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.