5. Innumeracy
People have difficulty with numbers.
Trouble with numbers is reflected in the folowing:
People confuse between "nominal" changes (greater or lesser numbers of actual dollars) and "real" changes (greater or lesser purchasing power). Economists call this "money illusion".
People have difficulty in figuring out the "true" probabilities. Put differently, the odds are that they don't know what the odds are. To illustrate this point, consider an example. In a lottery in which six numbers are selected out of fifty, what are the chances that the six numbers will be 1, 2, 3, 4, 5, and 6? Most people think that such an outcome is virtually impossible. The reality, of course, is that the probabiliy of selecting 1 through 6 is the same as the probability of selecting any six numbers.
People tend to pay more attention to big numbers and give less weight to small figures.
People estimate the likelihood of an event on the basis of how vivid the past examples are and not on the basis of how frequently the event has actually occurred.
People tend to ignore the "base rate" which represents the normal experience and go more by the "case rate", which reflects the most recent experience.
Monday 8 September 2008
Heuristic-driven biases: 4. Aversion to Ambiguity
4. Aversion to Ambiguity
People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes.
In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.
In the world of investments, aversion to ambiguity means that investors are wary of stocks that they feel they don't understand. On the flip side it means that investors have a preference for the familiar.
This is manifested in home country bias (investors prefer stocks of their country), local company bias (investors prefer stocks of their local area), and own company bias (employees of a company have a preference for their own company's stock).
People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes.
In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.
In the world of investments, aversion to ambiguity means that investors are wary of stocks that they feel they don't understand. On the flip side it means that investors have a preference for the familiar.
This is manifested in home country bias (investors prefer stocks of their country), local company bias (investors prefer stocks of their local area), and own company bias (employees of a company have a preference for their own company's stock).
Heuristic-driven biases: 3. Anchoring
3. Anchoring
After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.
Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the compny is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism.
Anchoring manifests itself in a phenomenon called the "post-earnings announcement drift," which is well-documented empirically.
Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.
After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.
Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the compny is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism.
Anchoring manifests itself in a phenomenon called the "post-earnings announcement drift," which is well-documented empirically.
Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.
Heuristic-driven biases: 2. Overconfidence
2. Overconfidence
People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.
The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations.
Overconfidence is particularly seductive when people have special information or experience - no matter how insignificant - that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.
Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous, create a illusion of control.
Is overconfidence not likely to get corrected in the wake of failures? It does not happen as much as it should. Why?
People perhaps remain overconfident, despite failures, because they remember their successes and forget their failures.
Harvard psychologist Langer describes this phenomenon as "head I win, tail it's chance". Referred to as self-attribution bias, it means that people tend to ascribe their success to their skill and their failure to bad luck. Another reason for persistent overconfidence and optimism is the human tendency to focus on future plans rather than on past experience.
Overconfidence manifests itself in excessive trading in financial markets. It also explains the dominance of active portfolio management, despite the disappointing performance of many actively managed funds.
People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.
The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations.
Overconfidence is particularly seductive when people have special information or experience - no matter how insignificant - that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.
Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous, create a illusion of control.
Is overconfidence not likely to get corrected in the wake of failures? It does not happen as much as it should. Why?
People perhaps remain overconfident, despite failures, because they remember their successes and forget their failures.
Harvard psychologist Langer describes this phenomenon as "head I win, tail it's chance". Referred to as self-attribution bias, it means that people tend to ascribe their success to their skill and their failure to bad luck. Another reason for persistent overconfidence and optimism is the human tendency to focus on future plans rather than on past experience.
Overconfidence manifests itself in excessive trading in financial markets. It also explains the dominance of active portfolio management, despite the disappointing performance of many actively managed funds.
Heuristic-driven biases: 1. Representativeness
1. Representativeness
Representativeness refers to the tendency to form judgements based on stereotypes.
For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray.
For example: Investors may be too quick to detect patterns in data that are in fact random.
Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realise that there is a lot of randomness in earnings growth rates.
Investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance.
Investors may become overly optimistic about past winners and overly pessimistic about past losers.
Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.
Representativeness refers to the tendency to form judgements based on stereotypes.
For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray.
For example: Investors may be too quick to detect patterns in data that are in fact random.
Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realise that there is a lot of randomness in earnings growth rates.
Investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance.
Investors may become overly optimistic about past winners and overly pessimistic about past losers.
Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.
Tuesday 2 September 2008
Behavioural Finance: Heuristic-Driven Biases
The important heuristic-driven biases and cogniive errors that impair judgement are:
- Representativeness
- Overconfidence
- Anchoring
- Aversion to ambiguity
- Innumeracy
1. Representativeness
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases.html
Representativeness refers to the tendency to form judgements based on stereotypes. For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school
2. Overconfidence
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-2.html
People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.
3. Anchoring
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-3-anchoring.html
After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.
4. Aversion to Ambiguity
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-4-aversion-to.html
People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.
5. Innumeracy
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-5-innumeracy.html
People have difficulty with numbers.
Strategies for Overcoming Psychological Biases
The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making. Here are some strategies for overcoming the psychological biases:
1. Understanding the Biases.
Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, "We have met the enemy - and it's us". So, understand your biases (the enemy within) as this is an important step in avoiding them.
2. Focus on the Big Picture.
Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.
3. Follow a Set of Quantitative Investment Criteria.
It is helpful to use a set of quantitative criteria such as
4. Diversify
If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.
5. Control Your Investment Environment
If you are on a diet, you should not have tempting sweets and savouries on your dining table. Likewise, if you want to discipline your investment activity, you should regulate or control your investment environment. Here are some ways of doing so:
1. Understanding the Biases.
Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, "We have met the enemy - and it's us". So, understand your biases (the enemy within) as this is an important step in avoiding them.
2. Focus on the Big Picture.
Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.
3. Follow a Set of Quantitative Investment Criteria.
It is helpful to use a set of quantitative criteria such as
- the price-earnings ratio being not more than 15,
- the price to book ratio not more than 5,
- the growth rate of earnings being at least 12%, and so on.
4. Diversify
If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.
5. Control Your Investment Environment
If you are on a diet, you should not have tempting sweets and savouries on your dining table. Likewise, if you want to discipline your investment activity, you should regulate or control your investment environment. Here are some ways of doing so:
- Check your stocks only once every month.
- Trade only once every month and preferably on the same day of the month.
- Review your portfolio once or twice a year.
6. Strive to Earn Market Returns
Seek to earn returns in line with what the market offers. If you strive to outperform the market, you are likely to succumb to psychological biases.
7. Review Your Biases Periodically
Once in a year, review your psychological biases. This will throw up pointers to contain such biases in the future.
Behavioural finance - The Irrational Influences
From the mid-1950s, the field of finance has been dominated by the traditional finance model (also referred to as the standard finance model) developed primarily by the economists of the University of Chicago. The central assumption of the traditional finance model is that people are rational.
However, psychologists challenged this assumption. They argued that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.
The finance field was reluctant to accept the view of psychologists who proposed the behavioural finance model. As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioural finance has received greater acceptance.
Although there is diagreement about when, how, and why psychology influences investment decisions, the award of 2002 Nobel Prize in Economics to psychologist Daniel Kahneman and experimental economist Vernon Smith is seen by many as a vindication of the field of behavioural finance.
Key differences
The key differences between "traditional finance" and "behavioural finance" are as follows:
However, psychologists challenged this assumption. They argued that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.
The finance field was reluctant to accept the view of psychologists who proposed the behavioural finance model. As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioural finance has received greater acceptance.
Although there is diagreement about when, how, and why psychology influences investment decisions, the award of 2002 Nobel Prize in Economics to psychologist Daniel Kahneman and experimental economist Vernon Smith is seen by many as a vindication of the field of behavioural finance.
Key differences
The key differences between "traditional finance" and "behavioural finance" are as follows:
1. Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioural finance recognises that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their beliefs and predisposes them to commit errors.
2. Traditional finance presupposes that people view all decisions throgh the transparent and objective lens of risk and return. Put differently, the form (or frame) used to describe a problem is inconsequential. In contrast, behavioural finance postulates that perceptions of risk and return are significantly influence by how decision problems are framed. In other words, behavioural finance assumes frame dependence.
3. Traditional finance assumes that people are guided by reason and logic and independent judgment. Behavioural finance, on the other hand, recognises that emotions and herd instincts play an important role in influencing decisions.
4. Traditional finance argues that markets are efficient, implying that the price of each security is an unbiased estimate of its intrinsic value. In contrast, behavioural finance contends that heuristic-driven biases and errors, frame dependence, and effects of emotions and social influence often lead to discrepancy between market price and fundamental value, thus market inefficiencies.
Types of Risk (Total risk = Unique risk + Market risk)
Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows:
Total risk = Unique risk + Market risk
Unique risk (Diversifiable risk or Unsystematic risk)
The unique risk of security represents that portion of its total risk which stems from firm-specific factors like
Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.
Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.
Market risk (Non-diversifiable risk or Systematic risk)
The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like
Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.
Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.
Total risk = Unique risk + Market risk
Unique risk (Diversifiable risk or Unsystematic risk)
The unique risk of security represents that portion of its total risk which stems from firm-specific factors like
- the development of a new product,
- a labour strike, or
- the emergence of a new competitor.
Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.
Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.
Market risk (Non-diversifiable risk or Systematic risk)
The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like
- the growth rate of GDP,
- the level of government spending,
- money supply,
- interest rate structure, and
- inflation rate.
Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.
Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.
Market Risk
Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate.
While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors.
There are periods when the investors become bullish and their investment horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares.
On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavourable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares regiter decline as fear and uncertainty pervade the market.
The market tends to move in cycles. As John Train says:
"You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later."
The cycles are caused by mass psychology. As John Train explains:
"The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic."
One would expect large scale participation of institutions to dampen the price fluctuations in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of ths kind has happened.
On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.
Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality than the general investing public and have succumbed in equal measure to the temptation to speculate.
As John Maynard Keynes had argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals supposedly possessing better judgment and knowledge compete in the market place.
Why? According to Keynes, even these peope are concerned with speculation (the activity of forecasting the psychology of the market) and not enterprise (the activity of forecasting the prospective yield of assets over their whole life).
While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors.
There are periods when the investors become bullish and their investment horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares.
On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavourable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares regiter decline as fear and uncertainty pervade the market.
The market tends to move in cycles. As John Train says:
"You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later."
The cycles are caused by mass psychology. As John Train explains:
"The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic."
One would expect large scale participation of institutions to dampen the price fluctuations in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of ths kind has happened.
On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.
Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality than the general investing public and have succumbed in equal measure to the temptation to speculate.
As John Maynard Keynes had argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals supposedly possessing better judgment and knowledge compete in the market place.
Why? According to Keynes, even these peope are concerned with speculation (the activity of forecasting the psychology of the market) and not enterprise (the activity of forecasting the prospective yield of assets over their whole life).
Interest Rate Risk
The changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up, the market price of existing fixed income securities falls, and vice versa.
This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security.
For example, a debenture that has a face value of MR 100 and a fixed rate of 12% will sell at a discount if the interest rate moves up from, say, 1% to 14%.
While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly.
The changes in the relative yields of debentures and equity shares influence equity prices.
This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security.
For example, a debenture that has a face value of MR 100 and a fixed rate of 12% will sell at a discount if the interest rate moves up from, say, 1% to 14%.
While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly.
The changes in the relative yields of debentures and equity shares influence equity prices.
Business risk
As a holder of corporate securities (equity shares or debentures), you are exposed to the risk of poor business performance.
This may be caused by a variety of factors like
Often, of course, the principal factor may be inept and incompetent management.
The poor business performance definitely affects the interest of equity shareholders, who have a residual claim on the income and wealth of the firm.
It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In such a case, debenture holders face the prospect of default risk.
This may be caused by a variety of factors like
- heightened competition,
- emergence of new technologies,
- development of substitute products,
- shifts in consumer preferences,
- inadequate supply of essential inputs,
- changes in government policies and so on.
Often, of course, the principal factor may be inept and incompetent management.
The poor business performance definitely affects the interest of equity shareholders, who have a residual claim on the income and wealth of the firm.
It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In such a case, debenture holders face the prospect of default risk.
Risk
You cannot talk about investment returns without talking about risk because investment decisions invariably involve a trade-off between the two.
Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.
More specifically, most investors are concerned about the actual outcome being less than the expected outcome.
The wider the range of possible outcomes, the greater the risk.
Sources of Risk
Risk emanates from several sources. The three major ones are:
Types of Risk
Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows:
Total risk = Unique risk + Market risk
http://myinvestingnotes.blogspot.com/2008/09/types-of-risk-total-risk-unique-risk.html
Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.
More specifically, most investors are concerned about the actual outcome being less than the expected outcome.
The wider the range of possible outcomes, the greater the risk.
Sources of Risk
Risk emanates from several sources. The three major ones are:
1. business risk,
http://myinvestingnotes.blogspot.com/2008/09/business-risk.html
2. interest rate risk, and
http://myinvestingnotes.blogspot.com/2008/09/interest-rate-risk.html
3. market risk.
http://myinvestingnotes.blogspot.com/2008/09/market-risk.html
Types of Risk
Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows:
Total risk = Unique risk + Market risk
http://myinvestingnotes.blogspot.com/2008/09/types-of-risk-total-risk-unique-risk.html
Return
Return is the primary motivating force that drives nvestment. It represents the reward for undertaking investment. Since the game of investing is about returns (after allowing for risk), measurement of realised (historical) returns is necessary to assess how well the investment manager has done. In addition, historical returns are often used as an important input in estimating future (prospective) returns.
The Components of Return
The return of an investment consists of two components.
Current Return: The first component that often comes to mind when one is thinking about return is the periodic cash flow (income), such as dividend or interest, generated by the investment. Current return is measured as the periodic income in relation to the beginnin price of the investment.
Capital Return: The second component of return is reflected in the price change called the capital return - it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return predominates.
Thus, the total return for any security (or for that matter any asset) is defined as:
Total Return = Current Return + Capital Return
The current return can be zero or positive, whereas the capital return can be negaive, zero, or positive.
The Components of Return
The return of an investment consists of two components.
Current Return: The first component that often comes to mind when one is thinking about return is the periodic cash flow (income), such as dividend or interest, generated by the investment. Current return is measured as the periodic income in relation to the beginnin price of the investment.
Capital Return: The second component of return is reflected in the price change called the capital return - it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return predominates.
Thus, the total return for any security (or for that matter any asset) is defined as:
Total Return = Current Return + Capital Return
The current return can be zero or positive, whereas the capital return can be negaive, zero, or positive.
Risk and Return - Two Sides of the Investment Coin
Investment decisions are influenced by various motives.
Some people invest in a business to acquire control and enjoy the prestige associated with it.
Some people invest in expensive yatchs and famous villas to display their wealth.
Most investors, however, are largely guided by the pecuniary motive of earning a return on their investment.
For earning returns investors have to almost invariably bear some risk.
In general, risk and return go hand in hand.
While investors like returns they abhor risk.
Investment decisions, therefore, involve a tradeoff between risk and return.
Since risk and return are central to investment decisions, we must understand what risk and return are and how they should be measured.
Monday 1 September 2008
Estimation of Intrinsic Value
The procedure commonly employed by investment analysts to estimate the intrinsic vlaue of a share consists of the following steps:
1. Estimate the expected earnings per share
http://myinvestingnotes.blogspot.com/2008/09/estimating-expected-eps-cash-flow-per.html
2. Establish a PE ratio
http://myinvestingnotes.blogspot.com/2008/09/establishing-pe-ratio.html
3. Develop a value anchor and a value range
http://myinvestingnotes.blogspot.com/2008/09/determine-value-anchor-and-value-range.html
1. Estimate the expected earnings per share
http://myinvestingnotes.blogspot.com/2008/09/estimating-expected-eps-cash-flow-per.html
2. Establish a PE ratio
http://myinvestingnotes.blogspot.com/2008/09/establishing-pe-ratio.html
3. Develop a value anchor and a value range
http://myinvestingnotes.blogspot.com/2008/09/determine-value-anchor-and-value-range.html
Determine a Value Anchor and a Value Range
1. Determine a Value Anchor
The value anchor is obtained as follows:
= Projected EPS x Appropriate PE ratio
In our illustration, the projected EPS is 5.00 and the appropriate PE multiple is 6.87. Hence the valu anchor is 34.35. However, as valuation is inherently an uncertain and imprecise exercise, it would be naive to put great faith in a single point intrinsic value estimate. Practical wisdom calls for defining an intrinsic value range around the single point estimate.
2. Determine a Value Range
For example, in the above illustration, where an intrinsic value estimate of 34.35 has been arrived at, it may be more sensible to talk of an intrinsic value range of say 30 to 38. When you define a range like this, you are essentially saying that a "there may be a bias and error in my estimate. In view of this, feel that the value range is 30 to 38." Given this value range, your decision rule may be as follows:
Market Price*** (Decision)
< 30***********(Buy)
30 to 28********(Hold)
>38************(Sell)
The value anchor is obtained as follows:
= Projected EPS x Appropriate PE ratio
In our illustration, the projected EPS is 5.00 and the appropriate PE multiple is 6.87. Hence the valu anchor is 34.35. However, as valuation is inherently an uncertain and imprecise exercise, it would be naive to put great faith in a single point intrinsic value estimate. Practical wisdom calls for defining an intrinsic value range around the single point estimate.
2. Determine a Value Range
For example, in the above illustration, where an intrinsic value estimate of 34.35 has been arrived at, it may be more sensible to talk of an intrinsic value range of say 30 to 38. When you define a range like this, you are essentially saying that a "there may be a bias and error in my estimate. In view of this, feel that the value range is 30 to 38." Given this value range, your decision rule may be as follows:
Market Price*** (Decision)
< 30***********(Buy)
30 to 28********(Hold)
>38************(Sell)
Estimating the Expected EPS & Cash Flow per Share
1. Estimating the Expected EPS
Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.
As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:
20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
202***216
Operating expenses
74***81***Increase by 9.5%
Depreciation
30***34
S&GA expenses
44***47
Operating profit
128***135
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
130***137
Interest
25***24***Decrease by 4%
Profit before tax
105***113
Tax
35***38***Increase by 8.57%
Profit after tax
70***75
Number of equity shares
15 m *** 15 m
EPS
4.67***5.00
Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.
As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.
It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.
2. Estimating the Cash Flow per Share
In addition to the EPS, the cash flow per share which is defined as:
= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares
is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).
Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.
As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:
20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
202***216
Operating expenses
74***81***Increase by 9.5%
Depreciation
30***34
S&GA expenses
44***47
Operating profit
128***135
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
130***137
Interest
25***24***Decrease by 4%
Profit before tax
105***113
Tax
35***38***Increase by 8.57%
Profit after tax
70***75
Number of equity shares
15 m *** 15 m
EPS
4.67***5.00
Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.
As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.
It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.
2. Estimating the Cash Flow per Share
In addition to the EPS, the cash flow per share which is defined as:
= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares
is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).
Establishing a PE Ratio
The PE ratio maybe derived from the
Constant Growth Dividend Model.
We derive the PE ratio for a constant growth firm from the constant growth dividend discount model.
PE Ratio
= Dividend payout ratio/ (Required return on equity - Expected growth rate in dividends)
Dividend Payout Ratio: Most companies treat their dividend commitment seriously. Consequently, once dividends are set at a certain level, they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear that a higher level of dividends can be sustained. Thanks to these policies, dividends adjust with a lag to earnings.
If the dividend payout ratio increases the above ratio increases, which has a favourable effect ont he price-earnings multiple. However, an increasein the dividend payout ratio has the effect of lowering the expected growth rate of dividends int he denomination of the above ratio which leads to a decrease in the price-earnings multiple. On the whole, in most cases, these two effects are likely to balance out.
Required Return on Equity: The required return on equity is a function of the risk-free rate of return and a risk premium. According to the capital asset pricing model, a popularly used risk-return model, the rquired return on equity is:
= Risk-free return + (Beta of equity) ( Expected market risk premium)
Expected Growth Rate in Dividends: The third variable influencing the PE ratio is the expected growth rate in dividends. The expected growth rate in dividends is equal to:
= Retention ratio x Return on Equity.
Cross-Section Analysis
You can look at the PE ratios of similar firms in the industry and take a view on what is a reasonable PE ratio for the subject company.
Alternatively, you can conduct cross-section regression analysis wherein the PE ratio is regressed on several fundamental variables. Here is an illustrative specification:
PE ratio
= a1 + a2 Growth rate in earnings + a2 Dividend payout ratio + a3 Variability of earnings + a4 Company size.
Based on the estimated coefficients of such cross-section regression analysis, the PE ratio for the subject firm may be derived.
Historical Analysis.
You can look at the historical PE ratio of the subject company and take a view on what is a reasonable PE ratio, taking into account the changes in the capital market and the evolving competition.
As an illustration, the prospective PE ratio for Horizon Limited for the past three years was
PE Ratio 20x5 9.25, 20x6 6.63, 20x7 6.23
The average PE ratio for Horizon Limited was: (9.25+6.63+6.23)/3 = 7.37
Considering the changing conditions in the capital market and the emerging competition for Horizon Limite you may say that the average PE for the past three years is applicable in the immediate future as well.
The Weighted PE Ratio
We arrived at two PE ratio estimates:
PE ratio based on the constant growth dividend discount model: 6.36
PE ratio based on historical analysis: 7.37
We can combine these two estimates by taking a simple arithmetic average of them - this means that both the estimates are accorded equal weight. Doing so, we get the weighted PE ratio of:
(6.36+7.37)/2 = 6.87
- constant growth dividend model, or
- cross-section analysis, or
- historical analysis.
Constant Growth Dividend Model.
We derive the PE ratio for a constant growth firm from the constant growth dividend discount model.
PE Ratio
= Dividend payout ratio/ (Required return on equity - Expected growth rate in dividends)
Dividend Payout Ratio: Most companies treat their dividend commitment seriously. Consequently, once dividends are set at a certain level, they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear that a higher level of dividends can be sustained. Thanks to these policies, dividends adjust with a lag to earnings.
If the dividend payout ratio increases the above ratio increases, which has a favourable effect ont he price-earnings multiple. However, an increasein the dividend payout ratio has the effect of lowering the expected growth rate of dividends int he denomination of the above ratio which leads to a decrease in the price-earnings multiple. On the whole, in most cases, these two effects are likely to balance out.
Required Return on Equity: The required return on equity is a function of the risk-free rate of return and a risk premium. According to the capital asset pricing model, a popularly used risk-return model, the rquired return on equity is:
= Risk-free return + (Beta of equity) ( Expected market risk premium)
Expected Growth Rate in Dividends: The third variable influencing the PE ratio is the expected growth rate in dividends. The expected growth rate in dividends is equal to:
= Retention ratio x Return on Equity.
Cross-Section Analysis
You can look at the PE ratios of similar firms in the industry and take a view on what is a reasonable PE ratio for the subject company.
Alternatively, you can conduct cross-section regression analysis wherein the PE ratio is regressed on several fundamental variables. Here is an illustrative specification:
PE ratio
= a1 + a2 Growth rate in earnings + a2 Dividend payout ratio + a3 Variability of earnings + a4 Company size.
Based on the estimated coefficients of such cross-section regression analysis, the PE ratio for the subject firm may be derived.
Historical Analysis.
You can look at the historical PE ratio of the subject company and take a view on what is a reasonable PE ratio, taking into account the changes in the capital market and the evolving competition.
As an illustration, the prospective PE ratio for Horizon Limited for the past three years was
PE Ratio 20x5 9.25, 20x6 6.63, 20x7 6.23
The average PE ratio for Horizon Limited was: (9.25+6.63+6.23)/3 = 7.37
Considering the changing conditions in the capital market and the emerging competition for Horizon Limite you may say that the average PE for the past three years is applicable in the immediate future as well.
The Weighted PE Ratio
We arrived at two PE ratio estimates:
PE ratio based on the constant growth dividend discount model: 6.36
PE ratio based on historical analysis: 7.37
We can combine these two estimates by taking a simple arithmetic average of them - this means that both the estimates are accorded equal weight. Doing so, we get the weighted PE ratio of:
(6.36+7.37)/2 = 6.87
Different PE ratios
Estimated EPS is based on a number of assumptions about the behaviour of revenues and costs. The reliability of the EPS forecast hinges critically on how realistic are these assumptions.
The other half of the valuation exercise is concerned with the price-earnings ratio which reflects the price investors are willing to pay per cents of EPS. In essence, it represens the market's summary evaluation of a company's prospects
Note that different PE ratios can be calculated for the same stock at any given point in time:
PE ratio based on last year's reported earnings
PE ratio based on trailing 12 months earnings
PE ratio based on current year's expected earnings
PE ratio based on the following year's expected earnings
An example may be given to illustrate the different PE ratios. The equity stock of ABC Limited is trading on August 1, 20x5 for MR 120 and the following EPS data is available:
EPS for last year (April 1, 20x4 - March 31, 20x5): 8 sen
EPS for trailing 12 months (July1, 20x4 - June 30, 20x5): 8.5 sen
EPS expected for the current year (April 1, 20x5 - March 31, 20x6): 9 sen
EPS expected for the following year (April 1, 20x6 -March 31, 20x7): 10 sen
The different PE ratios are as follows:
PE ratio based o last year's reported earnings: 120/8 = 15.0
PE ratio based on trailing 12 months earnings: 120/8.5 = 14.1
PE ratio based on current year's expected earnings: 120/9.0 = 13.3
PE ratio based on the folowing year's expected earnings: 120/10.0 = 12.0
We will generally use the PE ratio based on current year's expected earnings.
The other half of the valuation exercise is concerned with the price-earnings ratio which reflects the price investors are willing to pay per cents of EPS. In essence, it represens the market's summary evaluation of a company's prospects
Note that different PE ratios can be calculated for the same stock at any given point in time:
PE ratio based on last year's reported earnings
PE ratio based on trailing 12 months earnings
PE ratio based on current year's expected earnings
PE ratio based on the following year's expected earnings
An example may be given to illustrate the different PE ratios. The equity stock of ABC Limited is trading on August 1, 20x5 for MR 120 and the following EPS data is available:
EPS for last year (April 1, 20x4 - March 31, 20x5): 8 sen
EPS for trailing 12 months (July1, 20x4 - June 30, 20x5): 8.5 sen
EPS expected for the current year (April 1, 20x5 - March 31, 20x6): 9 sen
EPS expected for the following year (April 1, 20x6 -March 31, 20x7): 10 sen
The different PE ratios are as follows:
PE ratio based o last year's reported earnings: 120/8 = 15.0
PE ratio based on trailing 12 months earnings: 120/8.5 = 14.1
PE ratio based on current year's expected earnings: 120/9.0 = 13.3
PE ratio based on the folowing year's expected earnings: 120/10.0 = 12.0
We will generally use the PE ratio based on current year's expected earnings.
Peter Lynch's Classification of Companies
There are different ways of classifying shares. Here is Peter Lynch's classification of companies (and by derivation, shares).
Slow growers: Large and ageing companies that are expected to grow slightly faster than the gross national product.
Stalwarts: Giant companies that are faster than slow growers but are not agile climbers.
Fast growers: Small, aggressive new enterprises that grow at 10 to 25% a year.
Cyclicals: Companies whose sales and profit rise and fall in a regular, though not completely predicatable fashion.
Turnarounds: Companies which are steeped in accumuated losses but which show signs of recovery. Turnaround companies have the potential to make up lose ground quickly.
Slow growers: Large and ageing companies that are expected to grow slightly faster than the gross national product.
Stalwarts: Giant companies that are faster than slow growers but are not agile climbers.
Fast growers: Small, aggressive new enterprises that grow at 10 to 25% a year.
Cyclicals: Companies whose sales and profit rise and fall in a regular, though not completely predicatable fashion.
Turnarounds: Companies which are steeped in accumuated losses but which show signs of recovery. Turnaround companies have the potential to make up lose ground quickly.
Stock Market Classification of Equity Shares
Stock market classification of Equity Shares
Blue chip shares: Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.
Growth shares: Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.
Income shares: Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.
Cyclical shares: Shares of companies that have a pronounced cyclicality in their operations.
Defensive shares: Shares of companies that are relatively unaffected by the ups and downs in general business conditions.
Speculative shares: Shares that tend to fluctute wdely because there is a lot of speculative trading in them.
Note that the above classification is only indicative. It should not be regarded as rigid and straightjacketed. Often you can't pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.
Blue chip shares: Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.
Growth shares: Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.
Income shares: Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.
Cyclical shares: Shares of companies that have a pronounced cyclicality in their operations.
Defensive shares: Shares of companies that are relatively unaffected by the ups and downs in general business conditions.
Speculative shares: Shares that tend to fluctute wdely because there is a lot of speculative trading in them.
Note that the above classification is only indicative. It should not be regarded as rigid and straightjacketed. Often you can't pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.
The smart way to get rich
http://articles.moneycentral.msn.com/Investing/StockInvestingTrading/TheSmartWayToGetRich.aspx
The smart way to get rich
To get big rewards, you'll need to take some risks. What's important is knowing -- based on your needs, your time frame and other factors -- just how much danger you can handle.
By Annie Logue, MSN Money
Feel like taking a risk in hopes of hitting the jackpot on a rocket stock?
Before you make the leap, you might want to get a grip on risk.
Risk is great . . . when you make money
Prices go up, prices go down, and you never know which way they're headed next. A lot of folks would say, well, that's risk. But really that's only half the picture. The other half is what you do in response.
"Nothing goes up forever"
After all, there's nothing wrong with risk itself. What's important is how you handle it. To know how to manage the risk-reward equation, you're first going to have to get a grip on what you're playing with -- and how much you can afford to lose.
Graphic: How risky is it?
It's pretty hard to talk about investment risk without falling into a lot of clichés about roller coasters and bungee jumping and being able to sleep at night. That imagery is entertaining but maybe not terribly helpful. Instead, let's start with the basics. We don't want to lose money, right?
"Obviously, negative return is risk," says Lee Schultheis, the CEO and chief investment strategist at AIP Mutual Funds in White Plains, N.Y.
Pros such as Schultheis use some pretty powerful computer-driven tools in their analysis of risk. Here are just a few of the concepts that are important to them:
Standard deviation, much beloved of finance professors, measures how much the results of a process tend to vary. The higher the standard deviation, the more unpredictable the results.
Correlation, used by those managing diversified portfolios, tells you how much two assets move together to reinforce -- or offset -- performance.
Value at risk, often used by hedge funds, measures the likelihood that you will lose all of your money in any time period.
All three are mathematical concepts and require some comfort with statistics to calculate -- but not to understand. Each translates the uncertainties of risk into mathematical estimates of likelihood that offer a good basis for planning.
Math won't help everything
If you have an investment with a high standard deviation, close correlation to other investments or a high value at risk, you're taking on significantly more risk. If more than one of those factors is involved, watch out.
Let's say you're thinking about doubling up an investment in technology stocks. Results in that sector are going to be erratic to begin with. But because the new investment correlates positively with stuff you already own, the risk to you is much greater.
Normally, riskier investments hold the promise of greater returns over the long run. But that may not help you sleep at night.
What are acceptable losses?
Professionals will use concepts like standard deviation and correlation to balance risks in ways that can get pretty complicated. The average investor isn't equipped for that sort of thing. Fortunately, there are approaches that are a lot simpler to manage while still offering an approach that is fundamentally sound.
Edward Gjertsen, a certified financial planner with Mack Investment Securities in Glenview, Ill., encourages his clients to think about risk in a more personal way. He tries to focus their attention on their own fundamental needs.
How safe is your job?
He offers clients what he calls his seven-day cash challenge. Clients are asked to withdraw as much cash as they think they will need for all of their expenses -- coffee, groceries, whatever -- during one week. Then he asks them to report back on when the money runs out.
Very few folks make it through all seven days without a trip to the ATM.
"The ones who do it find it's eye-opening," Gjertsen says.
That's because most of us have a lot of expenses that we don't think about: birthday presents, a manicure before a party, prescription refills and the like.
"Every time somebody swipes a card, somebody's making money somewhere," Gjertsen says. "You don't necessarily realize this money is whipping through your hands."
The cash challenge helps Gjertsen's clients understand where they should draw the line on risk. Most of us do not want to gamble away the money we need to pay basic expenses and buy an occasional birthday present. But if we can take care of our basic needs, plan for college for the kids and fund a reasonable retirement, say, and still have a bit of money left over, that's different. There, maybe a bit of additional risk makes sense.
"Your portfolio should reflect whatever your underlying risk preferences are," says Leo Harmon, a senior director at Fiduciary Management Associates in Chicago.
To handle risk intelligently, you first need to make sure you can afford it. Then make sure it fits well into our overall investment strategy. Diversify. Don't bet the farm on a single sector. And recognize that it's not just how much money you'll need, it's when you'll need it.
For instance: A technology sector that sees a lot of ups and downs may be the worst possible investment for an individual who is planning to retire next year. But for the person with a 10- or 20-year time horizon, the same sector might make a lot of sense.
In the right situation, the addition of some well-managed risk makes sense and should have a positive effect on a portfolio. To profit from additional risk, though, you have to be comfortable enough to ride out the short-term fluctuations. Be prepared for some volatility, and understand that the ups and downs tend to get more extreme as the risks go up.
How competing economies help you
Meanwhile: Bear in mind that all investments carry risks of one sort or another. Just because a security has low volatility doesn't mean that there's no potential for loss. A steady loser is a lot worse than an investment that goes down a lot but then goes up by even more.
"It might not feel bad along the way because it only goes down a little bit at a time," AIP Mutual Funds' Schultheis says of the steady losers. In the end, though, a loss is still a loss.
If you think it through, risk can work in your favor. And you can still sleep at night.
Published April 11, 2008
The smart way to get rich
To get big rewards, you'll need to take some risks. What's important is knowing -- based on your needs, your time frame and other factors -- just how much danger you can handle.
By Annie Logue, MSN Money
Feel like taking a risk in hopes of hitting the jackpot on a rocket stock?
Before you make the leap, you might want to get a grip on risk.
Risk is great . . . when you make money
Prices go up, prices go down, and you never know which way they're headed next. A lot of folks would say, well, that's risk. But really that's only half the picture. The other half is what you do in response.
"Nothing goes up forever"
After all, there's nothing wrong with risk itself. What's important is how you handle it. To know how to manage the risk-reward equation, you're first going to have to get a grip on what you're playing with -- and how much you can afford to lose.
Graphic: How risky is it?
It's pretty hard to talk about investment risk without falling into a lot of clichés about roller coasters and bungee jumping and being able to sleep at night. That imagery is entertaining but maybe not terribly helpful. Instead, let's start with the basics. We don't want to lose money, right?
"Obviously, negative return is risk," says Lee Schultheis, the CEO and chief investment strategist at AIP Mutual Funds in White Plains, N.Y.
Pros such as Schultheis use some pretty powerful computer-driven tools in their analysis of risk. Here are just a few of the concepts that are important to them:
Standard deviation, much beloved of finance professors, measures how much the results of a process tend to vary. The higher the standard deviation, the more unpredictable the results.
Correlation, used by those managing diversified portfolios, tells you how much two assets move together to reinforce -- or offset -- performance.
Value at risk, often used by hedge funds, measures the likelihood that you will lose all of your money in any time period.
All three are mathematical concepts and require some comfort with statistics to calculate -- but not to understand. Each translates the uncertainties of risk into mathematical estimates of likelihood that offer a good basis for planning.
Math won't help everything
If you have an investment with a high standard deviation, close correlation to other investments or a high value at risk, you're taking on significantly more risk. If more than one of those factors is involved, watch out.
Let's say you're thinking about doubling up an investment in technology stocks. Results in that sector are going to be erratic to begin with. But because the new investment correlates positively with stuff you already own, the risk to you is much greater.
Normally, riskier investments hold the promise of greater returns over the long run. But that may not help you sleep at night.
What are acceptable losses?
Professionals will use concepts like standard deviation and correlation to balance risks in ways that can get pretty complicated. The average investor isn't equipped for that sort of thing. Fortunately, there are approaches that are a lot simpler to manage while still offering an approach that is fundamentally sound.
Edward Gjertsen, a certified financial planner with Mack Investment Securities in Glenview, Ill., encourages his clients to think about risk in a more personal way. He tries to focus their attention on their own fundamental needs.
How safe is your job?
He offers clients what he calls his seven-day cash challenge. Clients are asked to withdraw as much cash as they think they will need for all of their expenses -- coffee, groceries, whatever -- during one week. Then he asks them to report back on when the money runs out.
Very few folks make it through all seven days without a trip to the ATM.
"The ones who do it find it's eye-opening," Gjertsen says.
That's because most of us have a lot of expenses that we don't think about: birthday presents, a manicure before a party, prescription refills and the like.
"Every time somebody swipes a card, somebody's making money somewhere," Gjertsen says. "You don't necessarily realize this money is whipping through your hands."
The cash challenge helps Gjertsen's clients understand where they should draw the line on risk. Most of us do not want to gamble away the money we need to pay basic expenses and buy an occasional birthday present. But if we can take care of our basic needs, plan for college for the kids and fund a reasonable retirement, say, and still have a bit of money left over, that's different. There, maybe a bit of additional risk makes sense.
"Your portfolio should reflect whatever your underlying risk preferences are," says Leo Harmon, a senior director at Fiduciary Management Associates in Chicago.
To handle risk intelligently, you first need to make sure you can afford it. Then make sure it fits well into our overall investment strategy. Diversify. Don't bet the farm on a single sector. And recognize that it's not just how much money you'll need, it's when you'll need it.
For instance: A technology sector that sees a lot of ups and downs may be the worst possible investment for an individual who is planning to retire next year. But for the person with a 10- or 20-year time horizon, the same sector might make a lot of sense.
In the right situation, the addition of some well-managed risk makes sense and should have a positive effect on a portfolio. To profit from additional risk, though, you have to be comfortable enough to ride out the short-term fluctuations. Be prepared for some volatility, and understand that the ups and downs tend to get more extreme as the risks go up.
How competing economies help you
Meanwhile: Bear in mind that all investments carry risks of one sort or another. Just because a security has low volatility doesn't mean that there's no potential for loss. A steady loser is a lot worse than an investment that goes down a lot but then goes up by even more.
"It might not feel bad along the way because it only goes down a little bit at a time," AIP Mutual Funds' Schultheis says of the steady losers. In the end, though, a loss is still a loss.
If you think it through, risk can work in your favor. And you can still sleep at night.
Published April 11, 2008
Investing: When to bet the farm
http://articles.moneycentral.msn.com/Investing/StockInvestingTrading/InvestingWhenToBetTheFarm.aspx#pageTopAnchor
Investing: When to bet the farm
Big payoffs often require big risks. Bet wrong, and you could lose everything. Do you have what it takes? And how do you assess whether a dicey investment is worth it?
By Annie Logue, MSN Money
You want a big return? How big a risk do you want to take to get it? Gauging the risks associated with really promising investments, and handling those risks appropriately, can change your life.
"It's never safe to take a risk, by definition," says Carl Luft, an associate professor of finance at DePaul University in Chicago.
Yet successful investors take major risks all the time. They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. How big a payoff might the investment produce? And how likely is success?
Successful investors look hard at the downside as well. What would the price of failure be? And how likely is that?
Just jump in and take a risk
And what about all the outcomes in between?
Luft emphasizes that successful investors tend to have a broad view, taking the downside into account with the upside. They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."
"An expected return is an average," Luft says. "It's the probability of all of the outcomes."
Risk assessment gets pretty sophisticated at risk-oriented hedge funds. These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. But the basics are just common sense.
Russell Lundeberg, the chief investment officer for Barrett Capital Management in Richmond, Va., spends his days researching investments both risky and safe for the wealthy families in the firm's client base. He researches basic business practices as well as the big-picture business opportunity.
"The No. 1 most overlooked aspect of hedge fund due diligence is on the operational side," he says. "The things that can be potential risks and pitfalls are not always easy to spot."
Among the not-so-obvious business risks, Lundberg mentions high employee turnover, sloppy accounting and computers that aren't backed up. A mistake in the office can wipe out an investment's potential return even in the most promising environment, Lundeberg says.
Our own personalities add complexity to high-risk situations.
Bill Gurtin of Gurtin Fixed Income Management in San Diego points out the risks associated with overly emotional reactions.
"What you don't want to happen is for people to get emotional with the market," he says.
The more emotional we get, the more likely it is we will make a mistake, Gurtin explains.
A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.
Graphic: Three ways to analyze a company (Quantitative, Qualitative and Technical Analysis)
Where risk is high, the investor needs to analyze his or her life situation.
Is financial risk really risky?
"There are times in your life when it's appropriate to take different levels of risk," Gurtin says.
Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.
"Let's say you're young, in your mid-20s," Luft says. "If you take a big risk and something goes wrong, you have time to recover." On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.
Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed.
"In investing and in life, you have to look at everything on a risk-and-reward basis," says Manny Weintraub, the president of Integre Advisors, a New York firm that manages equities for long-term growth. "Volatility is not the end of the world."
Risk lesson from the OTB
Weintraub is a good example. He left the investment firm of Neuberger Berman in 2003 to start his own firm. He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.
"Careers are actually the easiest place to take risks, as long as you don't burn your bridges," Weintraub says.
Luft suggests younger investors, particularly, should be ready to gamble with their careers. But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.
Published Aug. 28, 2008
Investing: When to bet the farm
Big payoffs often require big risks. Bet wrong, and you could lose everything. Do you have what it takes? And how do you assess whether a dicey investment is worth it?
By Annie Logue, MSN Money
You want a big return? How big a risk do you want to take to get it? Gauging the risks associated with really promising investments, and handling those risks appropriately, can change your life.
"It's never safe to take a risk, by definition," says Carl Luft, an associate professor of finance at DePaul University in Chicago.
Yet successful investors take major risks all the time. They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. How big a payoff might the investment produce? And how likely is success?
Successful investors look hard at the downside as well. What would the price of failure be? And how likely is that?
Just jump in and take a risk
And what about all the outcomes in between?
Luft emphasizes that successful investors tend to have a broad view, taking the downside into account with the upside. They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."
"An expected return is an average," Luft says. "It's the probability of all of the outcomes."
Risk assessment gets pretty sophisticated at risk-oriented hedge funds. These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. But the basics are just common sense.
Russell Lundeberg, the chief investment officer for Barrett Capital Management in Richmond, Va., spends his days researching investments both risky and safe for the wealthy families in the firm's client base. He researches basic business practices as well as the big-picture business opportunity.
"The No. 1 most overlooked aspect of hedge fund due diligence is on the operational side," he says. "The things that can be potential risks and pitfalls are not always easy to spot."
Among the not-so-obvious business risks, Lundberg mentions high employee turnover, sloppy accounting and computers that aren't backed up. A mistake in the office can wipe out an investment's potential return even in the most promising environment, Lundeberg says.
Our own personalities add complexity to high-risk situations.
Bill Gurtin of Gurtin Fixed Income Management in San Diego points out the risks associated with overly emotional reactions.
"What you don't want to happen is for people to get emotional with the market," he says.
The more emotional we get, the more likely it is we will make a mistake, Gurtin explains.
A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.
Graphic: Three ways to analyze a company (Quantitative, Qualitative and Technical Analysis)
Where risk is high, the investor needs to analyze his or her life situation.
Is financial risk really risky?
"There are times in your life when it's appropriate to take different levels of risk," Gurtin says.
Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.
"Let's say you're young, in your mid-20s," Luft says. "If you take a big risk and something goes wrong, you have time to recover." On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.
Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed.
"In investing and in life, you have to look at everything on a risk-and-reward basis," says Manny Weintraub, the president of Integre Advisors, a New York firm that manages equities for long-term growth. "Volatility is not the end of the world."
Risk lesson from the OTB
Weintraub is a good example. He left the investment firm of Neuberger Berman in 2003 to start his own firm. He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.
"Careers are actually the easiest place to take risks, as long as you don't burn your bridges," Weintraub says.
Luft suggests younger investors, particularly, should be ready to gamble with their careers. But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.
Published Aug. 28, 2008
Thursday 28 August 2008
Understanding Stock Market Return
Stock market return
= fundamental return + speculative return
= (earnings growth + dividend yield) + (change in PE ratio)
http://turtleinvestor888.blogspot.com/2008/03/is-there-such-thing-call-value_19.html
= fundamental return + speculative return
= (earnings growth + dividend yield) + (change in PE ratio)
http://turtleinvestor888.blogspot.com/2008/03/is-there-such-thing-call-value_19.html
Sunday 24 August 2008
How to analyze the market? Bank
Because the service that banks provide is so vital to long-term economic growth, the banking indutry is almost certain to grow in line with the world's total output, no matter which sector generates the greatest need for capital. Whether the demand for money comes from an industry such as technology or pharmaceuticals or consumers' incessant demand for housing, banks will benefit.
The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers,profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as noninterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.
Interest income
- Interest expense
__________________
= Net interest income
- Provisions for loan losses
+ Noninterest income
__________________
= Net revenue
The low cost of borrowing - combined with the advantae banks have on the lending side - allows banks to earn attractive returns on their spread.
That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank beter than another? Here are a few examples of wide-moat banks with different strategies:
The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers,profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as noninterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.
Interest income
- Interest expense
__________________
= Net interest income
- Provisions for loan losses
+ Noninterest income
__________________
= Net revenue
The low cost of borrowing - combined with the advantae banks have on the lending side - allows banks to earn attractive returns on their spread.
That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank beter than another? Here are a few examples of wide-moat banks with different strategies:
- Citigroup uses its worldwide geographic reach and deep product bench to increase revenues and diversify its risk exposure, which allows it to perform well in even difficult environments.
- Wells Fargo is an expert at attracting deposits which area key source of lower cost funds, and it has a deeply ingrained sales culture that drives revenues.
- Fifth Third has an aggressive sales culture, a low-risk loan philosophy, and a sharp focus on costs.
It's all about Risk.
Whether a financial institution specializes in making commercial loans or consumer loans, the heart and soul of bnking is centered on one thing: risk management. Banks accept three types of risk:
- credit,
- liquidity, and
- interest rate,
and they get paid to take on this risk. Borrowers and lenders pay banks through interest or fees bcause they are unwilling to manage the risk on ther own, or because banks can do it more cheaply.
But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan losses grow faster than expected.
Saturday 23 August 2008
How to analyze the market? Business Services
While the companies in our business services sector operate in relative obscurity, the sector deserves more attention. Here, we can find a large number of firms running wonderful, wide-moat businesses - just the kind we like to buy at the right price and hold as long-term investors.
Companies in the business services sector are as varied as the businesses they serve. After all, the group include firms such as Fiserv (financial institution data processing), Waste Management (waste hauling), Omnicom (advertising), and even United Airlines (air transportation). Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at:
Although not all companies within the industry fit perfectly into just one of these categries, it's a useful distinction to make when you're analyzing a potential investment in business services. Despite being such diverse group of businesses, a few major themes impact the majority of business services companies.
Outsourcing Trend
Business-to-business services have grown significantly, increasing as a percentage of GDP from 3.5 percent in 1990 to 5.4 percent in 2001. Fueling the growth has been the popularity of outsourcing - the practice of offloading noncore tasks to third parties.
Many business services providers have essentially created markets for themselves based on this trend. Cintas, for example, has successfully convinced companies tha it's better to pay Cintas to service employees' uniforms than to leave the responsibility to each individual employee or to handle it themselves. Other industries developed to fill needs that would be difficult or impossible for companies to handle internally. It is impractical, for example, for every mom-and-pop retailer to develop its own infrastructur to facilitate its acceptance of credit and debit card payments. Instead, companies such as First Data and National Processing allow retailers to tap into larger systems, the fixed costs of which can be leveraged across many clients.
Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the sucess of their company.
Economic Moats in Business Services.
In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume - especially over fixed-cost networks - companies can lower unit costs and achieve greater profitability.
To capitalize on this, many business services firms have attempted to acquire their way to critical mass and achieve scale economies by consolidating the operations of multiple businesses. For example, data processing firms such as Fiserv, First Data, and ADP have all made acquisitions an important part of their overall strategies.
Size impacts the industry through branding as well. Often,brands play a major role in a business outsourcing purchase decision. Companies amy be hesitant to utsource payroll processing (and the related handling of employee pay and tax funds) to Fly-By-Night Upstart, Inc., but are comfortable entrusting the responsibility to ADP, founded in 1949 and currently the biggest payroll processor. Even in business services, brands count, and it's usually the biggest companies that have the most recognizable brands.
Many industries in business services have significant barriers to entry, making it tough for new players to enter the field. For example, a company that wanted to process credit card transactions for banks and retailers would have to build a processing infrastructure to support its business, including hardware, the software development to manage the data, and a sales network to sign customers. Such a company would have to go through considerable trouble and expense just to try to compete against a company such as First Data, which already handles billions of transactions each year.
Despite the relatively high barriers to entry in th electonic transaction processing industry, their's little protection against competition from other industry participants. For example, in 2001, Concord EFS lost Bank of America's electronic funds transfer switching business to a very aggressive bid from competitor Visa. Thus, although most business services industries have wide moats, companies still need to differentiate themselves further to fend off potentially intense competition from established industry players.
Companies in the business services sector are as varied as the businesses they serve. After all, the group include firms such as Fiserv (financial institution data processing), Waste Management (waste hauling), Omnicom (advertising), and even United Airlines (air transportation). Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at:
- technology-based
- people-based, and
- hard-asset-based subsectors.
Although not all companies within the industry fit perfectly into just one of these categries, it's a useful distinction to make when you're analyzing a potential investment in business services. Despite being such diverse group of businesses, a few major themes impact the majority of business services companies.
Outsourcing Trend
Business-to-business services have grown significantly, increasing as a percentage of GDP from 3.5 percent in 1990 to 5.4 percent in 2001. Fueling the growth has been the popularity of outsourcing - the practice of offloading noncore tasks to third parties.
Many business services providers have essentially created markets for themselves based on this trend. Cintas, for example, has successfully convinced companies tha it's better to pay Cintas to service employees' uniforms than to leave the responsibility to each individual employee or to handle it themselves. Other industries developed to fill needs that would be difficult or impossible for companies to handle internally. It is impractical, for example, for every mom-and-pop retailer to develop its own infrastructur to facilitate its acceptance of credit and debit card payments. Instead, companies such as First Data and National Processing allow retailers to tap into larger systems, the fixed costs of which can be leveraged across many clients.
Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the sucess of their company.
Economic Moats in Business Services.
In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume - especially over fixed-cost networks - companies can lower unit costs and achieve greater profitability.
To capitalize on this, many business services firms have attempted to acquire their way to critical mass and achieve scale economies by consolidating the operations of multiple businesses. For example, data processing firms such as Fiserv, First Data, and ADP have all made acquisitions an important part of their overall strategies.
Size impacts the industry through branding as well. Often,brands play a major role in a business outsourcing purchase decision. Companies amy be hesitant to utsource payroll processing (and the related handling of employee pay and tax funds) to Fly-By-Night Upstart, Inc., but are comfortable entrusting the responsibility to ADP, founded in 1949 and currently the biggest payroll processor. Even in business services, brands count, and it's usually the biggest companies that have the most recognizable brands.
Many industries in business services have significant barriers to entry, making it tough for new players to enter the field. For example, a company that wanted to process credit card transactions for banks and retailers would have to build a processing infrastructure to support its business, including hardware, the software development to manage the data, and a sales network to sign customers. Such a company would have to go through considerable trouble and expense just to try to compete against a company such as First Data, which already handles billions of transactions each year.
Despite the relatively high barriers to entry in th electonic transaction processing industry, their's little protection against competition from other industry participants. For example, in 2001, Concord EFS lost Bank of America's electronic funds transfer switching business to a very aggressive bid from competitor Visa. Thus, although most business services industries have wide moats, companies still need to differentiate themselves further to fend off potentially intense competition from established industry players.
Is the Firm Cyclical?
Firms that go through boom and bust cycles - semiconductor companies and auto manufacturers are good examples - require a bit more care. Although you'd typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they're likely to fall off soon. For cyclical stocks, your best bet is to look at the most recent cyclical peak, make a judgment whether the next peak is likely to be lower or higher than the last one, and calculate a P/E based on the current price relative to what you think earnings per share will be at the next peak.
High-yield stocks more appealing now
22-08-2008: High-yield stocks more appealing now
http://www.theedgedaily.com/cms/content.jsp?id=com.tms.cms.article.Article_e5adafa1-cb73c03a-df294000-75281632#
Stock markets worldwide have been, and will probably continue to be, buffeted by a myriad of uncertainties. Questions such as the health of the US economy and troubled financial markets appear unlikely to be answered anytime soon.
Stock markets worldwide have been, and will probably continue to be, buffeted by a myriad of uncertainties. Questions such as the health of the US economy and troubled financial markets appear unlikely to be answered anytime soon.
Investor confidence is depressed with the limited visibility. The Kuala Lumpur Composite Index has fallen nearly 26% in the year-to-date. Many have sold down their equity holdings and are staying on the sidelines.
Typically, when uncertainties are high, investors lean towards more defensive and stable dividend-paying stocks. And there are a fair number of stocks that pay good dividends, offering yields that exceed bank deposit rates.
Inflationary pressures and demand slowdown will affect company earnings by varying degrees. However, there are still pockets of strength - and some of these companies are paying higher dividends, in line with their earnings growth. Good dividends, in turn, should lend support to their share prices.
CSC Steel has generous dividend policy
Steel companies, for instance, are enjoying robust earnings. CSC Steel Holdings (RM1.36) reported net profit totalling RM73.5 million in the first half of 2008 (1H08), compared with RM79.7 million for the whole of 2007. Sales and earnings are being driven by higher volume and selling prices for its flat steel products, primarily cold rolled coils (CRC).
Outlook for the steel sector remains upbeat for the next one to two years. Despite a slight weakening in prices, few expect a significant correction from prevailing levels - with costlier iron ore, coking coal and energy providing fairly firm floor support.
CSC has a policy to pay out half of annual earnings as dividends. Hence, based on our estimated earnings of 35.2 sen and 37.2 sen per share in 2008-2009, respectively, dividends should rise to about 18-19 sen per share in those two years. That will earn shareholders very attractive gross yields of 13.2%-14%.
CSC's shares are trading at only 3.9 times our estimated earnings in 2008 and well below its latest reported net tangible assets of RM1.94 per share. Such low valuations would limit the stock's downside risks. The stock will trade ex-entitlement for interim dividend of 6.5 sen per share on Aug 27.
Nestle ups dividends in 2008
Consumer companies tend to enjoy more resilient demand and steadier earnings. Hence, they tend to have stable and higher-than-market average dividend payouts. The current downtrend in commodity prices would also bode well for earnings going forward.
Despite rising raw material costs, Nestle's (RM27.25) 1H08 net profit grew nearly 24% year-on-year (y-o-y) to RM176.1 million - on the back of demand increases and stronger exports. The company paid 61.19 sen per share special dividends earlier this year and has proposed another 50 sen per share interim dividends. The entitlement date was fixed for Aug 26. Assuming total dividends of 171.2 sen per share for 2008, shareholders will earn a net yield of 6.3%.
Amway maintains steady dividends
Direct selling company Amway (RM6.85) is also doing pretty well. Net profit was about 24% higher y-o-y in 1H08 at RM42.7 million. The company has been paying dividends very consistently over the years. With minimal capital expenditure required, Amway usually distributes the bulk of earnings back to shareholders.
Dividends are expected to total 61 sen per share in 2008. That translates into gross yield of 8.9%. Its shares are also trading at fairly decent valuations of roughly 12.9 and 12.1 times our estimated earnings of 53 sen and 56.8 sen per share in 2008-2009, respectively.
Note: This report is brought to you by Asia Analytica Sdn Bhd, a licensed investment adviser. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.
Tuesday 19 August 2008
Thinking of alternative investments?
18-08-2008: Thinking of alternative investments? by Aisyah Lam
There has been a lot going on in global financial markets. With volatility likely to continue, and general consensus of a slowdown in major economies, the question most frequently asked is: Where and what should I invest in next? Given the uncertainties and increasing challenges, investors are exploring various investment options to stay ahead of the curve, and opportunities to improve long-term returns.
This article will cover some of these investment choices known as alternative investments, which complement traditional investing and have been attracting a growing interest from institutional, high net worth individuals as well as retail investors.
Alternative investments
Investments in our market comprise mainly equity, bonds and property. These are traditional investment vehicles. Over time, with innovation and increased understanding of the markets, other alternatives have started gaining popularity.
Many alternative investments with minimal correlation to traditional benchmarks have proven to be resilient in volatile markets and uncertain economic conditions. This formula has worked well supporting the investment rule of thumb — portfolio diversification — and increasing resilience against risks.
An understanding of alternative investments may be helpful in supporting more informed investment decisions, for exposures to other than just equity and bond markets.
Alternative investments include familiar products such as private equity, real estate and structured products; whilst examples of more sophisticated options include managed futures and hedge funds.
In contrast to traditional investments, alternative investments seek absolute performance and depend on advisers’ skills for performance. They may use leverage and have historically low to moderate correlation with market indices. Typically, it is not as easy to liquidate such investments as there may be fixed periods ranging from monthly to yearly, and may include possible lock-up periods. Charges may generally be higher and in the form of performance fees.
Traditional investments, on the other hand, would seek relative performance where returns depend primarily on market performance. They have historically high correlation with market indices. These forms of investments generally do not employ leverage, offer daily liquidity and charge fixed management fee on assets under management.
Why invest in alternative investments?
Alternative investments offer opportunities to qualified investors to diversify their portfolios by combining alternative strategies with traditional holdings, aimed at generating steady returns and preserving wealth through fluctuating market conditions.
Over the years, while the risk-adjusted returns in the stock and bond markets have become less, modern investment instruments such as alternative investments have helped realise consistent returns over time, as they tend to move in opposite directions to traditional strategies.
Alternative investments have helped preserve opportunities for positive returns even during times when stocks and bonds under perform.
Types of alternative investment
1. Private equity
Private equities are privately negotiated deals that are invested in mostly non-public companies that may be in different business phases or categories. This would include start-ups, companies in the development stage or expanding, a buyout situation, perhaps restructuring. Investments could be in form of venture capital (VC); leveraged buyouts (LBO); mezzanine or distressed debt.
Private equity managers could be stand-alone or fully integrated organisations that may take an active role in a target company’s management with the objective of creating value during the period of investment, and to exit profitably.
2. Real-estate investment
This is probably one of the most commonly known forms of alternative investing. Real-estate investment would have an internal rate of return objective although there is no guarantee of the return objectives being met. Leverage could range from 0-75% and the investment has low correlation with market indices.
There is less volatility compared to equities and fixed income as investments are in physical assets, though investments would be relatively illiquid. Real-estate investment could offer an advantage in the form of potential inflation hedge.
Real-estate investment can be public and debt-based like commercial mortgage-backed securities (CMSB) or public and equity-based like real-estate investment trust (REIT) stocks or real-estate mutual funds. Other forms of investment include private and debt-based like mezzanine debt or senior loans or private equity like open and closed-end funds.
Investors should note that commercial real estate can offer portfolio diversification as historically it has low correlation with other asset classes and has provided steady returns over the long term. It has proven performance versus other investments. It is different from family homes and there is risk/return trade-offs in various real-estate investments.
3. Structured products
Of late, structured products have become popular in the market as it can offer the security of principal protection with the opportunity of further income upside. Structured products can be performance-linked, leveraged/arbitrage products and principal protected.
Performance-linked products may be linked to the performance of a basket of assets such as stocks, bonds or hedge funds; or to indices like Morgan Stanley Capital International (MSCI), FTSE or S&P Indices. They are usually illiquid and have no leverage.
Principal-protected products offer capital assurance with potential upside from returns linked to performance of predetermined assets. Principal protection is only valid if the investment is held till maturity.
Leveraged/arbitrage products are investment products that generate returns based on the spread between assets and financing costs. They normally have limited liquidity, with potential for high returns, which comes with association of high risk.
Structured products can be customised to fit the unique requirements of individual investors and can offer potentially higher yields than of market norms if certain scenarios materialise. The underlying structure could be in forms of various exposures to diversified market sectors — they could be offered in one packaged security or maybe repackaged as credit-enhanced/principal-protected products to be managed actively with the aim of improving the risk/return profile of the investment.
4. Managed futures
Managed futures are essentially an alternative investment strategy that offers access to global futures market via professional money managers called commodity trading advisers (CTAs).
CTAs use trading strategies and money-management techniques to attempt to achieve profits and control risks. They trade in global markets including futures, options and forwards on traditional commodities like gold, crude oil, soybean and crude palm oil. They also trade in financial instruments such as the US Treasury Bond, British Long Gilt and NYSE Stock Index as well as currencies, which include but are not limited to the euro, Japanese yen, Czech kroner and Thai baht.
As in any other forms of investment, there are risks involved. Due to the use of leverage, a small change in market price of a futures contract can produce major gains or losses for a managed futures contract.
Nevertheless, from January 1994 till June 2008, managed futures generated an average rate of return of 7.25% compared with the S&P 500 of 8.65%, Nasdaq of 12.6%, Global Stocks of 7.49% and Global Bonds of 7.83% (Credit Suisse Tremont Hedge Fund Index LLC, Lipper as at July 2008).
Given the sophistication of this investment class, fees are higher than that of traditional funds.
5. Hedge funds
Hedge funds aim to make absolute returns regardless of market conditions. They offer greater flexibility than traditional investment managers and can go long and short on stocks. Use of derivatives and leverage is allowed and normally hedge funds impose a higher minimum investment amount. Performance fees are charged based on returns generated by the managers.
Hedge funds do have liquidity restrictions and are moderately regulated with limits on capacity.
Here are several facts about hedge funds.
i) In the early 90s, the hedge fund industry was dominated by high-risk, aggressive macro players. It has since evolved significantly in terms of AUM as well as sophistication, and in 2007, there were over 10,000 hedge funds with many more diversified strategies. Hedge funds do not apply the same investment strategies as other funds.
ii) Hedge funds are not only for bear markets as they seek low or negative correlation to traditional long-term investing.
iii) Hedge funds do not always lack transparency. Whilst skill-based investing may be less transparent than traditional investing, some hedge fund managers make transparency their selling point.
Generally, hedge funds offer opportunity to improve portfolio efficiency with enhanced returns while potentially reducing risk. It also advocates diversification with low correlation to existing asset classes and the chance to participate in investments managed by top-rated hedge fund managers, using different strategies and employing a wide range of instruments.
A fund of hedge funds is a multi-manager hedge fund that has dedicated and expert teams of managers. The assembling funds of hedge funds create a significant advantage over private investors as it offers the opportunity of exposure to a diverse set of strategies in a single investment.
Multi-manager funds have access to the best managers, who often close quickly and limit allocations to long-term clients who buy and hold. Very importantly, fund of hedge funds offers diversification, as it minimises risks by combining funds and strategies.
Minimum investments are lower than single-strategy funds, hence reducing the strain of high-value investing. Transparency is not an issue as they are able to obtain and interpret complex information, which could be a challenge to private investors.
In a fund of hedge funds, strict due-diligence processes facilitate identification of quality managers, while continuous monitoring and reviews are enforced.
Portfolio construction and readjustments of positions are made throughout the life of the portfolio. These efforts are resource intensive and could not possibly be conducted by a private investor.
It is important for investors to read, research and understand the features, liabilities and benefits offered by alternative investments such as private equity, real estate, structured funds, managed futures and hedge funds. A well-diversified portfolio, which incorporates some form of alternative investment, could help increase returns and lower portfolio volatility overall.
Aisyah Lam is the head for wealth management products, Citibank Berhad
Friday 15 August 2008
How to analyze the market? Consumer Services
Consumer Services
We generally don’t find a ton of great long-term stock ideas in retail and consumer services because most economic moats for the sector are extremely narrow, if they exist at all. The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors’. It can do this by offering unique products or low prices. The former method is tough to do on a large scale because unique products rarely remain unique forever. It’s rare to find a retailer or consumer service firm that maintains any kind of economic moat for more than a few years.
The few consumer service firms that have established a wide economic moat:
Home Depot and Lowe’s in the home improvement area
Walgreen’s for prescription drugs and convenience items
Wal-Mart for just about everything.
These firms developed distinctive store prototypes that set them apart from their competitors and they now enjoy vast economies of scale that make it rough for competitors to earn consistent profits. Identifying and investing in firms like these (at the right price) is the best way to make money over the long haul in this classic “buy what you know” area of the market. Although you can also do well buying high-quality specialty and clothing retailers when the industry sees one of its periodic sell-offs, very few of these kinds of firms make great long-term holdings.
Companies we see everyday.
Most of the companies in the consumer services sector are very familiar: We shop at their stores and eat their food just about every day. The sector contains discount stores such as Wal-Mart and Target, drugstores such as Walgreen and CCVS, clothing stores such as Gap, home improvement shops such as Home Depot and Lowe’s, restaurants such as McDonald’s and Outback Steakhouse, and scores of other well-known names. Being able to peruse the aisles of these stores, interact with employees, and sample products is a huge advantage from an investment standpoint.
The consumer services sector has seen strong growth too. Our time-starved culture, with both parents working full time in more families, demands quick and reliable service and is willing to pay for it. Grocery stores offer more ready-to-eat or quick-to-prepare meals, discount stores now almost exclusively have centralized checkouts at the front of stores, and many drugstores stay open 24 hours a day. Companies that provide the best overall service at a competitive price survive and thrive, while those that don’t fade and eventually disappear.
According to the U.S. Census Bureau, the U.S. economy increased from $6 trillion in 1991 to $10.1 trillion in 2001. During that time, consumer spending increased from 66 percent to 69 percent of the economy. Consumer service firms are becoming a bigger piece of the economy, and we expect that trend to continue. It’s not surprising that these companies have outperformed the overall market over the past decade.
Consumer staples versus consumer discretionaries.
Because many consumer purchases other than food (consumer staples) are discretionary (can be put off for later), it’s not surprising that retail stocks generally outperform during periods of economic strength and underperform during times of economic weakness.
We generally don’t find a ton of great long-term stock ideas in retail and consumer services because most economic moats for the sector are extremely narrow, if they exist at all. The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors’. It can do this by offering unique products or low prices. The former method is tough to do on a large scale because unique products rarely remain unique forever. It’s rare to find a retailer or consumer service firm that maintains any kind of economic moat for more than a few years.
The few consumer service firms that have established a wide economic moat:
Home Depot and Lowe’s in the home improvement area
Walgreen’s for prescription drugs and convenience items
Wal-Mart for just about everything.
These firms developed distinctive store prototypes that set them apart from their competitors and they now enjoy vast economies of scale that make it rough for competitors to earn consistent profits. Identifying and investing in firms like these (at the right price) is the best way to make money over the long haul in this classic “buy what you know” area of the market. Although you can also do well buying high-quality specialty and clothing retailers when the industry sees one of its periodic sell-offs, very few of these kinds of firms make great long-term holdings.
Companies we see everyday.
Most of the companies in the consumer services sector are very familiar: We shop at their stores and eat their food just about every day. The sector contains discount stores such as Wal-Mart and Target, drugstores such as Walgreen and CCVS, clothing stores such as Gap, home improvement shops such as Home Depot and Lowe’s, restaurants such as McDonald’s and Outback Steakhouse, and scores of other well-known names. Being able to peruse the aisles of these stores, interact with employees, and sample products is a huge advantage from an investment standpoint.
The consumer services sector has seen strong growth too. Our time-starved culture, with both parents working full time in more families, demands quick and reliable service and is willing to pay for it. Grocery stores offer more ready-to-eat or quick-to-prepare meals, discount stores now almost exclusively have centralized checkouts at the front of stores, and many drugstores stay open 24 hours a day. Companies that provide the best overall service at a competitive price survive and thrive, while those that don’t fade and eventually disappear.
According to the U.S. Census Bureau, the U.S. economy increased from $6 trillion in 1991 to $10.1 trillion in 2001. During that time, consumer spending increased from 66 percent to 69 percent of the economy. Consumer service firms are becoming a bigger piece of the economy, and we expect that trend to continue. It’s not surprising that these companies have outperformed the overall market over the past decade.
Consumer staples versus consumer discretionaries.
Because many consumer purchases other than food (consumer staples) are discretionary (can be put off for later), it’s not surprising that retail stocks generally outperform during periods of economic strength and underperform during times of economic weakness.
How to analyze the market? Health Care
Health Care
Health care companies are often highly profitable, with strong free cash flow and returns on capital. Health care has also benefited from powerful growth trends. Health care firms benefit from consistent demand, as well.
Health care sector includes
Of all these areas, drug companies and medical devices firms are usually the most promising because they typically have the widest economic moats. However, investors often get swept away by these companies’ heady growth rates, so valuations can be steep.
Economic moats in health care.
Health care companies often benefit from economic moats in the form of high start-up costs, patent protection, significant product differentiation, and economies of scale. This makes it tough for new players to enter the market, particularly for drug companies with valuable patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records. These characteristics make for great profitability: The market-weighted return on equity for health care firms has averaged 23 percent over the last 5 years, despite the economic recession.
Health care companies are often highly profitable, with strong free cash flow and returns on capital. Health care has also benefited from powerful growth trends. Health care firms benefit from consistent demand, as well.
Health care sector includes
- drug companies,
- biotechs,
- medical device firms and
- health care service organizations.
Of all these areas, drug companies and medical devices firms are usually the most promising because they typically have the widest economic moats. However, investors often get swept away by these companies’ heady growth rates, so valuations can be steep.
Economic moats in health care.
Health care companies often benefit from economic moats in the form of high start-up costs, patent protection, significant product differentiation, and economies of scale. This makes it tough for new players to enter the market, particularly for drug companies with valuable patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records. These characteristics make for great profitability: The market-weighted return on equity for health care firms has averaged 23 percent over the last 5 years, despite the economic recession.
A Guided Tour of the Stock Market
A Guided Tour of the Stock Market
(Focus on the tools for understanding different areas of the market.)
It’s easier for companies to make money in some industries than in others. Moreover, some industries lend themselves to the creation of economic moats more so than others, and these are the industries where you’ll want to spend most of your time. The economics of some industries are superior to others. Hence, you should spend more time learning about attractive industries than unattractive ones. You should select those stocks that you think will perform better than others and invest heavily in your top-rated stocks.
Every industry has its own unique dynamics and set of jargon and some industries (such as financial services) even have financial statements that look very different from others. Study the different economics of each industry and understand how companies in each industry can create economic moats – which strategies work and how you can identify companies pursuing those strategies.
Where to Look?
Health care
Consumer services
Business services
Banks
Asset management and Insurance
Software
Hardware
Media
Telecom
Consumer Goods
Industrial Materials
Energy
Utilities
Conclusion
There are areas of the market with worthwhile investments because they contain so many wide-moat companies. There are great firms in even the least likely areas of the stock market.
When analyzing a company in a specific area of the market, seek answers to a few essential questions:
How do companies in this industry make money?
How can they create economic moats?
What quirks does this industry have that an investor should know about?
How can you separate successful from unsuccessful firms in each industry?
What pitfalls should you watch out for?
Over the long haul, a big part of successful investing is building a mental database of companies and industries on which you can draw as the need arises. The ability in compiling that mental database will make you a better investor.
Reference: The Five Rules for Successful Stock Investing by Pat Dorsey
(Focus on the tools for understanding different areas of the market.)
It’s easier for companies to make money in some industries than in others. Moreover, some industries lend themselves to the creation of economic moats more so than others, and these are the industries where you’ll want to spend most of your time. The economics of some industries are superior to others. Hence, you should spend more time learning about attractive industries than unattractive ones. You should select those stocks that you think will perform better than others and invest heavily in your top-rated stocks.
Every industry has its own unique dynamics and set of jargon and some industries (such as financial services) even have financial statements that look very different from others. Study the different economics of each industry and understand how companies in each industry can create economic moats – which strategies work and how you can identify companies pursuing those strategies.
Where to Look?
Health care
Consumer services
Business services
Banks
Asset management and Insurance
Software
Hardware
Media
Telecom
Consumer Goods
Industrial Materials
Energy
Utilities
Conclusion
There are areas of the market with worthwhile investments because they contain so many wide-moat companies. There are great firms in even the least likely areas of the stock market.
When analyzing a company in a specific area of the market, seek answers to a few essential questions:
How do companies in this industry make money?
How can they create economic moats?
What quirks does this industry have that an investor should know about?
How can you separate successful from unsuccessful firms in each industry?
What pitfalls should you watch out for?
Over the long haul, a big part of successful investing is building a mental database of companies and industries on which you can draw as the need arises. The ability in compiling that mental database will make you a better investor.
Reference: The Five Rules for Successful Stock Investing by Pat Dorsey
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