Showing posts with label concentrated portfolio. Show all posts
Showing posts with label concentrated portfolio. Show all posts

Sunday 17 May 2020

Portfolios and Selling

#Good company gets inexpensive, how much to buy?

When an understood, good company gets inexpensive, we buy its stock. But how much?

(1)  Enough uninvested cash (CASH)
My rule is simple. Provided that I have enough uninvested cash, I put 10 percent of the portfolio in it. I’ve seen other good investors use infinitely more complicated guidelines, but none that I’ve found to be more practical.

If I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.

(2)  Strong conviction (COURAGE)
A strong conviction is important in part because right after a buy the price of a stock is almost certain to drop. That’s the corollary to another near-certainty: that the price paid for a stock is unlikely to be a low. Rock-bottoms don’t send out invitations. So knowing when one will happen is impossible. The astute investor counts on missing them.

Correspondingly, I prefer not to put more than a tenth of the portfolio into a single equity. This reduces the chance that I’ll lack the cash necessary to take advantage of other opportunities that emerge.



#Buying is one aspect of portfolio construction. Another is selling.

There are two problems with selling. 

1.  The first is taxes. 

The profitable sale of stock is taxable in most circumstances. Just how much this eats into long-term returns is best illustrated by example.

Picture two portfolios. Each starts with only cash, buys only non-dividend paying stocks, and liquidates after 30 years. Assume that any stock sales are subject to a total long-term capital gains tax rate of 30 percent.

Portfolio one uses all its cash to buy stock on the first day. It appreciates 15 percent before taxes every year. It doesn’t sell anything until the liquidation date, at which point it immediately pays any taxes due.


Portfolio two also uses all its cash to buy stock on the first day. It too appreciates 15 percent per year before taxes. But it churns its holdings annually. At the end of every year, it sells everything, and uses all the after-tax proceeds to instantly buy different stocks. When it liquidates after 30 years, it too promptly pays any taxes due.

Portfolio one would end the 30-year period with more money. But what’s striking is just how much more. It would wind up with over twice as much cash. That’s because every year when portfolio two paid its capital gains taxes, it whittled down the amount set to grow at 15 percent over the following year. In other words, ongoing tax payments stunted the power of compounding.

By contrast, portfolio one’s capital was never whittled down. It regularly got to multiply its 15 percent by a bigger number:

http://www.goodstockscheap.com/17.1.xlsx

Of course one could never count on an equity portfolio to appreciate at exactly 15 percent annually, and the chance of immediately finding stocks to replace just-sold ones is low. Plus the 30-year period is arbitrary, and a 30 percent tax rate doesn’t apply to everyone. But however simplified, this example
highlights the toll that frequent selling takes.


2.  The second problem with selling is alternatives. 

Companies that are understood and good don’t go on sale every day. They’re hard to find. So absent an acute cash requirement, each stock sale mandates a hunt for the next opportunity.



#When selling makes sense

Even with these problems, selling does makes sense in some instances. I see four.

(a)  The first is when price flies past value. 
If EV/OI is over 25, and there are no mitigating facts, I find it hard to justify holding.

(b) The second instance is when a company that originally registered as good turns out not to be. 
This could be because the original analysis was wrong. Perhaps the threat of new entrants was stronger than it first appeared, or a market thought to be growing really wasn’t. Or it could be because circumstances have changed. Maybe a once-mighty retail chain has come under pressure from online-only sellers, or a company that thrived under regulation has faltered in deregulation.

The cognitive bias of consistency can make it hard to see such instances. We may want to hold just to validate our buys. But analyses really can be wrong, and contexts really can change. Selling in such situations keeps a snag from ripping into both a realized loss and a missed chance to redeploy cash into a better opportunity.

(c)  The third instance is when one is bought out. 
Public companies sometimes get acquired. Such transactions often happen at a premium to the recent trading price. A vote may be put to shareholders on the matter, but for everyone other than major stakeholders, it’s perfunctory. One effectively has no say.

I’ve been bought out several times. I dislike it. It turns a pleasantly appreciating investment into a taxable event. But if profitable, given the absence of practical options, it makes sense to accept such sales.

(d)  The fourth instance is when cash is needed to make an investment that’s clearly better than one already held. 
The problem with this is that fresh ideas often glow with a special promise. They’re new. The hope bias gets a prime shot at causing mischief. As such, I get extremely suspicious of my reasoning when I think that I’m spotting such a circumstance. I’ve never actually sold one company for the specific purpose of buying another.



#When selling makes no sense

Two commonly cited reasons for selling puzzle me.

1.  One is rebalancing. 
It’s selling part of a stock holding because appreciation has caused it to represent a disproportionately large percentage of the portfolio.

Rebalancing makes sense to those who equate risk with total portfolio volatility. I don’t. So on the sell side, I’ve never seen the merits of this practice.

It makes more sense to me on the buy side, since unless part of a holding was sold, a decrease in its portfolio prominence means that its price dropped. One could now buy more of it cheaper. But on the sell side rebalancing looks to me like the anchoring bias in action.

2.  A second common reason for selling is to prove that an investment was a success (taking profits). 
The sale is seen as a sort of finish line. Underlying this perception is a view that cash is somehow more real than stocks.

It’s not. Cash and stocks are different forms that wealth can take. Unrealized gains are not endemically less concrete than realized gains. Selling doesn’t demonstrate investing competence any better than does intelligent holding.


Yet another reason for selling is Industry compensation
There’s an additional reason that selling happens. It relates only to institutional portfolios, like hedge funds. It’s about compensation.

Investment funds often pay managers 2 percent of assets under management per year, plus 20 percent of any gain above some hurdle. That 20 percent is applied to pretax returns. It’s blind to taxes. For this reason professionals may emerge as more enthusiastic about selling than would their limited partners. After all, unless they’re tax-exempt, the limited partners are the ones that come to bear the bulk of the tax liabilities born of the fund’s realized gains.

One faces great impetus to sell. It feels good. It’s conclusive. It turns the brokerage statement into a congratulations card. But it also triggers a tax expense and—short of a pressing need for cash—forces a search for the next underpriced equity.

When a sale is wise, its justification is distinct. It’s an overpricing, an analytical error, a contextual change, a buyout, or a better opportunity. Absent that clarity, I hold.



#Equity portfolio can generate cash through buyouts and dividends
Even without active selling, an equity portfolio can generate cash. It can do so in two ways.

1.  The first is through acquisitions, as mentioned earlier.

2.  The second is through dividends. 
Dividends can become sizable. This fact gets lost in the commonly quoted metric of dividend yield.

Recall that dividend yield equals annual dividends divided by current stock price. But to an owner, current only counts in the numerator.

When I first bought Nike stock, the dividend yield was around 2 percent. Over a decade later when I sold it, it was still around 2 percent. But by then my dividend yield—the current annual dividend divided by the price I’d paid for the stock—was closer to 10 percent. Dividends had gone up over time, but my cost hadn’t. That’s how dividends can become a booming cash source underappreciated by all but those who get them.



#Over time, good focused (concentrated) stock portfolios outperform diversified portfolios.
Remember that my portfolio is concentrated. It contains no more than a dozen names, and usually far fewer. On purpose, it’s not diversified. Many good equity portfolios are, but mine isn’t.


1.  Good focused portfolio versus diversified portfolio
I choose to concentrate because I’ve observed over time that good, focused stock portfolios outperform diversified stock portfolios. This is because diversified portfolios are more like an index. They have more names in them. The more a portfolio looks like an index, the more it behaves like an index. It’s hard to both resemble and outperform something.


2.  Bad focused portfolio versus diversified portfolio
Of course a bad focused equity portfolio can certainly lag a diversified stock portfolio.

Concentration isn’t enough to assure outperformance. But if it’s purposefully constructed, a focused group of inexpensively bought good companies is particularly promising.



#Sequestered Cash outside of the equity portfolio for  ordinary expenses 
While I don’t diversify within my equity portfolio, I do diversify outside of it. I always keep enough cash on hand to cover expenses for a few years. As I get older, I expect to increase this number of years.

1.  In Federally insured banks
This isn’t cash inside the equity portfolio waiting to be invested in stocks. It’s cash outside of the equity portfolio, held in federally insured banks. It will never be anything other than cash or spent.

Sequestering cash enables me to confidently ride the wild price swings guaranteed to come with a concentrated equity portfolio. It’s what lets me take the long view. When the price of my stock portfolio halved during the 2008 financial crisis, I didn’t panic. I knew that I could meet all of my expenses. There was no basis for panic.

Many governments insure bank deposits. Coverage varies by country. In America, the Federal Deposit Insurance Corporation generally guarantees up to $250,000. In the United Kingdom, the Financial Services Compensation Scheme stands behind £75,000. In Canada, the Canada Deposit Insurance Corporation backs C$100,000.

Because the whole point of sequestered cash is to avoid the scare that forces ill-timed stock sales, it’s wise to stay well under the insured limit. Opening up accounts at several different banks is not hard.


2.  In same currency as one's expenses Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.

As I write this, the British pound has slumped to a 30-year low against the U.S. dollar. This follows Britain’s decision to leave the European Union.1 Some American investors think the slump is overdone and have invested in the British pound.

To people whose expenses are in U.S. dollars, those pounds don’t count as sequestered cash. Instead, they count as a currency investment.



#These repositories for sequestered cash aren't really good
Two things that may look like good repositories for sequestered cash really aren’t.

1.   The first is certificates of deposit, or CDs. 

Outside of the United States they’re commonly called time deposits. They offer higher interest rates than do regular bank accounts. Money must stay in them for a predetermined period. If it’s withdrawn early, a penalty is applied that more than wipes out the extra interest.

If the CD interest rate is much higher than the regular interest rate, one could theoretically keep a portion of sequestered cash in CDs. The portion would have to be limited to that which shouldn’t be needed for the duration of the lockup period.

That said, I don’t use CDs. Since the timing of cash needs can surprise, I prefer to keep the focus of sequestered cash on costless accessibility.

2.   The other repository is cash-like funds (commercial paper). 
They too offer higher interest rates. An example is a fund that invests in commercial paper. Commercial paper is short-term notes issued by corporations.

Such cash-like vehicles usually behave like cash. One can pay bills with them. But I’ve seen instances when they don’t. During the financial crisis, an acquaintance of mine was surprised to learn that her financial institution had temporarily halted withdrawals from such a fund. She couldn’t make payments with it.

This potential—the inability to immediately liquidate—is the problem with these alternatives. The purpose of sequestered cash is to free one from worry during equity market gyrations. If what’s used for expenses ever can’t be used for expenses, that benefit is lost. One can wind up having to sell part of an equity portfolio when it’s underpriced, erasing the benefits of stock investing.


#Problems with cash
Cash has its own problems, of course. Inflation erodes its purchasing power over time. Expansionary monetary policies—governments printing money— exacerbate this. But if held in government-insured accounts under applicable limits, at least it’s always there. That availability is what makes the interim ups and downs of an equity portfolio’s price not only bearable, but almost trivial.





Summary
1. Conviction prepares one for the likely price drop that follows a stock buy.
2. Selling stocks can make sense 

  • price flies past value, 
  • when a company thought to be good turns out not to be, 
  • in buyouts, or 
  • when a clearly better opportunity emerges.

3. The problems with selling are taxes and alternatives.
4. Questionable reasons for selling include 

  • rebalancing, 
  • memorializing success, and 
  • industry compensation.

5. Equity portfolios can generate cash without active selling through 

  • buyouts and 
  • dividends.

6. Good focused equity portfolios outperform diversified equity portfolios over the long term.
7. Cash sequestered for ordinary expenses in government-insured accounts makes equity portfolio price gyrations less troubling.


Reference:

Good Stocks Cheap by Kenneth Jeffrey Marshall 2017

Tuesday 2 October 2018

The intelligent and safe way to handle capital is to concentrate.

Diversification

The beginner in investing needs diversification until he learns the ropes.

Diversification is an admission of not knowing what to do and an effort to strike an average.



Concentration is the intelligent and safe way

The intelligent and safe way to handle capital is to concentrate.

If things are not clear, do nothing. 

When something comes up, follow it to the LIMIT.

If it is not worth following to the limit, it is not worth following at all.



How to start?

Always start with a large cash reserve.

Next, begin in one issue in a small way. 

If it does not develop, close out and get back to cash. 

But if it does do what is expected of it, expand your position in this one issue on a scale up. 

After, but not before, it has safely drawn away from your highest purchase price, then you might consider a second issue.




Greatest Safety:  Putting all your eggs in one basket and watching the basket

The greatest safety lies in putting all your eggs in one basket and watching the basket.

You simply cannot afford to be careless or wrong. 

Hence, you act with much more deliberation.

Of course, no thinking person will buy more of something than the market will take if he wants to sell, and here again, the practical test will force one into the listed leaders where one belongs. 

The less active a stock and the further distant the market, the more potential profit I need to see in it to make it worth buying.

It is purely a personal matter whether an investor feels that efforts at safety are more important than trying to get the maximum out of investing.



Stocks in the same business cycle

Diversification between the position of varying companies in their business cycle or as between their shares in their market price cycle is a very important consideration. 

Dividing one's funds between three or four different stocks which happen all to be in the same sector of their cycle can often be discouraging or dangerous.

After all, the final determinant of investment success or failure is market price.


  • For example, industries which are in the final stages of a boom with rapidly increasing earnings, dividends and possibly split-ups, often offer shares high in price but apparently rapidly going higher.  There is a sound justification for an investor who knows what he is doing to buy into such a situation, especially for short-term gains, but it would be quite dangerous for him to put all of his funds in three or four such stocks.


  • On the other hand, we naturally all seek deflated and cheap bargains, but very often shares like this will lie on the bottom much longer than we anticipate and if every share we own is in this same category, we may do very badly in a relatively good market.




Conclusions:

The greatest safety for the capable, lies in putting all one's eggs in one basket and watching the basket.  

The beginner and those who simply find their investment efforts unsuccessful must resort to orthodox diversification.

An Ever-Liquid Account (Concept)

An Ever-Liquid Account

In its operation, an ever-liquid account is normally kept fully un-invested; i.e., in cash or equivalent only. "Equivalent" means any kind of really liquid short-term security or commercial paper.

Book values and market values are always kept identical.

Income is real income; i.e., interest, dividends, capital gains realized and realizable, less capital losses taken or unrealized in the account, which is always marked to market.




Cash and Equivalent (Beginning of period)

add Income:  
interest
dividends
capital gains realized
capital gains realizable

less losses:
capital losses taken
capital losses unrealized in the account


Cash and Equivalent (End of period)




How to keep the account truly ever-liquid?

Income and appreciation are obtained in the ever-liquid account by entering the stock market as a buyer when a situation and trend seem clearly enough established so that a paper profit is present immediately after making the purchase.

In order to keep the account truly ever-liquid, one must use a mental or an actual stop on all commitments amounting to some predetermined percentage of the amount invested (e.g. 3% stop loss or 10% stop loss).

One does not make a purchase unless one feels rather sure that the trend is sufficiently well established to minimize the possibility of being stopped out.  Yet it will happen occasionally anyway.

The decision of what and when to buy is made on a personal basis using various yardsticks best understood by individual investors.




Concentrated purchases of single issues

This investment philosophy leads into concentrated purchases of single issues rather than diversification, because one of the primary elements in the situation is that one must know and be convinced of the rightness of what one is doing.  

Diversification as to issue and type of investment is only hedging - a method of averaging errors or covering up lack of judgement.




Profiting from trends and pyramiding

This ever-liquid method also rarely calls for attempts to buy at the bottom, as bottoms and tops are actually impossible to judge ordinarily, while trends after they are established and under way can be profitably recognized. 

It is a method that leans towards pyramiding; i.e., towards following up gains and retreating before losses.  Such an account, properly handled, bends but never breaks. 

"Averaging down" is, of course, completely against this theory.



Wednesday 26 September 2018

Concentrating on Your Best Ideas

Buffett has difficulty finding understandable businesses with sustainable competitive advantages and excellent managers that also sell at discount to their estimated fair values.

Therefore, his investment portfolio has often been concentrated in relatively few companies.

Buffett rejects the idea that diversification is helpful for the INFORMED investors.

On the contrary, he thinks the addition of an investor's 20th favourite holding is likely to lower returns and increase risk compared with simply adding the same amount of money to the investor's top choices.


Sunday 17 December 2017

Some stocks will perform better than others and these "stunners" will dominate the investor's portfolio.

You won’t improve results by pulling out the fl owers and watering
the weeds.
— Peter Lynch, ONE UP ONWALL STREET


For an investor who—like Keynes and Buffett—adopts a buy-and-hold policy in respect of stocks, portfolio concentration is something that tends to happen naturally over time. 

Inevitably, some stocks within a portfolio will perform better than others and these “stunners” will come to constitute a large proportion of total value. A policy of portfolio concentration cautions against an instinctive desire to “re-balance” holdings just because an investor’s stock market investments are dominated by a few companies.

Buffett illustrates this point with an analogy. If an investor were to purchase a 20 percent interest in the future earnings of a number of promising basketball players, those who graduate to the NBA would eventually represent the bulk of the investor’s royalty stream. Buffett says that:

To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.

Buffett cautions against selling off one’s “superstars” for the rather perverse reason that they have become too successful. 

The decision to sell or hold a security should be based solely on an assessment of the stock’s expected future yield relative to its current quoted price, rather than any measure of past performance  

Portfolio concentration can produce better results than diversification.

Portfolio concentration can produce better results than diversification due to a number of factors, including 

  • lower transaction costs—broker commissions proportionately decrease as deal size increases— and
  •  potentially lower administration costs. 
But perhaps the most compelling argument for portfolio concentration by informed investors is the simple logic expressed in one of Warren Buffett’s shareholder letters:
I cannot understand why an [educated] investor . . . elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices—the businesses he understands best and that present the least risk, along with the greatest profit potential. 
The same impulse that propels stock market speculation also motivates the drive toward diversification—the desire to be part of the crowd.


As the financier Gerald Loeb recognized, a widely diversified portfolio “is an admission of not knowing what to do and an effort to strike an averagefor those investors who believe that they can in fact rank stocks, a policy of portfolio concentration is preferable.  


Keeping It Simple
Diversification is, in reality, more a strategy of risk dispersion than risk reduction.

Keynes’ response to uncertainty and risk in the share market was radically different to the prevailing wisdom—as he explained in a letter to one of his business associates:
 . . . my theory of risk is that it is better to take a substantial holding of what one believes shows evidence of not being risky rather than scatter holdings in fields where one has not the same assurance.

To ascertain which stocks “show evidence of not being risky,” the value investor searches for those securities that exhibit a sufficiently large margin of safety—that is, those stocks with a substantial gap between estimated intrinsic value and the quoted price.

In undertaking this analysis, the intelligent investor will necessarily focus only on those businesses he or she understands. Keynes noted that he would prefer “one investment about which I had sufficient information to form a judgment to ten securities about which I know little or nothing.” His contention was that intelligent, informed investors will reduce their downside risk by scrutinizing only those sectors within their “circle of competence” —to use Buffett’s phrase—and then only investing in those stocks which exhibit a satisfactory margin of safety. 

Like Socrates, the intelligent investor is wise because he recognizes the bounds of his knowledge  

Monday 17 April 2017

Concentrated portfolio of stocks or Index funds or Mutual/Hedge funds

How should I invest in the stock market?

Should I invest in my own selected stocks and manage my own portfolio?

Should I entrust my money to the fund managers in mutual funds or hedge funds?

Or, should I just buy an index-linked fund or an ETF?



Investing in mutual funds and hedge funds

The problem here is, as an aggregate, these funds underperform the market, after taking into consideration the costs incurred.  

Over a one year period, these costs maybe small, but over a long period, these costs compounded into a huge amount that is leaked out of your portfolio, not available to you to reinvest into your portfolio.

It is generally sound to avoid these funds, since there are better alternatives.


Investing in index linked funds or ETF

Index linked mutual funds have on the aggregate given you the chance to capture the returns of the market at low costs.    

They have in general outperformed the mutual funds and hedge funds, as a group over the long term.

Due to recent awareness of the performances of the mutual funds and hedge funds due to the higher costs involved, more and more money are flooding into index linked funds or ETFs.


Investing in a concentrated portfolio of  a selected group of stocks

I believe this is possible for those with a good and sound philosophy and method; who are hardworking, knowledgeable and disciplined.

These constitute less than 5% of the investors in the market.

An example of a sound philosophy:
  • Know the business you are investing.
  • The business has durable competitive advantage.
  • The management has integrity and are capable.
  • The company is available at a fair or bargain price.
  • The investing time horizon is long term (> 5 years or more).
  • Dividends are reinvested.
The stock markets have returned averagely about 10.5% per year for a long period.  The returns of the stock market over the short term is extremely volatile; inflation over this short period is small.   On the other hand, the returns of the stock market for any 5 years or more rolling period have always been positive.   Those who choose the "good quality stocks" bought at "bargain prices" can expect to perform better than the average and should have returns better than the 10.5% per year.



In summary:

1.   If you are knowledgeable, do invest on your own.

Own a concentrated portfolio of good quality stocks (those with durable competitive advantage).

Do not overpay to own them.

Keep them for the long term, reinvest the dividends, and allowing compounding to give you the higher returns.


2.   If you are not so knowledgeable, but still intelligent in your investing.

Go for index linked funds.

Do you have the uncanny ability to pick out the best mutual or hedge fund managers?  If you have, you may wish to park your money with them.  If not, avoid these products altogether and go for index linked funds or ETF.










Saturday 10 March 2012

Why not start a portfolio for your child, like Simple Soul does for his daughter, Nora?


[quote author=soulsimple link=topic=27804.msg735122#msg735122 date=1328783721]
http://www.investlah.com/forum/index.php/topic,27804.0.html
goals for her portfolio.
after she was borned i started a little portfolio for her. hope that it grows well till she is 20. simple goal of 15% returns yearly. hope to add funds yearly into it(on top of dividends received) n might diversify into diff assets as time n opportunity permits.
how she is faring ok(i guess). pls feel free to share your opinions.
 :)
[/quote]


Nora was born on 8.9.2011.  Her father, Simple Soul started a portfolio for her.  Here is her portfolio.
http://www.investlah.com/forum/index.php/topic,27804.msg735140.html#msg735140

                 Avg. Price         9.3.2012           % Gain
Dlady............RM 19.8 ......RM.29.9............ 51.01%
GuanChg......... 2.183...........2.61...........19.56%
LPI..................12.29..........13.62..........10.82%
Nestle..............47.46..........56.24..........18.50%
Padini.............. 0.998..........1.52............52.30%
PetDag.............16.02..........18.36.........14.61%
UtdPlt.............. 17.36...........25............. 44.01%

Let's have a good look.  It is a portfolio of 7 stocks that are highly selected, that is, a concentrated portfolio.  5 of these stocks are from the consumer sector (Dlady, GuanChg, Nestle, Padini and PetDag), 1 from the insurance sector and 1 from the plantation sector.

All these companies are growing their revenues and earnings year on year.  Their businesses also throw up a lot of free cash flows.  All give dividends.  Another feature common to all these companies is they are growth companies, growing at various rates.  

What about their durable competitive advantage and economic moats?  Yes, these businesses, except UtdPlt do have these qualities.  UtdPlt is a well run plantation company and presently enjoy the good returns due to the high price from the crude palm oil.  CPO prices can be cyclical and CPO is traded like a commodity with its price determined by supply and demand.

By buying these companies at a time when the market was down in September 2011 and last quarter of 2011, Simple Soul has managed to buy these wonderful companies at fair or bargain prices.  The market is often volatile and in the short run, psychological factors drive stock prices.  However, over the long term, the stock prices are driven by fundamental factors.  By staying with wonderful companies with durable competitive advantage and economic moat, this portfolio is well constructed to protect against any downside risk and with a promise of a fairly good return.

Let's study the gains of the individual companies in this portfolio over this short period since its inception in September.  For the smart and shrewd investor, the like of Simple Soul, it is comforting to know that he can find bargains in September when everyone was leaving the market in disgust.  But this isn't surprising for someone who practises value investing.  Another point of note is to realise that it is not uncommon to see a stock price going up 50% or down the equivalent 30% within a short period of 1 year.  3 stocks in this portfolio have gone up about 50%.  The gains in the other 4 stocks are in the teens.  Who said that you have to invest in "lousy" penny stocks to seek such gains?  

However, the long term performance of this fairly concentrated portfolio will track the earnings growth of the individual stocks.  For this, Simple Soul has certainly selected his stocks well.

This is a story of a caring father who is investing for his daughter Nora.  Warren Buffett started his investing at the age of 13 years, and seriously so in his early 20s.  As Nora has a good 20 years headstart in her investing career and knowing the power of compounding, I shudder to project her networth when she too reaches her age of 80s. :-)

Well, Nora will realise someday how lucky she is having a caring father who has such a foresight.  Happy Investing to Simple Soul, 

Monday 4 October 2010

Value in the context of Your Overall Portfolio

A stock's value is the sum of its future cash flows, each discounted to today's value at the base return you're aiming to make.

But that doesn't mean you'd rush straight out and buy stocks at that value - if you did, you'd only expect to make whatever return you'd factored in, and you wouldn't be leaving yourself any margin for error.


Margin of safety

To be interested in the investment, we'd have wanted to see a discount to that fair value, and it's very much a case of the more the merrier.

The larger the discount to your estimate of expected value, 
  • the greater the likely returns and 
  • the less chance you have of losing money.


So how might the margin of safety work with a stock?

Let's say your expectation is for ABC Company to pay dividends in the current year of $1.20, and that you expect this to increase forever by 6% a year.
  • To get a targeted return of 10%, you'd therefore need to pay a price that provided a dividend yield of 4% (so that the yield of 4% plus its growth of 6% would equal your targeted return of 10%), which comes out at $30 ($1.20 divided by 4%, or 0.04.)

Calculations:

$1.20/4% = $30.

Next year, dividend = $1.20 x 1.06 = $1.272
Share price = $1.272/4% = $31.80
Total return = Capital gain + Dividend = ($31.80- $30) + $1.20 = $3
Total return = $3/$30 = 10%.

But that is just your estimate of a fair value for the stock. To get you interested in buying it, you'd need to see a discount to this - and the riskier the situation and the better the opportunities elsewhere, the more of a discount you'd need.
  • Balancing it all up, you decide you only really find ABC Company compelling at $20.
  • That would give you a 33% margin of safety, but it would also increase your dividend yield to 6% and your total expected return to 12% (the 6% yield plus the 6% growth).

The intrinsic value of $30 is also the level you might reasonably expect the stock price to return to (or 6% higher than that for each year into the future to allow for the growth) - so it also defines the capital gain you're secretly hoping to make if the price returns to the underlying value. 
  • The trouble is that you don't know when - or even if - the price will return to that underlying value.  
  • But the bigger the margin of safety and the more confident you are about it, the better your chances of capital appreciation.  
  • And if you're left holding the stock, a large margin of safety should at least make it a decent ride.
The price wobbles around, either side of the underlying value, and your aim is to buy when it's a good way below it.  
  • The further the price gets from the value, in either direction, the more likely a snap-back becomes.  
  • Riskier stocks are those that have a wide range of potential outcomes.  They will probably bounce more wildly, making the prospects of a snap-back less reliable, and you'll want to buy at a wider discount to provide some comfort.


Diversification

Even with a fat margin of safety, you wouldn't put too much just in single stock because of a remote and variable chance of a complete wipe-out.

With stocks, diversification comes from spreading your portfolio over a range of different companies and sectors, and from the amount of time you are invested. 

The more time you allow, the greater the chances of the value being reflected - which, of course, is why the sharemarket beats cash more consistently the longer you give it.



Interaction between diversification and margin of safety.

There's an interaction between diversification and margin of safety, because the more you've got of one, the less you might need of the other.

There is, however, a crucial difference:
  • as you increase the number of stocks in your portfolio, your selections gradually get worse.  
  • An increased margin of safety, on the other hand, will mean better selections.

The flip side is that margin of safety relies on you making correct assessments of value, while diversification will tend to take you towards an average return, whether you're getting the value right or wrong.  
  • So if you're very confident in your ability to assess value, you might focus on finding stocks where you see a huge margin of safety and not worry so much if you end up holding only a few of them.  
  • But if you're less sure about assessing value correctly, you'll want to focus more on achieving a decent diversification, with the inevitable reduction in apparent margin of safety from your additional selections.


Related:

    Sunday 3 October 2010

    It sure beats FD rates and it is safe too.

    It sure beats FD rates and it is safe too.
    http://spreadsheets.google.com/pub?key=tWENexpUrXS_RMxB7k73RgQ&output=html

    Revisiting this old spreadsheet reveals many lessons on "stocks selection" and "buy and hold" strategies.

    There are 9 stocks in this portfolio. 

    Buying prices:  
    Nestle:  10.20, 15.5, 22.80
    PPB:  3.85, 6.80
    Guinness:  4.38, 5.35
    DLady:  1.70, 11.30
    Tenaga:  3.32
    GENM:  1.19
    PBB: 4.48, 5.98, 6.80, 6.70
    PetDag:  3.98, 5.75
    UMW:  2.975

    The returns of the stocks were calculated based on the their prices on 5.3.2009 when the market was at its lowest in the recent Global Financial Crisis.  Even at these "low" prices, it is "safe" to hold onto these stocks in the portfolio.

    Always buy QUALITY.

    Click:
    *****Long term investing based on Buy and Hold works for Selected Stocks

    Friday 16 April 2010

    Buffett (1993): He believes in making infrequent large bets. "We'll now settle for one good idea a year."


    Warren Buffett's 1992 letter to shareholders shared his views on healthcare accounting and ESOPs. Let us now see what insight the master has to offer in his 1993 letter to shareholders.

    Ardent followers of the master might not be immune to the fact that whenever an extremely attractive opportunity has presented itself, Buffett has not hesitated to put huge sums in it. In sharp contrast to the current lot of fund manager who use fancy statistical tools to justify diversification, the master has been a believer in making infrequent bets but at the same time making large bets. In other words, he believes that a concentrated portfolio is much better than a diversified portfolio. This is what he has to say on the issue.

    "Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire's capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times. Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)

    The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."

    The master does not stop here. Like his previous letters, he once again takes potshots at academicians who define risk as the relative volatility of a stock price with respect to the market or what is now widely known as 'beta'. He very rightly contests that a stock which has been battered by the markets should as per the conventional wisdom bought in ever larger quantities because lower the price, higher the returns in the future. However, followers of beta are very likely to shun the stock for its perceived higher volatility. This is what he has to say on the issue.

    "In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote on our 100% position in See's or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?"

    http://www.equitymaster.com/detail.asp?date=1/10/2008&story=5