My Thoughts On Stock Investing

How To Make Money in Stocks Part 7: Pick Low-Hanging Fruit

2009-05-15T20:24:00.000-07:00

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Allied to this theme is: don't try to understand the whole world! (actually that was the original title, but I thought the low-hanging fruit thing sounds more professional)

Actually in my view, investing is a very simple process compared to most other forms of work in the world. Not making money from investing, mind you, but the process in itself. All the talk and academic theories about structuring portfolios, optimising risk-return etc, does it really do anything but add two or three percentage points of return over the market (if one is lucky)? But people actually make a good living out of this, not just fund managers, but also service providers like financial consultants, market forecasters, systems providers, and a myriad of financial-related cottage industries. I look at engineers and the gargantuan structures they come up with: aeroplanes, software, building systems .... and I wonder .... it's incredible that the financial industry is paid so much for coming up with so little! (albeit they have the uncanny ability to blow these little achievements up into monumental state-of-the-art triumphs).

The point to all the above rambling is that we are all exposed to, and have generally accepted, a certain line of thinking: that to achieve good market returns, we have to accumulate as much knowledge as possible about as many industries and countries as possible, so that we can find and take advantage of potential misvaluations. That is how the output of the broking industry has been structured: daily market research, continuous company reseach reports, economic strategy reports, etc.

While there is nothing wrong with building a competitive advantage based on superior knowledge, it makes more sense to identify a few key trends, what I call inevitabilities, that have a higher-than-average probability of materialising, and then focusing on them.

The alternatives are what many people tend to do: (1) try to read as many analyst reports as possible, end up being overwhelmed with the info and betting on the popular themes/sectors of the day; (2) try to enter or exit based on different analyst interpretations of the market outlook ie. market timing; (3) buying and holding stocks based on analyst recommendations of their potential. For (1), the investor tends to be late into the buying process, while passive buying into recommended themes based on day-to-day reports will tend to lead to a bloated and overly diversified portfolio. For (2) market timing based on reports has historically led to being whip-sawed by Mr Market. For (3) the buy-and-hold approach is fine but one must think deeply about the stock and be comfortable with holding it for a couple of years (or else you will end up in the value trap, like Temasek with Merrill Leech/ Bank of Assholes).

One can be inundated with all the information in the world, but there is no point if it cannot be converted into useful knowledge. Different economists, for example, can utilise the same facts and come up with diametrically opposite and yet equally plausible conclusions. Who to believe?

Investors should recognise that economic outcomes, like investing, is really a game of probabilities. There is nothing definite that will happen in the future, it not only depends on the structural issues, but also responses such as governmental reactions, corporate maneouvres and that most elusive of all --- public sentiment. Who knows what would have happened if Lehman had not been allowed to fail last year, for example? A different governmental response would have generated a different outcome.

Perhaps it is best to visualise things in this way: at every point in time, there is a range of possible outcomes that could develop in the future, but with different probabilities of happening. The investor's responsibility is not to understand all these possible outcomes, because it will tire him out trying to monitor all of them. Rather, the optimal approach is to pick out the outcome that has the highest probability of happening, and then invest according to that outcome.

All this sounds very mathematical, so let's illustrate with an example. At the start of 2009, the whole world was very nervous with the possibility of economic breakdown, with reports of problems surfacing in the US, the UK, Russia, emerging markets. Contrarians, however, noted that given the depressed valuations, potential returns could be very good should the situation clear up. So, invest or not to invest? Rather than leave the decision to a matter of faith, a better approach would have been to avoid trying to forecast how the entire world economy would pan out, but rather to identify who the strong players were and the actions they were likely to do. Who were the strong players? Only governments were able to borrow at low rates, so they were the strongest. What were they likely to do? They were under popular pressure to save the world, so obviously they had to apply stimulus in large enough quantities to replace dwindling export demand. The remaining research to be done would then have consisted of identifying which governments were in the best fiscal position to apply aggressive stimulus, and then identifying which industries would have been chief beneficiaries of such stimulus packages.

Half a year down, those who had been invested in China infrastructure builders, like China Communication Construction, China Railway, China National Building Materials etc, would have seen their money double or more. The infrastructure builders of China were the low-hanging fruit in January 2009, because China was in a strong fiscal position to finance a stimulus package, and was under strong political pressure to replace weak export demand with a domestic stimulus to keep its target growth rate up. Injection through infrastructure construction was a natural choice because China had a need for it, and traditionally this had one of the best multiplier effects.

I want to bring the issue of market timing into the discussion. Readers of my blog will know my long-standing philosophy: returns from stocks are typically driven by the market/sector/company in general 40/30/30 proportion (this is a philosophy because I have no statistics to prove this, it is more a belief/rule-of-thumb based on experience and logic), but rather than focus on the market, my approach has always been to focus my attention to deriving useful returns from the balance 60% based on sector and company. That's because I have always felt it's impossible to decipher a system of 1000 moving parts ie. the economy.

Well, the belief on the difficulties of deciphering a complex creature like the economy still remains, but I have modified my approach after watching the sychronised selldown in all asset classes (except Treasuries) in late-2008. The "pick low-hanging fruit" approach also works for the economy. Indeed one of the most inevitable outcomes of 2008's subprime crisis, in retrospect, was the danger of collapse facing the financial system. Hence, not only banking stocks, but indeed a risky asset class like stocks, should have been avoided studiously if one identified this macroeconomic inevitability. It was the "low-hanging fruit" of 2008.

What low-hanging fruit are available as of now? Maybe we could start with thinking about what is inevitable based on trends so far. I can think of two. For one, with low interest rates it is becoming difficult to implement monetary policy stimulus further except to print money, and that implies currency devaluation. Two, governments will continue to apply stimulus but they will have to find ways to finance it. That implies they will have to increasingly borrow from capital markets. This has implications on currency and bond markets. The above two will eventually happen, there're no two ways about it; governments have to take measures along these lines in order to reverse the potentially destructive effects of deleveraging. The low-hanging fruit will probably be found in these two markets.

Thanks Thailand, you screwed up the show again

2009-04-12T01:25:00.000-07:00

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Why some people love to shoot themselves in the foot I will never understand.

I am talking about the current political chaos in Thailand, which has forced its months-old government to call off the ASEAN summit in Pattaya on Saturday, and to declare a state of emergency in Bangkok just earlier today. There are rumours of yet another coup that could see yet another government change. My guess is that if it comes to this, it won't be as peaceful as the last few bloodless ones because the Abhisit essentially has the implicit blessings of the Thai king and the Bangkok elite and these power brokers will not let their man go quietly.

This is not the first time I'm saying this, but essentially it is tragic that Thaksin had to be forced out just when Thaksinomics was beginning to have a broad-based improvement on the lives of ordinary Thai citizens. I am not sufficiently clued-in on the depth of his corruption, but general consensus was that his reign from 2001-06 had steered Thailand from the abyss of the Asian financial crisis through stimulation of domestic demand and lessening the country's dependence on exports and volatile global demand. The rural regions had also benefited from Thaksinomics, which placed them as the primary target of its policies.

What is generally agreed, as well, is that there were green eyes over the rising popularity of Thaksin. Thus there was clear and strong motivation to remove him, and the means was available as well, for those green eyes allegedly belonged to the tradtionally powerful elite in Bangkok; that included the military, the rich and politically connected, the royalists. These people had the most to lose from a dilution of political tradition.

And so Thaksin was gone. From one who had led Thailand to the brink of being the de facto leader of ASEAN given a still recovering Indonesia (in 2005), Thaksin has fallen badly. He has been hit hard by the global recession since there's nowhere to hide, and there're now no political connections to leverage which could have cushioned his fall. His assets in Thailand are frozen. A desperate man makes a determined man --- the way the Thai authorities have cornered Thaksin has boomeranged back on them in the form of this latest attempt to re-take power in order to unfreeze those assets.

Since Thaksin left, the political situation has been in a state of limbo up till today. An army general took over in the interim, and during that period the Thai monetary authorities screwed up by imposing capital controls and then backtracking within a week. Then they had an election through which a Thaksin loyalist party took power. Samak became Prime Minister. However, he didn't last long as somebody figured out a way of removing him --- for receiving fees for his cooking show outside of his office. Then he was replaced by another Thaksin relative, who didn't last long either. Sheer farcical political theatre.

There are apologists who will argue that this is how modern democracy works and this shows that the people are free to express themselves. They are missing the point. Any political system should be judged by the way in which they can align the majority to pull together in one single direction; hence different political systems can be optimal at different times in a nation's development. The way political change has been enacted gives foreign investors and tourists increasingly little confidence in the stability of the country. Petty issues are used to remove governments, such as Samak. The way in which the yellow-shirted PAD was allowed to take over government buildings and then, horrifyingly, the airport, had shown how the broad national agenda could be hijacked by private ones. King Bhumibol was seen previously seen as a unifying figure that could stabilise the country, now the aging monarch is used by factions as an excuse to take power against majority will. And when he goes, I can't imagine how things will deteriorate.

Frankly, I wouldn't even care about how things go, except that this country is in our vicinity, and its political developments will affect how investors and people from other parts of the world will see our ASEAN region as a whole. And now you have this ASEAN summit which was supposed to be a platform to discuss economic stimulus for the region. The heads of six countries were to have joined the discussions: China, Japan, South Korea, India, Australia, New Zealand. Wen Jiabao, leader of the fastest emerging nation in the world and eager to be a benefactor to its neighbours in order to build its soft power, was to have been in Pattaya. The world was focused on the summit.

And Thailand has to screw it up. Yet again. Of course, this time it's the red-shirts' turn. But the blame is on the Democrat government for failing to ensure the security of the summit. Is it really so difficult to cordon off the supporters for ONE summit lasting just a few days??

I read online that China planned to sign an FTA with ASEAN members and announce a $10billion aid package during the summit. I don't know how true it is. We will never know. And you know what, I also read that the summit will now be held in August, a full 4 months away.

Thanks Thailand, you always have a way to make us feel superior.

Technical Analysis- A somewhat scientific look

2009-02-13T19:05:00.000-08:00

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I like reading the Review segment of the Straits Times because there are occasionally interesting analysis, and Andy Ho sometimes has interesting articles. This guy writes extensively on a variety of topics ranging from health to science to philosophy to political systems to economics ... all of which interest me (save maybe for health). Saturday's article in ST is the inspiration for this latest blog entry.

I had read a book on chaos theory some years back, which is the subject of Andy Ho's article, but had not really made the connection to stock market dynamics then, probably because my market experience then was not too extensive for me to make that connection. But some years later, on reading this article, it struck me how economic and stock market behaviour can be described by chaos theory's derivative, complexity theory (if it can even be called a theory, since there're no real quantitative equations).

The story goes that classical mechanics can describe the interaction between two bodies, such that if given a set of initial conditions (eg. position, speed) for both bodies, the equations can predict their future trajectories for all eternity. This is known as a deterministic system (ie. its future is predictable). However, things get much more complicated for a system of three bodies. Where initial conditions vary by a little bit, the subsequent behaviour of the system can vary by a lot. This finding forms the basis for complexity theory, which attempts to describe complex systems.

Imagine what happens when you have n bodies! The system will be too difficult to characterise, it appears at first glance. The first thought that comes to the stock market player's mind will be the parallels to the stock market where you have n millions of players interacting with one another.

However, one of the key findings of complexity theory is that, rather than throwing our hands up in despair, it is possible to find so-called "emergent" properties within such systems. Basically the idea is that although "their futures cannot be predicted, such systems exhibit patterns, so their stability is bounded" (I couldn't have described it better than Andy Ho, hence the quote).

The example of the graceful flocking behaviour of birds is given, where even though there is no preconceived coordination the herd movement appears elegant when viewed as a whole. In fact, the only rule that has to be followed individually is for each bird to keep constant the distance between itself and the one in front while flying in the same general direction. Extending it to anthropology, the way that people congregate in urban areas and interact gives their cities emergent personalities ie. small-scale interactions among many individual parts can lead to large-scale order.

You can see where all this is going. If we characterise technical analysis as an attempt to identify such emergent patterns within the interaction of millions of bodies ie. a complex system, it may not be too far off the mark. Note the word ---attempt --- that suggests discretionary judgment and interpretation and hence practitioners should always remember to exercise prudence in implementation.

I used to be more sceptical of technical analysis, primarily because of the lack of true scientific logic and its lack of quantitative rigour. My doubts were expressed in an earlier writeup in 2006 on the subject --- Technical Analysis --- where I attempt it describe it as a technique for the short-term while fundamental analysis is more effective for capturing market-beating returns over the longer term. I also expressed my views that since the market often priced in breaking news swiftly, it tended to be efficient over the short-term and hence it was more advisable to assess companies fundamentally and position for the long-term.

Today I'm not so sure. First reason: market volatility has increased since mid-2008, as described by the VIX index which shot up from its traditional 20s to as high as 80-90 (it is currently in the 40s). In the past reversal signals were triggered whenever the VIX breaks 30 .... so this current situation is out of the ordinary. A volatile market becomes a short-term oriented trading market, so anyone hoping to make money may have to pay more attention to TA. Secondly, one cannot fail to notice how simple TA rules would have got an alert investor out of the carnage in late 2008, or even early 2008. First example --- the double top pattern, which was exhibited in most stocks and all major country indices that I know of, would have signalled an exit in late 2007 right at the top. On retrospect, it stares at us right in the face. Second example --- moving averages --- once all the short-term averages for the S&P started going below longer-term averages one after the other in Sep 08, what followed was a rapid collapse that spread across the globe. Just two very simple TA indicators .... and the rules for interpreting the signs they carried were established long beforehand, and not on hindsight.

So how do they work? I used to think the self-fulfiling prophecy provides the major mechanics that describes how TA drives the market; that may well be true as its acquires a critical mass following who act according to its signals. But this is not the sole mechanism. If we go back to the example about flocking behaviour, simple trading rules observed by market players can result in patterns that repeat themselves time after time as graceful emergent behaviour ---- which is then lumped together under TA as chart patterns. For example, practice of simple cut-loss rules individually, eg. cut at 10% loss, can drive its own momentum that is naturally reflected in dips of near-term prices below their moving averages and provides a TA sell signal. Likewise, the likely behavioural pattern that culminates in a classic double-top signal can be characterised by many individuals thinking to themselves "damn, failed to sell it at the high the first time, next time it goes back up I'll make sure to sell" ..... hence resulting in strong selling resistance the second time round leading to a double top that never recovers. Thus, individual behaviour that follows simple rules, just like the flocking example, can lead to a herd behaviour that seems coordinated when viewed from the outside, as described by complexity theory. There is this saying "history never repeats itself, but it rhymes" which further illustrates how a study of the past and of TA patterns can foretell likely herd behaviour.

And of course, coming back to the example of the 2008 collapse, there is a third reason why short-term price behaviour is extraordinarily important: reflexivity theory is extremely relevant when the critical issue is banking, whose assets are marked to market and hence solvency is market-dependent. For further reading, here is my article "Reflexivity Revisited".

On Temasek Holdings

2009-02-07T21:01:00.000-08:00

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I do not often like to comment on political issues too vehemently but sometimes I feel so strongly about certain subjects in which I feel I have a reasonable overall grasp, that I have to blurt it out. Temasek is still a political organisation as of now, no matter their claims about how commercial they are (tell me how commercial you are when the former CDF can go straight from the SAF to Head of Portfolio Strategy of the organisation), and I think it will be difficult to shake off the political links. I mean, how can it possibly do so, unless it wants to deny that the money it is handling does not belong to the citizens and the state of Singapore???

So, Madam Ho Ching's resignation has signalled a recognition of the need for a change in the power structure in the organisation, and hopefully this will lead to a change for the better in all senses. My views about Temasek's execution through the financial crisis starting from 2007 are as follows:

1) Let's start from the most recent issue. I have nothing against Ho Ching. In fact, I have respect for the timing that she chose to step down, ironically because it was bad timing. People would more often than not choose to step down when things turn for the better, so that they can look good and save face. The fact that she did not do so and chose to let go to the next better player at this time says something about the lady.

2) But of course, that does not exonerate the mismoves of Temasek from late 2007 onwards when the subprime crisis first broke out. The purchase of big stakes in western financial groups started with Standard Chartered in 2006, but the real missteps were when it invested US$5.8bn in Merrill Lynch and US$2bn in Barclays as the first tremors of the global financial crisis were being felt. As of March 2008, the time of its last financial report, its portfolio was 40% loaded in financials. That stake is set to be trimmed drastically, mainly due to market movements, when its next report is due in March this year. I personally have never understood why fund managers are so captivated by financial stocks. I mean, unit trusts yes, they have to track their benchmarks so it is more understandable, but why SWFs like Temasek? Are banks the best way to play economic growth? I don't think so. Sector-for-sector, financials are the lazy man's way to play on economic growth, who claim that it offers diversification. I say that it's better to identify individual themes, say healthcare, consumer brands, infrastructure etc, and then go for the best-of-breed in each identified category, with an emphasis on not overpaying for the business. Financials should have been the one category to avoid in late 2007, given that the subprime crisis was just breaking, with possible contagion (which has become reality unfortunately). Leveraged institutions like banks would have been hard hit, not to mention the fact that they were in the eye of the storm in the first place. So why?

3) To be sure, Temasek did divest some financial institutions. It actually sold its stakes in some Chinese banks, at a good profit, in late 2007, in order to control its banking exposure. This is something that some foreign papers fail to highlight and I think we should be fair to Temasek and not just focus on its losses. Unfortunately, it turns out that it would have been best to have stuck to these Chinese banks while avoiding the Western institutions in the first place ie. we should have sat on our hands through 2007-8.

4) The most disturbing thing, in my view, is what Temasek actually sees as its role. This is what was written in a Financial Times article (link is here). (quote):"We felt, along with other [sovereign wealth] funds, that we had to do something to help stabilise the global financial system,” said a senior Temasek official, referring to the Merrill investment.(unquote). Ok, so the mission of Temasek is to save the world? Is that why its sister organisation GIC also bought heavily into Citigroup and UBS? This is disturbing because we have always seen the reserves we have built up over the years as one of our key national assets, and while these assets are substantial, they can hardly be adequate to support the national economies of developed nations with multiple times our GDP .... let alone the world. I agree with the view that SWFs should play a greater role in the world financial system, but I do not agree with the type of role ..... are SWFs supposed to provide dumb first-round recapitalising capital that have greater risk/reward profile (ie. downside risk is greater than upside potential) before the individual governments come in with the second, third rounds etc? I would've thought it works the other way.

The fact is that bigger nations with greater resources, perhaps China or Germany, can do that. These are the nations that have run a consistent trade surplus and the implicit understanding of the world system is for trade surplus countries to do more to reverse this surplus, through stimulation of domestic consumption or exporting their capital. That is to make up for their exporting their excess capacity to global demand. But in the words of our own PM, Singapore is a small sampan floating in international waters, subject to its waves and various propensities. Sure, we have one of the largest reserves in the world, but that was through painstaking accumulation. It would grieve me more if it was political pressure driving the decision-making process to buy into those Western institutions in 2007-8, more than if it was sheer foolishness or ineptitude.

Developing An Investment Philosophy Part 5

2009-01-04T05:32:00.000-08:00

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A friend joined a fund management firm recently and was amazed at how the analysts were expected to cover multiple geographical markets simultaneously, since the firm managed several Asia-Pacific funds. How was he supposed to do it, he wondered, since he previously was only familiar with the Singapore market. Indeed, was it even humanly possible for a person to cover many markets at the same time?

To me, there are three distinct aspects to developing one's expertise and effectiveness in the stock market: depth, breadth and philosophy. Be deficient in one aspect and he will be a much less effective investor by an order of magnitude because of it.

In fact there are many analogies that I can draw between this and kungfu (which I like watching, and in the mood to indulge in today because of the movie Ip-man) so I'll use the analogies liberally here. Depth is easiest to understand. If you master a certain kungfu style eg. Snake style or Eagle Claws (in that old Jackie Chan movie), you will know all the intricacies and be in a great position to fight all comers. Ditto for the investor who knows a market (usually his home market) or an industry really well; he will understand what drives it, the industry dynamics and cycles, the key market players etc, from which he can make money with more than even odds. This is what my friend had: depth of knowledge in the Singapore market. Often, depth of knowledge in one market can serve as a good launching pad for expansion into the next aspect --- breadth --- because the groundwork has been done; one knows what to look out for the second time round.

Just like the single-style kungfu expert who encounters other schools of kungfu. He will find it easier to learn them because he has the basic understanding gained from his mastery of his first kungfu style. And as this exponent encounters more and more different schools of kungfu, he gains breadth of understanding and knows their various interactions and how to deal with and counter each and every school. In the same way, breadth of knowledge of different markets will move the individual investor up another level because it will reinforce his knowledge of how sector peers in different countries operate, and relative valuations provide a guide to whether the particular stock he is holding might still be undervalued or is merely fairly-valued. Personally, I follow a "buy local, monitor global" approach given my limited time; at the same time I recognise the importance of expanding breadth, hence my "monitor global" emphasis ("My Research Routine").

But a lack of breadth, I said to my friend, could be made up for by excellence and consistency of application in the third aspect, which is sound investment philosophy/principles. A kungfu analogy will be the "internal strength" that shields top martial experts from serious damage by opponents eg. the ultimate Jiuyang Zhenjing in Jin Yong's Heaven Sword Dragon Sabre. Or how about Zhang Sanfeng's tai-ji ("no style is the best"). Once one has internalised certain values, he does not need superior knowledge across many markets or insider news to succeed in the market. Intangible facets of investment philosophy, such as an appreciation for value, decision-making based on upside potential vs downside risk, a balanced understanding of the key parts of business value, consistent and logical thinking and discipline in application, trading philosophies such as cutting loss and when to average down/pyramid up .... if one can internalise a philosophical framework within his investment approach, he will indeed be more effective in that most important measure --- market profit --- than the professional who is continually scrambling to expand his breadth of knowledge (sometimes at the expense of depth, I understand).

It will indeed be the most desirable to attain expertise in all three, for one can then claim to have achieved Investment Nirvana (and then spend the rest of his life peddling away to stay at the same point). Then again, for want of time, it is often important to prioritise, in which case I would advocate a clear investment approach anchored by frameworks of thinking, and depth of understanding in the various sectors that one is interested/vested in. One will then be confident of his position when he faces his counterparty in the transaction.

Reflexivity revisited

2008-11-29T00:29:00.000-08:00

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Let's review the various perspectives about the relationship between stock prices and "business fundamentals" as most people understand it. First, there is the advice given by the Sage of Omaha about Mr Market being manic-depressive and that the prices he/she/it quotes can have a disconnect with underlying fundamentals. Then there is the typical technician's/efficient market theorist's view that price reflects underlying fundamentals, even though it might not seem so at the time to the outsider. And then there is George Soros, who advocates that market prices can actually actively influence fundamentals. The last view is known as reflexivity, a term coined by Soros.

Despite Soros' celebrity fund manager status, reflexivity has never really caught on in popular investment literature, partly because it does not really have mathematical grounding. It is more of a philosophy than anything else, in its recognition of the two-way feedback between price and fundamentals, instead of the traditional view that fundamentals drive prices. But in the aftermath (I hope) of this credit crisis, it deserves serious all-round consideration and recognition now.

First of all, by virtue of the fact that Soros was among the first to recognise the seriousness of this crisis, calling it the greatest financial crisis since the Great Depression, his market ideas and philosophy deserve special elevation. Now everybody knows the current crisis as .... yes, "the greatest financial crisis since the Great Depression". Talk about parrots. But more importantly, the mechanics and evolution of this financial crisis indeed has the feel of a price-induced death spiral about it.

The most obvious linkage is market confidence. There is nothing that unnerves the self-assured long-term "fundamentals-driven" investor more than to watch the market value (and his net worth) of his investment drop day by day; it has the effect of shaking his conviction to the point of changing his perspective from "Mr Market is wrong" to "Mr Market might know something". The same applies to the bond investor of course, who will be driven more by credit concerns than earnings concerns (bond investors also tend to believe in market efficiency more). This is all fine if the stock is trading on the secondary market and the business is self-sustaining without funding concerns, because the business doesn't really care what price it's worth according to Mr Market, as long as its suppliers and customers continue doing business with it. Operations-side partners tend to be less market-sensitive; however financial-side partners are hyper market-sensitive, and this is where declining market valuation can feed into faltering confidence. If the company is constantly dependent on financing cashflow (not necessarily from stock market or bond market) to sustain its operations, or if indeed (in the case of banks) market trust is integral to its business model, then the reflexivity effect is particularly influential. Indeed, in Soros' original illustration of the reflexivity effect, he highlighted the case of REITs, which often funded new property purchases through issue of new units and therefore depended heavily on high market prices of their units to purchase these new properties at above-average yields ..... sort of a Ponzi scheme in my opinion. Today, REITs face a different market confidence-related concern .... they have trouble rolling over their current debt.

Another linkage is the interaction between market valuation and regulatory requirements. For the current crisis, the most obvious example is the mark-to-market rule which requires financial institutions to mark their financial assets at current market prices; given the collapse of mortgage securities and almost every other kind of financial asset except Treasuries, banks and insurance companies have taken a severe hit on their balance sheets. Regulatory requirements (eg. Basel 2 accord) requiring them to be sufficiently liquid or solvent then force them to have to raise cash, either by issuing new shares or bonds, or deleveraging through selling assets on the open market; any such measures are undertaken at unfavourable prices and adds further to the deterioration in market confidence.

Although I have pointed out earlier that operational-side partners tend to be less market-sensitive than financial-side partners, they will eventually be affected if asset prices correct significantly across entire markets. This is what is happening now as the financial crisis spills over to the real economy. Corporate customers unable to obtain trade financing have difficulty paying for ship charters, so ship owners are hit. Retail customers unable to obtain easy home loans or auto loans stop buying homes and cars, while those that hold significant paper wealth have effectively had their net worth halved or more, hence retailers are hit together with their previously free-spending customers. This is the capital market-to-economy linkage that presents another facet of reflexivity.

Such a positive-feedback spiral can feed on itself in the way that panic does. What are "fundamentals"? At the end of the day, it is hugely dependent on confidence. Without confidence that the future can be better, consumers will not consume. Without assurance that future consumer demand will grow, businesses will not invest. The demand curve is actually heavily dependent on sentiment, security and other intangibles; demand is what generates growth; it IS the fundamentals.

That is why the government has to come in to intervene, the way Keynes advocated and the way Soros believes has to be to break the reflexive spiral. It has to inject confidence through being the capital provider of last resort, revise regulatory requirements (or at least ease them), and provide counter-cyclical demand. Those who believe in letting the markets cure themselves, such as the Austrian school, the market fundamentalists and even Jim Rogers, are just hallucinating. Especially for Jim Rogers, I cannot understand why he was working with George Soros for years but does not seem to understand the government's role in breaking this crisis?

Those who want to read further about reflexivity should read Soros' book "The Alchemy of Finance" (link to my book review) where he expounds on his pet theory in greater detail.

Stockpicking in a bear market

2008-11-10T22:34:00.000-08:00

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Stockpicking in a bear market can be a hazardous business, because going long in deflationary conditions is by definition an attempt to pick a bottom (whether intermediate bottom or long-term bottom) on the stock price. It is easy to be bloodied by the falling knife, especially if one attempts to catch it naked (eg. contra, no ability to hold). One could thus simply choose to avoid risk and not hold stocks altogether, which is the reason why we have a bear market at all --- risk aversion leads to lower volumes and the stock prices drop by gravity due to lack of support. But yet, if we define risk as the potential loss on investment over say 3-5 years, rather than the standard textbook definition of price volatility which I have always maintained is more appropriate for short-term leveraged players than for long-term investors (see my article on risk), then buying stocks during a bear market could be a low-risk proposition indeed (because you are buying at a lower base and hence risk of losing is lessened over the long term), assuming that the bear cycle reverses in several years.

I feel that a good model for picking stocks in a bear market would be to examine the cash bailout potential of a stock over the medium to long term. I build my ideas based on the "cash bailout" concept as espoused by Martin Whitman in his book "The Aggressive Conservative Investor", which was written in the late 1970s when stagflation gripped the US. The general idea is to view a stock with regard to its potential to allow the holder to eventually bail out; under this umbrella of "cash bailouts", selling in the open market for capital gains is but one of the bailout exits; other potential exits include dividends and privatisation.

This way of viewing a stock is especially useful in a bear market where most small-cap stocks may be thinly-traded and selling out of them may be difficult. Yet, illiquid small-caps often offer the best potential gains. I adopt a two-horizon approach to picking these stocks in a bear market.

The two horizons refer to the medium-term horizon (6-12 months) and the long-term horizon (3-5 years). Under each of these horizons, I examine the cash bailout potential of the stock. For the medium term, I naturally demand lower potential returns as opposed to the long-term horizon.

Under the medium-term horizon, two main factors to look out for are privatisation potential and dividend yield. These are the two main cash bailout avenues in a recession/bear market where liquidity and capital gains opportunities might be limited. Dividend streams tend to be more easily predictable especially for older companies, and high dividends, perhaps in excess of 5-10% yield, would be a good clearing mark for potential stockpicks. Privatisation potential is harder to judge, but on top of the usual "good earnings/business" criteria, I would expect that tight ownership under a strong cash-rich owner, an operating niche or desirable brand name and steady free cashflows (operating cashflow minus investing cashflow) would attract potential privatisation offers from parties such as the main shareholder, business competitors or private equity funds.

Under the long-term horizon, capital gains look like a more viable, and probably the most profitable, cash bailout avenue. This is of course the preferred bailout avenue of the long-term growth investor. Two main issues must be considered with respect to stockpicking for this horizon: firstly, how many times can the stock price appreciate; secondly, can the company's fundamentals survive the recession unblemished. For the former, I would consider that if one is targeting 3-5 years down the road, he should be picking a stock with the potential to be at least a 4-5 times multibagging potential. That would translate to about 30-40% annualized gains --- quite ambitious but nonetheless a good way to filter out the real bargains among the many cheap pennies floating around in a bear market. Of course, the devil is in the details: the judgment of appreciation potential is critical and clearly the selected stock might not fulfil its hoped-for potential. For the second issue, it boils down to an examination of the company's accounts and operating business. I would say that the balance sheet (complete with footnotes) is the single most important source of information to make the judgment. Things to look out for would be heavy debt, contingent liabilities (under footnotes), consistently negative operating cashflows and insider selling. As Warren Buffett says about car racing, to finish first, you must first finish.

Ideally the selected stock would be satisfactory on all counts, both medium-term and long-term. But it may be difficult to find one that has multi-bagger potential and yet has clear indications of being taken over, say. Or it might pay miserly dividends. In my view, the dividends and the fundamental strength of the business to negotiate through the recession override the other two factors in terms of importance. Ultimately, they are the ones that are most easily judged from current and past data, can be judged objectively, and provide a clear operating basis to fall back on should privatisation or capital appreciation not work out. In short, they provide a floor for the stock price. Look out for these two parameters most of all.

Structured Products fiasco- What's reasonable, what's not

2008-11-01T22:55:00.000-07:00

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It is surprising that this storm has still not abated about one month after it initially started following Lehman's failure which ignited so-called "credit events" in many structured products offered around the world, most prominently in Hong Kong and Singapore (I wonder why these two countries in particular). With all due respect to the victims, my conclusion is that in Asia, money (and the loss of it) strikes at the raw emotions (and the corresponding activism) of people much more than anything else (eg. intangibles like democracy, politics, environment).

As this issue is covered almost every day in the papers, I cannot help but be saturated by all the reports. And I cannot help feeling that while there are obviously certain points that buyers of these Lehman minibonds/DBS Hi-Five/Merrill Jubilee notes (to name three of the most prominent) have strong reasons to be indignant about, there are other points that were raised which do not really hold any ground. I discuss a few of each below:

What's reasonable (ie. the investors have reason to be indignant about)

Terminology used: The misleading terminology used to market these products is one of their biggest bugbears, and rightly so. As I've said before, I never would have understood that there was a difference between capital-protected and capital-guaranteed until the shit hit the fan in the last two months. And calling the Lehman products "minibonds" certainly hints of an intention to lull the target audience into complacency. A rose by any other name is just as sweet (and the reverse applies for a pile of shit), but certainly the name is supposed to convey a certain first impression and underlying meaning.

Lack of understanding of products by sales personnel: For the level of complexity of the structured products which had even some experienced finance professionals struggling to comprehend the prospectus, it is highly debatable whether they should even have been made available to the masses. One thing is clear, and that is that many of the sales personnel were not equipped to explain their complexity to retail customers. There is anecdotal evidence on the part of the aggrieved customers, and partial acknowledgment of this fact on the part of the selling financial institutions. In my view, the caveat emptor principle is more valid when the investor is the one actively sourcing for investment targets to purchase; it is reasonable then to expect that he should do his own research. However, where the seller is conducting aggressive selling tactics, I feel it is their responsbility to explain the upside and downside of the product to their customer to give a complete picture. Most agree that it is doubtful that the sales personnel were even in an enlightened position to explain the risks of these products.

Poor financial advice: In the old days, the easy money was to be made in "widows' and orphans' money" --- it was easy to target the money of the most vulnerable. Anecdotal evidence suggests a key target for these structured bonds were the elderly looking for fixed deposits. This is not wrong in itself, except a key tenet of prudent investing --- diversification --- was ignored when a big part of these customers' money (several hundred thousand dollars for many) was eventually funnelled into one or two structured products. However safe a product might be deemed to be, surely it was unwise to put all the eggs in one basket? Perhaps the money could have been spread among several structured products?

What's not reasonable (ie. the investors shouldn't complain)

The yield and risk involved: Now this is one argument that I don't agree with. Some investors have pointed to the admissions of the banks that the structured products were risky ("probably a 8 or 9 on a scale of 10") as evidence that these were high-risk products that were mis-portrayed as safe products when they were marketed. Others claim that they had mistaken the products as being safe because they looked at the promised yields of 5% and thought that such low yields would surely mean that the products were low-risk ("high risk, high return" and vice versa). But people have to remember that at the time of issue, many of these instruments were rated AA or thereabouts, comparable to or even better than many emerging market sovereign bonds. The banks have a reasonable case that nobody expected then that the credit would deteriorate so fast. What the banks could have done better, though, was to regularly update their customers on the riskiness of these structured products, including any downgrades by the ratings agencies.

Role of the government: Some feel that our government has largely adopted a hands-off/passive approach to administering this issue and want them to offer more protection to the victims. Personally I feel the official reaction has already been quite active judging from the numerous comments from the authorities on the mass media, though people are apt to compare with other countries, notably Hong Kong. I don't really think taking too strong an official position on either side will be prudent, especially when one is wary of setting a precedent that could have implications down the road, or where it could cripple some financial institutions at a time of great crisis, and when our business reputation has always been built on fair governance without letting economic issues being corrupted by politicisation. For this issue in particular, it's really better to cross the river by feeling the stones.

Screening S-stocks

2008-09-27T19:13:00.000-07:00

DanielXX's intro: The below is extracted from the Nextinsight share investors' site, a no-nonsense website whose founders include a former business journalist and a head of a well-known local investor relations agency. The article is written by Sim Kih. The writeup was in turn based on a lengthy JP Morgan report on the dangers of S-stocks.

The reason for my highlighting this article is that it offers many key insights on what things to look out for when stockpicking S-chips, or so-called "warning alerts". An article worth archiving for future reference. It is my belief that once you know what red flags to spot and what stocks to avoid, you will have controlled your downside pretty well. Why else do you think JP Morgan is one of the survivors, or some might even say a key beneficiary, of the current credit crisis?

One thing to note: the valuation screens used can be moving targets. There is no reason to claim that say, a PE<10 means a good stock pick, if most other peers are trading at <5X. In other words, one has to watch the relative valuations available on the market and cannot use rules-of-thumb blindly.

(P.S: The following were extracted from another source and is not my original work.)

Considering the risky nature of S-chips, what are some potholes to avoid when stock-picking from the “bargain department”?

There are 10 barometers that suggest to seasoned investors there’s more than meets the eye. Many of these include detailed checks on cash, which is harder to manipulate than earnings.

Does your 'bargain gem' fail any of these 10 warning alerts?

Readers should note there could be sound reasons behind some of these “warning alerts”, so the discerning investor would investigate further before writing any stock off.

10 warning signs for troubled stocks

1. Extremely low deposit rate for cash

This is a major warning alert.

Using China’s annualized cash rates as an example:

0.72% Demand deposits
1.8% 3-month time deposit
2.5% 12-month time deposit

It is thus reasonable to expect interest on bank deposits for S-chips to exceed 1%.

JP Morgan screen:
Deposit rate for cash <1%
Total cash/market cap > 5%

2. High cash reserves, but high debt

A high-cash and high-debt scenario indicates poor financial discipline since companies can logically cut finance costs by paying down their debt with excess cash.

Investors begin to wonder there is “balance sheet management” around the book closure date, or in the worst case scenario, a possibility of fraud or embezzlement of cash.

JP Morgan screen:
total debt/market cap > 30%
total cash/market cap > 30%

3. Much higher capital expenditure for the same capacity

If a company's fixed asset investment per ton of production capacity increases sharply over its expansion schedule, investors begin to wonder if the increasing depreciation expense that shows up on the profit and loss statement could in fact be excesses in other operating expenses.

Inability to sustain growth

4. High gearing, high working capital requirement

High working capital requirements, low net margin and high gearing will slow growth.

JP Morgan screen:
High net working capital to sales ratio (>20%)
High gearing ratio (>35%)
Net working capital to sales ratio – net margin > 15%

5. Frequent fund-raising

JP Morgan screen:
Issues of new shares or convertible bond more than twice during 2004-2007.

Changes with key officers

6. Hit-and-run

When a controlling shareholder dilutes its stake to below 50% within a few years of listing, there may be reason for investors to ask questions.

Another situation would be a passive investor holding the controlling stake.

7. Resignation of key managers, directors or auditor

Most auditor replacements in Asia are related to unsettled disputes on accounting practices.

Investors should be alert if senior managers resign without a proper reason.

If the company was doing well, why would they leave instead of enjoying the corporate spoils?

Often, the resignations potentially indicate corporate governance issues that investors were unaware of before, said JP Morgan.

Poor corporate governance

8. Acquisitions that do not make sense

Investors require acquisitions to show synergy, and a fair acquisition price.

This is especially so if the seller is an interested party or an affiliated company. Volume and size of transactions could mask sharp unwarranted jumps in certain accounting items.

9. Lack of sufficient disclosure

This could include failure to disclose large payments related to subsidiaries acquired from a related party, and such payments were subsequently highlighted by independent auditors.

10. High cash reserves, but low dividend payout

JP Morgan screen:
net cash/market cap > 10%
rising cash level in the past two fiscal years
dividend payout ratio < 20%

(The above was extracted from Nextinsight with their kind permission)

Understanding stock valuation

2008-09-08T22:17:00.000-07:00

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To me, understanding valuation, or why the stock is priced the way it is over an extended period, is one of the, if not THE, key risk management method for the stock investor/trader. This is as opposed to the approach of many traders who use technical analysis, momentum trading, cut-loss etc. Indeed, if I may generalise, the upside gains from an investment comes from astute understanding of business dynamics and growth potential, but management of downside risk comes from understanding of the valuation.

There are several issues on valuation that I'll discuss here. First of all, understanding what type of valuation technique drives the price of a stock is winning half the battle. The favourite technique is PE (price earnings) but I am incredulous when people quote PE for companies which should more accurately be valued by their balance sheet assets eg. property stocks. PE is more relevant for companies which enjoy steady and sustainable growth in their core earnings because it is predicated on projecting a certain level of earnings growth into the future, and hence it's imperative that these earnings are predictable. Indeed, it's worth noting that often the best time to buy cyclical companies is when their PEs are high or even negative, because it will be at the bottom of the business cycle when this happens (ie. the market-timer can catch it at its bottom).

It's also interesting to observe how valuation technique can change at different points in the market cycle. In an up market, PE is often used because earnings are seen to be on a steady growth trend in the foreseeable future. The more cynical individual might also postulate, with some truth, that PE valuation offers a lot of latitude for the market analyst who wants to push a stock to derive a very high target price, through surreptitious methods like using high PE ratios (can anyone honestly explain why a stock should be worth 15X instead of 20X PE?) or using earnings 2 or 3 years later as the basis for the PE calculation. When the market turns, like now, suddenly analysts base target price at NTA (net tangible assets). It's worth guarding mentally against such skulduggery.

An associated issue is the elasticity in price valuation that each valuation technique produces. There is great amount of discretion that has to be exercised with respect to the PE ratio used, whether it should be 5X, 10X, 20X. Hence this method often can be dangerous in the event of a PE compression when liquidity is tight or sentiment weakens, simply because price targets can decline by multiples without earnings even changing. Valuation on the basis of NTA might produce a more solid base, because balance sheet assets don't just melt away; the analyst might decide, however, at different times to assign 0%, 10%, or 30% discount to NTA, or even premiums to NTA, when calculating fair value, depending on his or Mr Market's "mood". That is why one should perhaps buy both asset plays (valuation based on NTA) and growth plays (valuation based on PE) if he wishes to control the degree of price voilatility in his portfolio.

The last issue is to do with assessing the components of valuation. This could best be illustrated with the example of a conglomerate. For example, consider Keppel Corporation. Conglomerates' values are calculated on a SOTP (sum-of-the-parts) basis, where the value of various divisions are summed up. According to a recent GKGoh report on Keppel, I can observe that its offshore division constitutes >50% of the SOTP total value, its property division and Keppel T&T constitute >10% each, with its infrastructure division and SPC stake making up the balance. This provides a general reference for where the main price driver of Keppel lies, whether or not the target price eventually derived overshoots or not. Hence the valuation of Keppel will be most affected by changes in the offshore segment --- this is the one to watch if one is holding the stock.

This approach can be extrapolated to most companies as well to assess what drives their valuation. For example, my Hotstocksnot assessment of Lian Beng in October last year concluded that a large part of its valuation derived from its property developments with its construction segment forming the minority, and this formed the basis for my hotstocksnot conclusion because I felt then that property prices might have peaked which meant Lian Beng's heavy exposure in this segment would render it a substantial victim of a property downturn. Although Lian Beng had hitherto been known as a construction player, an in-depth assessment of its stock valuation would have rendered useful insights and prevented a disastrous entry into the stock.

That is why I consider valuation knowledge probably the most important aspect of an investor's toolkit. At the same time, it is important to recognise and keep in mind the fluid and dynamic nature of valuation approaches, so that one constantly evaluates the market and its interaction with the mainstream valuation approach.

The biggest bubble in the world

2008-09-06T19:36:00.000-07:00

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No it's not the US housing bubble or even the UK housing bubble. Though definitely quantitatively more substantial, the amount of euphoria and the way that prices were being chased up are nothing compared to the greatest one of all -- the English Premier League.

When player wages are inflating at an increasing rate even as global fundamentals are declining you either call that a growth industry or a bubble. Some statistics: in the first Premier League season the average player wage was £75,000 per year, but subsequently rose by an average 20% per year for a decade (source: Wikipedia) and in 2006 a survey by The Independent and the Professional Footballers' Association found that salaries of EPL players had jumped by a massive 65% within one year to an average basic pay of £676,000. Based on anecdotal evidence from 2006 onwards, I would think that rate of growth has continued to sustain itself, with the influx of wild money from abroad.

When you combine this with the fact that only eight of the 20 EPL clubs recorded an operating profit in 2006/7 - half the number which did so a year earlier (source: BBC news), you have to conclude that this is a bubble rather than a growth industry.

Two decades ago, cash-flush Japanese benefiting from a massive real estate and export boom at home combined with a greatly-appreciated yen post-Plaza Accord (see " Japanese bubble economy of the 1980s") went on an overseas asset buying spree, with the most infamous being their purchases of Impressionist paintings at absurdly high prices of tens of millions. When the economy bust, so did the market and prices for paintings. So today we see the phenomenon being repeated with petrodollar-rich Arabs and Russians, whose names have been so oft-reported in recent times that I need not repeat them here. Crazy liquidity chasing illusory status symbols.

While we're at this game, I might as well list down the various clubs and their possibility of extravagant takeovers/makeovers, and who SHOULD be buying them, in terms of personality fit etc. In the order that they currently occupy in the table:

Chelshit - Only Putin can take this one away from Roman. I hope he does and this biggest bubble of all gets relegated.

Liverfools - Admittedly, they're already a brand name with great tradition. That's why the filthy-rich won't buy them, because the idea is to flaunt your wealth and show how your money can transform a piece of rubbish into gold. Maybe a Spanish buyer might be interested, so that the Spanish transformation of this club will be complete. They can rename it La Fools.

Man Shitty - Already done. Might be attempting a trillion-dollar takeover of Man-U next, through buying their entire team over starting with the crying one. No-brand/house-brand manager Mark Hughes won't survive past half the season.

Arsenal - What's the point of takeover? Give him billions of dollars and the Frenchman prefers to spend millions (or thousands if possible) at most. If Anwar takes over the Malaysian government, he might like them. But Malaysia can't afford to buy this arse.

West Ham Utd - London address. Managerless. Excellent for a takeover with minimal opposition and freedom to install one's choice of management. With their tradition of violence, maybe Iran might be interested.

Middlesbrough - Currently going nowhere which makes it a good choice for remaking. Maybe some Japanese fund will buy it since they share similarly-coloured flags/jerseys and share similar recent histories of underperforming.

Aston Villa - Big club, middling performance. Prime target. Some kind of value buyer, say a bank or private equity, that can hype this into a speculative and exciting club and then hawk it to the Arabs amid the euphoria.

Bolton - You really don't want to buy a club that is in danger of relegation. Any makeover has to be extreme.

Man Utd - They are so profitable that they are going to be difficult to take over. As said above, Man Shitty's strategy is to empty them of their players. If anyone is going to buy them, it will be China --- a symbolic gesture (Chinese are big on these) of China's imminent world domination.

Blackburn - With a name like that, I think black-hearted hedge funds who will burn in hell might be interested.

Newcastle - Anil Ambani of Reliance rumoured to be bidding. For a club not known to be reliable on consistency, this is indeed ironic.

Hull City - CMI. Straight back down.

Wigan Athletic - Any club with Emile Heskey and Titus Bramble needs an extreme makeover. But I cannot fathom who will give it to them. This one will never become a Monet or a Renoir.

Fulham - The Harrods boss probably has loads of Middle-East connections so he might sell, but only at a huge premium. Saudi Arabia or Kuwait, maybe.

Stoke City - CMI. Straight back down.

Portsmouth - Dirty Harry allegedly loves to buy and sell players because he takes cuts out of each transaction. I cannot think of more appropriate buyers than another of those Russian oligarchs.

Everton - I hope Temasek or GIC buys them, so that I can claim to be patriotic when supporting Everton.

Sunderland - Should get a jersey makeover before anyone will consider bidding for them. Maybe one of those shady Al-Qaeda funds might like to buy them because they have a gigantic stadium and nobody visits the stadium, so they can use it for all kinds of training purposes.

Tottenham - Premium London address. Premium tradition of excitement, but mainly when going one-on-one rather than in group matches. Perhaps the US might be interested in going for them.

WBA - Can anyone tell me what these initials stand for??

My Investing Journey: Hurricane Katrina

2008-09-01T07:33:00.000-07:00

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If late-2004 and early-2005 are remembered for the corporate debacles of CAO, Citiraya and ACCS, the later part of 2005 will be remembered for the attention that centered on oil and refining. The catalyst was Hurricane Katrina, which was the worst-ever storm to hit the Gulf of Mexico and caused extensive damage to the refining facilities in the region, exposing the deep global capacity crunch in refining capacity.

Katrina formed over the Bahamas in late August 2005 and due to the unpreparedness of the authorities, caused severe destruction along the Gulf of Mexico coast from central Florida to Texas in the form of a Category 5 storm, with the most severe loss of life and property damage occurring in New Orleans. Of more interest to oil traders was the damage to the oil production/refining infrastructure in the most important offshore oil production area of the US, where numerous oil platforms were destroyed and refineries were forced to close; approximately half of the Gulf's oil production was shut over the subsequent 6-month period.

Oil prices making new highs had been the talk of town throughout 2005, but Hurricane Katrina brought into focus the glaring global tightness of refining capacity. Simple and complex refining margins spiked up several dollars per barrel after Katrina which bloated the profits of refineries across the world for 2H05.

Allied to this tale is the story of SPC. The story is told in my writeup on "Bull stock: SPC". Struggling with razor-thin margins and stagnating revenues in its refining business in the late 1990s when oil prices were in the pits, it was a massive beneficiary of the burgeoning demand for petroleum products after 2003 that translated in steadily rising refining margins from 2004 onwards. Net profits for SPC jumped an astonishing fourfold from S$60M in 2003 to S$250M in 2004, and within the year 2004 alone the stock shot up from 1.50 to 4. Remember that 2004 was a relatively tame, mildly bullish year, so this was a meteoric rise, reflecting the rewards that can be reaped when the investor recognises a single trend and bets on it.

Unfortunately, I did not see the trend, and so missed out on the bulk of the gains. There was plenty of talk online about this though, but I only read through the threads after the bulk of the price gains were done. Nonetheless, I got into the stock in early 2005 at $4 because of what I felt was an under-recognised strength of SPC: its being a complex refinery which meant it could handle heavy sour grades from the Persian Gulf countries, which were in abundant supply, while simpler refineries in other countries could only handle the more expensive sweet light grades. You can really learn a lot through good analyst reports especially those that cover an industry on the whole; typically such reports have less of a "sales" agenda compared to reports on individual companies: I learnt all the facts from several such reports on the refining industry before parlaying my bets in early 2005.

The stock did relatively well throughout 2005 but really spiked up post-Katrina when it shot from the high 4s to $6, when the tightness in refining capacity was revealed in its entirety and Singapore complex refining margins shot from US$5/barrel to US$15/barrel. In fact, it had been tight throughout 2005, with US and Asian refineries operating at above 90% capacity. Katrina was merely the catalyst that pushed it over the edge by knocking out spare capacity (and then some). The dramatic reaction of refining spreads is a manifestation of how prices for commodities can surge when demand just slightly tips over the thin margin previously existing between it and supply capacity.

It also is an example of the moral dilemma that often surfaces when one invests in stocks whose potential price catalyst could be some disaster that exposes the deficiencies in the industry and brings market attention to the particular niche that the stock serves. Offhand, I can remember stocks that benefited from such phenomenae such as Medtecs (which sells gloves, facial masks and medical consumables) during SARS and defence stocks during the US-Iraq war. Some might even see the glee that short-sellers exhibit in every new bite of bad news hitting the US banks currently as an example of such morbid moral ambiguity. How does one reconcile one's morals with one's market position?

I reckon the crux lies in whether one is actively hoping that a disaster will happen which he perceives will benefit his stock as a consequence. For SPC I had never bought in with such hopes so I never suffered any guilt pangs when Katrina struck and had a positive uplifting effect on prices of refining stocks across the board. However, I have seen people who, for example, bought Medtecs after the SARS crisis blew over and then hinted that SARS might come again, with the subtle hope that it WOULD indeed strike again. That is contemptible behaviour which is akin to building your happiness on public misfortune. On the other hand, it does not mean that the investor/trader cannot position himself in a fundamental trend which he feels is going to persist, even though this trend might be generally detrimental to society. The investor/trader might be betting on the inevitability of a development, and there is nothing morally wrong about that. Or he might be hedging his portfolio, which is even less reprehensible. But once he crosses the line between dispassionate betting based on return/risk/odds calculations to an active desire that something bad will actually happen to humanity, he will have lost the essence of being a human being in itself. Never put money above your own humanity.

For the record, I eventually sold SPC at the end of 2005 at about $5, when the stock retraced its steps back from $6 and I found other better stocks to switch to. I had also come to the view that the continually rising oil prices would not be good for refiners, because although in the early stages they reflected strong end product demand which basically pulled the entire supply chain (including refining margins) along, high crude prices in fact constituted high raw material prices for refiners which would actually harm their margins eventually if end product demand stagnated (see my writeup on refining margins). Ultimately, of course, SPC would reach $8-9 in 2007-8. But that would be more due to hopes for its upstream segment plus a bull market for commodities --- another thing altogether.

Katrina was the precursor to the annual August/September hand-wringing over potential hurricane impact on oil prices/refining capacity ever since, and the world have had scares now and then over approaching cyclones in the Gulf of Mexico, with the latest one being Gustav (which has turned out to be a mouse). In my view, the fact that people have worked themselves into a frenzy already guarantees that these storms will never again likely have the same impact as Katrina, because they will have prepared themselves to handle any crisis emanating from these storms (eg. shut down facilities, evacuated the coast). A bit like the stock market, where selldowns lead the real event, whether it does eventually transpire or not.

How To Make Money In Stocks Part 6: Identify spread divergence

2008-08-02T23:14:00.000-07:00

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As a fundamentals-based investor, I am always looking to find bargain buys on the basis of value and I often try to spot trends (see my blog Trendspotting) which could lead to a re-rating of particular stocks. Once one has identified a particular trend, he can find companies which have particular leverage to that trend. A useful framework for finding good companies is identifying a divergence in its revenue-costs spread, which is of course an elaborate way of describing the income.

The spread is simply the numerical difference between A and B (ie. A-B). The spread will widen/diverge if (1) A goes up while B remains the same; (2) A remains while B decreases; (3) A rises more than B or declines less than B. The most divergence is of course when A rises while B drops. A concept that is easily applied to the earnings framework for companies.

The key benefit for thinking about earnings as a spread between revenue and costs is that it compels the investor/trader to think about the components of income individually insofar as they contribute to the spread (which is also the profit margin). Often, the fundamental factors driving revenue are independent of that driving costs. Identifying stocks where certain trends favour revenue growth while other particular trends point to cost decrease ie. a form of spread divergence, could suggest a stock with potentially explosive profit margin growth.

The most obvious example would be banks. The business model for commercial banks is to borrow funds at a lower interest rate (depositors, inter-bank loans, wholesale market) and then lend it at a higher one (home loans, business loans, credit card loans etc), thus capturing the spread (see "Financials/Business Model"). Typically the borrowed funds are short-term while the bank loans offered are longer-term, because long-term interest rates are usually higher than short-term ones --- thus enabling the bank to make spread profits. In the early 1990s, when America was recovering from a recession triggered by housing-induced banking failures (sounds familiar?), the Federal Reserve lowered federal funds rates (short-term rates which it controls) aggressively, enabling banks (and many speculators) to benefit enormously by borrowing cheap and investing in higher-yield instruments like long-term Treasuries, stocks etc. The financials turned out to be among the best performers as a result of this Fed policy-driven spread divergence.

There are so many such drivers of revenue-costs spread divergence around, depending on the industry. For refining companies, it would be the refining spread, which will widen if petrochemical product prices (a function of refining capacity and product demand) grow faster than crude oil input prices (often subject to supply-side pressure). For manufacturers, revenue could be driven by industrial or consumer demand (which is in turn a function of trends that should be identified) while costs depend on raw material prices. An article I had written about stocks to buy to ride on the global inflation trend illustrates an application of this approach: capital-intensive businesses could be a way to go, since depreciation costs are flat, while selling price (revenue) could be adjusted in-line with inflation; this in effect transforms the inflationary environment to the company's advantage.

Another reason why thinking in terms of spread divergence is useful is because it can be applied to other areas other than the P&L statement. Specifically, it can also be used for balance sheet analysis, particularly for those industries whose stock valuations are more driven by NAVs (Net Asset Value) than by earnings --- for example, property. A favourable asset-liability spread divergence, driven by, say, rising property prices (culminating in higher asset valuations for holding properties) even as inflation rises (hence lowering the real value of debt liabilities), could mean higher NAVs than recorded on book. This model can easily be applied to other industries, such as shipping companies, steel traders, mining companies.

At the end of the day, what is important is that individual investors/traders need a consistent framework for crafting buy/sell decisions in a disciplined manner. Identifying possible outperformers on the basis of potential spread divergence is, in my view, as good a framework as any.

What wage-price spiral?

2008-08-01T01:30:00.000-07:00

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Inflation is in the air, and Singapore has not been spared. Indeed, as one of the most open economies in the world, we are seen as particularly vulnerable, even a precursor to what the rest of the world will experience several months later due to our lack of subsidies for many common products that typically shield consumers of other countries from immediate price impact.

Given the price pressure faced by people in their daily necessities as a result of imported inflation, it has become necessary to communicate the linkages between wages and prices. No less than two full ministers have come forward to explain the intricacies of inflation and why a wage-price spiral must not be allowed to develop --- which means wages must be controlled.

I sympathise with them because it must be politically difficult to explain to people that their income cannot rise in-step with their expenditure. Before we go further, let's briefly look at what wage-price spiral means. Essentially, it is a classical inflation phenomenon where wages are allowed to chase prices upwards. Prices, in turn, will be positively influenced by rising affordability (rising wages) and hence its upward momentum is not checked, leading to a positive reinforcement cycle. In a sense, inflation begets further inflationary expectations.

But let's look at it more closely. I am in no position to discuss it quantitatively, but let's reason things out qualitatively. Two key points on why I doubt a wage-price spiral will occur even if wages are allowed to rise: firstly, this is widely seen as a cost-push inflation; and secondly, Singapore's inflation is largely imported. A cost-push inflation is caused by drops in aggregate supply due to increased prices of inputs. For example, the 1970s inflation is widely seen as due to a sudden decrease in the global supply of oil due to the formation of OPEC which started to exert control over supply, which in turn increased oil prices. Currently, we are seeing prices of agricultural products, metals and energy commodities rising due to increasing tightening of supply and this is in turn feeding into rising prices of goods/needs that they're used to manufacture/fulfil. Meanwhile, Singapore's consumption expenditure is largely on imported goods because our manufactured goods are largely exported while we produce minimal agricultural goods. Piece the two together and it suggests that inflation is a function of largely external factors where prices are fed from interactions of world demand/supply dynamics directly into the country.

The classical reason on why a wage-price spiral must not be allowed to develop is that the demand-curbing effect of higher prices, which automatically checks and stabilises price inflation, is lost when wages rise in the same proportion to the effect that rise in expenditure is balanced by rise in income. But what if prices is independent of wages, as described above? A part of the argument for not raising wages for fear of a spiral will be lost. Indeed, life can get difficult if prices which are uncontrollable (domestically) rise faster than wages which are negotiable.

In such a scenario, provided that many other countries start to negotiate higher wages for their workers to cope with rising inflation, a country that has a stringent wage inflation policy will gain in competitiveness and become more attractive as an FDI (foreign direct investment) destination. That might also be another reason for not letting wages rise in proportion with inflation. Ultimately it might be a win-win situation too. However, this rationale has not really been presented strongly so far. Anyway, to preserve competitiveness through lower relative pricing does not seem a viable long-term strategy for a developed nation; creating higher value-add should be the way to go. Perhaps we are not ready for it yet?

Of course, wage pressures in certain industries should be checked lest they affect end-product prices, particularly when they are key to the development needs of the country. For example, in the construction industry which is crucial to the remaking of Singapore and where construction material cost pressures are already rampant, it may be important to control wage pressure such that the end-product (the building) does not become so expensive to build that it drives away developers and potential buyers, upsetting the long-term plans of the country. But surely, the control measures should be specific rather than broad-based (and anyway, there're ways of controlling wages --- by lowering regulations for foreign supply, for example)

Caveat: as a non-economist, all my rationalising above might be faulty. Any indignant economists seeing the fault, please kindly point me out in the right direction.

How much is one billion?

2008-07-24T19:18:00.000-07:00

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Not a lot if it is in Zimbabwean dollars (maybe could buy a loaf of bread), but really, are we getting numbed by billions being thrown around, being lost here, being written off there? Is this *gulp* an inflation phenomenon?

I guess it is a matter of context. For example, for a bank to write off $1B in the midst of the bull market last year would have been one hell of a shocker, as did indeed happen when banks started writing off amounts of that magnitude when the subprime crisis started and turned the bull market. But clearly people have become numbed as the crisis stretched and now the markets rally because banks "only" wrote off $1B.

It is also partly a psychological thing. Just as a $1 loss on a $20 blue-chip sounds more impressive than a $0.005 loss on a $0.05 penny stock (even though the percentage loss on the latter is double that of the former), $1 billion dollars just does not have the same aura as $500 million even though it is double that amount. Perhaps, it is because common people have always strived for that magical MILLION, and hence they can be impressed by SEVERAL HUNDRED MILLION. One billion, on the other hand, is something not many can intrinsically warm to unless it is framed in the context of ONE THOUSAND MILLION --- which we are seldom impressed upon.

How much is one billion also rests on the context. I am not going to go into the classic demonstrations of how many houses or cars or egg sandwiches that $1 billion can buy, but rather I will highlight three factors that would affect both perception and real impact.

First would be the absolute level of wealth. Clearly one billion as a fraction of one trillion, say, would be insignificant. If lost, it may merely be regarded as an expense of operation, a frictional loss, something that can be "learnt" from so that the future may be better. The source of that wealth is also important of course, for it makes a difference whether it is purely personal wealth or fiduciary funds that one is managing on behalf of another party, or whether the funds come from a cash-cow business or is simply non-renewable (in which case the one billion is ALL THAT ONE HAS).

Second would be the application for which the $1B is used for. Two broad categories of expenditure would be consumption and investment. Consumption is for the present, and any necessary consumption expenditure has to be undertaken no matter what the amount, though it tends to add no value beyond the period in question. Investment is building growth capacity for the future, and abstention from unnecessary consumption to invest for the future is a virtue and should be seen as such. The worst form will be bringing the money to a casino for gambling, in which case one billion dollars is a huge amount.

Thirdly, the time frame over which one billion is consumed/invested/expended. This is self-explanatory. One cannot expect to consume $1 billion over one year and not see it as huge unless he is Mike Tyson. In the same way, a return of $1 billion over one year is fantastic while a similar return over one century is still fantastic, but less fantastic. Ermm, the reverse applies of course.

Fund managers and corporate officers should keep these in mind when they manage billions of dollars and not lose the money perspective. It brings to mind the dehumanising process/system that facilitated German officials of World War 2, all ordinary citizens, to grow to see Jewish prisoners as simply "digits" to be handled when they all played a part in the supply chain that sent the prisoners to their doom.

Why Market Downturns Are Not All Bad

2008-07-11T21:46:00.000-07:00

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Yes yes, we are in a market downturn and it's depressing to see Mr Market's valuations of your stock portfolio (and your own valuation of your stockpicking abilities) going down and seemingly bad news all round with seemingly no hope of recovery in the next five years, but things are not all bad. No, this is not an article encouraging short-selling (think you'll be an idiot to short-sell the Singapore market at current levels) nor is it a tongue-in-cheek writeup where I don't mean what I say nor is it a shining example of ah-Qism (I hope not). It's not even meant to be chicken soup for the investor's soul because if one just sips it without acting on it, it's simply no use --- conviction is worthless unless it is converted into conduct. Here are my views:

(1) You can't have a market rally without a market downturn. Translating to something more intimate to our hearts, you can't have big profits without tolerating substantial drawdowns. Why does this always work? For one, the valuation goes from overvalued to undervalued, and valuations always regress to the mean. For another, in downturns the scrip moves from weak holders (margin, contra, institutions with investor mandate that could face redemptions etc) to the strong holders (pension funds, investors managing with no heavy liability considerations, wealthy people, other cash-rich fund managers) and setting the stage for a compressed spring effect.

(2) Certain things are controllable and one should not be beset by a sense of panic and helplessness. Aren't there some stocks that you always wanted to buy because they had all the elements of a Buffett-type long-term stock with economic moats and honest management and high returns on equity and all that, except that their valuations were too expensive? The good news is that in market downturns, the baby gets thrown out with the bathwater.

(3) The ironic thing is that one doesn't have to worry too much about the price-fundamentals linkage in down markets. In bull markets, one should take note if the price is weak despite apparently strong fundamentals; it might signal something wrong. In down markets, more often than not it's due to a rush for liquidity and institutional risk aversion. Of course, this conviction must be supported by an understanding of market dynamics and that the company is not going to be genuinely hit, especially in the long-term, by the declining real economy.

(4) It's an opportunity to swap the weaker companies in one's portfolio for stronger ones. If you bought Ipco at 10 cents in July 07 when Celestial Nutrifoods was at $1.50, you have the option of swapping one for the other now at no relative loss (they have both halved since then). Isn't it great, you can wash away your stockpicking mistakes in a down market?

(5) Market downturns offer validation of a stock's underlying potential, something like stress-testing. It offers you a chance to see the price action of the stocks you hold/are interested in under a market downturn scenario. Often it offers many insights on resilience of price supports, trading volume in weak markets (indicative of institutional interest), and of course fundamental earnings performance in a weak real economy. Very valuable information that either strengthens your conviction or removes it.

(6) For the investor, it allows him to practise value averaging effectively. If one is certain of the (non-cyclical) fundamentals of the companies he holds, market downturns offer the best justification for averaging down because often the stock's price decline has little to do with its core operating strength. Just as pyramiding in a bull market allows one to build on gains exponentially, averaging down in bear markets can work (big caveat: know the fundamentals with conviction).

(7) There are always certain sectors that will do better, or even flourish, stock market-wise. Check out William O'Neill's book "How To Make Money In Stocks" for a listing of the bull sectors even through the stagflation years of the 1970s.

(8) If not price-wise, there are always certain sectors that will do better operations-wise, while remaining quiet on the moribund stock market. So one will be able to get emerging champions at a good price in a market downturn. For the 1970s, an example of a new bull sector that would come to the fore and subsequently enjoyed a secular run over the next two decades was the electronics sector, specifically, computers. The important thing is to stay alert by tracking the news so that you can spot these sectors.

So there you have above, 8 reasons to huat from a market downturn. Of course, if in doubt, remain in cash. Risk-taking is a function of one's stomach, one's conviction, one's liability considerations and one's time horizon. There is no one-size-fits-all.

How To Make Money In Stocks Part 5: Learning to sell

2008-05-17T07:28:00.000-07:00

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It is my belief that if the retail investor does his research properly and bases his buying decisions on long-term business fundamentals coupled with a reasonable valuation, his downside is limited and he can expect the stock to eventually rise, whether on market realisation of the business potential, or on the margins hitting a sweet spot of the business cycle, or on management/fund buyouts reflecting insider/institutional awareness of the intrinsic value of the business. The key word is "eventually", because the time the investor has to wait for the stock to rise is unknown. But my point remains --- the patient investor will eventually see the stock gain some buying interest.

When that happens, another aspect of time becomes important for the investor: how long will the stock enjoy its place in the sun? Will it be just a short pump-and-dump operation by the big holders, or could the stock become one of those rare Cinderella stories and live happily forever?

There is a new branch of finance, known as behavioural finance, which essentially recognises the "humanness" of market participants that adversely affects their decision-making (as opposed to standard finance that assumes a "rational" investor). Behavioural finance sheds some light on human tendencies when faced with the above scenario. People tend to be overly-optimistic and have a fear of regret (ie. the stock soars after they sell) which leads them to hold rather than make any active decision to sell.

Hence, it is important to be aware of our own human nature and to consciously lean against its biases. In the case of what action to take when a particular stock holding rises substantially, sometimes it's better to let the profits run, sometimes it's better to lock in the profits, again there is no fixed rule, but it is my experience that selling is the most difficult thing to do for many people --- which is why patient investors might not make money in the end. Therefore an element of selling discipline is important to lock in the profits when they arise.

There are several other key factors why learning to sell is important, besides the abovementioned psychological bias.

Firstly, fundamental cyclical effects. This is a real danger of holding on too long to a stock that has risen substantially, and is particularly relevant for cyclical stocks like shipping, property, commodities, technology ...... or indeed in most sectors where product demand is discretionary and pricing is commodity-like (ie. the business is a price-taker rather than price-setter). Where profitability is highly dependent on industry prices which are in turn determined by demand-supply dynamics, the entire sector can come in for strong market attention when the pieces come into place at a particular part of the business cycle eg. technology at the early stages of recovery when inventory is low, production capacity is thin and consumer demand is growing at an increasing rate. The stock surges in response. But as manufacturers ramp up capacity and squeeze the margins, the product ASPs (average selling prices) can quickly fall even as raw material prices rise. If one misses selling at the sweet spot, he can be stuck for ages when the stock normalises. This is because capacity, once increased, is difficult to reduce until there is painful industry restructuring where smaller players exit ie. when losses become too hard to tolerate. The problem is that the level of tolerance of many business owners is very high.

The second main issue is market liquidity. How many times have we seen this: stock A, previously illiquid, gains some market attention on initiation of broker coverage (perhaps because the company is placing out new shares). The stock rises on optimism about the strength of its prospects, and fundamental investors accumulate. As volume picks up, the stock breaks past all resistances, attracting technical traders. The momentum carries it on day after day. Then it peaks, strangely on a day when good news came out and the stock failed to react. Classic "buy on rumour, sell on news". The stock retraces all the way back to where it came from, and liquidity dries away leaving the stock to the effects of gravity. And soon it becomes anonymous again as a new wave of market favourites take over. The loss of market liquidity, sometimes unrelated to intrinsic fundamentals but nearly always linked to sudden market-wide realisation of expensive valuations plus withdrawal of strong-hand support, is another reversion-to-mean effect that is often difficult to reverse and exacts high opportunity cost for the late-to-sell investor.

The devastating psychological effects on the investor should he endure an up-down cycle without anything to show for it cannot be ignored either. Those who have experienced it will know what I mean. Failing to sell at the peak, he will find it harder to sell at 10% down, even harder to sell at 20% down and hence arises the terrible situation where the more the stock drops, the more unlikely the investor will sell. That is because he had already mentally anchored his wealth at the peak of the stock's valuation. It is important not to let this happen too often, because it can eat into one's confidence and affect future decision-making.

The above reasons suggest that profit-taking, though not always leading to an implementation decision, should always be at the back of the investor's mind when a particular stock holding surges. Quite often, the most painful thing to do is the right one. Introducing some selling discipline, such as selling a portion of one's holdings once the stock reaches a particular valuation waypoint, say 15X PE (or whatever one deems a fair valuation), might be useful in altering the psychological state-of-mind and facilitate further liquidation on perceived peaking of fundamentals and/or momentum etc. This is in recognition of the fact that selling is as much a psychological issue as one based on financial evaluations.

And then again, letting the profits run might be the best thing to do in some cases. Without adding to the confusion, I will just point out that it happens less often and also that some find it prudent to set some moving sell-point that is say, 10% below the peak, so that even if one intends to ride the long-term momentum, he will be stopped out by a sizeable adjustment from the peak. The level of tolerance, and hence the maximum drawdown limit where one sets his sell-point, varies from individual to individual and from stock to stock, depending on the level of confidence about its long-term strength.

The Politicisation of the Beijing 2008 Olympic Torch Relay

2008-04-12T03:26:00.000-07:00

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The extremely warm reception that China's Olympic Torch Relay runners have been getting from supposedly pro-Tibet protesters in the various Western cities they have passed so far has been alarming, and though I'd like to believe the Western governments have nothing to do with the (seemingly well-coordinated multinational) protests, the veiled threats by various Western leaders to boycott the opening ceremony suggests that indeed, these protests exhibit signs of going all the way up to the top levels.

We have seen TV images of protesters in the Paris and London legs trying to sabotage the relay and then forcing the San Francisco leg to be cut short, casting a pall over the entire global torch relay and generating waves of righteous anger among Chinese citizens not just in China, but ethnic Chinese across the world. This is a continuation of the trend of the politicisation of the Olympic Games, with previous examples being the Berlin Olympics when Adolf Hitler tried to make a case against the blacks, the Munich Olympics when Israeli athletes were murdered by Arab terrorists, the Moscow Games and subsequent Los Angeles Games when Uncle Sam and the Evil Empire plus their respective cliques boycotted each other. The coming 080808 Games looks set to be one of the most politicised in years since the Evil Empire died.

What are the Western countries trying to do by such a show of force? It should be clear that China will not back down from their stand on Tibet or Darfur; they have already demonstrated their political intransigence and the determination to do things at their own pace with respect to renminbi revaluation, for example. It appears that they are purposely trying to make things difficult for China, with the popular interpretation being that the Western countries are jealous of China's rapid rise and are trying to spoil their big party.

It is not really that important how world opinion views it but it IS important how the Chinese leadership will see it. They might treat it benignly, seeing the protests as nothing sinister and showing understanding towards those Western leaders that have threatened boycotts as just opportunistic playing to their respective political galleries. Or they might see it as a deliberate insult and this would be unfortunate for future long-term relationships. On the economic side of it, for example, Europe would have much to lose simply because exports to booming China have driven so much of their growth in recent years.

And why shouldn't the Chinese think that way? The Beijing Olympics has been seen as a coming-out party for China ever since it was awarded years ago, and China has worked really hard to prepare for it, building massive infrastructures, putting a future President in charge of the Games recently, and coming out with all kinds of kooky rules to reduce air pollution such as allowing even-numbered and odd-numbered vehicles to travel on the roads on alternate days. All Chinese (not just mainland, but ethnic in general) hate losing face, and the violent protests and attempts to disrupt the Torch Relay appear to hint at an imminent attempt to spoil the big party on 080808. It is clear that the big issue is never about Tibet or Darfur, those are just platforms for the West to mount their moral high horse and browbeat Beijing into meek rightful Oriental submission. An artificially-induced cock-up at the big event in August will be a massive loss of face and the Chinese will never forget it. Already they operate under a siege and victimisation mentality and any attempts at spoiling the party they have spent billions to prepare will just reinforce that. And all this when they have been trying to maintain a "peaceful rise".

In any case, linking the Games to politics is wrong in itself and the protesters might not care about it, but surely their leaders should know better than to threaten boycotts? That goes against the spirit of the Olympics in itself, which is meant to unite and not divide.

I have been pissed off with the Chinese and their nationalism bred out of their victimisation mentality in the past (eg. attacks on innocent Japanese businessmen and tourists after Koizumi's shrine visits) but in this case I support the Chinese wholeheartedly. There is an outpouring of support for China from ethnic Chinese all across the world and indeed, feelings of racial proximity can transcend time and space. The Olympic Games as a coming-out party for China is also a source of pride for ethnic Chinese the world over, and it is terribly unfortunate if the Westerners through their antics were to instead unite the feelings of Chinese the world over against them.

The Torch Relay passes from South America into friendly territory for the next few legs: Africa, the Middle-East, Pakistan, India, Southeast Asia. The Australia and Japan legs should be uneventful as well. But the early episodes have already left a sour taste in everybody's mouths and hopefully will not be a precursor of things come August.

How To Make Money In Stocks Part 4: Keeping It Simple

2008-03-29T20:13:00.000-07:00

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"Complexity is not a cause of confusion. It is a result of it." This is a saying by Anonymous, the best I could find and the best reflection of my views. In the wake of the subprime crisis that all unanimously agree has arisen from the quantitative complexities of derivatives like CDOs and CDO-squared that baffle CEOs from proper risk management, mesmerise institional funds into blindly buying, and confuse regulators into despairing acquiescence, I think many more people would start to appreciate the beauty of simplicity. Or was that last 55-word sentence a bit hard to swallow as well?

The pinnacle of achieving simplicity will be the ability to reduce stock market behaviour and strategies to a series of equations that can be consistently applied to make money, but as I understand no academic has been able to achieve it yet (though nobody who's done it would really want to make it public). But in the absence of such a Unified Theory of the Global Stock Market, it'll be good to develop a few mental frameworks to facilitate one's assessment of the overall market and the various sectors and how they will develop in the foreseaable future: a sort of guide on the direction of change, since absolute valuation is obviously not viable. In short, develop a framework to integrate various fundamental developments and then translate them into a sector- and stock-picking strategy that will best ride on your simplified reading of the future.

The idea of simplicity ties in with my views on mental focus. Without reducing the everyday noise to a series of indicators to focus on, decision-making can be fragmented and lack conviction. In fact, everyone can have different frameworks for decision-making (which is why I shall not try to impose any of mine here) and still succeed because there're so many roads to Rome ie. so many different ways of making money in the stock market. I was reading a book on trend-following where traders like John W. Henry and Richard Dennis basically used one simple decision-making tool to trade: the price. Their belief is that the price reflects the public and hidden fundamentals. It is deceptively simple and yet they make great money because they understand the risks of this framework, and cut loss promptly when wrong. This is an example of one-reason decision-making (they just need a single piece of information for making a decision); the academic term is "fast and frugal heuristics", where one employs a minimum of time, knowledge and information to make adaptive choices in real environments. This is an example of simplicity at its barest bones.

What I plan to write on more in this article is actually what NOT to do. I believe that if one learns to avoid the bad things, the good stuff will naturally come (that's partly the reason for my HotStocksNot blog). Many people tend to venture into areas where retail investors with shallow pockets face no competitive strengths, partly out of curiosity, and for the more enterprising --- out of desire for more knowledge and to maximise profits. But it is easy to entangle oneself in complexities that favour more well-equipped professionals, and diworsify one's mental focus. My "one-audience" view is that therefore, it's best to avoid when in doubt, though there might be exceptions. Below are some of these "complicating" ventures that can prove stumbling-blocks:

1) Foreign markets. It is tempting to buy overseas stocks, especially the temptation to associate oneself with the brand names that one hears about all the time (say, Apple). But one is most likely to buy into the liquid overseas stocks where there is no discovery premium and potential gains are likely to be compressed (efficient market), simply because he has limited research facilities on these overseas stocks as well as probably high trading costs. There are a myriad of other issues, such as the fact that domestic investors are likely to be more protected in times of trouble. So, what for? Outsource it to professional unit trusts, with research facilities and administrative clout, in this aspect.

2) Derivative instruments. They are highly quantitative, and more than once have surprised punters with their behaviour (eg. puts that go down when markets drop). Their time decay aspects are often overlooked as people often only look at the underlying asset aspect, with the result that one can often be fundamentally correct on the underlying asset while still losing money due to unfavourable short-term movements. It is an example of layering complexity on complexity: one needs to be sure about the underlying asset short-term characteristics, and then be sure of the derivative pricing quantitatives.

3) Leverage. Use it sparingly and only when you have strong conviction and strict cut-loss rules. If you feel your competitive strength is in understanding the true long-term strength of the company, why complicate it by applying leverage and implictly betting that (a) this long-term strength will be recognised in the short-term and (b) your buy-in timing is spot-on and that the stock will not do a correction before reversing back upward?

4) Short-selling. This stems from a desire to take advantage of market downtrend ie. to continue to make consistent profits even as the market turns. In other words, it has a tendency to stem from greed. Again, leverage is involved, and one needs to understand the calculation of margin. For short-selling, if the position moves against you, it can be a double hit on the margin because numerator (equity) declines while denominator (total asset market value) rises (as opposed to buying on margin where while numerator declines, denominator will also decline). Always understand the risks and work out the possibilities.

Within the Singapore stock market and within the simple buy-and-sell approach, there are already so many possibilites. Why make life more complicated? Those seeking to "learn new things" should go back to school. Those looking to generate new conversation topics (by taking up new instruments) should attend cooking classes. Those looking for excitement should wait for the casinos to open.

How To Make Money In Stocks Part 3: The Illiquidity Premium

2008-03-24T08:30:00.000-07:00

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There is a premium for illiquidity that can be reaped and should be priced into a thinly-traded stock. This is acknowledged both qualitatively and quantitatively even by academic valuation theory, but common sense will suffice, actually.

For a stock that nobody is really interested in, for one reason or another --- even though it does have a certain intrinsic value --- the tendency is for the stock to sink under its own weight below intrinsic value. Firstly, there is unlikely to attract any speculative elements --- hence little overshooting above value; secondly, even institutions tend not to like these stocks because of the fact that they need good daily trading volume so that they can sell without too much market impact should a cash call arise; thirdly, many investors shun these stocks because of opportunity cost of holding; fourthly, many retail investors simply don't know much about these illiquid stocks because brokerages do not provide research on them. Clearly, there is an opportunity for the diligent individual here.

The opportunity arises because the individual's intended appetite is small, which facilitates entry and exit without too much market impact. He avoids initial overvaluation because of limited speculation in the stock. If he is willing to research into these companies, he can find hidden opportunities in a truly inefficient segment of the market. And because he has done research, he can hold with conviction and not be too bothered by persistent thoughts of opportunity costs. This is the essence of reaping the illiquidity premium.

The premium is the difference between the intrinsic value of the stock and its market price which is likely to be substantially lower. If things go well, and the market wakes up to the stock's possibilities due to say, a strong dividend or some new developments as a catalyst, the illiquidity premium is the first to be reaped. Then follows brokerage reports which excite the market and introduce institutional interest and then speculative elements, with PE revaluation on top of optimistic forward earnings projections. One may view the illiquidity premium as the margin of safety for the stock so that even if all the above does not materialise, there is still a buffer between buy-in price and intrinsic value that protects downside to an extent.

This is somewhat allied to the time horizon premium earlier mentioned, for one especially needs to have a long investment horizon to reap good rewards off illiquid stocks. It is important to do some in-depth research and to have a sense of value to unearth the correct illiquid stocks to invest in. Personally, I've had good experiences with illiquid stocks (before they became liquid): stocks like Boustead, Easycall (now China Education), Hiap Seng, Heeton, OKP, MTQ. Even when the illiquidity premium does not manifest, the losses are minimal: stocks like Tsit Wing, Bonvests, Pertama, for example. Some of these I will relate in my Investing Journey series another day.

Another situation where this illiquidity might reward boldness: when there is market-wide illiquidity, characterised by low trading volumes and often large bid-ask spreads for many stocks. That, of course, means there is marketwide uncertainty, and the market can be illiquid for an extended period of time as it resolves the uncertainty --- which means again, there is illiquidity premium to be reaped. Another way of seeing this is that the investor is rewarded for supplying much-needed liquidity to the market. Sir John Templeton has a nice saying that he would like to be a philanthropist in the market and always provide other people with what they need in earnest. That is, to be a buyer when others are desperately selling and a seller when others are greedy searching for stocks to buy. There is no better way to describe the illiquidity premium than that.

How To Make Money In Stocks Part 2: The Time Horizon Premium

2008-02-29T21:21:00.000-08:00

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There are several premiums that can be reaped which appeal to the investor. A key one among these is the time horizon premium.

This is nothing new in the investment world. Those willing to put their money in fixed deposits with long maturities can get better rates than for say, checking accounts. For bonds, typically the yield (interest rate) rises with increasing time maturity. The difference in yields between long and short-term instruments is to compensate investors for having their money committed for longer periods.

There are risks with having excessively long-term horizons. One of these is opportunity cost of better alternative investments. The second is liquidity mismanagement. Some might have become familiar with the structured investment vehicles, or SIVs, that have run into problems recently. These SIVs typically borrow short-term money to invest in long-term bonds and other instruments to take advantage of the higher yields. Now they find that it is difficult to roll over their short-term debt, and hence face the prospect of having to dispose of their long-term investments at firesale prices.

But really, for the individual retail investor like you and me, the need for short-term cashflow circulation should not be an issue as long as we do not incur big obligations (eg. oversized housing loans, margin debt). As long as we do not foresee any need to sell off our stocks at short notice to finance something, what is there to stop us from having a longer investment horizon, or holding period?

Note that this does not equate to a slavish adherence to the "buy-and-hold" philosophy. It does not mean that one can just sleep on his stock over a long period and expect to reap the "patience premium". To do so might entail frustration if the individual fails to monitor the company closely and it subsequently falters. Reaping the time horizon premium is not about laziness.

Rather, it is about an intelligent bet where one sets out deliberately to capture the time horizon premium at the expense of shorter-horizon players who are constrained by the need for short-term liquidity. I have often wondered why risk is defined as price volatility. Surely, day-to-day up-down swings should not be that important for the long-term player, as has been pointed out by Warren Buffett himself. And indeed, it is not important ...... except for the many institutions that need to manage asset-liability risk exposure and therefore cannot afford to see their asset prices swing violently to the point of defying prediction and "risking" the danger of they being forced to sell at the worst point (the price trough) to meet their short-term liability funding needs. These institutions include banks, hedge funds, the abovementioned SIVs and other structured vehicles, and even some pension funds, insurance companies and unit trusts (to meet redemptions). The concept of risk is defined for them, and it is not that relevant for the investor with a long-term horizon (read my article on risk). It is my belief that there really needs to be an alternative definition, but meanwhile let's just profit from it.

As long as one understands the long-term value in a company, then market swings which force short horizon-holders to sell good and bad stocks alike will produce the best opportunities for reaping this time horizon premium. In this kind of situations, the investor should be patient in holding, since he can afford to do so without need for immediate return. This, I believe, is essentially what Buffett means by "buy-and-hold" and his Mr Market analogies. The key thing to note about this strategy is that unlike bonds or fixed-deposits, there are no clear contractual promises about reaping this time premium: that is why it is important to monitor the investment consistently.

How To Make Money In Stocks Part 1: Back to the Basics

2008-02-21T23:09:00.000-08:00

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An idea for this series of articles (this will probably be a long one) came from a few readers who wrote to me asking about the exact issue described by the title. I thought it might be useful to do a few writeups on some general strategies to employ. No gaurantees of course.

Each of these strategies, like so many other things in life, would work when executed well but might fail when improperly done. Also, they might be mutually conflicting, so it's important to keep an open mind. For example, I can tell you trade aggressively in one article, and to be patient for value to emerge in another article. It can be confusing; the right thing to do often comes from experience and gut instinct, and the worst thing is to be paralysed by confusion like a deer in the headlights. Indeed, what I often do is to mix-and-match, but always keeping an eye on the balance between fundamentals, sentiment and valuation, as well as constantly scouring for alternative better stocks to plough into.

The title is similar to that of William O'Neill's book; however I can think of no other way to name it. I cannot profess to have made copious amounts of money off stocks but a crystallisation of my experiences and philosophies over the years would nonetheless be useful for future reference.

It is no coincidence that the first strategy is titled Back To The Basics. So many books have been written on this, that I shall not elaborate on how fundamentals drive share prices, how earnings are all-important, etc etc. Everybody probably knows this to death, thanks to Warren Buffett's real-life example.

But really, everybody knows this, how many people practise this? There are many who simply give up on interpreting the fundamentals and understanding industry dynamics, the demand and supply balance (or lack of), the competition, the company financial specifics ---- and resort to price-volume charts exclusively to predict the future. I have never said charts are completely useless --- after all a perspective of price history and buying interest is given by charts --- but technicals without fundamentals forms an incomplete framework for decision-making.

Understanding the fundamentals is actually not that difficult. If one is prepared to focus on the fundamentals, he can already cut down a lot of time diverted to learning chart-reading, for example. The key thing is making the most of your limited time doing something that really can make a difference to your investing effectiveness. And the key thing to fundamentals is understanding the industry, from upstream to downstream, the entire value chain, and where your particular company lies along the value chain, what chance does it have of maintaining its niche or competitiveness vis-a-vis competitors through good times and bad. Find the one or two indicators that best characterise the company's performance. For example, for palm oil stocks, it will be palm oil prices; for hotels, it will be tourism growth and REVPAR growth (read it up); for upstream oil stocks, it will be oil prices; for refining stocks, it will be refining margins; for shipbuilding stocks, it will be steel prices. If one gets the understanding and the indicators-to-watch part right, he'll be halfway done on the fundamentals aspect already, without having to labour through the financials which should take care of themselves (though it'll be good to analyse them too).

Back to the basics also means an understanding of what a share actually means to the holder. A piece of the business, yes, but the key thing is: what does it actually mean? What good is a share unless it brings one tangible benefits, which means tangible cashflow, which means dividends or other distributions. Going back to basics means understanding the valuation models of a stock, which always stresses dividends or cashflow. Assessing the sustainability and growth potential of this cashflow, together with the willingness of the majority owners to share this with the minority holders, is what investing is all about. Based on this, one can actually already filter down to a useful list of stocks that can commit to growing and paying out good dividends.

The key reason why mastering the basics is so important is that it provides a margin of safety. This is not the margin of safety as defined by Ben Graham; rather, it is the conviction and patience that an understanding of the business imparts to the investor. He can not only be relatively insulated from price volatility so long as he knows the core business is intact, but more importantly, he will know what to look out for if he suspects the price volatility indicates an underlying decay in fundamentals. He can then take active action to track and possibly exit the stock. Forming investment decisions based on price movements without fundamentals understanding is like driving a car watching the traffic ahead of oneself but without a map of the neighbourhood or any idea of his final destination.

The thing about fundamentals is: it can be very difficult to pick up from a standing start. There are many things in life that are difficult to do, and yet worth doing. For a start, read all the IPO prospectuses you can find on various industries for their description of the business and the industry. Read all the business magazines you can get your hands on. Find some books that actually discuss dynamics of various industries (eg. "The Five Rules for Successful Stock Investing"). That would take some dedication but at the end of the day it is something nobody can take away from you, and it becomes your competitive advantage. It is also the reason why I am willing to share so much of my experiences with readers while knowing that it is difficult to replicate all this knowledge in them without them putting a lot of hard work themselves in building up their own mental frameworks.

A letter to Warren Buffett

2008-02-07T22:14:00.000-08:00

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Dear Sir,

It is too expensive to buy a dinner with you so I thought I'd write instead to highlight an investment proposition to you --- one that would bring you running like an oversexed teenager in a whorehouse.

I am one of your fans, but unlike the countless others who profess their admiration for your investment philosophies and insights I am more a fan because of the enormous wealth that you possess, which makes you the first, second or third richest man in the world at various times, depending on Mr Market's daily evaluations of Microsoft's future and Mexico's potential.

My investment proposition is true to my patriotic nature --- come to Singapore to explore the wonderful bargains available that will allow you to diversify out of the terrible sinking US dollar, which I understand is your prime objective now. You may know that you are not the first one; a former affliate of George Soros is here already, allegedly to teach his happy daughter Mandarin.

This is not a cigar-butt proposition; it is not just a one-puff thing. This is a long-term story, and I happen to know that you absolutely love the long-term. A big ship takes time to turn, so it'll take you a while to switch out of your US assets into the secular rise of Asia --- with its domestic consumption and infrastructure buildup themes --- but you'll see the investment returns well before your breath wears out. And Singapore stands poised at the heart of the Asian story. It is increasingly mentioned in the same breath as the other Asian financial capitals: Hong Kong, Shanghai, Tokyo, Sydney. It is the logistics heart of Southeast Asia and the transhipment and transit hub of resurgent Asia. Ditto its refining hub; add to that its positioning along the entire value chain from research to services to alternative fuels to trading, plus the abundant resources from its neighbours and you have the makings of an Asian Houston in the future. You have a domestic reflation story, fuelled by government commitment to a rising population, new massive investments (two spanking new casinos) and a likely multi-decade remaking (together with associated investments) of the country towards services and away from manufacturing, and you have what you could call a country PE re-rating (upwards). Currently it is a developed country growing at developing country pace (5-7%). It might be volatile, but that's not a problem with you, I would imagine, you of the Mr Market and his crazy moods analogy.

That's the fundamental story for you.

You were recently quoted as saying that you don't believe a credit crunch will happen, and on this point I agree. There is plenty of cheap money around. Much of the current ready-to-invest money, however, resides in Asia's reserves and the Arabs' petrodollars, as evidenced by the sources of the buying sprees in the recent recapitalisation exercises of your US banks. In the wake of the US financial problems which are leading to downward pressure on both US equities and bonds alike, and given the long-term falling US dollar which reduces attractiveness of Treasuries, I would imagine (as you might have done so ten steps in advance of me) these money would go towards building up their own domestic economies (to cushion export stagnation) AND towards investing in still-buoyant themes --- which is of course Asia as a whole. What Mr Market will not pay in these current times, way-above-market-valuation M&A deals will: just look at the tussle for Rio Tinto (or even Yahoo! in the US). Check out the Middle-East funds and how they're moving acquisition targets from the traditional West to Southeast Asia, China, India. The general point in this is that Asia is the destination of significant liquidity in the absence of credible substitutes (since developed world equities and bonds have become risky), and there're still not many liquid and deep equities markets in Asia which thus limits their options.

That's where Singapore comes in, long-term liquidity-wise.

And sentiment is depression-like, which must surely complete the holy triumvirate of favourable investment criteria in your eyes. I can tell you from Ground Zero that the spectre of the Asian crisis ten years ago still weighs heavy on the guts of many who still want to wait for stock prices to hit rock-bottom before they want to buy. My reading is that should the stock prices hit their predefined level, they will again find excuses not to buy. Thus it is the mirror image of the "buy high, sell higher" mentality in bull markets; now we have the "sell low, buy lower" hope. It would be impolite to brand both as "greater fool" behaviour, though I am tempted. I will instead call it "a decoupling of the right and left brains"*. Local blue-chips have generally corrected 25% off their highs and now trade at 13-14X PE (historically 15-16X), while smaller companies have probably dropped 40-50% on average, in anticipation of a US recession. Among them are China-linked stocks of which about half or more trade at single-digit PEs, even as their Shanghai or HK-listed counterparts continue to trade at three times that PE, and even as we await a wave of Chinese QDII funds fanning out to invest outside China. And the mouth-watering proposition here is that the earnings of most of these companies are not leverage-enhanced ie. they are funded mostly by equity, unlike many US companies which often jazz up asset ownership and profits with debt and financial restructuring. There is capacity for growth with such balance sheet cushion, as you obviously would understand.

That is a cross-sectional view of the Ground Zero sentiment and valuation picture. It brings to mind one of your sayings: "Be fearful when others are greedy and greedy only when others are fearful".

Finally, I would like to express my admiration for the design of your Berkshire Hathaway website. It is truly one of the most iconoclastic corporate sites I've seen for a US top-10 company. I guess your best friend Bill Gates must have lent you some of his best Web design talent to come up with the site.

By the way, if you should decide to buy stocks on the Singapore market, please let me know which ones in advance since I'm the one who highlighted this proposition.

And last but not least, kateks die pain pain!

Cheers,
Danielxx

* Left brain-right brain: Left-brain focus on logical thinking, analysis, and accuracy. Right-brained subjects, on the other hand, focus on aesthetics, feeling, and creativity.

My views on the US subprime crisis

2008-01-26T01:21:00.000-08:00

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The crisis which erupted in August last year is now generating a full-blown domino effect on the "real" US economy and half a year after things have developed sufficiently for me to make an informed opinion on the state of affairs so far and how things could go from here.

Firstly, a confession to make. Although my mental analysis framework was pointing to a reduction in equities allocation as the problems in the US led to one hole after another in its economic fabric, I instead shifted my allocation to more defensive themes and stocks well-supported by NTA (net tangible assets), but ultimately it turned out everything was hit anyway. So the lesson of the day was not to ignore the tide, especially when it had a fundamental basis.

Two qualitative analysis frameworks work well here (which I sadly discounted). Firstly, that the general market is driven by three factors: fundamentals, liquidity and sentiment, and that one should watch out if the first two look to be declining or when the last factor is peakish. That credit creation (and hence liquidity) would be affected was clear, while the fundamental situation seemed mixed for a while as the US employment situation remained strong until December. Sentiment was mixed. It was a time to be careful. The second analysis framework was described in an earlier article: "The financial statement as an analysis framework". It showed a systematic way of thinking about revenues, costs, profits and how they eventually filtered through to stock valuations via P/E ratios, which were a function of liquidity. As liquidity declined, as did sentiment, there was a P/E de-rating, which is essentially what has happened over the last few months, especially for the small/mid caps and China stocks in particular. It remains to be seen whether the E will be affected in the coming months, in which case there could be another round of downward pressure on stock prices.

Another major issue is with regard to the seriousness and enormity of the crisis. There are actually two parts to this issue: how deep the crisis could become in the US, and how the rest of the world could be affected (the so-called decoupling hypothesis).

For the first part, the situation has the potential to deteriorate and comparisons have been made to the Asian financial crisis a decade ago where currency failures led to corporate bankruptcies led to mass loss in consumer confidence. The contagion effect within the various credit sectors and now consumer and business confidence in the US certainly shows that developed economies are not immune to such domino effects, and it would take a brave analyst to say things are not going to grow more pear-shaped, especially when everyone now seems to be talking themselves into a self-fulfilling prophecy that is recession. But there are several mitigating factors: (1) rate cuts are implementable without a seriously deleterious effect on exchange rates because of the USD's position as global reserve currency, an option not available to the hard-hit Asian nations in 1997 (indeed, they were forced to raise rates which worsened things); (2) the employment situation still looks relatively robust which if it continues might suggest the banks could actually write back some of those CDO losses if defaults are less than market prices suggest; (3) US companies have stronger balance sheets than during 1999-2000, derive more profits from overseas operations than ever before, and hence there is less potential for sudden bankruptcies (and mass loss of jobs). Arrayed against these mitigating factors are the sobering facts: (1) consumption constitutes 70% of US GDP, and hence a decline will filter through to GDP stagnation strongly; (2) asset values, of which home and stock market valuation are dominant, form two of the three pillars of consumer liquidity (especially when loans can be drawn against home equity --- a US invention), and asset values are almost certain to fall; (3) pessimism suggests US businesses will be reluctant to invest in new capacity. I feel things might swing more to the downside, though I feel the market is discounting this quite aggressively already. Actually, I am seeing a soft rather than hard landing where the economy slows as consumers spend less and businesses invest less, but no panic as general job losses and hence debt defaults are limited. (You notice I focus on the "credit demand" side and do not talk about the "credit supply" side (ie. the banks): that is because I feel there is general internal commitment to do big-bath writedowns that will put a bottom on valuation, general commitment from US government to support them, and general commitment from international governments to recapitalise them; the worst might be behind them. As a caveat, I will be watching the development of the monoline insurers episode and the moves of the credit ratings agencies closely.)

As for the decoupling issue, my view has always been that Asia decoupling from the Western economies is wishful thinking, because even if trade flows can decouple, it is quite impossible to expect financial flows to as well. I have been avoiding exporters as long-term holds for 1.5 years now given that US consumption has been slowing down since late 2006 ("US Consumption Slowdown"), but financial flows are impossible to trace though. But --- Asian economies have strengthened structurally both macro-wise and micro-wise since the painful lesson ten years ago and are in a position to substitute domestic investment for loss in export growth given their healthy surpluses. What it means is that if positioned correctly in correct sectors, one might still be able to make money. The likely credit destruction process in the West, however, means profit-taking must be more disciplined and less ambitious.

The third issue I wish to talk about is with regard to the management of this crisis by governments. There are many who criticise the Fed's emergency rate cut as being panicky behaviour that will send a signal that the economy is worse than it looks or that it is creating a moral hazard, or that the Bush tax plan is ineffective. They seem to want markets to right themselves by massive plunges to price in the desperate situation. I wrote something about this in a forum and I thought I will reproduce it wholesale here as representative of my thoughts:

"It is naive to think that the market and the economy can be separate from each other. George Soros' views on their inter-relatedness has been well-espoused and indeed, they can feed on each other in a death spiral if not managed. US markets have operated under what he calls market fundamentalism and if a free hand is given for markets to run they can become unstable because confidence and psychology is a big part of markets.

Understood in this context, we might be able to better understand the Fed's predilection for emergency rate cuts. They are signalling to the markets that they will not let market death spirals happen and further destabilise the "real economy". A big source of consumer expenditure, besides income, is the wealth effect from asset values, as well as from consumer debt/borrowing. Market valuations hence constitute a bigger part of the real economy than people give credit for. When banks mark down their balance sheets based on market value, as happened recently, the assumption is that markets produce "fair value". But is it true? My view is that mass hysteria and complete loss of confidence has produced unrealistically low valuations of many high-quality debt; because of mark-to-market requirements, banks have no choice but to write down up to 70% of their value. Probably the true value, in the form of discounted cashflows, is between the mark-to-market and mark-to-model valuations.

If the confidence crisis is allowed to develop and those in a position to do something instead do nothing, then that will truly be reproachable behaviour."

If one believes that the market is efficient all the time, then perhaps it's best to let the invisible hand rule. Behavioural finance has identified the flaws in such assumptions due to human psychological tendencies that distort rational behaviour and especially in extreme times these tendencies can be exacerbated either by rapidly falling prices or even rumours that might have seemed absurd in more normal times. Left unchecked, instabilities could develop and feed on themselves; perception becomes fundamentals which further reinforces perception. That, incidentally, also applies to many other things in life.

Short-selling Part 4

2008-01-23T07:01:00.000-08:00

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Derivatives, and warrants in particular, have become very popular instruments on the SGX over the past few years, and the SGX must be given credit for its successful promotion of this instrument the second time round (the first attempt in the 90s fizzled out). As more and more issuers enter as market-makers, there is now a critical mass and warrants form a substantial part of market trading volume.

For shorting in particular, exposure via derivatives is the cheapest method of all the alternatives, and the main instruments are index futures and put warrants. Cheap because there are no ridiculous financing costs as in the case of CFDs or SBL, although there still exist time expiry for both instruments.

Index futures on the SGX are offered for several North Asian markets and of course the local market, among which the Hong Kong index futures has become wildly popular due to its strong bullishness. Futures are very simple. You either go long (ie. bullish) or short (ie. bearish); the contract parties are the longist and the shortist. Typically both parties only have to put up a small amount of equity, but margin top-up is required when positions move against one of the parties. It is a useful instrument if one wishes to take a short position on an entire market, though he'd better be familiar with the index components!

Put warrants are not only offered on country markets (STI, HSI, KLCI and Nikkei), but more importantly also on individual stocks, in the most popular form known as structured warrants. Without going too much in details, put warrants offer the buyer the chance to profit from downside while limiting the potential loss to the initial cost of the put warrant. I have written on the perils of buying warrants in an earlier article: Buying warrants vs buying shares. Yet when used correctly, put warrants can be a cheap way of hedging one's portfolio by buying protective index puts such that when the underlying stock moves down, the index put gains in value and cushions the fall (hopefully, the index doesn't rise instead).

Another common put strategy is the straddle. Buying both puts and calls is the long straddle strategy; both seem to cancel each other out but in the event of volatile markets, both call and put gain in value. It is effectively a play on market volatility --- quite appropriate in today's markets. On the other hand, selling both call and put is a reverse play on declining market volatility, known as the short straddle. This strategy is not feasible anyway in Singapore because individuals can't write options.

Although cheap, the biggest problems with put warrants are their limited choice and their time expiry. The latter is a characteristic of the instrument, while the former means specific shorts on single stocks are near-impossible. This limits puts to probably hedging instruments, in my view, through the use of the above protective put; though if one is really bearish, he can always take directional bets.

For such reasons, I seldom buy puts because I have more conviction in my stock-picking skills than my ability to read the market in general. I eagerly await single-stock futures which are said to be launched sometime in the future. If I remember correctly, these futures existed in the past but died off after being blamed for the 1985 Pan-Electric debacle.

Short-selling Part 3

2007-12-28T06:46:00.001-08:00

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The second main instrument used for short-selling individual stocks is the CFD, short for Contract For Difference. The name is not very illuminating, but suffice to say that it acts like a form of stock futures where the gain or loss is the difference between the opening price and closing price of the underlying stock multiplied by number of shares specified. Like futures, it is a leveraged instrument, meaning the trader/short-seller only needs to put up a small portion of total nominal amount as equity; the rest is broker-financed as implied by the nature of the instrument.

Before I started my survey in detail, I'd only known of one local house that offered CFDs and that was Phillip Securities. Turned out that Lim & Tan also offers this facility, and also foreign boutique houses like IG Markets and City Index.

Again, management of one's margin position is important because it is tempting to put up the minimum equity (20% of total nominal amount) and leverage up to the hilt. This is not wise and really one should have sufficient cash to top up margin positions when the underlying price moves against him.

Unlike SBL, the trader does not actually trade in real shares on the stock market in the case of CFDs. It appears that the counterparty might be the proprietary account of the broker themselves. Some people are concerned about this, because there is a possible asymmetry of information here. It is difficult to say, but I guess the advantaged counterparties would have hedged their positions the way warrant market-makers do so.

My main issues with the CFD instrument are twofold. Once again holding cost is one of them. Financing cost for CFDs ranges from 4-8%/annum of the nominal amount of stocks short-sold, depending on house and individual stock. Commission is about 0.3%. However, CFD contracts differ from SBL in that they have expiry periods, typically one month, and if one wishes to extend his short position, he has to rollover the contract; every rollover incurs a new commission, hence a new commission is actually charged every month instead of per round-trip trade. Again supposing that one assumes a CFD short position on $100k worth of shares over three months, the financing interest will be $1000 (based on lowest 4% financing interest) plus $1200 round-trip trading commission (start buy, end sell, + 2 monthly rollovers), comparable to an SBL position of the same duration (see Part 2). For longer durations, CFDs become more expensive than SBLs because of this monthly rollover commission, all other costs remaining similar. And of course, the unsophisticated "buy-and-hold" investor will incur much less costs, as had been compared earlier.

Note that the 4% financing cost is limited to a small number of stocks. For Lim & Tan, they number about 100-odd. For Phillip, all short CFD positions require 8% financing. The problem with using CFDs to short is that there are limited counters for which this facility is provided, the second issue I have with these instruments. The foreign houses (IG Markets, City Index), being not so locally-focused, typically offer CFD contracts on STI/SIMSCI index stocks and miscellaneous other semi-blue chips. One might not find a CFD facility for the counter he wants to short-sell, a particularly vexing problem (at least to me, since I focus on mid/small caps). And another thing: the list of CFD-able stocks is often subject to review monthly. That means if one is holding a (short) CFD position for a stock which is taken off the CFD list at the end of the month, he is no longer able to rollover. Again that creates uncertainty, much like the issue of recall of borrowed shares in the earlier SBL instrument.

Generally, CFDs are marketed as being more convenient as the traditional SBL because of less adminstration process (no need to wait for share borrowing from CDP) and savings on settlement/exchange clearing charges (since the transaction is with the broker and never goes through SGX). Different CFD houses have varying rules on corporate actions; most facilitate dividend adjustments but some require the contract to be closed in the case of stock splits/bonuses (eg. Lim & Tan) while others simply make price adjustments to the CFD contract (eg. Phillip). Traders are advised to check these minor issues out before they become a major issue down the road.

In the next article I move on to put options and associated strategies.

Chronology of the economic cycle

2007-12-20T09:25:00.001-08:00

DanielXX's intro: This entry consists of just one picture.

I saw this in a journal and thought it provided a good overview of how inflation relates to the economy as well as the wealth effect of the stock market. If you refer to the picture, inflation has an effect on both interest rates and individuals' wages which in turn determine spending power (via borrowing and disposable income respectively). Spending power is also dependent on the wealth effect which emanates from asset appreciation (via stock market). But note that what's important to business profitability ("corporate profits") and further investment ("capital spending") is real consumer spending which is the actual tangible demand (adjusted for inflation). Corporate profits provides the basis for employment which underpins consumer borrowing and individuals' wages, completing the loop.

The above was extracted from a journal whose name I've forgotten (sorry).

Short-selling Part 2

2007-12-16T18:52:00.000-08:00

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We start with the SBL account, an abbreviation for Shares Borrowing and Lending. This is the traditional method for short-selling, whereby one borrows from a pool of ready-for-lending securities in order to sell short. This enables the trader to hold longer than if he were doing "naked" short-selling, where he basically just sells the stock short without borrowing scrip. In naked short-selling, one has to cover within the same day or else SGX will do it for him over T+3 period, at unknown prices. The trader with the SBL account has the luxury of holding his short position, albeit curtailed in some ways (will be explained shortly).

SGX does facilitate SBL accounts by providing a ready pool of various companies' stocks for lending to interested parties. The list can be found in the CDP website. Traders cannot borrow directly, but have to do it through brokers, who probably earn a spread of >3% by borrowing these shares at 4% and then re-lending it to their clients at 7-10% varying.

I assume that readers will be familiar with the idea of margin in short-selling, which is basically putting up a certain amount of equity (own money) to assume (long or short) positions in a stock, that equals about 30-50% of total assets (stocks + cash). This is inherent in short-selling, where one is essentially borrowing the scrip. One way to think about this is that the trader is taking up broker's loans to finance the scrip borrowing, and his margin money serves as additional collateral so that should things go bad, the broker will not run into bad debt problems. And of course there is the margin call, which is basically when share prices do go counter to the trader's hopes, in which case he has to top up the margin. The problem in Singapore is that typically he has to top up margin within T+2, while sales of his stock will only yield payment at T+4. Hence it is impossible to react to margin cash call by selling one's other stocks on the same day.

It is interesting to observe what attitudes some brokers have towards short-selling. Some brokers are simply ignorant about it. Some are quite guarded eg. DBS Vickers and DMG Securities said "We do not encourage short-selling." and that was that. The local ones that offer SBL would be Kim Eng, Phillip and iOCBC. I wonder why the former two do not, since it is really lucrative. See below.

The key costs and possible complications are both open and hidden. The commissions and charges are disclosed openly. The key one to watch out for is borrowing interest. This is the interest on broker's loans used to acquire the scrip, and it is exorbitant. One can be borrowing at rates from 7-10%/annum, as mentioned above, to take up short positions, and that is calculated based on total value of shares borrowed regardless of what he puts up as margin. Hence, even if the trader is not aggressive and puts up a lot of margin, the financing charges are still the same. If one was operating on the long (ie. buy) side, this charge is non-existent (if he does not borrow). Thus the only charge for the long trader is 0.3% commission. The Internet SBL short-seller pays that commission as well, and 7-10%/annum interest on top of that. Supposing one assumes an SBL short position on $100k worth of shares over three months, the financing interest will be $2500 (based on 10% financing interest) plus $600 round-trip trading commission, 5 times that of a long position which incurs only round-trip commission. And that ratio further rises if the short is held over a longer period. It is expensive to short.

The other main thing to note is the issue of scrip recall. Note that the lender has the right to recall the scrip within a T+4 period should he wish to sell the stock. Consider the following two scenarios:
(1) Stock rises, rightful owner (lender) decides to sell to take profit. SBL short-seller has to return shares and cover, sustaining losses. He then has to look for other scrip to borrow.
(2) Stock falls, rightful owner (lender) decides to sell to cut loss. SBL short-seller has to return shares. Although he makes gains, he cannot ride further on the downward momentum of the market unless he finds other scrip to borrow.

This means that the shares might well be recalled at the most inopportune time to the SBL short-seller.

There are also other miscellaneous issues like the payment of dividends, the issue of stock splits which can be pretty confusing and complicated. All this conspires to put pressure on the short-seller and inculcate a sense of siege mentality within him/her. The next article covers CFDs which ameliorate some of the abovementioned problems but also have some problems of their own.

Short-selling Part 1

2007-12-15T23:03:00.000-08:00

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Long-time readers of my blog would know that I have so far been quite resistant to trying to profit from short-selling. But not for moral reasons, for really there is nothing immoral about taking the view that markets will go down and hence backing up that view by selling first before buying up (covering) later. What is immoral is the additional measures the unscrupulous short-seller takes to back up his position by manipulating the market, such as spreading untrue negative rumours (there was a recent case).

I am starting this series of writeups on short-selling for several reasons: firstly, due to increasing possibility of a US recession and contagion to worldwide markets triggering a likely interest in profiting from falling markets (there was already a writeup on shorting in this week's The Edge); secondly, as a learning journey for myself as I develop the material for the writeups and further understand the short-selling process through my articulations; thirdly, for fellow investors/traders to contribute their past short-selling experiences, if any. So please, feel free to give comments or correct me, for I am fresh to short-selling too.

Previously my impression of short-selling was based on pieces of information culled from various market players and from what I had read. More recently, I have spent the last two weeks or so conducting a survey of various shorting instruments available in Singapore's market and will be writing my thoughts on them in subsequent parts. Mainly, I'll be writing about CFDs and SBL accounts, and exploring their characteristics and more personally, my own grouses with them (think this part will be more helpful).

What kind of stocks to short? Perhaps a list of characteristics, culled from this book I have read recently, might be more useful than my personal views, since I haven't shorted (intentionally) before:

1. Emotional rise not founded on reality
2. Rise on increased volume (because people will take profits on the way down)
3. Seems to have stopped rising
4. Has broken down from top area of distribution (characterised by high volume)
5. Has not yet declined >10-15% from secondary peak
6. Very high PE
7. Not thinly-capitalised, not illiquid
8. High downside volatility in past chart action
9. In industries on the downgrade
10. Completed very bearish chart pattern eg. double-top, head-and-shoulders
11. Popular/widely-traded

(extracted from "Bear Market Investing Strategies" by Harry Schultz)

You will notice that a lot of the recommendations are technicals-based. This is probably in recognition of the fact that the horizon of short-sellers is typically short-term. Markets fall much faster than they rise; fear evokes stronger emotions than greed. At the same time, the long-term trend of human development, and hence markets, is upwards. It is probably fatal to sell-and-hold (ie. reverse Warren Buffett).

At the same time, short-sellers, at least in the US, are known to do better research than their long-only opposites. It is probably the siege mentality at work; one needs to be sure, especially when they have the brokerages (typically the bull promoters) lined up against them, and when losses could potentially be unlimited (prices charge to the sky and the short-sellers still need to cover). This is another reason why I'm exploring short-selling; it pays to be in tune with all the bulls and bears and their tools of the trade so that one will not be overly-biased psychologically on the long side.

P&L: Sustainable earnings

2007-12-02T05:43:00.000-08:00

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For the fundamentals analyst, the financial statements provide a wealth of information. I am busiest during the months of February, May, August and November when most quarterly/interim/final results are released. The P&L statement is often the one most people focus on, because it's used to calculate the most popular metric, the PE ratio. However, it is important to recognise the components that make up the denominator E (earnings).

The most important factor is sustainability of earnings. And the key component to watch is extraordinary, or non-recurring, income, which are one-offs that should be isolated and eliminated from earnings calculations. Often, it is not difficult to identify these components, because P&L statements typically recognise these as "Other income" and further confirmation can be obtained by checking the footnotes on "Other income". The most common extraordinary profit is gains on asset sales, where sales price is substantially higher than that recorded on book, hence constituting a profit. Other non-recurring items (might also be expenditures, in which case they should be reversed) are forex gains and asset revaluations (increasingly common among property companies under new accounting rules).

Case in point: Many offshore support companies have been padding their earnings in recent years by selling vessels at huge profits over book value eg. Ezra, Swissco. Others have booked huge profits selling their stakes in other offshore companies eg. KS Energy selling its stake in Ezra on the market. All this can be considered non-recurring.

Sometimes things are not so simple. The non-recurring characteristic of the earnings is embedded in the numbers and the nature of the business. Cyclical companies, especially, enjoy huge profits at cycle upturns but the high margins cannot be forever because of business cyclicality. Sometimes, companies might also enjoy high margins because their inventory has appreciated considerably in price. But since their inventory constitutes their raw materials, the huge profit is embedded in the higher revenue, the manifestation of higher selling prices.

Case in point: Tai Sin, which sells electric cables, benefitted tremendously from high copper prices which enabled them to raise their selling prices of their electric cables. As cost of inventory was low (purchased sometime back), the gross margin was fantastic. This enabled them to have a superb 1H07 where profits trebled. However, the non-sustainability of the margin manifested in 2H07 when margin slumped significantly (though still very high).

And sometimes, what appears to be non-recurring earnings might turn out to be quite sustainable. This might form the basis for a good buy, especially if the market doesn't recognise this insight but the individual investor captures its essence.

Case in point: Boustead has been disposing its logistics assets (warehouses, customised high-tech buildings) to various buyers (mostly REITs) for the last few years, all at substantial gains. But this has been taking place so often that it seems almost sustainable. And perhaps it is. After all, when one builds the assets, and then sells them later, does this not constitute a recurring business? Does it matter whether it holds them as fixed assets/investments (in which case it is classically considered as extraordinary gains) or as inventory/development properties (in which case it is normally booked as core revenue)?

And so discerning the sustainable components of earnings can sometimes be a matter of judgment, though often it is as simple as stripping away the "Other income". Taking this step of determining earnings sustainability often improves the accuracy of future projections substantially, and one will be able to determine the general trend of profit margins with much less distortion.

My Investing Journey: Full-time investing

2007-11-20T05:40:00.000-08:00

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In fact in 2004, I was effectively doing full-time investing. I was on a one-year sabbatical and would not resume working until the following year. And hence I led a life that many market players would envy.

Well, not really full-time in the strict sense, as I had some other personal ventures going on, and besides, my style had never been to stay glued to the screen and day-trade. That's why investing was a more appropriate word than trading. Indeed, I did considerably more reading off books than off the computer screen during my time off in this period.

It was with the benefit of this experience that I wrote two articles on full time trading (Part 1 and Part 2), where I highlighted the pitfalls, tangible and intangible, that should be considered by those planning to take this route. One needs the passion to sustain himself, especially when the market takes a downturn. Some ability to manage risk and the stomach to take it won't hurt either.

The fact is that, at least for my case, full-time doesn't mean one has the luxury of time to cover the market comprehensively. Whether one has one or twelve hours every day, he must learn to optimise it and select the focus of his investment attention, otherwise there will never be enough time.

I focused my time on doing investment research across greater breadth and depth than I could have afforded when I was working. I read newspaper reports in more detail, finally got to pore through the Newsweek magazines I regularly subscribed but previously could only skim through, and got my hands on numerous brokerage reports where I sifted the wheat (facts) from the chaff (opinions). I read investment books of all varieties at the rate of one a week. I read through numerous annual reports and IPO prospectuses to cultivate an instinct for industry value chain dynamics. I built up more fundamental analysis knowledge that year than would have been possible in five or ten if I had been working.

The second thing I did more of was that I did more thinking. About my investment approach and philosophy, my portfolio stocks, various potential stock themes. It is amazing how one realises his beliefs are just a patchwork of haphazard ideas from various books he has read if he just thinks about it; that is why one is easily confused when his stock drops and one part of his brain tells him Warren Buffett says buy and hold while another part of his brain says all savvy traders cut loss to preserve capital. Without a coherent and internalised investment philosophy, one cannot have the conviction to take decisive action. Some daily ruminations on the stocks one holds and on likely hot themes in the near future kept unearthing new daily insights while further anchoring my conviction on my stock holdings.

The third thing was that I exercised more. I did regular swimming and jogging, and I cannot overemphasise the importance of physical fitness should one want to do such a sedentary activity like trading full-time. Mental alertness and discipline must be inculcated, and physical exercise will bring that.

And my results? Not as great as I had hoped at the end of that year, partly because of the market ("The Scandals of 2004"). But the fruits of my fundamental analysis training, which is basically what I had undergone, would bear me benefits over the longer term. But that is another story for another day.

My thoughts on the Uni-Asia episode

2007-10-19T20:52:00.000-07:00

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And so it has blown. The blowoff was anticipated even before the event, for an IPO stock (with no post-listing track record) that had quadrupled within three weeks with no apparent fundamental developments. The catalyst for the collapse was widely seen to be trading curbs imposed by various local brokerages, leading some retail investors to question if unfair insider trading by the proprietary house traders who had known of the curbs in advance had led to the subsequent collapse. More than 30 retail investors went down to the Singapore Exchange yesterday to lodge a complaint against stock brokerages that they felt had acted unfairly, something which has not happened for years (not even in the CAO episode, I believe).

My first thought upon hearing about this was a mental flashback to the Horizon Towers episode when en-bloc sellers tried to back out of their apartment sales to HPL as property prices accelerated upwards following their purchase. The parallel that is drawn is that contracts properly drawn up at the time of transaction should be respected and both parties should not have cause for complaint no matter how the market situation develops subsequently. Given the contemptuous attitude held by general Singaporeans towards the relenting en-bloc sellers in the Horizon episode, which is a product of our culture that respects the letter/spirit of the law, my instinct was that the investing public would also not be very sympathetic towards the Uni-Asia protestors. So far, it seems my view is right, judging from the reaction of online forumers.

Second thought was: caveat emptor. As noted above, most traders (except the truly naive) knew the Uni-Asia run-up was a greater fool game, given the high volume, low free float, lack of true fundamental catalysts and amazing price surge. They chose to go in irregardless. As they say, it is horses for courses, and those that played the right way, by controlling their greed and taking profit fast on such stocks, gained big-time, while those that chose to "buy-and-hold", together with those that came in at the edge of the cliff, would be the victims.

As it happens, earlier this week I was reading some investment magazines from the 1990s. Then, the SGX, known as SES at that time, was a tightly-regulated regime. Brokers and dealers who stepped out of line were speedily slapped with hefty fines; listed companies which failed to comply with SES requirements just as quickly got their knuckles rapped; greedy investors out to make a crooked buck from the market were swooped upon and heavily penalised. The result was that the market was sanitised and purged of undesirable speculative elements. Then unlisted, the SES scored top marks for being the most "bull-headed regulator in Asia".

The flip side was that there was also criticism that such emphasis on tight regulation had retarded the development of the capital markets in Singapore as companies found listing requirements and compliance too difficult; an example was Creative Technology (then a shining beacon of local entrepreneurship) heading to Nasdaq to list instead. The same, incidentally, is also being said of the NYSE and its overly-strict Sarbanes-Oxley Act driving companies to list overseas (eg. LSE) instead. At the end of the 1990s, the SGX slowly transitioned to a disclosure-based regime and the caveat emptor principle, in recognition of this fact.

My digression to a narrative on history is to illustrate the inevitable life-cycle development of capital markets in recognition of the fact that tight hand-holding retards growth (it applies in life as well). As a country/market matures, it is natural that the need for strict rules to protect investors should slowly be loosened. Of course, dishonest behaviour should always be punished, but the balance between market regulation and market development is a bit like that between inflation and growth: both are important, but loosen the screws on one too much and you will squeeze the other, probably to the long-term detriment of both. And vice versa.

I have long maintained that SGX cannot both be a regulator and profit-driven public-listed entity and expect the investing public to believe that it has minority investors' interests as its top priority all the time (see "If I were running the SGX"). However, in this case, I do think there are no compelling reasons for it to step in and take drastic action on behalf of the minority investor.

As noted above, people knew before they entered that Uni-Asia was a game of merry-go-round until the music stopped. So the caveat emptor principle holds. Were there any lapses in disclosure? Not as far as we know. As for the brokers and their "unfair" trading curbs, first of all, it should be pointed out that contra trading is a form of broker credit issued to its clients and they have the right to limit it when they perceive credit risk. As for possible unfair house trader front-running (ie. shorting ahead of the trading curb), I doubt one can dig up evidence of deceitful behaviour though if proven, the culprits should be punished under insider trader rules. But the fact remains that whether or not those guys shorted in advance, the stock would still have collapsed once the trading curb became public information, and I doubt those protestors would have got out in time anyway.

And unfortunately, the likely result of the above public spat is that Uni-Asia will drop further next week as SGX comes into the picture (under public pressure) and the fear starts to spread that the stock might be suspended (like the case of Links-Island several years back). That is probably the only definite consequence of this soap opera.

My Investing Journey: The scandals of 2004

2007-10-01T08:15:00.000-07:00

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The year 2004 was actually a year when the market languished in quiet ferment, when the STI went above 2000 but the small-caps as represented by the SESDAQ slowly stagnated or declined (read "Bull Markets and the Wall of Worry"). This could be explained by several factors: consolidation after strong gains in 2H03, plus the sporadically re-emerging triumvirate of US rate hike fears, rising oil prices and US trade deficits.

Although these external/global factors would serve as the wall of worry that had to be scaled, my view is that the major reason for the quiet 2004 market was domestic: it was a background of fear accentuated by a series of corporate scandals involving hitherto market darlings that disrupted market momentum throughout the year, making people uneasy about committing too much money in the markets for fear that their target could be "the next one".

There were a few. Early in the year, Informatics declared heavy provisions for bad and doubtful debts that wiped out all of its earlier declared profits; CAD investigations initiated in the middle of the year revealed aggressive and dishonest revenue recognition. The company's stock price was hit badly and has never recovered since then despite a series of corporate restructurings and recapitalisation exercises.

Later in the year there were several smaller scandals, such as New Lakeside (which reported shocking losses due to provisions right after listing) and Auston (wich had to make significant restatements to past results). At the same time, there was a shocking number of IPOs whose profits collapsed straight after IPO, for example Azeus, Media Asia, Anwell, which sapped investor confidence in SGX oversight, auditor vigilance and corporate governance.

But the real shocker was to come in October 2004, in what was the biggest corporate failure on the SGX ever. China Aviation Oil, a fund manager favourite, declared a massive US$550M loss sustained through its oil derivatives trading, which set it back into negative equity and imminent collapse. It had hitherto been considered THE premier China-themed stock on the SGX. The recriminations went all the way to Beijing, and eventually a high-level task force led the restructuring of the company.

I remember China stocks were hit hard by CAO then, correcting 10% or more the day after the shock announcement of the massive losses. The wariness towards them persisted through the rest of the year. Indeed, I was rocked enough to guide my own purchases with a focus on corporate governance (quality of directors and their independence) plus management commitment to the company (indicated by strong insider purchases). Only with such stringent selection criteria could I be persuaded to hold on to stocks instead of cash.

Today in end-2007 we are at another extreme of the China stock sentiment spectrum, with the announcement of the QDII (Qualified Domestic Institutional Investor) outward investment policy being likely to encompass so-called S-stocks. It may still be pertinent to recall the lessons of 2004 and exercise healthy cynicism when surveying investment opportunities, whether domestic or foreign.

The financial statement as an analysis framework

2007-08-29T07:41:00.000-07:00

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One is buffetted by so much breaking news every day that if he does not develop a disciplined framework for analysing the impact of those news on the stock market and the sectors/companies within, he will quickly be overwhelmed. Such a framework should be standardised, versatile and intuitive.

The simplest method to parse the qualitative, or even quantitative, effects of new developments, such as the recent sub-prime crisis, is none other than via utilisation of the financial statement as a mental framework. Over the years, I have come to rely on it as the quickest and most intuitive way of thinking about stock price impact.

If one considers fundamentals as being the main rational driver of stock prices over the medium-term, and earnings being a chief source of these fundamentals, then the below diagram, split into two parts, should make sense immediately.

The first part (1) is basically a compression of the P&L (profit & loss) statement to its key components Revenue and Costs. A consideration of the effect of a new development on these two components would yield an idea of its earnings impact.

The second part (2) illustrates how earnings impact translates to share price impact. One has to recognise that Valuation multiple (eg. PE ratio) is what bridges the two. While the valuation provides a potential "price target" so to speak, it is Liquidity, on the other hand, which greases the wheels and determines whether the "potential" can be fulfilled. And so the "fair" market price is determined.

I believe that this is a more comprehensive way of thinking about fundamentals rather than simply earnings as a catch-all, which is what most people often focus on. Consider, for example, the recent sub-prime crisis and its implications on fair market prices.

Walking through the framework, it is possible that for many companies, especially export-oriented ones, revenue might be affected as a result of poorer consumer sentiment contagion from the US across the world (incidentally, I'd discussed this in an article last December "US consumption slowdown"). Cost impact may not be so significant, unless the company has heavy financing costs which might escalate as banks demand higher lending yields (might be offset by lower raw material prices as global demand falls).

The more immediate share price impact, however, relates to the twin factors of valuation and liquidity in the second part of the framework. Fair value multiples tend to contract in the face of uncertainty, which can be seen in the lower PE targets set by brokers nowadays (take a look at their reports the last two weeks). Liquidity was the greatest factor; in fact the credit scare two weeks ago, when no banks wanted to lend to one another, was a reason to sell in itself, because of the terrible implications it portended for global finance and liquidity should the situation persist. Thankfully, the clouds appear to have cleared.

What the framework brings out, therefore, is a methodical approach to look at earnings components (revenues, costs) and also how it bridges across to share prices (via valuation and availability of liquidity). By careful consideration of its implications, one can sometimes also get a better idea of what sectors to buy and which to avoid. For example, in the sub-prime example, the clear sectors to avoid based on revenue consideration would be exporters such as electronics companies, which depend on the US consumer for growth. Also, those companies which supply to US homeowners should also be given a wide berth on basis of retarded future growth, for example furniture companies. Some risk-averse investors might even choose to avoid stocks as an asset class altogether, given that global liquidity might have tightened for the medium-term at least.

Another Sentiment Curve

2007-08-14T16:33:00.000-07:00

DanielXX's intro: I posted a sentiment curve earlier in my blog. Came across this new one which looks more interesting. It's even got a few kinks and also shows the rate of climb (steady) vs the rate of decline (swift) in proportion.

Source: Unknown.

My Investing Journey: Boustead Part 2

2007-08-13T09:08:00.000-07:00

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I have been tempted to sell off my Boustead line several times over the past 2-3 years, on the basis of certain events (director leaving, force majeure in Yogyakarta, Indonesia where Salcon had a project, selling during corrections to go to cash) but whenever I did so, I always have had to buy back at a higher price. So much for market timing; I came to the conclusion that illiquid long-term stocks simply could not be traded in this manner without the risk of high opportunity costs.

What are the characteristics of long-term buy-and-hold stocks? I can point out two from the example of Boustead. Firstly, it should be held by strong hands. By that, I mean that it is not speculative in nature to the extent of attracting the wrong type of crowd who gets alternately euphoric and panicky, thus imparting the same characteristic to the stock price. Warren Buffett, interestingly, also tries to cultivate investors of his Berkshire Hathaway stock along his well-known philosophy of long-term buy-and-hold, refusing to split the stock to enhance trading liquidity (eventually he created a new class of cheaper shares, recognising that some people want to liquidate for their own needs). I have observed that Boustead tends to hold well during market corrections, and this is a sympton of strong holders, many of them institutional. Institutional funds hate price volatility (which they interpret as risk), and hence are drawn to stocks with strong hands. Thus it is that a critical mass of institutional holders is often a drawing point for new funds to come in --- an example of a benign cycle.

But this must be anchored by a long-term vision and competitive strategy --- the second characteristic. Most blue-chips exhibit strategic vision and the means to execute upon it --- which is why they are valued at a premium. Boustead's positioning in the oil & gas, water engineering and niche industrial construction fields turned out to be spot on, as each sector came into market prominence over the last 2-3 years --- first water in 2004-05, then oil and gas in 2005-06, then industrial construction in 2007. Each arm of Boustead successively took over as the main pipeline of engineering contracts, smoothing out and growing the topline and bottomline at a steady pace. At the same time, there was a process of asset value unlocking going on, as the company divested its ownership of industrial facilities at substantial premiums every year.

One of these assets was Easycall, now known as China Education, in which Boustead held a substantial stake. In 2005 the company distributed the majority of this stake to its shareholders as a share dividend. Easycall was worth 10-15 cents then. Today it is trading at >40 cents, and reached as high as 90 cents earlier this year, after Raffles Education came into the picture. Without this share distribution, I would not have taken note of Easycall and accumulated further. This is the serendipity I mentioned in my earlier article, and makes me somewhat superstitious that sometimes, there are stocks that can make you money in one way or another (while conversely, others lose you money no matter how hard you try). And when you find them, it pays to hold tight.

My Investing Journey: Boustead Part 1

2007-07-31T08:01:00.000-07:00

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My general approach these days is skewed towards a typical medium-term holding period of less than a year, because as a stock in my portfolio rises in price an alternative often arises in the overall market with a better value proposition. I have often maintained that Warren Buffett's buy-and-hold approach that he preaches is a consequence of his enormous holdings necessitating such a style in order to limit market impact costs (see "Warren Buffett Platitudes"); however I will admit that I am also, at the core, partial to this approach because of my fundamental inclinations. Boustead would be a prime example of the success of the buy-and-hold method.

I eased into Boustead in mid-2004 and have stayed with at least half of my original position till now. How did I pick it? I never had any intention of making it a long-term buy-and-hold stock then; only Buffett can have the acumen to do that kind of trick. But quite simply, I had noted then that it had risen from 30-odd cents to 80-odd cents over late-2003 before the penny-stock correction in early 2004 cut it down to size by 20-30%, despite a slew of new positive broker coverages --- initiation of analyst coverage was usually a good sign, because it meant increased liquidity and market attention; it was also trading after the correction at a reasonably bargain price of ~12X PE. I was searching for a diversified engineering company then, and Boustead had a good mix of water plus oil and gas engineering which sounded appealing. And so I bought at 60 cents, the start of a long and beautiful relationship.

Most long-term relationships are built on continuous communication and deepened understanding resulting in a positive feedback mechanism; as I said, I never set out to make it a buy-and-hold. I accumulated my initial line, found out more about the company, liked what I read and bought more. Between Sembcorp Industries (my other choice for the diversified engineering company pick) and Boustead, both would have roughly gained the same percentage amount (4X initial investment) by now, but there turned out to be other serendipitious turns of luck that enabled me to derive much more return out of this stock than purely the abovementioned capital gain (to be mentioned in next part).

Boustead today enjoys wide institutional support from several funds and I think a large part of it is due to its impressive management and investor relations efforts. This point was evident to me from the start, and was a strong factor in my continuing to hold over these years. Those in the loop about the company would know about Wong Fong Fui and his reputation as a turnaround specialist, with previous experience in restructuring QAF. I was also impressed as I read his online exchanges with retail investors (an online Q&A session after every results announcement), not just the technical aspects, but also a particular instance where a forummer posed some questions after the forum had already closed the Q&A, but FF Wong actually came back and answered the forummer's questions in detail. Little things like that count for a lot; to me it demonstrated quietly the management's shareholder orientation. FF Wong himself owned a big chunk of the company, around 30%.

Where management and shareholder objectives are aligned and management show a record of looking after shareholders' interests, I reasoned, it fulfilled a critical condition for holding on, just to see what value could be unlocked. Over 2004-07, the topline and bottomline continued to grow, and these obviously further supported my decision to sit tight.

Some tips for part-time investors

2007-07-06T21:24:00.000-07:00

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With the stock market at historical highs and retail investors getting into the groove, I thought I might as well join in the fun. A common question asked by many part-time investors is how to juggle their investments with their office work effectively without jeopardising either. Here're some suggestions, some tried, some theoretical, some partly tongue-in-cheek in the mood of a lazy Saturday morning, so tread with care (and don't blame me if you are caught with the smoking gun!).

1. Get your boss on your side. Get him/her interested in stocks. Many of them already are anyway, so you don't have to try hard. Once their views on the relative benefits/evils of the stock market are aligned with yours, they will be more lenient towards any minor offences of investing/monitoring investments on the job. They may even look to you for stock tips, hence cementing the win-win relationship.

2. Find like-minded colleagues and find strength in a group. Then you can exchange tips on stocks and on new innovative ways to juggle work and investments. Nothing bonds like sex and money, and if you can't have one, try the other.

3. Outsource monitoring operations to family members. Most often it's the wife, if she's not working. Now, not only are you both bonded by coital relations, you're also bonded by monetary interests. One more topic to talk about at the end of the day.

4. Be careful about using your office computer to check stocks. NEVER use it for online trading. Exception is lunchtime where companies are usually amenable to employee usage of PCs for whatever purposes. Note that the computer audit trail goes all the way to the IT department. If usage for stock market-related purposes is interpreted as overt evidence of using office resources, as well as paid time, to do one's own stuff, then it won't look too good. Not unless it's your ah-kong's company.

5. There are three periods in the day when the time belongs to you. Early morning, lunch-time and after-office hours. (For SAF personnel, insert in morning break and tea break for a total of five). Use them well. Early morning -- check out overseas market performances, and more importantly, read the papers to find out latest fundamental developments/trends. Lunchtime -- review mid-day stock prices and decide whether you want to buy/sell. After-office -- check out corporate developments and overall sector/stock performances, in order to decide possible action for next day.

6. Find a mobile device that enables you to monitor stocks. Check with your broker on what stock monitoring services they provide; they usually do. Don't monitor the stocks (using the mobile device) the office. Make full use of your time. Do it in the pantry when you're getting fresh water supply or in the toilet behind closed doors.

7. A good service to use could be Singtel's I-DEAS News/Finance service. You customise a list of stocks beforehand online; then send an info-requesting SMS everytime you want current quotes on these stocks. The service sends back the required information. Very useful except that it sets you back you 20 cents every time.

8. Familiarise yourself with various stop-loss/limit order options. You could place these orders online the night before or the early morning before going off to work, so that you limit any need for monitoring stocks during working hours. Some brokerages also offer SMS alerts if a stock hits a certain price from above or below. If you're chummy with your broker, he/she might also alert you to certain price triggers from time to time.

9. If one needs to place an urgent order and can't wait till lunchtime or end of the day, call the broker to do a broker-assisted trade. It costs more but don't penny-pinch; it's a matter of 0.1% more commission or so, that's all. Keep your reputation intact, don't use the computer.

10. Turn your weakness into a strength. Your job allows you insider knowledge to a particular industry; look around for new potential stocks in the industry that you know are doing well, in your interactions with your boss/colleagues/subordinates/peers/suppliers/customers. Not only does this confer an investment advantage over fund managers who will not have first-hand industry knowledge, it also makes you alert over time to industry developments and gives you a good overview of how various sub-sectors fit together within the industry you're in. Many companies/bosses fail to appreciate this fact and I genuinely believe that street-savvy employees are of more value to any organisation.

At the end of the day, the name of the game when using office time to undertake your market operations is: Be Discreet. Then you'll be alright. Because everybody does it, believe it or not.

PS: But please don't quote Danielxx and this column if you get into hot soup though. Danielxx does not make any guarantee, representation or warranty, express or implied, as to the adequacy, accuracy, completeness, reliability or fairness of any such information and opinion contained in this article and accordingly, neither Danielxx nor any of my affiliates nor my related persons shall not be liable in any manner whatsoever for any consequences (including but not limited to any direct, indirect or consequential losses, loss of profits and damages) of any reliance thereon or usage thereof.

A closer look at P/B valuation

2007-06-27T07:50:00.000-07:00

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The most common stock valuation method is the PE, or price/earnings ratio. But it is often not a useful measure where cyclical companies are concerned. This is unfortunately the case for many companies in Singapore, for example the hot theme of the moment -- property stocks. Often, the best reality check figure in such cases is the price/book ratio (also see "Non-PE stock valuation metrics").

As a reality check figure, when will P/B be considered high? It really depends on the sector of concern (eg. service companies tend to have higher P/Bs because their main assets --- human capital, is not capitalised), and one way is by comparing with sector peers. The next reality check is via comparison with historical mean P/B.

The latter historical comparison is the basis for Citibank's downgrading of Singapore market equities as a group several days back, which has been blamed for the significant market correction these few days. The fact that market P/B ratio was high compared to historical trends was suggested as indicating that Singapore stocks were overvalued. To a certain point this is reasonable, according to the law of reversion to the mean. However, on another level, the intricacies of the "correct" P/B ratio are worth exploring.

P/B ratios, and indeed most valuation ratios in general, have a close relationship with return on equity (ROE), which is basically the profit that can be yielded per unit of book value. One can take it that the "correct" P/B ratio varies directly with ROE of a company. If we use the Dupont model of splitting ROE into its component factors:

ROE = Profit margin X Asset turnover X Leverage

(Asset turnover = Sales/Total Assets)

we can identify the main operational/financing factors that drive ROE of a company, and hence its "correct" P/B ratio. It is not my intention here to suggest that the secular trend for ROE has risen over that of its historical mean; I don't have the statistics to prove that it is so. However, it is important for the individual investor to consider the main driving factors as listed above, and then think for himself whether we still dogmatically follow historical figures as a guide. In particular, one should examine the period over which the "historical mean" was derived (remember that the last few years before 2004 contained the Asian financial crisis followed by several years of recession) and consider whether current trends for profitability might revert to past averages, remembering that economic structure might differ significantly from the past (eg. electronics being no longer as important, new emerging industries driving growth). At the same time, capital structure and balance sheets are generally acknowledged to be less leveraged than before, which suggests there is capacity for improving ROE further by taking on more debt. So firstly, is the "historical P/B mean" derived in a comprehensive manner, and secondly, is it reasonable that reversion to this mean should take place over the medium to long-term? Or does a new paradigm of emerging Asia justify a higher equilibrium P/B that supports future valuations? These are questions that the individual investor should ask himself in response to such macro calls, instead of just following them blindly.

My Investing Journey: Stamford Tyres

2007-06-16T10:46:00.000-07:00

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My episode with Stamford Tyres was, overall, a profitable one. But even when an investment is profitable, the way one handled it may not have been optimal. It was the case for this stock.

I bought Stamford Tyres in July 2003 after it announced a better-than-expected set of full-year results and revealed plans to go into wheel manufacturing, adding a new dimension to its rather staid, though recession-proof, tyre distribution business. By a serendipitous turn of luck, the stock rose immediately after I bought at 80 cents, doubling over my purchase price (split-adjusted; the stock split 5-for-2 during this period) within 9 months, no doubt aided by a bull market in its early stages. I let the profits run.

In June 2004 the company announced a strong set of results but expressed caution about performance for the coming year due to tight tyre supply from principals and setup costs for its new wheel manufacturing plant. The market chose to ignore the results and focused instead on the gloomy company projection: stock price steadily declined post-results announcement. Taking the view that its long-term expansion plans were intact, I held on to everything and waited for the selldown to abate.

The wait took two years. There were no surprises for the FY05 results, it was significantly weaker than FY04 as the company had projected. By FY06, the results recovered to above FY04 levels, as the wheel manufacturing plant came online. But in the meantime, due to lack of newsflow plus lacklustre FY05 results, market enthusiasm over the stock had completely died and trading liquidity had slowed to a whimper; with it the price gradually drifted downwards. The continuing bull market of 2004-06 had completely passed it by. When the recovery in Stamford's operations were confirmed by its strong FY06 results, it was trading at a split-adjusted 25% above my 2003 purchase price. Now that's scant reward for my investor's patience!

I used to scoff at those who exited a stock which was experiencing short-term slowdown but with long-term fundamentals unaffected. But I have come to realise that opportunity costs are the most insidious costs of investment that constitutes significant, albeit invisible, drag on portfolio returns. A non-performing stock locks up funds that can be re-deployed elsewhere to investments that show more probability of short-term return. In the time that one waits for the long-term fundamentals of the long-term hold stock to sink in over the short-term slowdown, one could have turned over the locked-up funds several times into stocks with more obvious short-term catalysts. Of course, this is not always true, and one needs to view different circumstances in their context. But the episode of Stamford Tyres taught me not to default to long-term fundamentals when the stock suffers short-term problems; I had fallen into the value trap, the classic symptom of which was intellectualisation: I continually rationalised the reasons why I should hold on to the stock. The problem, of course, was that these were all long-term reasons.

Another reason that explained why I had difficulty selling the stock early on was due to my comparing the considerably lesser returns I would obtain on the stock if I sold with the earlier 100% gains in late 2003/early 2004 (when the problems hadn't surfaced). This was the problem of anchoring: I had fixed the gains I "should" get to a certain target based on historical experience, and was not willing to settle for less. And of course, the more I dithered, the further the "target" drifted away.

It is not so easy to cut emotions out of the decision-making process. Ideally, one should pick stocks that would not put one in an awkward position of deciding whether to cut loss or not. Given that it is inevitable, I have learnt to view opportunity cost as the greatest enemy of an investor/trader in a bull market; I have also learnt to employ techniques to neutralise the effects of emotions, for example by selling the stock in stages such that the mind becomes more neutral with each successive sale.

For the record, I eventually sold out of Stamford Tyres in July 2006, right after its announcement of its strong FY06 results. I have not regretted the decision; the unlocked capital was put to better use since then. Although the results were good, it was in a business that was recession-proof but would never provide supernormal profit growth nor upward valuation re-rating in a bull market and hence I had to take the two-year wait (for its profit to recover) as sunk cost and move on.

Building An Asset Base Part 4 - On Risk

2007-05-22T07:55:00.000-07:00

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How is one able to build his asset base quickly? I have talked about consumption habits, using compounding, using leverage. But ultimately, the key ingredient to building wealth has to be the ability to take risk and to recognise it.

The key tenet of valuation theory is that expected return of an investment varies directly with its risk, and common sense tells us the same thing: to get great rewards one has to put more bets on the line. What is the point of having a million dollars if one is going to put it in the bank and earn a measly riskless 2-3% annual return? Add the phenomenon of compounding and the mistake of underutilising the value of risk is multiplied over the long-term.

Put another way, it is getting risk to do work for oneself, to get above-market returns. It helps if one is young, because a long investment horizon facilitates higher-risk investments. But my experience is that increased knowledge can somehow dilute risk-taking appetite too. I have talked about this in a previous article ("Is too much knowledge a good thing?"). Risk appetite is a function of many factors including lifestyle and financial constraints, but more often than not it is diluted by over-analysis, a tendency that develops over time as one gains more experience/knowledge. Obviously I am not saying that more knowledge/experience makes one worse, but one has to be aware of how it affects one's decision-making and risk-taking.

Because, think about it this way: why should there be sellers in a stock if it is so good? Buyers seek reward, sellers seek to exit and cut holding risk; the price trades at the margin. If one over-analyses and tries to cut risk out of the investment, he is merely seeking to avoid the uncertainty that is the lifeblood of speculation and potentially massive market revaluation should the uncertainty resolve itself one way or another in the future. There are so many factors in a stock that can affect its price: fundamentals, liquidity, ownership structure, sector rotation, market, technicals, sentiment. One simply has to come to grips with uncertainty and seek not to avoid it, but to embrace and live with it.

One of my friends is an experienced professional in the financial sector and when I asked him in early 2005 what was a good stock to buy, he said "Food Junction". Why, I asked, and he said it was a defensive stock with good solid cashflow through good times and bad. Well true enough it was, but in early 2005 we have just had 1.5 years of recovery from the 2001-03 doldrums and was it risky to gun for more "uncertain" stocks? It was certainly not a time to be defensive, put it that way (of course, some will say I'm operating with 20/20 hindsight). Or how about ST Engineering, that favourite stock of The Capital Group that is universally acknowledged as the ultimate defensive stock in all senses of the word (and one would therefore guess this redeeming quality is priced into the stock as well) that has hardly managed to grow more than 10% per year over the last few years? In a bid to minimise risk and ensure regular dividends, the holder would have sustained tremendous opportunity costs. These are but two of the "safe" stocks that have underperformed the last few years; there are many more.

As indeed, there are many risky stocks that have caused the buyers anguish. That is the other facet of risk management that has to be emphasised: recognising the inherent downside risks in an investment. This is not mutually exclusive with my earlier point on developing an appetite for risk: my point is, one must recognise the potential risks in an investment, but NOT let it paralyse one into inaction or into taking "safe" investments.

Buying on the excitement of potential upside return without recognising the downside risk is seen to be the most common mistake of new investors/traders. For it is a simple mistake to make: psychologically, one will be optimistic about his new buy (otherwise why buy, he asks?), and tends not to subject himself to the self-doubt that might arise from a proper recognition of the inherent risks involved. And yet, not to do so is basically not giving respect for the opinions of the sellers, for why would they sell if not because they were relatively pessimistic (on the average)? Not recognising the risks of the investment also means one will probably have no exit strategy, because if he doesn't have a feel for where potential problems might arise for the business, then he won't be able to monitor these risks and catch them at the bud. The best way of managing such risks is typically to provide a margin of safety in one's investment selections.

The basic idea, after all the gobbledygook, is not only to see the risks for what they are, but also then seek to manage them and not let them manage you. Diversification, for all the offhand dismissals by the gurus, has some place in risk management, but the key is to understand exactly what type of risk one is trying to manage ("The case for diversification"). The other thing is to recognise that opportunity cost is often the most insidious risk that can creep into a non-performing "safe" portfolio; manage that risk by taking risk!

Building An Asset Base Part 3 - On Debt

2007-05-12T06:30:00.000-07:00

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The traditional idea of corporate leverage is viewed with favour --- debt is seen as an additional source of capital that can be applied on top of equity to jack up return on equity. If we extrapolate this view of corporate finance to personal finance, surely it indicates that it is reasonable to borrow money to finance purchase of more investments?

But there is one critical difference. If the limited company becomes insolvent and cannot pay up its debt, the businessman can wind it up with limited impact on his personal assets (if he knew how to guard their ownership); for the individual investor, his personal assets are in the line of fire straightaway, and he could become bankrupt.

For shares investing in particular, what sources of debt capital are there? Many market players employ two avenues of debt financing: contra and margin. The former is essentially very short-term debt (with no interest) and the trader will have to dispose/pay back within 3-5 days since he is unable to pay up; the latter uses shares purchased as collateral and hence one could face margin top-up pressure from the broker should the collateral value drop (ie. share price drops).

To be sure, there is no right or wrong about using such debt financing, because the danger involved is basically a function of the trader's market experience and trading style. When done well, margin trading allows one to pyramid his gains as he buys more on the way up on the strength of his appreciated share collateral, a technique that Jesse Livermore perfected. The danger is part-emotional: such get-rich-quick hopes can seduce the trader to take more financial risk than he can handle; market experience is crucial here in managing such risk. Also, leveraged trades demand a keener awareness of short-term market conditions, and hence suit those with a shorter investment horizon. For those who are more inclined towards the long-term "weighing machine" mechanism of the stock market (ie. fundamentals sink in), like myself, margin debt or even worse, contra, is at odds with their investment style and hence should not be employed.

It always amazes me to read of how hedge funds can employ tremendous leverage to execute their quantitative-based arbitrage trades so that they can squeeze out the maximum gain from what by itself offers very thin profit margins; that's the nature of arbitrage. It is true that the risks associated with arbitrage are small but leverage magnifies these risks several fold. The collapse of Long-Term Capital Management was a classic example of over-exposure to leverage causing the ruination of a group of the world's most brilliant financial wizards.

There are other scenarios where the debt financing issue comes in. There was a recent discussion in an online forum on whether, in the purchase of a $1M property say, it was better to pay up the full $1M cash (assuming one had it) or to keep the cash and instead take up and service a $1M 4% interest home loan, given that the cash could (presumably) be employed to get better investment returns. Perhaps a good way to think about this is that one is effectively borrowing $1M from the bank at 4% interest rate, with the house as collateral, to invest for better returns.

Now, the danger is there, for who can guarantee >4% investment returns all the time? If the market turns down, most likely the stock market prices and the property market prices would be correlated, which means the aggressive borrower-investor sustains a double whammy. But I would argue that the loan structure is preferable to margin loans, for example, for the following reasons: (1)the property collateral allows lower interest rates ie. lower servicing costs, and more importantly, (2) the banks cannot apply pressure on the mortgagee even if the property value goes down (negative equity), so long as he services the loan faithfully. The main issue actually, is that it is not exactly prudent to take such a huge sum as $1M to play the stock market; it may be worth considering paying partially for the property and borrowing the balance from the bank, effectively creating a source of bank-financed property-backed loan to invest at higher returns. As I said, there is no black-and-white.

The long and short of it is that debt is an instrument to compound returns at a faster rate, and hence to build the asset base faster. However, the key thing to remember, as I pointed out earlier, is: don't assume that just because many successful businessmen have done it, hence it is the way to go. There are many more who have suffered the ill effects of it. And the sword being double-edged, it doesn't take long to wipe out the unlucky investor/trader, either.

Building An Asset Base Part 2 - On Compounding

2007-04-12T06:24:00.000-07:00

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The whole idea of building a capital base is to let it compound itself. Over a long period of time, an unimpressive initial sum can compound itself into a great fortune --- Warren Buffett's 25-30% CAGR (compounded annual growth rate) over 40 years has grown his fortune by tens of thousands of times to his current US$40B.

You may also have heard the anecdote about an ancient Indian prince and a wise man who played a game of chess in which the latter won. Asked what he wanted as a reward, the wise man replied that he wanted only one grain of rice, doubled successively for every consecutive square on the chessboard (there were 64). The prince was amused and agreed only to find that he was ruined because if you double a grain of rice 64 times you end up with more rice than there was in all of India.

If the compounding rate is 100%/year, fortunes can be accumulated amazingly fast like in the above example. However clearly nobody achieves that kind of return consistently over an extended period (though I have heard of some who have already doubled their portfolios as of today compared to end-2006 --- a testimony of the 2007 bull market so far). Most academics put an achievable long-term return on the market at about 15%/annum.

There is an approximate rule known as the Rule of 72 used to find the number of years needed to double your money. Divide 72 by the expected percentage annual return, and you get the number of years required. If the annual investment return is about 15%, then 5 years would be needed. How many five years do we have in our life?

It makes sense to hence start early, have a substantial capital base to shorten the compounding process, and to have a prudent and consistent investing process from which one should not try to keep withdrawing from the fund (prudent consumption habits, as highlighted in the preceding article, would help). I also have some additional views on how to best utilise the so-called magic of compounding:

BHAG:
BHAG stands for Big Hairy Audacious Goal. It is an acronym introduced in the popular business/management bestseller Built to Last.

The idea is to set ambitious targets, and I believe this is applicable across all aspects of life, not just business management. It is the best way to keep one on his toes, a form of mental stimulation, so that he never sits on his laurels (or his stocks) and avoids what I have come to realise is one of the worst portfolio performance drags --- an inability to recognise opportunity costs.

Here you target for a high compounding rate to guide your investment/trading decisions. Not too high that it is unrealistic, but not too low as to be easily within reach. It is only through pressure (self-driven or not) that one learns best.

More on this in my writeup "Setting Investment Targets".

Frequency of compounding:
Instead of targeting an annual investment return, why not think in smaller time units? The principle of compounding will be more powerful the smaller the time unit: a monthly return of 2% compounded to one year is 27% ---- 3% higher than an annual return of 24%, for example. Compounded over many years, this difference will magnify.

Put in practice, this means one can make a case for trading at high frequency, to increase the compounding effect. However, in my view, it is predicated on two things: firstly, a favourable market (which I feel constitutes the strongest component of individual stock returns), and secondly, a competitive advantage that the investor possesses (or feels he does), such that he has a (maybe slightly) better chance of making money than the average market player. When these stars are in alignment, one presses the advantage. If not, then relak a bit lah.

More on this in my writeup "The Case for Trading".

Health:
I think it is often forgotten that a key ingredient for the magical compounding effect to work is time. As noted above in the rule of 72, it take 5 years to double your money assuming an annual return of 15%. It then follows that how many 5-years we have in our lifetime determines how much we can accumulate at the end of it (although some might feel it no longer matters at the end of our life ... well the point still stands).

Hence, our health is very important in asset accumulation. It is a long-term investment in itself .... an investment to augment the compounding effect. Poor health affects asset accumulation in three ways:
- You have to withdraw from the piggybank to fund medical expenses, depleting the capital base.
- Poor health compromises decision-making ability and drains the drive to constantly monitor one's investments/find new ideas.
- A shortened life cuts short the compounding effect (although you can teach your offspring how to fish and continue the compounding).

More on this in my writeup "The Importance of Physical Fitness".

The three points above target three different aspects of the compounding effect: the rate of return, the frequency of compounding, and the lifetime over which the compounding takes place. As long as one remembers the compounding principles, it is possible to find many other ways of improving the compounding effect which is the lifeblood of asset accummulation (leverage would be one additional example).

Building An Asset Base Part 1 - On Consumption

2007-04-03T07:52:00.000-07:00

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My last two articles have been rather technical and I apologise for the heavy reading. Here I take a stab at personal finance and discuss an issue that should be interesting for most: the building of an asset base, or more specifically, cash base.

The importance of this cannot be overemphasised for investors/traders. For the majority (like me) not born with a silver spoon in the mouth, we start our market journey with limited amount of capital to buy stocks. (Market knowledge, of course, is the other resource we sorely lack initially, but it is another discussion for another day.) Yet, it should be clear to most that without a critical mass of equity capital, it is either very difficult or very risky (eg. contra, margin) to build wealth in the stock market.

For example, my opinion (read Full Time Investing/Trading Part 1) is that one should only consider doing full-time investing/trading on his own account if he has at least 500k cash + a steady recurring source of income, OR if he has at least a 1M cash base. Obviously, not many have this kind of money in their beginning years of work.

The most natural starting point is to focus on consumption. The reason is that if we consider our personal cashflow from the perspective of a "personal P&L statement", what happens for many people is that their expenses take up a large proportion of their "revenue" (personal income), such that the "net profit", or remaining money available for savings/investment, is limited. In fact, many live on the edge in this way without a reserve fund for rainy days, and investment notwithstanding, they might not even be able to handle any liquidity needs (eg. medical needs) that surface unexpectedly.

Controlling consumption is the critical step in building one's asset base. Every unnecessary dollar spent is a lost opportunity to compound returns (which ironically suggests that the higher the returns a stock investor can achieve, the more frugal he should be).

My take on consumption is that it may be useful to group consumption expenditure along three distinct avenues: necessary consumption, discretionary consumption, and conspicuous consumption. Description as follows:

Necessary consumption:
Whatever is needed for personal, and for your closest (family etc). Food is necessary consumption, and really.... how much food can one eat? Transport perhaps, and the occasional entertainment/social expenses. Whatever is needed to keep the individual sane.
The greatest error people make are in considering certain expenses as necessary expenditure when they are not, for example they think a car is necessary when public transport suffices. Do you need a car to keep you sane? Another great error, in my opinion, is underspending on necessary expenditure for the people closest to them; it is surprising how people can consider splurging on themselves as "necessary" while omitting the most basic expenditure for their parents eg. monthly housekeeping expenses (especially if they stay under one roof). There should be a re-allocation of expenses from the former to the latter, and one will find that the people around you will reciprocate in unexpected ways.
Necessary consumption is pretty much flat expenditure, whether one's income is $2k or $20k. It probably comes up to $500-1000 monthly. It simply cannot be scrimped upon, but its flat nature means if one cuts down on the other two classes of expenditure, the individual can save substantial amounts as his personal income increases (an equivalent concept would be "operating leverage" for companies).

Discretionary consumption:
This is sort of a halfway-house, not really so necessary but yet as we progress in life, we would like to indulge our interests and fashion etc. Hence girls buy their pretty fashion accessories and guys buy their IT gadgets and gamestations. As one grows more affluent, he may feel a car is affordable especially as he needs to travel more often. And he may be able to service mortgages comfortably enough to consider buying a condominium.
There is nothing "bad" about such expenditure, except that it must be viewed in relative terms to the ability of the individual to make timely payments without compromise to his liquidity, and without making a big dent on his asset base. What distinguishes this class of expenditure from the last one (conspicuous consumption) is that I believe discretionary expenditure should serve some intrinsic need (eg. for entertainment, for hobby, for wellness, for social, for family) but NEVER should it be for vanity (not the "beauty" kind, but the "show off" kind of vanity).
The size of discretionary expenditure is probably a function of personal income, but my feel is that no matter how much utility one might derive from the discretionary consumption, annual discretionary expenditure should not exceed 15-20% of one's personal income (remember the necessary consumption needs), nor should it exceed 5% of one's cash base.

Conspicuous consumption:
It is this last one that will kill you. It costs a lot to look good (as defined above). An example of the difference between conspicuous consumption and discretionary consumption would be to choose to buy a BMW 7-series when a Toyota Camry, say, would suffice. The idea of conspicuous consumption is to outdo the Joneses. If one indulges in sucn expenditure, it will be difficult to build any kind of cash base that can be funnelled into the market. Indeed, a side-effect is that the lack of discipline that defines such propensity to consume also is likely to lead to a tendency to try to get-rich-quick on the markets and to attempt to use the markets as an ATM machine to pay for one's expenditure ..... both big no-nos in risk management.
One should only conspicuously consume if he has assets of $10M or above. This is more of a mental anchor rather than through some meticulous calculations of mine. Until then, a siege mentality should be the operational mode, and (current) asset accumulation, rather than dissipation, should be the priority.

If we follow such consumption rules, then as personal income increases over the years, discretionary consumption takes away a fixed proportion (equivalent to "variable costs") while necessary consumption forms a flat sum (equivalent to "fixed costs") but the amount left for investment will increase exponentially. Compound that by typical annual investment returns of 10-15% (some might call this estimate conservative nowadays .... an MP claimed recently that the CPF Board should be able to achieve 10% returns on CPF with little risk), plus extra returns due to improved market knowledge/experience of the investor/trader over the years, and the ascent to a sizeable stake could be quite rapid indeed.

The only equation the share investor will ever need

2007-03-18T19:22:00.000-07:00

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In terms of quantitative stuff, the only equation that the share investor needs to understand is the following, known as the dividend discounting model:

Value of stock is equivalent to price; dividend is usually calculated as the most recent dividend; discount rate is the cost of equity (usually related to interest rate + a risk premium for shares ---> the riskier they are, the higher the premium); dividend growth rate is directly related to earnings growth assuming the company adopts a steady dividend payout policy as a function of earnings.

The idea is based on the fact that the value of a stock is basically the sum of all cashflows (all the way to the distant future), via dividends, to the investor. The further into the future a certain cashflow, the more it must be discounted by the interest rate, to get its present value.

Although the quantitative model is simple enough, it is often easy to forget its qualitative implications. I find it useful to remind myself of the DDM implications once in a while:

(1)The importance of dividends - The value of a share is all about the actual cashflow to the investor, typified by the flow of dividends and their growth. There are differing schools of thought on dividends, with some arguing that if the return potential of corporate growth opportunities exceed that of the individual investor's, profit should be withheld. Yet if the individual investor has doubts in his reinvestment capabilities, he should not be practising active investing in the first place. That two terms in the DDM: the numerator and the dividend growth rate term in the denominator, are related to dividends, surely mean something. As Cuba Gooding Jr. says in Jerry Maguire: "Show me the money!". For further reading, refer to my article on "The attraction of dividends".

(2)The importance of shareholder orientation - The value of a stock lies in the tangible benefits it brings to the investor, in the form of cashflow, rather than reported profits, which is just a figure on paper. It is worth noting how many steps there are from corporate profit trickling down as cash benefit to the investor. First the profit has to be collected from debtors/customers ie. receivables need to be converted to cash. Then management has to decide on cash allocation for investments, working capital, debt repayment etc, to maintain operations integrity. Finally, the residual is available for distribution to shareholders. And management might just want to keep all this cash to themselves! Why so? Perhaps they want to make acquisitions to expand the scale of operations, sometimes for intentions less than noble. Or their parent company may not be in favour of generous dividend payouts, maybe because they want to keep cash assets within the overall group to make balance sheets look good (especially when financial figures are consolidated), or for other reasons (eg. for Isetan, it was for tax considerations). Whatever it is, the chain is only as strong as its weakest link, and if shareholder orientation is weak, profits might not translate to dividends for shareholders at all (those interested can examine the case of Swing Media).

(3)An appreciation for risk - Consider the denominator term. It is the difference between discount rate and corporate growth rate. This means a small change in either means a lot to the stock valuation. Let's focus on the discount rate, which is linked to both the base interest rate and a superimposed equity risk premium (due to the investing risk people perceive of shares). A rise in either raises the discount rate and profoundly affects the "fair price" of the stock adversely. Thus the "fundamentals" of a stock can relate to more than just the business of the company per se --- if one considers valuation of the stock as part of its "fundamentals" (has to be, right?), then a rise in interest rate, or a rise in investor risk aversion towards risky assets ...... all this leads to a decline in fair value. Suppose, for example, that due to increased debtor risk, the banks decide to raise interest rates to factor in increased default risk. At the same time, investors around the world decide that they will be more risk-averse in case a liquidity crunch arises. Sounds familiar, right? The DDM equation, in fact, implicitly takes into account the effects of liquidity as well as investor sentiment/perception within its fold.

Lastly, I have never believed that it is possible to calculate the fair value of a stock based on the DDM equation stated above. Rather, indeed, it is often used instead to reverse-calculate the equity risk premium incorporated into market prices. But the equation itself holds tremendous value in allowing us to understand the qualitative aspects of what lies behind the fair value of a stock. Internalise it and its principles can be applied to many other investment instruments.

On risk

2007-03-03T21:04:00.000-08:00

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With every correction, the issue of risk comes into focus more than the upside potential of a stock. Fundamentally, risk is easy to define: how much we stand to lose if things go wrong. In fact, academically and quantitatively, there is a precise definition: the volatility of returns from the stock. The more volatile the historical returns (eg. +/-20% is definitely volatile) as interpreted from historical stock prices, the greater the "market beta" of the stock and the higher the risk.

Market analysts have always used this measure as a means of characterising the risk of a stock and hence deriving the valuation/target price from there. This is obviously a very convenient quantitative measure because historical market prices are readily available and qualitative measures (eg. business trends) are difficult to quantify for those maths whizzes; however I have always had some major issues with this quantitative description of risk.

Firstly, the way that risk is quantitatively measured. The volatility that characterises risk is measured through the historical stock price trends and fluctuations. Basing on historical price patterns is dodgy because one, it begs the question of how far back the historical data should go, and two and more importantly, it ignores the present and the future projections for the industry/company. I have always felt it more useful if the recent price trends, which tend to be more in touch with present and future fundamental developments, are at least weighted more strongly.

Secondly, is volatility really risk? A highly volatile stock suggests there is high potential downside and high potential upside (from historical trends). Contrast this with credit risk for bonds. Now that is pure downside risk, because if there is no default the investor only gets his interest+principal as specified, nothing more, but in the case of default he might suffer losses. In the equity definition of risk, the investor has as much upside "risk" as downside risk, so is a higher return premium really required for higher volatility? Warren Buffett himself puts it this way: he would accept a lumpy 15% return over a steady 10% return, anyday.

And this brings us to the last point. Is the risk measure of the stock an objective definition that can be applied for every single investor irregardless? Note that I'm not talking about portfolio risk and how investors with different risk profiles choose different portfolios, but rather the individual stock itself. My view is that different investors will see the "risk" of a stock differently, even though there is only one quantitative measure of risk for the stock, commonly measured by its beta. This is because there will be investors who don't mind volatility and therefore will not demand a high return premium, while other more risk averse investors will hate volatility and hence expect disproportionately higher returns. Thus different investors will have different expectations of a stock although there is only one quantitative beta.

What does all this mean? It means that firstly, it is occasionally possible to get good returns on a stock if there is a change in the prospects of an industry or a stock, a turning point, that veers it from a risk profile as suggested by its historical price/return volatility --- which is where superior fundamental analysis and anticipation comes in; secondly, that qualitative interpretation of risk based on industry analysis should be a strong complement to quantitative measures, perhaps even dominate the latter; and thirdly, that what works for other people may not work as well for us ie. seek your own stock picks!

Notes from a casino

2007-02-27T07:54:00.000-08:00

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That casino is not the SGX as you might have anticipated, but a real casino -- Genting. I was there over Chinese New Year and it was crowded with visitors. This writeup is about some observations at the resort, the casino in particular.

It is easy to see how the resort is a cash cow for Genting Berhad. Tourists have always been one of the most easy-spending groups of consumers, and a resort with a casino shows tremendous ability in facilitating the transfer of money. Consider: the tourist who makes the long and winding trip up to Genting Highlands obviously has half his mind set on gambling in its vaunted casinos, and will have brought a sizeable amount of money to last his gambling rounds. Once there, he either loses money at the casinos, or in the rarer case he wins money and then spends it on the resort's various other attractions anyway .... the end result is the same, the money flows through to the resort's topline. The enclosed nature of the resort, the many retail outlets and restaurants and amenities like theme parks and entertainment centres, all serve to draw casino money leakages back into the fold. Several thousand visitors a day, several hundred dollars for each visitor, all ready (and indeed, determined) to be spent .... no wonder it is a good business.

There are differences between gambling and stock market investment/trading. In gambling, the game is set with pre-determined and clear-cut odds while in the stock markets the interpretation of the odds is subjective and depends on one's reading of the situation. In a particular set of definitions, the gambler is one who plays the game despite the odds being against him, while the investor or speculator is one who thinks that his potential returns outweigh the the risks and is therefore willing to bet on it. The difference lies in the odds. Almost everybody knows that gambling odds favour the house. Given that the casino must necessarily win in the long run, what kind of strategy should the gambler adopt?

Ideally, he should not step into the casino at all. But since he IS stepping in, clearly he wants entertainment and to enjoy himself. The strategy should then be to utilise his betting money to last as long as possible, as long as marginal utility from gambling does not turn negative. Which means his money management and bet sizing should be geared towards this. Too big bet sizes and you can be wiped out by a few successive losing bets. Employ the martingale strategy too aggressively (ie. double on successive bets when you lose the current one) and you also get wiped out fast. And of course, if you're no longer enjoying the game (eg. having a losing streak, or been at the table too long) then it's time to disengage since utility from gambling is obviously negative while the odds still remain the same.... you're not going to cut down the odds through slogging on.

Walking around the tables, one can also draw visible parallels with the markets despite the abovestated differences. Each gaming table represents a counter. The players face off against the house, a situation most accurately mirrored in the structured warrants market where the market-maker is effectively the banker. The game and its outcome, whether of roulette, of baccarat, of blackjack, is what the various parties bet on. One can be amazed at how the casino dealers can be so polite to punters who are often gruff and impatient, until one realises that the last laugh is the house's; it effectively draws a commission through every bet a punter makes. The broker draws his income through commissions on every trade; in the casino things are a bit different because, as has been mentioned above, the house has a probabilistic advantage and this is the commission which is exacted on the punter. There is no free lunch in the world.

One cannot expect to beat the house in the long-term. However, if he is lucky enough to come off with winnings, he should thank his lucky stars and consider leaving the table. Too often, I have seen gamblers pile up their chips in a winning streak, and then, greedy for more, lose it all back. The desperate losing gambler tries to win back his stake but ends up losing more, spoiling his entire holiday. Human emotional interplay is most visible at the casino tables, and no less common on the markets.

I spent my time mostly in an enclave within the casino with computerised gaming. The action is no less "live"; there are dealers still rolling the roulette ball, or shaking the dice. However, this is done in a central area within the room while surrounding them are the computerised betting machines where gamblers can enter their bets directly on the touch-screen. The experience is altogether much more healthy (no smoke in your face), faster (dealer does not need to undertake token-changing, table administration etc; all handled via the computerised betting system), and easier to get seats compared to the main table gambling areas. Forthe casinos, it is probably more space-efficient, and also time-efficient (more gaming rounds within a period of time). I believe this is the way casinos should go in the future .... although they probably won't, because the less tech-savvy older generation still prefer the person-to-person contact.

It was refreshing to spend the New Year there. Unfortunately, after a post-CNY market surge, market sentiment has now taken a sudden downturn with two huge falls these two days. With the above observations from the casino listed above, it may be prudent to take some winnings off the table if you have done well. True, the odds may not be so obviously rigged in the house's favour in the stock market, but consider it as paying for a more objective view of the market by going partially short on it (when you sell, you are effectively short, whether you currently hold the stock or not). An objective view squares the apparent odds more clearly in your overall sizing of the situation.

On starting young

2007-02-03T01:10:00.000-08:00

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The current bull market has probably sucked in thousands of new investors, attracted by the lure of quick and easy money. I am particularly struck by anecdotal evidence of many university graduates playing the markets; there are also investors' clubs being set up at these local universities and run enthusiastically by students who dream of making it on the markets. The Business Times has even created a new section called BT Young Investors Forum or something like that. The most famous example, of course, is from the last bull run in 1999-2000, when a certain actress still in university dabbled in the markets and ultimately lost heavily on contra in a certain stock (rumoured to be Chartered Semicon).

Financial literacy is always something that is worth acquiring as early as possible and it is good that such awareness is slowly seeping into our educational system. There is also the much-talked-about "magic of compounding" which suggests that the younger one starts, the better. However, this is not the main thrust of my views here, which are more inclined in the opposition camp. The discussion below is centred mainly on tertiary students dabbling in the stock markets.

It is actually quite difficult to articulate my opposition to these newbies investing young; everybody has to start somewhere, obviously. It is more of an instinctive feel that it is not the right time. My impression of these emerging investors is a group eager to make money and not miss out, striving to get a headstart over their peers in the world of investing and being very enthusiastic in the pursuit of stocks.

All neutral to positive traits; there is nothing wrong about these characteristics. Yet to me, at the age of 21 (or thereabouts), it is very easy for these impressionistic young chaps to get obsessed over the stock market, especially when they start making money in the markets. The way trading is facilitated nowadays, via online systems, forms an uncanny and disturbing comparison to the MMORPGs (Massively Multiplayer Online Role-Playing Games) that we see teenagers playing wide-eyed in LAN arcades nowadays. I myself find my eyes drawn to the real-time price quotes flashing relentlessly on a trading day. I am not sure that at a time when these young students should be acquiring a diverse set of real-world skills, that developing instead an affinity to the stock market is a good idea. The opportunity costs are tremendous, if one accepts that their market interest can crowd out time for academic learning and structured development of their thought processes. Academic pursuit is not everything; however it puts a finishing touch to the formative intellectual process of a young thinking adult. It would be terrible if an obsession with money is developed so early. That is my view.

Incidentally, I would make a distinction between young entrepreneurship and starting young in the markets. They are not the same. The former would entail a fair degree of effort to set up, not to mention succeed, and this develops a healthy appreciation for the value of hard work and in understanding the ins and outs of business dynamics, positioning, administrative work etc. As I've mentioned, the addictiveness of market trading/investing in contrast could subtract more from the budding undergraduate investor than it adds in value to his "real-world savvy". There is a time for everything, and it is not too late to start investing when one starts working.

Venturing into the stock markets while still studying has one other problems: lack of money. By lack of money, I mean that these students would most likely to playing with other people's money (OPM), since they are obviously not earning it themselves. These "other people" would most likely be their parents. For those who have traded/invested for some time, you would know how different it is when your own money is involved, as opposed to OPM. I have written something on managing OPM, where I opined that a lack of ownership is possibly the greatest problem. Knowing your own money is at risk when you enter a trade generates a different level of intensity and involvement in your decision-making process, which you will never experience if downside is completely protected. That is why I believe virtual trading is a complete waste of time. And the same goes for arrangements where the sponsor lets his young investor get all the profits without having to absorb any losses. That is the typical arrangement for these budding young investors of course.

Given that the opportunity costs of focusing too early on the stock markets can be high while the development of a healthy investing mindset and decision-making process is hampered by the fact that the money is not one's own (unless the capital was earned by the young investor himself), I think a better time to start is when one starts working. The learning process can be more efficient then, because one can instantly relate investing and business fundamentals to his job, which stimulates further insights into both areas. For example, if one is a marine engineer, he will be familiar with the shipbuilding and offshore industry and will feel more confident in making his stockpicks in this area, aided by an understanding of the business and hence a sound basis for investing. At the same time, he accumulates further insights about the industry while doing research for and monitoring the marine stocks he has shortlisted and/or invested in, which facilitates greater overall understanding of his job. This is a positive feedback mechanism, a very powerful iterative process which reinforces understanding both ways. And when one attains a good understanding of an industry, he can apply his understanding of industry dynamics laterally to other industries. Work experience is crucial to building one's investing worldview. While Peter Lynch selects consumer stocks by going to the mall and watching buyer patterns, in Singapore where industrial stocks prevail, nothing beats experience on the job.

My Investing Journey: Bull Markets and the Wall of Worry

2007-02-01T07:39:00.000-08:00

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Today we look at the STI at above 3100 and the SESDAQ at above 180, and we wonder: is the end looming near? There are many who worry about this every time the market drops a few percentage points, and quite a number among this many who have actually taken action on this worry ie. liquidated their holdings. There are others among this many who cannot sleep at night, as evidenced by the late-night postings at 3am or 4am on some of the online forums.

Without attempting to influence opinion either way, I think back to late 2003-early 2004 when I was struck with the same worry about how long the "great market" would last. From the pits of market sentiment in mid-2003 when SARS gripped the country, and sometimes even our omnipotent government, in fear and helplessness, a stealth bull had risen from the ashes and lifted the tide until fear turned to hope and then hope turned to excitement. From 1300 points in mid-2003, the STI was up to 1750 by October 2003 and the SESDAQ went above 120, from about 50 just four months earlier. The holding period percentage gain makes today's mature bull market pale in comparison.

In those days, technology stocks were the hot stocks. Cyclical and volatile, they are the first to boom in a recovery when capacity utilisation suddenly shoots up. The picks were Huan Hsin, Seksun, Amtek, Meiban, Allied, Surface Mount --- all suppliers to the electronics industry. Several of these had doubled within several months. As I looked at the newspapers every morning, I wondered how long the bull would last.

This is human nature. When something trends strongly and we benefit from it, we will wonder how long our good fortune will last. I was making good money in late 2003. It is the rational part of our soul begging to be heard; it is also our vanity telling us not to behave like those mindless masses who are bidding everything to the moon. Get a grip on yourself, the good times won't last! I am sure many others were also struck by this kind of thoughts, even those aunties and uncles who were beginning to talk about stocks again. After all, it was not even five years from the last crash, and memories were still fresh.

Anyway, I was then reluctant to leave the market because surely three years of bear had not positioned us for only a half-year of bull? Besides, my hand was strong; I never played margin (and probably never will) and so be it if the market decided it was going to be another sucker's rally. In short, I was damn gung-ho, even though market sentiment was obviously peakish (read my writeup on Allied Technologies: a good gauge of peakish market sentiment is that it can choose to interpret corporate developments in a totally irrational manner). Another thing that I recollect is scanning through the Shares Investment publication in January 2004 and finding few single-digit PE stocks even among the "Lowest PE" section, less than 30 I think, which is really low compared to the total number of stocks then on the market (about 600-odd I think). In short, sentiment-wise and valuation-wise, there were grounds for exiting the market to protect oneself. There was a perfectly valid wall of worry there.

Just for the record, the bull did fall off from that wall. The STI sort of stagnated in 2004 but the rot in the smaller-cap stocks, encapsulated by the SESDAQ index, set in as early as November 2003 and dropped steadily to below 90 by mid-to-late 2004 (there were also market dampeners such as corporate scandals and China applying administrative controls which added to the gloom). So, if one looks at the glass of water and chooses to see it from the half-empty perspective, he would have found incriminating evidence in the above intermediate market correction to prove his point that reading the tea leaves would have helped one to exit the market in October 2003 and hence capture all the gains and none of the subsequent anguish.

And yet, an ex-post (after the event) view is obviously hindsight trading (a new term I learnt on an online forum). What has borne out in the years since 2004 has proven that the long-term fundamental view was intact, manifesting itself in a broad-based, structural bull market that overcame the initial hiccup (which was what the early-2004 market downturn turned out to be) to drive on through 2005 and 2006. Suppose that the hiccup had happened only much later, say in early 2006: the market timer who'd exited in October 2003 would have missed out on a large portion of the secular bull market. That is the opportunity cost risk that cannot be avoided. Another issue, of course, is that of sector rotation. The tech stocks were the market leaders in the first segment of the bull market, pricing themselves to excess by late-2003; but as they fell in 2004, new sectors came to prominence, most notably the shipping (exemplified by NOL) and commodities sectors (exemplified by Noble and SPC); so rather than thinking of the market as a single bull scaling a wall of worry, one may instead imagine it as a horde of bulls that are successively stopped by obstacles along various parts of the course. The alternative, more sanguine market timer's task would then be to analyse which is the next bull to ride on when the current one gets stopped in its tracks, rather than choose to exit the bull race altogether.

And of course, it is quite likely that after making such a case for a long-term bull market scaling a wall of worry as described above, the market might just collapse tomorrow. :-)

How Many Stocks Should One Hold?

2007-01-17T15:22:00.000-08:00

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Assuming that the investor is purely equity-focused in his approach, one of the key questions he should ask constantly is: what should be the optimal number of stocks in his portfolio?

This will obviously be a function of the monetary size of the portfolio, the number of investment ideas he has, and his belief and need for diversification. For portfolio size, anything below $50K may not justify diversification, if we consider that a meaningful position should be at least $10K. 5 stocks --- that will be the maximum one should have in his portfolio for that amount. But for higher portfolio sizes, it may then be relevant to start thinking about whether to have many or few stocks in one's portfolio. The number of investment ideas is also a factor, because if one has ten different investment ideas (hot sectors, or stocks) which he considers to be equally good, then the option of investing in all these ten ideas then surfaces; that is what Peter Lynch does (he held thousands of stocks in his Fidelity portfolio); however a more "discerning" investor may only consider a very limited pool of stocks/ideas to be top-of-the-line, and hence his core holdings are much lesser in number (eg. Warren Buffett).

With regard to diversification, it is easy to dismiss it but the logical arguments for it are quite compelling. Those interested can read an earlier writeup on "The case for diversification". The point is that one must know what one is trying to diversify against: market risk, sector-specific risk or company-specific risk? Those arguing for focused stock holdings point out that diversification dilutes returns and is practised by those with little confidence/domain knowledge in their stockpicks; that is borne out by experience apparently. However if we consider the figures below:

The top graph shows a portfolio with two stocks A and B perfectly correlated with each other ie. their returns at any time over the market cycle are directly related to each other; this could be seen as a focused portfolio with one stock (because A and B are perfectly correlated). The bottom graph is a portfolio where A and B are inversely correlated and therefore offer diversification. The diversification is achieved here because although both portfolios have the same average return, the bottom portfolio eliminates all the variability in the returns. Focused portfolio believers argue that they can achieve better returns because by cashing out at point X on the upper graph, they can achieve double the return. What they ignore is that a diversified portfolio also enables them to achieve a similar performance --- by cashing out at two points: X1 for stock B and X2 for stock A. True, good timing is required for this, but isn't timing required for getting out at point X in the earlier focused portfolio as well?

The limiting factor is really the ability of the individual investor to monitor the various fundamental developments for his stock portfolio. Supposing one has 30 stocks, how is he going to monitor the company and industry developments effectively? The issue here is really one of dilution of attention focus, not of returns.

Personally, I structure my portfolio by sectors into which I populate with stockpicks. Imposing structure on the portfolio is a useful way of allocating resources, much in the way that a company splits into different business/functional divisions ("Your stock portfolio is your company"). Therefore I only need to monitor in detail the few sectors that I invest in, as a proxy to the various stocks in the sector group. The stocks that populate a particular sector/theme are then chosen on certain attributes, such as valuation, a coveted position in the value chain of the chosen sector etc. A few stockpicks within one sector/theme enables company-specific diversification in case one of the companies (touch wood!) suffers a negative corporate development eg. an unexpected receivables writeoff. It also enables corroboration of market outlook on the particular sector through cross-comparisons of price trends of one's various portfolio stockpicks in the particular sector/theme (eg. if one holds Hiap Seng and Rotary in his portfolio on the oil/gas infrastructure theme, the price strength in both stocks will help to corroborate each other's price trends, and the optimism surrounding the sector in general).

That, in essence, is quite similar to how unit trusts structure their portfolio, admittedly. The key point is that structure is important. The difference is in how many stocks we can manage in our portfolio. Again from personal experience, 3-4 sectors/themes are a good rule-of-thumb, and within each sector/theme, about 3-4 stocks would give good exposure and diversification without overly putting pressure on the individual investor's attention focus. Thus a good portfolio, in my view, should consist of anything from 10-15 stocks. By limiting oneself to a certain numerical limit of stocks in his portfolio, it also forces the investor to look and think deeper about potential stockpicks instead of buying on impulse, any stock that comes into market focus on a particular day.

2006 - A Recap of an Extraordinary Year on the SGX

2006-12-29T19:49:00.000-08:00

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The headlines scream bull market. The feel-good factor is truly in the air, as the effects of a strong economy start to filter down to the masses even as the segmentation of Singaporeans into two distinct tiers --- the rich becoming richer, the poor becoming somehow caught in a poverty trap that is exacerbated by the entry of competitively-priced foreign labour supply --- forces a re-consideration of the social welfare system, or rather the lack of it. The stock market is what we're concerned with, and is what I describe chronologically, in broad brushes, of an extraordinary year on the SGX.

1Q06
The year started cautiously as 2005 had ended on a weak note. By the end of the quarter, the bull market was in full bloom. And the stars of the bull were clear: China stocks.

It started with fundamentals, and ended on froth. Initially stocks with strong newsflow eg. Celestial, Fung Choi, were bid up, then followed stocks based on the China domestic consumption theme eg. China Hongxing, Beauty China, Hongguo, and then spread rapidly to new IPOs like China Fishery, Luzhou Biochem, China Milk, and at the close of the quarter, inferiors/laggards eg. Zhongguo Jilong, China Infrastructure, China Great Land. 20-30% gain in one day for these stocks in play, culminating in multi-baggers within one month, were common. It was scary for investors and exhilarating for traders. See my Hotstocksnot writeup on China stocks for a full description of the evolution cycle.

2Q06
It continued from where 1Q06 ended, and ended at where 1Q06 started. The great event that will surely leave its marks on some unfortunate market players who burnt their fingers would be the huge correction in May.

There were some noteworthy news events in this quarter. The general election was held on May 6. It is interesting to note that the market peaked and collapsed soon after, giving some credence to the view that there was market support before the election. But probably the greater factor was the coupling effect with the global market corrections, such as the India Sensex which collapsed several thousand points. The STI started the year at ~2300 points; it ended 2Q06 at around the same level. Investors and traders were panicking and selling out as they interpreted it as the end of the multi-year bull market that had commenced in mid-2003.

2Q06 also saw the award of the Marina IR licence to Las Vegas Sands which did not arouse great market interest (the punting will be in the Sentosa IR later on) and the World Cup, which sucked away further market interest.

3Q06
The market crash did not materialise, and the market consolidated and started to rise again. By the end of the quarter, the market was back in the groove.

The focus had moved from the China theme, so dominant in early-2006, to a variety that moved into focus at different times, such as technology, oil and gas, shipbuilding, oil and gas, plastics recovery, property. But caution was in the air, and there was a move towards quality, as reflected in the STI which moved relentlessly upwards with little correction, if you look at a chart of the STI from Jun06 onwards.

4Q06
One theme established itself strongly in this quarter, and that was domestic reflation with the accompanying beneficiaries of the property, construction and banking sectors.

If one follows the economic cycle, consumption typically lags the cycle, but the wealth effect will eventually manifest itself as liquidity and sentiment climb. Talk is now of rising psfs being traded, of rising office rents amid tight supply, of a new paradigm for Singapore properties amid the impending IRs. Genting, the winner of the Sentosa IR licence, was bid up to the skies, along with most property stocks. Banks, provider of all the liquidity for mass consumption, were revalued upwards. Construction-related stocks came into focus as 2006 drew to a close.

We start 2007 probably with the STI above 3000, if the opening is favourable. The STI is up 25-30% for the year, with the SESDAQ up 50% or so. There are people who report having doubled or tripled their portfolio value. Market sentiment is high as long-dormant retail players look to move back in with their bonus money, together with those unfortunate players who cashed out too early in anticipation of a bear that never came, and are now looking to re-position themselves back into equities.

Overall
2006 was probably the first full year where there were no real market scandals. CAO in 2004, then ACCS and Citiraya in 2005, sapped market confidence and made investors/traders cautious. There were the odd earnings shock eg. Biotreat, but no real frauds that shook the market. The bull markets around the world scaled a wall of worry, but found at every point that things were not as bad as they thought, and so they continued climbing. 2006 was originally thought to be a year for the stock-pickers ie. it would not be easy unless you were a really good stock-picker; at the same time high oil prices were thought to be a huge market-braking factor; eventually the markets have survived and the oil companies/prices and the global economy are still relatively strong.

2007 will be considerably more challenging simply because people's expectations of the stock market have been raised, such that 20% annual return will be considered a failure. Under this kind of circumstances, there is great potential for the greater-fool theory to manifest itself as people keep bidding prices higher in anticipation of other people coming in to take over their line of stock; the challenge will be to exit at the high.

The beauty of simplicity

2006-12-22T06:46:00.000-08:00

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In investing, as in life, I believe that simple things are the best.

Perhaps it is due to my training as an engineer. The phenomena of nature are diverse and complex, but the beauty of science lies in systematically categorising these phenomena and building simple models to explain the system behaviour, whether it is the flow of air over an aerofoil, or how heat spreads from a point source, or how spring-damper-mass systems can be used to model the dynamics of a wide variety of mechanical systems. Or how about the concept behind the I-Ching, the oldest of the Chinese classics --- that simplicity is the root of the substance, that fundamentals govern complexity.

Below are three instances in investing where I feel simplicity rocks.

Firstly, in stock selection, I always go for the stocks where it is easy to see how the business operates, what its competitive strengths are, what the key risks are as well as where growth is likely to come from. It should preferably be backed by a theme, or a "story" that will excite investors. Ok it is a cliche because Peter Lynch has said a similar thing in a different way: that if you can't summarise the reasons you should buy a stock in one or two sentences, then it is not worth buying. But hey, it's true. Not for me the complex investment undertakings of Ipco, or the circuitous financing arrangements of Unifiber in its attempted Kiani Kertas acquisition, or even recovery stocks like Yongnam where the theme (construction recovery) can be obscured by a dubious set of financials that complicate any growth story. In short, the search for simplicity often leads me to well-financed companies which are typically market leaders in the niche/sector that I target. The monitoring part post-purchase is also easier, because one just monitors the "story" to make sure that it doesn't turn sour. The more complex the "story", the more monitoring effort one has to expend and the greater the risk that he will get things wrong.

Secondly, given the myriad of events and breaking news that pervade our senses every day, it is necessary to find a structure to the chaos. It is often simpler to understand the spirit behind the corporate moves or new government regulations or whatever --- that is the crux of the issue. It is more important to read the intentions and general shareholder orientation of a company's directors/management from their various corporate moves (a good example would be the Lim Seck Yeow-linked companies) with which further corporate developments can be corroborated. It is more important to understand the spirit behind a government's regulations in the long-term than to keep track constantly of new rules (eg. China's new medium-term goal of "sustainable development" under Hu Jintao is giving rise to reform in the healthcare sector, its push for energy security, and its development of inland regions). Without simplifying things and developing a coherent world-view, it is very easy to be overwhelmed if one attempts to keep track of everyday news.

Thirdly, my search for simplicity leads me to eschew quantitativeness in favour of qualitativeness. Quantitative strategies are necessarily complex --- they involve things like arbitrage where one typically plays off one investment instrument against another related instrument (eg. mother stock and warrant) in the hope that their divergent prices will converge. Or some might buy a stock about to undergo merger to capture the small difference in current price and acquisition price --- known as risk arbitrage. These quantitative strategies can work but are typically practised by professionals using leverage and advanced quantitative modelling tools. So I'd prefer to assume that the market is generally efficient on such pricing (ie. it has smoothed out any big potential gains from quantitative-based trades) and instead focus on qualitative aspects like figuring out a business's medium to long-term prospects. The historical and forward financial metrics can be worked out and projected in a straightforward way mathematically, nothing complicated, because the difficult part is in understanding the business dynamics. Here, therefore, I practise quantitative simplicity.

To end, a quote from Albert Einstein: "Everything should be made as simple as possible, but not one bit simpler."

The importance of sector bets

2006-12-08T21:51:00.000-08:00

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Bottom-up investors advocate starting the stock selection by analysing the financials of companies, and to concentrate your firepower on a few good picks. There is nothing wrong with that logic per se, and yet without the advantage of control of the company, the minority shareholder will always wonder whether he is having the raw end of the deal. Since there is a buyer (the individual), there must be a seller at the other end of the deal. What if the counterpart is the proverbial big boy or the company insider who knows more than you? That is always something that niggles at the end of the mind, and it is not seldom that we could buy and sell at the worst moments.

Diversification is not a dirty word. I have written on the case for diversification in an earlier article; the gist of the article was that you must know what you're trying to diversify. If you're bullish on the particular country's market in general, you diversify away sector and company risk by buying an index fund, for example. If you're bullish on the sector rather than the undervaluation of a particular company within that sector, it makes sense to diversify company risk by buying several companies within that sector. If it's the other way, then you concentrate your firepower and don't diversify. Those were my main points.

Today, I was examining the index trends for the Singapore market and the various sectors that I track on my Hotstocksnot blog. It has been a scintillating half-year and I am sure many have made a lot of money (I believe there's going to be an article tomorrow on some 30-year old Singaporean guy who has $200k in stocks). Also glaring at me from the figures was the fact that one could have made a lot of money by simply playing the hot sectors without painstaking company analysis. Take a look at the performance figures using 9 June (when I started tracking my personal sector indices) as the base:

Performance of various indices since 9 Jun 2006
Index Last value Change % Change
STI 2865.14 527.70 (22.6%)
SESDAQ 132.73 41.49 (45.5%)
SGX Finance Index 2126.11 388.95 (22.4%)
SGX Property Index 1138.73 350.59 (44.5%)
SGX Hotels/Rest Index 948.79 152.60* (19.2%)*
SGX Construction Index 423.71 140.91 (49.8%)
Plastics Index 94.22 -5.78 (-5.8%)
Env/Water Index 108.28 8.28 (8.3%)
Energy Index 125.27 25.27 (25.3%)
China Index 133.65 33.65 (33.7%)

* The Hotels/Restaurants index performance was adjusted due to certain aberrations in the index on 5 Oct; I believe it was due to removal of some key components that were not appropriately adjusted in the index. Presented above are my adjusted performance figures.

(Note: The SGX Finance, Property, Hotels/Restaurants and Construction indices are incumbent indices produced by SGX).

The point from an assessment of these figures is that if one had picked the right sectors, he need not have spent too much effort to achieve quite a phenomenal return. If he had picked property, construction and even China-themed stocks and diversified extensively within the chosen sectors, he'd have grown his assets by a magnificent 30-50% within half a year. He won't have done too shabbily in energy or finance either (~20%). On the other hand, if he'd chosen the plastics sector on the basis of bottom-picking the sector, the returns would have been totally unsatisfactory.

Hence my point that it may be possible to take the middle road (sector, and not market(top-down) or company (bottom-up)) and take appropriate diversification action to hedge away all non-related, specific risks. A sector, if I may argue, is easier to monitor than a company because various information sources (TV, newspapers, Internet) now offer us tremendous access to industry developments, if we care to look. Companies per se firstly can be quite opaque, and secondly might not react in the expected manner to a certain sector development (eg. a tyre distributor might be impacted adversely rather than benignly by tyre shortages because their allocations might be reduced). The fact that risks are diversified in a sector bet is obvious; however the evidence that performance can still be stellar should not be understated.

To be sure, even if one had chosen to put his money on the broad market, he would still have been able to do extremely well --- >20% for the blue-chip STI, and >40% if he took the position on small-caps (represented by SESDAQ) as a diversified market bet. If anybody can claim himself as a bottom-up investor and have much better performance figures than these indices thus proving that the bottom-up company analysis/concentrated bets approach is better, please feel free to comment.

Zodiac-based stock picking

2006-11-29T17:48:00.000-08:00

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I seldom recommend stocks down here in my blogs but I was inspired by a report in the Straits Times Money section today which cites studies claiming the effects of the lunar calendar as well as the Chinese zodiac on stock returns. For the latter, the recommendations reported were highly inadequate, given that it only says that "it is the year of the Dog, hence the underdog China stocks have had a bull run". So below, here're my stock picks for the twelve years of the Chinese zodiac calendar, to enable the discerning and astute market investor to practise market timing in a systematic and intelligent manner.

Year of the Rat
Given the the rat sparked the Black Death several centuries ago, and how people hate the colour black when it is associated with the stock market (such as "Black Friday" last week when in fact it was meant to signal the start of the US Thanksgiving season which propels retailers' bottomlines into the black), it is a year to avoid stocks.
However, for those really addicted, you may want to buy stocks which have a history of rodent-like behaviour, such as mDR (a.k.a. ACCS) and Centillion (a.k.a. Citiraya) and China Aviation Oil (a.k.a. US$550M).

Year of the Cow
The premier stock in this year must be China Milk. Cows love bull semen. Well, other milk stocks are also investible, such as China Dairy. Leather-related stocks like HTL and Man Wah could also benefit.
Also, to try another flavour, why not buy stocks from the Land of the Holy Cow, which incidentally only number the total of one on the SGX --- Meghmani. Never mind, since it removes the need for diversification.

Year of the Tiger
There can only be one Asia Tiger.
For the prudent investor, he can unlock intrinsic value in Haw Par which boasts the Tiger Balm Oil.

Year of the Rabbit
There can only be one China Kangda, which slaughters the white furry creature and packages it as exotic delicacies for the very cultured mainland Chinese.

Year of the Dragon
It is time for the China stocks to roar. By now, if you notice, the previous three Zodiac years have all involved China stocks. This explains why China stocks are the most investible category in the entire stock universe, according to the Chinese zodiac.
Although it is not listed on the SGX, investors should make an effort to open an account on the Hong Kong Exchange so that they can buy Nine Dragons Paper, the bluest of the blue in this red-hot Dragon year (for those less acquainted with Chinese culture, the number 9 is the ultimate in Chinese culture. The Chinese emperor had 999 rooms in his palace to house his concubines). Well, to pick on the "9" theme, more homely investors can choose Jiutian Chemical which means Nine Days in Chinese.

Year of the Snake
This is a bit difficult. It is a year for the really good stock picker. The Chinese Zodiac investment advisor, who is usually very good and accurate with his picks, cannot help here.
Ok, but for those who are desperate, understand that snakes are highly territorial creatures, and they guard their property jealously. Hence, property stocks are the pick of the bunch. Also, given their oft-quoted comparison with the reptilian creature, banks might be a good pick as well.

Year of the Horse
What else? The prime pick must be Interra, otherwise known as the Wonder Horse in its previous life as Van der Horst. I have plenty of research on this wonderful stock, in my Hotstocks pick on Interra.

Year of the Sheep
Time to go for all the penny stocks below 5 cents. This is the year when the Sheep can be easily led to whatever destination one wants to take it, similar to the way lemmings follow one another to their final noble destination.

Year of the Monkey
The Monkey is known for its mischief, and its ability to swing up and down trees. Expect a year of great volatility.
What thrives in volatile conditions? By the Black-Scholes option pricing model, it is options and warrants (this intricate understanding of academic theory shows Zodiac investment advisors are not to be trifled with).

Year of the Rooster
The obvious pick would be the pure-play Elite KSB, which slaughters chickens for a living. For those looking for dividend plays and stocks of slightly better quality, there's always Cerebos with its Brand's chicken essence. And wait, there's a new player on the chicken essence scene: Eu Yan Sang ..... and the good thing is, its chicken essence does not contain caramel! What a revolutionary concoction!
Panning out to the top-down perspective, the Zodiac outlook for the year also suggests that asset allocation strategy should shift to cash early in the year, because the rooster crows once at dawn and then remains silent for the rest of the day. A suggested manner of handling the cash is to head down to Geylang Lorong XX where there are plenty of young chicks around.

Year of the Dog
That's the current year we're in, and whatever the Straits Times reported in its article this morning, it must be true, hence I shall not elaborate further here.

Year of the Pig
There's no shortage of stock picks here. We have two pork processors from China, People's Food and United Food, to choose from.
Although, come to think of it, are these stocks that slaughter the relevant Zodiac animal stocks to be avoided, rather than picked? Frankly, that depends on how the Zodiac God dispenses his/her judgment. That is another story for another day --- the influence of astrology on the stock market is such a vast subject that we will all be glad for the national papers to cover it in more detail in the future.

My Investing Journey: United Food Circa 2003

2006-11-26T06:03:00.000-08:00

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Over the years I must have been involved in dozens of stocks. I had talked about one that was obviously speculated to the heavens (Allied Technologies: Part 1 and Part 2) earlier. Let's look at another one that looked like it had solid fundamentals ..... even up till today, there are die-hard supporters of this stock.

If one looked at the financials and valuation of United Food in 2003, he would understand why it was highly regarded by so many fundamental investors. That included Curtis Montgomery, otherwise known as the Wallstraits Sage, who recommended it strongly on his Wallstraits forum. Listed in 2001, the China-based pork processor had enjoyed compounded annual profit growth rate of >40% the previous three years pre-listing, and had continued to grow profits post-listing by annual rates of 20-40% up till FY02. Its balance sheet looked fabulous, with zero gearing and lots of cash. The cashflow statement showed attractive free cashflow. The prospects looked great; you can't go wrong with a potential market one billion strong, and growing. Warren Buffett would have liked this stock.

In mid-2003, in the wake of the SARS crisis, United Food was trading in the mid-30s. This meant its trailing PE, based on FY02 results, was 4X. 4X! Price to NTA was 1.1X. 1.1X! Frankly, if you ask me today again, I would have done the same thing and bought it in a rush. The contextual background behind the stock market valuation in mid-2003 was that there were lingering concerns of SARS afflicting the pig business in China structurally, as well as that three-year bear market that had worn down even the sturdiest of bulls. Nobody knew that the tide was about to turn. Of course, that sealed the fate of the bear.

I bought United Food at 35 cents. Over the next three months it shot up ~60-70% to above 60 cents. But of course, I guess everything else did. In August, feeling encouraged, I doubled up at 61 cents. The purpose of this article is not to illustrate what a great buy United Food was for me, but rather, what a great sell it was.

I sold out everything in mid-September 2003, reversing my recent buy just two weeks earlier. And it was on a very simple premise. It was because the main shareholder inexplicably sold out in early September 2003. There are shareholder sales and there are shareholder sales. Chairman and CEO David Yip, just shortly after my second purchase of United Food, placed out 100 million shares of United Food, amounting to 9% of total shares outstanding, to an unnamed buyer which later turned out to be Value Partners, a relatively well-known Hong Kong investment fund.

When a main shareholder sells out a key stake, one can read the move from a half-full glass perspective or the half-empty glass viewpoint. The common explanation employed is that it will "increase the market liquidity of the stock", a sometimes acceptable explanation if the stock is thinly traded and the company hopes to "spread the ownership" to some strong hands, say institutional funds which can increase market awareness of the stock. One wonders, however, whether this was necessary for United Food when it was relatively liquid, had good retail participation, its share price was apparently on the upward trajectory and was still relatively undervalued from all appearances under standard stock valuation parametrics. Another common explanation is why would the buyer buy in unless the outlook was good? Well, it depends how one chooses to see it, I guess. From the half-empty glass viewpoint, such a large sales tranche by a key company insider indicates possible urgency to exit, especially when again, the stock still looked relatively undervalued.

There is often a thin line separating the two contrasting perspectives; those in the market long enough will know what I mean. The market is all about dichotomies. I wouldn't say that my judgment had been sharpened at that stage and prompted me to exit; rather I think the episode of Global Tech earlier in the year had sharpened my focus on monitoring managerial moves and if necessary, emphasing such qualitative developments over quantitative measures. Under other circumstances I could have been wrong; for example recently Cosco directors have been selling aggressively and yet the company has continued to secure new contracts and the stock has been on the up (a mitigating explanation is that these guys got their options really cheap). However, events proved eventually that I had sold well. United Food announced a benign set of results for FY03, but in FY04 it reported a shocking 50% collapse in profits and the bottomline continued to decline ever since. Rumours have plagued the company, which I shall not repeat here.

Today, the stock trades at below 20 cents, 50% below its NTA and fundamental investors point out that its cash holdings alone could support its current market cap. Yet nobody dares to buy. It has probably been among the top market underperformers since 2003 given its collapse amidst the rising market tide. Nobody has really come out to explain David Yip's equity sales in late 2003. But the benefit of financial hindsight makes it abundantly clear. The business was on a decline, and the scale of its impending decline must have been very clear to insiders before it manifested itself in the shocker 2004 results. The potential market was one billion strong, but not many have been able to tap this one billion customers. United Food was spreading itself too thin, trying to diversify in too many fields (chondroitin sulphate, animal feeds) and expanding up and down the supply chain (it was even into pig-farming, an activity which bigger processors like People's Food chose to outsource); it was losing market share in a tightening market that was even affecting market leader People's Food. Scale of operations was important; as a regional operator United Food might not have had the necessary scale. All these are explanations offered after the event by analysts. It was not easy to make this out in 2003, which is why I must thank David Yip. He was my early warning system for United Food.

The case for trading

2006-11-16T21:52:00.000-08:00

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The buy-and-hold investor can beat the short-term trader over the long-term. True or false?

There have been many academic studies done with evidence in favour of the former. To me, it is a question of two issues: firstly, of probabilities, and secondly, of how one defines market performance.

Consider the hypothetical case where the investor has odds weighed slightly in his favour, such that he has a 51% chance of making money on his trades and 49% against. I can run a Microsoft Excel simulation based on this, with different holding periods (call it P; ie. if P is higher, the investor holds it for a longer period). Subjecting it to 10000 runs, the results are clear:

P=1 ==> 50.6% of making money over that period (theoretically, it would be 51%)
P=50 ==> 58.4%
P=1000 ==> about 100%!

The implication of the simple simulation is that if you hold long enough, you can't lose .... assuming you have a very slight advantage (of course, if one is lousy, time can't help him make money). So if one defines investment performance as not losing money (as opposed to maximising gain) then it makes sense to hold long-term. No wonder gurus like Warren Buffett advise so. Since their message reaches a wide audience, by definition everybody cannot be above-average investors; hence the imperative switches to at least ensuring less people lose money, hence the advice for holding long-term. Even if the individual is below-average, at least he won't be compounding his sub-50% probability many times through frequent trades (which would lead to even greater losses compared with holding long-term).

Consider however, the expected return. Whether the individual is holding long-term or trading short-term, the holding period return is still expected to be a function of his win/lose probability only. The simulation results below:

Win/loss probability 0.51 ==> 2% gain regardless of P (holding period)
Win/loss probability 0.60 ==> 20% gain regardless of P
Win/loss probability 0.75 ==> 50% gain regardless of P

Mathematically speaking, assuming win/lose probability remains constant (this is a key assumption), there is absolutely no advantage to holding over a long period, in terms of percentage gains. In other words, time increases your chances of winning (or at least decreases your potential losses), but does nothing for the magnitude of your gains. (Many will dispute this of course based on personal experience; I will elaborate below.)

Under such a scenario, the best thing to do is of course not to hold, but to trade with high frequency. Assuming that the investor's win/loss probability is due to his stock-picking and is not stock-specific, it makes sense for him to compound his gains ie. if his win/loss probability is 0.51, then he can compound his gains through successive trades eg. 5 trades means 1.02 X 1.02 X 1.02 X 1.02 X 1.02 = 10% gain.

As stated above, many will dispute my conclusion. The common argument is that a good stock is able to compound growth year-on-year, say 10-15%, so isn't that equivalent to my above "successive trades" compounding? Well, that is supposing one is able to find such stocks. My analysis is based on the investor's win/loss probabilities, and using that to simulate the expected period gains/losses. The focus switches, therefore, from the stock to the investor's capabilities (those really interested can e-mail me for a copy of my Excel simulation).

The critical assumption, actually, lies in the win/loss probability. There is no way to determine/verify this for the individual, except of course from past trading/investing record. Suppose, of course, that the individual views himself as having a slight advantage in the market, say 51% of winning. So he trades assiduously. What if he is actually not as good as he thinks, and that the real probability is actually 49%? He would actually be amplifying this weakness by trading, losing 10% over 5 trades for example (as per earlier example). Hence, there must be a sufficient margin of safety surrounding the individual's self-assessment of his track record: if he deems his win/loss margin to be 75%/25% (based on track record) en-route to his subsequent decision to trade, then a slight over-estimation of his abilities won't be so bad.

The other fact, of course, is that it is seldom that this win/loss margin can remain constant over time for the individual investor/trader. Unless, of course, the entity we are talking about is a broking firm with systematic advantage of being able to move the market with new research on its stock holdings. The market moves through cycles, not just of bull and bear but also of rotations in favour of various styles : value vs growth vs momentum, blue-chip vs small-cap, investment vs speculation. It would be unfair on the investor to expect him to retain the same margin of win/loss.

Last but certainly not least, I would see the win/loss margin over a shorter duration as smaller than that over a longer duration. Short-term, the market is efficient; day-traders are competing with the law of randomness, with no systematic advantage ie. win/loss probability is likely to be 50/50. Over a longer period, say the medium term of several months, any systematic advantage due to good analysis/insights can then begin to emerge.

Having discussed all these provisos, the bare fact remains that if one is confident that he has a certain competitive edge, he should look towards trading at a reasonable frequency rather than holding over the long-term. That is the best way to compound this advantage and translate it to monetary gains. If he feels he doesn't have it, then hold long-term lor .... and concentrate on building competitive advantages in the meantime!

The Selling Process Part 4

2006-11-04T19:32:00.000-08:00

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Looking through the topics I have discussed, the selling process is the one with the most parts to it (Part 1, Part 2 and Part 3), together with Investing Philosophy. To me, selling is probably the most important in the three-step process Buy-Hold-Sell; especially for me, because I recognise that my personality conditions me to be able to buy with confidence, hold with patience but unable to sell with grace. I suspect that many people face this problem too. That is why I have to constantly remind myself of reasons why I should not sell, while assiduously searching for reasons why I should.

It may shock some fundamentalists but one of the factors that I look at nowadays when considering reasons for selling a stock is the price trend. As Warren Buffett goes: when the price of the stock goes down, it should become more attractive and one should buy more.

Provided, of course, that the caveat, that the fundamentals of the underlying business haven't changed, is true. Many people miss out this proviso of Buffett's statement. The tendency to view a stock with rose-tinted lenses when one holds it in his portfolio is all-too-human, to the extent that one can be prone to intellectualisation (ie. finding reasons not to sell) in the face of a steadily falling stock price.

Yet, investing is all about dichotomies. A high PE can mean dangerous valuation or an indication of a strong defensible business model; portfolio diversification can be good or bad since it means reduced returns but also reduced risk (though for academicians it seems to be unaffected return and reduced unsystematic risk); raising of interest rates can be good or bad because it respectively signifies a booming economy (which leads to rising inflation that must be controlled) and a crimping of liquidity which will squeeze asset prices. So it is with falling stock prices: it can either mean the stock is a better buy than before because of an improvement in the relative valuation/fundamentals ratio, or it can hint at non-public information that the fundamentals have declined, which has driven down stock prices. So which is driving which? That is the chicken-and-egg problem which has no easy solution.

Actually if one think about it, considering stock price as one of the factors in one's selling decision is not illogical at all. After all, firstly, the stock price is what determines our gains/losses. How can it not be a factor? Secondly, it rises and falls according to the fortunes of the business --- long-term. How certain is one about how far the long-term is? It could be now, and the price is factoring in the declining fundamentals right now. Thirdly --- and this is one for the academicians --- stock price volatility is how they determine beta, the market risk of a particular stock. Supposing that near-term price becomes volatile, surely that means the near-term risk has increased? (In fact, I may go one step further and qualitatively claim that beta as a measure of market risk should be weighted more towards near-term price volatility rather than over the long-term ie. near-term price volatility should be more important). Fourthly, isn't the old adages "never catch a falling knife" and "buy on the way up" examples of correlating the buy/sell process with price trends? People don't seem to have trouble following that.

Obviously, deciding whether to sell when stock price declines is a case of judgment. If I can suggest some factors that will influence it, they are as follows:
- Blue-chip or small-cap (the former has a greater assurance of business fundamentals, hence are more likely to rebound)
- One's degree of confidence in his understanding of the company's business
- Opportunity costs (maybe it's a chance to exit and buy into that stock you've been eyeing in your watchlist all along?)
- The risks. The risk aspect of a stock is always underestimated because the general tendency is to look at the upside. Instead, risks should be what's important to understand when the price is falling, because they are likely to be the ones causing the decline
- The weightage of the stock in question in one's portfolio. It's a case of managing your risk exposure.
- Technical factors eg. selling on high or low volume? Support levels broken?

It is indeed walking a tightrope, because making such sell decisions is a process of balancing the two parts of the dichotomy of the meaning of price action. For me, I myself had a recent episode where I was faced with a 10% decline in the price of a stock I was heavily into. It was a decline on above-average volume. Considering the fundamental risk factors and the fact that there was no clear reason for its decline --- the greatest danger, because there is no way to quantify any potential downside --- I decided to dispose of part of it although initially I had bought into it on high hopes of it being a multi-bagger (I shall not reveal the name here lest I am accused of pushing stocks). Frankly, it is as much a process of thought clarification as well as risk management. I have found that it aids one in being more objective in his thought processes surrounding the stock once he sells part of it. It helped, of course, that I had several other targets and considered opportunity costs of waiting for price stabilisation to be too high.

Margin of safety

2006-10-17T07:11:00.000-07:00

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One of the concepts in investing that left the deepest impression on me in my early investing days and which I (would like to think) have internalised within my stock selection and general investment routine is the idea of margin of safety. Part of the reason is because it is the central tenet to Benjamin Graham's ideas on investment and which has been further promoted by Warren Buffett.

The other reason is that it is such a natural idea to me. As an engineer, I deal in margins of safety, or what we also call safety factors in our line, all the time. A component must be able to withstand several times the load it is designed to handle, because it should be able to handle contingencies. The more critical the application, the higher the safety factor required (eg. passenger lifts).

To take the engineering analogy a bit further, the safety factor is usually calculated by considering the various modes of failure that the component could undergo, for example by tension (pulling), compression (pushing), bending etc. It is an analytical process which requires insight into the various loads the component could be subject to, and consideration of the worst case scenario. The corollary when applied to investing is to consider various situations where the investment could go awry and whether one has factored it in his consideration of the investment case.

There are several approaches to ensure that the component does not fail and cause catastrophic engineering failure. One is through regular maintenance through which faults (such as cracks) can be detected; compare this with the need for regular monitoring of one's investment portfolio. Another is what is known as the fail-safe approach: even if the component fails, the system is still able to function (perhaps with parallel mechanisms). One parlays this idea to investment management by insisting on the availability of alternate exit strategies during stock selection such that should the main premise for buying the stock fail to materialise (say, one bought it in anticipation of a merger that didn't happen), it is possible to fall back on say, the strong fundamentals of the stock that will mitigate any disappointment manifesting big-time through a price collapse. This is one facet of margin of safety --- the existence of alternate exit strategies.

The most oft-mentioned approach to attaining margin of safety is through price management ie. buying cheap, low-PE stocks; this is just one method. I myself base my hotstocksnot picks often on the basis of the high stock valuations offering little margins of safety (eg. Raffles Education). Alternate approaches include the abovementioned close monitoring/portfolio maintenance approach, and the multiple exit strategies approach. On the portfolio management side, diversification is one way to apply the failsafe approach from a holistic view; failure of one stock will not cause such a big impact on the entire portfolio (while limiting upside too, of course). What one does not do also provides a margin of safety: not using leverage provides a margin of safety, a cushion that would be removed if he were to adopt margin financing or take overdrafts at high rates to buy stocks hoping to outperform the borrowing rates. Personally, I would rather buy high risk-high return stocks on my own money, than leverage on margin on lower-risk stocks. One can be a strong hand (ie. have holding power) on the stocks one pays for out of his own pocket, with the availability to exercise alternative exit strategies (and hence utilise the margin of safety) by holding for a longer period than anticipated/hoped; with borrowed money/margined stocks, the margin for error is smaller, and one's hand is weakened by the need to service debt or maintain margins should things move against him. True traders use leverage liberally; my approach however is to press aggressively for the medium/long term (weighting heavily towards growth stocks in areas and fundamental trends I favour) while maintaining a liberal margin of safety for the short term. That is in recognition of the fact that it is easier to be wrong over the short term than the longer term.

Of course, different brushes, different strokes. Others may have alternative means of finding their margin of safety. Returning to the engineering analogy, theoretical analysis of the margins of safety is not enough; product testing is the ultimate proof of strength. And so it is for investment portfolios; running through one up-and-down stock market cycle could be considered a proof test of one's portfolio management techniques and whether he has managed his risks well. Of course, whether the bullets might be exhausted after this entire cycle is another story altogether. It's better to be safe than sorry; hence it's better to be more conservative initially and tack on more margins of safety than less. After acquiring enough experience, one can then exercise "engineering judgment" and take on more discretionary risks ie. reduce margins of safety (and amplify potential upside).

Developing An Investment Philosophy Part 4

2006-10-06T22:49:00.000-07:00

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It is useful to consider a few instances of investment philosophies here, for those who thrive on examples. There are many categorisations (the fundamentalist/technicalist categorisation, the contrarian/momentum categorisation, the macro/micro categorisation, the growth/value categorisation etc) but one useful set of examples is a classification by Charles D Ellis, one of the leading thinkers in investment management.

The "Show Me The Money" column in the Business Times every Saturday by Teh Hooi Ling is a weekly staple reading for me, because she discusses perspectives to investing that broaden my mind. In today's column, Charles D Ellis' views were discussed, where he classified investment methods into the intellectually difficult, the physically difficult and the emotionally difficult.

A brief overview: the "intellectually difficult" way is pursued by those who understand the "true nature of investing", and are willing to take long-term positions based on their views that might seem unpopular at that particular time. They are otherwise known as value investors, though they could also easily be known as growth investors, since Warren Buffett, who obviously has been classified in the intellectually difficult group, practises investing in growth at a reasonable price (GARP) as much as he practises distress investing. The "physically difficult" refers to those who try to beat the market by working physically hard: staying late, reading many reports, going for more meetings with analysts and generally trying to outperform the market by outworking the competition. The "emotionally difficult" approach is the most straightforward: working out the individual's own long-term investment policy, then sticking to it despite others' exhortations to enter or exit the market because the market is "too hot to miss out" or is "going to crash". Often this involves staying out of the market for long periods (waiting for market indices to revert to the mean) while everyone else around boasts of how much they have made. In all three cases, we can see what are the difficulties in practice, hence the terminology.

These are obviously three philosophies (or you can call it manner of thinking) in which market players seek to make money on the stock market, and I will build a discussion further on it below. Firstly, it would be wrong to operate along one, and only one, of these lines of thinking, in one's search for market success, but rather, one should be aware of the stocks and investment horizons that are suitable for each approach. The "intellectually difficult" approach entails at least a medium-term investing horizon because that's when the (perceived) fundamental strengths of the business behind the stock weigh in, and often the stock in question would be considered "low-probability" (in terms of price appreciation) at the time of purchase. And surely this approach involves scuttlebutt such as talks with management(where possible), real-life assessments of product popularity at the mall, stock- scanning and what is that but a facet of "physically difficult" investing? On the other hand, "physically difficult" investing would probably involve shorter-term horizons with "high-probability" stocks --- high probability because the emphasis for such physically difficult investing tend to be on catalysts for the stock (earnings surprises, contract announcements etc) that will move the price. "Emotionally difficult" investing is essentially a contrarian approach which often ties up with the psychological propensities of "intellectually difficult" investors. So the three classfications are inter-linked. Furthermore, what's to stop one from practising say, "intellectually difficult" investing together with "physically difficult" investing? The greatest danger is to pigeonhole oneself into one of these classifications and say,"I don't try to outwork fellow investors" etc. However, if one sees his competitive advantage in one of these (read a related article: "Full-time investing/trading Part 2"), say in his ability to predict fundamental trends, then he should focus on that type of investing. However, my view is, never rule out the rest: the only rule should be that the investment that maxmises the perceived potential-risk ratio should be chosen.

Which brings us to the second point, which is that "intellectual-based" investing tends to be glamourised. It is no surprise since most would rather be called smart than hardworking or mentally strong. Yet investing involves hard work and mental discipline. For myself, I seek to build on two aspects of competitive advantages: the advantage of speed and flexibility vis-a-vis the big institutional investors (see "Advantages of Being a Small Investor") and secondly, "to outsearch, outread and outthink on business fundamentals" vis-a-vis fellow retail investors (see "My Investing Journey: Hypothetical Situations"). The first involves some elements of contrarian thinking and conquering mental instincts, while the latter involves real hard work. Other fellow investors (ThinkNotLeft in "My Investing Journey: Hypothetical Situations") have said that some of their more important competitive strengths lie in certain emotional edges (i.e. discipline, patience etc) which allow them to suffer the ravages of the market (which suggest he is a contrarian). Although it is certainly ego-boosting to be able to claim at parties that your stock has risen several multiples through ups and downs over the years (implication would be that (1)you had good judgment and chose wisely; (2)you had the courage of your convictions to hold, just like Warren Buffett), it is difficult in practice to buy the "correct" stock without examining all the possibilities and doing all the extensive reading for likely future trends.

The point in all the above, is that (1)it is ok to mix-and-match; (2)do what's right (and suits your personality and abilities), not what's fashionable.

An alternate market experience

2006-10-05T07:16:00.000-07:00

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To me, it is always useful to get an understanding of how other peers have invested or traded on the stock market: their thought processes, their journey, the results. By living their investment lives vicariously, one can get various perspectives other than the one that he sees in the mirror every day.

This is especially important when one is in a bull market as we are undoubtedly in now, a bull which has sustained itself through the last three years. Although I am not an advocate of market timing in its purest form (ie. straight disposal into cash), I see the need to attenuate my optimism about the market once in a while, through articles such as "The 10 worst stock market crashes", which remind me of the potential downside, and of course through my HotStocksNot blog itself.

Way before I started penning down my thoughts and investing experiences in my blogs starting June 2005, there was a fellow market investor/trader who had started a daily trading journal in Shareinvestor.com's personal pages. I just read about it today on that forum, and, visiting it, was astonished to find that it numbered 2000 over posts (not all by him of course --- it also included comments from readers).

The journal was started in late August 2002, and the author was meticulous in documenting his everyday trades, his rationale, his emotions, the results. Most of it was about pain and anguish, as he assumed trading positions primarily based on outside recommendations from gurus (eg. Wave Trader) or black boxes (newsletters, charting systems etc), or by short-term forecasting (of expected results and other market events, what the market would be like the next day etc) and more often than not had to close out these mainly contra positions at losses.

If one remembers the late 2002-early 2003 market, it was one of gloom and pessimism as the market searched for a bottom. Valuations went lower when it seemed they were already at bargain basement prices. It appeared to be the primary reason for the author suffering such a bad spell (in a good market, the novice can seem like a genius), because he operated mainly on a contra, even intra-day, basis, given that he was undercapitalised. He himself acknowledged that trading in mid-term and long-term time frames, facilitated by reasonable levels of personal capital, offers greater probability of success.

Mark my words, he is no fool by common definitions. He writes well, is able to articulate his trading history and emotions, and by his account was in the IT industry and studying for an MBA. His trading journal provided an avenue for him to cross-analyse his own trading decisions, and he was honest about his losses. It is not my intention here to stand on a pedestal and mock him or debase his trading record. Instead, my intention is to highlight the fact that even an intelligent person can suffer in a bad market if he is too anxious to attain quick gains.

To be fair, everybody got killed during that period. I myself probably lost 20-30% of my trading capital on paper over that period. But by trading frequently, the above protagonist of the journal probably exacerbated his situation. As noted, he had to, because he had limited capital. Furthermore, he had got addicted to the adrenaline of trading, and had the compulsion to trade more when he lost money on earlier trades in an effort to make back the money. As in a boxing match, when one is getting hammered, the best strategy is actually to cling/hold the opponent to limit further blows from his punches.

It was a sad tale of a bear market not giving any leeway to an addicted trader who seemingly knew his own problems but still fell into potholes. He ultimately lost $70-80K in his trades in a matter of weeks, was retrenched admist a restructuring economy, and had his credit lines cut. He was a married man. Although he eventually found a new job, his disastrous trading experience had so traumatised him that he was unable to bring himself to participate in the bull market starting in mid-2003. His dreams of developing his own trading system, after paying tuition fees in the market, had come to nought. There his trading journal ended.

Those with access to Shareinvestor historical archives can check out the thread titled "The Trading Journal" to get the full story. There're plenty of amazingly detailed advice from fellow forummers, some of which are obviously from professionals and accomplished traders. Those were the days, when Shareinvestor was a closely-knitted community and one could truly learn stuff.

Setting investment targets

2006-09-30T20:11:00.000-07:00

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Is it important to set investment targets? By targets I mean specific quantitative annual rates of return which one hopes to achieve on his investments. If so, what are reasonable numbers to aim for?

I used to be rather leary of setting investment targets. All unit trusts seek to outperform benchmarking indices rather than aim for absolute returns, in recognition of the fact that their performance is subject to the vagaries of the market. Of course, hedge funds do aim for absolute returns, but that is because they employ a variety of strategies such as shorting and arbitrage which are seldom available to the retail investor because one needs enormous leverage to magnify the small spreads. A relevant article that I've written is with regard to setting target prices for stocks, where I argue against being too rigid in setting price targets for stocks, given the changing dynamics of the market.

Yet, if we relate to businesses, why do companies set corporate profit targets? The purpose is to provide something to aim towards, a source of motivation for the staff. It is normally in recognition of the reality of the marketplace, or the target loses all credibility in the eyes of everyone. So perhaps we also need an investing target. And while we're at it, why not make it a big target. After all, the only people to whom the target is relevant is ourselves.

One of the things I remember most about Sim Wong Hoo is his coining of the acronym BHAG, for Big Hairy Audacious Goal. That is how he drove Creative relentlessly forward to become the global kingpin in soundcards, before they recently lost their way in MP3 players. Take in the essence of his philosophy: the target needs to be there to provide a sense of purpose or even mission, and it should not be too conservative as to lose the meaning of a "target". While it is not advisable to set price targets on stocks (effectively setting low upper limits) because we should try to let profits run where they can, it also makes sense to set audacious investment goals for our portfolio to keep us constantly on our toes (ie. setting high upper limits).

Warren Buffet says a reasonable target for a good to excellent investor is ~15% a year. That to me is not adequate as a target, which in our revised definition should be a bit divorced from reality (ok, you can choose not to read on if this sounds crazy). Employing another of his pet concepts, the margin of safety, perhaps one should also allow for some slack in the investment target and his actual performance, such that he will still be satisfied with the returns even though the audacious target has not been achieved (eg. 50% return though one aims for 100% target).

Setting high investment targets is effectively a form of alteration of one's mental state. One perspires only when one aspires, and one achieves only when one perspires. The secondary target must be to improve one's methods, and the constant drive to attempt to reach the primary target of high returns almost always leads to achievement of the secondary target. Let me share my personal experience: at one stage in 2004 I was holding on to relatively safe stocks that I felt comfortable with, could sleep well with and needed relatively little effort to monitor. These included thinly-traded stocks like Pertama, Tsit Wing, Sincere Watch. I knew the businesses were stable though rather staid in terms of growth potential; these stocks also paid good dividends. I was ok with holding them because I felt holding stable businesses wasn't a bad way to invest ..... eventually they would come to the attention of the market. The key word was "eventually" ---- how long is "eventually"? In retrospect, I figure it's always better to stack the odds in your favour, rather than relying on hope as a strategy. With no ambitious investment target, one can be content to just sit on stocks based on buy-in decisions that one had made at a single point in the past ..... though firstly, things might have changed; secondly, it makes sense to constantly revisit one's assumptions such that the buy-in/hold decisions are reconsidered subsequently at multiple points; and thirdly, one needs to account for market interest, through trading liquidity as one of the factors. At the end of 2004, I rethought my philosophy, chose a big hairy audacious investment goal, and almost immediately realised I had been getting too comfortable with my methods and the stocks in my portfolio. The second thing I realised is that there are almost always good bargains on the stock market better than what one currently has provided one looks assiduously, just as there will always be overpriced stocks that I can source for my HotStocksNot blog. The business cycle is evolving, various sector developments are evolving, other investors' responses and investment horizons are evolving. The market is dynamic.

I shall not reveal my personal investment target, which is clearly ambitious. However, it'll probably get less ambitious as I grow older. One of the key dangers is that one tacks on much more risk than he can manage given his age profile, in a bid to reach his audacious investment goal. As in a business, spot the opportunities, but also manage the risks, and do not bite off more than one can chew. Aggression in process improvement is generated by ambition.

Market Timing

2006-09-29T07:20:00.000-07:00

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One of the most controversial topics in investing is the practice of market timing. Apparently the great investors don't, people like Warren Buffett and Peter Lynch: they focus on stock-picking and place an implicit faith in the ability of the markets to bounce back if it should experience a downturn. On the other hand, there are many who believe it is possible to spot the gathering clouds and bail out before the storm; these are often the more sophisticated technicalists who try to read the tea leaves from their charts and economic figures.

There is no doubt about the potential riches that could be obtained or losses avoided if market timing could be practised effectively. I have always believed that the market factor has the greatest influence on the performance of a stock, compared with sector and specific company performance (I usually think about it as 40:30:30 weighting).

To be sure, to a certain extent, the tea leaves could be read. There are three major factors that drive the stock market: fundamentals (valuations such as PE, dividend yield; operating performance figures such as margins), liquidity (money supply and bank credit, broker margins) and sentiment. It is obvious that when there is no more "spare capacity" in all three factors (for example, fundamental valuation have reached extreme levels, M1 money supply is at upper end of the range, sentiment has peaked to euphoric levels), there is nowhere for the market to go but down, in the same way as when a company has maximised profit when it maximises its capacity utilisation to 100% ie. no more room to grow. When only one of these factors appears to have reached a high value, the market may not have peaked. This is what happened in the dot-com boom when valuations reached 100X PE but because sentiment continued to surge and liquidity was floating around (cash-heavy unit trusts ready to buy, venture capitalists hunting for any dot-com startup to fund), the market continued to defy rational expectations of seasoned investors like Buffett.

The big question of course is, whether one can do this with impeccable flair. Judging whether there is "excess capacity" in the system to fuel a continued upward rise requires strong qualitative (on sentiment) and quantitative (on valuations, money supply) judgment. Similar to the ship captain who has to decide whether to cast off all heavy valuables (to make the ship more maneuvrable) because he thinks there might be a huge storm ahead, the decision to do market-timing is a function of one's willingness to sacrifice potential gains (in a bull market) or sustain further losses (in a bear market), of committment to stick to the course, and of confidence in one's judgment (the ship captain had better be right else his passengers would have something to say!)

Consider the two schools of thought in macroeconomic management: activist and non-activist. Activists believe they can intervene at appropriate periods to cool down or pump-prime the economy, while non-activists believe it is quite impossible to time these interventionist policies well even with a set of leading indicators. The usual practice now is limited intervention given that both schools have their points. Given that it is already so difficult to time policies to stabilise the economy, what more the stock market? The stock market itself is a leading indicator used to time macroeconomic policies, so surely the investor faces an even tougher task trying to time the stock market.

The other factor to consider is the psychological effect. The market timer who finds that he exited too early may wait until it is really late before plunging back in, thus sustaining a double loss: the opportunity cost of not riding the continued surge after exiting, and then re-entering at the wrong time when sentiment and the market has peaked. It is especially difficult to get out the second time, because the investor is likely not to want to repeat his "mistake" of exiting too early the second time round, and hence is more likely to hold the baby as the market peaks.

Ultimately, like most real-life issues, there is no definite rule and the decision to market-time (or not) is part of the investment mental framework one adopts. For me, I am loathe to lose my positions on my stocks and I am therefore quite resistant to the idea of trying to time the market by selling my holdings and hoping to buy back at cheaper prices later. At the same time, there are many ways to adjust one's positioning depending on his conviction of the market direction, and one way is a more defensive stock allocation eg. shifting preference towards non-cyclical stocks. It also makes sense to have a feel of which stage the economy is along the business cycle (early-stage bull, mid-stage bull, late-stage bull, early-stage downturn etc) and concentrate on appropriate sectors accordingly. This, I guess, is also a form of market timing, but less extreme than liquidating positions completely. However, I am open to doing that should market valuations get seriously out of whack, say the market trades to 20X market-wide PE.

One final note is with regard to calendar effects, exampled by sayings such as "Sell in May and go away", the much-talked about Capricorn effect, and month-end window-dressings etc. Given that the whole world is aware of these calendar effects, when does one start to adjust portfolio in anticipation of these effects? The likelihood is that they will get priced in earlier and earlier, such that in the end it doesn't make sense to attempt to capitalise on it at all. The market is most efficient in pricing in such "phenomena" like these.

The World's Ten Cheapest Emerging Stock Markets

2006-09-21T09:23:00.000-07:00

DanielXX's intro: This entry consists of just one picture. I hope Yaser Anwar won't mind me extracting this diagram from his blog Investment Ideas. It gives a good global perspective of the cheap markets around the world. I feel it is especially pertinent now because apparently the cheapest one according to the chart was Thailand, and the bloodless coup two days ago has just explained why it is so cheap. There are reasons for everything, and readers may also want to think about the other cheap markets and the reasons for their low valuations. It is interesting to note that quite often the reasons are political, validating my view that one has to be an all-rounder to be a "fox" in the stock market (to consider businesses from various perspectives).

The above was extracted from this excellent blog I'd just chanced upon: Investment Ideas by Yaser Anwat. It contains good writeups on investment ideas; the focus is more centered on the US market.

My Research Routine

2006-09-16T00:37:00.000-07:00

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To me, my competitive advantage is to search harder for good stocks than everybody else, read more about emerging trends than everybody else, and think more deeply about business fundamentals (see "My Investing Journey - Hypothetical Situations"). It may vary for different retail investors in different sets of contexts and holding different philosophies (I'm generally a fundamentals guy), and I don't suggest that what I do should be replicated wholesale; nor is it static, as I'm constantly sourcing for new ways and new investing tools to do things more efficiently, or to cast a wider net.

Let's assume that the investor is not-so-greenhorn and is already well-acquainted with the technical aspects/terms of investing eg. PE, NTA, dividend, cash flow etc. What follows is a routine process of news gathering/monitoring; this is increasingly important given that the world is so globalised that for example, plastics companies can be hit hard by oil prices, precision engineering firms by aluminium prices, Singapore properties by foreign investments etc. One either has to have a real zest for following the ebb and flow of various facets of global and local news, or he will find that active investing is not for him --- better to outsource to a unit trust.

Where does one start for such news monitoring? In order to monitor one's stocks, it makes sense to adopt a top-down approach -- understand world and industry trends, then you'll understand your stocks. Obviously the newspapers are a good way to start. In terms of the business news coverage our newspapers are definitely worth higher than a 147th ranking. In my earlier investing days, I used to read the newspapers in the morning on the bus and finish them before reaching my workplace --- it helped that my workplace was about one hour's journey then. Most of my understanding of world and local trends, including those written on my Trendspotting blog, were picked up from the papers. It is amazing how all this potential money-making information is just staring in front of you every morning, waiting to be turned into knowledge, while people ignore them and concentrate on watching the stock prices. It does take time, however, to figure out which articles are worth reading; as a rule I don't read articles repeating facts which I already know about, unless they show promise of relevant and alternative viewpoints. I've also started reading The Business Times in recent years, given that the benefits far outweigh the costs. Granted that the main idea is to cull the facts and trends, sometimes coverage by these papers even explains why certain stocks surge upon trading for the day (there was an article by Teh Hooi Ling in The Business Times today on this phenomenon)---- this often takes place in a sideways-market such as recently.

More breadth and depth in emerging trends can be covered in various periodicals since newspapers typically comprise huge doses of daily breaking news. The Economist has been called the finest economics analysis magazine in the world, but it's too much of a tedious read, is too analytical and goes several layers deeper than what I would like (given my limited time). In other words, it is too intelligent a magazine for me. I subscribe to Newsweek and Forbes Asia --- they give excellent worldwide coverage (the latter with good focus on Asia) with minimum fuss. They wrap up two weeks' worth of news in a concise summary with emphasis on the important developments in each region --- macro news that are important for the investor to take a pulse on the world (and the region), as well as highlighting various emerging trends in a large number of sectors.

Drill down to the company level and there are several mechanisms for monitoring the stocks, both those in your watchlist (you should have one) and in your current portfolio. I have mentioned several of the belowmentioned before and it's worth repeating them here, for completeness. First off will be various websites online: the Internet has reduced the information asymmetry between the retail investor and the "big boys" (the institutional investors) like never before and I am so thankful I'm living in this age. The SGX website is the newspaper equivalent for monitoring daily company-specific news, and I check it out at the end of every day. Online forums, if one knows how to use them, are an extremely useful source of information, both past and present. They are also useful for bouncing your views off others and getting their comments in return --- you get different perspectives, many-to-many interactions that compound the network effect. Some forums worth visiting are the Channelnewsasia Markettalk, Shareinvestor, Shareowl and Sharejunction forums (PS: for those who complain I always say negative things about stocks in my Hotstocksnot blog, I am not a sourpuss --- I do post positive stuff about stocks I like on these forums). I stop short, however, of subscribing to online newsfeed services like Dow Jones or AFX --- they encourage too much of a short-term mentality.

There are two company monitoring routines that I find useful. One is to simplify his stockwatch routine to the monitoring of one or two highly relevant general indicators, which might vary daily, monthly or quarterly; they could be input prices, product average selling prices, customer sentiment, even proxy share prices (ie. monitor peers or listed subsidiaries). I've mentioned this in an article "Watching Stock Holdings" and I think if one is judicious in use of these indicators, it can often give a good indication of any imminent change in industry fundamentals that will ultimately impact the stock. The second is a routine scanning of this very useful fortnightly Singapore shares periodical: Shares Investment, which allows me to contextually scan through the whole universe of Singapore stocks. Note contextually --- it is my view that valuation figures (eg. PE, P/B, dividend yield etc) as provided on some online sites have limited use in themselves unless accompanied by an understanding of their various business segments, their recent performance and track record, upcoming dealflow. Stock screening is not a matter of picking the lowest-PE or lowest P/NTA stock off a data screen, but a measured contextual consideration of all abovementioned factors --- doing this manually with a useful updated shares publication is the best.

Why am I sharing with you all this? A genuine competitive advantage does not rely on "secrets of the trade"; as I mentioned, it's all about working hard, working efficiently and amalgamating the different tools to improve one's judgment and decision-making. It is seldom that I find people who can do this better than me (in an unbiased manner.... that rules out the analysts) :-)

My Investing Journey: Allied Technologies Part 2

2006-09-11T02:42:00.000-07:00

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At 64.5 cents I sold out of Allied. I can remember that afternoon at the office in late October 2003, when I called my broker to sell my entire line after seeing the stock continue to rise during my lunchtime check on the market. I had told him to execute the sell at 63.5 cents, and in a matter of say, 30 seconds, it had jumped to 64.5! That's the price at which my sell order was executed. Not that I was complaining. It just showed how strong the buying momentum was.

I believe the relief that I experienced upon the sale can be understood by those who have sold out of big winners. It is a release of pent-up tension and the constant itch to pull the trigger as the price soars skyward, especially if it is an inexplicable rise. The tension builds up as one's emotions transit from gladness at seeing the initial rise, to vindication as the share price approaches what one considers fair value, to disbelief as it continues surging upward on increasing volume, and then a fear of regret constantly eating away at his increasingly frequent profit-tasking impulses.

I sold because I could no longer tahan the price valuations. At 63 cents, the stock was trading at 18X PE, and it was a recent IPO with limited post-listing track record! Even I knew it was too good to be true. Niggling at the back of my mind was how the seller of the LCD plant (see Part 1) would be willing to let go of such an incredible money-making asset to Allied Technologies if the claims on topline and bottomline contribution as claimed in the newspapers were true. I reasoned that it was time to recycle the capital and switch to other more fundamentally deserving stocks (not that there were many in the wild bull market in late 2003 which was soon to correct in early 2004).

The rest is history. The stock went up to above 70, the market somehow realised it had been overly euphoric and within a matter of weeks the price corrected downwards to the mid-50s, no doubt dampened by a subsequent company announcement that some orders had been delayed. Operations at the LCD plant started, but big losses were incurred that actually dragged down the group. The LCD assembly operations are still loss-making as of the last financial year. Allied Technologies is an illiquid stock today, trading at 11-12 cents.

They say that one learns most from his mistakes, but I think I also learnt a lot from this Allied Technologies experience, even though I had made an obscene amount of money (a two-bagger for sitting out 3 months .... a 400% gain if annualised) for what had essentially been a mistake, if one considers Allied's subsequent poor set of results. The episode taught me that market enthusiasm can often bid up prices to wild levels, and big money can be made in resisting the impulse to sell at whatever "rational" price targets one had set(If I had sold at "fair value", I would probably have foregone 20-30 cents of price appreciation). In other words, follow the flow. Fundamentals are but one part of the stock market, and there's no point being too honest or straight about it. Secondly, the willingness of the market to believe unproved "concepts" (the LCD plant with no track record) left a deep impression on me; that was the power of a bull market. That's why I believe among the three major forces that shape a stock's price trend --- market, sector and company --- the first one is the most important; hence my qualitative view that relative importance is weighted 40:30:30 respectively (however, I still believe market timing is very difficult). Lastly, it was a valuable experience for me in balancing the two conflicting adages "let your profits run" and "take profits, do not be greedy". As mentioned above, one must take into account market psychology, but at the same time he must avoid falling in love with his stock, or even worse, resist selling because he doesn't want to miss the excitement or any further possible upside. When the stock goes way above the fundamentals, there has to be a point when one says "Enough is enough!". Unfortunately, the lesson was not ingrained deeply in me, and I have had a few subsequent experiences when I followed the stock all the way up and then (nearly) all the way down. This time, though, I do believe my timing in selling Allied was near-perfect. Good money made on a dubious stock pick. Serendipity indeed.

My Investing Journey: Allied Technologies Part 1

2006-09-10T01:14:00.000-07:00

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I shall give a flavour of the recovery boom in mid-2003, and talk about my experiences in a stock that to this day remains my greatest market success in annualised percentage gain and one of my biggest gainers in dollar terms even up to today, when I have a significantly bigger portfolio. It is a vivid illustration of the low probability-high return stock that might often lie dormant with little chance of being bid up by the market, but once it is, the lucky investor can expect oversized returns (because the valuation, such as PE, starts from a low base).

The stock was Allied Technologies, and it listed on the Mainboard in late June 2003. Led by a Taiwanese, it was reputedly one of the top metalworking firms in Singapore, probably behind Amtek but a peer of Seksun (albeit different customer bases). It was a top metal parts supplier for HP printers.

In early July 2003 I bought into the stock at 27 cents, and then when it rose to 30 cents in late July I felt encouraged enough to double up my stake. To understand my rationale for the purchase: at 8X PE it looked cheap, its niche was in printer parts manufacturing which I'd felt was stable enough not to give any bad surprises, and I was generally bullish on the precision engineering sector, which had showed steady growth even over the bear years of 2001-03. If one remembers the mood in mid-2003, it was one of relief and yet apprehension about whether it was a rebound rally in a bear market. I was generally cautious too, and placed a high premium on risk (hence concentrating on low-PE stocks).

On retrospect, the reason for the subsequent charge-up was partly due to the fact that I'd chosen the right sector to buy in. The precision engineering sector was sufficiently dependent on the electronics sector to be considered part of it, and electronics is the first to benefit from a recovery in the business cycle. For those who want to find out about what stocks to buy along different stages of a business cycle, I would strongly encourage you to read the chapter on "Stocks to Pedal During The Business Cycle" in the book If It's Raining in Brazil, Buy Starbucks by Peter Navarro. Again on retrospect, I may have second thoughts about buying into the stock if it is today, simply because I have learnt to be more cautious on IPO stocks after witnessing several post-IPO collapses in the past few years eg. New Lakeside, Daka, Azeus, Anwell where everything seemed similarly rosy at IPO time but earnings dissipated the year after. I've discussed this before in "Is Too Much Knowledge a Good Thing?".

Back to the stock. It continued to enjoy strong trading volumes post-IPO but until end-August it was still hovering in the mid-30s. However, over one month from September to late October the stock moved up from 35 to over 70 cents, accompanied by heavy volumes peaking at 140,000 lots per day! It was an exhilarating surge.

This sort of surge truly transforms one's psyche, because it is not a measured rise over a long period (with consolidation etc) but rather, a momentum-fuelled charge on wild volume. I remember myself watching a movie (it was "Seabiscuit") on an afternoon off in mid-October, which also happened to be the day when Allied was the top volume counter (not a mean feat in a booming market) and surged up 8 cents and then retreating 5 cents towards closing. I could hardly concentrate on the movie as I checked prices on my phone regularly, and wondered whether this suggested buyer exhaustion.

Of course, this kind of frantic trading attracts attention from the SGX market surveillance department, and the news emerged that the company was acquiring an LCD monitor assembly plant for several million dollars. In a newspaper report the next day, there was speculation that the revenue contribution from this new plant could reach US$100M (if I remember correctly), effectively doubling the company's current revenue then.

That explained the price surge. Of course, of course. The market was ready to intellectualise and rationalise in the bull market that had become full-blown by October 2003 (now that's one October that defied the calendar effect, which claims October is a terrible month for the market). To fully comprehend the mania, one must note that the precision engineering and electronics sector had become a hot sector in a hot market; Amtek had doubled to $1.60 from its April low at $0.80, Seksun had gone up to $1.30 from $0.80 six months earlier. Allied was in this sector.... and now it had a catalyst. By late October it was trading at 70+ cents, or 20X trailing PE.

The use of leverage

2006-09-04T02:30:00.000-07:00

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Financial leverage is the use of debt to magnify the rate of return on equity. In business, it involves bank borrowing which is used together with shareholder's equity (including retained earnings) to jazz up growth. For the small investor, it typically involves buying on margin, such that he only contributes a certain proportion of the total value of shares purchased through his own pocket, say 50%; the remainder is financed through broker margin, essentially a loan from the broker.

Margin financing is tremendously attractive for those who wish to ramp up their trading capital quickly and magnify potential earnings; clearly there is no such thing as a free lunch and besides the interest payable on such margin loans the trader also knows that he is also liable to magnified losses. Fair deal and just a matter of risk and return? I don't think so. I have never done margin buying and will not do so in the future.

The main reason is that margin buying, by virtue of the way the deal is structured, forces the hand of the retail investor/trader and requires him to make short-term calls on the market. He could be right about the stock in the medium/long term but yet he could lose money through buying the shares on margin. For the common initial margin percentage of 150% (meaning 2/3 of shares financed by margin) a 7% drop in share price brings him to the maintenance margin of 140% where he is subject to margin call; he has to sell if he does not have additional capital to top up. Even if he finances through a margin percentage of 200% (ie. only 1/2 of shares financed by margin), margin call is triggered in a 30% drop for the share price. Such price moves are possible in a market undergoing a correction (such as that in mid-May) and the weak holders, first the contra players and then the margin holders, are whipsawed. Either they have to sell off the margined shares, or they have to liquidate other stocks in their holdings to obtain the cash for topping up their margin accounts. Now the market is back where it was pre-correction. For those who buy futures, the inherent leverage is even higher, about 20 times, meaning the margin for error in judgment is even thinner.

The long and short of it is that there is limited room for error in the short-term for margin players. It is not just that returns and losses are magnified, but also that investment/trading horizon has to be considerably shortened. Not being right in the short-term will lead to margin calls, which is basically a system implemented by the brokers to protect themselves. Yet the short-term is considerably more of a random-walk process than the medium/long term; there is no real competitive advantage for the analyst who tries to find companies with good fundamentals and value, given that more often such value manifests in prices over a longer period. In other words, buying on margin erodes the competitive advantage of the fundamental analyst. On the other hand, good traders may find buying on margin a useful way to make money if they feel they have some competitive advantage in the short-term, say a superior ability to gauge market technicals or better access to information (assuming they don't believe in an efficient market); margin calls may be irrelevant anyway if their stop losses are set above the prices at which margin calls might be made.

It is worth noting that the most sophisticated of market players today, the hedge funds, use substantial leverage to magnify their returns, reflecting an inherent confidence in their mathematical models. The main motivation for using leverage is that it is difficult to obtain good returns for big money without substantial borrowing to magnify returns. The kinds of strategies that they often practise, which often involves a combination of long and short positions to cancel out each other, or various forms of arbitrage strategies, offer highly liquid investment channels for the huge sums managed but typically involve small profit margins which they therefore magnify through borrowing to boost return on equity. This has led to occasional disasters such as Long-Term Capital Management. The small investor will never practise these hedge fund strategies, has no pressure to perform for the short-term for demanding clients, and therefore has no reason to tack on the substantial risks and compromises on his investing horizon that margin financing brings.

My Investing Journey: Hypothetical situations

2006-08-31T06:48:00.000-07:00

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Sometimes I wonder how my investing philosophy and methods would have been different had I started out on an alternate path. Many newbies lament that they are completely lost where they try to invest in the stock market from a standing start: opening the trading account is the least of their problems (brokers are only too eager to help), after that they wonder where to find out more information about the various stocks, what are good ones to invest, how to read charts and number-crunch the financial statements etc. I read this all the time in the online forums, increasingly in recent months as more and more people realise that investment and not savings is the best way of growing one's nest egg for the future.

I myself started out on a blank slate 6-7 years back, with no-one to seek ready advice from (my friends were not the stock market type). I sometimes read of forumers on online forums claiming that they have "Masters" to teach them the ins and outs of trading, and it sounds great to have a mentor to guide the greenhorn investor/trader up the learning curve. If I had a sinseh in my early days I probably would have found the going less tough. There are however a few issues that one must note with regard to having a mentor to guide oneself: firstly, the quality of the mentor is by no means assured, and this is especially dangerous for the newbie who has no way of telling good from bad; secondly, the quantitative and technical aspects of the stock market eg. how to calculate EPS, NTA, the various operating ratios etc can be taught, but (especially for traders) the "stomach" for risk and money management cannot be imparted --- some things can only be learnt and internalised through experience and actual market participation; thirdly and most importantly in my mind, the "Master" is usually able to teach things from one single set of perspective, which may be adequate in black-and-white subjects like the sciences but may subject the newbie to tunnel vision in the highly subjective field of investing/trading where there are no fixed laws/rules of nature and various situations are highly contextual and subject to good judgment which favours the "fox" who can see things from different angles and weigh probabilities rather than take absolute positions.

Obviously I'm being a bit Ah-Q here because I'm trying to see the half-full glass, or the advantages (retrospectively) of not having somebody to learn from in my early investing days; however learning about the stock market from scratch is, in my mind, really not that difficult nowadays. The penetration of the Internet has democraticised the spread of stock information, and information asymmetry is probably less than at any time in the past. In addition to books, online investing sites like Investopedia and MarketWatch were highly educational in my early investing days, and I also got a feel for the Singapore stock market through online forums where there was much sharing in the early days (I was lucky there.... nowadays there's probably less sharing). Indeed, the online forums, if one learns to sift the wheat from the chaff, are the single most useful resource for the newbie because one can learn the subject matter from different "Masters", hence exposing him to different perspectives (see "Using Online Forums").

What if I had started out in the financial industry instead of in a totally unrelated profession (engineering)? For one thing, my focus would probably have been different. Brokerage analysts would be more familiar with the market technicals, such the big buyers/sellers, market depth, associated technical charts etc, by virtue of their easy access to all these facilities. I would think the overall effect would be to inculcate a shorter-term focus and a trading mentality, by virtue of their better market timing. I myself have tried three or four times to pick up technical analysis in detail seriously, once in my early days, once following my Global Tech debacle when I was re-looking my investment approach, and the most recent after the CAO debacle, where I was not directly involved but had heard traders claim that technical analysis could easily have predicted the coming scandal. However till today my buy/sell timing is often terrible, which is why I prefer to take a medium-term investing approach. Those with analyst backgrounds, like Gallen from the KelongStocks blog, are much better stock-buying timers. At the same time, a trader's mentality typically include risk management techniques such as cut-loss which would probably have taken away most of my big wins.... up till today I believe that such risk management techniques often lull the trader into a sense of complacency that dissuades him from researching or thinking too deeply about his stock picks ("if the stock doesn't perform, I can always cut loss"); I have my own risk management methods but I have developed a bigger stomach for sustaining losses in anticipation of bigger gains.

Secondly, I wonder if I would have had as great an interest in the stock market now if I had started out in the financial industry. Somehow, churning out research on companies day after day as part of routine work would probably have taken the fun out of things way early in my career. Bearing the brunt of criticism from retail investors who suffer from drawing the short end of the stick would probably have been even more deflating. The journey from casual interest to mild obsession over these years has been a more rewarding one for me.

Ultimately, as the saying goes, there are many ways to skin a cat. Thinking about these hypothetical situations is interesting but at the end of the day the best way is to integrate past experience to build a competitive advantage. For me, it is simple: search harder (for good stocks) than everybody else, read more (about emerging trends) than everybody else, think more deeply (about business fundamentals) than everybody else.

My Investing Journey: War and SARS

2006-08-28T08:00:00.000-07:00

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When the year 2003 came the market was in its doldrums. The mini-rally that the market attempted in mid-2002 had died out and the market kept sinking over the second half of the year.

Lesson No. 1: It is the anticipation of a war that will kill a market.

Uncertainty is the worst element in a market, because another word for uncertainty is risk. In late 2002 the uncertainty of war with Iraq drained the market of its energy, because the stalemate dragged into 2003 as George Bush searched around for an excuse to fix Iraq with an accusation of WMD possession.

It is a historical lesson that wars do not cause the stock market to crash, indeed the end of wars often bring about bull markets. The swiftness in which the war in Iraq reached a resolution in early April 2003 might have brought about a rally, only that it was followed by the spectre of SARS that hit Asia badly, in April-May 2003.

Lesson No. 2: When the market doesn't react badly to a looming crisis, it might have bottomed.

In retrospect, the SARS crisis marked the best time for buying (and I show no disrespect for those who suffered). With the exception of certain sectors which were badly hit (travel-related, such as SIA and Star Cruises, for example) the market seemed to have bottomed as it remained relatively stable over the crisis. The STI had fallen below the post Sep-11 levels in Mar-03 (~1200) but never went below that level during the SARS crisis, and the SESDAQ never sank below 50. The liquidity was like steam in a pressure cooker; once the worries over the SARS episode started to ebb away, the lid was popped open for a bull that has arguably sustained itself all the way till today.

Lesson No. 3: Keep your cool and keep buying.

It helps to have a regular income which is like a tap from which you regularly collect water and use it to water your withered plants. It is one of the reasons why I always believe one should not consider full-time investment without assuring himself that he either has considerable capital or has an alternative source of income (see "Full-time investing/trading"). Continually investing funds in the stock market is a form of averaging down, which might be dangerous when one applies them to individual stocks that have plunged while the market is generally bustling, yet if the stock is down as a result of a generally weak market tide, then it may well be a worthwhile thing to do. One just needs to have faith in the ability of the market to spring back, while making sure that the particular stocks he chooses to buy do not have faulty "springs". Those who practise market-timing and try to sell during periods of weakness and then buy when the market strengthens would have sold during SARS at the bottom and then struggled to get back into the market as the market bid itself up aggressively from May 2006, rather suddenly. The bull rally post-SARS has reinforced my conviction not to try to time the market. Anyway, I never practised that; I held on to my stock portfolio that had gone ~20-30% below capital cost through the Iraqi stalemate and SARS crisis, adding new promising stocks with new investible funds, and the market rewarded me for my faith when it recovered in May.

Non-PE stock valuation metrics

2006-08-24T07:15:00.000-07:00

DanielXX's intro: This is extracted from an article by Yeoh Keat Seng, the chief executive officer of Commerce Trust in Malaysia, on alternative stock valuation metrics. Sometimes they might be more relevant than PE as the best single valuation metric in certain situations, eg. where earnings growth is not steady, or where the value of the business is in its assets, or where one wishes to estimate takeover/acquisition value etc.

(P.S: The following were extracted from another source and is not my original work.)

There are many other valuation models in use today. Some are as easy to grasp as the PE, and yet no less powerful in application.

Others are more esoteric, having been developed in more recent times to overcome the limitations of the PE model.

The dividend yield model is widely accepted because it is simple and unambiguous. It is the ratio of the gross dividend a company pays in a year to the share price. As the name suggests, it indicates the cash return you earn from investing in the company’s shares.

You can think of dividend yield as being one of the two components of total return from your investment. When you invest, the hurdle rate is your opportunity cost of funds, say FD rate of 3.5%.

A stock which provides you with a dividend yield of 5% is obviously a candidate to switch your funds into, assuming its other attributes also fit the bill.

Since the higher dividend yield compensates for the interest foregone from putting your money in FDs, in theory, you are getting a free ride to earn the other component – capital appreciation of the shares.

You have to take into account two things however. First, the dividend rate must be sustainable, otherwise the argument does not work. Second, unlike putting your money in FDs, both the principal and the return are at risk when you invest in shares.

Hence, the company you invest in must be able to earn recurring, or better still growing, returns. This helps ensure a sustainable dividend yield and capital appreciation of the stock over time.

Equally importantly, you must be comfortable that the management will not do something stupid to destroy the value of the company.

The strategy of buying into high dividend yielding stocks is very apt during economic downturns when interest rates are low or declining, and when the relatively high dividend yields provide downside protection for the stock.

Further, given that these stocks are often perceived to be very safe, they are likely to be re-rated first when the market turns.

High dividend yielding companies tend to have strong cash generating businesses, and they are often in somewhat matured industries such as tobacco, gaming and consumer.

By the same logic, companies in a high growth phase cannot afford to pay high dividends because their earnings have to be ploughed back into the business. This inability to pick high growth companies is one of the greatest flaws of the dividend yield model.

Another simple but useful measure of value is price to book, or P/B. It denotes what you are paying for the company in relation to the book value of its net assets.

Given that the value of assets in financial statements here is normally stated at historical costs, P/B is usually a conservative measure of what the company is worth.

As a general rule, a P/B of close to 1 (or lower) is considered attractive as you are investing in the company at almost the same cost as its original shareholders. The goodwill the management most likely has built in the business over the years e.g. a good brand name, strong distribution and good relationship with clients, comes for free.

Relying on P/B alone, however, is not adequate, as it does not tell you anything about the earnings generating and dividend paying ability – ultimately that is what matters to a shareholder.

So what if a company is trading at a P/B of 0.5x, if it never develops its assets to earn profits, or has no intention of selling those assets?

P/B is often used as a complementary measure to PE, serving as a value-screening device. On its own, a variation – price/market value (instead of historical cost) – is commonly used in the valuation of property development businesses, as it provides an indication of earnings generation potential beyond the immediate fiscal year.

This same measure is also commonly used for investment property and investment holding companies, but I personally feel the application is somewhat academic, unless the company intends to dispose its assets, or unless there is a possibility of someone buying over the company with the intention of disposing those assets.

It is also often used on a stand-alone basis for loss-making companies, where PEs are not applicable. Sometimes, even insolvent companies are worth something, as debts can be restructured or creditors may be asked to take a haircut. In such instances, asset-based measures are probably more useful than earnings-based ones.

Many variations of earnings-based measures have also been developed, in order to overcome some of the inherent flaws of the PE model.

For example, the PE being a single-period model, it treats every investment as if the risk is uniform and the contention that cash flow gives a better indication of returns from investments than earnings.

Hence the use of price to cash flow ratio, and its more sophisticated cousin, the discounted cash flow (DCF).

The latter’s much touted advantages are that it uses cash flows instead of earnings, it is a multi-period model, and that it recognises the time value of money and the unique risk of each investment.

Enterprise value (EV), a more recent phenomenon, measures the value of the business – funded by both shareholders and creditors as opposed to the value of the company – the portion of the capital funded only by the shareholders.

When used together with cash flow (denoted by earnings before interest, tax, depreciation & amortisation, or EBITDA in short), the EV/EBITDA ratio further develops on the payback concept of PE, but to both creditors and shareholders, not just the latter.

Finally, another increasingly used measure works on the concept of economic profit. The economic value add (EVA) recognises that there is a cost to capital, just like there is to debt, even though paying interest on debt is obligatory, while paying dividends is not.

Capital is never free because shareholders could have earned a return had they chosen to put their money elsewhere. EVA is calculated by charging a cost of capital to profits reported using the traditional accounting convention.

Beyond PE, dividend yield and P/B, most of the other measures discussed above usually have narrower applications in more specific industries, and are probably less suitable for retail investors because of their complexity.

Equipping yourself with a good understanding of the basic concepts of PE, dividend yield and P/B should suffice for a start, I believe.

(The above was extracted from Sahamas forum (a Malaysia forum site), on which I occasionally post. It is specifically taken from the "All About the PE Ratio" thread in the Investing Treasury Chest sub-forum.

How to make money from charity organisations

2006-08-21T17:16:00.000-07:00

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Note: For all serious charity organisations, please forgive my unwitting trespasses.

From my observations the last year or so, it appears that starting a charity organisation is a really good idea. Registration red-tape is minimal (as has been pointed out in the papers today), revenue source is relatively low-cost because you don't have to show as much value-add as you have to tug at people's heart-strings, and what's even better, these contributors don't really care where the money goes to because generally the contributions form a small part of their income and they feel they have "done their part" after forking out the money.

Let's look at a few ways to make money in a charity organisation:

Paying yourself high remuneration
A concept immortalised by the "peanut" salary of $600k/year paid by TT Durai to himself, approved by a remuneration committee in a board dominated by himself. In addition to monetary compensation, why not pay yourself in kind as well, through necessary luxuries like first-class travel, gold taps etc. See a related article on the NKF.

Another example to emulate must be Mr Vincent Lam of Youth Challenge who cashes in $13k/month (or $156k/year) on an organisation revenue (read: funds raised) of ~$400k/year and reserves of ~$100k. What a high expense ratio the organisation has. Depending on how one interprets the profit margin, it is a really good business proposition (How do we interpret profit here? Benefits accruing to the beneficiaries of course. The youths? Of course not, stupid.)

After slogging for several decades and being entrepeneurial enough to found the charity organisations, this remuneration is only what you deserve. Besides, your peers are all earning substantial amounts as well, so why not you?

Related-party transactions
Although the charity organisation was founded by you, strictly speaking you do not have a share in the organisation.... it is a public organisation, with equity from the general public. You are a trustee/manager. However, it is possible to own stakes in private companies on the side to which you can farm out the various outsourcing services required by the charity organisation you are empowered to manage.... for example IT, marketing.

The "float"
This is the investment concept made famous by Warren Buffett. In his early days he was managing a small fund and was thinking it was a shame he could not parlay his investing skills that yielded >20% annual returns to a larger capital base. Then he discovered the insurance float which gave him access to huge insurance premiums where the cost of capital could be deferred to a period far back. As long as charity funds are kept in reserve instead of being paid out to the intended beneficiaries, they essentially are the "float"; imagine what a private full-time investor can do with these funds!

Now for some constructive opinions .... a definite requisite of any critical blog article nowadays. I guess the newly-formed charity supervisory council should have covered all the angles, in particular the governance aspects which appear to be the most lacking. Corporate organisations increasingly try to align management objectives with shareholder objectives by payment of options rather than fixed salaries, such that management will try to create shareholder value (ie. higher profits, higher shareholder total returns). Who are the shareholders for charity organisations? It is either the giving public or the receiving needy, but the common objective must be to maximise assistance (both short-term and long-term) for the target audience. Pegging the performance of charity organisations to the number of people helped and the quality of help rendered relative to the funds raised/in reserve, and then pegging management remuneration to such performance, may provide some form of objective alignment similar to options (if we see greater assistance rendered = greater shareholder value). In other words, somebody should really come up with a set of key performance indicators to judge value-add objectively. While over-regulation runs the risk of being counter-productive, perhaps one should tighten the screw and then release it gradually, when there is increasing evidence of slack governance.

Shareholder activism

2006-08-17T09:16:00.000-07:00

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Minority shareholders have always been treated as rank outsiders in the power hierarchy of a listed company. Not just in Asia, but also in the West, which has a long tradition of equity ownership. It is only after the scandals during the first years of the new millenium (Enron, for example) that shareholders in the US have been flexing their muscles and forming coalitions with like-minded investors or acting through their mutual fund companies to bring up proposals to the management at AGMs, with issues ranging from limits on chief executive officer pay (the most common proposal) to nondiscrimination policies that include sexual orientation. See the article link to CorpWatch in the US for more information.

In a typically non-confrontational, tripartite-driven Asian society like Singapore, many will be averse to the idea of shareholder activism, from the top down to the minority shareholders themselves. The tradition has been to place faith in the management to do the right thing, and given that growth in the past has not been driven by common equity, but by government funding, debt and foreign investment, it is understandable that company management will pay less attention to minority retail investors. The active lobbying and questioning is typically "outsourced" to the brokerage analysts at separate analyst briefings while AGMs tend to be insipid affairs with little shareholder participation (see my article on "The value of AGMs"). So both sides generally don't appear to be interested in interacting with each other, save for the same old regulars (retiree brokers etc).

The fact is that the stakeholders within a company are driven by different objectives. Shareholders will be driven by profits and will want to maximise the economic value of the firm; if the owners are also the managers, they will tend to manage with the same objective of maximising shareholder wealth. However, agency problems arise when the managers are non-substantial shareholders, because their managerial goals may diverge; for example they may seek non-accretive acquisitions to increase their power and prestige. Even manager-main shareholders could take advantage of minority shareholders through inter-related party transactions (something the Indonesians were famous for) to siphon funds from the listed company to their own 100%-owned private arms. If minority shareholders don't look out for themselves and speak out when needed, they will end up being the ones sustaining these so-called agency costs.

A lot of such minority shareholder inaction has to do with lack of knowledge, both of regulations as well as implications of corporate moves. Generally most retail investors don't go further into the financial statements beyond the P&L statement, and don't pick out things like management remuneration, revised aggressive depreciation policies, related-party transactions etc, all of which could constitute grounds for further questioning. There was some confusion over the Pacific Century episode, where firstly it was unclear whether the concurrent offer by private equity firms still stood, and secondly over the rather cheap buyout of PCCW's telco assets by a China-affliated investor. The general offer by OCBC for the rest of Great Eastern also triggered some confusion over listing validity and shareholder options should they reject the offer. These two episodes were highlighted by the press, otherwise they would have remained in the dark. In the absence of clear-cut alternative options, retail investors tend to take the path offered by company management, out of fear (of being left out).

The most well-known shareholder activist organisation in Singapore would be SIAS, the Securities Investors Association of Singapore. Formed in the aftermath of the Malaysia CLOB debacle, its charter is to represent the interests of the retail minority investor. However, monetary support from the investor population it aims to fight for has been weak, and in the end it has had to resort to sponsorship from Singapore GLCs as well as providing their own in-house stock research services to support its staff.

The most visible symbol of shareholder activism in Singapore in recent years has probably been Oei Hong Leong, and his prime target, Natsteel. His sometimes incongruous positions notwithstanding(eg. why oppose the recently proposed change of Natsteel's name?), he has been able to extract value for all Natsteel shareholders, including himself, through aggressive posturing at company AGMs, and he is now pushing for cash-rich Natsteel to either do a cash distribution to shareholders or find a new business quickly, following its divestment of its steel business. This is a good example of how shareholder activism can keep management on their toes, and to highlight to the managers what are the priority issues important to shareholders.

Activism brings to the mind of management scary images of confrontational individuals dragging the whole decision-making process into the mud, and they point to cases in the US where corporate sharks with no interest in the core business acquire stakes in order to strip the assets; sometimes they acquire large stakes and then force the target company to repurchase the stock at a substantial premium to prevent a takeover, a process known as greenmail. While noting that Singapore shareholder sophistication is nowhere near there, it could also be argued that with the exception of interference with strategic decision-making, the above shareholder-driven moves bring as much benefit to minority shareholders (through unlocking of value) as they damage management interests.... and who owns the company, ultimately? A more active shareholder community facilitates greater interaction and communication with the management, tends to drive an appreciation for better-quality stock research, and ultimately creates a shareholder community at greater ease with their stock holdings and hence more ready to take a longer-term buy-and-hold investment horizon/approach (instead of the wheeling-dealing we see on the markets predominantly, in part driven by an inherent distrust/perceived ignorance of company prospects/direction). When shareholders actively ferret out information on the company and surface them to other investors or to management, the end result will be a more efficient market that prices in the inherent risks ..... and ultimately higher trading liquidity and higher valuations over the long-term.

Utilising stock indices

2006-08-13T21:30:00.000-07:00

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I have just come up with an Energy Sector Index on top of my earlier China Stock Index, given that there are no comparable indices for these sectors/themes on the SGX. Somebody asked me what was the best way to use these indices and I thought I'd write about some suggestions here.

Firstly, market indices or sector indices can be used to track the fortunes of the general market or sector respectively, and compare(or contrast) the performance of one's portfolio picks against the index, which indicates the average performance. That should be pretty obvious to all market players. I have mentioned in an earlier article about benchmarking portfolio performance: on the first level of benchmarking you benchmark against the broad market performance; however on the second level it makes sense to benchmark your individual sector performance (assuming you perform sector allocation in your portfolio) against the relevant sector indices. Otherwise you might possibly be outperforming the market but underperforming your individual sector; not good to find out but good for self-evaluation.

Secondly, these indices provide a good basis for development of an index portfolio if one is really keen on the sector. Ok, maybe not, more like some specific stock picks since we're not managing big funds here. Index stocks represent the largest market-cap stocks in the particular sector, which are more likely to be in the radar screens of fund managers. Ultimately we're trying to find stocks that the fund managers would buy, because that's where the big money's coming from. But don't take the index component stocks as the best; maybe you should check out my HotStocksNot blog for any views on that particular stock (note that there're a few index stocks I've previously recommended against buying for both my Energy and China theme indices) ;-)

Thirdly, a view of the long-term performance of a particular sector index against the general market index provides an idea of the correlation between the two. By correlation I mean the sector's response toward a directional move by the general market. Some sectors, like banks, enjoy strong correlation with the general market (partly also because they are major components of the market index); some sectors/themes only exhibit patchy correlation (eg. SESDAQ small-caps vs STI sometimes); some themes might even have negative correlation (eg. healthcare might rise when STI falls because of their defensive characteristics). It might be useful to note, for example, if a sector is underperforming the STI although historically it has had a high direct correlation to the latter; it might suggest an investment opportunity.

That is the purpose of market and sector indices, and I hope my two new indices will be useful for readers who are optimistic about the Singapore market.

Index	Last value	Change	% Change
STI	2865.14	527.70	(22.6%)
SESDAQ	132.73	41.49	(45.5%)
SGX Finance Index	2126.11	388.95	(22.4%)
SGX Property Index	1138.73	350.59	(44.5%)
SGX Hotels/Rest Index	948.79	152.60*	(19.2%)*
SGX Construction Index	423.71	140.91	(49.8%)
Plastics Index	94.22	-5.78	(-5.8%)
Env/Water Index	108.28	8.28	(8.3%)
Energy Index	125.27	25.27	(25.3%)
China Index	133.65	33.65	(33.7%)