Friday, December 31, 2010

Thinking about the long-term and as part-owners the Warren Buffett way

I remember reading in The Essays of Warren Buffett about how investors can really benefit by building portfolios based on the idea of accumulating stocks that they believe will result in their portfolios generating the best possible long-term look-through earnings.  Buffett says this will force investors to think about the long-term business prospects of the companies behind the stocks in their portfolios and not the short-term prospects of the stock market.

Look-through earnings reflect in the operating income of a company both its share of the earnings paid out as dividends and its share of the operating earnings retained by the companies it has a below 20% stake in. GAAP or generally accepted accounting principles only let a company take into account the dividends it receives from the companies it owns less than 20% of, but not its share of the earnings retained by those companies, which is being reinvested for its economic benefit. You can read more about look-through earnings in this article I wrote here

Here's the formula for calculating look-through earnings: the company's operating profit + the company’s share of the operating earnings retained by the companies it has a below 20% stake in – the extra taxes it would have to pay if those retained earnings were all paid out as dividends. To calculate the look-through earnings of your investment portfolio, simply total the look-through earnings belonging to each of your holdings.

After all, the best way to invest is to buy small pieces of great companies and hold on to those shares for the long-term. And if we don’t have this mentality of making long-term commitments to businesses, but think of investing in stocks as simply buying pieces of paper that we hope to sell to someone else for a higher price because of reasons not related to the underlying businesses, then we’re gambling, and gamblers never win in the long-term.

If you don’t focus on the long-term and on becoming a part owner in your investing approach, then it becomes very unlikely that you will ever find stocks that will  make you incredibly wealthy, stocks like the modern day versions of young Berkshire Hathaway and McDonald’s that can multiply your investments in them by many, many times.  

Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a very happy new year!    

Thursday, December 30, 2010

Start/buy a private business or buy some stocks?

Investing in a stock and investing to start up a private business are more or less the same things, as they both are in essence businesses with the only difference being that when you invest in a stock you are buying a small portion of a business, and when you start your own business you own the whole thing (for simplicity’s sake, we’ll assume that there are no partners). As with any other choice between 2 investments, you should pick the option which you believe will generate the highest long-term risk-adjusted returns.

And while stocks and private businesses are in essence the same things, there are some differences that can have an impact on their risks and the returns that they produce. In this article, I will be talking about some of the advantages of owning a business outright, as well as some of the advantages of owning a small fraction of a business.   

Control over hiring and firing decisions

If you have your own company, you will have control over hiring and firing decisions. You will be able to take your time and really select to join your organization good, honest, hardworking people who are good culture fits and who are passionate about what your company is trying to do.You can also fire managers or employees that might be destroying shareholder (you) value.

Getting the right people on board and firing the people that hold a company back is a main ingredient in creating a great company that generates really excellent long-term profits.

If you owned shares of a public-listed company, however, it can be very difficult or almost impossible for you to remove a management team that is more interested in their perks and bonuses than in creating value for shareholders. Sure, you can vote against the re-election of board members and maybe voice your displeasure at the annual general meeting, but unless you are very rich and own a huge amount of shares in the company, or if you and a lot of other shareholders team up together, you probably won’t be able to change very much.

I don’t know the exact number, but I believe that quite a number of public-listed companies have damaged their competitive advantage and their long-term profitability by hiring people that are dishonest or people that might not necessarily fit in well in their organizations. How many times have you shopped at a retail outlet that had really lousy customer service and you vowed never to shop with that company again? What about management teams that took on excessive risks only to see shareholder value destroyed when their bets didn’t pay off?

While you might have control over firing and hiring decisions in your own business, some publicly traded companies have really great hiring processes, superb cultures, and effective training programs. These companies select the right people and help them grow in a way that is mutually beneficial for both the employees and their businesses. Because of their reputation of hiring only really good people and having in place really good training programs, these companies are also able to attract really talented people to apply for jobs with them. Unlike those companies that are experiencing deteriorating competitive advantages and profitability due to them having sub-standard employees working for them, the employees at these companies  drive profitability and keep their companies relevant and ahead of the competition.   

Your newly started company might also find it difficult to attract talented people, as it might not have a reputation as a good place to work at yet. It might also take a long time to develop a great culture and put in place excellent training programs (and many companies, both private and public-listed, fail to achieve these things); these things have to be in place for your employees to grow, remain relevant, and create great value for your company.   

Control over capital allocation decisions

Being the owner of a private business, you get decide exactly how to allocate your company’s capital. How you deploy your capital today will determine the kind of returns you get in the future. I can only imagine the number of sub-optimal decisions regarding the deployment of capital that have been made by management teams of public-listed companies. These sub-optimal decisions range from buying back shares when they are overvalued, not investing enough in their divisions that can generate good returns on investment, investing in divisions that generate poor returns on investment, holding on to too much cash for too long and letting inflation eat into shareholders’ wealth, and etc.

There will always be managers that are absolutely horrible at allocating capital, but there are also managers that are really excellent capital allocators, and their decisions on how capital should be deployed can very well make their shareholders very rich. It is also a fact that not all private business owners are good capital allocators themselves, and they can very well end up destroying a lot of value.    

Competitive advantage

There are some really great companies with really have great competitive advantages which you can buy shares in. These competitive advantages will help protect those companies from the threat of competition, put those companies in a better position during economic downturns, and allow those companies to grow at a healthy rate and reap greater profits than the average company in their industries. All this can translate to lower risks and higher long-term returns for you if you are a shareholder of those companies.  

When you start a new business or buy a private business, that business might not have a significant competitive advantage or even any competitive advantage at all. It can take many years to develop a durable competitive advantage, and I don’t think many companies succeed in doing that.

But if you believe that you have a great concept or can create a business that can serve a certain market segment better than other competitors in that market, then you can build on this concept and develop competitive advantages that can sustain and grow your company for the long-term.

While I believe that the best returns and lowest risks come from investing companies with very good competitive advantages or starting companies and developing durable competitive advantages for those businesses, the fact is that there are a lot of companies, both publicly traded and private, that don’t have a significant competitive advantage but are still profitable and still can grow (although the long-term growth and profits will never be as impressive as those companies with important competitive advantages).

So, it might be ok to invest in mediocre companies when they are trading at a very steep discount to intrinsic value (as long as you sell once they approach 2/3 of their intrinsic value, and probably even before that  depending on your tolerance for risk) and to start mediocre businesses that might not have much growth prospects but can generate a reasonable amount of cash to justify the investment to get them up and running.    
Price

This applies more to buying stocks vs. buying a private business than buying stocks vs. starting a business, but investors can sometimes find stocks trading at such a steep discount that the companies behind those stocks have market caps that are only a fraction of the price that they would fetch if they were private companies being bought in a negotiated transaction. 

The lower the price paid, the lower the risks, and the higher the returns; if you buy a business for $20,000 that you estimated is worth $100,000, there’s a lot of room for a mistake to be made in your estimations or for the business’ profitability to be impaired before you start losing money on your investment (not paper losses but losses in the sense that intrinsic value falls below the price you paid for the stock). There might not be much of a margin of safety if you buy a private business at full price.


If you have any questions, or if there's anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a very happy new year!

Thursday, December 23, 2010

Do your portfolio really need exposure to international equities?

Everybody’s mother wants to participate in the growth of emerging markets. And considering that the  average stock should only grow about as fast as the GDP growth in its country, a strong case can be made for having significant exposure to international stocks.

But before making a decision of whether or not to invest in stocks from a particular country, we need to  look at whether or not the country observes the rule of law, and also look at the political condition of that country to determine if the country is a stable place to invest our money. I don’t think I would ever invest in a country run by dictators (even if stocks in that country are trading at a P/E ratio of 2) who could seize the assets of the private sector whenever they feel like it. We should also take the time to look at inflation, budget deficit, national debt, and some other macroeconomic factors just to make sure things won't go out of control anytime soon.  

Foreign stocks and domestic stocks are in essence stocks. And like any other stock, the price you pay plays a huge part in whether or not your investment will turn out to be a success. Yes, we have to pay more for a company with a good long-term growth rate, but if we pay too much, then the company needs to keep growing without any hiccups for a very long time before its intrinsic value catches up to the price we paid for it. Usually things don’t always go so smoothly, and there usually will be hiccups which can cause the price of the stock to crash back down to reality leaving the investors who paid too much with significant paper losses for what could be a very long time. 

One of the main reasons for investing internationally is to get better returns, and the price we pay plays a very significant role in the kind of returns we get. So, by paying too much for a foreign stock, we are defeating one of the main purposes of investing in foreign stocks. I will pick a domestic stock with decent growth and solid fundamentals trading at a discount to intrinsic value over an overpriced foreign stock any day.

There are also companies based in the US that do a significant amount of business outside the US, but might not trade at a premium, as they are not based in a “hot” country. If you invest in these companies at sensible prices, you could potentially enjoy better returns than the average US stock due to the companies you invested in having higher growth rates from their international business units. You also could potentially earn much better returns than if you were to invest in overvalued foreign stocks which could very well produce dismal returns or even heavy losses.

Even if a company only has operations in the US, doesn’t necessarily mean it’s a bad thing. The US is still the largest economy in the world, and it’s a huge market for any company to expand and grow healthily in (especially for small-cap and medium-cap companies which might only have operations in a few states or maybe even a city).

While it’s always foolish to bet against the US, the fact is that it’s prudent to try and diversify your portfolio to have some international exposure. Emerging markets will probably continue to be the big story for a long time to come, and while emerging market stocks can be overvalued at times, there are also times when fast growing, good quality emerging market stocks trade at a discount or trade at a fair price (just remember that a company really needs to have excellent fundamentals for you not to need a margin of safety when investing in it), and this kind of opportunities if acted upon can potentially result in really spectacular returns for investors.

I personally believe that the best way to go about things is to, of course, invest in equities that you believe will produce good risk-adjusted returns regardless of where those companies are based, but also try to pick up  some domestic stocks with international exposure and good quality emerging market stocks when the opportunities present themselves.
  
Another strategy to get international exposure that I like and might consider using in the future is to allocate a certain amount of money every month or so to dollar-cost average into a few country ETFs or maybe even just one country ETF if you really like equities in that country. I talked about why I like ETFs to get exposure to foreign stocks in this article here. I would just like to say that it might be wise to avoid countries which stocks might be too overvalued as the risks can be too great even with dollar-cost averaging.       

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a great holiday!

Wednesday, December 15, 2010

How value investors think about risk

Quite a number of people will tell you that investing in stocks is very risky, and that you can lose a lot of money by buying stocks. A significant number of these people think stocks are risky simply because they can drop in price.
While it is true that there are a number of risks in investing in stocks, short-term market fluctuations is definitely not one of them (This assumes that you know what you’re doing, invest for the long-term, and apply sound investing principles. And if you don’t have these things in your approach to investing, you shouldn’t be buying stocks anyway.)

When you invest in stocks, you are investing in small pieces of companies. And because of that, a lot of the risks you face are generally related to whether or not those stocks or companies you have invested in will remain financially stable and continue to be profitable and grow profits at a healthy rate. Some of the other risks that investors face are paying too much, dilution of their holdings, and etc. In this article, I will be talking about some of the risks that value investors look at when investing in stocks.

Side note: Investors should avoid picking individual stocks if he or she doesn’t know how to value them. This doesn’t mean that investors who can’t value stocks can’t get invested in stocks. You can still get exposure to stocks through dollar cost averaging into a low-cost index fund or a good mutual fund.    

Financial strength

The better the financial position of a company, the less likely it will go bankrupt, restructure, or do things that will destroy significant shareholder value, and the lower the risk of you losing a huge part or even all of the money you invested in that company (when I talk about losing money, I don’t mean paper losses, but permanent impairment to the profitability of the company). True, just because a company is financially stable doesn’t mean you won’t lose money investing in it. But if you don’t get the basics right, you will always be exposed to significant risk, and a strong financial position is the foundation of a company that’s unlikely to wipe out their shareholders anytime soon. 

Here are some of the things I look at when deciding whether or not a company is financially stable:

The company’s operating cash flow need to be able to comfortably fund its interest payments and capital expenditures.

The company shouldn’t have too much debt, and should have enough cash on its balance sheet to keep operations running (even in severe downturns) without taking on significant debt, diluting existing shareholders and issuing new shares, restructuring, or etc.  

Growth

In his “Conservative Investors Sleep Well” writing, Philip A. Fisher wrote, “It has already been pointed out that in this rapidly changing world companies cannot stand still. They must either get better or worse, improve or go downhill. The true investment objective of growth is not just to make gains but to avoid loss.”

The main reason investors put their money into stocks is to beat inflation and end up with more money (in real terms) in the future. If the earnings and revenue of the stocks you invest in don’t grow or grow at a very slow pace, you will face the risk of inflation eroding the value of your investments. To reduce this risk of losing our money slowly to inflation (or even quickly if inflation really spikes), we have to invest in stocks that we believe will consistently grow both profits and revenue at a faster pace than inflation.

It is ironic that some, if not most, of the same people that avoid stocks because they think that stocks are too risky expose themselves to a much higher risk of losing money in real terms to inflation by having too much of their assets in cash or even very low yield bonds (cash are incredibly lousy long-term investments, and I don’t think you will do very well lending money to IBM at 1%).       

Competitive advantage

Investors can reduce their risk by investing in companies that have a competitive advantage over their competitors, as these companies’ competitive advantages will, to a certain extent (this depends on the significance of the competitive advantage), protect their current profitability and give them the opportunity to grow healthily and profitably.   

There are quite a few different types of competitive advantages. Here are a few of them: Having a strong brand, being the low-cost producer, having a near monopoly over a certain market, and etc.

Management

One of the main purposes of a company’s management team is to minimize the risk of shareholders losing money (as I said earlier, when I say losing money, I don’t mean losing money in terms of paper losses, but losing money in terms of impairment of the long-term profitability of the company) and create good value for shareholders by making sure the company stays financially stable, grows profits and revenues at a healthy rate, constantly increases its competitive advantage, reinvest its profits at a good rate of return or pay out dividends if it can’t, and etc. Needless to say, bad management equals high risk of losing money. That’s why we need to invest in companies headed by good management teams if we want to reduce our risk.

I wrote this article here about some of the things we should look at when evaluating the quality of management. It’s a good sign if management does what it says, is honest with shareholders, own, in relation to their annual compensation, a significant amount of shares in the company, and consistently achieve a good return on equity for shareholders.  

Price

It’s always important to utilize Benjamin Graham’s margin of safety concept when investing,and generally only buy a stock when it is trading at a significant discount to your estimation of intrinsic value. The lower the price you pay for the stock in relation to its intrinsic value, the larger your margin of safety and the lower your risk.

Just think about it this way:

If you pay too much for a company’s stock, the company has to keep producing fantastic results for maybe even a long time (I think most companies will eventually disappoint), and if it doesn’t, reality will catch up to the stock and its price will plummet.

But if you buy a company’s stock for cheap, the company can perform poorly and you still might get away with your principal intact. This is the case as the price you paid for the stock might reflect that of a company that’s of a much lesser value than what the company’s current intrinsic value is. So, even if the intrinsic value of the company significantly declines, the company’s declined intrinsic value per share might still be somewhere around the price you paid for each share of the company’s stock.

Circle of competence

Risk comes from not knowing what you're doing. –Quote from Warren Buffett

How you value a company should also be affected by the industry the company is in. Example: same-store-sales are important for retailers, while cost of funds and a strong deposit base is important for banks.

It can be very dangerous to invest in companies from an industry that you do not understand, as you might buy a stock that you think is cheap and has great fundamentals, only to find out later that because you didn’t take into account something significant during your evaluation of the stock, you actually overpaid for the stock and/or the fundamentals are actually quite lousy.

It really isn’t important to have a large circle of competence, as you can make a lot of money by simply having a very good understanding of a few or maybe even one industry, and investing in good companies (when they trade at attractive prices, of course)  in those industries or industry. As long as you invest in companies you understand, the risk of losing money is significantly reduced.

This circle of competence concept also applies to investing. If you don’t know how to value companies, you should regularly invest your money in a low-cost index fund or a good mutual fund instead of picking individual stocks.


If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Tuesday, December 7, 2010

Asset Allocation methods from the masters Part 1: Peter Lynch

I recently watched an episode of the Suze Orman show where someone with about $2 million in net worth asked Suze if she could afford to retire soon, and Suze actually gave that person a pretty low grade (it was a C- I think). The problem was that lady had a significant portion of her assets in undeveloped land that doesn’t generate any income for her.

Side note: I’m recalling what I saw on the Suze Orman show strictly from memory, and my account of what happened might not be 100% accurate. But you get the point I’m trying to make.

After watching that episode, I really started to appreciate how much asset allocation mattered. Sure, saving money is good. But knowing where to invest your money or how to allocate your assets is crucial to building significant wealth.

In part 1 of this 3 part series, I will be looking into the asset allocation method suggested by Peter Lynch. I will be talking about the asset allocation method suggested by Benjamin Graham in part 2 of this series, and in part 3, I will be talking about an asset allocation method inspired by Warren Buffett.

Here’s the asset allocation method suggested by Peter Lynch:

In his book “Beating the Street,” Peter Lynch talked about how stocks will outperform bonds over time, and that if an investor wants to increase the value of his or her portfolio, that investor better have part of his or her portfolio invested in stocks.

Peter Lynch suggested that investors increase the stock component of their portfolios to as much as they can tolerate, as unlike bonds, stocks can appreciate in value and increase the dividends they payout to investors. He even included data in his book showing the results of $10,000 invested for 20 years in all bonds, split 50/50 between bonds and stocks, and 100% in stocks (In the 3 scenarios, it was assumed that bonds paid 7% interest and stocks had a dividend yield of 3% and appreciated at 8% a year. True stocks might not return that much anymore, but I believe stocks will still easily outperform bonds over the long-term, especially if companies like IBM can borrow money at 1% interest).

A 100% bonds portfolio would return $14,000 in interest income and the original principal of $10,000.

A 50/50 split between bonds and stocks would return $10,422 in interest income, $6,864 in dividends and a portfolio worth $21,911.

100% invested in stocks would result in $13,729 in dividends and a portfolio worth $46,610.

Another scenario in the book showed that even if you need income, stocks still make for a much better investment than bonds (The scenario assumes a 3% dividend yield and an annual 8% in capital gains). Here’s the scenario:

If an investor had $100,000 to invest and needs $7, 000 in income, the investor can just put all of the $100,000 in stocks, even if stocks only have a 3% dividend yield. This is the case as the investor can just sell some shares to supplement his or her income until the dividends reach his or her income target ($7,000 in this case).

So, the investor would get $3,000 in dividend income at the end of the first year, and have to sell $4,000 worth of stock to get $7,000 in income. But if the investor’s stocks appreciated at 8%, he or she would have a portfolio worth $104,000 after selling the $4,000 worth of stock.

At the end of the second year, the investor’s dividend income would have increased to $3,120. This would result in the investor only having to sell $3,880 worth of stocks. The investor’s portfolio should, according to my calculation, be worth $108,440.

Every year, the investor’s dividend income rises, and he or she will need to sell less stock (eventually not needing to sell stock at all). The investor’s original investment would also have grown every year. At the end of 20 years, the $100,000 would have turned into $349,140, and the investor would have had income of $146,820. A 100% bonds portfolio that pays a 7% interest would only return $140,000 in interest income and the original principal of $100,000.


Peter Lynch pointed out that even if investors know that stocks are much better than bonds, stocks don’t appreciate in a straight line, and not all investors can keep their emotions stable and ride out the corrections of the market or sometimes even sell some of their shares at depressed prices to supplement their income. That’s why I think he recommends investors to hold in their portfolios as much stock as they can tolerate instead of have a 100% stock portfolio.

I personally am almost fully invested in stocks, as I believe that businesses will continue to be the greatest creators of wealth, and investing in stocks is one way to get invested in businesses. The other way is, obviously, through setting up your own private companies, but that might not be for everyone (I have plans to set up a holding company sometime in the next few years, but until then, stocks will probably be the only asset class I’ll invest in).

In my next article for this 3 part series, I will be talking about an asset allocation method suggested by Benjamin Graham. So, check back soon if you’re interested.

Before I go, please allow me to be true to my “captain obvious” nature and list down some “very obvious” points related to this asset allocation series. Here are the “very obvious” points:

We should all have a 6-8 month emergency fund in case something unexpected happens and we need cash (this emergency fund should not be thought of as part of your investment portfolio, and should generally be established before you start investing).

It’s ok if you don’t understand how to value stocks or companies. You still can get exposure to stocks by investing in a low-cost index fund or a good mutual fund.

Sometimes stocks can be drastically overvalued, and it might not be such a good idea to buy stocks for your portfolio during those times. It might, however, be a good idea to build up cash when you can’t find attractive opportunities, so that you have some cash to put to work when you do find investment opportunities that you believe are attractive.

You should only invest money that you won’t need for a very long time to come.

You don’t need to follow the asset allocation method in this article or the asset allocation methods I plan to talk about in the future articles of this “asset allocation” series of articles. Just make sure that you understand what you’re investing in (whether it’s stocks, real estate, commodities, or etc).

Common sense and rational thinking should always prevail.


If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

This article is featured in the carnival of value investing, check it out for interesting investing articles! 

Thursday, November 25, 2010

My take on investing in cyclicals

I never really paid much attention to cyclical companies before. I might have bought a cyclical stock or two (maybe more) when I didn’t know any better, but that’s it. With the recent General Motors IPO, however, I couldn’t help but get excited about valuing cyclicals.

Side note:   Although I’m interested in valuing cyclical companies, I have no interest in investing in GM’s stock. Warren Buffett once said, “Turn-arounds seldom turn.”  And while it’s true that GM has reduced costs, and management said that it’s committed to improving GM’s balance sheet, I will still rather wait and see if management actually does what it says. Sure, there’s a possibility that GM will create good value for shareholders, but there are lots of other opportunities out there.

Before I go on any further, please allow me to explain what a cyclical is (or at least what I think a cyclical is). Feel free to skip the next paragraph if you already know about cyclicals.

Cyclical companies are companies that really have their fortunes tied to the economy.  Sure, any company will do better in a period of economic boom as compared to a period of economic downturn, but cyclicals are especially sensitive to the economy, and can go from making astronomical profits during the good times, to making huge losses during recessions (We only need to look back to the recent great recession to see how fast we can go from boom to bust). Airlines, steel producers, and automakers are examples of cyclical companies.

In this article, I will be talking about some of the things I would think about when evaluating the investment appeal of cyclical stocks.

The P/E ratio

I remember reading in Peter Lynch’s book “Beating the Street” that for cyclicals, a low P/E ratio can be a bad thing, and a high P/E ratio can be a good thing. This is the case, as when a cyclical company has a low P/E ratio, it could mean that the company’s earnings has peaked and will rapidly decline once the economy takes a turn for the worse. On the other hand, when the cyclical company has a high P/E ratio, it could mean that the company’s earnings are finally on the road to recovery (this is the best time to invest in cyclical, as profits have a lot of room to rise before tumbling down again; when profits rise, the price of the stock obviously rises too).

Captain obvious side note: For regular stocks, you want to see low P/E ratios and not high P/E ratios, as the lower the P/E ratio the cheaper the stock.

So, if you’re planning to invest in cyclicals, get interested in them when they are just starting to recover from a recession (their P/E ratios should generally be high during this time), and avoid cyclicals when they have low P/E ratios and are reporting very good earnings.     

Financial strength

Due to their nature of doing extremely poorly in recessions, being financially strong is absolutely crucial for cyclical companies, as that will allow them to weather what could be very heavy losses during the bad times. Here are a few things that investors should look at when determining whether or not a company is financially strong:

The company should have a healthy amount of cash or liquidity on its balance sheet to keep its operations running, meet its debt obligations, make the necessary capital expenditures, and take care of any unexpected  expenses without loading up on debt to unsustainable levels, selling off key assets, issuing stock and diluting existing shareholders, or even going into bankruptcy.

The company shouldn’t have to make large, regular capital expenditures in relation to its operating cash flow, as this might result in the company having to either raise more money or skip making certain expenditures and take a hit to future profitability (which might require much larger expenditures to fix).

The company shouldn’t have too much debt on its balance sheet. Too much debt is, obviously, bad for any company, but it can be absolutely devastating for a cyclical, as not only will the cost to service the debt eat into profits during the good times, but it might even cause the company to rack up huge losses when the economy turns sour.

Being a low-cost producer is a great thing for a cyclical (well, it’s a great thing for any company), as it makes the negative impact a recession will have on the cyclical company’s earnings more manageable.

Average out earnings

It is useful to average out the earnings of a cyclical company over a period of time that’s long enough to cover an entire business cycle (I think that 10 years should generally be alright, but we should adjust the time period if we can get a significantly better coverage of the business cycle), as this will give us a midpoint figure that we can use to help us determine if earnings are at their cyclical highs or at their cyclical lows.

After you have found out what the average earnings of the stock are, you can compare the company’s current earnings to its average earnings. It can be a good sign if the company’s current earnings are significantly below its average earnings, as it could mean that profits are starting to get better (as mentioned in “The P/E ratio" segment, this is the best time to pick up a cyclical).    

By averaging out earnings and comparing it to the current earnings to see if current earnings are low, we will get a better picture of whether or not a cyclical company is on the road to recovery than if we were to look at the P/E ratio to see if it is high, but we can save a lot of time by looking at the P/E ratios and narrowing the list down to only cyclical companies that we think is worth researching (It’s during our research that we do things like try and get a better picture by comparing average earnings to current earnings, evaluate the company’s financial strength, and etc).

Side note: It is important to remember that while we should look for cyclicals with high P/E ratios or cyclicals that are reporting profits that are significantly below their average earnings, we need to make sure that the cyclicals we are valuing are reporting low profits because they are just beginning to recover from an economic downturn, and not because those companies are doing lousy because they have lousy fundamentals. We should also generally avoid cyclical sectors that currently have a high P/E ratio on average because a rise in the prices of the raw materials they use have wiped out most of their profits.   

Don’t buy and hold

Unlike those non-cyclical companies with good competitive advantages, honest and shareholder oriented management, and high returns on equity, we can't buy and hold cyclicals for the long-term, as it will usually result in us earning not very good returns. We want to buy cyclical stocks when their earnings are at cyclical lows, and sell cyclical stocks when their earnings are at cyclical highs (before the economy corrects itself, and the earnings and the stock prices of cyclical companies plummet).

I’m certainly no expert, but I think that if investors want to be prudent, they shouldn’t wait for the cyclical companies they have invested in to start reporting profits that are close to cyclical highs before selling, but should instead start selling once earnings reach about 3 quarters of its peak (and that’s at the latest; when it come to cyclicals, there’s no shame in taking your profits early).

Investors should also sell a cyclical once its earnings show signs of plummeting; common sense should, obviously, be applied when making this decision. Buying shares in a cyclical company that’s currently earning 5 cents but  can potentially earn 5 dollars at the peak of its cycle, and then selling those shares 6 months later because earnings have dropped from 6 cents to 5.5 cents obviously doesn’t make sense.


I believe that the returns you can get from investing in great companies at attractive or even fair prices, and holding on to them for the long-term will far exceed the returns you can get from buying and selling cyclicals. But it’s not every day you get an opportunity to invest in a great company at an attractive price. And while waiting for that opportunity to come by, we can consider investing in cyclicals, as it can be a good way to make some money.

If you have any questions, or have anything that you would like to add, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Thursday, November 18, 2010

Securitizing your greatest assets Part 1: The benefits of teaming

Unlike the securitization of mortgages that helped caused the “great recession,” putting people into teams or securitizing your greatest assets(your employees), if done properly, can result in far greater value created for your company than if your employees were all working as individuals. On the other hand, if teams are not built properly, it can lead to major destruction in value. In part 1 of this two part series, I will be talking about some of the benefits of teaming.

Better decisions and solutions

When people with different roles, holding different positions work together as a team, the team can make better decisions and come up with better, more innovative solutions. This makes sense as teams will have more and different experiences, skill sets, knowledge, and points of view to draw upon and get better results with.

Here’s an example: If a team responsible for purchasing washing powder only consists of the staff that negotiate and buy the washing powder but never actually use it, that team might not buy the brand that cleans the customers’ clothes the best. On the other hand, if the team also consisted of laundry staff that regularly uses washing powder, and therefore knows which brand produces the softest, cleanest, and best smelling clothes, the odds get much better that a good washing powder brand will be bought.

It’s crucial to include in the decision-making process people that actually get affected by the decision, and have seen first-hand how past related decisions have worked out.   

Employee satisfaction

Employees will realize that their contributions matter and their opinions are valued when they are part of a self-directed team that makes important decisions, and is responsible for doing things that are bigger than the employees’ individual tasks. When employees feel valued, they will be more satisfied with their jobs, and that will result in higher productivity and a lower employee turnover rate for your company.

Help your employees develop new skills

When working in a team, employees can learn new skills from others (especially the more experienced employees), and have a better understanding of how things work in your company. This hands-on experience along with the training you provide your employees with will, over time, develop leaders that will drive change and successfully navigate the future.

I learned a lot about teamwork and teaming in “The Disney Way” book. The book is excellent, and can really help us with becoming better managers and/or building great businesses.


In the second part of this series, I will be talking about some of the things companies can do to build successful teams. So, check back soon if you’re interested. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Monday, November 15, 2010

Why value investors can’t help but smile in a down market

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. –Warren Buffett

A lot of people get upset and even panic when the prices of their stocks fall. I had a friend who constantly had to check the price of the stock he invested in every few hours, and got upset at himself when the stock’s price fell, saying that he made a mistake and that maybe he should cut his losses (While it’s fine to sell a stock if its fundamentals deteriorated, there’s absolutely no reason to sell a stock just because its price fell. But who knows, maybe he did want to sell because his stock’s fundamentals have been impaired).

Value investors on the other hand embrace down markets, as they know that the greatest opportunities are found during the bad times. Economic downturns not only allow us to pick up great assets for cheap, but also help us identify the companies that have been well-managed in terms of being well-funded and not needing to raise or borrow more money, having good control over costs and mitigating the drop in profits, avoiding serious risks, and making investments that will increase their competitive advantage and set them up for good growth when things recover.

Another thing to note is that when we invest in stocks, we are investing in small pieces of companies. So, we shouldn’t worry if the price of the stock drops, but worry only if the fundamentals of the company start to decline. Irrationality prevails in downturns, which results in the stocks of good companies being punished when the fundamentals of those companies might not really have been affected at all (some of the companies might have even taken advantage of the recession to take market share and improve their competitive advantages when assets are cheap).

The surest way to get rich is to buy great assets at fair prices, never mind cheap prices. And a market downturn (or the Santa Claus for value investors) presents us with opportunities to get invested in really top quality assets at significant discounts. So, don’t get depressed when the markets go south, but rejoice and smile, as that’s the time to invest and build a portfolio that will shamelessly mint money for you when the sun starts to shine again.
 

Thank you for reading, and may you always sustain good returns on your portfolio. Take care. 

Friday, November 12, 2010

Mistakes of a young investor

I remember making a lot of downright dumb mistakes when I first started investing (most of the major mistakes I made was before I discovered the magical world of value investing). And while I still have much to learn and many more mistakes to make, I believe I picked up some really valuable, common sense lessons from when I just started out on my journey as an investor. Here are some of the mistakes I made and, hopefully, learned from:

Don’t sit on your hands when a great opportunity is in your face

I missed quite a few opportunities to get invested in some really great companies at really attractive prices, all because I was foolishly waiting around for those stocks to drop a few more percentage points, only to see them soar to prices that might no longer be very attractive. I believe I would have done much better had I just bought shares in those companies the moment they became undervalued instead of waiting and trying to time the market.

Size doesn’t matter

Unlike a cheeseburger or an ice-blended mocha, size generally shouldn’t influence your decision of whether or not to invest in a company’s stock. The things that you should consider when valuing stocks are the return on equity, balance sheet strength, profit and revenue growth, the profit margin, the strength of the brand, and etc.

If I knew this early on, I wouldn’t have invested in a few big companies that had really mediocre fundamentals, which I discounted with the very misplaced believe that the sheer size of those companies will make everything workout, and I will make money no matter what (I did make a little bit of money when I finally sold them off, but I was really lucky that time, and I wouldn’t ever want to try my luck like that ever again).

Side note: While I believe that size doesn’t matter in general, I do not extend this believe to the really micro-cap stocks; I may be wrong but I think that picking really tiny companies is a little bit too risky for the average investor. How small the size of a company can get before you decide to reject it as a candidate for potential investment is, of course, up to you. I personally have invested in a few companies with market caps of below $500 million; I’m also currently valuing a company that has a market cap of only about $60 million.

Dividends matter

While size doesn’t matter, dividends sure as hell do matter. According to Jeremy Siegel, 99% of the after-inflation returns are a result of reinvested dividends. For quite some time, I didn’t really think much about dividends, as they didn’t seem like very much (maybe enough to go out for a good meal, which I, of course, did). What I didn’t know was that dividends were the bricks that will form the foundation of my future empire (even if it’s a very tiny empire; we all lose ourselves in daydreams every now and then, don’t we?).

If you’ve ever watched an episode of Suze Orman, you would probably have heard her talking about how even very small amounts spent on stuff today can compound to thousands and thousands of dollars in the future. I don’t know exactly how much future money I missed out on by not reinvesting my dividends I received in the past, and letting the power of compounding work in my favor, but I do know that it’s a lot.

Maintain ample liquidity

Earlier in this article, I mentioned that it’s important not to market time, and that we should just invest in great companies when they are trading at attractive prices. While I obviously believe that’s true, I also believe in having cash in reserve (this doesn’t include your emergency fund) to keep buying as long as the stocks you want to get invested in stay undervalued (and hopefully drop significantly more in price).

I had a couple of pretty painful experiences where I invested most of my cash in stocks that I believe to be undervalued, only to see those stocks tank some more. I wasn’t unhappy because they dropped in price, but because I couldn’t buy more. I have no doubt that those investments that I made will make me a lot of money in the future, but it would be a whole lot sweeter if I had the liquidity to buy more when those stocks fell further in value. By maintaining ample liquidity, we can really have our cake and eat it too.


It’s inevitable that we’ll make mistakes, both in business and in life. But that’s not necessarily a bad thing. In fact, some of our biggest lessons come from the mistakes we make, and that’s why we should embrace our mistakes and learn from them. It’s of course also great to learn from other people’s mistakes as much as we can, as that will help us avoid learning some lessons the hard way.  

I hope that I helped at least some of you out by sharing some of my past mistakes (even if they are really just common sense stuff). Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Saturday, November 6, 2010

Hedge Funds: The devil is in the fees

We have all heard stories of hedge fund managers making huge bets that paid off big for their investors and, of course, themselves. We also know of the high fees charged by hedge funds and the risky activities engaged in by quite a number of hedge funds.

Hedge funds typically charge fees of 2% on the principal and 20% on the increase in the value of the principal (if any). This is, obviously, very high. Just think about it this way:

From 1989 to 2009, the compounded annual growth rate of the S&P 500 was about 9.25%. If a hedge fund manager charging the standard fee (2% on the principal and 20% on the increase in the principal’s value) for his expertise were to help his investors achieve average stock market returns, his fund would have to return about 14% (the figure I came up with may be a bit off, but whatever it is, the fees are significant, and are a definite drag on performance).

People that invest in hedge funds will, of course, demand higher than average returns. So, assuming that an investor would be happy earning returns of 2% above the returns of the average stock (I would demand more), a hedge fund manager would have to get returns of 16.5%. This kind of returns is pretty hard to achieve long-term, and even if some top fund managers can sustain this kind of returns, I don’t think the average fund manager can generate for his investors long-term returns in excess of 16.5%. Warren Buffett wrote in one of his letters to shareholders that fees and commissions will cause a lot of investors to earn below market returns. 


Quite a number of hedge funds engage in activities that might be too close to market timing and speculation; not things that any value investor would like to be a part of. While market timing can result in good returns if the fund manager is lucky, it can also result in very heavy losses if the fund manager makes a bad bet.

There are, however, hedge fund managers like George Soros that have generated good long-term returns for their investors by employing strategies that might seem speculative (I don’t know if Soros is still active as a fund manager, but you get the point). And while I don’t believe in speculation, I can’t argue with success. I just won’t invest in things that I don’t understand (especially if someone else is managing my money), even if it means that I would miss out on a lot of profits. If I had to invest in a hedge fund, I would pick a fund run by someone that I really respect, and who employs sound value investing strategies.

I generally do not believe in investing in hedge funds because of the high fees they charge, and because I love valuing and investing in stocks on my own. But if I do come to know about a hedge fund manager that I believe will be the next Warren Buffett or Peter Lynch in terms of putting money to work, and if I have already amassed enough wealth to safely meet the steep minimum investment requirement of most hedge funds, I might seriously consider putting a significant portion of my money in his or her fund.


Thank you for reading and may you always sustain good returns on your portfolio. Take care and have a great day!

Wednesday, November 3, 2010

Great service in 1,2,3(Ps)

Great service is one of the few things that can really differentiate your company from the competition. We all know the 4Ps of the traditional marketing mix, but to provide great service, we must pay attention to another additional 3Ps that’s part of the service marketing mix: people, process, and physical evidence.

People

Your employees are the people that will deliver your company’s service to the customers. And while process and physical evidence are important, a company’s employees will play the biggest role in determining whether or not your company provides good service, and establishing a positive emotional connection between the customers and your brand or your company.

Customers love it when staffs are polite and welcoming, knowledgeable about the service they are delivering, able to solve their problems, and show genuine care for them. Here are a few things you can do to motivate and help your employees to deliver 5-star service to your customers:

Empower your employees to make decisions. Better decisions will be made as a result of the empowerment of front-line employees, as not every customer has the same needs or problems, and it’s your front-line employees that will best understand the needs of your customers, and therefore suited to make the best decisions for what could be unique situations.     

Align their compensation with what you want them to do. Also, pay your employees well and take care of their needs through relevant benefits and etc; as John W. Marriott once said, “Take care of your employees and they will take care of your customers.”   

Train your employees and help them grow to adapt to a constantly changing environment.

Have a vision that your employees can believe in and be inspired to work toward achieving.

Process

Our processes help our employees deliver our services to the customer. A well-planned out, well-implemented process can significantly increase the efficiency and the quality of your service, which, of course, translates to happier customers.

We need to have a customer-oriented approach when looking at out processes. This approach will really help us identify things we can do to make the customer experience better, as well as things that we can do without as they don’t create value for the customer. By improving our processes with our customers in mind, and by eliminating waste in our processes, we can both better satisfy our customers and cut costs; two very strong drivers of profits.

Zappos, one of the most customer-oriented companies in the world took control of warehousing its products and greatly improved the warehousing part of its process, so that it can deliver its products to customers more quickly and more accurately. This is a great example of how improving your process can translate to a better experience for the customer.   

Physical evidence

Physical evidence is the physical elements that your customers come in contact with when consuming a service. Physical evidence can play a huge part in determining whether or not a customer is happy with your service. A customer will not enjoy his experience with a restaurant if he’s seated at a dirty table, while a customer will feel good about her experience at a chocolate shop where the chocolate is displayed nicely and the shop is beautifully decorated.

I remember staying at a resort for a holiday when I was a kid, and every day when I came back from the beach, I would find a small bar of chocolate under my pillow. This small but very significant physical evidence made me really enjoy my stay at the resort. This just goes to show how physical evidence, even small ones, can go a long way in creating great memorable experiences for your customers.  


I believe that understanding the additional 3Ps of the service marketing mix can really help us in our efforts to provide excellent service. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.