Archive for October, 2008

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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.

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Posted in Investor Education, Value Investing | 4 Comments »

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.

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Posted in Investor Education, Value Investing | 10 Comments »

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!

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Posted in Investor Education, Value Investing | 2 Comments »

Is it time to buy stocks in times of intense fear and volatility? Part 1: Introduction

Monday, October 27th, 2008

Let’s say you are a long-term investor who is not into timing the bottom of the stock market. After having seen the market falling into intense panic and fear over the past few weeks, you may wonder whether it is now time to buy stocks for their long-term value. No doubt, in this climate of intense volatility and fear in the market, stocks of good businesses along with the bad ones are indiscriminately sold. Even if a depression is coming, not all businesses will be affected equally. Some of the better quality ones will fare better (and even thrive) in such a harsh environment. For example, during the Great Depression, some businesses’ profit even grew (see Which industry?s profitability grew as the Great Depression progressed?)!

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. In other words, the right answer to this question for two different people can be different. In the coming articles, we will explain how to go about answering this question based on probability, reward and loss. Keep in tune!

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Posted in Investor Education, Value Investing | 2 Comments »

Will RBA’s cutting of interest rates help?

Sunday, October 26th, 2008

Recently, Associate Professor Steve Keen made the prediction that interest rates in Australia will be cut to zero by 2010. As this news article reported,

University of Western Sydney associate professor of economics and finance Steve Keen is radically bullish on interest rates, predicting a 2% cash rate by the end of 2009, dropping to 0% in 2010.

Dr Keen said the RBA would become more concerned about high household debt levels than inflation, as deep rate cuts in 2009 failed to stimulate the economy.

”The debt bubble is bursting and when it bursts, people stop spending and borrowing,” he said.

Investors should realise is this: if interest rates is ever cut to zero (i.e. Zero-Interest-Rate-Policy or ZIRP), it will not be good news for the economy. It will reflect the complete failure and impotence of monetary policy in regulating the ‘temperature’ of the economy. In other words, to arrive at ZIRP, it means that the economy is in a very serious trouble.

Japan fell into ZIRP in the 1990s. As we all know, the malaise in the Japanese economy lasted 16 to 17 years before a glimmer of hope was seen at around 2003. Today, due to the global credit crisis, they are falling back into the recessionary hole. With interest rates at 0.5%, they have no more room to cut further.

One thing that is different about the Japanese economy from the Australian/UK/US economies is that Japan had a relatively high savings rate. During their lost decade of the 1990s, the Japanese drew on their savings and retreated to their economic bunkers as their economy and asset prices contracted year after year.

In contrast, Australia/US/UK today have no savings and are heavily indebted.

If the RBA cut interest rates further, it will be in reaction and anticipation to Australians closing their wallets, cutting up their credit cards and shunning debt. As we explained before in Will Australia?s own pump-priming work?, all we need is for Australians to stop borrowing in order to induce a deflationary force of $250 billion. This deflationary force alone will wreck havoc to many Australian businesses, which in turn will wreck havoc to the employment market. Once mass unemployment appears, a lot of prime debt will become sub-prime debt. When debt becomes sub-prime, cutting interest rates to zero will not help.

Dangling pornography in front of a dead man will not induce him to open his dead eyes. Likewise, the RBA dangling free credit to banks (i.e. ZIRP) will no longer induce banks to lend because of the pervasive fear of bad debts. To understand this, we highly recommend that you read What makes monetary policy ?loose? or ?tight??.

Currently, Australians are voluntarily shunning debt (as shown by the rapidly decelerating rate of credit growth) as banks are still willing to lend money (although lending standards are tightening). When this voluntary action crosses over to involuntary, it will be the day when the deterioration will accelerate.

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Posted in Economics/Finance, Looking Forward | 12 Comments »

What is your personal price inflation rate?

Thursday, October 23rd, 2008

Yesterday, we read this news article, Inflation spike erodes savings,

With [Australia’s] inflation running at 5 per cent, savers will struggle to preserve the value of their finances due to sliding bank deposit rates.

Inflation is also running high in the rest of the Western world. Worse still, many of the official measurements of inflation run counter to personal experiences. In fact, official statistics are so often doctored up that some entrepreneur came up with a business (Shadow Stats) that “exposes and analyzes the flaws in current U.S. government economic data and reporting, as well as in certain private-sector numbers, and provides an assessment of underlying economic conditions, net of financial-market hype.” For example, if the pre-Clinton era CPI is used to measure today’s US inflation figures, it will come up with figures that are twice the official ones!

Anyway, the entire idea of price indices is logically invalid. It is a number that is the work of many arbitrary decisions. As we quoted Ludwig von Mises in How much can we trust the price indices (e.g. CPI)?,

If she [a judicious housewife] ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

Today, we would like to hear from our readers. What is your personal experience with prices over the year? Do you think the official 5% figure accurately reflects the rising cost of living in your personal life?

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Posted in Economics/Finance | 16 Comments »

Government’s contradictory messages

Wednesday, October 22nd, 2008

Back in Can China save Australia?, we mentioned about SBS’s Insight program, Greed. As we read the transcript of that program, we cannot help but realise that while the government officials are busy trying to deal with this crisis, they are sending out contradictory messages as a side effect.

For example, take a read at this:

JENNY BROCKIE:  But what sort of possibilities are we talking about here? I mean unemployment going up to 10%, 20% in the event of this taking hold in Australia? What could happen?

LINDSAY TANNER:  Definitely not. None of us can see into the future and the international crisis is obviously so unprecedented that it’s very hard to make predictions, but the fundamentals in Australia are very strong. We’re better off than virtually anybody else in the world to deal with these problems and we remain optimistic that we will be able to ride through this buffeting in reasonable shape.

On one hand, Lindsay Tanner ruled out the possibility of Australia’s unemployment going north of 10%. Yet, on the other hand, he said that no one knows the future and make predictions. If you notice, by saying “Definitely not,” he is already making a prediction!

Incidentally, in Jobless rate may double as China slows, JPMorgan Australia’s chief economist Stephen Walters said that

“We now expect the jobless rate to more than double to 9% in late 2010, from the current 4.3%,” Mr Walters said. “Softer growth in one of Australia’s leading export destinations means Australia’s export volumes will be lower, as will be the terms of trade.

“That said, on our forecasts, there will be 1 million unemployed Australians by the second half of 2010.”

The current way of measuring the employment rate includes those who are under-employed (see Nearly 600,000 Australians under-employed). When the economy slows down, it is those kinds of jobs that will be shed first, especially jobs in businesses that depend on discretionary spending (e.g. retailing). Therefore, a figure of 1 million unemployed people is not so unthinkable after all.

The next contradictory message from the government is on spending:

JENNY BROCKIE:   OK, there are quite a few things in what you’ve said that I’d like to pick you up on because we live in very contradictory times at the moment. You’re saying we should be thinking about thrift. You’ve just released a $10.4 billion package and you’re telling people to go out and spend. I mean, should Siobhan keep spending, keep getting into debt? What’s the message the Government is sending at the moment?

We believe that the government’s $10 billion stimulus package is a misguided Keynesian policy that will not solve the problem.

Firstly, as we said before in Will Australia?s own pump-priming work?, it is far too little to combat the deflationary force.

Secondly, even if it is big enough to induce the masses to spend, it is the wrong medicine. If such policies are carried out to the extreme, the outcome will be hyperinflation (see Bernankeism and hyper-inflation). As we explained in Supplying never-ending drugs till stagflation,

Students of the Austrian School of economic thought will understand that indiscriminate ?printing? of money will worsen the plague of mal-investments and structural damage in the economy. Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ?printed.?

Without the liquidation of mal-investments and restoration of the structural imbalances that is brought about by deflation, applying bigger and bigger stimulus packages will only function in similar ways to drugs- more and more for less and less effect. The reason why Keynesian reflationary pump-priming worked during the Great Depression was that it was applied after the cleansing effects of the deflation had done its work. But today, in reaction to the financial crisis, governments all over the world are doing so before the purge of fire. As a result, the much-needed economic correction that the economy had to have will not happen.

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Posted in Economics/Finance, Looking Forward, Market Observations | 12 Comments »

Can China save Australia?

Tuesday, October 21st, 2008

Today, we watched SBS’s Insight program, Greed. It is basically a small forum where audiences and experts mingle together and talk about the global financial crisis. Near the end, Peter Schiff said that Australia will be fine because China’s insatiable demand for commodities will intensify as the Chinese revert to consuming their own produce. This will intensify China’s demand for Australia’s commodities, which means that Australia will be in a very safe position.

Here, we disagree with Peter Schiff. Our reasoning goes like this:

  1. Yes, in the very long run, as we said before in Example of a secular trend- commodities and the upcoming rise of a potential superpower, China’s demand for commodities will continue to grow. But the question is what happens in the interim (i.e. the short to medium term). The worst case is a epic bust for the Chinese economy (see Can China really ?de-couple? from a US recession?). The best case is a slow-down. In between these two scenarios is a major Chinese economic correction. Furthermore, we believe that this slowdown could be within the designs of the Chinese government in order to achieve their long-term plans. We will talk more about it in the coming articles.
  2. Australia has a very highly leveraged economy (see Aussie household debt not as bad as it seems?). It is this high leverage that can be the undoing of Australia’s economy in the interim.

This is a subtle point that eludes many people, including the experts. Sure, the end point may be a paradise in the mountain peak. But it is a mistake to assume that the path to the mountain peak is an upward slopping straight line. The current high leverage of the Australian economy can pull us down to a deep valley of hell in the interim. The problem is, many will not survive through the valley and for those who survive, they will be transformed (and even scarred) by the experience.

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Posted in Looking Forward | No Comments »

If property prices follow long-term inflation, will prices not fall in the long-term?

Monday, October 20th, 2008

Back in Do property price always go up?, we have looked into a Dutch study, which found out that in a period of more than 300 years, property prices ultimately follow the general price levels. In other words, in the long-run, property prices are flat in real terms.

For today’s discussion, let us suppose that this is true.

Does this mean that it does not matter when one purchase the property (assuming that one is only concerned about real capital preservation) because in the long-run, it will always preserve your wealth by tracking the price inflation rate? If one thinks that the answer is yes, then one has fallen into a mental pitfall called Lazy Induction. Back in Mental pitfall: Lazy Induction, we explained that

The trouble starts when the sample that we used for our observations is drawn from our own personal bias. Then, from the observations of the biased sample, we make generalisations based on our flawed observations. Lazy Induction allows us to prove anything that we want to be true. All we have to do is to pick a sample of observations that conforms to our bias and then generalise from there.

The error in the logic of that answer lies in the crucial fact that one implicitly assumes the long-term price appreciation starts on the day that one bought the property. To explain this point more clearly, we will use Professor Steve Keen’s graph of property prices relative to CPI:

ABS Established Home Price Index vs CPI

Source: Rescuing the Economy or the Bubble?

This graph shows that property prices have been tracking CPI till around 1998, after which it took off.

Now, let’s imagine that you have a time machine and travel forward 300 years. Let’s say that our assumption that property prices follow long-term inflation rate still holds true in 300 years. What will we see? Assuming that long-term price levels follow a nice gentle rise (i.e. no hyper-inflation), we will see that the prices from 1998 to, say 2008, is part of a small blip before returning to the long-term price levels.

So, what is the implication of this? If surge in prices over the past 10 years (1998 to 2008) is a huge aberration away from the long-term up-trend, then it will have to fall in due time in order to follow the long-term price levels. That is, property price can still fall a lot in real terms if it has a prior huge run-up in real prices. If price inflation is relatively benign, then this will mean a fall in nominal terms too.

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Posted in Investor Education, Property, Thinking Tools | 12 Comments »

To be a successful investor, know yourself first

Sunday, October 19th, 2008

To be successful investor, you have to know yourself very well. By this, we mean that you have to understand your internal motivations so that you can remain rational. This requires an X-ray vision into your own emotional state, which is not very easy to do consistently. Whether one invest in a particular investment or not, a position is taken. For example, if you choose not to invest in property, you have to decide where to put your money. If you decide to put them in ‘cash,’ you are still taking upon a position. The problem is, your investment position will inevitably influence your emotional attachment to it. There is nothing wrong with having emotional attachments as long as you remain a human being. But the important thing for investor is that you must develop the skills to detach your emotional attachment from your investment.

Today, we will elaborate more on this. Let’s say you have taken an investment position. When that happen, there will be 3 questions that you have to sort out within yourself:

  1. What should happen to the investment, looking forward? This is what should happen to the investment if the rest of the market is rational. For example, after a market crash, you have identified an undervalued stock. You buy it from the stock market. If the rest of the world is rational, the stock should reflect the intrinsic value in due time. For those who want to read more on what we mean by “undervalued,” please read our guide, Value investing for dummies. For other class of investments like property, your views on what should happen may be based on your values and vision on society.
  2. What will happen to the investment? As we all know, the market is not rational most of the time. We don’t know why, but that is how it is. When it is not rational, what will happen is not what should happen. For example, currently, we are at a bear market for stocks. Some of the good businesses, along with bad businesses are sold down indiscriminately. Some bad businesses are not sold down enough. So, assume that stocks will continue to sell off, you can see that there is a divergence between what will happen and what should happen.
  3. What you want to happen to the investment? Sometimes, there is a divergence between what you think should happen and what you want to happen. For example, let’s you you bought a stock when it is overvalued. The stock should fall in price. But you may develop such an emotional attachment to it that you want it to rise in price. In another example, let’s say you have bought an investment property. Regardless of whether you buy it at the right price or not, you want it to rise in price.

When making investment decisions, investors can make the following pitfalls:

  1. Confusing what they want to happen with what will happen. For example, those who owe debt will want inflation. But whether that will happen or not is another matter.
  2. Confusing what should happen with what will happen. For example, an investor may short overvalued technology stocks in 1998. But it turned out that these stocks continue to rise for a couple of years before crashing.
  3. Ignoring what will happen. An investor may do his/her homework and conclude that an investment should rise and want it to rise. As a result, he/she may leverage himself to that. But alas, as Keynes said, “the market can remain irrational longer than you remain solvent.” The leveraged investment turned out badly and the investor lost a lot of money.

In conclusion, before you take up any investment position, sort out your “should,” “will” and “want” first.

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Posted in Investor Education | 6 Comments »

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