Archive for the ‘Value Investing’ Category

Closing in for the kill in value investing

Monday, January 3rd, 2011

In our previous two articles, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses and Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses, you have learnt about which businesses to avoid and which ones to look out for as your investment candidates. Once you have identified such businesses, the next question is, when do you make a move to invest in them?

First, you need to have some idea how much that business is worth. Our previous articles, Measuring the value of an investment and Effects of inflation on value of investment will give the mathematical explanations on how to value a business. But do not confuse mathematical precision with accuracy. As we said before in Confusion between precision & accuracy,

As the above-mentioned analogy shows, precisely wrong numbers are useless. If we use them, then the quality of our investing decision will degrade considerably.

For this reason, it is better to be vaguely right than to be precisely wrong.

Second, you must remember this: never ever pay for more than what the business is worth. In fact, it is advisable that the price you pay be of a certain margin (say 15%) below its worth. This is to give you a margin of safety against errors in judgement.

The next step is to wait patiently, stalking the business like a hunter. Eventually, bad news will strike the business, revealing the changes that will occur. Then the stock market will typically overreact, pulling the stock price to a level that is far below what it is worth. That will be the time to strike. The stock market overreacts because it is not rational and suffers the common mental pitfalls that ail every human. To be a successful investor, you need to be more rational than the market collectively. We recommend that you familiarise yourself with the common mental pitfalls as explained in our guide, Common mental pitfalls that leads you astray and Why are the majority so wrong at the same time and in the same ways?.

However, this step is the trickiest one and errors in judgement are most likely to be made. Bad news comes in two flavours:

  1. Changes to the business are temporary and therefore, a recovery will eventuate in due time.
  2. Changes to the business are permanent and therefore, there will be no recovery.

Thus, you have to discern the nature of the changes, understanding whether the context of the underlying trends in which the business changes occur is secular or cyclical (see Understanding secular vs cyclical). For example, as we explained before in Should value investors be ?bullish? in a bear market?,

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ?typical? bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current ?Buy? recommendation will be very wrong.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

This is where value investors are most likely to get wrong.

Reader’s question on Warren Buffett

Tuesday, August 18th, 2009

Recently, one of our readers asked this question at the forum:

So why is Warren Buffett’s net worth so much higher than Charlie Munger’s? And why Ben Graham, the founder of the idea, never really make it? It seems like value investing only works extraordinarily well with Buffett. I was hoping someone like Ed could give some insight.

We see that this is an excellent discussion topic. So, what do you think? Join in the forum discussion now!

Quantitaive demonstration of the effects of price inflation on your investment

Thursday, March 12th, 2009

For the hypothetical business in our previous article, Revealed: The error in the Buffett logic, we will show you how earnings are valued (using the discounted cash-flow method) and the effects inflation with a table:

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Here are the explanations for the columns on the table:

  1. Year – The table shows the year-by-year outcome in a 20-year period. This column denotes the year.
  2. Earnings – It shows the earnings of a business. You can see, at the end of the first year, the business will generate $100 of earnings. Earnings will grow at a rate denoted by the corresponding entry on the 6th column (Earnings Growth). In this example, earnings are growing at a rate of 25% per year. You can see, at the end of the 20th year, that business will earn $6938.89.
  3. PV of Earnings – This is the present value of earnings earned at the end of the year. The discount rate used in the present value calculation is 30%, which is defined in the 7th column of the table. As you can see, the present value of the 20th year of earnings ($6938.89) is only $36.51. As you can see, if you add up first 10 figures of that column, you will get $648.87, which is the number we gave in the previous article.
  4. Total PV – This is the sum total of the previous column. This is also the valuation of 20 years worth of earnings at the discount rate of 30%.
  5. Accumulated Re-invested Earnings – What happens if you re-invest all the earnings at an investment return rate that is the same as the discount rate (30%)? Each row of this column will show you what your total accumulation of that business’s earnings. As you can see, at the end of year 20, you will have accumulated $206,626.93.
  6. Inflation Rate – This column define the price inflation rate.
  7. FV of Total PV Due to Inflation – What if inflation is allowed to do its work to devalue your cash? In this column, it shows how much $1,087.23 (the valuation of 20 years worth of earnings) at the beginning of the first year will have to be in order to maintain the purchasing power at the end of the year. As you can see,  $94,301.83  at the end of the 20th year can only buy as much as $1,087.23 at the beginning of the first year, given price inflation of 25% for every year.

As this table shows, as long as you can re-invest the earnings of the business at a compounded return equivalent to the discount rate (30%), which is higher than the price inflation rate (25%), you will beat inflation. That is, your wealth in real terms will rise. But if you decide to stuff your earnings as unproductive cash under the bed, you will lose out to inflation. That is, at the end of the 20th year, you will have accumulated $34,294.47 in cash but price inflation will mean your original $1,087.23 investment have to grow to $94,301.83 in order to preserve its purchasing power.

If you apply a discount rate of only 10%, the valuation will balloon to $7,928.52, which is equivalent to  $687,689.46 in 20 years time due to inflation. But if you can only re-invest your earnings (which is growing at 25%- the same as inflation) at 10% (compounded), you will only accumulate $53,339.12, which means inflation will destroy your wealth in real terms.

Revealed: The error in the Buffett logic

Tuesday, March 10th, 2009

In our previous article, we asked our readers to spot the flaw in Warren Buffett’s logic. Today, we will reveal the answers. Before you read on, please take the time to understand our guide, Value investing for dummies.

As Buffett said, staying in cash and cash equivalent (e.g. government bonds) is a bad move because price inflation is likely to be very high in the future. This, we agree. But does it mean one should switch from cash to stocks today? If the answer is “yes,” then there’s an error in logic.

First, by that very statement, Buffett was implying that the yields of government bonds are far too low. Essentially, this means that those who buy and hold those bonds will have their wealth frittered away by price inflation.

Next, as we explained in Value investing for dummies, value is a relative concept. Stocks are valued relative to risk-free government bonds, which in turn is suppose to reflect future price inflation. If the yields in government bonds are wrong by a long shot, then stock valuation will be wrong.

To explain this point better, let’s use an example. Let’s suppose the following conditions:

  1. 30-year Treasury bond yield is 3.5%.
  2. An almost risk-free business with monopolistic powers (let’s imagine it is Woolsworth).
  3. That business can raise prices and grow its earnings at 25% per year.
  4. The first year earnings of the business is $100.

If we apply a 5% discount rate on 10 years of that business’s earnings, we get a present value of $2358.76. That 5% is arbitrary chosen from the fact that it is a little above the Treasury bond yield.

As long as the long-run average price inflation is around the vicinity of the 30-year Treasury bond yield, buying the stock at below the present value of its earnings is a bargain. But what if the bond yield is way way way wrong? Let’s say the price inflation rate turns out to be, say 25% (in other words, the business earnings grow fast enough to merely keep up with inflation). You can see that applying a discount rate of only 5% will give you a return far below price inflation (but slightly higher than Treasury bond yields). If you want a return higher than price inflation, your discount rate will have to be north of 25%.

If we apply a 30% discount rate on 10 years of that business’s earnings, we get a present value of only $648.87! That 30% is arbitrary chosen from the fact that it is a little above the price inflation rate.

So, if you believe that government bonds are severely under-pricing future price inflation and you have no idea how the ravages of price inflation will look like, then how can you value stocks correctly? If the price inflation turns out to be Zimbabwean-style hyperinflation, then you will lose big money (in real terms) investing at today’s stock price.

Spot the error in Warren Buffett’s logic

Sunday, March 8th, 2009

In Warren Buffett’s latest shareholder letter, he said that,

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgement confirmed when they hear commentators proclaim ?cash is king,? even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Currently, as we said before in Why are nothing-yielding US Treasuries so popular?,

One of the thing that confounds us is the fact that short-term US government bonds are yielding almost nothing. A 10-year US Treasury bonds yields a measly 2.79% while a 30-year bond yields 3.57%.

Therefore, on that paragraph alone, we agree with Warren Buffett. That’s the main idea of our earlier article, If you save, government will wage economic war on you. But assuming that this is true, what is the implication for investors? Did Warren Buffett mean that investors should shift from cash to stocks?

If the answer to the second question is “Yes,” we can’t help but notice a flaw in his logic here. We will turn over to our readers to spot the flaw at our discussion forum. The first person who spot it will be given a pat on his/her back and be quoted! 🙂

Doubts over value-investing

Tuesday, March 3rd, 2009

Warren Buffett’s latest dismal performance had many fans of value-investing taken note (see this Bloomberg article). In his latest shareholder letter, he confessed that

During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. I will tell you more about these later. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.

Some of his fans are even questioning the whole philosophy of value investing. One of Australia’s value-investing tip-sheet (which we will not name here) confessed that

Ben Graham began his seminal piece on value investing with that quote, and several of his disciples built impressive records over many decades using it as their guiding principal. Buy established businesses when their share prices have fallen substantially and are out of favour, the theory goes, and sell them when the world comes to its senses. It worked for the best part of 70 years. Then, in 2008, it stopped working.

I wouldn?t go that far but it?s clear this financial and economic crisis is different to anything Warren Buffett has experienced. Unless you?re an octogenarian, that makes it different to anything you or I have seen either. It?s time to tread extremely carefully.

Today’s Global Financial Crisis (GFC) is something that we warned our readers. As recent as last month, we wrote in Should you follow Buffett and be greedy now? that

Finally, take note of this: Warren Buffett has never experienced the Great Depression for himself. Neither has he experienced hyperinflation of Weimar Germany. All his life, he lives in America as an American. Today?s America is at a turning point and there?s no guarantee that it will return to the America that Buffett experienced all his life.

In December last year, we reported in Is the Warren Buffett way dead? that Marc Faber said that

I think The Warren Buffett approach is dead, and it?s been dead for ten years, and it?s going to be dead for another ten years.

In July last year, we wrote in Should value investors be ?bullish? in a bear market?,

Here, we see a potential trap for the unwary value investor.

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses.

If the global economy falls into a Greater Depression, many of today’s ‘bargain’ stocks will still turn out to be value-traps. For us, we are not buying stocks yet.

Book value in deflationary times

Thursday, December 11th, 2008

In fundamental analysis of stocks, one of the most important numbers is the book value. Basically, book value is calculated by total assets minus intangible assets (patents, goodwill) and liabilities. Roughly speaking, it is the value you get if you liquidate the company.

But in times of debt deflation, how reliable is book value?

Remember, as we said before in Will deflation win?, such a deflation

… is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

When that happens, there is widespread liquidation of assets in the economy. Furthermore, buyers tend to be few as cash tend to be hoarded. In such an environment, it will be extremely difficult to realise the book value of a company if it has to be liquidated.

Therefore, when analysing a company’s balance sheet, be very sceptical of the carrying value of its assets, especially the very large and illiquid ones (e.g. buildings, plants). In times of deflation, the actual realisable value can be very far below the stated value. Therefore, the book value can be a very hollow number.

Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses

Thursday, October 30th, 2008

Today, we will continue from our previous article, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses. After learning what type of businesses to avoid, you will now learn which type of businesses that makes ideal investment candidates.

The legendary investor, Warren Buffett favours businesses with durable competitive advantage. As The New Buffettology, explains, a business with

… durable competitive advantage typically sells a brand-name product or service that holds a privileged position in the stream of commerce that allows it to price its product or service as if it faces little or not competition, creating a kind of monopoly. If you want this particular product or service, you have to purchase it from one company and on one else. This gives the company the freedom to raise prices and produce higher earnings. These companies also have the greatest potential for long-term economic growth. They have fewer ups and downs and they posses the wherewithal to weather the storms that a short sighted market will overreact to.

As we mentioned before in Two uncertainties of valuing a business- risk & earnings,

To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates.

Therefore, businesses with durable competitive advantage are the ones that can be valued more accurately.

Before we go elaborate on durable competitive advantage, we need to devote a paragraph to explain how businesses make money. Businesses become successful in two ways: (1) having the highest profit margins and/or (2) selling the highest volume of goods/services. Ideally, the businesses that you invest in have both characteristics. If not, either one of them will do. But avoid those that have neither.

Businesses with durable competitive advantage are most likely to be the ones with high profit margins and inventory turnover. They have:

  1. Competitive advantage– they are the only ones producing a unique products/services. This means that unlike price-competitive businesses, price is not the most important consideration of their customers.
  2. Durable– Not only must they just have a competitive advantage, that advantage must be durable as well. That means they must be able to keep that advantage in the long term without needing to expend great amount of capital and energy to maintain it.

There are some businesses that have competitive advantage that are not durable. Consequently, vast sums of shareholder wealth have to be expended to maintain it instead of returning them back to the shareholders. Intel is an example of such business. No doubt it has a competitive advantage and a monopoly on computer chips in the market. But it has to spend billions of dollars in research and development and come up with new products continuously to maintain that monopoly.

In the next article, we will discuss how do we go in for the kill to invest in our chosen business.

Is it time to buy stocks in times of intense fear and volatility? Part 3: Stock picking approaches

Wednesday, October 29th, 2008

Today, we will continue from Is it time to buy stocks in times of intense fear and volatility? Part 2: Leverage position,

What if you are one of these contrarian investors seeking to increase your risk in the stock market? Which stocks to pick?

Broadly speaking, there are two approaches to stock-picking: (1) top-down and (2) bottom-up.

The bottom-up approach is, as we explained in Confidence back? Beware of bear market rally,

… invest in businesses based mainly on its individual merits and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ?bullish? or ?bearish.? Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

The last few articles of our guide, Value investing for dummies, will elaborate more on the basics of the bottom-up approach. If you want to utilise the bottom-up approach, please understand that it has a major weak point, as we explained in Should value investors be ?bullish? in a bear market?:

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses.

The top-down approach is to start off by looking at the broad macroeconomic themes and then zoom into individual businesses that may benefit from those themes. An example of such approach is to look at the broad macroeconomic implications of rising long-term energy prices (see How to profit from rising energy prices?) and then study the merits of investing in oil companies and alternative energy developers.

This approach has intuitive appeal because of human tendency to seek out a story. Macroeconomic themes are always expressed in the form of stories. But you must be aware that due to your human weaknesses, the appeal of stories can cause you to fall into narrative fallacies (see Mental pitfall: Narrative Fallacy). In addition, a superficial understanding of stories tend to lead one to oversimplify the thought process of picking stocks based on macroeconomic themes. For example, just because commodity prices is in a very long-run secular up-trend does not mean that any mining stocks will be good long-term investments (see Rising metals price=rising mining profits? Think again!)- there are much more subtleties involved.

In the next article, we will talk about the bottom-up approach by continuing on the incomplete series at Value investing for dummies.

Is it time to buy stocks in times of intense fear and volatility? Part 2: Leverage position

Tuesday, October 28th, 2008

Today, we will continue from Is it time to buy stocks in times of intense fear and volatility? Part 1: Introduction. The question was:

Surely, some of these stocks are undervalued by now right? Should you buy now? Even Warren Buffett is buying.

Well, the answer will depend on your personal circumstances. More specifically, it depends on your current level of leverage.

Before we continue, we must stress again that anything on this publication should NOT be considered as personal financial advice. We are approaching the above posed question from a philosophical point of view. Thus, we will be making many assumptions, generalisations and simplifications. The point of this article is to provoke you to think about your investment decisions based on risk-reward probabilities and should not be seen as some kind of economic analysis/prediction. Now, let get back to the gist of the article…

Let’s look at one extreme scenario. Suppose you are currently very highly leveraged. Also, you are not sure what the long-term economic outcome will be. Will the future pan out to be a V, U or L shape recession (see What type of recession is coming?)? But you believe that a V-shape recession is unlikely. Between the U or L shape recession, you are not sure which one will turn out. Now, let’s work out your risk-reward outcomes for each scenario:

  • V-shape recession (unlikely): You will stand to gain immensely when the economy bounces back ‘soon.’
  • U-shape recession (more likely): You will suffer some losses for an extended period of time. But eventually, you will recover and gain.
  • L-shape recession (not so likely but possible): You will lose your entire life-savings, go bankrupt, lose your home and become destitute because of your high leverage (e.g. someone using their mortgaged home as collateral for their stock market investments).

Now, let’s suppose you are at the opposite extreme: complete absence of leverage (i.e. 100% in cash). Let’s look at your risk-reward outcomes:

  • V-shape recession (unlikely): You gain and lose nothing when the economy bounce back ‘soon.’ Relative to the highly leveraged investors, you are very much worse off.
  • U-shape recession (more likely): Compared to the very highly leveraged investors, you are better off during the downturn. Eventually when the economy recovers, you will not be too much worse off than the highly leveraged investors either.
  • L-shape recession (not so likely but possible): You will be way ahead of the highly leveraged investors.

As you look at these two scenarios, it becomes clear that for the very highly leveraged investors, they will sleep much better at night by reducing risk of catastrophic loss through the reduction of potential for gain. That means de-leveraging. For the completely un-leveraged investors (maybe a person who is 100% in cash should not be called an investor?), they increase their prospect for gain (without increasing the prospect of disaster significantly) through increasing their risk of loss. In other words, for the cashed-up investor, the reward outweighs the risks.

In today’s free-falling market conditions, it is clear that the majority of investors are de-leveraging because they want to reduce their risk. Contrarian investors should be approaching the market from the position of extremely low risk seeking towards a gradual and measured increase of risks.

What if you are one of these contrarian investors seeking to increase your risk in the stock market? Which stocks to pick? Keep in tune!