance – how well they did when compared to a benchmark index or to their peers. For them, the greatest risk is not losing money; the greatest risk is missing the upside if the market continued to go up.

A prudent individual investor would not eat relative performance. What matter to him is absolute performance – the dollar value of his portfolio in 5 or 10 or 15 years.

The risk for money managers is more on career risk than investment risk. What counts is the past 6 month performance. Even if they lose 15% of the client’s money when the benchmark index loses 18%, they are the seen as the star performer of the industry.

Creative accounting

In recent times, honesty has eroded. It was once pretty easy to tell the good guys from the bad. Back in the 60s, virtually all of America's most-admired firms avoided deception. And most investors at that period knew who was playing game.

Now, many major corporations still play things straight, however a significant and growing number of executives have come to the view that it's fine to manipulate earnings to satisfy what they believe are Wall Street's desires. In fact, many think this kind of action is their duty with the intention of so-called "maximizing shareholder's value."

These managers too commonly start with the assumption that their jobs is to encourage the highest stock price possible - something which I adamantly disagree. To achieve this aim, at first, they strive for operational excellence. But when operations don't produce the desired result, unadmirable accounting tricks - alternatively known as creative accounting - take place. This either manufacture the "desired outcome or earnings" or set the stage for them in the future when needed.

Creative accounting is not illegal. As what Michael Kinsley said: "The scandal isn't in what's done that's illegal but rather in what's legal."

Managers rationalize this behaviour oftenly by saying that shareholders will be hurt if their stock is not fully-priced, and they also argue that in using creative accounting, shareholders are getting what they want. Once such an "everyone is doing it" attitude takes place, ethical misgivings vanish.

An instance of a legitimate accounting entry that is highly questionable is one-time expenses such as "restructuring charges", an accounting entry that is often a device for manipulating and misleading real earnings. In some cases, a large chunk of costs that should rightly be attributed to a number of years is dumped into a single quarter or year, usually one that is already fated to disappoint investors. In other cases, the aim is to clean up earnings misrepresentations of the past, and in others, it is to prepare the ground for future misrepresentations. Many times, wreaks like these are often swept under the carpet discreetly under the nose of innocent and ignorant investors. In both cases, the size and timing of these charges are dictated by the cynical proposition that Wall Street will not mind if earnings fall short of $5 per share in a given quarter, just as long as this shortage ensures that quarterly earnings in the future will constantly exceed expectations by 5 cents per share.

In the acquisition arena, restructuring is often an art form. In many cases of leverage buyouts, business is acquired wholly, then brought private, spruce up with condiments, and then take it public again. In this short period, they can turn a dollar into 3 dollars easily when they sell the business back to investors. Acquisitions and mergers are all about rearranging the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings. An instance will illuminate the case. When a business is acquired, the buyer sometimes simultaneously increases its loss reserves, often substantially. This boost may reflect the previous inadequacy of reserves. But such moves set up the possibility of "earnings" flowing into income at some later stage, as reserves are release later when they explain the earlier reserves were overestimated. When deals occur in which liabilities are increased immediately and substantially, simple logic tells us at least one of the virtues have been lacking or the acquirer is setting the framework for future infusion of "earnings."

As pointed out by Warren Buffett on a true story that happened in the 90s: "Here's a true story that illustrates an all-too-common view on corporate America. The CEOs of two large banks, one of them a man who'd made many acquisitions, were involved not long ago in a friendly merger discussion (which in the end didn't produce a deal). The veteran acquirer was expounding on the merits of the possible combination, only to be skeptically interrupted by the other CEO: 'But won't that mean a huge charge,' he asked, 'perhaps as much as $1 billion?' The 'sophisticate' wasted no words: 'We'll make it bigger than that - that's why we're making the deal.'"

So, in a great and honest management, they would rather disappoint you with earnings than with their accounting. Meeting Wall Street earnings forecast does not play much of a factor to them. They will spend more time on work that increases the real earnings of the business than to spend more time attending to investor relationship answering to what Wall Street wants to hear.

Is Productivity good or bad? (Part 2)

Ultimately, the consequence of a productivity bubble would be unemployment. In a piece published by David Tice’s Prudentbear.com, Donald Perry used a story to make the point.

“Basically, productivity in the coop increases when chickens lay more eggs per day,” “Early on farmers noted that hens could produce more eggs when confined to a cage, instead of running around searching for food, being chased by cocks or having to evade predators. To understand productivity as it relates to the economy substitute the word ‘chicken’ for ‘worker.’”

However when more eggs are produced, eventually the price of eggs will fall. The egg business at best will tread water. Too many eggs, like too many cell phones or computers, leave the chicken farmer with little power to raise prices. The solution for the farmer is “to send some of the chickens to Campbell’s.” – ending up literally in their soup. The farmer then has fewer chickens to feed, gets the highest average output per chicken, and makes a little extra money in the process.

In the real world, however “human chickens are not sent to Campbell’s,” Perry pointed out, “they get unemployed and buy fewer goods.” And when there are fewer buyers, the excess of eggs becomes even greater. Now obviously, the market corrects itself by “wringing out the excesses.” Ultimately, many egg farmers are going to go out of business. So when you someone touts productivity gains you should be think logically if productivity is after-all a good thing. It could mean “Who will be going out of business next?”

A boon in anything may or may not be due to logical reasons one needs to always ask why. Rising productivity “makes economic sense when production rises faster than ‘hours worked’, but it makes little or no sense when – as in recent years – hours worked fall faster than rising productivity.”

When productivity gains are linked to jobs vanishing, we see no miracle.

Is Productivity good or bad? (Part 1)

Generally, when people talk about “Productivity”, they are referring to the amount of goods and services the nation or economy produces per hour. In recent times, the dues given towards a higher productivity rate has often been overrated. In part, this is due to human nature thinking that anything that is going up must always be beneficial or advantageous. In today world of the “New Economy” – a term coined in the late 90s – the productivity miracle depended to a fair degree, on a blind fate.

In theory, when businesses produce more per worker, they increase profits and raise wages which will in turn allows worker to spend more to drive the economy upwards when they feel richer. Indeed, with the emergence of new technology, it helps spur productivity to yet another level.

When productivity increases, it means there is more supply to cater to the existing demand. Whatever that are produced must be absorbed by the consumers. If productivity increases to a level where demand cannot catch up, there will be a big problem. Businesses will have to reduce their prices to clear stocks.

Many believe spending on new technology gives an edge against their competitors. However, when a technology that is readily available to the market, everyone can buy the same thing. In the end, the only one who benefit is the consumers. If a business intention of capital expenditure is to increase profit, in this case, many in recent times, did not achieve this aim. To the contrary, when business sink billions into technology willy-nilly, more capacity becomes excess capacity and as supply swamps demand, profits plunge. This cannot be any much truer for those who operate in very competitive market. This is precisely what happened in the late 90s when prices of computers plunge – Intel, Dell and so on have been forced to cut prices.

Every now and then, productivity level of the country will be published. In a world where productivity is greatly influence by technology, the figures given is only a very rough gauge at best – often figures are revised due to counting errors. So what are these counting errors? The problem is it is very difficult to assess the value of the new technology. Until it is set to profitable employment, a computer is just a piece of furniture. Like a piano, its utility depends on the individual. He may play “The moonlight Sonata” or simply “Happy Birthday.” So like most on Wall Street, a rosy picture is often painted. The new economists simply estimated the value of technology produced by the new economy by assuming all individuals studied at Juilliard.

The Buying Opportunities

Here are 3 ways in which value is higher than price and thus, each of this presents an opportunity for an investor to buy.

1. When values increases while price stays flat - Many value investors take advantage of this opportunity. For example, General Electric has been creating value while its price have fallen from previous high and stagnated. Eventually when companies continue to create value, the market will give them their due.
2. Price falls when value stays flat or even increases - Unfortunately, the opportunities are so rare that you have to be there when it happens. In the late 90s and early 2000, Berkshire Hathaway stock price fell by almost half. Why did it fall so drastically? Perhaps many people thought Warren was losing his touch because he is technophobic. Or people thinks Berkshire being a holder of many business is holding some tech stocks too. Berkshire, was however creating value.
3. Price rises while value rises even higher - This method can be tough for most traditional value investors.

Managing greed and psychology

In investing, managing greed is as important as managing how you allocate your capital.

Personally, I have my share of greediness which causes me a lower return on my capital. A simple illustration as follows.

A value investor has bought AAA at $2. Before he got it, he had in mind that the stock is worth $4 in time. So after a year, the stock rises to $4. But he did not sell it, the greed behaviour of human had taken over the logical value thoughts. Then the stock went up to $4.5, he still being greedy thinks it'll goes up more. Yes, he was right, it went up to $5, then $5.2, then $6 And he was still holding to it. Then the stock came tumbling down, from $6to $5. Then for a few days, it hovers around $5, he still did not sells, thinking that it's just a market correction, hoping for it to rise. Then again, the market crashes, it went to $4.5, then $4, then finally, $3.5 and here, it bottoms out. He finally sold off at $3.5 and still made a pile but his initial target was not met because of greed.

In another scenario, this is about managing psychology or so-called "lost" profits. In the same case, the investor got AAA at $2 with a target of $4. When it hit $4, he sold it off. Then the stock was driven way up to $8 because of speculative forces. This investor feels he had taken the wrong strategy because of what happened, attributed to lunatic speculation forces. This is an important junction where the investor's initial discipline on his faith in value strategy is finally tested. If he were to hop onto the other lane, he has lost his discipline in the hope of searching for a hopeful result. If he stay on the same lane, whatever future investment he does, he will most always have a certain result. And he may have missed the peak, but more importantly, he missed the wreak that followed.

In investing, it is important to know the pitfall of greed and how psychology affects your feelings. Psychology is to do with feelings, not facts. Facts will correct everything that deviates from it. Feelings are something that causes the result to deviates from the facts.

Value versus Growth and psychology

Before I start, it is of utmost importance to define what is growth. Growth is in fact a component of the value equation - sometimes a plus, sometimes a minus. However in general, most others think that Growth and Value are two different approaches in investing. For those who thinks so, it clearly shows their ignorance and superficial skills to investing, not their sophisication as assumed by them.

In a bull market, everyone seems oblivious to the danger that comes with pursuing stocks that belongs to the "Growth" school of thoughts. Those who can actually makes a pile from such way are those who can exit before the party ends. In the late 90s, funds that pursue the growth strategy, returns were up much more than those funds who pursue the value strategy. For most investor, they do not care if the fund pursues the value or the growth strategy, what they care is they do not want to miss out on the fund that makes the most money, even if it was speculative. In stocks, you can only exit when someone takes your place. So for those who are vested in the Growth stocks, those who really make a pile are those who cash out before the tumble.

The value strategy is always most discredited or disregarded during the bull market - almost out of fashion. Growth investors flip stocks like houses in the Hamptons because they are only interested in short-term results and the illusion of things being under control. This people are like drivers you see on the road weaving in and out of lanes, trying to get ahead as quick as they can. He gets behind you, then in front of you and then he bangs right into a trailer. Then the one who drives steady will turn his head to see what happens and then moves on.

For this, it is appropriate to mention what Pascal once said "All men's miseries come from their inability to sit quiet and alone." Buffett once said "Most success can be attributed to inactivity." But for most humans, people cannot resist the temptation to constantly move. They can't sit still. It takes discipline to appreciate the value way of investing.

Every investment strategy has its own risk. For the value investor, the risk is time. Sometimes, he may have to wait for years before the stock price reflects its value, staying flat for a couple of years.

In the bull market where prices are driven by the growth strategy, it makes sense to be out of the market especially when prices are driven way out of logical senses. If you are playing cards for money, you do not want to play with lunatics for it is impossible to guess what they might do next. As a value investor, during a bull market, it takes a whole lot of discipline to stay out of it while you see the market still ever advancing at a great rate. In the late 90s, it took a couple of years before the bubble finally was pricked, but it was a few years before that when the price is already driven out of senses. Unless you have a magical ball, then it is safe to pump in fresh funds in the bull market.

Those who pursue the growth strategy believes the market will always be ascending. That's why in the bull market, more people are tempted towards the growth strategy, because a bull market will only happens when stock prices has advanced for a few years before that. Psychologically, the longer the market rises, the more people will believe it will go up perpetually. But if you look at history, you know everything runs in cycles. But that's the way psychology works.

For a value investor, the lesson here is;

1) It is important to recognise the game of playing. If the game is not played your way, it's no longer your game and you should stop playing. The worst is for you to join the other side who is apparently winning for the moment. If you can't understand your game well, you can never play it correctly. It's always more important to protect your funds than to make much more because of greed overcoming one.

2) You could never expect to outrun the bull that had taken charge of the market. The only way to be on the same pace is to hop onto its back which is as good as joining those in the growth lane.

In investing, it is like building Rome, it takes years to build it solidly but if you stumble, it takes a day or two for it to fall like a stack of cards.

In most things you do, success does not comes with foolish risk-taking, though risk comes with everything. It is how you manage risk that determines success. Many will say that the more risky it is, the more returns you get, well, it is true to a limited extent. But for something to be successful throughout the lifespan of it operating, being risk-adverse and managing the risk to a minimal level returns the most.

In fooled by randomness: The hidden role of risk in the market and in life

To gain an advantage in the stock market or investing in general, it is important to understand the experience in life is generally intertwine with the workings and behaviour of an investor.

Imagine an eccentric and bored billionaire who offers you $10 million to play a game of Russian roulette. He gives you a revolver with 6 chambers, a bullet in one of the 6 chambers, and challenges you to hold it to your head and pull the trigger. Chances are 5 in 6 that you'll get away with $10 million; chances are one in six you won't come away at all. That is, there're six possible paths that your story will take - but after the fact, we'll see one one of them. And if you survive, you may be used as a role model by others, including the media. If this roulette player is a mutual fund player, he'll perhaps end up on the cover of a magazine showing "Savvy investor beating the Index."

Of course, if the roulette-betting fool kept on playing, the chances of failing will catch up with him. From the first round of 5 in 6 chances to survive, it reduces to 4 in 5 chances, then 3 in 4, then 2 in 3, then finally, a 50% chance.

So when you look at the stock market's darling we're looking at the survivors from a very large pool of players. Imagine now there're a large pool of 25 -year-olds willing to play the russian roulette, playing on the first day of each year. With each passing year, there'll be less players, eventually after 20 years, we can expect to see a handful of players left. And this remaining few will be extremely rich and celebrated by the media - and a very large cemetary for those who had fallen. Most likely, they'll be thought by others to have the skills and ways around on how to survive in a roulette game.

These group of players would be hailed as winners - the alternative possibilities of what could have happened to them would be ignored and forgotten.

For every game, someone have to wind up in the top percentile. In a game of luck, it is the same and the important fact here is that none of these players can claim to be an expertise in a game of luck. But still, somebody must always be in the top 10, some in the middle, others trip at the first hurdle.

Simple lesson from Warren Buffett

Imagine you are a sprinter, looking for an edge in your race and Adidas has invented a shoe that can shave a second off your 100-metre run. The shoe is at a bargain price of $150. How many race can you win owning to this great technology invention? 5? 10? Or all the race that you enter?

The answer is ZERO, NONE. Yes, you are not reading wrongly. ZERO is screaming. The reason is very simple. All the rest of the runners are wearing the same pair of shoes. You can bet that all others can easily fork out the $150.

So what has this got to do with investing or Mr. Buffett for the matter? Now, we shall look back in history. The Berkshire Hathaway today is a full-fledged holding investment business for all the businesses that they own. Back in the 1960s when Buffett acquires Berkshire, it was then in the fabric mill business. Then the operating business managers at Berkshire would bring to Buffett's table with well-conceived plans for upgrading of processes, machinery and things you name it. These would on paper at least, save the plant a lot of time and cost of production, which means bigger potential profits for the company. But before long, Buffett realized that such capital expenditures were a waste. These advances were also available to the other mill plants out there. So with everyone else being able to generate the same cost and time savings, and passing them to the customers to boost sales, the only beneficiary will be the customers.

By realizing how to best allocate his capital in the best way, Berkshire turns into an investment-driven company and the rest like they say, is history.

The lesson here is multi-proned.

Firstly, never throw good money after bad money. Let's say if you make a bad investment, never throw good (fresh) fund after the bad funds (which is the bad innvestment made).

Secondly, being able to distinguish the things of all th competitors of the business which you are thinking to acquire are doing. If you can tell that the things which your potential targeted business is doing is something which all the rest are doing, then most likely, they are not having any durable competitive edge.

Thirdly, look for business which has a durable competitive edge.

Last but not least, a great business at a fair price is always better than a fair business at a great price.

How to get comfortably well to do in life?

The simpliest formula to this is to do what a person loves to do. By doing what you like to do, you are in the top half of the crowd - the other half being those who dislike doing what they do. So when you do what you love to do, naturally, you increases the odds of you doing well. Common sense will tells you the odds are against you if you do something where you are neither here nor there.

Here are quotes from given by the most successful investor, Warren Buffett and one of his associates, Mr Wertheimer, from Iscar.

"Do what you love. Buffett was asked for tips on how to make the first million, but he had no answer. Stef Wertheimer came to his aid, telling the questioner, "Do what you love - do it well and you'll succeed." Buffett agreed. "Stef is right. I enjoy what I'm doing very much. If you do what you really want to do, that's what will get you going."

Another quote from Mr Buffett to those who do not practise the intelligent way of investment and rely on charting or timing the market.

"Be greedy when others are fearful. Be fearful when others are greedy."

Real gold, Fool gold

What I am gonna to present is a very primitive form of way to "do up" or enhance the financial statement. I'm not sure if this may be a legal way but definitely, it is not a method that a business which is values integrity will use in any means. This can be used thru the means of structured products.

The idea behind this special and primitive trade is this: Suppose you pay $100 for a pot of gold. Half of the pot is real gold, while the other half is fool's gold. The portion of the real gold is worth $90, while the fool's gold is worth $10. If tomorrow, the two halves are still worth $90 and $10, and you sell the real gold for $90, can you register a profit? The answer must be no, right? If the real gold cost $90 and you sold it for $90, the profit should be ZERO, right?

WRONG, at least in certain markets where you buy such products. Suppose you buy the pot of gold and claim that each half cost "on average" $50. Tomorrow, when you sell the real gold for $90 - BINGO - you have booked a $40 gain. How? The real gold didn't cost you $90; it cost you $50 - "on average", at least as carried on the balance sheet of the business who purchase the pot of gold - and you sold it for $90 and "gain" $40. Of course you didn't make any profit, but by this way, you can register a gain. And for the fool's gold, you can hold it for as long as the business can, and it will be kept in the cabinet under locks. So by holding, you will never register a loss. It will still be at cost. Many management who are only interested in their paychecks can used such methods to meet the Street earnings expectations. Such problems will eventually surface many years down the road - at such point, it'll most likely be someone else problem - when someone new takes over and the skeleton will have to be brought out from the closet.

This is financial alchemy at its very best.

Frictional Cost

Here are two figures from 1998 on the Fortune 500 companies for you to consider. When you talk about the Fortune 500 companies, you are really talking about America Inc. because companies in this universe account for about 75% of the value of all publicly traded American businesses.

Fortune 500 profits in 1998 = USD334,335,000,000
Market value on March 15, 1999 = $9,907,223,000,000

In the equity market, investors have a habit of wanting to change chairs, or at least getting advice if they should change. When this happens, it cost real money - big money. This is called frictional costs. It is paid for a wide range of items. It could be for the market maker's spread, the sales loads, the management fees, the commissions, the custodial fees, the wrap fess and even subscription to financial publications. Never brush off these expenses off as irrelevances or unimportance. If you were evaluating a piece of investment in real estate, would you not deduct management costs in deriving your return? So in exactly the same way, equity investors must face up to the frictional costs they bear.

If the frictional expense cost a percent of the deal - which is quite possibly on the low side - investors would have paid USD100 million on frictional cost. This expense makes up about a percent on the Fortune 500 market value in 1999.

Perhaps 1% on the whole deal seems to be minute to pay for on a market value of 9.9 trillion. But if you look at what you are paying in frictional cost in relation to the real profit generated by the 500, you will notice it cost almost 1/3 of the whole pie of profit. So it leaves investors with a real profit of $250 million which is slim pickings on the return of their 9.9 trillion investment.

So it links you back to the very basic but yet ignored and forgotten theory - future returns are always affected by current valuations. Investors must always bear in mind - make it cast it on stones - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Surely, in the interim before the party ends, you and I can sell each other stocks at higher and higher prices till the last fool becomes wise. Let's say the Fortune 500 is just one business and that the people in this room each own a piece of it. In this case, we could sit here and sell each other piece at ever-ascending prices. You personally could outsmart the next fool by buying low and selling high. But no money from the business would leave the game when that happened. You'd simply take out what the next fool had put in. When it is driven so high, the day of judgement will come sooner than later. And when it comes, the real money that talks will be what the business has earned over time, not the money that had transacted between the buyers and the sellers. Investors must also inscribe in the thoughts that the absolute most that the owners of a business can get out of a business in aggregate is what the business earns over time.