Is stock investing a zero-sum game?

This question has puzzled me for a long period of time since I started my journey on learning about investing. Different people hold different views to this question. Some say stock investing is a zero-sum game while others say that it is not. Is stock investing a zero-sum game?

The idea of zero-sum game implies that in every stock investment transaction, one party must benefit at the expense of another party who is making a loss. It seems that during every transaction of a stock in the stock exchange, the proponents in support of investing as a zero-sum game hold the view that one party must always benefit from the transaction from another party who is making a loss. 

For example, buyer buys a stock at a particular price from a seller who sells at a loss to him. This seems true during a bear market when a seller might be selling a stock at a loss due to a down-trending market to a buyer who buys the stock at a cheaper price which later rises in price resulting in a profit for the buyer. This also seems true when a seller sells a stock at profit at a particular price to a buyer after which the stock price goes down resulting in a loss for the buyer. 

However, do stock prices always behave in a zero-sum game fashion? Is it always necessarily true that one party must make a profit from a transaction at the expense of another party who is making a loss? 

Through my own experience with investing so far, I noticed that any stock investment transaction on the stock exchange may not necessarily follow a zero-sum game fashion. For instance, when I sold off a stock at a particular stock price making a profit, the buyer of my stock did not make a loss thereafter as the stock price continued its climb further. In this case, both parties made profits on their transactions. In another case, when I sold off a stock at a loss, the buyer of my stock did not make a profit as the stock price continued to decline further. In this case, both me the seller and the buyer made losses together on our transactions.

Thus, it is not always in a stock transaction that one party will make a profit at the expense of another party making a loss. This is the randomness of the stock market as described by Benjamin Graham, the father of value investing that in the short-term, the stock market is a voting machine, but in the long term, it is a weighing machine.

In the long term, stocks belonging to businesses with good fundamentals may grow their value over time rewarding their investors with appreciating stock price. For example, one cannot imagine a small company that has grown over time to become a large enterprise generating larger amount of revenue, income and cash flow to be still trading at the same share price when it was once in its infancy stage of growth. Unless this company keeps issuing more outstanding shares enlarging its equity at a faster rate than the growth of its earnings to dilute its earnings per share. Then, we might see a stock price that has not grown over a long period of time as the earnings per share remains the same due to dilution effects of more shares issued over time.

Thus, the company that can steadily grow its earnings per share over time, while growing and managing well its other tangible and intangible fundamentals such as revenue, income, cash flow, margins, branding, market share, corporate governance, debt loads, debt servicing, working capital need, etc. will generate appreciating stock value over time. This is why the stock market is a weighing machine over time as time will tell the difference between a good company and a lousy one. 

An investor can invest in a company at its early stage of growth and exit from the company by selling off his shares at a profit to another investor after the company has grown into a medium size enterprise. The latter investor can also benefit by staying invested with the same company which grows into a large enterprise similarly seeing the share price of the company continue its appreciation over time and making also a profit on his investments. Both investors, the earlier and latter one derive benefits by staying invested with the company that grows in value. No one benefits at the expense of the other as both made their profits on their investments. 

If one is a good value investor, there is no concern over whether stock investing is a zero-sum game or not. This is because no matter which period of time he has bought his shares (assuming he always tries his best to buy at lower than his estimated intrinsic value per share of a good company securing a margin of safety), he will be rewarded with an appreciating share price over a period of time. Thus, stock investing will never be a zero-sum game for any investor as no matter at which stage of growth in the company, as long as an investor rides on the growth, he will be seeing the share price of his invested company appreciate over time as the company grows. This is on the assumption that he has invested in a good company at a reasonable share price that grows its fundamentals steadily over a long period of time. 

Is stock investing a zero-sum game? By the looks of it, it is not. A company can grow over time and an investor who has invested in a good company that grows in value over time will see his shares in the company appreciate over time. Thus, stock investing is not a zero-sum game as it will reward any patient and astute investor who rides along the growth of a good company, seeing his invested shares grow in their share price over time. This is only so true of a company that grows in value instead of destroying value for its shareholders over time.

Stock investing is not a zero-sum game. 

Any investor can derive value from a good company by participating at different points of its growth.

If you get the customer experience, you have the business.

I am sharing a basic fundamental truth about running businesses but it is so basic that people may take it for granted. Every business exists to fulfil a need or want from the customer. If the business can understand the need or want of the customer really well and also execute their service or sale of products to meet the relevant need or want and even exceed the expectation of the customer, they have got the customer hooked. A satisfied customer means potential repeat sale and even word-of-mouth referrals by the satisfied customer for introducing more customers to the business. On the contrary, if a business provides lousy experience for a customer and keeps doing so long enough, the result is potential permanent loss of customer. This results in permanent loss in repeat sale from the same customer and also potential word-of-mouth referrals for introducing more customers to the business.

I personally have experienced this fundamental truth in business. I was once patronising a particular car servicing company. However, after some years I switched to my now current car servicing company. Ever since the switch, I have so far been satisfied with the service provided by my current car servicing company for the past few years. Why did I make the switch? 

Originally, I was satisfied with my previous car servicing company. It was a car dealer company as well and my first and second used car were bought from this previous car company. When I was buying my first used car, the car company got me a medium size used car from their list of used cars. I was satisfied with my first used car and had it serviced at this same car company over a few years. After a few years, I decided to change to a smaller used car. However, when I was making my purchase decision at the same car company, I was persuaded by the car salesperson to go for a medium size Japanese brand used car because the reason given was that it will carry a high resale value should I sell the car after a few years usage.

The advice given by the salesperson was not wrong and sounded logical. I went ahead with the purchase and got a medium size used Japanese car. I continued to service this second used car with the same car company. I decided to change my second used car again after another few years. This time round, I again wanted to purchase a smaller used car. Unfortunately, the car company happened not to carry a small used car in their list of used cars at that time. The salesperson tried to persuade me to buy one of their medium size Japanese used car using the same argument again that this type of car has a better resale value.

All seemed well. However, little did the salesperson knew that I had already set my mind this time to get a smaller used car and was thinking of holding on to this third used car for a long time and will not be changing car any time soon. I did not get a chance to voice my needs to the salesperson as what I got from the conversation was just the salesperson keep talking and explaining to me the logical sense to get a medium size used car. This could be because he was eager to make a sale since they did not have a smaller used car at that point of time to sell me and was hoping I would change my mind to get a medium size used car instead.

Guess what? I told the salesperson I would go back and reconsider my decision and return to the car company to make my purchase. The result is that I never did get back to the car company again. I eventually visited another car company and made my purchase of a smaller size used car as I intended to. Days later the previous car company called me up to ask for my decision and I was sorry to disappoint them that I had made my purchase with another car company. As for my car servicing with this previous car company, you would have guess it correctly that I did not return to the car company again for my car servicing needs but changed to my now current car servicing company.  

My current car servicing company has served me well. I could feel their sincerity in wanting to do their best to fulfil my car servicing needs with reasonable car servicing response time. There is also a personal touch as they actually remembered me as their client every time my car is due for servicing. Sometimes, when I asked for a discount on their car servicing, they will provide a small discount for me. Even if I am a loyal customer to them deserving a small discount, they have also done their best to keep me as their loyal customer and supporter of their service.

From my experience as a customer, the business that can understand my needs or wants better and can fulfil them better will get my sale. Sometimes, it is not just the price of the products or service that matters, but more so the quality of experience provided to the customer. I am glad to say that I have remained a loyal customer of my current car servicing company even though I received many advertisements on cheaper car servicing by other car servicing companies. Why do I stick with my current car servicing company? This is because they have provided quality customer experience so far and people tend to stay with familiar comfortable experience. Familiar quality customer experience is such a strong positive reinforcement and feedback that keeps the customer returning for more. This is a virtuous cycle that ensures repeat sale from the same customer and may even through word-of-mouth referrals from existing customers to help the business expands its customer base.

As such, the revenue of the business will grow steadily over time. The business will thus expand in size to service more customers. Then, it will be time to look at how the business can find ways to accommodate the increased customer base to maintain or even improve their level of quality customer experience. As long as the business continues to provide better quality customer experience, it will keep growing and have to constantly seek to accommodate the increased customer base and keep up their quality customer experience. 

Do not underestimate the power of quality customer experience as it is a fundamental truth which obviously will make or break a business.  

12 lessons Steve Jobs taught Guy Kawasaki.

Twelve lessons Guy Kawasaki learnt from Apple's Steve Jobs. These lessons I feel are not only applicable to entreprenuers but are also useful for any employee who constantly want to improve at how they think and function at work. Anyone can think and feel like an entreprenuer no matter an employer or employee. Any work that one do is likely to be involved in dealing with providing goods and services to people. Even an employee working in an organisation is providing service to his employer, his fellow colleagues across various departments and also their customers (even back end support staff who think that dealing with customers is not their job is in fact providing indispensable support to their front end colleagues who deal directly with customers).

Twelve inspiring lessons from one of the World's greatest entreprenuer Steve Jobs that can be applied for everyone who wants to improve at how they think and feel in their work, enjoy!

Summary of the 12 lessons:
1. Experts are clueless. 
2. Customers can't tell you what they need. 
3. Biggest challenges beget the best work. 
4. Design Counts. 
5. Big graphics, big fonts. 
6. Jump curves, not better sameness. 
7. If it works or doesn't work, that's all that matters. 
8. Value is different from price. 
9. A Players hire A Players. 
10. Real CEOs can demo. 
11. Real entrepreneurs ship. 
12. Some things need to be believed to be seen.

How much money does one need to reach financial freedom?

In my earlier post "So you want to retire in Singapore?" under the label "Financial Planning", I did an estimation of the amount of money needed to retire in Singapore. The estimation of the retirement amount varies depending on the current age of the person. However, a conservative estimate runs in the likes of retirement funds of at least one million Singapore dollars to retire comfortably. Not many people will be able to reach this amount upon their retirement. I see around me many retirees who are on family retirement support meaning they are supported financially by their children. It comes as no surprise as not many people can have a decent amount of savings upon retirement to depend upon. Thus, the burden of retirement will have to rest upon their children.

It is good and well for children to support their parents financially in their retirement years since their parents have put in their sweat and toil to raise up their children. This is the tradition of many Asian families having their children support their parents' financial needs during their retirement years. However, wouldn't it be great if the parents do not require any financial support from their children in their retirement years? It will mean that parents have no financial worries since they are self-supporting and their children will have no financial burden to support their parents. I am not saying this to mean that children do not have the responsibility to care for their parents, but rather that it will be truly beneficial to everyone if there is no financial worry to both parents and their children if elderly parents have no need for any financial support.

Therefore, it is important for everyone to work towards becoming financially free. One will no longer have the worry of earning the next paycheck in order to survive another day of living. Working can then become a matter of choice and perhaps enjoyment, and not just one of necessity for the income that work brings. One can live a life of choices having the time to do the things that one likes to do when one becomes financially free. One can choose to engage in a work out of passion rather than necessity for the earned income. Aside from the choice to continue to work, one can also engage in meaningful activities that are beneficial for oneself as well as others. Afterall, one has only one life to live and our time is limited. Live a meaningful life. 

For me, living a meaningful life means living a life for God. One does not need to be financially free in order to live a meaningful life. Financial freedom is just a platform to allow one to have extra time on one's side to make the choice to live a meaningful life.   

After knowing the objective of becoming financially free is to have the choice to use one's freed up time to engage in meaningful activities for meaningful living, the golden question to ask is "How much money does one need to reach financial freedom?". In my reading, I found out a guideline that one can use. The amount of money to reach financial freedom can be estimated to be around twenty times the annual expenses of a person.

For example, if Albert lives in Singapore and spends a total of SGD$24000 in annual expenses, he will need an estimated sum of SGD$480000 to become financially free. One may raise the question of how this is possible. Afterall, if one requires a total sum in savings of at least one million Singapore dollars to retire in Singapore, how can half the amount at SGD$480000 make one financially free?

This is where the difference in having investment knowledge kicks in. The estimated sum of SGD$480000 is not going to work miracles if it is not invested and providing passive income. Due to inflation and spending, this amount is not going to last very long. However, if this amount can be invested at an annual yield of 8%, it will provide a passive income for Albert that will fight inflation and allow him to be perpeptually financially free if he maintains his current lifestyle in annual expenses without increasing his financial expenditure.

How does the SGD$480000 work out in terms of fighting inflation and still providing enough passive income for Albert? For a yield of 8%, Albert will receive $38400 annually in passive income. He must not spend all these money or else inflation will erode away his subsequent years' spending power since the price of goods and services has increased due to inflation. Instead, if Albert is financially wise and disciplined, he will set aside 3% out of total 8% annual yield religiously every year for reinvestment into his original capital sum. This reinvested amount will keep growing his original capital sum in order to receive more passive income in every subsequent year to fight the effects of inflation (assuming long term annual inflation rate at average of 3%). 

The remaining 5% out of total 8% annual yield then works out to be exactly what Albert requires to meet his annual expenses. So, the magic numbers are a capital sum of twenty times one's annual expenses to be invested at an annual yield of at least 8% and 3% out of 8% annual yield is to be reinvested every year leaving only 5% out of 8% annual yield in any year to meet the annual expenses. Thus, financially freedom can be met if the magic numbers are observed. However, this is just a theory which may not work out in real life as the annual yield on one's investment may vary every year. If one can truly invest at a constant yield of at least 8% per annum, one is not very far away from the realities of financial freedom should one be able to accumulate a capital sum of twenty times one's annual expenses to be invested at such annual yield. 

Of course, it does not take an intelligent mind to appreciate that if one requires less annual expenses to meet his lifestyle needs, one can become financially free faster. A person with an annual expenses of $12000 only needs a capital sum of SGD$240000 to become financially free in Singapore if the above magic numbers are observed. There again, is it possible to survive in Singapore with an annual expense of $12000 which works out to be approximately $1000 monthly expense? This is probably wishful thinking if not impossible to survive with such meagre monthly expense in a state of financial freedom. Who knows? Maybe there are already people who are financially free on a low living expense?

There are two choices. 

Control money to reach financial freedom 

or let money control oneself never to reach financial freedom.

Dividend reinvestment program (DRIP)

Recently, one of my invested real estate investment trust (REIT) has announced a dividend reinvestment program (DRIP). This triggers the question as to whether DRIP is a good thing and should investors take up the DRIP. Before we delve into the advantages and disadvantages of such a program, we can look at what is a DRIP.

DRIP is a way for investors to receive the dividends from an invested company in the form of new shares or units (in the case of REITs). In a DRIP, an investor can choose to participate in it fully or partially. When an investor chooses to participate fully in DRIP, he is opting to receive fully all his cash dividends in the form of new shares/ units. When an investor chooses to participate partially in DRIP, he will elect to receive only part of the cash dividends in the form of new shares/ units while the remaining dividends is still disbursed to him in cash.

In calculating the number of shares or units an investor will receive, he will need to know the exercise price per share/ unit under the DRIP. For example, ABC company has announced a DRIP in which new shares are issued at the price of $1.95 per share. If an investor is receiving a cash dividend of $1950, he can opt to participate fully to receive approximately 1000 new shares in place of his cash dividend of $1950. Of course, he may also opt to receive partially his dividends in new shares and remaining dividends as cash. He may even choose not to participate in the DRIP in which case, he will still receive his dividends fully in the form of cash.

Advantages of a DRIP

1. It allows an investor to reinvest his dividends directly in a company as he is opting to receive new shares/ units in the company instead of cash dividends. By doing so, an investor can save on brokerage fees as he will need to pay brokerage fees should he buy new shares in the same company through a brokerage firm instead of participating in DRIP to receive new shares equivalent to the amount of his cash dividends.

2. A DRIP encourages investors to have a long term investment mindset towards a company. By giving investors a chance to participate in DRIP, some investors (especially those who choose to participate in DRIP) may stay invested with the company for longer term. This encourages price stability in the share price of a company when more investors are holding the shares of the company for longer term instead of actively trading the shares of the company.

3. A DRIP benefits the company as it can conserve its cash earnings to use it to further the growth and expansion of the company since some dividends are disbursed in the form of new shares instead of cash. Warren Buffet's Berkshire Hathaway Inc. has been known not to give out dividends to its investors but instead conserve its cash earnings to keep investing in growing and expanding its businesses. By doing so, it is able to expand its businesses and future earnings. In return, long term investors in Berkshire are rewarded by the capital gain from their shares which comes up to a substantial amount of returns over a few decades which will not be possible had Berkshire disbursed part of its earnings in dividends to its investors instead of using its earnings to grow and expand its businesses.

Disadvantages of a DRIP

1. A DRIP has its disadvantage as sometimes, an investor may not receive his amount of dividends fully for an equivalent amount of new shares/ units of the company. This is because any fractional new shares/ units under the DRIP are rounded down and disregarded. For example, the exercise price of a DRIP is $1.943 and an investor is opting to receive fully his dividends of $1950 in the form of new shares in a company. His amount of new shares equivalent to the amount of cash dividends of $1950 is approximately 1003.6 new shares. In this situation, he will only receive 1003 new shares instead of 1003.6 new shares as fractional shares are disregarded. However, this is only an insignificant amount as he only loses around $1.16 of cash dividends for that puny 0.6 fractional new share he lost.

2. Another disadvantage of DRIP is that an investor usually lands up with odd number of shares. In the above case, an investor opting fully for the DRIP will land himself with 1003 new shares. Assuming he has existing 11000 shares in the same company, he will now have 12003 shares after the DRIP. When he decides to exit fully his shareholding in the company in future, he will have difficulty selling the extra 3 shares on top of the 12000 shares. In order to do so, he will need to sell his odd number of shares through his brokerage firm on a different market catering to odd lot shares which will incur higher brokerage charges compared to selling the usual number of shares on the normal market.

3. The exercise price of a DRIP may not be attractively priced compared to current traded share price in open market and intrinsic value per share. If the existing shares of the company participating in a DRIP is traded at $2.00 per share in the open market and the exercise price of the DRIP is at $1.98 per share. As such, an investor will be better off with receiving the dividends in cash and wait until the traded share price is below $1.98 to buy new shares in the open market at a lower price than the exercise price of the DRIP. If the traded share price of this company should become lower for example at $1.93 per share in the open market, the investor may even save some money (after factoring in brokerage costs) if he purchases new shares in the open market instead of participating in the DRIP at a higher exercise price of $1.98 per share. Such swings in traded share price is not unusual within a short term period given the volatility in the stock market. Also, if the exercise price of the DRIP is higher than estimated intrinsic value per share determined by the investor, there is no margin of safety in participating in the DRIP as an investor will be receiving new shares through the DRIP which are not attractively priced. Thus, does one wait to buy at lower share price or participate in the DRIP? Let the investor decides for himself since the exercise price of the DRIP is not attractively priced.

Conclusion

In considering whether to take up a DRIP, one has to look beyond the advantages and disadvantages of a DRIP. As Benjamin Graham, the father of value investing puts it, "Investing is most prudent when it is most business-like". How an investor should approach DRIP is from assessing the business behind the listed company. 

Questions to ask include:

1. Does this company have a competitive moat?  

2. What is the future growth prospects of the company?

3. How is the management of the company? Are they trustworthy and capable?

4. How is the financial track record of the company? How are its performance in growing its revenue, managing its expenses, profit margins, cashflows, debt levels (is it precariously over leveraged) and short term/ long term liquidity?

As one can see, the focus is not whether a DRIP is good or bad for the company or its investors. A DRIP actually brings one back to investigating the fundamentals of the business behind the listed company. DRIP for a gem or DRIP for a rock. Let the investor decides whether the fundamentals of the business behind a company offering DRIP points to the company being a gem or a rock. As always, one should seek to purchase shares at undervalued or fair valuations. That includes reinvesting in new shares through DRIP only at fair valuations.

Water the right plants (participate in reinvesting in good companies through DRIP) that will grow to produce much better yield through time. A caveat to note that not all companies are even good to invest in, much more consider their DRIP.

Have you bought insurance for your shares?

We insure ourselves for a lot of things in life from our home, our belongings, our car, our medical expenses to even our lives. Insurance is just a way to protect ourselves from the uncertainties in life. In an unexpected event, we are still able to carry on surviving through life in the case of all types of insurance coverage which allow a financial payout secured through an insurance company to tide through life crisis except in the event of death which already cost us our lives. In this case, our loved ones who are still around are able to carry on life based on the insurance payout to tide them over the crisis of losing a loved one (especially if the lost one is the breadwinner of the family). 

In stock investment, one can consider buying insurance for his investment. By this, I do not mean literally buying insurance, but "buying insurance" in the sense of preparing for the wild swings of the volatile stock market. Stock investing is volatile in the short-term, but profitable in the long-term. To protect against the wild swings of the volatile stock market, one has to "buy insurance" by having an adequate amount of emergency fund and opportunity fund to capitalise on any wild swings in the stock market.

There is no hard and fast rule to how much emergency fund and opportunity fund one should hold on to in preparation for investment opportunities when the occasions arise. It depends on the investor. A conservative investor will hold more emergency fund and opportunity fund in proportion to the amount of his investments. An agressive investor will likely invest almost all of his available cash leaving little cash reserves each time to capitalise on any opportunities which may arise occasionally.

A general guide is to have an emergency fund which is equivalent to three to six months of expenses to tide through any emergency such as retrenchment from work or inability to work due to circumstances like disability, illness or sudden change in family situation (e.g. sudden death of a family member). Having both emergency and investment opportunity fund will mean that one has "bought insurance" for his stock investment. In the event of any emergency in the life of an investor, he need not liquidate his shares at a wrong time (especially in a down market) to raise fund to meet the emergency. When a down market is presented, an investor having opportunity fund will be able to invest upon such down market opportunity buying undervalued stocks and will not miss it and thus be subjected to the volatility of the stock market playing out on him.

Thus, an investor has to ensure he has "bought insurance for his investment" by setting aside an emergency fund and also an opportunity fund. I found out that there are approximately three to five profitable chances in any year based on compiled statistics of historical stock market behaviours to invest in stocks yielding good reasonable returns. The more times one invests in a year in excess of five times may not guarantee good profits. This means that an investor has to be very patient to observe the stock market every year to invest for only up to a maximum of five times in any year. The rest of the time in any year is spent observing for a good moment to invest.

This is pretty much like fishing, waiting for the fish to bite the bait. In this case, the bait is the amount of opportunity fund one has set aside while the fish is the valuable stock one is eyeing for to purchase at an undervalued or reasonably valued price in any year. There may be only one good opportunity to invest in any year to catch a stock at its undervalued or reasonably valued price. There may be a few more opportunities to catch the same stock at an undervalued or reasonably valued price in any year. However, there is no such thing as a great value every day for the same stock. Even if one is a trader, he also knows his boundaries to stick to his trading signals and trade only when opportunities arise.

Since there is so much uncertainty in the stock market due to the European debt crisis, slow recovery of the US economy and slow down in China's economy, one must be ready with opportunity fund which will be his insurance to protect against any potential swings due to the volatility of the stock market which is affected by a myraid of economic events worldwide. When a down market does arise, he will be able to exercise his insurance (opportunity fund) to buy up undervalued stocks. Even if such down market does not arise any time soon, the investor can sleep well every night knowing that he is insured and will be able to purchase into undervaled stocks with an adequate opportunity fund set aside whenever the down market arises.

The stock market will always continue to be volatile due to the different sentiments of many stock market investors. There will be highs as well as lows. With insurance (an opportunity fund) set aside, an investor just need to be a fisherman patiently waiting for his fishes (stocks) to bite the bait (to become undervalued) so that he can reap a harvest of fishes (buy into undervalued shares of companies). This opportunity will surely come a few times in a year. Just be patient to have an adequate opportunity fund ready to insure against such down markets and exercise this insurance (opportunity fund) to purchase undervalued shares without feeling the stress of having to face a down market while not being able to invest into undervalued shares.

Not having insurance creates uncertainty. However, it is also no good to be over insured. Cash on hand depreciates in value with time. Thus, one has to have an adequate amount of opportuntity fund but not in excess so that one is over insured and under invested. Cash can only grow in value while being invested. The value in holding cash is for emergency use, opportunity fund for investment or some personal immediate uses. Holding too much cash is not going to act as insurance but on the contrary is depreciating one's networth by the day.

Have you bought insurance today against the volatility of the stock market by having enough emergency fund and opportunity fund (to capitalise into investment opportunities when presented), but not in excess (being over insured and under invested)?

There will be "rainy days" (stock market lows) in the stock market in any year. Having enough insurance (adequate amount of  emergency fund and opportunity fund) will allow one to capitalise on that few investment oppotunities (during stock market lows) in any year and to sleep well every night while waiting for that rare few investment opportunities to be presented.

Pricing strategy.

For everyone, we have definitely encountered times when we need to sell anything, be it selling our products or services for a business, or selling our own personal items. How do we price the products, services or even our very own personal items we sell? I have always held the opinion that it is never good to compete to sell anything based on prices alone. Even if an item is a commodity which does not differentiate itself from another same commodity being sold by a competitor, one can still adopt a creative selling approach to make the item of commodity become unique in the eyes of the buyer. This involves creating added value to the buyer so that he will not be just buying the same item which he can easily buy elsewhere from another competitor. It does not take much thinking to appreciate that the same Coca Cola can drink can be sold at different prices at different venues. A can of coke sold off the shelf of a supermarket in Singapore costs approximately $0.70. The same coke sold off a vending machine costs approximately $1.20 while the price of this same coke sold in a restaurant costs approximately $2.80.

Why is there such a disparity in the prices of the same item, a can of coke? I consider this creative selling which involves creating added value. The same coke sold off vending machines bring convenience to the buyers as they can go to any nearby machine to buy a can of coke at anytime of the day including wee hours when everyone is sleeping when a particular buyer has a sudden craving for this soda. A restaurant offers a comfortable dinning environment to enjoy this can of coke. So, the price of coke is sold higher for the consumer not only to drink coke, but also to drink it at a very comfortable environment. This creation of unique added value makes the selling of coke becomes uniquely different commanding different selling prices. For the vending machine, it targets consumers who want the added value of convenience. For the restaurant, it targets consumers who wants the added value of comfort to enjoy this soda.

Well, do people still pay much higher prices for a can of coke sold off a vending machine or in a restaurant? Your guess is as much as mine. Yes. People do pay for higher prices. The difference is that coke sold in a restaurant only attracts a certain target consumer group, those going for added value of comfort while vending machines attract another group of consumers, those going for convenience. As to coke sold off the supermarket, it does attract peope who are price sensitive and do not need any added value to their purchase of the coke (placing their only buying consideration on price alone and nothing else that can move their hearts to pay more). Thus, by focusing on the creation of value even when selling the same item, higher selling prices can be commanded and the product or service can be sold to a relevant target group of consumers who see the added value they are paying more for.

There are 5 different ways by which most businesses priced their products namely:

1. Making wild guesses.

2. Following industry norm.

3. Clients dictate their prices.

4. Cost plus pricing.

5. Target return pricing.

1. Making wild guesses

This needs no explaining. The seller prices his products and services according to what he thinks buyers are willing to pay. There is no survey and research done. Neither is there any history to base the pricing on. The pricing is based on luck mentality. If the product can sell at this price, it sells. Otherwise, it will not.

2. Following industry norm

This way of pricing looks into what prices the other competitors are selling the same or comparable product or service. Usually, an average selling price in the middle is derived by considering the highest price and lowest price other competitors are selling comparable products or services. This works on the assumption that other competitors in the industry must be doing the right thing since they are able to sell their products and services.

However, assumptions may not always be a good thing. What is applicable for other competitors may not be applicable for oneself as their situation is uniquely different from each other as well as different from oneself. For example, a larger competitor may be able to sell their products or services at lower prices based on their economies of scale without eroding their profit margin. A weaker competitor may find it hard to follow suit with low pricing as this will mean a much lower profit margin or even making a loss resulting in the inability to sustain itself. In the long term, even if the weaker competitor is able to barely survive, there will be very slow growth (if any) as without profits, growth will slow down. Thus, a pricing which works for a competitor may not necessarily work for oneself.

3. Clients dictate their prices.

This way of pricing places priority in the clients to dictate what maximum prices they are willing to accept to buy one's products or services. This is done by running surveys, focus group discussions or causal talks with clients to know what maximum prices they are only willing to accept when buying one's products or services. It is good to always listen to the needs of one's clients. However, if one decides on the selling price solely on the clients' wish, it may mean lower profit margin thus resulting in unsustainability or lethargic growth in a business.

A business exists to serve the needs of its clients. However, also as important is the need to be profitable so as to continue in existence to serve the needs of its clients and even serve it better. If a business is not making profits, how can it grow and improve its products and services to continue serving its clients with better products and services. So, profitability of a business and its great meaning and purpose to serve through providing relevant products and services to clients go hand in hand. Greater value offering comes at higher prices. Higher prices fuel profitability to further improve value offering.

By not allowing clients to solely dictate the selling price, one is also training its clients not to focus on price alone but consider the value in the product and service offering of a business.

4. Cost plus pricing

This way of pricing considers the cost of producing a product or service, and the selling price is derived by adding a desired amount of return based on cost. This way of pricing has some inherent flaws. By using this way of pricing, one is not considering whether the clients can accept the selling price. Clients generally do not care about how much it cost to produce one's products or services and also the amount of desired return one requires when pricing the product or service. What they generally do care is whether they need or want the product or service and whether they want to pay or can afford to pay at a particular selling price.  

In this way of pricing, one may also need to carefully consider the true cost of producing a product or service. Sometimes, it may suddenly require a large increase in cost to acquire a machine or more manpower cost and delivery cost to sell products or services to the clients. Thus, costs do fluctuate significantly sometimes. Also, there may be seasonal demand for one's products or services. Is a business going to sell at a much significant lower price when the cost of producing a product or service has gone down due to slower demand for some periods of the year? Can one really fix a suitable selling price based on cost plus way of pricing?

Furthermore, pricing of a particular product or service may influence sales of other different product lines or service lines in a business. If pricing a product A at a certain price results in more of the product sold and less of another product B being sold, the loss incurred on product B has to be amortized and accounted for as a cost added to product A. Thus, there will be changes to costs of individual product or service lines.  

Also, there may be differential costs in selling the same product through different people or different means. For example, it may cost more to deliver the same product overseas than locally. It may also involve different costs to sell the same product by different salespersons.

Thus, this way of cost plus pricing is a difficult way to determine the selling price of a product or service as one will need to know the actual true cost of producing the product or service.

5. Target return

 

This way of pricing looks at a business and its prices as an investment. A target return on the capital invested in a venture is set. This is one's required return on investment. This way of pricing is more focused on profits, but it can also ignore the realities of the market similar to cost plus pricing, by focusing on unrealistic return on investment.

What is the purpose of pricing?

 

As one can see, no matter which way of pricing one chooses, the purpose of pricing is still to make profits for a business to ensure growth and sustainability. Even if one is taking a loss by lowering prices for example in giving discounts, it must still serve the purpose of taking a loss today in order to make a greater profit tomorrow.

 

Price skimming

 

One way of ensuring high pricing is to adopt a price skimming method. The objective of price skimming is to serve clients who are not price sensitive and are willing to pay higher prices for the exclusive value they can get from one's products or services. This is similar to the analogy of skimming off the top cream of the milk much like skimming off the top level of clients who are willing to pay higher prices for the exclusive value they get. This ensures high profit margins.

 

Sequential skimming

 

Another method related to price skimming is sequential skimming. For this method, clients who are willing to pay higher prices for premium value they get from a product or service is secured first. When demand for the product or service drops, the price of the product is lowered to increase demand for the product serving the next level of buyers. The price is again lowered when demand further drops after sometime thus attracting the next lower level of buyers. This method of sequential skimming is evidently seen in the sale of many electronics such as computers. When a new computer product is newly introduced in the market, it is priced at a premium attracting the first level of buyers who are not price sensitive but are focused on the immediate value they get from their purchase. When demand drops, the selling price is decreased to attract the next level of buyers and so on. 

 

Penetration pricing

 

This method of pricing involve lowering prices below the competitors to quickly attract more clients thus seeking to increase market share. Penetration method works on the assumption that people are always attracted by lower prices. This method may be useful to increase market share quickly, but it can also become damaging to profit margins. Thus, this method is a short-lived method to penetrate one's market to gain market share and should be carefully used. In order to sustain long term growth and profitability, other methods of pricing such as skimming are better. One should not only consider the market share for his products or services, but more importantly the profits. For without profits, a business cannot sustain itself.

 

 

Conclusion

 

Pricing of product or service is an important part of a business. Purpose of pricing is to make profits without which a business can not sustain itself or see long term growth. There will always be people who are not price sensitive and willing to pay premium prices for premium value they can get from their purchase. This requires the business to adopt creative ways of offering premium value in their products or services in order to charge higher prices to attract their top level buyers. Sequential skimming is a method which can help to maximise the prices at each levels one can sell sequentially to different levels of buyers. Profits should be also considered in addition to gaining market share when using price penetration. For what good is there in gaining market share when a business is selling products or services at low prices which does not sustain profitability and results in causing long term irreparable damage and loss to the business.

 

Pricing is an important part of a business. The purpose of pricing is to make profits which results in long term growth and sustainability of a business. 

How much do you think a particular real estate property should be worth?

John and Jane were walking down a street when they chanced upon a signage in front of a residential property which the contents read, 'Property for sale at $700,000. Hurry! Best value for your money! Call xxx-xxxxx to view!' John exclaimed, "Wow. This property is up for sale. It sure does not look cheap at $700,000." Jane replied with skepticism, "Are you sure this price is not cheap? I think this price feels reasonable to me." At that instant, a passerby who saw both John and Jane in a bit of argument over the fair value of the property asked them what had happened. After knowing their argument over what the fair value of the property should be, he said, "Maybe we should find out more details from the seller of this property and do a bit of calculations to estimate the fair value of this property. This is at least better than trying to guess what the fair value of this property should be, isn't it?" 

Many a time, we may have heard of comments on prices of real estate properties from different people. The perception of cheap or expensive for a price tagged to a particular property can be very subjective. In coming up with the valuation of a property, there are many different methods that can be used such as a sales comparison method, cost method, or profits method etc.

The sales comparison method seeks to derive the fair value of a property by comparing the property with the prices of other similar comparable properties that have been recently transacted in the market. The cost method is a method which seeks to arrive at a fair value for a property by estimating both the cost needed to build a similar comparable property to the property in question plus the market value of the land. The profits method seeks to arrive at a fair value for a property by considering the amount of business that can be carried out using the property thus providing certain amount of profit yield for the owner of the property. A discounted cash flow model can be used in the profits method to derive a fair value for the property.

I am not an expert in appraising a property. However, I will share in this post one of two ways I think are quite useful even for a layperson to derive a reasonable fair value for a property. By using some science over here in deriving the fair value of a property, hopefully one will avoid the same circumstance faced by John and Jane in the above scenario whereby the judgment of the fair value of a property is solely up to one's emotional gut feel. Therefore, the next time when one chances upon a property up for sale, one will not be making a rash emotional judgement on the fair value of a property but instead make a better judgement if not the best based on some science and numbers.

Before I delve into sharing the one out of two ways I learnt in deriving the fair value and profitability of a property transaction, there are some common simple ways to look at profitability of a property. Assuming a property is rented out, one can look at the annual rental returns to derive his return on investment or return on equity. 

Example: A property has monthly rental income of $2000. The annual rental returns is $2000 X 12 = $24,000.

If the property was bought at purchase price of $600,000, 

Return on investment
= (Annual rental returns / Purchase price) X 100%

= ($24,000 / $600,000) X 100%

= 4%

This property was bought with a downpayment of 20% of its sale price which is $120,000.

Return on equity
= (Annual rental returns / Downpayment) X 100%

= ($24,000 / $120,000) X 100%

= 20%

Notice that the return on equity is much higher than the return on investment. This is the magic about property investment which uses high leverage such that the investor earns a much higher returns on the money he has put in which is only the downpayment and other costs (which are not significant compared to the purchase price of the property). The small downpayment is the equity he owns in the property in order to reap a high profitability (his return on equity) while someone else (the tenant) is paying for his liabilities (the mortgage loan and maintaining expenses) on the property.

The long term effect of this is that the landlord eventually pays up the property with only his initial downpayment and other costs involved (which are not significant) while most if not all of the mortgage loan is paid by someone else (the tenant) for the landlord. A caveat here to note is that the investor must ensure he or she is financially able to have holding power on the property over a good number of years to continue to earn a high return on equity while possibly enjoying capital appreciation of the property as well. If property investment is done carefully, this is one of the best investment asset class which promises a high return on equity plus potential capital appreciation.

Now, let us look into the two scientific ways of assessing the fair value and profitability of a property investment, namely by looking at the Net Present Value (NPV) and Internal Rate of Return (IRR). However, I shall only focus on the first way in this post which is NPV.

Net Present Value (NPV)

Net present value (NPV) of a property is derived by the present value of the inflow from the property (rental income and other benefits) subtract the present value of the outflow from the property (all costs).

Any investment such as property investment is profitable if the NPV is positive. This means that the present value of all benefits outweighs the present value of all costs in owning the investment.

NPV used in assessing the profitability of a property purchase

An investor bought a condominium at $800,000 and paid a downpayment of 20% of its purchase price and after adding other costs such as stamp duty fees and legal fees his initial cost in buying the property comes up to $180,000.

The net positive cash flow is $5000 for the first year, $7000 for the second year, $7000 for the third year, $7000 for the fourth year and $7000 for the fifth year. The net cash flow per year is derived by the total annual rental income for the year subtract the total annual maintenance fee, total annual loan repayment and annual property tax.

The formula for NPV is somewhat similar to the formula for discounted cash flow (DCF) as NPV works on the principle of DCF.

CF = cash flow

n = number of year

r = required rate of return (in %)

The required rate of return by this investor is 8% (his expected rate of return when considering entering into this investment compared to other investments).

Thus, for this investor, his calculated NPV is as follows.

For CF0, it is a negative number of -$180,000 since the investor's initial cost is an outflow. The calculated NPV is -$153,902.88. From this negative value, we can see that holding a property for rental income for a few years still incur more outflow than inflow in present value as the initial sunk in cost of $180,000 is not a small sum. It takes more number of years to see profitability in NPV (NPV showing a positive value) especially after the mortgage loan is fully paid up and there is a significant increase in the cash flows thereafter.

In most cases, an investor seldom holds a property for very long term. He or she will try to sell the property for capital gain given an opportunity. That brings us to the discussion of what is a fair value that this same investor should sell his property at the end of 5 years.

NPV used in assessing the profitability and fair value of a property sale

Assuming his estimated mortgage loan balance outstanding after 5 years is $850,000. He decides to sell his property at the end of the 5th year. Two buyers are interested to buy his property. Buyer A quotes him $1,000,000 while buyer B quotes him $1,100,000.

When the investor decides to sell his property after 5 years, he will incur an agent fee (approximately 1% of selling price) and legal fees (approximately $2000). We will proceed to calculate his final cash flow at the 5th year (also known as the reversion value) when he sells his property.

Final cash flow at 5th year (reversion value)

= Selling price - Selling fees (include agent fees and legal fees) - Mortgage balance outstanding

For the investor, his reversion value for selling to buyer A

= $1,000,000 - $12,000 - $850,000

= $138,000

His reversion value for selling to buyer B

= $1,100,000 - $13000 - $850,000

= $237,000

Selling to buyer A, the investor's NPV is calculated as follows.

Selling to buyer B, the investor's NPV is calculated as follows.

In both cases, the investor's required annual rate of return is 8%. We can clearly see that if the investor sells to buyer A, his NPV is a negative value at -$59,982.40. This means the present value of all outflows is more than present value of all inflows. A negative NPV is thus not profitable for the investor.

On the other hand, if the investor sells to buyer B, his NPV is a positive value at +$7395.33. This means the present value of all inflows is more than present value of all outflows. A positive NPV is thus profitable for the investor.

Therefore, when presented with two different asking price of $1million and $1.1 million for this investor's property, he should sell only to buyer B at $1.1 million to make his transaction profitable. Though both selling prices are only a difference of $100,000, this difference will determine whether the investor will make a profitable or non-profitable transaction. We can see that the fair value for this property after doing calculations of its NPV should be more fairly priced at $1.1 million instead of $1 million when the investor decides to sell after holding his property for 5 years.

An emotional investor may just see that selling price of $1 million is already more than his initial purchase price of $800,000. However, it is only the astute investor after doing his calculations will know that selling at $1 million for this property is actually not profitable at all. A fair value will be $1.1 million instead considering the NPV of this investment. Emotions may lie to an investor but numbers show up the facts about an investment and its fair value. This is the science of successful investing.

PS: Please note that the example and figures quoted in my post are fictitious. The example quoted is not an actual property transaction. The learning point here is that an investor can carry out his own calculations based on details of his investment to determine the profitability and fair value of his property investment.

It is only fair to both parties in a transaction to know the fair value of the item transacted!

A must-have cash flow asset in any investor's portfolio!

I believe this asset class is one of the best asset classes around if not the best to be owned by anyone. The asset class I am referring to is real estate property. I am not referring to real estate investment trusts (REITs) which is what I call the paper equivalent of owning real estate property as one only has minimal control over the physical properties under management by the REIT unless one is a major unitholder in the REIT. I am referring to one being the owner of real physical properties, having the full rights over the physical property.

There are three common major types of real estate properties one can own namely, residential, commercial and industrial properties. I am by no means an industry expert in properties. However, by my limited research so far, all three types of properties have their individual unique strengths and attributes. It really depends on what an investor is looking for, capital appreciation or cashflow from owning the property.

I shall not delve into the unique strengths and attributes of each of these types of properties in this post. However, I will like to impress upon the reader that real estate property is one of the best investment asset classes around to own. I call it a must have in any investor's portfolio. Real estate property may also form a large portion of an investor's porfolio since a real estate property is usually in the hundreds of thousands or even millions in the case of high-end properties. I am sharing this in the context of property valuations in Singapore. Private residential property such as condominiums are easily priced at $500,000 and above in a normal market. Gone were the days when one can buy private residential properties at below such a value. Commercial and industrial properties are also not cheap over here in Singapore with prices also in the range of hundreds of thousands to millions.

As such, a typical investor with no enormous cash reserves has to apply leverage when investing in real esate properties. It is the application of leverage that makes real estate properties very attractive as an investment class. What makes it further outstanding is that in Singapore, the leverage one can apply when investing in properties is one of the cheapest around. This is what I call cheap leverage applied onto a stable investment asset class.   

A typical investor buying into residential real estate over here in Singapore needs to pay a downpayment of cash and/or CPF of 20% on the valuation of the private residential property such as a condominium. In additional to this, there are also other costs such as agent commision fee, stamp buyer fees and legal fees. After one factors in all of the costs and downpayment needed in buying a private property, the amount of capital needed to invest in a property is still not too high compared to its valuation. This provides a very favourable loan to value ratio. One can apply for a high amount of loan with a low initial capital commitment compared to the valuation of the property.

This makes real estate property a highly leveraged asset class for an investor. Furthermore, the interest rate for mortgage loans to buy properties is one of the lowest around compared to other types of loans in Singapore. This makes investing in properties a cheap highly leveraged asset class for investors. Properties tend to hold their values or increase in value over the long term (if the property in question is really a good buy). This further adds on to the attractiveness of real estate properties as an investment class as one can look at stable capital apppreciation over the long term (in many cases, capital appreciation in properties is known to beat inflation over the long term).

If an investor decides to rent out a property and the rentals collected are able to pay for the expenses in maintaining the property and even pay for the mortgage loan, the result of this is that another person (the tenant) is effectively paying the property for the investor. Once the property is fully paid for, the investor can sell the property at a profit (when the valuation of the property is higher than the initial purchase price) or continue to rent out the property for rental income which translates to recurring passive cash flow income which may be perpeptual (in the case of freehold properties).

As such, real estate properties can potentially provide a source of recurring passive income (once the property is fully paid for and the liabilities on the property is significantly reduced) for an investor's retirement period. I have personally known of people who have enjoyed and are still enjoying the recurring passive rental income stream from owning real esate properties. Of course, one can critique that this income stream is not totally passive as an owner of the property still needs to engage the tenant fulfiling his obligations to the tenant to manage the rental property. However, this property management work is not taxing at all compared to holding a full-time job. If a landlord chooses not to get directly involved in managing the property and tenant, he or she can engage a property management company at a cost which still makes the cash flow on the property attractive minus the headache of managing the property and tenant.

With prudent planning considering that one is able to buy and has holding power on a property through the ups and downs of the property market, not over commiting financially, one will be able to reap the rewards of a cheap and highly leveraged investment asset class which promises good cash flow. This is a must have cash flow asset that any investor should aspire to own in his portfolio. The important thing in any investment is to assess one's capability to buy and hold the investment asset while reaping the cash flow and financial reward, and only sell at a right time (when capital appreciation far outweighs the potential future cash flows or when another better investment asset comes along).

In all these, the caveat of buying undervalued or reasonably valued cash flow assets and selling over valued assets  still holds even when investing in real estate property. Successful investing is simply a numbers game (a science) and also a sound judgement game (an art). It was never meant to be an emotional game (getting caught up with greed and fear). If the numbers are good after one has assessed the potential of the investment asset, one should own the asset. 

PS: Please note that this post is just a very small time discussion on the topic of property investment. There are so much more things to know about the topic of property investment. I thought that real estate property is such a noteworthy and very important investment asset class that any investor must not miss in his investment portfolio.

PSS: Do note also that any information provided in this post is in the context of Singapore property market. I am also not to be held responsible for any misinformation in this post. One should always do his own research before investing in any asset classes. Prudence is the mark of a successful investor.

Real estate property, a must-have cash flow asset in any investor's portfolio!