Investment is like a bet
Tags: Ang Kok Heng | Berjaya Group | Elliott Wave | Forecasted profit | Hedge fund | HF Managers | Investment | Iskandar Development Region | MACD | management | risk management | Stochastic
Written by Commentary by Ang Kok Heng
Monday, 21 June 2010 11:23
There are risks in every investment which will result either in a profit or a loss. In a way, investment is like a bet — heads you win, tails you lose. If we hit it right we make a gain, but if we are wrong we will most likely end up with some losses.
Although investment is different from speculation, which depends more on luck rather than judgement, there is still uncertainty in every investment no matter how careful we are. Everyone will definitely want a good bet which has a higher potential for profit than loss. The job of an investor is to avoid a bad bet.
Before deciding on an investment, most people will consider various aspects of risk so as to avoid choosing a bad bet.
Investors bet on management
Management is one of the most crucial factor investors will look at, especially in emerging markets. Most Malaysian listed companies are run by the owners themselves who set up the business. The fate of the company will depend on the few key persons.
Before the company grows big, this is the way to go. This is unlike multi-national corporations which run on an established system — standard procedures, a clear work flow, internal control, risk management system, clear accountability, etc.
Serious investors who buy based on management is also betting on the management’s ability to continue to deliver what they have in the past. Management is the most crucial attribute of a good stock. Good management will be able to predict potential problems, overcome troubles, identify business opportunities, implement expansion plans, reduce costs, optimise efficiency, etc. Investing in such a company is like having a reliable member of staff who can handle most of the boss’s workload.
There are also other management risks, and we can hope that the strong track record of the past will continue into the future. Hopefully, there will be no change in the senior management, staff will remain highly motivated, there will be no internal squabbling and no resignations en bloc. One of the main challenges of the present management is to groom up the second echelon to take over the baton in order to maintain the growth of the company. Only with an equally capable manager can it be ensured that the growth of the company will not be disrupted.
Another danger of betting on management is the fall in vigour of the key drivers. When the owners become richer, they may not be as “hungry” as before. There are also other factors which may change the drive of the owners, such as health factors, family problems and less eagerness to take risks as age catches up.
Bet on business growth
Investing in a company is betting on the future earnings growth. Certain industries have stable growth — for example, power, telco, utilities, toll concessionaires, gaming and consumer-related businesses.
But there are also many industries which are very cyclical, such as plantation, property, construction and technology. It is the cyclical businesses that require more attention.
When a major up cycle comes, it will benefit all the companies in the sector. However, at a certain point in time, the cycle will turn downwards and earnings will also plunge. Attempting to catch the ups and downs of these cycles is similar to the endeavour of predicting the top and bottom of the market.
The earnings of companies are affected by many factors. Some may be related to raw material prices, foreign exchange rate, changes in government regulations, adoption of new technology, emergence of a major competitor, changes in consumer trend, etc. Whenever such events occur, the company’s profit will surge or plunge, depending whether it benefits or suffers from such changes. Such a swing in earnings can only last for a few quarters before profit stabilises at the so-called “economic profit” again, after the industry players adjust their production capacities.
Some analysts and fund managers are good at sensing such opportunities before they come. Hedge fund managers are also good at predicting business cycles by studying demographic and economic data. For long term investors, they may position themselves in a certain sector way ahead of time. For shorter-term investors, timing is crucial, as they do not want to squat on a stock for more than two quarters. In the case of punters, their time frame could even be shorter, perhaps over a month or two.
Bet on forecasted profit
Most fundamental investors rely on the earnings of a listed company to determine its value. A company that makes more profit will attract more investors.
The profit is derived based on orders received, expected revenue, cost of production, operating capacity, bad debts provision, margin, etc. Some profit forecasts are rather simple, but there are also many companies which have diversified into many lines of businesses, where their profit forecasts are more complex.
Investment based purely on forecasted earnings is like a bet placed on the reliability of the profit. It is not uncommon to see listed companies providing earnings guidance to analysts for the coming quarters.
But that is as far as it will go. Analysts who track the quarterly earnings may not be able to predict what will happen in two to three years time. As fundamental investment is a long-term commitment, earnings over the medium to longer term is more important than the quarterly profit. Many a time, analysts make a 180° turn in recommendation after realising that quarterly earnings are off track. By then, the stock price could have fallen substantially.
As such, there is no assurance that investment based purely on forecasted profit will definitely be a successful one.
Bet on a theme play
Some fund managers like to bet on a particular theme. The theme can be in terms of a business sector such as tech, auto, plantation, property, construction, power, water, banks, telco, oil and gas, etc.
The idea behind sectoral theme play is to ride the cyclical upturn in the earnings of these sectors. An improved outlook could be due to a change in business environment, favourable government policies, increased demand, surge in selling price, fall in cost of production, etc.
As cycles come and go, theme play has a finite life. Prices of stocks that were chased up will eventually come down. The bet on theme play relies on the ability to determine how long the cycle will last. The risk of riding a theme play is being caught in the middle of the cycle when prices suddenly fizzle off.
Theme play can also relate to other ideas. Some of which are related to location (for example, a Sarawak play or a play on the Iskandar Development Region), business group (for example, Berjaya Group), business activity (for example, export-oriented or domestic-oriented industry), size of company (for example, big-cap or small-cap stocks), etc. Other themes popular among fund managers include dividend play, defensive play, growth theme, etc.
Bet on specific economic/political event
It is also common for investors to be confronted with economic or political troubles from time to time. There is no single year in which the market does not encounter uncertainties. As uncertainty is part and parcel of the stock market, all of these events require certain forms of judgement as to what to do: sell, buy or hold.
How an economic or a political problem will eventually play out is not an easy guess. Not only are we limited by the required information we need, an understanding the mechanics of the problem is also very challenging. Every problem could be different, and the past pattern may not necessarily be relevant, though it is not uncommon to find analysts and economists using historical experience as a guide.
As the outcome of an economic or a political predicament will depend very much on the interference of the authorities and how the public will respond to those actions, it is very difficult to provide a good prediction. Investors who make a decisive call to buy or to sell are taking a bet on the outcome.
Take, for example, what the outcome of the Greece debt crisis will be. Will it lead to a domino effect causing other southern European economies to collapse? Will it result in eventual disintegration of the European Union? Will it cause further deterioration of Eurodollar? Those who believe the rescue package is sufficient to prevent the contagious debt crisis in Europe will take the recent market selldown to buy. Investors fearing further deterioration of the debt crisis will sell on panic. Only time will tell who is right and who is wrong. Optimists who load fully on stocks now and pessimists who cut all their holdings are taking extreme risks.
Bet on situational play
From time to time, there are some situational themes which will last for a short period. Year end window dressing is an annual affair keeping investors guessing which stocks will be pushed up for the sake of “dressing” so as to provide a better valuation. On the other hand, October always reminds investors of the many mishaps that had happened in the month.The listing of a large initial public offering (IPO) will also attract the attention of investors on similar stocks in the same industry. Some investors may try to bet on the spillover effects from the large IPO.
Following the government’s intention to pare down its investment in quoted GLCs and subsequent proposed privatisation of Pos Malaysia, investors are betting on which is the next to be disposed off.
Bet on chart reading
For technical chartists — using tools like MACD, Stochastic, Elliott Wave, etc — technical readings provide the timing to buy or sell, to enter or exit a position. Technical indicators provide guides as to what to do. Some of them may also indicate the potential profit from a buy signal and at what level to get out.
Even though technical pointers act like the eyes to traders, they cannot guarantee profit for every trade. As such, traders can only bet that what happens in the past will be repeated.
Choosing reliable indicators are crucial for a successful trader. If the trader sincerely believes the technical indicators he is using and the bet is right, profit will be made. If the bet is wrong, then he will have to admit it and get out with some losses. Traders know that every trade is a bet, a calculated bet at least.
Risk and return trade off
Every trade, be it based on technical readings or fundamental reasoning, has a risk. But every trade has its corresponding potential return too. Traders and investors will have to weigh each trade by looking at the risk and return trade off. They have to determine what is the upside potential from a particular purchase and what happens if they are wrong, resulting in possible losses.
In analysing the risk and return trade off, liquidity is important — especially for institutional investors whose positions could be big, as the stocks must be liquid for them to exit if necessary. Fundamental investors have more considerations than stock traders do. Fundamentalists — basically longer-term investors — incorporate risks such as management trustworthiness, corporate governance, business predictability, pricing power, business volatility, business scalability, cashflow sustainability, fluctuation in interest rate, changes in political outlook, shift in government policies, etc.
The fundamental risk of investment encompasses a wide range of uncertainties, some foreseeable but many of which are unexpected. Despite all the various hindrances, investors will still have to bet on each stock based on the best judgement at the point of purchase.
Incorporating probability
Since investment is a game of uncertainty, it is best to incorporate probability in each and every risk-and-reward bet. What we should look for are trades which provide high profit if our forecast comes true. We will never venture into an investment which only yields low return even if we are right.
HF managers
The technique of incorporating probability in every trade is widely used by hedge fund (HF) managers, who are usually misconstrued to be high risk operators. Many HF managers are cautious traders. Each and every position they take is well calculated based on the risk involved and potential profit. To HF managers, every move is a bet. Taking a position in a stock is a risk. Holding longer than the required time frame is a risk.
HF managers screen through much data, and come up with various possible scenarios. Although not all scenarios can be converted into profitable trades, they do provide various trading ideas.
Looking for trading ideas are the challenges facing HF managers. As HF managers are not emotional, they treat each investment as a trade or a bet with the intention of making money. When a trade has served its purpose, it will be closed, regardless of whether it provides a profit or a loss. A bet is initiated when it is deemed profitable, and it is liquidated when it is deemed to be unfavourable.
Risk management
As there are risks in every position taken, risk management is crucial in investment. Good traders know that risk management is very crucial in trading. The survival of traders depends on risk management to protect their capital. They can only survive and remain in the market if their capitals are not entirely wiped off.
In this way, a single-stock portfolio has higher risk than multiple stocks portfolio. A portfolio which diversifies into several stocks is deemed to be prudent. The diversification is not about getting higher returns but about managing the risk.
Position sizing
Diversification requires investors to place a weight on each stock. The weight is the percentage of the portfolio in a single bet. Obviously, higher weightings will be placed on the more attractive bets, and a smaller proportion of the investment will be placed on trades that are less promising.
Some traders initiate each trade with 2% of the portfolio money. If a trade becomes more attractive from the risk-reward perspective, more money will be placed on the bet. Controlling the size of each trade is important and also requires lots of discipline.
Placing a certain amount of portfolio money in a single trade is known as position sizing. It is a good risk management control. Regardless of investment or trading, investors and traders should use the concept of position trading to manage risk.
Ang has 20 years’ experience in research and investment. He is currently the chief investment officer of Phillip Capital Management Sdn Bhd.
This article appeared in The Edge Financial Daily, June 21, 2010.
