The Value Investor's Handbook

March 20 2011 

Value investing, and any type of investing for that matter, varies in execution with each person. There are, however, some general principles that are shared by all value investors. These principles have been spelled out by famed investors like Peter Lynch, Kenneth Fisher, Warren Buffet, John Templeton and many others. In this article, we will look at these principles in the form of a value investor's handbook.

Tutorial: The World's Greatest Investors

Buy BusinessesIf there is one thing that all value investors can agree on, it's that investors should buy businesses, not stocks. This means ignoring trends in stock prices and other market noise. Instead, investors should look at the fundamentals of the company that the stock represents. Investors can make money following trending stocks, but it involves a lot more activity than value investing. Searching for good businesses selling at a good price based on probable future performance requires a larger time commitment for research, but the payoffs include less time spent buying and selling and fewer commission payments. (False signals can drown out underlying trends. Find out how to tone them down and tune them out in Trading Without Noise.)

Love the Business You BuyYou wouldn't pick a spouse based solely on his or her shoes, and you shouldn't pick a stock based on cursory research. You have to love the business you are buying, and that means being passionate about knowing everything about that company. You need to strip the attractive covering from a company's financials and get down to the naked truth. Many companies look far better when you judge them on basic price to earnings (P/E), price to book (P/B) and earnings per share (EPS) ratios than they do when you look into the quality of the numbers that make up those figures.

If you keep your standards high and make sure the company's financials look as good naked as they do dressed up, you're much more likely to keep it in your portfolio for a long time. If things change, you'll notice it early. If you like the business you buy, paying attention to its ongoing trials and successes becomes more of a hobby than a chore.

Simple Is BestIf you don't understand what a company does or how, then you probably shouldn't be buying shares. Critics of value investing like to focus on this main limitation. You are stuck looking for businesses that you can easily understand because you have to be able to make an educated guess about the future earnings of the business. The more complex a business is, the more uncertain your projections will necessarily be. This moves the emphasis from "educated" to "guess."

You can buy businesses you like but don't completely understand, but you have to factor in uncertainty as added risk. Any time a value investor has to factor in more risk, he has to look for a larger margin of safety - that is, more of a discount from the calculated true value of the company. There can be no margin of safety if the company is already trading at many multiples of its earnings, which is a strong sign that, however exciting and new the idea is, the business is not a value play. Simple businesses also have an advantage, as it's harder for incompetent management to hurt the company. (For a complete guide to reading the financial reports, check out our Financial Statements Tutorial.)

Look for Owners, Not ManagersManagement can make a huge difference in a company. Good management adds value beyond a company's hard assets. Bad management can destroy even the most solid financials. There have been investors who have based their entire investing strategies on finding managers that are honest and able. To quote Buffett, "look for three qualities: integrity, intelligence, and energy. And if they don't have the first, the other two will kill you." You can get a sense of management's honesty through reading several years' worth of financials. How well did they deliver on past promises? If they failed, did they take responsibility, or gloss it over? (Find out more about Buffett's investing in Warren Buffett: How He Does It.)

Value investors want managers who act like owners. The best managers ignore the market value of the company and focus on growing the business, thus creating long-term shareholder value. Managers who act like employees often focus on short-term earnings in order to secure a bonus or other performance perk, sometimes to the long-term detriment of the company. Again, there are many ways to judge this, but the size and reporting of compensation is often a dead give away. If you're thinking like an owner, you pay yourself a reasonable wage and depend on gains in your stock holdings for a bonus. At the very least, you want a company that expenses its stock options. (Still wondering how to investigate the top brass? Check out Evaluating A Company's Management.)

When You Find a Good Thing, Buy a LotOne of the areas where value investing runs contrary to commonly accepted investing principles is on the issue of diversification. There are long stretches where a value investor will be idle. This is because of the exacting standards of value investing as well as overall market forces. Toward the end of a bull market, everything gets expensive, even the dogs, so a value investor may have to sit on the sidelines waiting for the inevitable correction. Time, an important factor in compounding, is lost while waiting, so when you do find undervalued stocks, you should buy as much as you can. Be warned, this will lead to a portfolio that is high-risk according to traditional measures like beta. Investors are encouraged to avoid concentrating on only a few stocks, but value investors generally feel that they can only keep proper track of a few stocks at a time.

One obvious exception is Peter Lynch, who kept almost all of his funds in stocks at all times. Lynch broke stocks into categories and then cycled his funds through companies in each category. He also spent upwards of 12 hours every day checking and rechecking the many stocks held by his fund. As an individual value investor with a different day job, however, it's better to go with a few stocks for which you've done the homework and feel good about holding long term. (Learn the basic tenets that helped this famous investor earn his fortune in Pick Stocks Like Peter Lynch.)

Measure Against Your Best InvestmentAnytime you have more investment capital, your aim for investing should not be diversity, but finding an investment that is better than the ones you already own. If the opportunities don't beat what you already have in your portfolio, you may as well buy more of the companies you know and love, or simply wait for better times. During idle times, a value investor can identify the stocks he or she wants and the price at which they'll be worth buying. By keeping a wish list like this, you'll be able to make decisions quickly in a correction.

Ignore the Market 99% of the TimeThe market only matters when you enter or exit a position; the rest of the time, it should be ignored. If you approach buying stocks like buying a business, you'll want to hold onto them as long as the fundamentals are strong. During the time you hold an investment, there will be spots where you could sell for a large profit and others were you're holding an unrealized loss. This is the nature of market volatility.

The reasons for selling a stock are numerous, but a value investor should be as slow to sell as he or she is to buy. When you sell an investment, you expose your portfolio to capital gains and usually have to sell a loser to balance it out. Both of these sales come with transaction costs that make the loss deeper and the gain smaller. By holding investments with unrealized gains for a long time, you forestall capital gains on your portfolio. The longer you avoid capital gains and transaction costs, the more you benefit from compounding. (Find out how your profits are taxed and what to consider when making investment decisions in Tax Effects On Capital Gains.)

The Bottom LineValue investing is a strange mix of common sense and contrarian thinking. While most investors can agree that a detailed examination of a company is important, the idea of sitting out on a bull market goes against the grain. It's undeniable that funds held constantly in the market have outperformed cash held outside the market, waiting for a down market. This is a fact, but a deceiving one. The data is derived from following the performance of indexes like the S&P 500 over a number of years. This is where passive investing and value investing get confused.


In both types of investing, the investor avoids unnecessary trading and has a long-term holding period. The difference is that passive investing relies on average returns from an index fund or other diversified instrument. A value investor seeks out above-average companies and invests in them. Therefore, the probable range of return for value investing is much higher. In other words, if you want the average performance of the market, you're better off buying an index fund right now and piling money into it over time. If you want to outperform the market, however, you need a concentrated portfolio of outstanding companies. When you find them, the superior compounding will make up for the time you spent waiting in a cash position. Value investing demands a lot of discipline on the part of the investor, but in return offers a large potential payoff. (Looking for a little more information on index investing, see the Index Investing Tutorial.)

by

Andrew Beattie

Read more: http://www.investopedia.com/articles/fundamental-analysis/09/value-investing.asp?partner=basics021710#ixzz1mjpmDWOA

Selling: The Hardest Decision of All

Many investors are able to spot a bargain but have a harder time knowing when to sell.  

• One reason is the difficulty of knowing precisely what an investment is worth.  
• An investor buys with a range of value in mind at a price that provides a considerable margin of safety.  
• As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases.  
• Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.

To deal with the difficulty of knowing when to sell, some investors create rules for selling based on 

• specific price-to-book value or price-to-earnings multiples.  
• Others have rules based on percentage gain thresholds; once they have made X percent, they sell.  
• Still others set sale price targets at the time of purchase, as if nothing that took place in the interim could influence the decision to sell.  

None of these rules makes good sense.  Indeed, there is only one valid rule for selling:  all investments are for sale at the right price.

Decisions to sell, like decisions to buy, must be based upon underlying business value.  Exactly when to sell or buy depends on the alternative opportunities that are available.

Should you hold for partial or complete value realization, for example?

• It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains.  
• By contrast, you would not want to sell a stock at a gain (and pay taxes on it) if it were still significantly undervalued and if there were no better bargains available.

Some investors place stop-loss orders to sell securities at specific prices, usually marginally below their cost.

• If prices rise, the orders are not executed. 
• If the prices decline a bit, presumably on the way to a steeper fall, the stop-loss orders are executed. 

Although this strategy may seem an effective way to limit downside risk, it is, in fact, crazy.  Instead of taking advantage of market dips to increase one's holdings, a user of this technique acts as if the market knows the merits of a particular investment better than he or she does.

Liquidity considerations are also important in the decision to sell.

• For many securities the depth of the market as well as the quoted price is an important consideration.  
• You cannot sell, after all, in the absence of a willing buyer, the likely presence of a buyer must therefore be a factor in the decision to sell.  
• As the president of a small firm specializing in trading illiquid over the counter stocks once told me:  "You have to feed the birdies when they are hungry."

If selling still seems difficult for investors who follow a value-investment philosophy, I offer the following rhetorical questions:  

• If you haven't bought based upon underlying value, how do you decide when to sell?  
• If you are speculating in securities trading above underlying value, when do you take a profit or cut losses?  
• Do you have any guide other than "how they are acting," which is really no guide at all?

Adopt a Value-Investing Philosophy and Start Investing Today

Once you choose to venture beyond U.S. Treasury bills, whatever you do with your money carries some risk. 

Don't think you can avoid making a choice; inertia is also a decision.

It took a long time to accumulate whatever wealth you have; your financial well-being is definitely not some thing to trifle with.

For this reason, I recommend that you adopt a value-investing philosophy and either

• find an investment professional with a record of value-investment success or 
• commit the requisite time and attention to investing on your own.

There are a number of issues that investors should consider in managing their portfolio.

While individual personalities and goals can influence one's trading and portfolio management techniques to some degree, sound buying, and selling strategies, appropriate diversification, and prudent hedging are of importance to all investors.

Of course, good portfolio management and trading are of no use when pursuing an inappropriate investment philosophy, they are of maximum value when employed in conjunction with a value investment approach.

Ref:  Margin of Safety by Seth Klarman

Evaluating Investment Results of Yourself and Your Fund Managers

The decision to employ an investment professional should only be made after a thorough analysis of the past investment performance of the individual or organization under consideration. Some questions are obvious:

• How long a track record is there? 
• Was it achieved over one or more market and economic cycles? 
• Was it achieved by the same person who will manage your money, and does it represent the complete results of this manager's entire investment career or only the results achieved during some favorable period? (Everyone, of course, will be able to extract some period of good performance even from a lengthy record of mediocrity.) 
• Did this manager invest conservatively in down markets, or did clients lose money? 
• Were the results fairly steady overtime, or were they volatile? 
• Was the record the result of one or two spectacular successes or of numerous moderate winners? 
• If this manager's record turns mediocre after one or two spectacular successes are excluded, is there a sound reason to expect more home runs in the future? 
• Is this manager still following the same strategy that was employed to achieve his or her past successes?

Obviously a manager who has achieved dismal long-term results is not someone to hire to manage your money. Nevertheless, you would not necessarily hire the best-performing manager for a recent period either. 

Returns must always be examined in the context of risk. 

• Consider asking whether the manager was fully invested at all times or even more than 100 percent invested through the use of borrowed money. (Leverage is neither necessary nor appropriate for most investors.)
• Contrariwise, if the manager achieved good results despite having held substantial amounts of cash and cash equivalents, this could indicate a low-risk approach. 
• Were the investments in the underlying portfolio themselves particularly risky, such as the shares of highly leveraged companies? 
• Conversely, did the manager reduce portfolio risk through diversification or hedging or by investing in senior securities?

When you get right down to it, it is simple to compare managers by their investment returns. It is far more difficult - impossible except in retrospect - to evaluate the risks that manger incurred to achieve their results.

Investment returns for a brief period are, of course, affected by luck.  

• The laws of probability tell us that almost anyone can achieve phenomena l success over any given measurement period.  
• It is the task of those evaluating a money manager to ascertain how much of their past success is due to luck and how much to skill. 

Many investors mistakenly choose their money managers the same way they pick horses at the race track. They see who has performed well lately and bet on them.

It is helpful to recognize that there are cycles of investment fashion, different investment approaches go into and out of favor, coincident with recent fluctuations in the results obtained by practitioners.

• If a manager with a good long-term record has a poor recent one, he or she may be specializing in an area that is temporarily out of favor.  
• If so, the returns achieved could regress to their long-term mean as the cycle turns over time, several poor years could certainly be followed by several strong ones.

Finally, one of the most important matters for an investor to consider is personal compatibility with a manager.  

• If personal rapport with a financial professional is lacking, the relationship will not last.  
• Similarly, if there is not a level of comfort with the particular investment approach, the choice of manager is a poor one.  
• A conservative investor may not feel comfortable with a professional short-seller no matter how favorable the results, by contrast, an aggressive investor may not be compatible with a manager who buys securities and holds them.

Once a money manager has been hired, clients must monitor his or her behavior and results on an ongoing basis.  The issues that were addressed in hiring manger are the same ones to consider after you have hired one.

How should investors choose among these several valuation methods?

How should investors choose among these several valuation methods?  When is one clearly preferable to the others?  When one method yields very different values from the others, which should be trusted?

At times a particular method may stand out as the most appropriate.  

• Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low.
• Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis.  
• Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value.  
• A closed-ended fund or other company that owns only marketable securities should be valued by the stock market method, no other makes sense.

Often several valuation methods should be employed simultaneously.  

• To value a complex entity such as a conglomerate operating several distinct businesses, for example, some portion of the assets might be best valued using one method and the rest with another.  

Frequently investors will want to use several methods to value a single business in order to obtain a range of values.  

• In this case investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reasons to do otherwise.  
• True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

Analyzing Investment Opportunity Begins with an assessment of Business Value

To be a value investor, you must buy at a discount from underlying value.

Analyzing each potential value investment opportunity therefore begins with an assessment of business value.

While a great many methods of business valuation exist, there are only three that I find useful.

1.  Net Present Value
The first is an analysis of going-concern value, known as net present value (NPV) analysis.  NPV is the discounted value of all future cash flows that a business is expected to generate.  A frequently used but flawed short cut method of valuing a going concern is known as private-market value.  This is an investor's assessment of the price that a sophisticated business person would be willing to pay for a business.  Investors using this shortcut, in effect, value business using the multiples paid when comparable businesses were previously bought and sold in their entirety.

2.  Liquidation value.
The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off.  Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not.

3.  Stock market value.
The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries consider separately, would trade in the stock market.  Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Each of these methods of valuation has strengths and weaknesses.

• None of them provide accurate values all the time.
• Unfortunately no better methods of valuation exist.  

Investors have no choice but to consider the values generated by each of them, when they appreciably diverge, investors should generally err on the side of conservatism.


Ref:  Margin of Safety by Seth Klarman

The discrepancy between the buyer's and the seller's perceptions of value can result from various factors

Markets exist because of differences of opinion among investors.

• If securities could be valued precisely, there would be many fewer differences of opinion; market prices would fluctuate less frequently, and trading activity would diminish. 
• To fundamentally oriented investors, the value of a security to the buyer must be greater than the price paid, and the value to the seller must be less, or no transaction would take place. 

The discrepancy  between the buyer's and the seller's perceptions of value can result from such factors as

• differences in assumptions regarding the future, 
• different intended uses for the asset, and 
• differences in the discount rates applied. 

Every asset being bought and sold thus has a possible range of values bounded by the value to the buyer and the value to the seller; the actual transaction price will be somewhere in between.


For example:

In early 1991, for example, the junk bonds of Tonka Corporation sold at steep discounts to par value, and the stock sold for a few dollars per share. The company was offered for sale by its investment bankers, and Hasbro, Inc., was evidently willing to pay more for Tonka than any other buyer because of economies that could be achieved in combining the two operations.  Tonka, in effect, provided appreciably higher cash flows
to Hasbro than it would have generated either as a stand-alone business or to most other buyers. There was a sharp difference of opinion between the financial markets and Hasbro regarding the value of Tonka, a disagreement that was resolved with Hasbro's acquisition of the company.

The difficulty of accurate business valuation,

To illustrate the difficulty of accurate business valuation, investors need only consider the wide range of Wall Street estimates that typically are offered whenever a company is put up for sale. 

• In 1989, for example, Campeau Corporation marketed Bloomingdales to prospective buyers; Harcourt Brace Jovanovich, Inc., held an auction of its Sea World subsidiary; and Hilton Hotels, Inc., offered itself for sale. 
• In each case Wall Street's value estimates ranged widely, with the highest estimate as much as twice the lowest figure. 

If expert analysts with extensive information cannot gauge the value of high-profile, well-regarded businesses with more certainty than this, investors should not fool themselves into believing they are capable of greater precision when buying marketable securities based only on limited, publicly available information

The essential point in security analysis is to establish that the value is adequate

Businesses, unlike debt instruments, do not have contractual cash flows.  As a result, they cannot be as precisely valued as bonds.  

Benjamin Graham knew how hard it is to pinpoint the value of businesses and thus of equity securities that represent fractional ownership of those businesses.  In Security Analysis he and Dodd discussed the concept of a range of value.

'The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security.  It needs only to establish that the value is adequate - e.g., to protect a bond or to justify a stock purchase - or else that the value is considerably higher or considerably lower than the market price.  For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.'

Indeed, Graham frequently performed a calculation known as net working capital per share, a back-of-the-envelope estimate of a company's liquidation value. His use of this rough approximation was a tacit  admission that he was often unable to ascertain a company's value more precisely.

Business value cannot be precisely determined: Be approximately right than be precisely wrong

Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined.

• Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value.  
• Projected results are less precise still.  

You cannot appraise the value of your home to the nearest thousand dollars.  Why would it be any easier to place a value on vast and complex businesses?

Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors.  So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal.

Any attempt to value businesses with precision will yield values that are precisely inaccurate.  The problem is it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.

NPV and IRR - place more importance to the Assumptions than to the Output. "Garbage in, garbage out"

Any attempt to value businesses with precision will yield values that are precisely inaccurate.  The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.

Anyone wi th a simple, hand-held calculator can perform net present va lue (NPV) and internal rate of return (IRR) calculations.  The NPV calculation provides a single-point value of an investment by discounting estimates of future cash flow back to the present.  IRR, using assumptions of future cash flow and price paid, is a calculation of the rate of return on an investment to as many decimal places as desired.

The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really as accurate as the cash flow assumptions that were used to derive them.

The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts.  Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions.  "Garbage in, garbage out" is an apt description of the process.

Net Present Value and Internal Rate of Return Summarize the Returns for a Given Series of Cash Flows

NPV and IRR are wonderful at summarizing, in absolute and percentage terms, respectively, the returns for a given series of cash flows.

When cash flows are contractually determined, as in the case of a bond, and when all payments are received when due, IRR provides the precise rate of return to the investor while NPV describes the value of the investment at a given discount rate.

In the case of a bond, these calculations allow investors to quantify their returns under one set of assumptions, that is, that contractual payments are received when due.

These tools, however, are of no use in determining the likelihood that investors will actually receive all contractual payments and, in fact, achieve the projected returns.

The short-term and long-term perspectives on an investment can diverge.

In a rising market, many people feel wealthy in the short run due to unrealized capital gains, but they are likely to be worse off over the long run than if security prices had remained lower and the returns to incremental investment higher.

Ways to Limit Opportunity Cost - Most Important is holding Part of your Portfolio in Cash

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.  

• Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. 

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.  Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.  Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

• Equity investments in ongoing businesses typically throw off only minimal cash through payment of dividends.  
• The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.  
• Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.

Another way to limit opportunity cost is through hedging. 

• A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. 
• If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities .

If you are buying sound value at a discount, do short-term price fluctuations matter?

In the long run, they do not matter much; value will ultimately be reflected in the price of a security.  

• Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact.  
• For example, short-term price declines actually enhance the returns of long-term investors.  

There are, however several eventualities in which near-term price fluctuations do matter to investors. 

1.  Security holders who need to sell in a hurry are at the mercy of market prices.  The trick of successful investors is to sell when they want to, not when they have to.  Investors who may need to sell should not own marketable securities other than U.S. Treasury bills.

2.  Near-term security prices also matter to investors in a troubled company.  If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds.

3.  The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell.

• If you hold cash, you are able to take advantage of such opportunities.  If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.  This creates an opportunity cost, the necessity to forego future opportunities that arise.  
• If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

Investors should expect prices to fluctuate

The Relevance of Temporary Price Fluctuations

In addition to the probability of permanent loss attached to investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value.

Many investors consider price fluctuations to be a significant risk:  if the price goes down, the investment is seen as risky regardless of the fundamentals.

But are temporary price fluctuations really a risk?

• Not in the way that permanent value impairments are and 
• then only for certain investors in specific situations.

It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals.  The reality may only become apparent after the fact.

While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility.  

Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.

Unlike return, risk is no more quantifiable at the end of an investment than it was at its beginning.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that.

Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning.

Risk simply cannot be described by a single number.  

Intuitively we understand that risk varies from investment to investment:  a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about the risks the way food packages provide nutritional data.

Rather, risk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment.

• If exploratory oil well proves to be a dry hole, it is called risky.  If a bond defaults or a stock plunges in price, they are called risky.  
• But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made?  

Not at all.  The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made. 


There are only a few things investors can do to counteract risk:

• diversify adequately, 
• hedge when appropriate, and 
• invest with a margin of safety.  

It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount.  The bargain element helps to provide a cushion for when things go wrong.

For most investments the amount of profit earned can be known only after maturity or sale.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that.

For most investments the amount of profit earned can be known only after maturity or sale. 

• Only for the safest of investments, is return knowable at the time of  purchase:  a one-year 6 percent T-bill returns 6 percent at the end of one year.  
• For riskier investments the outcome must be known before the return can be calculated.  If you buy one hundred shares of XYZ Corporation, for example, your return depends almost entirely on the price at which it is trading when you sell.  Only then can the return be calculated.

Risk is dependent on both the nature of investments and on their market price

The risk of an investment is described by both the probability and the potential amount of loss.

The risk of an investment - the probability of an adverse outcome - is partly inherent in its very nature.

• A dollar spent on biotechnology is a riskier investment than a dollar used to purchase utility equipment.  
• The former has both a greater probability of loss and a greater percentage of the investment at stake.

In the financial markets, however, the connection between a marketable security and the underlying business is not as clearcut.

• For investors in a marketable security the gain and loss associated with the various outcomes is not totally inherent in the underlying business; 
• it also depends on the price paid, which is established by the marketplace.

Greater risk does not guarantee greater return, risk erodes return by causing losses.

Greater risk does not guarantee greater return.

To the contrary, risk erodes return by causing losses.

It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.

By itself risk does not create incremental return, only price can accomplish that.

Warren Buffett - What is Franchise Value?

Buffett restates the greater fool theory

The Oracle of Omaha restates the greater fool (note the lower case ‘'f'’!) theory: “the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the  rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth – for a while”.

There is too much money in Malaysian politics

Mix of politics with business fuelled economic woes, says Ku Li

By Clara Chooi

February 16, 2012

KUALA LUMPUR, Feb 16 — Tengku Razaleigh Hamzah today charged that years of political patronage and the long standing system of co-dependency between business and politics arising from the Mahathir era had led to neglect of the people’s “real socio-economic problems”.

The outspoken veteran Umno leader added that economic policies of the past, which kicked off from the 1980s onwards, had also widened inequality in Malaysia and would worsen if the present administration does not move to separate business from politics.

“With this pre-condition, Malaysia’s economy can avoid a crisis worse that what we see in the West,” he said during a luncheon talk today.

There is “too much money in politics”, he continued, adding that this forced further disparities between those who benefit from this “dysfunctional system” and those who suffer from it.

“No democratic system, no institution as envisaged by our Constitution, can survive a political economy of this nature.

“There is just too much money in politics and it has become inseparable from power and the electoral process,” said the Kelantan prince popularly referred to as “Ku Li”.

Ku Li (picture), known to be one of the greatest critics of the New Economic Policy (NEP) and Tun Dr Mahathir Mohamad’s handling of it, was speaking on the state of Malaysia’s political economy during a luncheon at the Royal Selangor Club here.

The Gua Musang MP said what happened in the 1980s was a “deviation” from the ideals of promoting unity and equitable distribution of wealth, as enshrined in the 1971 Second Malaysia Plan.

The NEP, he said, had “unfortunately” failed to survive the leadership prior to 1980 and faded before its full impact could be felt.

“What happened from 1980 onwards was an intervention of a new form of capitalism that was not obvious but reflected in the way the leadership that came after the mid-1980s conducted itself in the implementation of economic policies and the exercise of political power,” he said.

Eventually, said Ku Li, political power became a means to business and accumulation of wealth, thus creating a co-dependency between the two.

“All those in the hierarchy of the system also benefited and, in order to maintain that system, they supported the centralisation of power within the party leadership and the government,” he said.

To ensure its political survival, this “centralised power”, he said, had to feed those within the system with business opportunities.

As such, those on top enabled the discretionary use of political power to distribute public procurements, contracts and privatisations programmes and created a self-serving economic system, he added.

“In these circumstances, money became a dominant political weapon in political parties and the entire political process. This new culture of politics released forces within the political parties and the public arena unseen before,” he said.

But, added Ku Li, the system eventually led to neglect of the people’s socio-economic problems as essential changes to the economy were either ignored or misconceived.

He pointed to the growing household debts of Malaysians across the racial divide and employment problems, caused by the alarming presence of foreign labour in the job market.

Ku Li also drew links between Malaysia’s political system and the Arab Spring and urged the present administration to learn from the Middle Eastern uprising.

“The lesson we have to learn from the Arab Spring is that a dysfunctional democracy, however well-dressed by public relations exercises or subsequently by media, cannot withstand the realities that are the natural consequence of abuse of power and wanton accumulation of wealth.

“That is the most important message, I think, that the Arab Spring has conveyed and we must take cognisance of it,” he said.

http://www.themalaysianinsider.com/malaysia/article/mix-of-politics-with-business-fuelled-economic-woes-says-ku-li/

Ku Li: Corruption may see BN’s downfall

Syed Jaymal Zahiid

 | February 16, 2012

Razaleigh pointed that no 'public relations exercises' can mask corruption and 'dysfunctional democracy'.

KUALA LUMPUR: Respected Umno veteran Tengku Razaleigh Hamzah today said no government rife with corruption can survive public anger and warned Putrajaya that it may suffer the same fate as ousted regimes in the Arab Spring.

Speaking at the Royal Selangor Club luncheon talk earlier today, the Kelantan prince spoke of Malaysia’s “dysfunctional” political economy, which he blamed on money politics as a result of the of the policies under the tenure of former prime minister Dr Mahathir Mohamad.

Malaysia under Mahathir is often characterised by neo-liberal policies which Razaleigh said kickstarted the politics-business relations and resulted in crony capitalism.

“As a consequence of economic policies in the past, inequalities have also widened. Today, Malaysians suffer from a very wide inequality… and the widening inequality will go into a deeper crisis of confidence among the people.

“No democratic system, no institution as envisaged by our Federal Constitution, can survive a political economy of this nature.

“There is too much money in politics and it has become inseparable from power and the electoral process,” he said.

Razaleigh, the Gua Musang MP, often described as “the country’s last statesman”, has been vociferous in his criticism against the Najib administration and his own party Umno.

He had helped set up Angkatan Amanah Merdeka (Amanah), an NGO aimed at rekindling the spirit of the Federal Constitution.

But observers say he is using it as a platform to put pressure on the ruling coalition to clean up and buck up.

Lesson from the Arab Spring

His deputy in Amanah, a former minister and a senior Umno member, Sheikh Kadir Fadzil, had also been vocal against the Najib government.

He claimed leaders from the ruling party practised widespread money politics to win votes and posts in party elections.

International observers and economists say corruption remains the biggest problem in Malaysia, denting the country’s economic edge and repelling investments.

Foreign direct investments to Malaysia have dropped significantly as investors now opt for its neighbours.

Razaleigh said that no “public relations exercises” can mask corruption and “dysfunctional democracy”, citing the bloody Arab Spring that saw voters ousting governments that had ruled for decades.

“The lesson we have to learn from the Arab Spring is that a dysfunctional democracy, however well dressed by public relations exercises or subsequently by the media, cannot withstand the realities… of the abuse of power and wanton accumulation of wealth.

“That is the most important message, I think, that the Arab Spring has conveyed and we must take cognizance of it,” he said

http://www.freemalaysiatoday.com/2012/02/16/ku-li-corruption-may-see-bns-downfall/

UK: Bank leaves door ajar for more QE

By David Milliken and Fiona Shaikh

LONDON | Wed Feb 15, 2012 7:34pm GMT

(Reuters) - The economy faces substantial headwinds despite recent signs of recovery, Bank of England Governor Mervyn King warned on Wednesday, leaving the door to more stimulus slightly open after the bank presented new, higher inflation forecasts.

The Bank raised the key medium-term forecast in its latest inflation report to close to its 2 percent goal, indicating that another dose of quantitative easing beyond the 50 billion pounds agreed last week may be less certain than economists expected.

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But with the government's hands tied by its pledge to erase a huge budget deficit, the pressure to boost the economy remains firmly on the Bank.

The governor said more easing was possible if needed, but he again rejected calls to support credit-strapped firms more directly, saying this was tantamount to subsidising them and a decision for the government to make.

"These remain ... challenging times for the UK economy. Substantial headwinds are hampering our recovery and rebalancing," King said at a news conference, stressing again the dangers posed to Britain by the euro zone debt crisis.

"Nevertheless, growth is likely to recover gradually, supported by rising real incomes and the additional stimulus provided by the asset purchases announced last week," King said.

Inflation looks set to fall from the 3.6 percent hit in January as weak growth in the coming months pushes up unemployment and spare capacity in the economy, and bears down on wages and prices.

Chocolate maker Thorntons became the latest retailer to report a hit to its profits because it had to lure cash-strapped Britons with hefty discounts.

Signs have been mounting that Britain may have avoided a renewed recession despite the contraction at the end of 2011.

Even the labour market showed unexpected signs of resilience. The unemployment rate stabilised at 8.4 percent in December and the jobless numbers dipped compared with November as employment rose and firms offered more jobs.

QE QUESTION MARK

Before the forecast update, economists polled by Reuters had expected the central bank to extend its asset purchases again in May. But the new inflation projections raised doubts about the Monetary Policy Committee's readiness to do more.

"The report indicated that the MPC does not see a strong case for more QE, although it retains a bias toward further loosening," Barclays economist Simon Hayes said. "The report therefore places a big question mark over whether more QE is likely in May."

The March gilt future fell sharply immediately after the report was published, but recovered during the course of King's press conference.

The Bank upped its inflation forecast for two years from now to around 1.8 percent, higher than most economists had expected.

In its quarterly report, the bank predicted sluggish growth in the short term and said that the euro zone crisis posed the biggest threat to Britain's economic recovery. But it added that a return to average growth was likely within a couple of years.

King said quarterly growth this year was likely to "zigzag" due to extra public holiday's to mark the Queen's Diamond Jubilee, with a quarter of contraction likely.

Last week the Bank's policy committee voted for 50 billion pounds of quantitative easing over the next three months, taking the total to 325 billion pounds, though some economists doubt whether the vote of the nine policymakers was unanimous.

In the report, the Bank said the pace and extent of future falls in inflation was unclear. Oil prices and the uncertain impact of high unemployment on wages and firms' profit margins made it hard to predict how fast inflation will fall.

"There remains a range of views among Committee members regarding the relative strength of the factors affecting the outlook for inflation."

Some MPC members, such as chief economist Spencer Dale, have been concerned that past Bank forecasts were overoptimistic about how fast inflation would fall, worrying about a loss of productivity in the economy.

http://uk.reuters.com/article/2012/02/15/uk-medium-term-inflation-idUKTRE81E0L020120215

Buffett: The case for shares. "It will be by far the safest."

Unsurprisingly, Buffett makes the case for investing in shares – the productive capacity of democratic capitalism. He also gives a sense of the best businesses to own. Buffett prefers '‘first-class'’ companies that can keep up with inflation and that also require only minimal new capital to produce their returns. Buffett cites Coca-Cola (NYSE:KO) as one such example.

He says “I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three (gold, cash & bonds and shares) we've examined. More important, it will be by far the safest.”

That’s a critical point – equities are often characterised as risky, volatile and complex (and some companies’ shares can be all three), but when compared to the risk taken by buying assets that don’t sustain your purchasing power, Buffett argues that the safest way to secure your financial future is to swap some shorter term volatility for longer term ‘'purchasing power'’ protection.

Comparing the returns from investing in the three asset classes discussed since 1965.

• $US100 invested in US government bonds would have compounded to be worth $US1336 by the end of 2011. 
• Gold would have far outpaced cash, turning into $US4455. 
• But equities would have done over one-third better, compounding its way to $US6072.

Read more: http://www.watoday.com.au/business/motley-fool/why-buffett-is-cold-on-gold-20120214-1t3vk.html#ixzz1mUyR1s59

The Oracle of Omaha restates the greater fool (note the lower case ‘'f'’!) theory: “the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth – for a while”.

Buffett: Cash Holdings are among the most Dangerous of Assets

Buffett agrees that holding cash is a path to the poor-house. In fact, he says they may be “thought of as “safe”. In truth they are among the most dangerous of assets.”

While the nominal dollar value of your investment may be protected, the purchasing power of that cash is being eaten away while it sits there. To cement the point, Buffett remarks that the US dollar has fallen in value by 86 per cent since 1965, due to just that phenomenon.

Read more: http://www.watoday.com.au/business/motley-fool/why-buffett-is-cold-on-gold-20120214-1t3vk.html#ixzz1mUxb7FEt