Friday, March 16, 2012

Thinking rationally about growth


It is not uncommon for a fast-growing company to get overvalued by the market. And as we all know, investing in overvalued stocks is never a good recipe for attractive long-term returns. Sure, growth is great, but how do we take a company’s revenue and profit growth rate into account when valuing that company’s stock?  This article will give you my take on valuing growth companies:

I usually treat growth as a bonus, and value a growth company based on its current profitability. In other words, I would value a growth company just like how I would value any other company. However, there is value in the company’s growth, and I will account for that value by requiring a smaller discount to intrinsic value before investing in the stock (Benjamin Graham’s margin of safety concept states that stocks should be bought at a discount to their intrinsic value to reduce risk). One of the best ways to reduce risks is to earn more money; that’s my rationale for requiring a smaller discount to intrinsic value if the company is growing earnings at a good rate.

It’s only in the case of a very attractive company (both high growth and excellent returns on equity) that I might consider paying a higher valuation than what the company’s current profitability would suggest as appropriate. In this type of situations, I will look to the price/earnings to growth ratio that Peter Lynch popularized. The PEG ratio is basically the P/E ratio divided by the growth rate. As a general rule, you only invest in the stock if its PEG ratio is below 1. Example of the PEG ratio in action: If company Awesome Inc. has a P/E ratio of 15 and an estimated annual growth rate of 20%, then its PEG ratio would be 0.75 (15/20 = 0.75) which seems pretty good.

I don’t project growth into the future by plugging in a growth component when discounting future cash flows because you need both expert knowledge of the industry and the company to make any reliable estimates of growth. Even then I’m doubtful that someone can accurately predict the company’s growth rate far out into the future (you need to have a timeframe of at least 10 years if you want to be a serious long-term investor). For people without good knowledge of the company and the industry, adding a growth component when discounting future cash flows is dangerous in the sense that they can drastically overvalue the company.

It’s important to remember this point on growth made by Warren Buffett that growth is only good if the company can achieve good returns on capital. There’s a long-term adverse impact on shareholders’ wealth if the company retain earnings and load up on debt to pursue growth opportunities that yield subpar returns. So, when thinking about a company’s growth rate, don’t forget to look at the company’s return on equity and whether or not it has a durable competitive advantage (at the end of the day, a company can only sustain good returns on capital if it has a durable competitive advantage).

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

Saturday, March 3, 2012

Classroom Investing Myth 1: Risk-free asset


A lot of the finance and investing theories taught in the universities today are simply nonsense. If anyone just took some time to rationally think about classroom stuff like risk-free asset, dividend growth model, beta, and efficient markets, they would come to the conclusion that those ideas are just plain wrong and financially dangerous if applied in reality.

In the first part of the “Classroom Investing Myths” series, I will be looking into the legend of the risk-free asset. Side note: I don’t know how many parts this series will have as it is sort of me just writing an article whenever a bogus investing theory comes to my mind.

Just flip through any finance textbook, and chances are that you would find something about government issued securities being risk-free assets. Nothing can be further from the truth. In fact, you will probably lose money in the long-term if you invest in U.S. treasury securities at current low yields. You might not lose money in nominal terms, but you will almost certainly lose purchasing power (According to this article at InflationData.com, inflation has historically averaged around 3.4% annually; the current 10-year treasury yield is only about 2%). This defeats the purpose of investing as defined by Warren Buffett in his article in CNN Money (You can read Buffett’s article here). Here’s how Buffett defines investing: “At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power -- after taxes have been paid on nominal gains -- in the future.”   

You can’t even make a case that you’re investing in treasury securities to preserve wealth. If inflation outpaces an asset’s yield, your wealth will be destroyed not preserved. So what if you have slightly more money in nominal terms after the investment matures. If you can’t purchase as much stuff after making the investment as compared to before, then by definition you’re worse off.

Take the 10-year treasury yield for example, you will lose 1.4% in real terms every year if inflation just went back up to its historical average (and who is to say that inflation won’t go significantly above the historical average for a sustained period of time). Not only that, you won’t be compensated for risks such as the large deficits and the humongous amount of debt of the U.S. government which will lead to the printing of money which in turn will result in higher inflation. In the case of Greece, investors had to take a “voluntary” hair cut on their Greek government debt holdings leading to both a nominal and real loss.

It’s a fallacy that there are riskless investments. Those people planning to park their money in U.S. treasury securities for the long- term because they’re afraid of risks seriously need to reevaluate their decision. You might face risks investing in a bond fund, mutual funds, individual stocks and other assets, but it sure beats the slow painful decline in your purchasing power that you will almost certainly experience if you just held on to treasury securities at their current yields for the long-term. To invest in assets like stocks, real estate, or any asset for the matter, you of course need to know what you’re doing or you might just end up in a much worse position than if you invested in treasury securities (you might still underperform if you knew what you were doing, but odds are you will come up on top).

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

Thursday, February 23, 2012

Cash and Profits


If you’re a follower of my blog, you would know that I value an investment based on the future cash flows that the investment is expected to generate for shareholders (I wrote extensively about cash flows in this article here). That doesn’t mean I think profits don’t matter. In fact, I think profits are very important and will determine whether or not the company will turn out to be a good investment.

Side note: The return on equity is the best measure of profitability as it measures the returns earned on the money belonging to shareholders, the returns earned on your money. The return on equity must not have been achieved by means of using excessive debt or taking excessive risks.

We make an investment because we think that the asset we invested in will generate more cash (after adjusting for inflation and taxes) than our initial investment. But to be able to generate cash, the company needs to hire people, buy materials, and make capital expenditures. And if the company achieves only a low return on equity and is very asset-intensive, then the company will be in a position where it has to plow back huge amounts of cash, cash that could be paid out as dividends and invested by the shareholders at higher returns, to maintain its future cash flows. The company would be throwing good money after bad.

On the other hand, if the company is asset-light and earns good returns on equity, then the company would need to reinvest less money to maintain future cash flows. This would leave the company with more cash to do share buybacks, pay out dividends, and/or reinvest in the business to increase future cash flows.

Now that we have established that both profits and cash flows are important, the next step would be to decide on a level of profitability that we should require from our investments. I personally look for companies that generate long-term returns on equity of 15% and above (higher if the company operates in a high inflation environment, after all it’s real profitability that we’re after not nominal, inflated profitability). I will generally reject any potential stock investments that don’t meet this criterion.

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

Tuesday, February 21, 2012

Ideas and Business Part II: The validity of the mind to make decisions and the character to take personal responsibility

Too often we see people struggle to make decisions or give a straight answer. We see these same people hedge whatever decisions they make so that they won’t be held accountable if anything goes wrong. We read about how some business executives destroy billions in shareholder value because they refused to face the facts of reality and take responsibility for their mistakes. We hear about how people lost their shirts because they blindly followed the herd and didn’t think for themselves.   

These types of destructive behavior are inconsistent with living a productive life and creating wealth. To create wealth, one needs to be able to use his mind to think and comprehend reality. After understanding reality, one needs to arrive at a decision based on principles and his own independent judgment of what’s good for him. After making a decision, one needs to implement his decision through action while at the same time observing reality to see if things are going according to plan. If the facts indicate that his decision was a wrong one, then he should take responsibility and try to correct the mistake.

In the second part of this 3 part series(you can check out part I here), I will be talking about the validity of the mind to understand the facts of reality and make good decisions. I will also be talking about how the truth should never be avoided and how you should always take personal responsibility for your decisions. Here’s the article:

There are absolutes in reality and we are capable of knowing these absolutes

One of the reasons why people try really hard to avoid making a decision is due to the belief that there are no absolutes. Many times in university I was taught that there is no wrong answer, and that anything can work but stating with certainty that something works should be avoided because nothing is certain and we need to be flexible and change our positions to whatever is in trend at the moment. How can you ever trust your mind to understand reality and come to a correct decision if you hold such an impotent position?

There are absolutes in reality, and this truth will not change regardless of how many times someone tells himself otherwise. An investor’s long-term returns from a stock will only be as good as the return on equity generated by the businesses underlying the stock, a business can only be successful in a free market if it creates value for its customers, stealing from the private sector to provide a stimulus package does not create economic prosperity but destroys it. These things are absolutes and people who ignore them do so at their own peril.

To be successful in business, investing, or any productive activity, we have to understand that there are absolutes and that we are capable of looking at the evidence and finding out with certainty what the current problems are, what are the consequences of a specific course of action, what the correct decision is, and etc. We have to avoid the fool’s or coward’s way out of making a decision and taking responsibility for it by claiming that lots of things can work without naming a specific solution, and at the same time claiming that we can be certain about nothing (in other words, they’re saying that they don’t want to make a decision and that they can’t be held accountable if they did make a decision).

Make decisions based on principles

Indecisiveness and terrible decision making can be a result of not making decisions based on principles (When I talk about principles, I mean the principles that are consistent with reality and not irrational principles like “self-sacrifice” and the “public good”). A chemist can’t make decisions that are in violation of the principles of chemistry; an investor has to make decisions that are consistent with the principles of investing. Once you understand the principles of a certain field, you will find it easier to make decisions related to that field and you will be better equipped to avoid making really bad decisions. Abandoning or compromising on principles can only lead to disastrous results.  

Make independent Judgments

There are people that avoid the effort to think and make decisions because they believe, at least subconsciously, that their minds are impotent and they’re incapable of coming to a right decision (or they’re just plain lazy). These people will either let the herd decide for them or just imitate someone else without knowing how that person came to such a decision. This way, these people can shift the blame if things don’t turn out well (shifting the blame, however, won’t erase their losses). The subprime mortgage crisis is something a lot of bankers could have steered clear of if only they did not replace independent rational thinking with the blind instinct of the herd.

In business and in life, blindly copying some group or someone can lead to huge losses. And even if you do manage to profit by leeching off the effort of someone else’s mind, can you really take pride in those profits. There’s nothing wrong with looking to others for advice, but take responsibility for your life and act on your own independent judgment and not on the opinions of others. Have some self-esteem and acknowledge the validity of your mind to think and come to correct conclusions.    

Facing the facts of reality and taking personal responsibility

A lot of wealth was destroyed because some business people refused to face the facts of reality. If the executives that made a bad acquisition didn’t simply blank out whenever the topic came up (hoping that the acquired company won’t be bad if they just didn’t say it was bad), but instead tried to sell off, restructure or wind down the acquired company, then that acquisition wouldn’t be continuously sucking up resources and destroying shareholder value. If Greek bond investors just looked at the evidence staring them in the face, they would have dumped those bonds a long time ago and wouldn’t have to “voluntarily” take a huge haircut. These are problems that can be avoided, or at least mitigated, if the people in charge didn’t evade reality but made decisions to turn things around instead.

While it’s ok to make mistakes, it is definitely wrong to avoid taking responsibility for our mistakes. Just because the decision was made by me doesn’t mean that it’s special and detached from reality, the decision will not work out well if the facts indicate that the decision was a wrong one. When we realize that we made a mistake, we can either avoid naming the truth and deny that we made a mistake (this will lead to much more disastrous results in the long-term) or we can take responsibility by admitting that we made a mistake and take action to correct our mistakes.      

Conclusion

We need to believe that our minds are potent and that we are capable of comprehending reality. We need to understand that we have to make principled decisions based on our own independent judgment and take personal responsibility for those decisions. These things are true whether we’re running a business, evaluating an investment opportunity, or doing any other activity to achieve our values. You can evade the effort to understand reality and make principled decisions, but you cannot change the fact that this virtue is needed to achieve your goals and be successful.

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

Monday, February 13, 2012

The fundamental rule of investing: It’s all about the cash

The most reliable way to get rich is to keep investing in assets that generate more cash than you have to put up to buy those assets. That’s why the most important question that you need to ask yourself when valuing an asset is whether the expected future cash flows from the investment is adequate to compensate you for the risk you’re taking and the time you delay spending your money. To answer that question, we will need to apply the discounted cash flow method.

A discounted cash flow is simply today’s value of a future cash flow (a future coupon payment from a bond for instance). You get today’s value of a future cash flow by discounting that future cash flow back to the present at an appropriate discount rate over an appropriate number of periods.

The appropriate discount rate is the rate of return required to compensate you for the risks inherent in the investment. Future cash flows from a company that has a weak balance sheet should be discounted at a higher rate to compensate you for the risk that there will be zero future cash flows if the company goes bankrupt. On the other hand, future cash flows from a company with a strong brand would need to be discounted at a lower rate as the future cash flows are more secure.

The appropriate number of periods to discount a future cash flow is simply the number of periods that you have to wait before receiving that future cash flow. For example: If you want to know the present value of the annual cash flow a company is expected to generate 5 periods from now, then all you have to do is discount that future cash flow over 5 periods (5 years as in this case 1 period = 1 year).

Side note: Contrary to what is written in finance textbooks, the cash flows that should be discounted to get a stock’s value are not the dividends it pays, but the owners’ earnings it generates; even if a company doesn’t pay out all its profits to shareholders, the profits that are not paid out still belong to the shareholders and are being reinvested for their benefit. Owners’ earnings is a term coined by Warren Buffett; owners’ earnings refer to the amount of cash shareholders can take out of the company every year without impairing the company’s future profitability. You can get owners’ earnings by using this formula: Net income + Depreciation and Amortization + or – changes in working capital – capital expenditure necessary to maintain the company’s profitability.

The sum of the present values of the future cash flows as calculated by you will be your estimation of the assets intrinsic value or real value. After calculating the present value of all the future cash flows (the asset’s true value), compare the asset’s true value against the investment you have to make to acquire the asset. If the present value of the future cash flows is higher than the cost of the investment, then it means that you can be expected to be compensated for the risks and earn a return on investment. The greater the present value of the future cash flows over the cost of the investment, the higher the expected return; you would also have a larger margin of safety in case you made an error valuing the asset or a risk event like higher taxes occurs.

Side note: The margin of safety is a concept popularized by Benjamin Graham. The concept states that the higher the discount to intrinsic value at which an investment security can be bought, the safer the investment. This is the case as the intrinsic value of the investment has more room to fall before it’s worth less than what you paid for it. It’s important to note that when I talk about the intrinsic value of the company falling, I’m not referring to the daily movements of the stock price, but to the real value of the company as derived from the company’s profitability. Profits are the driver of a company’s value; a company’s intrinsic value will only go down if its profitability gets impaired. If there’s no impairment to profitability, the day to day movements in share price should be ignored (or taken advantage of by snapping up more shares after they experience large price declines).

Here’s an example of the discounted cash flow method in action:

Awesome Burgers Inc. generates 20 million in owners’ earnings every year. The company is valued at $100 million. Awesome Burgers has a very strong balance sheet, great brand, and operates in a low inflation, politically safe country. It’s safe to say that Awesome Burgers is a very safe company, and since it’s such a safe company, we conclude that a discount rate of only 7 percent should be used. Assuming that we’re long-term investors and that 1 period is 1 year, we conclude that 20 years of expected future owners’ earnings should be discounted back to the present.

After plugging in the numbers, the sum of all the discounted future owners’ earnings of Awesome Burgers is slightly over $211 million. Since the company is only trading at $100 million, it stands to reason that we can make a good return from investing in it. You can use this calculator provided by investopedia.com to help you with the calculations.

A country that’s racking up huge budget deficits and has an unsustainable amount of debt decides to issue 10-year bonds. Each bond will cost $1,000 and has a coupon rate of 10% paid semi-annually (in other words, the bond pay $50 every 6 months). Since the country has a high risk of default, we rationally came to the conclusion that a 20% discount rate should be applied to the bond’s future cash flows.  Here are the numbers we should plug in to get the real or intrinsic value of the bond:                Cash flows = $50   Discount rate = 10% (since coupon payments are semi-annual, discount rate of 20 needs to be divided by 2)   Periods = 20 (coupons paid semi-annually for 10 years). The bond’s principal will also be paid back at maturity, here are the numbers: Principal = $1,000   Periods = 20   Discount rate = 10% (you can use this calculator to calculate the present value of the bond’s future principal repayment). The intrinsic value of the bond is only $574.32, so investing in the bond at $1,000 is a bad idea.

At the end of the day, the fundamental rule in investing is to put money in assets that will generate even more cash for us in the future. While this is a simple rule, and the discounted cash flow method is simple and straightforward to use, there are many things to consider when calculating the intrinsic value of an asset. When valuing a stock, you need to understand the nature of the business to come up with an accurate estimate of the company’s owners’ earnings. You need to understand the risks a company faces to come up with an appropriate rate to discount the company’s future cash flows to the present.

While investing is not easy, it isn’t very hard if you enjoy the investing process. Investing can also be very profitable if you know what you’re doing. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Thursday, February 2, 2012

Saving money the John D. Rockefeller way


For anyone that wants to save money, I can’t think of a better way for you to that than to employ this simple technique used by one of the greatest businessmen of all time, John D. Rockefeller. I remember watching a documentary about the Rockefellers quite some time ago, and I picked up the money saving technique from there. That saving technique was simply to write down all of his expenses down to the very last penny. John D. Rockefeller maintained this practice even when he was very rich.

I tried this simple technique and achieved satisfactory results. I would maintain a file on Microsoft Excel where I would write all my daily expenses down such as my meals, transportation, and the occasional packet of M&M’s I would pick up at the convenience store. By doing that, I was always thinking of how a certain purchase would affect my daily budget, and that caused me to cut down on a lot of things I didn’t really need and stay on budget. I would also know when I’ve overspent and would make up for it by spending a little less the next day.

By keeping track of all your expenses in a notebook or spreadsheet, you will be able to look back at your spending data over a period of time (say a month or so) and identify the things that you spend the most money on. With the knowledge of your monthly (or whatever time period) expenses, you will really be able to make the cuts that matter and have a significant impact on your savings results. You might find some really interesting things when you look back over your spending data. For instance, I found out I was spending a bomb on cab fare and decided to wake up earlier and take the bus; this resulted in significant savings that I used to make more investments.   

There’s 2 ways to have more money, either make more or save more. It doesn’t take much effort to list down your daily expenses on a spreadsheet, but the impact on your bank account can be huge over the long-term. This technique from John D. Rockefeller has saved me a significant amount of extra money while I applied it to my daily life (I have not been writing down my expenses for quite some time, and unfortunately my savings have dipped).

If you liked this article, you might also like Basic Investing Lessons from John D. Rockefeller. If you have any questions or have anything that you would like to add please comment or send me a private message. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.