Wednesday, 19 December 2018

What is a bear market and what causes them?

By definition, a bear market is when the stock market falls for a prolonged period of time, usually by twenty percent or more. It is the opposite of a bull market. This sharp decline in stock prices is normally due to a decrease in corporate profits, or a correction of overvaluation [i.e., stocks were way too expensive and needed to fall to more reasonable levels]. Investors who are scared by these lower earnings or lofty valuations sell their stock - causing the price to drop. This causes other investors to worry about losing the money they've invested, so they sell as well... and the vicious cycle begins.

One of the best examples of such an unfriendly market is the 1970's, when stocks went sideways for well over a decade. Experiences such as these are generally what scare would-be investors away from investing [which, ironically, keeps the bear market alive... since there are no buyers purchasing investments, the selling continues.]

How do they affect my investments?

Generally, a bear market will cause the securities you already own to become undervalued. The decline in their value may be sudden, or it may be prolonged over the course of time, but the end result is the same: What you already own is worth less [according to the market.]

This leads to two fundamental truths:
1.) A bear market is only bad if you plan on selling your stock or need your money immediately.
2.) Falling stock prices and depressed markets are the friends of the long-term investor.

In other words, if you invest with the intent to hold your investments for years down the road, a bear market is a great opportunity to buy. [It always amazes me that the "experts" advocate selling after the market has fallen. The time to sell was before your stocks lost value. If they know everything about your money, why they didn't warn you the crash was coming in the first place?]

So what do I do with my money in a bear market?

The first thing you need to do is to look for companies and funds that are going to be fine ten or twenty years down the road. If the market crashed tomorrow and caused Gillette's stock price to fall 30%, people are still going to buy razors. The basics of the business haven't changed.

This proves the third fundamental truth of the market:
3.) You must learn to separate the stock price from the underlying business. They have very little to do with each other over the short-term.
When you understand this, you will see falling stock markets like a clearance sale at your favorite furniture store... load up on it while you can, because before long, the prices will go back up to normal levels.

Additional notes:

Fear Index

What are you doing with your money?

-  I'm buying stocks while they are cheap.
-  I'm staying put in the market for the long-term.
-  I'm taking some money out of stocks. I don't want to risk everything.
-  I'm selling all stocks and moving to CDs.
-  I'm in a panic. Where's the nearest mattress?

Tuesday, 11 December 2018

Another milestone - TOTAL PAGEVIEWS 3,033,886 (1.8.2008 - 11.12.2018) Hope my readers have benefited too. Thanks.




From The Essays of Warren Buffett: “In Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the lifetime of the asset.”

My Investing Philosophy

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Sparkline 3,033,886





My first article in this blog


Investment Policies (Based on Benjamin Graham)

Summary of Investment Policies

US Savings Bonds (FDs or Amanah Sahams for Malaysians)

(1) INVESTMENT FUNDS bought at reasonable price.
(2) Diversified list of primary common stocks (BLUE CHIPS) bought at reasonable price. 

C. INVESTMENT CHIEFLY FOR PROFIT: 4 approaches are open to both the small and the large investors:
(1) Representative common stocks bought when the MARKET level is clearly LOW.
(2) GROWTH STOCKS, when these can be obtained at reasonable prices in relation to actual accomplishment – GROWTH INVESTING.
(3) Purchase of securities selling well BELOW INTRINSIC VALUE – VALUE INVESTING.
(4) Purchase of WELL-SECURED PRIVILEGED SENIOR ISSUES (bonds and preferred shares).
(5) SPECIAL SITUATIONS: Mergers, arbitrages, cash pay-outs.

(1) Buying stock in new or virtually new ventures (IPOs) .(2) TRADING in the market.


@15.20   Jesse Livermore's trading rules

The Rich Invest for Cash Flow. The Others Aim for Capital Gains.

DECEMBER 8, 2018

Have you lost money or got burnt from an ‘investment’?

Perhaps, you did. It can be painful. The level of hurt or ego bruised depends on how emotionally attached you are with money.

For years, I have received private emails where readers shared their failures on ‘investing’. Many were disappointed. Here, I’ll list down some of their blunders when it comes to ‘investing’:

– I lost 16% from my unit trust investment.

– My stock portfolio is downed by 30% in 6 months.

– I bought Bitcoin when it was US$ 11,000. Now, it is US$ 3,300.

– I am still trying to sell my property. The mortgage is now ‘eating me alive’.

Perhaps, you may share some of the same experiences as mentioned above. If you did, let us think for a moment: ‘Why did you make that ‘investment’ in the first place?’ ‘What was your objective at that point of time?’

Recently, I read a book, ‘Who Took My Money?’, written by Robert Kiyosaki. In Chapter 2, he shared the difference between a person who invest for cash flow and one who invest for capital gains. In most cases, their difference lies in their mindset and words spoken. For instance,

Words of a Cash Flow Investor

– I received an average of 5% dividend yield from my stock investment.

– The gross rental yield from my investment property is 4% per annum.

– ABC Bhd has made RM 0.50 in EPS in 2018, up from RM 0.45 in 2017.

Words of a Capital Gains ‘Investor’

– I bought BCD Bhd at RM 0.50 and sold it for RM 1.00.

– I bought an under construction property for RM 300k and flipped it for RM 500k.

– I expect my unit trust to go up by 8% per annum.

The Common Denominator

As I read, I realised that the common denominator for failures and losses from an investment stems from one’s desire to achieve capital gains. Most made an investment hoping that ‘it will go up’ and not ‘produce cash flows regularly’. It has become a root cause for many heartaches, hurts and even sleepless nights.

How to Reduce Risk Significantly from Your Next Investment?

I believe, one of the answers is to have a greater appreciation of ‘cash flows’. It is cash flow that makes the rich truly rich and the wealthy truly wealthy. Here, I would share how the ultra-rich got themselves richer from the same vehicles of investment that most people invest into today.

Example 1: Who Makes Big Bucks from Unit Trust?

Is it the investors or the companies that are selling unit trust as an investment?

I think the answer is obvious. But, please be mindful that I am not here to start a blame game. Instead, my intention is to explain a major difference in mindset between unit trust investors and unit trust companies.

Think about it. Most bought unit trust because of promises of capital gains over the long-term. Very few, or none at all, is mentioned about its ability to bring in cash flow. Most agents promoted ‘dollar-cost-averaging’ as a smart investment strategy in unit trust. From it, millions of investors poured in millions or billions of Dollars per month into unit trust funds in search of ‘Capital Gains’.

So, what does it mean to unit trust companies?

Answer: Abundance in Cash Flows. First, they earn sales charges from each unit transacted from their investors. Second, they earn annual management fees on their unit trust funds regardless of their performances. If a fund made profits, it pays itself higher fees. If a fund incurred losses, it pays itself lesser fees.

It means, unit trust companies will ‘more or less’ guaranteed themselves stable sources of ‘Cash Flows’ regardless of how their funds performed in the future.

Let us use Public Mutual as an example to illustrate how an ultra-rich looks unit trust as an investment. Apart from sales charges and management fees, I found that a handful of its funds invest their investors’ money into Public Bank. This is brilliant as Public Bank is receiving tons of capital ‘interest-free’, which allows it to be well-capitalised. Hence, to an ultra-rich, unit trust is a Cash Flow Business and an effective vehicle to raise funds consistently.

I am not sure how well you did in your unit trust investments. But, as for Public Mutual, it has achieved CAGR of 15.3% in profits before tax (PBT) over the past 10 years. Its PBT had grown from RM 183.3 million in 2008 to RM 660.9 million in 2017.

Source: Annual Reports of Public Bank Bhd

Example 2: Why Value Investors Like Public Bank Bhd?

Answer: Abundance of Cash Flows.

For a start, most ‘investors’ are not really investing. They are trading, gambling, or speculating. How do I know? Simple. If I asked, ‘Why did you buy the stock?’ and his reply is, ‘I expected it go up because its stock price went up or down by 20% or 30%.’, then I know, chances are, he is a speculator or gambler.

Investors view stocks as businesses. Investing is about being a part-owner of an enterprise. Instead of chasing stock prices, investors read annual reports. Why? Because they want to know, whether or not, the business is profitable and has the capability to generate ‘Cash Flows’ consistently.

Take a look at Public Bank Bhd. Its shareholders’ earnings have grown by CAGR of 8.7%, up from RM 2.6 billion in 2008 to RM 5.5 billion in 2017. If an investor bought shares of Public Bank at the start of 2008 and held it to today, he would have made total returns of 171.5%, consisting of 125.4% in capital gains and as much as 46.1% in dividend yields. Hence, it is ‘Cash Flows’ that leads to ‘Capital Gains’ for a savvy stock investor.

Source: Annual Reports of Public Bank Bhd

Source: Google Finance

Example #3: How to Build Wealth Faster than Flippers?

Let us use two men in their 30s as examples: Tom and Jerry.

Tom is a flipper. He had bought an under-construction property at RM 400,000 with the intention of selling it at RM 600,000 upon receiving his keys to his unit upon completion. 4 years later, he managed to dispose his unit for RM 600,000 after receiving his keys. After deducting a RPGT of 20%, his final gain works out to be RM 160,000. Awesome!

Jerry is an investor. He bought a property for RM 400,000 in a sub-sale market and rents it out for RM 1,400 a month. Based on a DSR calculation of 60%, the amount of monthly instalments Jerry is eligible for has increased by RM 840 a month. Based on the Rule of 200, Jerry’s mortgage eligibility would be revised upwards by another RM 168,000.

Unlike Tom, Jerry is able to ‘cash out’ the RM 168,000 to fund his purchase of a new property almost immediately without the need to sell his current property 4 years later at a higher price. Why? Because Jerry is receiving Cash Flows from his property and bankers are happy to extend mortgages to investors as rent is recognised as one of the viable sources of income.

This explains how property investors are able to keep on buying properties one after another. The answer lies in Good Cash Flow Management.

5 Lessons to be Learnt

In short, I hope that you have a much better appreciation about the differences between cash flow and capital gains and why the rich gets even richer and how most people lost money in their investments. Here, I’ll leave you with 5 lessons that could be learnt from this article:

  1. The Rich invests for Cash Flows. The Rest aim for Capital Gains.
  2. Never invest just because ‘it will go up.’
  3. Many lost money in an investment because of lack of skill, knowledge, and know-how but yet have a desire to achieve capital gains.
  4. Capital Gain Investors tend to handover money to Cash Flow Investors.
  5. Cash Flows often leads to Sustainable Capital Gains in the long run.

Ian Tai is the founder of, a platform that empowers retail investors to build wealth through ownership of fundamentally solid stocks. It is an essential tool that sifts out stocks that grow profits consistently from a database of over 900+ stocks listed mainly in Malaysia.



Price 3.79 (10/12/2018)
Market Cap 601.38m
Shares Outstanding 157.43m
ttm-EPS RM 0.43
ttm-P/E  8.80

FY 2017

Income Statement

Revenue 694m
Gross Income 103.4m
EBIT 67.3m
Non-Op Income 17.3m
Interest Exp 1.8m
PBT 82.3m
PAT 57.4m

EPS RM 0.37

Balance Sheet

Cash 92.2m
ST Debt 96.6m
LT Debt 11.0m

AR 81.3m
AP 17.4m

Inventories 289.4m

Total CA 464.6m
Total CL 132.6m

CR 3.5
Quick Ratio 1.32

Total Liabilities 138.1m
Total Equity 473.6m
Total Assets 611.7m

Cash Flow Statement

Net Income 82.3m
D&A 16.5m
Funds from operations  80.7m
Net Operating Cash Flow  43.2m

Capex (5.9m)

Cash Dividends (58.8m)

FCF 37.3m
FCF Yield 6.2%.

ttm 30-9-2018

ttm-Revenue  797.4m
ttm-PAT 66.5m
ttm-EPS  RM 0.42

Monday, 10 December 2018

Dutch Lady

Price 62.30 (10/12/2018)
Market Cap 4.05 Billion
ttm-EPS 1.88
P/E ttm 33.17

FY 2017

Income Statement

Revenue 1065m
Gross Income 401m
EBIT 228m
PBT 158m
PAT 118m

EPS 1.84

Balance Sheet

Cash 61.3m
ST Debt 0
LT Debt 0

AR 103.8m
AP 206.9m

Inventories 115.8m

Total CA 286.8m
Total CL 281.6

CR 1.02
Quick Ratio 0.61

Total Liabilities 290m
Total Equity 104m
Total Assets 394m

Cash Flow Statement

Funds from operations  43.2m
Net Operating Cash Flow  43.2m

Capex (16.3m)

Cash Dividends (179.2m)

FCF 27.5m
FCF Yield 0.68%.

ttm 30-9-2018

ttm-Revenue  1046.5m
ttm-PAT 120.1m
ttm-EPS 1.88

Saturday, 8 December 2018

Wealth Distribution

Wealth Distribution – What is a private trust?
November 18, 2018, Sunday

Wong Chaw Chern

A complete and holistic financial planning pyramid encompasses three wealth components – accumulation, protection and distribution.

Broken down, it describes the process flow where you start to accumulate your savings and investments, then protect your wealth against any unexpected events with insurance before deciding on how you will distribute your asset when the time comes.

In our opinion, the average Malaysian already has in place, a well thought-out and decently executed investment and insurance plan.

These covers the wealth accumulation and protection components. Briefly, here’s an example of what they generally consist of:

1)Wealth accumulation – Investments in properties, shares, Unit Trust Funds and bank deposits

2)Wealth protection – Medical and life insurance.

3)However, in many cases, the application of the third component and final piece of the financial planning pyramid puzzle – wealth distribution, is still found wanting.

A news report published in 2013, stated that RM45 billion worth of inheritance claims are still frozen by various agencies, lends credence to our belief.

Whether it’s the thinking that death is too taboo a word or procrastinating the idea of planning the distribution of wealth until a ‘later’ age, the truth is – one should plan, and preferably, to do it as early as you can.

Unexpected events do occur and sometimes, at the unlikeliest of times.

For example, if the deceased had not made any wealth distribution plans before passing on, a bickering among his/her beneficiaries or children on who should receive what, can have enormous repercussions. These can potentially tear the family apart, and with it, the family wealth and values.

Proper estate planning can go a long way towards preventing any unwanted occurrences.

So write your Will or remember to update it if there has been any significant changes such as: changes to your marital status, replacement of beneficiaries or if there are notable changes to the size of your estate.

However, if either retaining control of your wealth even after planning to distribute it away or wanting a more tailored approach towards your estate planning, a Private Trust may be more of what you are looking for.

A Trust is a legal instrument which is written on a Trust Deed for the Settlor (the person who creates the Trust) to provide instructions to the Trustee or Trust Administrator for them to hold, manage and distribute the assets to his intended beneficiaries. In this issue, we will talk about a Private Trust, which is a living trust.

Advantages of a private trust from a will

1)Assets are not frozen

Even after writing a Will, when a person passes away, his/her assets will still be frozen while waiting to obtain the grant of probate from the court.

The grant of probate is needed to allow the designated executor, who is appointed by the deceased person to administer and distribute out his/her estate. Generally, this may take between three to six months. Crucially, this may be the time when the deceased’s family members may need the money the most.

For example, if the sole breadwinner has passed away, his spouse may be unable to use the frozen money to pay for the children’s college tuition fees or other important monthly expenses.

In the case of a Private Trust however, for the assets already held by the Trust, they are not frozen and the Trust operates as normal and pays out according to the Settlor’s instruction.

For the assets which the deceased have nominated to the Trust eg: EPF or insurance proceeds, the transfer process can be started immediately without the grant of probate.

If a person dies intestate or without a Will, a long, lengthy and costly process await the family members.

Furthermore, the deceased’s assets would be distributed according to the Distribution Act 1958 instead of what may be his/her wishes.

2)Decisive appointment of beneficiaries and conditions

The Settlor can appoint anyone as the beneficiaries, even himself. For Muslims, assets held under the Private Trust falls outside of the Settlor’s estate, hence is not subject to the Faraid distribution.

Besides that, the Settlor can determine the timing and condition of the particular distribution eg: Instruct the Private Trust to only distribute out the beneficiary or children’s portion upon turning 30 or for the Trust to help with grandchildren’s education expenses.

Instructions can be as specific as spelling out that the Trust will only pay as long as the grandchildren is able to maintain a minimum grade of 3.5 CGPA.


When a Private Trust is created, all the assets are held in the name of the Trust hence the Settlor and Beneficiaries remain confidential.

Moreover, unlike a Will, when the assets are distributed, it is done so to the intended beneficiaries discreetly and privately.

4)Emergency needs

When a Trust is already in place, it can provide a safety net to the Settlor or for the family in case of unexpected occurrences.

If a person falls under mental incapacitation which renders him/her unable to execute any decisions, all his assets remain under his ownership.

In other words, the beneficiaries are unable to utilise the money and the assets for the family’s needs.

With a Private Trust, the Trust is able to take over and perform the necessary procedures as previously instructed by the Settlor.

These may include arranging for medical care, application for EPF withdrawals and providing for the family’s expenses.

In the case of other emergencies, for example, if for whatever reason the Settlor is put in lockup and no next-of-kin to post bail, a Private Trust may come in handy.

5)Professional management

The assets in the Trust will be professionally managed in accordance to the Settlor’s specified mandate; this helps to prevent any mismanagement by beneficiaries who may not be financially astute or to prevent any spendthrift family members from mis-using the assets.

Depending on the size of the Trust, the fund managers can be instructed to invest in local, regional or in various asset classes.

The Trust will be managed to achieve its specified objectives eg: generating returns necessary for successive generations and make available liquidity whenever distributions or payments are necessary.

6)Bankruptcy or creditor protection

A Private Trust is able to provide creditor or bankruptcy protection for all the assets held under the Trust; provided the Trust structure is made Irrevocable and it will take effect after 5 years.


A Private Trust can be set up to last for a maximum period of 80 years.

Combined with the Settlor’s ability to set the timing and condition of the distribution, a Private Trust can be made to benefit successive generations of a family – provided the assets are substantial of course.

Conclusion Contrary to popular and long-held belief, Trusts are not reserved exclusively for the rich.

Neither are the fees staggeringly high nor the assets required to be in the mind-boggling tens of millions of ringgit range.

In some cases, RM500,000 could be enough to set up a Private Trust.

However, it is important to consult a financial adviser or investment professional like Areca Capital in order to specifically tailor the Trust to the Settlor’s needs.

Talking about assets for the Trust, aside from cash, there are various other assets that can be used to inject into the Private Trust.

Areca Capital is a niche Malaysian fund management company. We are a firm believer in the advisory-based approach towards investing. For any enquiries, ontact us at 03-79563111 or by email:

Disclaimer: The article is produced based on material and information compiled from reliable sources at the time of writing. The article is not an offer, recommendation or advice to transact in any investment products, including the stocks or funds mentioned within. Investors are advised to consult professional investment advisers before making any investment decision.

‘Balancing of raising rates too much versus not enough’

‘Balancing of raising rates too much versus not enough’
November 16, 2018, Friday

WASHINGTON: The US central bank is aiming to prolong the economic expansion but must balance the risk of raising interest rates too much or not enough, Federal Reserve chairman Jerome Powell said.

Amid increasing concerns in financial markets that the Fed will have to become more aggressive to head off inflation, Powell likened the job to walking in a dark room full of furniture.

In a discussion about the economy with Dallas Federal Reserve Bank President Robert Kaplan, Powell said the central bank is trying to steer between two common errors.

Holding the benchmark lending rate too low for too long could allow inflation to gain a foothold, he cautioned.

But the “other mistake – and we had plenty of advice to do this – is to raise rates too soon, and prematurely terminate an expansion.

“We haven’t done that,” Powell said.

However, “We’re at a point now where we have to take both of those risks very seriously, and that’s why we’ve been raising rates quite gradually.”

Economists almost unanimously expect the fourth rate increase of the year in December, but with a recent report showing wages finally beginning to rise, they are watching for indications about the likely pace of moves in 2019.

The Fed has repeatedly said it is likely to continue to raise rates gradually, with inflation holding right around its two percent target despite very low unemployment and continued job gains.

But Powell stressed that officials have not made the decision yet and will watch incoming data.

Likening the policymaking to “walking through a room full of furniture and the lights go off,” Powell asked, “What do you do? You slow down, you stop probably and feel your way. It’s not different with policy.”

The Fed chief also noted that the global economic outlook is slightly less optimistic this year.

There have been “growing signs of bit of a slowdown, and it is concerning,” he said.

Asked about the impact of President Donald Trump’s aggressive trade policies on the economy, Powell said while officials hear complaints from businesses, the effect of higher tariffs have not yet showed up in lower growth or higher inflation.

“We’re very pleased about state of the economy right now,” he said.

“If you look down the road you see challenges ahead” and “we have to be thinking about how much further to raise rates and the pace at which we will raise rates.”

Starting in December, Powell will hold a press conference after every policy meeting, rather than just four times a year, which he said means markets will have to get used to the possibility a rate move could come at any time. — AFP

Genting likely to still work on terminated theme park

December 4, 2018, Tuesday

By Sharon Kong,

AffinHwang Capital believes that Genting Malaysia will still work on the outdoor theme park, although management did not provide any colour on its plan for the outdoor theme park due to the impending law suit against Fox and Disney.

KUCHING: Genting Malaysia Bhd (Genting Malaysia) will likely still work on the recently terminated Disney-Fox theme park, analysts project, despite the management not providing any details on the group’s plan.

Affin Hwang Investment Bank Bhd (AffinHwang Capital) believed that Genting Malaysia will still work on the outdoor theme park, although management did not provide any colour on its plan for the outdoor theme park due to the impending law suit against Fox and Disney.

However, AffinHwang Capital projected that the opening date is likely to be delayed beyond the planned first half of 2019 (1H19).

“As such we have lowered our visitation rate forecast, with the assumption that an outdoor theme park will open its doors in 2020,” the research firm said.

“In our view, even without a branded theme park, visitation growth is still sustainable, albeit not as strong as previously forecasted.

“As an indication, prior to the refurbishment, the ‘old’ theme park managed to attract circa two million to 2.5 million visitors a year.

“Overall visitation for the first nine months of 2018 (9M18) is up 14 per cent year on year (y-o-y), even without the presence of the outdoor theme park.”

Meanwhile, the research arm of Kenanga Investment Bank Bhd (Kenanga Research) highlighted that since the Budget 2019 announcement in early November, the share price of Genting Malaysia had tanked 37 per cent and it is likely to slide further today as the RM1.83 billion impairment is negative for sentiment.

According to Kenanga Research, the fall in share prices started when the casino operator was slapped with 10 per cent hike in casino duties during the announcement of Budget 2019, then the news of unexpected termination of Twentieth Fox Theme Park last week, which pushed the share price to multi-year lows.

“Although the impairment is one-off, we believe this will impact the already fragile sentiment further,” the research arm said.

AffinHwang Capital noted that management did not provide any guidance on earnings before interest, tax, depreciation and amortisation (EBITDA) margins after the upcoming gaming tax hike, but did allude that current 9M18 margins of 35 per cent are unsustainable.

“Genting Malaysia will likely have to undergo a cost rationalisation program to lower its costs, while seeking a balance between margins and volume,” the research firm further noted.

“Thus, we are lowering our margin assumptions for 2019-2020E to 28 per cent (from 32 per cent), as we believe Genting Malaysia will need to sacrifice margins to remain competitive in the VIP segment. The government has raised the gaming tax on net wins to 35 per cent (from 25 per cent) from January 1, 2019.”

Friday, 7 December 2018

Intrinsic Value of a Stock by Warren Buffett

As the Dow tanks, here is Warren Buffett on the biggest puzzle for investors: Intrinsic value of a stock

  • Warren Buffett's Berkshire Hathaway recently repurchased close to $1 billion of its own stock, a move made after the billionaire investor changed the trigger he uses for stock buybacks.
  • Instead of basing share repurchases on a discount to the company's book value, which Berkshire had been doing for years, Buffett now is using a stock price below "intrinsic value."
  • Intrinsic value is a concept that Buffett has talked about a lot over the years, but it is not an easy stock market valuation method for investors to master, though it is important at times of elevated asset prices.

Warren Buffett (L) and Berkshire-Hathaway partner Charlie Munger
Eric Francis | Getty Images
Warren Buffett (L) and Berkshire-Hathaway partner Charlie Munger
In May of 2007, as the markets were reaching new records (and moving closer to a bear market precipice and the financial crisis), Warren Buffett and Charlie Munger were discussing intrinsic value at the annual Berkshire Hathaway conference. The decade-long run for the current bull market and widespread concerns about elevated values in U.S. stocks leading to days like Tuesday, when the Dow Jones Industrial Average fell by close to 800 points, are reminders that getting at the true value of corporations is as important as it has ever been.
The concept of intrinsic value came up earlier this year when Buffett made the decision to change his trigger for buying back Berkshire shares from a quantifiable discount to the company's book value (1.2 times book value) to a discount to intrinsic value. In moving back to monitoring intrinsic value, Buffett invoked the method also used by J.P. Morgan CEO Jamie Dimon.
As buybacks across the corporate sector continue to reach new records, it becomes more questionable whether all of these companies are basing their share repurchases on a valuation metric that uncovers a discount in a stock's trading price to intrinsic value — or are just buying back stock to keep shareholders happy and prop up earnings. Jamie Dimon said on Tuesday at a Goldman Sachs conference that buying back stock when market prices are high is not a wise idea, and companies should be reinvesting in the business instead.
Now the issue of valuation isn't limited to buyback analysis. As many sectors within the S&P 500, including one of Buffett's favorites (banking) are in correction, every investor should be questioning the value of what they own in their stock portfolio.
Buffett recently bought $4 billion worth of J.P. Morgan, a bank stock that has since entered a correction, and if he performed his analysis right, he might be buying more of it now. So no one should be making rash decisions, and Buffett reminds the fearful that the stock market is there to serve investors, not instruct them (echoing Ben Graham's maxim).
But having conviction in the staying power of your market bets becomes much more difficult when everything stops going up in unison. As Buffett famously wrote in an early '90s annual letter and said at the 1994 shareholder meeting, "You don't find out who has been swimming naked until the tide goes out."
Over the years, in annual Berkshire Hathaway shareholder meeting Q&As and in annual letters, Buffett has made clear — if in a roundabout way — just how difficult a concept intrinsic value is to explain. At the 1998 meeting, Buffett described it as "the present value of the stream of cash that's going to be generated by any financial asset between now and doomsday. And that's easy to say and impossible to figure."
Maybe that is why he has written that "what counts for most people in investing is not how much they know, but rather how realistically they define what they don't know." That may also explain why he added, "An investor needs to do very few things right as long as he or she avoids big mistakes."

The classic valuation models

In the classic business text Business Analysis and Valuation, which he wrote with fellow Harvard University professor Paul Healy, Krishna Palepu laid out two primary models for calculation of intrinsic value: the discounted cash-flow model and the accounting earnings-based valuation model.
But Palepu noted in an email to CNBC that even in using these models, getting to an intrinsic value requires the input of some significant assumptions, such as how long a company's outperformance can last: "The key is to start with the company's strategy and current performance and ask how long that performance is likely to be sustainable, given the nature of the industry and competition. Much of the value estimate in DCF lies in terminal value."
Terminal value is the estimated value of a business beyond a reasonable earnings forecast period, which some finance experts put at three to five years. Terminal value can take two paths: assuming that a company will continue to have a normalized growth rate even after its best years are over, or it assigns a takeout price for the firm.
Palepu continued: "The accounting based valuation technique puts some discipline in estimating the terminal value by using the company's current book value, and also its 'advantage horizon' — the time period over which the company's competitive advantage, if any, is sustainable."
The reason why an intrinsic value model can work so well — in terms of making people like Buffett a lot of money — is because so few people can effectively master them. "Since value is about the future, it is obviously based on forecasts. Forecasts have to be based on assumptions," Palepu wrote via email. He added: "The question really is how to make your assumptions sensible and grounded in fundamentals. That is why it is called fundamental analysis. If there is a mechanical way to do this, it won't have much payoff in the investment process, since everyone would have the same information, and it is tough to make money with common information in a market. So assumptions are a double-edged sword. They are subjective, but they are also the source of superior investment returns."
The principles related to intrinsic value can be laid out, but there is no one formula into which an investor can plug the ideas and come out with the same result as Buffett. If nothing more, the attempt to understand the ideas and calculate a publicly traded company's intrinsic value, even done imperfectly, could help an investor avoid the big market blunders before hitting the buy button. Or an investor would be perfectly correct to come away from an attempt to understand intrinsic value and say, "I'd rather just buy an S&P 500 index fund" — Buffett also approves of that antistock-picking strategy.

1. The bad news: There is no magic method, and most companies are too hard to value.

Berkshire Hathaway Vice Chairman Charlie Munger provided one of the most frustrating definitions of intrinsic value ever.
"There is no one easy method that could be simply mechanically applied by, say, a computer and make anybody who could punch the buttons rich. By definition, this is going to be a game which you play with multiple techniques and multiple models, and a lot of experience is very helpful," Munger told Berkshire shareholders at the 2007 annual meeting.
Munger went on to deflate the hopes of any investor who is confident enough to think they have valuation mastered. When it comes to valuation of companies, even he and Buffett draw a blank most of the time. "We throw almost all decisions into the too hard pile, and we just sift for a few decisions that we can make that are easy. And that's a comparative process. And if you're looking for an ability to correctly value all investments at all times, we can't help you."
Buffett's statements about intrinsic value over the years can seem like a labyrinth as well.
When stating Berkshire's new buyback policy in July, Buffett said, "The tough part is coming up with the intrinsic value. There is a lot more to intrinsic value than P/E,and there is no way to work intrinsic value out to four decimal places, "or anything of the sort."
At the 1994 Berkshire annual meeting, Buffett said a corporation's publicly reported financial statements can only help so much. "The numbers in any accounting report mean nothing, per se, as to economic value. They are guidelines to tell you something about how to get at economic value. ... To figure out that answer, you have to understand something about business."
But he went on to say at that meeting, and on other occasions, that when it comes to intrinsic value, "the math is not complicated."
Maybe a bit of an overstatement. But where to begin?

2. Start by breaking a business down to its basics.

Consider an iconic business: the American family farm. That's what Buffett did at the 2007 Berkshire Hathaway annual meeting, when he tried a little harder than Munger to explain the concept in terms that anyone could understand.
Catalog the basic stats:
  • The farm can produce 120 bushels of corn per acre.
  • It can produce 45 bushels of soybean per acre.
  • The price of fertilizer is X.
  • The property taxes are Y.
  • The farmer's labor is Z.
That simple accounting will lead the investor to a dollar value that can be generated per acre "using fairly conservative assumptions."
But those assumptions are a big part of the riddle.
"Let's just assume that when you get through making those calculations that it turns out to be that you can make $70 an acre. ... Then the question is how much do you pay for the $70? Do you assume that agriculture will get a little bit better over the years so that your yields will be a little higher? Do you assume that prices will work a little higher over time?"
An investor looking for a 7 percent return and predicting the acre's cash value at $70 annually could determine that the acre is worth $1,000. But you wouldn't want to pay that price.
"You know, if farmland is selling for $900, you know you're going to have a buy signal. And if it's selling for $1,200, you're going to look at something else," Buffett explained to Berkshire shareholders. "That's what we do in business. We are trying to figure out what those corporate farms that we're looking at are going to produce. And to do that, we have to understand their competitive position. We have to understand the dynamics of the business."
The most important dynamic of the business may be its cash-generating potential.

3. Place value on cash generation.

Telling investors it is critical to "understand a business' competitive position" and the "dynamics of a business" are the kind of opaque clues that make this valuation concept so fuzzy. Even in the farm example, Buffett noted that the investors need to make assumptions about the future direction in agricultural commodity pricing, and even if reasonable assumptions can be made based on recent pricing trends in a market, they are still assumptions.
At that 2007 meeting, Buffett went even folksier than the farm, invoking Aesop's fables from 600 B.C. as the original source text for "the mathematics of investment":
"A bird in the hand is worth two in the bush."
For the investor, the questions that follow from this approach are:
  1. How sure can you be that there are two in the bush?
  2. Could there be even more?
(There is one additional question Buffett posed, which we will come to in the next section.)
"We are looking at a whole bunch of businesses, how many birds are they going to give us, when are they going to give them to us, and we try to decide which ones — basically, which bushes — we want to buy out in the future. It's all about evaluating future — the future ability — to distribute cash, or to reinvest cash at high rates if it isn't distributed."
Of course, investors who follow Berkshire know that is has never distributed cash, and even as it has conducted limited buybacks in recent years, Buffett remains against paying a dividend. Berkshire also is sitting on more than $100 billion in cash currently, and that is a balance-sheet figure that Buffett said in 2007 is the underlying basis for the company's value.
Even refusing to part with the cash at any given time, "it's the ability to distribute cash that gives Berkshire its value." Though Buffett also has said in the past at times when Berkshire has more difficulty in figuring out how to invest its cash, it does become more difficult to calculate the intrinsic value. Berkshire ended September with close to $104 billion in cash.
He warned any investor who cannot come to conclusions about future cash flows of businesses in which they invest.
"There are all kinds of businesses that Charlie and I don't think we have the faintest idea what that future stream will look like. And if we don't have the faintest idea what the future stream is going to look like, we don't have the faintest idea what it's worth. ... Now, if you think you know what the price of a stock should be today but you don't think you have any idea what the stream of cash will be over the next 20 years, you've got cognitive dissonance. ... We are looking for things where we feel — fairly high degree of probability — that we can come within a range of looking at those numbers out over a period of time, and then we discount them back. ... We are more concerned with the certainty of those numbers than we are with getting the one that looks absolutely the cheapest."

4. You have to discount the future.

To "discount" the numbers back, as Buffett remarked, is the third question that proceeds from Aesop's original "mathematics of investment":
What's the right discount rate?
That question is the key to evaluating the value of a company's cash generation, and it circles back around to Buffett's example of an investor expecting a farm to generate a 7 percent return, and basing a purchase decision on that return assumption and the current business price. There are essentially two components to the discount rate-based risk modeling: the concept of time value of money, and the additional risk premium for the investment.
The time value of money is typically accounted for using the long-term government rate. It is the way investors contend with the fact that the value of a dollar today will be lower in the future. The additional risk premium, because an investor buying a stock is taking risk versus the purchase of a bond, can be modeled by using a higher, customized discount rate, or by building what Benjamin Graham called a "margin of safety" directly into the cash flows (a concept we will come back to in the next section). For example, an investor believes there is a 90 percent probability of receiving the cash flow, they multiply the cash flow by 90 percent.
In the 1992 Berkshire Hathaway annual shareholder letter, Buffett turned to another writer, and a five-decade old business text, to explain stock value better than he thought he could himself. The text was "The Theory of Investment Value" written by John Burr Williams, a prominent figure in the history of fundamental analysis.
"The value of any stock, bond or business today is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the asset."
The "remaining life of the asset" makes it difficult to specify an exact period of time for this calculation, though in an example laid out by a Berkshire Hathaway shareholder to Buffett in an exchange back in 1999 (and which we will come to later) Buffett did say that the shareholder's model for intrinsic value looking out 20 years into the future was stated well.
Buffett went on to explain a few key differences between a discount rate for bonds and stocks. Bonds have a coupon and maturity rate that define its future cash flows. Stocks, on the other hand, are subject to cash flow estimates that even the best analysts can mess up, and, in addition, the performance of company management.
Buffett has been clear about the discount rate he prefers to use, saying at the 1996 shareholder meeting that he doesn't think he can be very good at predicting interest rates and so he thinks in terms of "the long-term government rate," as long as the business being considered first meets another requirement: it is one that the investor can understand. A higher discount rate is justified for riskier businesses, he said. Pertinent to the current market environment, he added: "And there may be times, when in a very — because we don't think we're any good at predicting interest rates, but probably in times of very — what would seem like very low rates — we might use a little higher rate."
But this doesn't mean Buffett is not also factoring a risk premium into his models. A "margin of safety" is likely built directly into his models so the additional risk premium is not required as a separate discount modeling rate.

5. It is important to act as if you won't get it exactly right.

Buffett added to the definition provided by John Burr Williams in his own 1992 text that, "The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value."
But he made it clear that getting this right is a lot more difficult in practice. If the mathematical calculations required to evaluate equities are not difficult, Buffet still said that experienced and intelligent analysts can "easily go wrong in estimating future 'coupons.'"
Expecting to get things wrong about future cash flow is why Berkshire places so much emphasis on investing in businesses that the buyer understands, and only buying the businesses at prices which are reasonable — low enough to withstand mistakes in the model's assumptions.
"If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success."
The margin of safety is not a single ratio or percentage that can be used across the board. It is a concept — some in the market have referred to it as more of an art than a science — and its methods can vary. It can be evaluated based the difference between the calculation of a company's intrinsic value and its trading price; it could also be evaluated based on the stock's return potential versus the risk-free rate (government bond rate).

6. Don't think in terms of growth stocks vs. value stocks.

One thing is certain: Intrinsic value is not to be confused with the way the word "value" is used to denote an entire class of stocks. In fact, even as many pundits position Buffett as one of the greatest "value" investors of all time, he dismissed the entire stock-picking industry that has been built around choosing between growth and value stocks in his 1992 letter to shareholders.
Buffett said the difference between companies judged to be growing faster than the market even if trading at relatively high prices (growth stocks) and those priced lower than peers based on measures like price to earnings ratio but with strong earnings potential than the market consensus believes (value stocks) is no way to pick stocks.
"Most analysts feel they must choose between two approaches customarily thought to be in opposition: 'value' and 'growth.' ... We view that as fuzzy thinking … Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. ... In addition, we think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation (which is neither illegal, immoral nor, in our view, financially fattening)."
Buffett added that a low ratio of price to book value, a low price- earnings ratio, or a high dividend yield, "even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments."

7. The Berkshire Hathaway shareholder who (sort of) got it right.

At the 1999 Berkshire annual meeting, a shareholder from Bonita Springs, Florida, took the risk of asking Buffett and Munger whether his attempt to model Berkshire's intrinsic value was on target.
"You've given many clues to investors to help them calculate Berkshire's intrinsic value. I've attempted to calculate the intrinsic value of Berkshire using the discount of present value of its total look-through earnings. I've taken Berkshire's total look-through earnings and adjusted them for normalized earnings at GEICO, the super-cat business, and General Re. Then I've assumed that Berkshire's total look-through earnings will grow at 15 percent per annum on average for 10 years, 10 percent per annum for years 11 through 20. And that earnings stop growing after year 20, resulting in a coupon equaling year 20 earnings from the 21st year onward. Lastly, I've discounted those estimated earnings stream at 10 percent to get an estimate of Berkshire's intrinsic value. My question is, is this a sound method? Is there a risk-free interest rate, such as a 30-year Treasury, which might be the more appropriate rate to use here, given the predictable nature of your consolidated income stream?"
Buffett's response: "Investment is the process of putting out money today to get more money back at some point in the future. And the question is, how far in the future, how much money, and what is the appropriate discount rate to take it back to the present day and determine how much you pay? ... And I would say you've stated the approach — I couldn't state it better myself. The exact figures you want to use, whether you want to use 15 percent gains in earnings or 10 percent gains in the second decade, I would — you know, I have no comment on those particular numbers. But you have the right approach."
Buffett stressed again that getting to an intrinsic value that an investor can be comfortable with doesn't ever mean paying that price.
"Now, that doesn't mean we would pay that figure once we use that discount number. But we would use that to establish comparability across investment alternatives. So, if we were looking at 50 companies and making the sort of calculation that you just talked about, we would use a — we would probably use the long-term government rate to discount it back. But we wouldn't pay that number after we discounted it back. We would look for appropriate discounts from that figure. But it doesn't really make any difference whether you use a higher figure and then look across them or use our figure and look for the biggest discount. You've got the right approach. And then all you have to do is stick in the right numbers."
Easier said than done.

The pros and cons of building your own valuation model

Tim Vipond, CEO of the Corporate Finance Institute (CFI), said in an email to CNBC that there are three primary models of valuation it teaches. There is the cost model, which is predicated on the cost to build a business or its replacement cost. Then there are the more common approaches for valuing corporations, which are the relative value and intrinsic value models. Relative value relies on public company comparables and transactions that set a precedent in the market. In order to perform an intrinsic valuation analysis, an investor needs to build a discounted cash flow (DCF) model.
Start by thinking of how you would build a DCF model for a bond. "It would be relatively straightforward. ... You know the timing of when all the cash flows (interest and principle) will be paid, and you know exactly how much they will be (assuming the company doesn't default)," Vipond explained.
That's not the case for equities. "To build a DCF model for an equity investment is the same concept, however, it is much more complicated to estimate how much cash flow there will be for equity investors. How much will revenue grow? What will the expenses be? How much capital investment is required? etc. etc."
CFI does not provide investment advice and would not instruct an investor to give up, or go ahead, with building their own intrinsic value model. But Vipond did offer a note of caution as to a disadvantage most investors might face: "To build a 'good' model may require access to management, the CEO, CFO (interviews, essentially, which institutional investors like Warren Buffett can do, but retail investors cannot."
On the plus side, it also requires access to materials that many investors can get: equity research reports, lots of reading over 10-Ks and other company filings.
Buffett reads voraciously about companies, as many as 500 pages a week during his career, and reading is what he once told Columbia University students — including current Berkshire stock-picker Todd Combs — was his "secret."
From his earliest days as a student investor with Moody's securities manuals, through his married, family life when he would hole up in a home office at night, to his current octogenarian stock-picking, his life has been consumed by that practice.
"Read everything you can," he told shareholders in 2007, and be prepared to feel lucky if only 1 percent of it leads to a great investment idea.
An investor would be wise to start by reading a lot more about intrinsic value, as this barely scratches the surface. Or, if it all seems like too much, stick with an index fund.
For more of Buffett's views, consult CNBC's Warren Buffett Archive , the world's largest collection of Buffett speaking about business, investing, money and life.