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/