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.

Reflections on my investing journey so far - "It is still cash flow that triumphs".

As I reflect on my past three years plus of investing in stocks and shares, I learnt many lessons, some slightly bitter ones and some are good ones. So far, I am glad to say that I have not made any realised losses from the stock market yet. In fact, I have made steady returns of approximately 13% per annum over the past 3 years plus of investing mainly through recurring cash flows from dividends received from my stocks investments and some gains through selling of shares (a lesser amount though compared to dividends received). This figure of returns may not be exceptionally significant, but it is already better than most other alternative forms of investments. Also, I have not made a single realised loss on my investments so far.

I have learnt through my humble experience in investing so far that it is better to have the mindset of building assets that return stable continuous cash flow than to invest for quick returns. Even if one is going for an accelerated way of investing by investing for appreciation in value of assets (be it paper assets like stocks and shares or physical assets like real estate properties), one must still own an increasing amount of assets through the years that provides recurring and increasing cash flow that can beat inflation over the years.

Getting positive cash flow through owning assets is really everything about successful investing. Appreciation in value of assets is an icing on the cake. Even after one sells off an asset that has appreciated in value and made a gain, he is still faced with the decision to reinvest his gains and original capital into another asset. If he does not reinvest his cash, then cash will depreciate in value over time. By not investing one's cash, one is getting poorer by the days.

Ultimately, I believe the distinction between rich and poor people is just in the mentality of how they view money. The rich becomes financially educated and invests to control or own assets that provide them recurring and increasing cash flow that fights inflation. Of course, any appreciation in value of the assets is also welcomed. The poor views investing as risky or is just ignorant of the merits of doing proper investments. The simple key to successful investing is just to continue learning how to invest and just do it and really learn from mistakes and successes whenever investment decisions are made.

The more learning and experience one gains through own research and learning from mentors, the better it becomes as one matures in his investing journey. As I have already expressed in an earlier post quite sometime ago, my view on successful investing has not changed now. Building up the amount of high quality assets one can have the most control (be it paper assets - this tends to have lesser control for the investor as shares are just meager part-ownership of an invested company unless one is a major shareholder, physical assets or business) over time and getting increasing recurring cash flow which beats inflation will allow one to reach financial freedom sometime in life. Cash flow received from assets is further plough back to reinvest in more quality assets which further increases cash flow. This is a virtuous cycle of increasing cash flow over time (by compounding), cash flow that further feeds more cash flow.

Patience and endurance to resist instant gratification in seeing immediate gains is important. Surprisingly, I learnt through these three years plus of investing that money goes to the one who is not greedy for it. The more one is not greedy for money, the more rational and composed one is when it comes to long term financial planning and constantly making the right investment decisions. It is all about the mindset of the investor. The success and failure of investing is not so much affected by the economy, but often it is the wrong emotions of greed and fear that causes the investor to make unwise investing decisions.

I will continue to look out first and foremost for quality assets (be it in paper or physical assets or business) to invest for good quality cash flow while secondly welcoming the idea of appreciation in value of invested assets. Building cash flow through owning and controlling more and more quality assets over time that beat inflation heads down is the crux of successful investing that will enable one to reach financial freedom. Better yet is that the quality assets one has owned can appreciate in value over time. This simple rule of successful investing has not changed through the ages. I believe it will not in future too.

Are you into building more and more positive cash flow (by owning and controlling more quality assets) or "building" more and more negative cash flow over time (by spending more than one's income, chalking up bad debts or making unwise investment not in cash flow producing assets but in investments that may lose their value in the end resulting in a loss)? If 'cash' thinks that it is really king, 'cash flow' will be laughing his heads off at 'cash'. Perhaps, the mindset of wanting cash flow is probably better than the mindset of wanting cash when it comes to successful investing?

Think of cash flow investing as installing more and more taps that can be opened to provide more and more cash inflows. The choice of the right taps to install is important so that the right taps (quality cash flow positive assets) can continually provide more and more cash inflows over a long period of time to build one's passive income.

Does growth adds value or destroys value?

All businesses experience growth. If a business does not grow at all to aspire towards becoming a market leader, it is just a matter of time when a competition catches up and takes over the competitive advantage of an existing business. Some companies grow for the better creating more wealth and shareholder value while other companies destroy wealth and shareholder value as they grow. Thus, there is nothing great about growth if growth does not create more wealth and value.

How do we distinguish good growth from bad growth? To understand the distinction, we look first at a company with balanced growth. A company with balanced growth will increase it's revenue and other items in the financial statements such as net income, equity, liabilities and total assets at the same percentage every year. This means that the ratio of such important items in the financial statements to revenue remains the same every year. Other metrics like net profit margin and return on equity remains constant.

For a balanced growth company, the steady increase in revenue and net income makes the company more valuable through the years. However, the trade off is that the company has to maintain this growth with new capital every year that grow at the same rate as the growth in revenue and net income.

A typical balanced growth company has the characteristics on it's financial statements as follows. To make things simple, this company is assumed to be without debts and has only equity as the sole consideration for it's capital invested.

For this example of a balanced growth company, revenue, net income, equity and the amount distributable to shareholders (amount distributable to shareholders is calculated from net income minus additional required capital investment in the form of equity) all grow at similar rate of 10% per annum. Net profit margin and return on equity are relatively constant at 10% and 20% respectively.

To calculate the present value (PV) of the distributable cash flow to shareholders, one can use the formula as follows.

PV = C X [(ROC - G) / (R - G)] ,

C is the amount of capital at the start                                      

ROC is the return on capital

R is the cost of acquiring capital

G is the rate of growth

For this balanced growth company, it's return on capital (ROC) is 20% (same as it's return on equity) since it is assumed to have only capital in the form of equity and no debts. It's capital at the start (C) is the equity it has which is $100 million. It's rate of growth (G) is 10% since it grows it's revenue and net income at 10%.

Where growth does not add value nor destroy value

For the case when the return on capital (ROC) is equal to cost of acquiring capital (R) (e.g. both ROC and R are 20%),

PV = $100 million X [(0.20 - 0.10) / (0.20 - 0.10)]

      = $100 million

Thus, the present value (PV) of the distributable cash flow to shareholders ($100 million) is the same as the amount of capital invested by shareholders at the start ($100 million). The shareholders do not get more in present value of distributable cash flow as compared to their capital invested at start. This means that the company does not add value nor destroy value for it's shareholders even with a 10% growth rate of it's revenue and net income.

Where growth adds value

For the case when the return on capital (ROC) is more than the cost of acquiring capital (R) (e.g. ROC at 20% and R is 12%),

PV = $100 million X [(0.20 - 0.10) / (0.12 - 0.10)]

      = $500 million

Thus, the present value of distributable cash flow to shareholders ($500 million) is higher than their capital invested at start ($100 million). This means the company adds value to it's shareholders even with a 10% growth rate of it's revenue and net income.

Where growth destroys value

For the case when the return on capital (ROC) is less than the cost of acquiring capital (R) (e.g. ROC at 20% and R at 22%)

PV = $100 million X [(0.20 - 0.10) / (0.22 - 0.10)]

      = $83.3 million

Thus, the present value of distributable cash flow to shareholders ($83.3 million) is lower than their capital invested at start ($100 million). This means that the company destroys value to it's shareholders even though there is a growth rate of 10% in revenue and net income.

Conclusion

It is time to debunk the belief that all growth creates value for shareholders. Growth of a company usually requires some amount of additional investment of capital (be it in the form of equity or debts). Financiers of equity or debts will require their interests or returns on their capital provided to the company. This is the cost of acquiring capital the company has to bear in order to allow growth to be possible. When a company requires a higher cost of acquiring capital compared to the returns on acquired capital in order for growth, then growth may not be that good afterall since it destroys value for shareholders. Thus, the next time a company speaks of magnificent growth plans, it is time for a potential investor to look deeper into whether growth does creates value or not.

Termite infestation, a case where rapid growth destroys value.

Indicators of management effectiveness.

Through my readings, I discovered that the famous investor Warren Buffet selects potential companies to invest based on the management effectiveness of the companies. After acquiring companies with good management, Warren Buffet lets the original management continue with their management of the company. There is usually no replacement of the original management after acquisition since the managment has already have a proven track record in profitability and a good organisational culture in place.

I shall share some pointers I learnt through my research on what makes a good management. My sharing is by no means exhaustive as the knowledge of good business management is vast beyond measure and constantly evolving.

A good management focuses on four indicators namely:-
1. Product and service quality
2. Reliability
3. Speed of execution
4. Adaptability

1. Product and service quality

The product or service offered by a company to it's customers must always be of the best quality possible. Products or services of the best possible quality will completely meet the needs of the customers and may even offer higher value than the expectations of customers. On the internal side of the organisation, the managment will put in place every controls to make sure the final product or service is of the best possible quality to meet customers' expectations and beyond.

For example, in a hotel, all product and service offering from the hotel rooms and furnishings, customer service by staffs, hotel food offering and ambience will need to be of the best quality based on the type of the hotel standards. The hotel should meet the expectations of it's customers, if not exceed their expectations in terms of it's products and services offered. To do so, the hotel must seek ways to find out what are the expectations of it's customers so as to better meet their expectations. The hotel must also seek feedback from it's customers on it's products and service offering so as to constantly maintain and even improve their standards in terms of product and service quality.

So, one indictor of management effectiveness is the product and service quality that the company is offering to it's customers. A lot goes into the strategic planning and execution by the management in order to reach the final presentation of it's quality product and service offering to it's customers. It is by no means easy.

2. Reliability

Reliability means how consistent the product and service offering can meet the expectations of the customers of a company. No use offering quality products and services that only meet the expectations of customers sometimes and while at other times, the products and services offered fail to meet the expectations of customers. An effective management must ensure consistency in it's product and service such that it will be able to meet the expectations of all it's customers all the time.

For a hotel, this means hotel rooms must be periodically maintained. Phone calls at the service counter must be answered within a set time. Room guests must always get their rooms at exact set times for check-ins and check-outs must be finished within a set time (as fast as possible) to prevent any delay to the schedule of the guests. Food must be prepared and always served at exact set times for the room guests.

As one can see, reliability is based on consistency in standards. A good management always strives to maintain a consistent standard in the quality of it's product and service so that the product and service quality is not only good but most importantly also consistently good.

3. Speed of execution

The quality product and service offered must be able to meet the expectations of customers fast enough.  There are different expectations in terms of speed of execution depending on what type of products or services are offered. However, generally customers will expect a reasonable time frame within that the product and service must be offered to them. The product and service must always be ready any moment to answer the needs and expectations of customers whenever required.

In a hotel, speed of execution in the product and service offered is more evident. To most hotel guests, time is of essence. The challenge of the hotel is to meet the personal schedule of every hotel guests so that no guests are delayed when they should expect to get their service on time.

It is by no means easy in terms of manpower and execution in order to answer the needs of every hotel guests on time so that no one gets delayed. This is thus another indicator of management effectiveness to make sure the product and service is offered with fast enough speed of execution to meet the expectations of customers at an agreed time frame.

4. Adaptability

This is another test of management effectiveness, the ability to make sudden changes when required to respond to changing needs of the customers. For a hotel, if a guest ask for a food that is not found on the food menu of the hotel restaurant, a good hotel service standard will mean the hotel will still try it's best to answer the unique needs of the guest. The hotel can promptly send personel to buy the ingredients for the new food and prepare it if possible. Or the hotel can try to order the food if it is available from another hotel nearby. The idea here is not to reject the requests of customers as much as possible, but instead try it's best to be flexible to make sudden changes to answer a different new expectation of the customer.

This is another test of management and organisational effectiveness, to be flexible always to anticipate sudden changes to the needs of it's customers.

Conclusion

These four indicators of management effectiveness are by no means easy to reach. However, the management that can better meet these four indicators will have in place strategies and execution measures to ensure the productivity of the organisation is always on the high side.

For an investor, one should look out for good management of businesses to invest in.

Wealthy or rich?

This is a follow up post from the last post. The question goes like this:-

Imagine a farmer has bought a goose for $36 that lays one egg each day that one can sell for $0.01. Only a few months after he bought the goose, a second farmer comes along and offers to buy the goose for $54. Should the first farmer sell his goose which can help him derive regular income for the next 15 years (assuming the goose can live another 15 years)? The potential capital gains is 50% for the first farmer if he sells.


What if yet a third farmer comes along and offers to buy the first farmer's goose at $72. The potential capital gains is 100% if the first farmer sells his goose.

Should the first farmer sell his goose, and to the second or third farmer does he sell should he decide to sell?

As I mentioned before, everyone is entitled to their own choice in making decisions, especially investment decisions depending on their personality and financial objectives. However, I believe there is an objective way of looking at things, doing things that really make good sense.

The first farmer in my humble opinion should sell his goose to the third farmer. If no farmers come along to offer him a higher price for his asset (the goose) which is currently generating recurring cashflow for him, he should stick to his asset since it is giving him a consistent 10% yield annually (assuming his yield can be always adjusted to account for inflation maintaining a consistent 10% annual yield). The second farmer offered him a capital gain potential which is much lower than the third farmer.

The third farmer's offer of 100% potential capital gain for the first farmer is attractive enough for him to let go of his cashflow generating asset. By doing so, he will now receive $72 for his goose. Assuming the price of a goose has not increased yet, the first farmer should go back to the market and buy back two geese now with $72. With two gesse in his hand, he can now receive more recurring cashflows, in fact double the amount of recurring cashflows he once received with only one goose.

Of course, one may question is there likely to have such a person as the third farmer who will offer a potential capital gain of 100% to the first farmer. In life, anything can happen. All kinds of people exist. Some are shrewd, some are impulsive, some are careful, some are careless, some are calculative and yet some are generous. So, such a third farmer character may not always come along. The idea here is 'may not' but does not mean 'do not'. There is still a probability for one to capitalise on a substantial capital gain (in magnitude of at least 100%) just that this scenario does not happen easily.

When this happens for the farmer's case, he should grab the chance to realise his capital gains. And, the important thing here is after he has got his capital gains, he went back to buy two geese with his money. For the first farmer, he saw the importance of recurring cashflow income in his business of selling eggs. So, he places his priority on building his cashflow generating assets (his geese). Capital gains is but only an icing on the cake, good to have only if it is really good to have. In his case, the capital gains has allowed him to further his acquiring of more cashflow generating assets.

So, come to the conclusion of the matter. Invest for both cashflows and capital gains. The foundation of investment is on building up and generating good amount of recurring cashflows. To accelerate this purpose, capital gains on any assets must be reinvested to acquire more cashflow generating assets. Then, this makes some good sense to go for capital gains in addition to just collecting cashflows alone from investments.

The problem with many is that one can be blinded by immediate gratification of a capital gains and tip the scale in favour of always going for capital gains in investments. This brings me to the title of this post, "Wealthy or rich?".

To be wealthy, one has to acquire cashflow generating assets. It does not matter how much in total value one's assets is. It is not the total value of assets that matter, but the yield on the assets one is receiving that matters. A person may only have for example $500,000 in total value for all his assets. However, if he is receiving $250,000 annually from all his cashflow generating assets, he is getting a yield of 50% (this is just for illustration - it is not easy to get such high yields).

On the other hand, one who is rich has a lot of money, but no cashflow generating assets. For example, one can be a millionaire with $1,000,000. But he may not be receiving any cashflows at all if all his money is held as money. So, effectively, his yield is 0% annually. No cash flows into his pocket since he does not own any cashflow generating assets. But, cash is constantly flowing out of his pocket. He has to use his money somehow if not for buying luxury items, at least for minimal survival needs.

For such a person, he is rich but not wealthy. The problem with him is that his money will be drained out sooner or later through his expenses. Another invisible force that is slowly draining away his money is inflation. Due to the US free printing of currency, the value of currency will be eroded. More money is flooding the market as time goes by. So, even if this person does not use a single cent of his $1,000,000, the same $1,000,000 will not be worth this amount some years down the road because one has to use more money to buy the same goods and services in future. That is why prices of houses has increased through the years. It is not the houses that have increased in value, but our money that has decreased in it's value due to printing of currency and inflation. We have to use more money to buy the same type of house in future.

So, be wealthy or rich? To be wealthy means deriving good amounts of recurring cashflows from cashflow generating assets. To be rich means having a lot of money, pure money that can potentially erode in value until zero with the passing of time.

Investing for capital gains or cashflows??

I am thinking hard recently as to whether to invest for capital gains or cashflows. I believe everyone should know the meaning for capital gains. Buy a stock at a certain price and then sell at a higher price at a later time. The duration to hold the stocks can be short or long depending on the amount of capital gains one desires. I have also touched on how much capital gains one should preferably aim for (for a trading mindset or long term investing mindset) in an earlier post based on my own research.

As for cashflows, I am referring to the dividends one receives for all his stock holdings in his portfolio. This question is important to ask as we are surely approaching the next bear market anytime in future. Nobody knows when. But, everybody should know the "bear will surely wake up from hibernation" sometime in future. The valuation for most if not all stocks will be send to the depths again during the next bear market. Again, nobody knows how much the extent of the next bear market in terms of duration and damage to valuations of equities globally.

I believe it is always wise to think one step ahead and make preparations for something that is certainly to come. So, this raises the question of whether one should go for capital gains or cashflows. I have heard from a friend who has invested through a few market cycles of bull and bear holding on to his same stocks which were bought many years ago. He told me that the valuation of his stocks now compared to his initial bought in valuations many years back is higher. However, the difference in valuation is not much. He does agree that it would be wiser for him to sell at the height of a bull market locking in his capital gains and buy back again during the depths of a bear market and keep repeating the same process through the few market cycles he had seen. The only problem is even as he knew about this simple possible strategy, he did not commit himself to do it and so left his stock holdings through the years to the mercy of the many market cycles.

However, one thing he commented is that he still receive good amount of dividends from his stock holdings and the total amount of dividends had increased through the years. Of course, he does reinvest his dividends and make further capital investments to buy more stocks through the years so his total amount of dividends received has been growing through the years.

So, back to the same question again. Invest for capital gains or cashflows? My answer is a consolidation of thoughts from all my earlier blog posts based on the summation of all my research so far. I do not count myself as a knowledgeable investor as knowledge is never ending and I am always learning new things about investment everyday. The answer I arrived at is that one should invest for both capital gains as well as cashflows.

Both ways of investing, for capital gains or cashflows, have their merits and shortfalls. Capital gains of a substiantial amount (at least 30% for short-term trading and 100% for longer term investing) can help to lift one's net worth in his stocks portfolio at a fast rate. However, one does not always have the good fortune to buy into a stock that can have such magnitude of capital gains (please note that I am discussing based on the Singapore stocks market; other stocks market such as the US stocks markets may have much wider swing in valuations). Even with penny stocks, it is also not a guarantee to see substantial capital gains even after one has bought into a penny stock with a popular theme or fundamentals (whatever you call it). So, investing for substiantial capital gains has a low chance of realisation. Nevertheless, one can still lower his expectations and sell any stocks at a lower capital gains as long as it is still attractive enough for the holding period in consideration. Also, selling stocks for capital gains does make sense when one is trying to escape an impending bear market. Why leave it to chance and let the valuations of one's stock holdings that has increased have the potential to drop back to the original bought in valuations or even lower?

Thus, investing for substantial capital gains though having a low strike chance, is still well worth the effort to do so to accelerate one's rate of return on his investments. The other way of investing for cashflows has it's own merits as well. Cashflows investing is a stable consistent way of deriving recurring income from one's portfolio. Cashflows income is difficult to build in the initial stages but when one's stocks portfolio size is big enough, the amount of regular dividend income one can derive is not to be looked down upon. However, when investing for cashflows, one needs to hold his dividend paying stocks for a long term to keep building and sustaining his dividend income.

The frustrating question comes when his dividend paying stocks have risen so much in valuations to allow him to have the possibility to capitalise on a substantial capital gains by selling off his regular dividend income paying stocks. Imagine a farmer has bought a goose for $36 that lays one egg each day that one can sell for $0.01. Only a few months after he bought the goose, a second farmer comes along and offers to buy the goose for $54. Should the first farmer sell his goose which can help him derive regular income for the next 15 years (assuming the goose can live another 15 years)? The potential capital gains is 50% for the first farmer if he sells.

What if yet a third farmer comes along and offers to buy the first farmer's goose at $72. The potential capital gains is 100% if the first farmer sells his goose. I believe we might have reach a simple conclusion ourselves whether the first farmer should sell or not, and if he sells, to which farmer should he sell.

For those interested to share your ideas as to what action the first farmer should take, you can drop in your thoughts under the comments for this blog post. 

Lastly, my conclusion is that one should invest both ways, for capital gains and cashflows. An analogy for this is that cashflows represents a normal car while capital gains represents a turbo engine that can be fitted to the car. The turbo engine can not be fully utlilised during the entire duration of operations of the car as it will cause the car to overheat and wear out very fast. But, if the car does not have a fitted turbo engine, it cannot achieve another quantum leap in it's maximum speed and torque. So, use both capital gains and cashflow investing to one's advantage. A basal amount of cashflows from recurring dividend income is always welcomed. In addition, some capital gains can also help to accelerate the rate of return on one's investments.

PS: Please note that this post is just a simple discussion and by no means an indepth discourse on both ways of investing. There are certainly more considerations (e.g. investor's individual personality and financial objectives to look at when investing).

Value, value and still value........

What is the most important thing investors should look out when investing? I had the fortune to meet up with and had a short chat with a venture capitalist. It was indeed an eye-opener to hear from how professional investors think and act. The conclusion I have from the short but eye-opening chat can be summarised into one important word "value".

Value, value and still value. This word got me pondering hard for quite a while. One simple word but it carries a very important and heavy essence to investing. It challenges my long held principles to investing and set me thinking hard whether I have captured this important essence to investing - that is always to think of the value of any investment.

I learnt something very important about value. If an investment is not valuable at all, do not invest in it, run away from it, not to mention even thinking of it for any longer moment. To ascertain whether an investment is valuable, it may not mean one must analyse the investment to perfection. Sometimes, the more analysis one goes through to justify an investment is good may mean that more reasons have to be dug out to prove one's correctness about the investment. Do not get me wrong. I am not trying to say one should not analyse every investment. Afterall, investing must be a careful activity. However, sometimes, good things that are obvious about an investment even to a layperson may already mean an investment is obviously valuable.

So, analyse each investment with care. However, value may be somehow always noticeable. If it is not noticeable, one may need to question why an investment is not obviously valuable and needs the careful analysis to unlock it's value? Value is where there is a protected strong demand for the existence of a business. Everybody from all the working staffs in the business to the customers and any other interested parties it serve depend on the business and continues to derive value from the existence of the business. If such a business cannot be replicated by other potential competitors (ensuring high barrier to entry), thus is the value of the business.

So, think value, value and still value. Invest in really valuable businesses.

Price can lie, volume of transactions does not lie........

There are two basic parameters when one is looking at any particular stock counter during a trading day, it's price and volume of transactions. These two parameters may change during each trading day. And, the price and volume over a period of trading days are almost always different (unless the stock counter is an illiquid one).

For every stock market participants, we are affected by the price and volume of transactions of any particular stock counter. Like it or not, the stock market is an open market for all to participate, so it is a supply and demand principle at work in the many transactions of any stock counter listed on the stock exchange.

Since we are looking at supply and demand in the stock market, we need to know how many outstanding shares of a company is traded on the stock market, also known as it's free float. One also need to know whether this free float is likely to increase or decrease in the future. If free float increases, more shares will be flooding into the market from the particular stock increasing it's supply of shares in the market. On the other hand, shares buy back by the company will ensure some shares are retreated from the market and decrease the supply of shares in the market.

By examining the daily volume of shares transacted for any stock counter, one can also see some insights into the supply and demand situation for any stock counter. When large volume of trasactions occur and the daily volumes of transactions over a period of time experience steady growth, coupled with a growing stock price, the stock is in demand. Just looking at growing price alone over a period of time may be misleading, unless it is supported by a growing volume of transactions over the same period of time too. This shows that "volume of transactions cannot lie" as these are actual recorded transactions of trades made for a particular stock counter over a period of time. However, the "stock price may lie" whereby it is increasing over low volumes of transactions showing the growing price may not be well supported and there may not be a good demand for it's shares just by looking at growing stock price alone.

On the other hand, a decreasing stock price coupled with increasing volumes of transactions over a period of time may mean the demand for the shares of a stock is decreasing. Market participants keep selling the shares by volumes upon volumes at lower and lower prices indicating the desire to get out of a stock. We see this phenomenon in the last bear market when the volume of transactions was large over the entire period of the bear for decreasing stock prices.

So, when one looks at the fluctuating stock price of any counter next time, remember that the "stock price can lie" and an increasing stock price or decreasing stock price may not mean anything. However, when one looks at the volume of transactions together with the changing stock price over a period of time, one sees  the whole picture of the supply and demand for a stock as "volume of transactions does not lie" as it indicates how many shares are changing hands to cause the stock price to increase or decrease.

No matter whether one is a long term or short term market participant, it can be rewarding to estimate the demand for the shares of a stock to know whether one can invest into a stock by checking out if it has growing demand and stock price. Next time, when someone gets excited by an increasing stock price or decreasing stock price, be forewarned that changing stock price may not mean anything much when one does not look at the daily volumes of transactions over the same period of time. Be careful of getting trapped by the fluctuating stock prices when looking at it alone.

The big players.

In the stock market, there are small and big players. Small players are retail investors while big players may be instituitional investors or other high net worth investors. When a stock is chosen by big players to be invested in, the stock may follow certain behavioural dynamics in it's price. If small players like the common retail investors can pick up some simple behavioural dynamics of the big players in a certain stock, they can ride on the strength of the big players and derive profits by understanding the mechanics of how big players invest in certain stocks.

Usually big players invest in a sequence as follows:
1. Selection of a potential stock to invest in.
2. Period of accumulation.
3. Period of flushing out weak players.
4. Period of pushing up a stock price.
5. Period of unloading the stock at a suitable higher price.

Selection of a potential stock to invest in

Big players like to select stocks that can rise in stock price. What are stocks that can rise in stock price? Most often, these are stocks with a current or near future popular theme. Some ages back, we have stocks like the internet stocks which were chased like crazy having their stock prices pushed to sky high. It is not always the case that a stock must have a popular theme to be selected, just that it is very common to "fish at a river that have many fishes" (where there is a popular theme for the stock). Another consideration is that the stock price must be suitable to invest in so that there is some room for appreciation in the stock price (usually this may involve investing onto a bull run when the general market sentiment is bullish).

Period of accumulation

After a stock is selected, there is a period of accumulation by the big player. The period of accumulation can be long as the big player patiently buy up slowly and accumulate a large number of shares over a period of time. By accumulating slowly, the stock price is prevented from being pushed up too fast.

Period of flushing out weak players

Sometimes, if the big player cannot accumulate a substantial amount of shares at low prices, it can push up the stock price a little bit (e.g. by 10% price appreciation) and buy in from short-term investors who are willing to let go their shares after getting a 10% profit. During this period of flushing out weak players, big player can also create a resistance point whereby it suppresses the stock price from going higher by some amount of selling. Weak players once seeing the stock price appreciate a little followed by a little bit of falling in prices, quickly sell their shares to lock in some amount of profits and avoid loss. In doing so, the big player continues to accumulate some more shares to build up their position. The objective of the big player is to accumulate a major portion of the shares so that when the price appreciates later, it being the biggest player will have the most reward from the gain in stock price.

Period of pushing up the stock price

Once the big player is satisfied that it holds a large enough portion of the stock, it goes through a period of pushing up the stock price. This move will see the stock appreciate by a large magnitude. Some smaller players who have not leave the scene yet will get their rewards from riding on the wave of the stock price movement.

Period of unloading the stock at a suitable higher stock price

Once the big player has managed to push up the stock price, it has to unload it's shares to finish this whole cycle of investment. So, there is a period of unloading whereby the big player slowly sell off it's shares to other unwary investors. Usually unwary retail investors after seeing the stock price has appreciated by a large magnitude, may become filled with greed and buy from the big players hoping that the stock price can continue to appreciate further. Little do they know that the game has just ended, so these unwary retail investors become the final people to carry the shares at a "high price", shares that will not appreciate further but almost often depreciate after the big player has left the scene.

Conclusion

By understanding the mechanics of how big players work, a retail investor can be better informed and be wary of certain behavioural dynamics in the stock price movement over a period of time. The big players are a force not to be trifled with as these are players with extremely large capital to inject into a stock. So, it pays to understand how they work so as to ride on their success and get a pie of their gains.

Going for the "big win"......It's occasional, but pays well........

Many investors are mediocre players in the market struggling to fulfil "bread and butter" rates of returns on their investments. Many lament that the stock market is full of many "dangers" and "pitfalls" making winning consistently in the stock market an imagination too far to be reached. This is because many market participants fail to go for the "big win", and instead thrive on the many small winnings. When one big loss comes their way, it swallows up whatever small winnings they had in the past, so they end up breaking even or at most making only a meagre net return on their investments.

Why do many market participants fall into this trap of making only multiple small winnings only to find themselves run into the risk of losing back all their small winnings or even suffer a net loss on their capital when a big loss comes their way? It all boils down to the habit of thinking in making investment decisions. The thrill of immediate winning is more enjoyable than suffering immediate loss.

There are two general types of participants in the market, the short-term players who trade actively and long-term players who invest with a longer time horizon. No matter who is participating, all short-term and long-term players both face this problem of falling into the trap of making multiple small winnings only to suffer a bigger loss that trims off the winnings eventually.

For short-term players, the emotional side of the trader tends to disrupt the objective system of trading. It is known to many traders that it is important to stop loss with a small tolerance level (e.g. stop-loss around 10% or even lesser) and let trailing-stops work their way for a winning stock so as to maximise the returns. If the trader does not stick to such strict rule of the game which works on the principle of making a "big win" by using trailing-stops and promptly stopping any losses by strict "stop-loss" measure, then the "big win" effect cannot be realised.

For such emotional traders, it becomes the other way round, making the occasional "big loss" because they let a small loss snowball into a big loss, and making multiple small winnings since they are not able to resist the thought of not realising their immediate gains if any from their winnings. Their consolation after every small win is that, "What can go wrong with taking immediate profits off the table since I have the money in my pocket?". There is nothing wrong with taking profits. However, there is something wrong when taking multiple small profits cannot cover up a big loss eventually. So, to ensure consistency in making "big wins", work on maiximising returns from each winning using trailing-stops and ensure one is covered on the downside by using strict "stop-loss" measure. A simple illustration: if a trader aims for at least 30% returns on each single trade before realising the profits, this returns from that single trade can cover up for 3 losing trades with a "stop-loss" at 10% each. If the stop-loss is more stringent (e.g. stop-loss at 5%), then the cover up on the losing trades is even better with each winning trade. So, the old adage for traders, "let your winnings run and losses stop promptly" is very applicable for making the "big win" when it comes to playing the stock market on a shorter time frame.

For longer term market participants, when does one sell? Aim to sell at a returns of at least 100% on invested capital. Since one is going for a longer haul, it does not make sense to sell at a lower rate of returns. To achieve such returns is not an easy feat. How many market participants can resist the temptation of sitting on unrealised returns for long? Again, their consolation being human is all the same, "What can go wrong with taking immediate profits off the table since I have the money in my pocket?". There you go again. Same excuse, no matter so called long-term players or short-term players, all being humans fall into the tendency of emotional judgment when it comes to investment decisions.

So, no matter long term or short term market participants, there is always this tendency of realising profits too early and stopping losses too late. In doing so, they seems to work along the line of making multiple small winnings and big occasional losses such that their overall investment performance is mediocre at best.

If one has the patience and fortitude to hold the ground after selecting the right stocks at a suitable attractive valuation, only going for the "big win", just a 100% realised returns each year on one single stock in one's portfolio (provided one does not diversify to many stocks: maximum 7 stocks) for a few consecutive years and reinvested, can compound one's portfolio at an alarming rate of return.

So, always be patient to wait for right price to buy (during a bear market or major correction) and right price to sell (at least 100% returns on a single stock) to maximise the gains. Afterall, what is the purpose in investing if one only aims for a meagre returns from the stock market after taking on a bigger risk than other safer investments such as bank deposits? If one is fearful and impatient to wait for a larger magnitude of returns before realising profits and/or is adverse to loss taking which is sometimes necessary, then the stock market may not be suitable for such a person who may be better off putting his hard-earned money into safer investments that he can sleep soundly every night without worries.

A word of caution for readers: there are other considerations such as holding period, fundamentals of a stock and general market sentiments, so please take my sharing with a good dose of caution when going for the "big win".

Simple rule for investing (maintain a strong foundation of a pyramid).

We know of the old adage, "Buy low, sell high." How many investors can be disciplined to put this principle into practice? No wonder only approximately 5% of all stock market participants make the cut and get their deserved returns from the 95% who fail to do so.

How do one buy into the market? When prices are low during bear markets, buy aggressively so as to build a good foundation of shares of selected potentially good companies at cheap valuations. As stock prices increase, buy lesser amount of shares each time as the price heads higher. With each rise in stock price level, the amount of shares purchased must be lesser and lesser. This culminates into an analogy of a pyramid with more shares bought at lower prices and lesser and even much lesser shares bought as prices head higher and higher.

This simple idea of a pyramid buying process is not unknown to many but yet "seems to be unknown" to many. This is because we still hear of many market participants making losses on their investments lamenting the fact that they got caught at high stock prices. To be able to generate returns, one needs to be abnormal compared to the rest of the many market participants. When prices are heading higher and higher, a normal investor will buy more aggressively thinking of only better days ahead. This makes him practise an "inverted pyramid" way of buying when the head is heavy and the base is not able to support the head since more shares were bought at high prices instead of lower prices. With a weak foundation through "inverted pyramid" way of buying, it is no wonder when prices start to head back to lower grounds, the poor investor is left hanging with many shares bought at higher prices, and the probability of capital loss is high.

More shares bought at lower prices and progressively lesser shares bought at higher prices creates a strong pyramid foundation where base supports the head

So, the more abnormal an investor is, refusing to be caught up with greed which is normal to the common crowd who chase after higher stock prices, the higher the chances to avoid risk of capital loss and higher the chances to make returns on investments. Thus, investing is mechanical and boring and made simple with the idea of a pyramid way of buying stocks. Don't be typically normal in investing. Consider being abnormal instead.

Wearing FA "lens" and TA "lens".......seeing from two different angles of the same market

We have heard of both fundamental analysis (FA) and technical analysis (TA) used by investors (be it retail or professional investors) as working principles of doing stock investments or other forms of investments. More often, we hear also the debate behind the effectiveness of one of these skills over the other in getting investment performance. I have always stayed on a neutral stance though I am applying fundamental analysis in making my investment decisions. I have also researched on TA, though not very extensive yet. I have now got a better appreciation of TA. However, I am not an expert in terms of knowing the inside out of this set of skills.

My discovery so far is that FA and TA are both useful and should be used in conjunction when making investment decisions. The danger is to swing to either side totally, be it TA or FA, and ignore the realities of the one side of the same story (the story about the investment one is making decision on). FA tracks the fundamentals of a company, it's historical business performance and future projected performance based on track record. TA tracks the market sentiments (usually short term basis) towards the performance of the company and it's share price. In doing so, TA also takes into account the larger market in view too (based on ongoing macroeconomics). If one thinks the share price of an excellent company based on FA is undervalued but bought at a time when impending correction of a significant magnitude is likely going to take place based on TA, undervalue can get more undervalue. So, TA does have it's merits and both FA and TA should be used in conjunction to be more effective.

The decision making process need not be complicated and clouded by one skill, be it FA or TA over the other. These two skill sets are not contracdictory in nature. They are just skill sets for the investor to use. The investor is the one who manages the use of these two sets to the best of their use so as to make the best possible investment decision at a particular point of time. By doing so, the investment decision hopefully is better thought out in thoroughness. So, I will not say I use FA or TA. I will say I use my prudence in making investment decisions. FA or TA, both are just skill sets for the investor to use, and both are effective and makes investment decision making more thorough if the investor is careful not to be confused emotionally by the use of one technique or the other. 

Just a parting note, in a bear market like last time, no amount of FA can save an investor from watching his portfolio depreciate sharply in value. In such occasional moments, probably TA can offer help in terms of allowing the FA investor to put on another pair of lens to look from the other side of the same situation to make his investment decision on how to navigate the bear market. Wear FA lens or TA lens to see the market? Both exist for the same reason, to allow the practioner of the skill set to garner good returns from making his investment decisions. The trick lies in the user, not the type of "lens" as both lens can and should be used..........

A short excerpt of investment wisdom from Benjamin Graham

Benjamin Graham was the investor who during his time taught that investments should be approached by sound principles of analysis. He taught that it is possible to valuate investments to estimate their value by fundamental approach. Here, I include an excerpt from one of my readings of his writings from the book, "The Rediscovered Benjamin Graham, Selected Writings of the Wall Street Legend by Janet Lowe."

"Let me close with a few words of counsel from an 80-year-old-veteran of many a bull and many a bear market. Do those things as an analyst that you know you can do well, and only those things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that's the row you should hoe. If you're really good at picking stocks most likely to succeed in the next 12 months, base your work on that endeavor. If you can foretell the next important development in the economy, or in technology, or in consumers' preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination and by continuous testing of performance, that you have what it takes to produce worthwhile results.

If you believe - as I have always believed - that the value approach is inherently sound, workable, and profitable, then devote yourself to that principle. Stick to it, and don't be led astray by Wall Street's fashions, illusions, and its constant chase after the fast dollar. Let me emphasise that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.

But whatever path you follow as financial analysts, hold on to your moral and intellectual integrity. Wall Street in the past decade fell far short of its once-praiseworthy ethical standards, to the great detriment of the public it serves and of the financial community itself. When I was in elementary school in this city, more than 70 years ago, we had to write various maxims in our copybooks. The first on the list was "Honesty is the best policy." It is still the best policy....."

Graham has addressed a few issues by this sharing from a veteran investor. First, there may not be only one successful approach to investing. An investor can live out any investment philosophy he is comfortable with. However, whichever investing approach an investor chooses, he must not fall in love and be deluded with it's usefulness but instead test out rigourously whether the approach really yields success in getting consistent good returns on investments.

Second, investment success is not only exclusive to the selected experts in investment field (e.g. fund managers, financial analysts, or anyone with depth of training in the field of finance and investments). The qualities essential for investment success are reasonably good intelligence, sound principles of operation and firmness of character. Of course, an investor needs to learn first to acquire a set of sound operating principles and then have the tenacity to follow through the sound operating principles for investment success. As such, one has to be careful of any distractions that promises 'seemingly fast money' based on following certain 'dubious investing methods' unless that method has been already rigourously tested for it's consistent results.

Third and last, as financial analysts, one should handle his trade with moral and intellectual integrity. As such, this is also a warning for one to view any form of research reports related to investments with healthy skepticism and objectivity since one does not know the analyst(s) behind any research reports is(are) reporting based on upmost moral and intellectual integrity.

A random walk down the stock market - a case of coin tossing

I recently borrowed an audio book from the library titled "A Random Walk down Wall Street". The author stated an interesting hypothesis about the randomness of the stock market. He used the analogy of coin tosses. A mathematics professor in a lecture hall asked his students if he were to make 50 consecutive tosses of a coin, what will be the likely results of the coin tosses. Many students gave very similar answers of alternating heads and tails from the tosses. Answers given were likely to be, "Head, head, tail, tail, head, head,........." or "Head, tail, head, tail, head, tail,..........". Some answers were quite different as it consisted of a longer string of heads followed by some tails and heads again and tails again.

The professor after hearing all their answers told the class that they missed out something very important though most of their answers were correctly based on randomness of chance in coin tosses. He asked them whether is it likely to get all heads in the 50 tosses or all tails in the 50 tosses or maybe to a lesser extent almost a string of 40 heads followed by a string of 10 tails. The class hesitated for a while and finally a student broke the silence and said, "Yes, it is still possible. I did not think of that though."

As head and tail has equal chance of appearing each time, it is still mathematically possible to get all heads or all tails in all the 50 tosses in theory. Applying this analogy into the dynamics of the stock market, the author proposed that the stock market is certainly random similar to coin tosses. Stock prices can fluctuate within a range, or stock prices can climb and keep climbing higher and even keep climbing higher when one thinks the odds are against the prices which are already overvalued climbing higher. The same can happen to prices keep falling, and falling and even falling some more. Reversal in stock prices can also happen suddenly seen by the sharp rally from March until now. Even though many economists and analysts based the stock price movements on global macroeconomics or the business earnings forecast of a company, one can still see that the stock market is a random place where many market players are engaged in constant trading of securities.

Father of value investing, Benjamin Graham used a fictitious character "Mr Market" to depict the randomness of the stock market. Mr Market is really a moody character and at some days he will priced securities at higher prices and at other days at lower prices. One thing is certain, he will keep changing his moods almost everyday depicted by daily price movements of the stock market. I have already seasoned myself to view the stock market with such randomness long time back when I was starting my investing journey. As time goes by, I started to become more immune to price swings from the stock market. Now, I only look at valuations to decide when to buy, to hold or to sell. My view of investing is long term.

The stock market from decades past until now will keep on fluctuating in prices. One thing is certain. Each business that has excellent economics will have it's estimated intrinsic value. No investor in the right frame of mind will sell a business at undervalued prices unless during a sharp bear market. Let the stock market's moods change all it wants. As a focused value investor, I will gladly focus on buying good businesses that someone else is willing to sell me at ridiculously low price or sell a business that has exceeded it's intrinsic value by grossly overvaluations. It is still in my wildest dream that big names like SPH, Keppel Corp, DBS, OCBC, SembCorp, CDL, etc. will trade at below $1 per share. If that should happen, it is great news for value investors like me and others.

So, in a nutshell, my investing approach is based on a "firm foundation theory" that each businesses has it's own intrinsic value and my job is to seek out excellent businesses to invest in them at below what they are worth or to sell them at much higher than their intrinsic value (assuming the business I intend to sell has not much future growth).

Discussion points:- The stock market is not always efficient. Prices of stocks can be traded at ridiculous valuations at times. 

The stock market is also random. It may not always follow trends and can change suddenly. We have seen the roller-coaster effect of the randomness of the stock market so far in this year already.

As a value investor, the market fluctuations do not concern me except by providing investing opportunities at certain times (e.g. gross undervaluations or gross overvaluations). Other times, a value investor is patiently waiting (inactivity) to catch the most lucrative moments when such moments come along (not frequent but surely will come once in a while).  

Protected by Margin of Safety - A value investor's 'airbags'.

By early 2009, I had bought most of my stocks that I held today. My portfolio during early 2009 included stocks like CapitaCommercial Trust, MacArthurCook Industrial REIT, Parkway Holdings, Tat Hong Holdings, Keppel Corp, Jaya Holdings and STI ETF. I kept to less than 10 stocks adopting a focused investing approach since I was determined to pick up skills in analysing businesses, and I will only hold stocks that I find after analysis that have good continuing business economics in the long run. There is no need to hold too many stocks (more than 10 stocks) since I only need a few big winners in my portfolio to achieve good returns.

Diversification is for investors who do not want to or do not know how to get involved in knowing about the underlying businesses of their portfolio stocks. As such, these investors are better off with diversifying into owning more than 10 stocks so that some may generate returns while others losses and it may still provide the investor with average returns in the long run. He may also consider investing in exchange traded funds (ETF) which also offers diversification to achieve average returns. At least diversification is a conservative approach which may still yield average returns suited to the "know not" investor.

However, since I was determined to be a focused value investor, I had to learn more about focused value investing. Focused investing requires me to learn how to evaluate businesses. This will help me to select only stocks of a few good businesses to invest in since my funds are focused in only a few businesses. I shall discusss more of my experiences on learning how to evaluate businesses in later posts. To some, focused investing may sound risky. What makes one thinks he can be absolutely correct about a business's long term potential? What if he makes mistake in his evaluation and invested in a lousy business, he will have to incurr larger losses since he will have more funds invested in every selected businesses? Yes. Focused investing is one of the best ways to achieve greater returns than STI index benchmark. However, there is a flipside to it. It magnifies returns and also magnifies losses as well since there is no diversification.

Focused investing will not be complete if there is no value investing approach. It will be like a body without limbs. Both focused investing and value investing are intertwined together and complement each other. One cannot do without the other. Therefore, a more appropriate way to call this excellent method of investing is "Focused Value Investing". Focused means focusing on evaluating and investing in businesses with great business economics. Only a few businesses is selected since the selection process must be rigourous. Not any business can be selected for investment. A focused investor only constantly seeks the best few businesses around for investment investing heavily in such few businesses. Value investing means only investing in such few excellent businesses at undervalued prices.

I shall focus my discussion on value investing and concept of margin of safety. An investor can peg a fair stock price for every stock. This can be a subjective affair since not every investor perceive the underlying business of the same stock in the same ways. The business underlying the stock maybe perceived as average performing to one investor but high performing to another. It all depends on what measurements each investor uses to evaluate the business. There are just too many measurements and ways to go about evaluating a business that this affair of business evaluation is more of an art than science. This is also what captivates me most (the thrill of evaluating businesses).

When a value investor has determined after analysis a fair stock price for a stock, he then seeks to invest at only below this fair stock price (or sometimes called intrinsic value of stock). By doing so, he buys the stocks only when its stock price is traded below its intrinsic value. This will make it a bargain buy. Another important note is that by buying at bargain prices, an investor is also buying the stocks at a margin of safety (this importance is usually underestimated).

I bought stocks of Jaya Holdings from October 2008 to April 2009 after some evaluation of its business. I perceived it as having an excellent track record (high consistent EPS, ROE and profit margins, high dividends and consistently increasing shareholders' equity value). As I bought more of this stocks over early this year, my average holding price was around $0.30 per share. When news of the difficulty in refinancing its business came, its stock price dropped drastically from around $0.60 plus range to close to $0.30 plus range. Then, came news of impairment losses on reducing some of its vessels that it intends to build. This resulted in its net profit for the most recent year plunged heavily until around making only 1 to 2 % net profit for the year. Thankfully, revenue and profits from its support vessel chartering business is still growing and prevented the company from making a potential loss.

I decided to divest this stocks after considering that there are better companies around to invest (e.g. companies with net cash position in their war chest or low gearing). I had the ease of exiting this stocks at around $0.40 plus range and still made a small profit on divestment. Whether I had made the right choice of exiting this stocks, only time will tell. However, my ability to divest without making a loss was due to the fact that I had pursued a low average holding price giving me adequate margin of safety. I was protected from the sharp fall in price due to a margin of safety made only possible by buying at as low price as possible below the intrinsic value of the stocks (fair value of the stocks). This is akin to driving with airbags installed (holding stocks at low undervalued prices) providing a margin of safety from getting hurt in car crashes (sharp fall in future stock price). One does not want to have car crashes or sharp fall in stock price. However, it pays to be prepared for this uncertainity which may come without knowing.

Of course, buying at undervalued prices below what a stocks is worth not only offers a margin of safety. It also provides potential for greater long term returns since one is paying less to receive the total net earnings or total free cashflows a company can potentially generate over a period of time.

Discussion points:- Focused value investing is a total approach. Focus one's energy and capital on evaluating and finding a few great businesses to invest heavily in. Invest heavily in such few excellent businesses by paying less for their great value (value investing). These two approaches complement and is interdependent on each other like the body and its limbs.

Value investing has two benefits. It provides a margin of safety to buffer against future drop in stocks price. It also allows the investor to pay less to receive the total net earnings or total free cashflows a promising company can potentially generate over a period of time.

Waiting for the perfect pitch - Looking at yield on one's investment

I shall discuss 2 sections here. First section is on the concept of "waiting for the perfect pitch". Second section is on recognising the perfect pitch, on when to invest based on looking at long term yield on one's investment.

First section:- "Waiting for the perfect pitch."
Warren Buffet describes wise investing as having a punch card with limited number of lifetime investment decisions (20 times perhaps). Each time a decision is made, the card is punched once. One can only excecute at most 20 investment decisions in one lifetime (each decision maybe a single buy or sell order). Once exhausted the 20 limited number of decisions, one cannot carry out any more investment actions. Though unrealistic, this really paints a strict investing principle of "one should only invest when it is wise to do so, otherwise do nothing". It also makes one thinks very carefully before making each investment decision.

Further to the punch card example, a more suitable demonstration of "waiting for the perfect pitch" describes a baseball batter who needs to constantly decide when to swing his bat at the ball. Warren Buffet describes a famous baseball batter who divides the batting range into many smaller square sections where the ball can fall into when flying towards him. This baseball batter only swings his bat when the ball is flying into a few particular square sections that give him a very high probability to hit the ball for a perfect pitch. Otherwise, he does nothing.

Investing is wise only after it is given thoughtful and careful consideration as shown in the punch card and baseball examples. One only invest when there is a high probability of winning (making excellent returns) and low probability of losing one's capital. As such, Warren Buffet also has two golden rules for his investment:- First rule is never to lose money. Second rule is never to lose money too.

A point to note is that this concept of "waiting for the perfect pitch" cannot be misinterpreted and wrongly applied. For example, a contra player in the stock market may buy heavily into the stock of a particular company after a good news is released about the company thinking the stock price will soar on short-term. He thinks he is betting heavily since he has a perfect pitch. However, Buffett's intention for using this concept of "waiting for the perfect pitch" applies mainly to a long term nature of investing (e.g. he makes his perfect pitch to buying a company stocks not for a short-term speculative gain). His investments are mostly held for long term compounding returns, and his idea is to buy particular stocks when it is most attractively priced for its value with great long term potential for excellent returns.


Second section:- "Recognising the perfect pitch - when to invest based on looking at long term yield on one's investment."
There are many ways to determine whether a stocks is most attractively priced for its value to make good one's investment. One can look at price-earnings ratio (P/E), price-book ratio (P/B), intrinsic value (which is subjectively determined). Traditionally, the lower the P/E ratio (10 and below) and P/B ratio (1 and below), the more attractively priced is a stocks for its value.

Through my reading of investment books, I came across a book based on Buffett's wisdom of recognising when is the perfect pitch. One can look at the long term yield on one's investment. E.g. One buys a share of a company (e.g. XYZ company) at $1 and the company has a earnings per share (EPS) of $0.10. This means for every $1 dollar invested, one expects to receive $0.10 returns on the $1. The current yield on this investment will be ($0.10/ $1) X 100% = 10%. Is this a good deal?

If shares of another company LMN is priced at $1 per share and EPS is $0.20, the investor gets $0.20 for every $1 invested. The current yield is 20%. This is definitely a better deal than the earlier one. Of course, the investor does not get the full $0.20 returns per share physically on his $1 invested per share. Only dividends is given back to the investor and all remaining earnings of a company is usually used as retained earnings to further grow its business. However, as long as the investor remains invested, he still has interest to the full earnings (dividends already given to him plus any earnings not given to him but retained by the company).

It gets a bit tricky when we look at the growth of earnings per share (EPS). EPS of company XYZ is projected to be growing at a compounded rate of 20% per annum while EPS of company LMN is growing at compounded rate of 5% per annum. After 10 years, the EPS of company XYZ will be $0.62 while that of company LMN will be $0.33. So, an investor with company XYZ will have a future yield after 10 years of 62% on his initial $1 per share invested getting $0.62 on every dollar invested. On the other hand, an investor with company LMN though starting with a higher yield of 20% will only end up with a yield of 33% in 10 years time (not a significant increase in yield of returns).

In conclusion, one can look at current yield and future yield to determine whether a company is worthy of being a "perfect pitch".

I bought into the shares of Keppel Corp during March 2009 @ $4.05 per share. Illustrated below is the 6 years record of EPS for Keppel Corp.

2003: $0.511,     2004: $0.603     2005: $0.721     2006: $0.954      2007: $0.715       2008: $0.69

Therefore, my current yield based on year 2008 EPS is ($0.69/ $4.05) X 100% = 17.0%
Based on the 2003 EPS and 2008 EPS, the annual compounding rate of growth in EPS over this 5 year period is 6.19%. Assuming Keppel Corp keeps growing its EPS at this compounded rate per annum, its EPS after another 10 years will be $1.258.
My future yield will be ($1.258/ $4.05) X 100% = 31%.

31% yield may not be too impressive. However, it is still a decent figure getting 31% future yield per annum and growing still. Some stocks were trading at even higher yield based on their EPS and share price (more than 20 %) during March 2009. To an astute investor who can recognise high yielding stocks (current yield more than 20%) that can grow their EPS at high compounded annual rate (10% or more), it may not be too surprising to see the future EPS of such company may even reach the initial share price an investor paid for. By then, the investor that holds onto his shares may get a 100% yield ($1 returns for every original $1 invested).

Discussion points:- Wait patiently for the best chance to invest which is waiting for the perfect pitch. Otherwise do nothing.

One of the way to recognise the perfect pitch is to look at current yield and future projected yield. Buy stocks only when their current yield is high (more than 20%) and their EPS is projected to grow at high compounded annual rate (more than 10%). Thus, one should expect to get a high future yield on one's original invested capital (assuming one holds the shares long term and the company is still performing well).

Averaging down - A bane or a blessing in disguise?

Now that I have purchased my first 5 lots in CapitaCommercial Trust units @ $1.95 per unit late June 2008, I waited for a few weeks until the unit price descended to hover between around $1.80 to $1.85 per unit range. I recalled the price held strongly over that range for a few weeks, and I got impatient and bought two more lots around $1.83 per unit price hoping to average down my unit average holding price. I thought that averaging down was a good way to increase my amount of units in CapitaCommercial Trust and decrease my average unit holding price. Averaging down does provide these two benefits especially if the investor is convinced after analysing that a company's shares is worth further investment that he should rightly buy even more shares at a lower price.

However, averaging down has its loophole depending on the manner in which it is conducted. Firstly, averaging down does not work on an impatient investor. My situation was that I was too impatient and my next lower purchase price ($1.83 per unit) was simply not much attractively priced compared to my earlier purchase price ($1.95 per unit). Though averaging down can work, but I could not get it to work harder for me as I did not use this strategy properly. I landed up with even more units (7 lots) held at average price of only $1.9157 per unit after averaging down (compared with my earlier holding price of $1.95 per unit). So much for wasting my money in brokerage transaction fee and locking up more money into more units bought.

Secondly, the stock market was still in descent in July to August 2008, so the probability of the unit price going further down is very high. By averaging down, I was in fact repeating my earlier mistake of catching some more falling knives. Indeed, the unit price continued its descent further to come close to $1 per unit range by October 2008. Before October 2008, I made further purchases around $1.60 price per unit and $1.37 price per unit, and finally gave up getting tired of catching some more falling knives. It was a really gruelling and horrible experience of averaging down for me.

Due to my inexperience back then using the averaging down strategy, I suffered the consequences. It was also during that period of time that I came to know about technical analysis as the alternative approach to fundamental analysis for timing entry and exit into a particular stocks. Many technical analysts back then would tell of the dangers of entering the market because all technical indicators point to strong continued descending price action. Actually on hindsight, it was also not difficult nor mysterious to tell that the market is going on a bear descent even for a layperson. Had I been more patient and less emotional, I would not have made further purchases in the name of averaging down to my disadvantage.

It was much later that the unit price of CapitaCommercial Trust continued to decrease further until around the range of $0.60 to $0.70 per unit during March 2009. On hindsight, if I had been patient, I would have bought significantly more units at such low prices and my average holding price during March 2009 would be around $0.95 per unit assuming 20 lots were bought @ $0.70 per unit and adding in earlier 5 lots @ $1.95 per unit. So much difference in bringing down my average unit price from $1.95 per unit to $0.95 per unit. Of course, one can argue that had I waited even more patiently until March 2009 to buy all 25 lots @ $0.70 per unit, I would be even much better. My answer to this statement is that "I am not a prophet nor fortune teller, so do not assume I can do that."

Discussion points:- Averaging down needs to be used properly and can work in two unique situations.
First:- The investor knows a company is worthy of continued investment after careful analysis. He has an initial holding price of the company shares that is already undervalued (below the intrinsic value of the company shares). Upon further descent in share price below his initial holding price, he is in fact purchasing even more undervalued shares of the company. However, if the company share price is beaten down because of permanent problems with the underlying business, an investor should exercise extreme caution because the lower share price may ultimately mean shares having no value instead of undervalued.

Second:- Averaging down does not work on a prolonged sharp market descent (prolonged bear market or recession) because prices are free falling. Instead, an investor should be waiting patiently for the perfect pitch (waiting for prices to stabilise after the sharp fall which does not usually happen in a few days or few weeks, but may take months) before purchasing more shares to average down only at the best opportunate moment.

More on the concept of "Waiting for the perfect pitch" or "Betting heavily at the only best moment, otherwise it is always better to do nothing" in later post..........

Emotions do not rule in stocks investment

After setting up a trading account with a local stock brokerage firm in late June 2008, I was all geared up to make my first purchase into stocks. I had only by then read up only a few books on stocks investment and had got complacent that I should be ready to start my first stocks purchase. I call this a first-timer enthusiasm kills.

I made my first purchase (5 lots (5000 units) of CapitaCommercial Trust units @ $1.95 per unit). I recalled I was quite eager to hit the buy button of my online trading platform while watching the unit price of CapitaCommercial Trust keep changing by the second. It was like my moods was caught and held by the constantly changing quoted price on the online trading platform. It was a trying moment for me to keep my cool and patience watching the constant price change. I waited for the whole first day since the start up of my trading account and decided against buying the units. However, the second day came and I watched with the same undying enthusiasm at the constantly changing unit price of CapitaCommercial Trust. I finally gave in to my temptation and hit the buy button to purchase my 5 lots of CapitaCommercial Trust units. I consoled myself that the unit price has already dropped a few cents after one day's time, and I should have made a good purchase at that unit price.

Little did I know that a few days later, the unit price of CapitaCommercial Trust went on a further descent, and it continued its descent weeks later like going on a road of no return. It was during July 2008 when stocks market was still heading downwards. I got my first taste of the bear market descent. The feeling of watching the unit price keep descending was next to horrible. It was like a falling knife. It was also later that I learnt of the term "to catch a falling knife" which expresses my situation back then very aptly. I was really catching a falling knife without knowing (getting locked into the descent of my purchased units).

I further encountered some more bumps and knocks in my stocks investing adventure further ahead before I learnt some more lessons the hard way.

More to be continued...............

Discussion points:-
Thinking back, I commited several mistakes through my initial stocks purchase.

Mistake One:- I was affected by my emotions (extreme first-timer enthusiasm) which really kills at stocks investing.

Mistake Two:- I neglected and underestimated the effects of the financial crisis already looming at large causing the global stocks market to go on a descent. It was really heartache to catch a falling knife watching one's stocks holdings continually depreciating in value.

Mistake Three:- I did not analyse the fundamentals of the stocks carefully before I made my purchase. Back then @ $1.95 per unit, the distribution yield of CapitaCommercial Trust was only around 5% to 6% which was average, and not particularly attractive. I also did not consider the possibility of any maturing debts due for refinancing within one year's time. The unit price @ $1.95 was only slightly below its net asset value (NAV) around $2.50 per unit one year back which was not very attractively cheap.

Emotions kill at stocks investing.

One should consider also the macroeconomic big picture after considering an attractive company to purchase its shares. This is to time one's purchase into stocks carefully to "prevent catching a falling knife" (betting against a market descent which spares no investors). However, one should not try to time market bottom as it maybe unlikely for anyone to accurately do so.

No matter what investing approach one uses, it is always prudent to analyse the underlying business fundamentals of a stocks before purchasing to avoid any unwelcomed surprises.