Posts Tagged ‘risks’

Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses

Wednesday, October 15th, 2008

Yesterday, in Two uncertainties of valuing a business- risk & earnings, we mentioned that risk and earnings are the two uncertainties in valuing a business. As we said in that article,

However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates.

Today, we will start off with a mini-series about choosing businesses that have strong economics. Such businesses have relatively lower uncertainties regarding their earnings and are also much less risky. Businesses with weak economics are much more difficult to value because of their higher risks and earnings uncertainties. For today’s article, we will look at identifying such businesses to avoid.

First, what are businesses with poor economics? They are the ones in price-competitive industries. As this book, The New Buffettology explains,

A price-competitive type of business manufactures or sells a product or service that many other businesses sell and competes for customers solely on the basis of price.

Example of such business is steel making, agriculture and manufacturing of mass generic products like clothes hangers. If you see a businesses in which its customers’ strongest motivation to buy is price, then you know it has poor economics. For such businesses to survive and defeat their competitors, they have to beat their competitors in costs. To beat their competitors in costs, they have to continuously engage in ruthless cost-cutting measures and improvements in techniques to keep their businesses competitive. This often requires additional capital expenditures and energy to keep the wheels running non-stop, which translate to more long-term debt and less distribution of profits to shareholders. Often, cost-cutting measures and improvement techniques are easily replicated. Therefore, businesses in price-competitive industries end up under-cutting each other continuously, which erodes profit over time. For such businesses, good quality and intelligent management is crucial to keep the business profitable. Also, they are more prone to strokes of bad luck.

So, to be a successful investor, the first step is to avoid businesses with poor economics.

Is it a good time to buy Australian financial stocks?

Tuesday, September 30th, 2008

By the time you read this, the global financial markets will be in mayhem, thanks to Congress’s rejection of Henry Paulson’s bailout plan. Last night, the Dow fell 777 points, the greatest one-day drop since the crash of 1987. Central banks are busy pumping hundreds of billions of dollars worth of credit into the financial system as the credit market freezes up. Stock markets around the world are plunging.

Some people reckon that this is a good opportunity to buy Australian stocks, especially financial and bank stocks, which are hardest hit. After all, the mainstream belief is that the Australian banking system is rock solid and prudently regulated. That implies that the sell-off of financial and bank stocks will be overdone and lead to opportunities for value-oriented investors.

What do we think of this idea?

The problem with this idea is that it is only half-right. This half-right idea is dangerous. Sure, it may be true that the Australian banking system is strong. But this is based on the premise that the current situation will extend into the indefinite future. This leads to the very crucial concept of Black Swans. Due to a quirk in the human mind, it is very easy for one to understand Black Swans nominally, but when it comes to decision-making, act as if one has totally lost that understanding. To understand the concept of Black Swan, we highly recommend our earlier article, Failure to understand Black Swan leads to fallacious thinking. We must stress that it is crucial that you understand the content of that article before reading the rest of this article.

Now, what’s wrong with Australian banking and financial stocks?

Well, the issue is not with their future earnings. Based on statistical probability of the past, there is no reason to doubt the forecasts of their future earnings. The more cautious analysts may even adjust their forecasts downwards to account for the expected reduction in earnings due to the credit crisis. Thus, a sell-off in banking and financial stocks may lead to their prices looking very undervalued.

This is where the fallacy such thinking begins. As we said before in Two uncertainties of valuing a business- risk & earnings,

Between earnings and risk, the latter is the most subjective of all in the business?s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness.

In other words, earnings are very much ‘visible’ and taken into account. But risks are ‘invisible’ and therefore, get ignored and overlooked. That is where the grave error lies. Risk is the playground of the unknown unknowns. The problem with such stocks is that at this stage of the credit crisis, they are particularly vulnerable to the unknown unknowns. In other words, these unknown unknowns will have a massive and colossal impact on their earnings. As we explained before in Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Why do we say that?

A simple word answers this question: leverage.

Due to the amount of leverage (in the Australian economy, banks balance sheets and the global financial system), when the unknown unknowns pops up, earnings can go terribly, utterly, totally and massively wrong (we are running out of adjectives here). For example, as we quoted Brian Johnson in How safe are Australian banks?,

?We?re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,? he said.

The Australian economy itself is highly leveraged. As we explained before in Outlook 2008,

Currently, Australia?s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia?s economic prosperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust.

As we refuted Shane Oliver in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

The global financial system is still highly leveraged, particularly with derivatives (see How the CDS global financial time-bomb may explode?). As we said before in Potential global economic black hole: credit default swaps (CDS),

Currently [January 2008], the CDS market is valued at around $45 trillion, which is three times the GDP of the US.

The notional value of derivatives world-wide is said to be at the range of hundred of trillions of dollars.

Australian banks are highly leveraged to a highly leveraged economy in a highly leveraged global financial system. To put it simply, there is only a razor thin margin for ‘error.’ When there’s no ‘error,’ all will be fine. But if there’s an ‘error,’ there can be a colossal bust. Please note that we are not predicting financial Armageddon. For all we know, maybe there will be no ‘error.’ But should it slips in, the last thing you would want to hold are the banking and financial stocks.

Two uncertainties of valuing a business- risk & earnings

Monday, September 29th, 2008

In our previous article, Measuring the value of an investment, we learnt about the theory and mathematics behind the valuation of a business under artificial conditions that are clearly defined. Under such conditions, we know exactly the business’s future earnings and its risk relative to government bonds. Therefore, valuing artificial businesses is easy and straightforward. But in the real world, earnings and risks are the very things that cannot be so easily and clearly defined and quantified. As we said in that article,

So far, this is the theory behind value investing. In practice, in a world of uncertainty and Black Swans, it is not possible to know the exact amount of future cash flow of any business. Also, risk is not something that we can easily quantify nicely in order to derive a value for the discount rate. That is the ?art? of investing.

Thus, we should not be under the impression that the dollar number that is produced from the valuation of a real-world business is a scientifically precise number. Rather, no matter how precise that number is, it is just an estimate. And it is far more important for that number to be accurate than for it to be precise. If you are confused with what this means, we suggest that you read our previous article, Confusion between precision & accuracy and Example of precisely inaccurate information.

First, we will discuss the earnings of a business. Stock analysts spend a lot of effort trying to divine the future cash flows of the business that they are analysing. However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates. For some, they can even be unpredictable or volatile. To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates. We will explain the characteristics of businesses that favour accurate earnings estimates in future articles.

Next, we will discuss the risk of a business. The mainstream finance uses volatility of prices to define risk. As we said before in How do you define risk?,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time.

But we see risk differently. As we explained before in Measuring the value of an investment, the risk in value investing is a relative concept. The payments of government bonds are assumed to be completely risk-free whereas the earnings of a business are not so certain. Risk relates to how secure the future earnings of a business is. To illustrate this concept, let’s suppose there are two different businesses with identical earnings estimates. One is located in a geologically stable place (e.g. Singapore) while the other is located in an earthquake prone area (e.g. Tokyo). We can say that the latter one carries more risk because its earnings can be cut due to an earthquake. Therefore, it will carry a higher discount rate.

Between earnings and risk, the latter is the most subjective of all in the business’s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness. For earnings, all we have to do is to compare earnings estimates with the actual earnings to have a gauge of the estimate’s accuracy. But you cannot do so for the discount rate. Thus, in any valuation of a business, the discount rate is the first to be fudged by analysts.

Bear that in mind when you look at analyst reports on the price targets of stocks.

Prepare for asset repricing, warns Trichet

Wednesday, January 31st, 2007

In this news article, Trichet, the president of the European Union central bank warned that that instability of global financial markets can lead to ?re-pricing? of assets. He said that:

There is now such creativity of new and very sophisticated financial instruments . . . that we don’t know fully where the risks are located… We are trying to understand what is going on?but it is a big, big challenge.

As we mentioned in Spectre of deflation, the majority of global liquidity is made up of derivatives which is estimated to be valued at US$450 trillion. However, world GDP is estimated to be only US$46.66 trillion?only one-tenth the size of the value of derivatives!

With such massive quantity of derivatives sloshing around the global financial market, there is very little wonder that no one, not even governments or central banks can fully understand what is going on. Thus, opinions on derivatives are highly polarized?some think they are beneficial because they reduce risks by spreading it, whereas others see that they are currently too dangerous because they encouraged too much leverage and risk taking behaviour. Whichever the truth is, we believe that with all these absurdities in the financial world, it is more likely that risks are underestimated than overestimated.

Now is the time to reduce both debt and leverage. Start hedging.