VIEWPOINT May 5, 2010, 11:01PM EST
Risk Is Not a Four-Letter Word
Speculation has gotten bad press recently. But Businessweek.com's Frank Aquila says that for investors, avoiding risk may be the greatest risk of all
By Frank Aquila
While central bankers, small business owners, and stock market analysts rarely agree on much of anything, all appear to acknowledge that too much risk fueled the subprime mortgage bubble that led to the worst financial crisis since the Great Depression. The consensus view appears to be fairly simple and straightforward: risk is bad.
Certainly, foolish and excessive risk-taking can lead to financial catastrophe. But is all risk bad?
While excessive risk can indeed be dangerous, eliminating risk in any investing scenario is neither possible nor even beneficial. In the space of a few years, we have seemingly gone from a period in which no risk was too big, to a period in which no risk is too small. Fortunately or unfortunately, risk can never be truly eliminated, and in fact, an appropriate tolerance for risk is essential for meaningful economic growth.
RISK WILL ALWAYS BE WITH US
Since many more things could happen than will ever actually happen, some level of uncertainty will always exist. No matter how much care is taken in making any decision, a negative or unintended outcome is always a possibility. In short, risk will always be with us. Uncertainty may equate to risk, but that does not mean risk must always lead to danger.
As Peter Bernstein noted in his book Against the Gods: The Remarkable Story of Risk, the history of the modern world is marked by a "tension between those who assert that the best decisions are based on quantifications and those who base their decisions on more subjective degrees of belief about the uncertain future." So while proposals for financial and corporate governance reform strive to eliminate all risk, we need to ask whether artificial limits on all "risk" may actually create the greatest risk of all.
Consider for a moment a world in which the tolerance for risk is zero, or at least one in which perceived risk is heavily penalized. In a risk-intolerant environment, markets would require enormous returns on equity investments and significantly higher interest rates on debt for all but the safest "blue chip" borrowers. In such an environment, few new businesses would ever be started, funding of research and development would disappear for all but a handful of projects, and business development would slow to a trickle. Growth would simply be priced out of the market.
Since businesses today operate in a 24/7 global economy, it must be understood that "black swans" in obscure corners of the world could lead to unexpected, and possibly negative, consequences from Wall Street to Main Street. If excessive risk can be appropriately reduced, it is more likely than not that risk will lead to economic growth than it will to danger.
PRUDENT RISK: AN OXYMORON?
Risk is the fuel that feeds growth and the spark that permits creativity to flourish. But the acceptance of risk need not be synonymous with the acceptance of recklessness. So how do we avoid recklessness, without penalizing prudent risk-taking?
First and foremost, rewards must be tied to the risks being taken. Reward without risk is neither fair nor rational. The best, and perhaps most painful, recent example of imbalances that can result from risk/reward decoupling is the subprime mortgage crisis. The ability to pass along the risks to others is at the core of what created the subprime mortgage crisis. Mortgage brokers earned commissions by writing mortgages that were promptly resold, effectively decoupling the reward of the commission from the traditional risk of the mortgage holder: that interest and principal payments would be made on a timely basis until the loan was paid in full. Mortgage brokers were rewarded by writing mortgages, but they had no stake in whether those mortgages were ever repaid.
The logic that underpinned these mortgages was simple and seemingly incontrovertible: Home prices will always rise, so no matter what the price of the home sale or the terms of the mortgage, the transaction would be riskless. Ironically, one of the biggest hazards in modern financial history was created by millions of these "riskless" transactions, because at least in part, the risks were decoupled from the rewards at a crucial step in the chain.
Second, risk takers should be expected to act with discretion and intelligence, taking into account all the known facts and the relevant circumstances. When acting on behalf of others, a risk taker should be expected to act in the same manner as that person would with his or her own business or personal finances. The so-called prudent person rule is a long-established legal principle that has served us well. Risk takers, entrepreneurs, and inventors all create enormous wealth for the broader economy; their risk-taking should not be punished so long as they are being prudent. When investors and lenders finance these visionaries, particularly with other people's money, they must be expected to exercise discretion and due diligence and to dampen any unrealistic expectations that such entrepreneurs and inventors may have.
A VITAL INGREDIENT OF GROWTH
If we seek to eliminate risk, who will create the next Microsoft or Google? If we punish risk takers, will anyone invest in the next microchip or cellular technology? Or fund development of the next Lipitor or Celebrex? If governments will not support risk, how will the next Internet ever be created? Avoidance of excessive risk may well be necessary, but any attempt to eliminate risk would be the greatest risk of all.
Risk is an essential ingredient of economic growth. As legislators, regulators, and central bankers consider the causes of the financial crisis and ways to prevent the next one, it will be vital that they recognize that risk will always be with us and, in fact, that appropriate risk is a necessary evil. To paraphrase one of the silver screen's legendary investors, Gordon Gekko, "risk is good."
Aquila is a partner in the Mergers & Acquisitions Group of Sullivan & Cromwell LLP.
http://www.businessweek.com/print/investor/content/may2010/pi2010055_924787.htm
Thursday 17 June 2010
Busting property investing myths
Busting property investing myths
Max Newnham
June 9, 2010 - 4:27PM
Australia's love affair with property is well-known. When it comes to investing, a negatively geared property has long been a preferred investment. Many people find it hard to go past the security bricks and mortar offer.
Unfortunately there are many myths about the tax advantages of property investing. When an investor does not understand the taxation rules, and they are audited, the resulting tax penalties can eat up any investment benefits.
One of the first tax myths of property investment relates to claiming travel costs. This is especially the case for interstate property ownership. There is a general misconception that all costs associated with visiting a rental property are tax-deductible. This includes airfares, accommodation and incidentals. Nothing could be further from the truth.
The proportion of travel expenses that can be claimed is determined by how much time is spent travelling related to the rental property. If you had a Queensland rental property and flew up there, stayed a week, and spent an hour inspecting the property, very little of the travel costs would be tax-deductible.
On the other hand if you spent a week arranging repairs, carrying out some repairs yourself, visiting the agent, buying furniture, and generally spent nearly all of your time on property matters, the whole of the travel costs would be tax-deductible.
Motor vehicle travel costs can also be deductible for local properties. Again, if the travel involves driving past the property it would be hard to justify a claim. Whereas if the trip relates to inspecting the property when a tenant leaves, doing the mowing or carrying out repairs, a claim could be made for the travel on a kilometre basis.
Another tax myth of property investing is the tax-deductibility of interest on loans. The property used as security for a loan does not dictate whether the interest is tax-deductible. Rather, it is the purpose for which the funds have been borrowed that determines tax-deductibility of interest. If the purpose of a loan is to purchase a home, rather than an investment property, the interest on the loan will not be tax-deductible.
A situation where this occurs is when a decision is made to purchase a new home but keep the old home as a rental property. Often the loan to purchase the original home has been almost repaid and there is a lot of equity in the property. Where a new loan is taken out using that equity, and the funds are used to purchase the new home, the interest is not tax-deductible.
From a tax point of view it makes a lot more sense to sell the original home, make a tax free capital gain on the sale, use the funds to purchase the new home, making this loan as small as possible, then find a new property to purchase as an investment.
The final tax myth of property investing is that all amounts spent on repairing a property are tax-deductible. A tax deduction can only be claimed on repairs to a rental property – not improvements. Improvements are any work that makes an asset better than the condition it was in when purchased.
It is for this reason repairs carried out after purchasing a property, to get it into a condition where it can be rented, are not tax-deductible. Where a property has been rented for some time, and work is carried out such as painting to repair damage while it was rented, the cost will be tax-deductible.
Investment tax questions can be emailed to max@taxbiz.com.au
This story was found at: http://www.smh.com.au/money/on-the-money/busting-property-investing-myths-20100609-xw3y.html
Max Newnham
June 9, 2010 - 4:27PM
Australia's love affair with property is well-known. When it comes to investing, a negatively geared property has long been a preferred investment. Many people find it hard to go past the security bricks and mortar offer.
Unfortunately there are many myths about the tax advantages of property investing. When an investor does not understand the taxation rules, and they are audited, the resulting tax penalties can eat up any investment benefits.
One of the first tax myths of property investment relates to claiming travel costs. This is especially the case for interstate property ownership. There is a general misconception that all costs associated with visiting a rental property are tax-deductible. This includes airfares, accommodation and incidentals. Nothing could be further from the truth.
The proportion of travel expenses that can be claimed is determined by how much time is spent travelling related to the rental property. If you had a Queensland rental property and flew up there, stayed a week, and spent an hour inspecting the property, very little of the travel costs would be tax-deductible.
On the other hand if you spent a week arranging repairs, carrying out some repairs yourself, visiting the agent, buying furniture, and generally spent nearly all of your time on property matters, the whole of the travel costs would be tax-deductible.
Motor vehicle travel costs can also be deductible for local properties. Again, if the travel involves driving past the property it would be hard to justify a claim. Whereas if the trip relates to inspecting the property when a tenant leaves, doing the mowing or carrying out repairs, a claim could be made for the travel on a kilometre basis.
Another tax myth of property investing is the tax-deductibility of interest on loans. The property used as security for a loan does not dictate whether the interest is tax-deductible. Rather, it is the purpose for which the funds have been borrowed that determines tax-deductibility of interest. If the purpose of a loan is to purchase a home, rather than an investment property, the interest on the loan will not be tax-deductible.
A situation where this occurs is when a decision is made to purchase a new home but keep the old home as a rental property. Often the loan to purchase the original home has been almost repaid and there is a lot of equity in the property. Where a new loan is taken out using that equity, and the funds are used to purchase the new home, the interest is not tax-deductible.
From a tax point of view it makes a lot more sense to sell the original home, make a tax free capital gain on the sale, use the funds to purchase the new home, making this loan as small as possible, then find a new property to purchase as an investment.
The final tax myth of property investing is that all amounts spent on repairing a property are tax-deductible. A tax deduction can only be claimed on repairs to a rental property – not improvements. Improvements are any work that makes an asset better than the condition it was in when purchased.
It is for this reason repairs carried out after purchasing a property, to get it into a condition where it can be rented, are not tax-deductible. Where a property has been rented for some time, and work is carried out such as painting to repair damage while it was rented, the cost will be tax-deductible.
Investment tax questions can be emailed to max@taxbiz.com.au
This story was found at: http://www.smh.com.au/money/on-the-money/busting-property-investing-myths-20100609-xw3y.html
Low interest rates lead to debt: RBA
Low interest rates lead to debt: RBA
June 15, 2010 - 1:34PM
Financial deregulation and structural declines in the cash rate have led to increased household indebtedness, the Reserve Bank of Australia (RBA) says.
But while evidence suggests increased levels of debt have not left Australian households over-exposed, pockets of stress remain, RBA deputy governor Ric Battellino said on Tuesday.
"All countries have experienced rises in household debt ratios over recent decades," Mr Battellino said in a speech in Sydney.
Between 1985 and 1995, the average cash rate in Australia was 11.4 per cent, compared with the average 5.3 per cent between 2000 and 2010.
The current cash rate is 4.5 per cent following six rate hikes since October last year that took the rate off a 49-year low of three per cent.
However, Mr Battellino said first home buyers will bear close watching in the future while pockets of stress have emerged in Western Sydney following a sharp run up in house prices between 2002 and 2003.
"More recently there are some signs of increased housing stress in south-east Queensland and Western Australia, again following sharp rises in house prices in these areas," he said.
Mr Battellino said despite increased levels of debt, evidence suggests Australian households are servicing it well.
"If we look at the distribution of debt by income, we can see that the big increase in household debt over the past decade have been at the high end of the income distribution.
Mr Battellino was speaking to the Financial Executives International of Australia at the law firm Clayton Utz.
The event was closed to the media and an embargoed copy of the speech was provided.
This story was found at: http://news.smh.com.au/breaking-news-business/low-interest-rates-lead-to-debt-rba-20100615-ybxl.html
June 15, 2010 - 1:34PM
Financial deregulation and structural declines in the cash rate have led to increased household indebtedness, the Reserve Bank of Australia (RBA) says.
But while evidence suggests increased levels of debt have not left Australian households over-exposed, pockets of stress remain, RBA deputy governor Ric Battellino said on Tuesday.
"All countries have experienced rises in household debt ratios over recent decades," Mr Battellino said in a speech in Sydney.
"Clearly, therefore, the forces that drove the rise in household debt ratios were not unique to Australia.
"The two biggest contributing factors were financial deregulation and the structural decline in interest rates."
Between 1985 and 1995, the average cash rate in Australia was 11.4 per cent, compared with the average 5.3 per cent between 2000 and 2010.
The current cash rate is 4.5 per cent following six rate hikes since October last year that took the rate off a 49-year low of three per cent.
However, Mr Battellino said first home buyers will bear close watching in the future while pockets of stress have emerged in Western Sydney following a sharp run up in house prices between 2002 and 2003.
"More recently there are some signs of increased housing stress in south-east Queensland and Western Australia, again following sharp rises in house prices in these areas," he said.
Mr Battellino said despite increased levels of debt, evidence suggests Australian households are servicing it well.
Most household debt is being raised to buy assets, while debt is being taken on by households in the strongest position to service it.
He noted financial assets held by households have grown to the equivalent of 2.75 years of household income, up from 1.75 years income in the early 1990s.
"If we look at the distribution of debt by income, we can see that the big increase in household debt over the past decade have been at the high end of the income distribution.
"Households in the top two income quintiles account for 75 per cent of all outstanding household debt.
"In contrast, households in the bottom two income quintiles account for only 10 per cent of household debt."
Mr Battellino was speaking to the Financial Executives International of Australia at the law firm Clayton Utz.
The event was closed to the media and an embargoed copy of the speech was provided.
This story was found at: http://news.smh.com.au/breaking-news-business/low-interest-rates-lead-to-debt-rba-20100615-ybxl.html
Online Investing Tools Refine the Personal Touch
PERSONAL FINANCE May 28, 2010, 9:01PM EST
Online Investing Tools Refine the Personal Touch
Businesweek.com's latest look at online tools for individual investors reveals innovative new features for the do-it-yourself set
A year after the worst financial crisis in 80 years shook investors' confidence, mounting fear of contagion from Europe's debt crisis and rising market volatility offer fresh reminders of the need for greater vigilance. Investors and consumers may find it wise to adopt a hands-on approach in managing their personal finances and retirement accounts.
There is no shortage of resources for the do-it-yourself crowd. In its latest look at tools and technologies for individual investors, Businessweek.com examined nine websites (see slide show) that specialize in a range of areas, from actively managed investment portfolios and asset allocation advice to analytical stock research and personal finance. Whatever the topic, it is clear that there's a growing hunger for better ways to deal with money.
On kaChing.com, active investors get access to 16 different professional money managers. Their accounts can be as small as $3,000, vs. the minimum of $500,000 usually required by the managers' firms, and they pay ultra-low trading commissions because managers split commissions for each trade among all the clients who subscribe to their model on a pro rata basis.
Managers on kaChing get an investor IQ rating that takes into account how closely they stick to their stated investment style, their risk-adjusted returns (which weigh the performance of all their holdings separately), and the soundness of their investment strategy. An investor IQ must be at least 140 on a scale of 1 to 200 for a manager to be listed on kaChing.
This is a much more innovative way to measure a manager's skills than what's provided by the mutual fund industry, where no one can see what transpires in a portfolio between quarter-end dates, says Andy Rachleff, kaChing's co-founder and chief executive officer.
THE DOWNSIDE TO FIVE-STAR FUNDS
"Lack of transparency leads to an inability to develop a compelling ratings system," Rachleff says. "Without transparency, the only way to evaluate a mutual fund is on past returns, which aren't indicative of future returns," he says.
Once they have received a five-star rating from mutual-fund data provider Morningstar (MORN), mutual funds on average underperform the broad market, says Rachleff. When the influx of money that often results from Morningstar's highest rating has to be put to work, it tends to get invested in stocks that fund managers are less convinced about in order to avoid 5 percent ownership in the equities they already hold. (Owning a 5 percent stake in a company requires a more detailed level of financial disclosure to the Securities & Exchange Commission.)
Manager fees on kaChing average 1.25 percent of an investor's portfolio value, and one-quarter of the fee goes to the site. Investors also pay trading commissions on top of that, but commissions on an average account size of $10,000 tend to be 70¢ per trade, vs. the $7 to $10 you'd typically pay an online brokerage such as Charles Schwab (SCHW).
Unlike kaChing, Covestor Investment Management lets users follow both registered investment advisers and nonprofessionals, then replicate their trades. Covestor caps the risk investors can take according to their tolerance level, as well as if they're investing for a retirement account. The site won't replicate trades for stocks whose market cap is below $50 million in order to minimize liquidity risk. It warns clients about any performance drift from the model manager's returns because of the inability to replicate all trades, and it displays the average returns of investors who follow any single manager.
Clients must put a minimum of $5,000 in any model they subscribe to and the model managers set fees that can range from 0.5 percent to 2.3 percent and are split 50/50 with Covestor. In lieu of fees, nonprofessional managers receive royalty payments from Covestor for letting others follow and replicate their trades.
Growing interest in self-directed investing hasn't quieted the longstanding debate between proponents of active portfolio management and those who hew to index investing on the belief that it's impossible to beat the market consistently. In contrast to sites such as kaChing that stress active management and take a certain portion of management fees, MarketRiders offers only exchange-traded funds (ETFs) and shows users how much they can save in disclosed and hidden fees over the long run by avoiding active managers.
MENU OF ETFS AND MONTHLY REBALANCING
"The main difference with us is that philosophically we think if you start paying anybody more than 20 basis points [0.2 percent] to manage your money, you're going to end up with a lot less when you retire," says Mitch Tuchman, founder of MarketRiders.
Based on a user's age, stated risk tolerance, level of investing experience, and when he or she will begin to need the money, MarketRiders recommends an optimal asset allocation from a menu of ETFs vetted for superior performance and low fees. The site sends users monthly alerts about which holdings need to be rebalanced to return their portfolios to target allocations. Users pay $9.95 per month for the service, paying trading commissions only when they rebalance.
Andy Cohen, who manages a website that focuses on caring for older parents, began using MarketRiders a year and a half ago while it was in its beta testing phase. He uses the site to manage his retirement IRA and his 14-year-old son's college savings IRA, executing via a brokerage account at Charles Schwab (SCHW).
"I feel like I'm getting lots of diversification and it's very inexpensive," says Cohen. "I'm [investing in] stuff like commodities and international stocks, which I wouldn't have had the confidence to pick without MarketRiders telling me what to pick … and the right percentage of my portfolio to put in."
Cohen also likes the "non-nagging tone" of the monthly e-mail alerts about rebalancing. Another user, Bev Doughty, says it's pointless to use MarketRiders if you don't buy into the idea of rebalancing when assets either outperform or underperform target allocations.
Since it launched in March, Goalgami.com's audience has been primarily financial advisers who like the software's potential for helping them collaborate with clients—and communicate better with those who may not yet have figured out their goals. The site offers people privacy with which to work out various financial goal scenarios before they're ready to consult a professional adviser.
RISK CAPACITY VS. RISK TOLERANCE
Goalgami is based on the idea of goal-based investing, which holds that an individual's household balance sheet offers a better basis than a risk tolerance questionaire—the tool most advisors use to determine how conservative or aggressive a client's portfolio should be—for advisors to gauge what's appropriate for their clients.
"It's the difference between risk capacity and risk tolerance," says Advisor Software President Neal Ringquist, a proponent of goal-based investing and the creator of Goalgami. "The balance sheet measures how much risk a household should take, not how much risk they can bear to take psychologically."
On Goalgami's platform, users select goals and drop them onto a timeline or table. This allows them to see how these obligations translate into monthly costs and how they affect the user's affordability meter. With the drag of a mouse, the platform shows them how much money they could save by delaying retirement by five years, for example.
Investors aren't the only ones gravitating to the Internet in search of smarter ways to manage and build their wealth. Consumers trying to maintain a household budget, pay down debt, or save toward buying a home or some other important goal are finding comfort and practical advice at sites such asMint.com and LearnVest.com.
Ezzie Goldish, a young New York accountant, began using Mint just before the birth of his first child in June 2008. A month later, he lost his job while his wife was still working part-time so she could care for their baby. With Mint's help over the next year, the couple organized their finances and managed to pay off 40 percent of credit-card debt despite a 40 percent cut in income.
"As much as we thought we knew what we were doing, until you see [how you're spending] in front of you, it's a lot harder," he says. Goldish, who had already been getting calls for financial advice because of his profession, posted an economics survey on his blog for people in his Orthodox Jewish community. He has received hundreds of comments expressing interest in Mint from around the world.
AN ACTION PLAN TAILORED TO WOMEN
Mint can save a lot of time because it automatically integrates information from all of your accounts, eliminating the numbing task of having to input everything.
Although few people have been adequately schooled in personal finance, women tend to be especially unsure of themselves when it comes to understanding financial products and sticking to a financial plan, says Alexa von Tobel, founder of LearnVest, a website created specifically to help women meet their financial needs. Users appreciate being able to create a customized action plan that helps them save for graduate school or other goals, as well as the daily e-mail reminders to keep them motivated.
"They've created a tone that falls between your smart older sister and your best friend," says Bettina Scott, who's been using the site since last fall. "It's not like someone nagging you, but telling you this might be a good thing to think about."
LearnVest also offers insightful content written addressing how to buy a nice, affordable Mother's Day bouquet or throw a dinner party without spending a lot. "Consciously or unconsciously, it changes your mindset about finance. It makes you feel more comfortable with it" says subscriber Alexandrine Koegel.
Online tools available to investors and consumers have increased in sophistication and utility over the years. Will they prove to have made a difference over the long term? Leslie Linfield, executive director of the Institute for Financial Literacy in Portland, Me., wonders.
"Do they really stick with it?" Linfield asks. "It's about following through. Don't get caught up in the bells and whistles."
Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.
http://www.businessweek.com/print/investor/content/may2010/pi20100526_506024.htm
http://www.businessweek.com/print/investor/content/may2010/pi20100526_506024.htm
US government extracted $20 billion escrow fund from BP. How much did the Bhopal disaster victims get?
One cannot but empathize with the Bhopal disaster victims in India. After lengthy court cases, and over many years, how much were they compensated?
Contrast this with what the US government extracted from BP.
Contrast this with what the US government extracted from BP.
Wednesday 16 June 2010
The link between keyfinancial ratios and ratings
The link between keyfinancial ratios and ratings
Tags: Financial ratios | GDP | MARC | ratings
Written by A report by MARC
Monday, 14 June 2010 11:02
Introduction and sample description
This statistical report by MARC Fixed Income Research explores the degree of correlation between a set of financial ratios and assigned credit ratings based on available financial information from 2004 to 2009. We used the same financial information used by rating analysts in their credit rating process.
Since the majority of the 2009 financial information used in this analysis is unaudited and incomplete at the point of writing this report, caution must be exercised when going through the median ratios.
Our sample is limited to corporate debt and project finance issuers with long-term ratings and sufficient financial data. Companies lacking financial information are excluded from the sample. The data of these companies are available consistently throughout the period under analysis.
Median financial ratios along this time horizon are presented to eliminate the number of distortions that would have otherwise resulted from a reading of averages.
Moreover, the medians are derived under three different scenarios in which we first estimated the long-run median financial ratios using data from between 2004 and 2009.
The ratio medians vary throughout the six years, which could be due to various reasons such as change in sample size, economic cycles and changes in rating methodology.
The impact of cycles on companies’ performance is established using estimates of three-year medians for two periods: 2004-2006, which can be characterised as a boom period when real gross domestic product (GDP) grew at 6% on average, and 2007-2009, when average real GDP growth halved to 3% amidst a steep decline in global economic activity in 2008 and 2009.
This statistical study features the median ratios across three major rating bands, namely “AAA”, “AA” and “A & Lower” among rated corporate, excluding financial institutions. The lower rated institutions are grouped under “A & Lower”, due to the extremely small number of ratings belonging to that segment of the rating universe.
Medians of financial ratios reported in this study cannot be used on their own to benchmark issuers across different rating bands, as the judgmental credit scoring model used by credit rating analysts incorporates non-financial and qualitative considerations.
Nevertheless, historical financial measures may complement analysis undertaken in respect of an issuer’s business and industry risks.
Linear relationship between selected median financial ratios and the spectrum of long-term corporate ratings
During the period 2004-2009, we found a consistent pattern in the relationship between financial ratios and rating bands, with the strongest ratios witnessed among issuers positioned at the highest end of the rating scale.
For instance, median operating margins — which are used as a gauge of corporate profitability — stand at 30.3% for AAA-rated companies, 22.5% for AA-rated companies and 10% for A & Lower-rated companies.
While our rating analysts rely on debt-to-equity to evaluate the gearing level in assessing corporate credit quality, we added debt-to-Earnings before interest, taxes, depreciation and amortisation (Ebitda), which provides a rough measure of how many years of Ebitda would be necessary to repay all debt (assuming both the levels of debt and Ebitda are constant).
It is worth noting here that the usage of debt-to-Ebitda in this study does not indicate that this ratio is superior to debt-to-equity; indeed, rating analysts may have their own considerations for using debt-to-equity such as volatility in reported year-to-year Ebitda in evaluating debt servicing capacity from another angle.
The debt-to-Ebitda for AAA-rated companies stands at 2.5 times — and as we move down the ratings scale, the “AA” and “A & Lower” rating bands have a reading of 3.8 times and 7.1 times, respectively.
Other median financial ratios related to debt servicing capacity, namely the cash flow from operations-to-total debt (CFO), free cash flow-to-total debt (FCF) and debt service coverage ratio (DSCR), are also consistent with the credit strength of companies in our sample as depicted in Exhibit 2.
We measure interest coverage in terms of Ebit and Ebitda, and both ratios indicate a higher coverage among highly-rated credits with a reading of Ebitda interest coverage of 6.4 times for “AAA”, 2.5 times for “AA” and two times for “A & Lower bands”.
To supplement this analysis further, we also incorporate other statistics such as the three-year credit risk premiums, corporate default rates and corporate rating stability along those rating bands. The corporate default rates and rating stability measures are derived from our annual corporate default study.
Median financial ratios for contrasting points in economic cycle: the boom of 2004-2006 vs the gloom of 2007-2009
The cyclical component of corporate performance derives directly from business cycle, which — in turn — is generally correlated with the level of economic activity. The median ratios under the two contrasting points in the economic cycle; the boom of 2004-2006 and the downturn of 2007-2009 are set out below in Exhibits 3 and 4.
The 2004-2006 period is characterised as the boom period, with low market volatility and normal corporate risk premium levels.
The 2007-2009 period, on the other hand, is categorised as a downturn triggered by a significant global recession. It was during this period that we saw a sharp rise in market volatility and risk premiums alongside declining aggregate demand in the domestic economy and compressed profit margins.
The downturn in the economic cycle took a visible toll on corporate profitability which was evidenced by the retreat in operating margins from 21.4% during 2004-2006 to 17.8% during 2007-2009.
Nevertheless, the linear relationship between margin compression and our ordinal credit ranking system remains consistent, with issuers in highly rated bands continuing to exhibit relatively favourable ratios compared to issuers in the lower rated bands.
Other median ratios measuring interest coverage and debt servicing capacity also deteriorated in the 2007-2009 business cycle.
Another significant finding from our analysis is that cash from operations can be quite volatile during a downturn cycle, even for companies in the higher rating bands.
As can be seen from Exhibit 4, the differences in CFO-to-total debt along the rating bands become less significant compared to the period of stable operations in the 2004-2006 business cycle.
The volatility of free cash flow is even more extreme where the median FCF-to-total debt for the AA-rated companies which stood at 4.2% in 2004-2006 fell to -0.4% in 2007-2009, hence eliminating the linear relationship seen in the period of stable operations.
The behaviour of the median financial ratios under boom and downturn scenarios appears to justify the apparent increasing downward rating momentum seen, particularly in 2009.
There was a weakening of corporate balance sheets during the economic downturn. Again, as can be seen in Exhibits 3 and 4, the average corporate default rate rose from 0.6% in 2004-2006 to 2.2% in 2007-2009, and during the same period, credit risk premiums also widened considerably across all rating bands.
Rating stability of the overall corporate portfolio was notably affected, but then again, the resilience of issuers positioned in higher rating bands during the period of downturn is borne out in the consistent linear relationship between each of two variables and rating bands.
This article appeared in The Edge Financial Daily, June 14, 2010.
Tags: Financial ratios | GDP | MARC | ratings
Written by A report by MARC
Monday, 14 June 2010 11:02
Introduction and sample description
This statistical report by MARC Fixed Income Research explores the degree of correlation between a set of financial ratios and assigned credit ratings based on available financial information from 2004 to 2009. We used the same financial information used by rating analysts in their credit rating process.
Since the majority of the 2009 financial information used in this analysis is unaudited and incomplete at the point of writing this report, caution must be exercised when going through the median ratios.
Our sample is limited to corporate debt and project finance issuers with long-term ratings and sufficient financial data. Companies lacking financial information are excluded from the sample. The data of these companies are available consistently throughout the period under analysis.
Median financial ratios along this time horizon are presented to eliminate the number of distortions that would have otherwise resulted from a reading of averages.
Moreover, the medians are derived under three different scenarios in which we first estimated the long-run median financial ratios using data from between 2004 and 2009.
The ratio medians vary throughout the six years, which could be due to various reasons such as change in sample size, economic cycles and changes in rating methodology.
The impact of cycles on companies’ performance is established using estimates of three-year medians for two periods: 2004-2006, which can be characterised as a boom period when real gross domestic product (GDP) grew at 6% on average, and 2007-2009, when average real GDP growth halved to 3% amidst a steep decline in global economic activity in 2008 and 2009.
This statistical study features the median ratios across three major rating bands, namely “AAA”, “AA” and “A & Lower” among rated corporate, excluding financial institutions. The lower rated institutions are grouped under “A & Lower”, due to the extremely small number of ratings belonging to that segment of the rating universe.
Medians of financial ratios reported in this study cannot be used on their own to benchmark issuers across different rating bands, as the judgmental credit scoring model used by credit rating analysts incorporates non-financial and qualitative considerations.
Nevertheless, historical financial measures may complement analysis undertaken in respect of an issuer’s business and industry risks.
Linear relationship between selected median financial ratios and the spectrum of long-term corporate ratings
During the period 2004-2009, we found a consistent pattern in the relationship between financial ratios and rating bands, with the strongest ratios witnessed among issuers positioned at the highest end of the rating scale.
For instance, median operating margins — which are used as a gauge of corporate profitability — stand at 30.3% for AAA-rated companies, 22.5% for AA-rated companies and 10% for A & Lower-rated companies.
While our rating analysts rely on debt-to-equity to evaluate the gearing level in assessing corporate credit quality, we added debt-to-Earnings before interest, taxes, depreciation and amortisation (Ebitda), which provides a rough measure of how many years of Ebitda would be necessary to repay all debt (assuming both the levels of debt and Ebitda are constant).
It is worth noting here that the usage of debt-to-Ebitda in this study does not indicate that this ratio is superior to debt-to-equity; indeed, rating analysts may have their own considerations for using debt-to-equity such as volatility in reported year-to-year Ebitda in evaluating debt servicing capacity from another angle.
The debt-to-Ebitda for AAA-rated companies stands at 2.5 times — and as we move down the ratings scale, the “AA” and “A & Lower” rating bands have a reading of 3.8 times and 7.1 times, respectively.
Other median financial ratios related to debt servicing capacity, namely the cash flow from operations-to-total debt (CFO), free cash flow-to-total debt (FCF) and debt service coverage ratio (DSCR), are also consistent with the credit strength of companies in our sample as depicted in Exhibit 2.
We measure interest coverage in terms of Ebit and Ebitda, and both ratios indicate a higher coverage among highly-rated credits with a reading of Ebitda interest coverage of 6.4 times for “AAA”, 2.5 times for “AA” and two times for “A & Lower bands”.
To supplement this analysis further, we also incorporate other statistics such as the three-year credit risk premiums, corporate default rates and corporate rating stability along those rating bands. The corporate default rates and rating stability measures are derived from our annual corporate default study.
Median financial ratios for contrasting points in economic cycle: the boom of 2004-2006 vs the gloom of 2007-2009
The cyclical component of corporate performance derives directly from business cycle, which — in turn — is generally correlated with the level of economic activity. The median ratios under the two contrasting points in the economic cycle; the boom of 2004-2006 and the downturn of 2007-2009 are set out below in Exhibits 3 and 4.
The 2004-2006 period is characterised as the boom period, with low market volatility and normal corporate risk premium levels.
The 2007-2009 period, on the other hand, is categorised as a downturn triggered by a significant global recession. It was during this period that we saw a sharp rise in market volatility and risk premiums alongside declining aggregate demand in the domestic economy and compressed profit margins.
The downturn in the economic cycle took a visible toll on corporate profitability which was evidenced by the retreat in operating margins from 21.4% during 2004-2006 to 17.8% during 2007-2009.
Nevertheless, the linear relationship between margin compression and our ordinal credit ranking system remains consistent, with issuers in highly rated bands continuing to exhibit relatively favourable ratios compared to issuers in the lower rated bands.
Other median ratios measuring interest coverage and debt servicing capacity also deteriorated in the 2007-2009 business cycle.
Another significant finding from our analysis is that cash from operations can be quite volatile during a downturn cycle, even for companies in the higher rating bands.
As can be seen from Exhibit 4, the differences in CFO-to-total debt along the rating bands become less significant compared to the period of stable operations in the 2004-2006 business cycle.
The volatility of free cash flow is even more extreme where the median FCF-to-total debt for the AA-rated companies which stood at 4.2% in 2004-2006 fell to -0.4% in 2007-2009, hence eliminating the linear relationship seen in the period of stable operations.
The behaviour of the median financial ratios under boom and downturn scenarios appears to justify the apparent increasing downward rating momentum seen, particularly in 2009.
There was a weakening of corporate balance sheets during the economic downturn. Again, as can be seen in Exhibits 3 and 4, the average corporate default rate rose from 0.6% in 2004-2006 to 2.2% in 2007-2009, and during the same period, credit risk premiums also widened considerably across all rating bands.
Rating stability of the overall corporate portfolio was notably affected, but then again, the resilience of issuers positioned in higher rating bands during the period of downturn is borne out in the consistent linear relationship between each of two variables and rating bands.
This article appeared in The Edge Financial Daily, June 14, 2010.
Li Lu sharing his Value Investing Strategies (Video)
Li Lu: Berkshire Hathaway CIO Candidate?
Video:
Video on Value Investing by Li Lu
http://www.megavideo.com/?v=J8XLH2O0
http://www.dailymarkets.com/stocks/2010/06/01/who-is-li-lu/
This past weekend was the Berkshire Hathaway (NYSE:BRK.A / BRK.B) annual shareholder meeting. At one point during the Q&A, a questioner asked Warren Buffett about the status of Berkshire’s CIO candidates. Charlie Munger remarked that one candidate who he is particular close with was up 200% in 2009 with 0 leverage. Some people think that the person Munger is referring to is Li Lu, a fund manager who turned Munger and Buffett onto BYD.
Lu personally owns at least 2% of BYD, which rose 400% in 2009. I don’t know anything about his investments beyond that one position, but I know he is a huge believer in taking concentrated, high conviction positions. If that is the case here, BYD’s spectacular results must have contributed a lot to his returns for 2009 which may make a 200% for the year possible.
Here is a brief bio on Lu:
Li Lu was born in China in 1966. He attended Nanjing University in China and later came to the U.S., and earned three degrees (BA, JD, MBA) simultaneously from Columbia University. After graduation, he worked in an investment bank until 1997, when he founded Himalaya Capital Management, which today manages both LL Investment Partners and Himalaya Capital Ventures, funds focused on publicly traded securities and venture capital. Li Lu was named a global leader for tomorrow by the World Economic Forum in 2001, and a Henry Crown fellow by the Aspen Institute in 1998. He is a member of Council on Foreign Relations and Young Presidents’ Organization.
Fortune: Barnstorm Green
There isn’t a whole lot of information about Lu’s investing style out there. But I thought I would share some notes from a lecture he gave to Columbia Business School back in 2006. All of this is paraphrased, so don’t take anything as a direct quote and there may even be some inaccuracies. Still, I believe you will find these notes insightful, especially with respect to improving your own abilities as an analyst and investor. Even if Lu is not a Berkshire Hathaway CIO candidate, he is an investor with a tremendous work ethic that we could all learn from.
Below are my notes from Lu’s lecture:
Li Lu at Columbia Business School – 2006
-15 years ago, Lu was accidentally brought in to a lecture by Warren Buffett. Had epiphany moment, Lu thought he could do something in the investment business.
-At the time, Lu had just escaped China. Did not know very many people. No money, deep in debt. Worried about making a living in the US.
-In the middle of Buffett speech, made him think differently about the stock market.
-The more Lu thought about it, the more he thought it was something he could do.
-Value investors see themselves as owners of a business. Therefore, fortunes are up and down with the nature of the business.
-You demand a margin of safety.
3 Traits of a Value Investor:
1. Basically, you don’t think of yourself as a paper shuffler who constantly buys and sells securities. You think of yourself as a real owner of the business.
2. You only own a small piece of the business, so you demand a huge margin of safety.
3. Because you think of yourself as an owner, not trading all the time, you think everyone else is different — like Ben Graham’s Mr. Market
On Value Investing
-Under 5% of all assets are run under value investors, a real minority in the investment world.
-The stock market is created for the other 95% of people, that is where your opportunity and challenge is.
-That was one lesson that stuck in Lu’s mind when listening to Buffett’s lecture.
-Biggest challenge: understand whether you are the 5% or the 95%
-It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
-5% have a spectacular return, but 95% of money probably always resides to somewhere else.
-Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
-If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
-You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
-The more you know, the better you are as an investor.
-Politics, science, technology, literature, poetry, everything can affect businesses and help you.
-Occasionally you can find insights that will give you tremendous insights that other people don’t have.
-Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?
-Started fund in late 1997. Been through really traumatic events: Asian Financial Crisis, Tech Bubble.
-Fall of 1998: Lu’s search process is very general. Got hooked on value line, loved to read the whole thing from beginning to end. The best kind of education, you should do this if you want encyclopedic knowledge of companies. Go through it page after page, it is enormously helpful.
-First thing Lu checks is new low list. New low P/Es, P/Bs, etc.
-Does not care where something traded before.
-First looks at valuation. If the valuation doesn’t fit, doesn’t go beyond it.
-If you see a low P/B ratio, ask – What is in the book? How much is the book?
-Encyclopedic knowledge is helpful when looking across different industries.
-Look at pre-tax and pre-interest earnings. Look from an un-leveraged basis. Figure out how much capital is deployed in the business. Look at ROIC.
Example: Timberland
-Start by giving a 5 second look at the business. Timberland. The business is trading around clean book value, consisting mostly of tangible liquid assets, working capital, plus 100M in real estate. Deployed capital is 200M with 100M return.
-Then check why the business fell apart and became cheap. Think if you had owned the entire business at that price.
-At the time, was the height of the Asian Financial Crisis, saw their sales falling off the cliff in Asia. Any thing with exposure to Asia was falling apart. Try to check what other people are thinking about this. You may not listen to their advice but you may want to know what other people are looking at.
-Timberland had no other analysts covering it.
-Why no coverage?
-Look at business across years. Timberland has been growing, pretty profitable, did not need financial markets. Family owned. Owns 40% controlling 98% vote.
-Immediately, that is a turnoff to most people. You can do a quick data search.
-You need to have a curious, active mind to ask questions and find answers.
-Timberland had most of the vote, no analyst coverage, a bunch of shareholder lawsuits. If you were a member of the other 95% of the investment business you might say maybe management is milking the business.
-Download every court document lawsuit. Read it. You NEED a very curious mind to figure out WHAT is happening. Dig every single time. READ EVERYTHING.
-The first time, it takes a couple minutes to look over financials. Then gather questions and do deep research.
-Most lawsuits came from Timberland missing guidance, annoying investors, which annoyed the owner of the business. They decided to stop talking to Wall Street. So it was not about milking the business or fraud. They were not crooks.
-How do you determine if they are good managers? Decent people?
-Act like an investigative journalist. Most business owners leave a trail for you to follow and see how they deal with different situations. Most professional managers would not see this as part of their job, but YOU are part of their 5%.
-Go to their community, visit people they know, their Church, their Synagogue, introduce yourself to their friends and neighbors. It is worth it to spend as much time as possible, to find what these business people have done and what their neighbors say about them to accurately get an idea of their personality.
-The father seemed like a simple, decent guy, just a high school graduate. the son went to business school, was already COO of the company even though he was Lu’s age. Lu saw what boards the son sat on, and noticed that they had a mutual friend. Managed to get himself on the board with the son and became friends quickly. Came to realize these where high quality, very ethical businessmen.
-After all that, saw the stock was still trading low. Decided he did not miss anything. The other 95% may not have done enough research to see this or have some kind of institutional imperative that prevents them from owning.
-If you are not a good analyst, you will never be a good investor.
-But we decide to buy. How much do we buy? Imagine having $900. The other 95% will take tiny positions, 50 basis points. You need to use concentration, a $200 position. Think of how much work you did. Lu visited all the stores to see how margins improved – they had a fad going on where kids wanted the shoes. Their asian business is tiny, reduced earnings by less than 5%.
-Lu put a ton into Timberland. What happened after next 2 years? Stock went up 700%. Propelled by earnings. No real risk – went from trading at 5x earnings to 15x with earnings growing 30% a year. It adds up.
Be a Learning Machine
-When an investment opportunity comes, you have to seize it. Devote day and night so you can act quickly. Do everything complete but do it fast. You have to train yourself to jump on opportunity.
-When opportunity presents itself you can smell it. The only way to do that is by training yourself and reading page after page of financial report.
-Uses S&P manuals for viewing foreign stocks.
-As an owner, don’t think about per share information.
-Use your brain, when looking at stock manuals, each page should really only take 5 minutes. Don’t use calculators. Use mental math.
Example: Korean Company
-60M market cap, pre-tax earnings of 31M, roughly 2x pre-tax earnings.
-Book value of 230M, what constitutes book value? If you are an owner, look at: fixed assets, working capital, don’t count on goodwill.
-Basically you see with 60M in market cap, 30M in pre-tax, $240M in book value ($180M in fixed assets)
-It might be cheap.
-Determine what the earnings is. The book. The working capital.
-Use common sense, common logic and think about the business.
-Most employees never went to business school, Lu finds they are easier to train.
-Of the 70M in current assets, it is all cash
-Of 180M in fixed assets, they own 100% of a hotel, recorded 30M as book. Own 13% of a department store recorded as 30M.
-Look up the department store, it roughly has a market cap of 600M. 13% gives you roughly 80M. So the book value undervalues it by another 50M.
-They own 15% of 3 cable companies and a whole bunch of real estate.
-The department store has exactly the same profile. Trading roughly around cash and investments, good earnings, and own a whole bunch of assets. Turns out they are the second largest cable operator as well
-The department store operates like a hotel, do not take inventory, more like a shopping mall.
-They charge a percentage on the top line of all merchant sales.
-Put it all together: Paying 60M, 70M in net cash, another 100M in stock, 30M in hotel with a value that has not been changed in last 10 years while real estate market has gone up in 10 years. Went to Korea, looked at hotel and department stores.
-Checked recent transaction of properties in neighborhood, value is likely 2-3x what is on the book. But take what is on the book anyway, add 150M. Add that to rest and you get 320M in assets that you are paying 60M for and earning 30M annually from operations.
-Insiders own 50%
-Many factors going in your favor, but you need to look at how local investors see it. They need to be buying it for the price to go up.
-Department store used to trade at 22 went to 100
-This company was at 12 now trades around 70
-each went up 5-6x
Don’t just listen. Do it.
-This type of an approach is not natural to an investor.
-If you decide your personality fits in with the mutated gene pool, that this is something you might be looking to do, there is a lot of money in it — proven by Ben Graham to Buffett
-You have to put in a lot of work into your analysis.
-You can make a lot of money if you are really interested, listening, and actually DOING IT.
-Lu benefited from listening to his value investing class and then actually going out and doing the work required.
-Value investing is not really about theory, it is about what works.
-Young analysts have energy and nothing to lose, so they should go and do the work.
-Before you become a good investor, you need to be a good analyst.
Lu says you need two things to be a good analyst:
1. Provide accurate and complete information. You have to go to an extra length to get it done. Most of the time you will stand alone against everybody else. If you are not competent about what you know, you cannot possibly take conviction positions when things go into free fall and everybody else is laughing at you.
2. Most money is not made in stocks from the examples. They do not provide out-sized returns. You can do the Tweedy Brown/Graham or the Buffett/Munger school. Your returns will come from a handful of stocks. You need tremendous insight by continuous intense curiosity and study.
Investment Mistakes
-Most mistakes come from inaccurate or incomplete information.
-Biggest mistake: most people wanted 2 week or monthly returns. They wanted to go up in down markets.
-Lu’s biggest mistake was straying, was working with Julian Robertson, started shorting — have to think like a trader when you are shorting because your downside can be unlimited. It’s like Charlie Munger says — having your hands tied behind your back while getting into a fight.
-Missed the opportunity to buy a business below cash, even though Lu knew the management and had great insights. The business subsequently went up 50-100x. Could not bring himself to buy it because of his mindset at the time.
-You make a mistake when you have not finished your work but like it enough. You start betting on probabilities instead of real analysis.
Constantly search for ideas
-In your life, you may only have 5-10 key moments of insight. You only get it from continuous learning. Find an American business and then find the Asian counterpart. Some businesses studied for 15 years. You need to know what that business is, how it ticks, so you can swing with conviction. If you cannot do that you will not make huge out-sized returns.
-If you do what Ben Graham or Tweedy Brown does, you will make 15-20% returns but you wont make the huge returns of Buffett.
-The biggest ideas can give 10,000x returns.
-Opportunities are not easy to find. They require a lot of factors to come together – Charlie Munger’s lollapalooza. You need a whole bunch of things working together where you have the insight and are willing to bet.
-This is what drives Lu in business.
-Lu started in physics, mathematics, law, economics, got interested in other subjects. Wife has a PhD in biology, he has learned a lot from her.
-Learn from everything, be intensely curious
-Eventually you will stumble into one big opportunity.
-In the meantime, you will stumble into Timberland style investments which aren’t bad.
-There might be years without opportunities, then years with a lot of opportunities.
-Depends on what becomes available to you.
-They do not come in a steady pace, not like once a week an idea.
-In 6 years, Lu had maybe 3-4 great ideas. But you get progressively better and better, improving the amount of opportunities for you since you will be quicker at your analysis.
-Go through every day by learning something. In a year you have to learn a great deal.
-When Lu reads biology, physics, history, it is all searching for ideas. If one idea jumps out, it is all Lu does. Rest of the time is spent with wife and kids and Lu learns from them too, especially with seeing how human cognition develops which is enormously important.
Li Lu’s Investing Checklist:
1. Is that cheap?
2. Is it a good business?
2. Who is running it?
3. What did I miss?
-Lu goes through the checklist, ‘what did I miss’ is greatly affected by psychology. This kind of cognition happens early on and Lu learns it from interacting with his girls.
Three characteristics of a value investor:
1. Business owner mentality
2. Difference in time horizon
3. Demand a huge margin of safety
Think like a Business Owner
-It all comes from one thing, that you are a business owner. You cannot force management changes, so you demand a margin of safety. You have a long time horizon because you think like an owner.
-But why dabble with stock market? Stock markets are made for people who can dream. That is why 95% of people never buy into value investing. Human nature prevents it.
-You do not belong to the stock market but you have to understand its perspective to position yourself properly. If you are truly think like a business owner, you will eventually leave the asset management business and run a real company. That is why Buffett and Munger left it.
-Or you become a private equity investor.
-The people who the stock market is designed for are fundamentally flawed people. Traders are bound to make mistakes due to fear or greed. They will always make room for value investors.
-Used to be strict about selling with great business. Now, sometimes Lu feels he has insights about the business that allows him to believe the probabilities are in his favor for the business actually improving year after year.
-That is the law of distribution in good businesses. The leaders perform spectacularly well.
-Selling makes you pay a huge amount of tax and you might not get that good buying price again.
-If a business can generate 50-100% ROIC, the mathematics get interesting very quickly.
-Caveat: you have to be very confident. Investment bankers use BS and project into infinity. You cannot project that long. There are only a few opportunities where you can project that long.
-If you are good, and spend your entire lifetime studying, across 50 year career maybe 5-10 opportunities where you can confidently project the next 10-20 years. At that point, you don’t want to sell. By holding you don’t pay the tax on capital gains, so you are really compounding 40% interest free, the business is deploying the capital at 40-100% a year in a tax efficient manner. That is what you do.
-You have to identify businesses that are getting stronger and stronger every year.
-What makes one business more successful than others? Why are they making more and more money compared to others?
-The only way you can find that is by studying the ones that are established.
-Look for great businesses, not just businesses owned by Warren Buffett
Example of a great business: Bloomberg LP
-Product was superior to others, high switching costs
-Bloomberg is a fabulous case study, it came out of no where.
-Gained market share little by little, crossed a milestone point, became a monopoly
-At a certain point, after being highly relied upon for daily work, the switching costs become to high so winner takes all.
-Suppose you have an opportunity to see how an industry evolves early on. At a certain point they cross the line
-Maybe when introduced to all businesses. There is a time when that line gets crossed and a public company is poised to benefit by becoming a monopoly business.
-Why did Microsoft succeed over Apple? Little by little they eroded Apple’s 100% market share.
-Offices were using Windows. Today – do you have a choice of not using Bloomberg?
-Bloomberg visits almost every month and asks what you do, how you use the system. Bloomberg terminals have tens of thousands of functions, they don’t give you a manual
-They want you visually hooked so it is a behavioral connection and you don’t mind paying tens of thousands of years where you don’t have a choice if they raise prices
-They keep coming back to you because they know you are a trader and want to provide you with more services so you are hooked.
-That is why Bloomberg is a fabulous business because you get hooked. Think about switching from that or a competitor coming up with a rival product. How do you compete with that?
-Lu doesn’t know. Suppose you know the inflexion point. Do you want to invest? Lu would invest in Bloomberg at that point.
-You need insight. Study every business. They all have more or less this type of dynamic.
-Your job as a good financial analyst is to study that business ALL THE TIME. Observe those trends.
-Once in your life, maybe you will find that opportunity.
-Why doesn’t Bloomberg want to sell? He doesn’t need to sell.
-When you have a business like that, you don’t need to sell.
-Lu has made many private investments, ex: CapitalIQ, which copies Bloomberg’s business model. Same method with an investment in an engineering service.
-Lu likes to know as much as he can. He likes to be friends with people, with Timberland, the CEO and his son actually became investors in Lu’s fund.
-You can learn and observe from everyday business decisions and learn dynamics.
-Nothing is constant. Everything is changing that is why you have to keep learning.
-Businesses change, Microsoft has threats now.
-You need an active mind, so you are prepared to act and you can seize opportunity due to your insights.
Comment:
Value investors: Distinguishing features (1) You are a business owner. (2) As you own business, nsight (big ideas) into many businesses so that you can bet big when all the factors come together in your favour, a huge wave behind you. With that insight, you will be willing to bet, based on your complete insight.
As you get better and better, you establish a good insight. Continue to learn. You only need less than 5 minutes to smell out a good company.
The market is designed for traders and not designed for value investors. Those who trade will occasionally make mistakes, that is when you as a value investor comes in.
When you have the confidence to project a business earnings into next 10 or 20 years, why do you need to sell? These companies' valuations are usually established and are getting stronger and stronger.
Why is this business getting better and better, making more and more money? Why are some companies making money some years and making less money or not making money other years?
Sometime, companies coming from no where, somehow began to make an in-road into their industries and they become a monopoly. Observe the industry, determine when the threshold is crossed. Having this sort of insight is what you should have. Think Microsoft in its early years ... little by little, it crossed that line. Now with free browser sites, the dynamics affecting Microsoft are different.
Excellent video. Smart and powerful ideas which are very applicable in your investing.
Video:
Video on Value Investing by Li Lu
http://www.megavideo.com/?v=J8XLH2O0
http://www.dailymarkets.com/stocks/2010/06/01/who-is-li-lu/
This past weekend was the Berkshire Hathaway (NYSE:BRK.A / BRK.B) annual shareholder meeting. At one point during the Q&A, a questioner asked Warren Buffett about the status of Berkshire’s CIO candidates. Charlie Munger remarked that one candidate who he is particular close with was up 200% in 2009 with 0 leverage. Some people think that the person Munger is referring to is Li Lu, a fund manager who turned Munger and Buffett onto BYD.
Lu personally owns at least 2% of BYD, which rose 400% in 2009. I don’t know anything about his investments beyond that one position, but I know he is a huge believer in taking concentrated, high conviction positions. If that is the case here, BYD’s spectacular results must have contributed a lot to his returns for 2009 which may make a 200% for the year possible.
Here is a brief bio on Lu:
Li Lu was born in China in 1966. He attended Nanjing University in China and later came to the U.S., and earned three degrees (BA, JD, MBA) simultaneously from Columbia University. After graduation, he worked in an investment bank until 1997, when he founded Himalaya Capital Management, which today manages both LL Investment Partners and Himalaya Capital Ventures, funds focused on publicly traded securities and venture capital. Li Lu was named a global leader for tomorrow by the World Economic Forum in 2001, and a Henry Crown fellow by the Aspen Institute in 1998. He is a member of Council on Foreign Relations and Young Presidents’ Organization.
Fortune: Barnstorm Green
There isn’t a whole lot of information about Lu’s investing style out there. But I thought I would share some notes from a lecture he gave to Columbia Business School back in 2006. All of this is paraphrased, so don’t take anything as a direct quote and there may even be some inaccuracies. Still, I believe you will find these notes insightful, especially with respect to improving your own abilities as an analyst and investor. Even if Lu is not a Berkshire Hathaway CIO candidate, he is an investor with a tremendous work ethic that we could all learn from.
Below are my notes from Lu’s lecture:
Li Lu at Columbia Business School – 2006
-15 years ago, Lu was accidentally brought in to a lecture by Warren Buffett. Had epiphany moment, Lu thought he could do something in the investment business.
-At the time, Lu had just escaped China. Did not know very many people. No money, deep in debt. Worried about making a living in the US.
-In the middle of Buffett speech, made him think differently about the stock market.
-The more Lu thought about it, the more he thought it was something he could do.
-Value investors see themselves as owners of a business. Therefore, fortunes are up and down with the nature of the business.
-You demand a margin of safety.
3 Traits of a Value Investor:
1. Basically, you don’t think of yourself as a paper shuffler who constantly buys and sells securities. You think of yourself as a real owner of the business.
2. You only own a small piece of the business, so you demand a huge margin of safety.
3. Because you think of yourself as an owner, not trading all the time, you think everyone else is different — like Ben Graham’s Mr. Market
On Value Investing
-Under 5% of all assets are run under value investors, a real minority in the investment world.
-The stock market is created for the other 95% of people, that is where your opportunity and challenge is.
-That was one lesson that stuck in Lu’s mind when listening to Buffett’s lecture.
-Biggest challenge: understand whether you are the 5% or the 95%
-It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
-5% have a spectacular return, but 95% of money probably always resides to somewhere else.
-Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
-If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
-You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
-The more you know, the better you are as an investor.
-Politics, science, technology, literature, poetry, everything can affect businesses and help you.
-Occasionally you can find insights that will give you tremendous insights that other people don’t have.
-Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?
-Started fund in late 1997. Been through really traumatic events: Asian Financial Crisis, Tech Bubble.
-Fall of 1998: Lu’s search process is very general. Got hooked on value line, loved to read the whole thing from beginning to end. The best kind of education, you should do this if you want encyclopedic knowledge of companies. Go through it page after page, it is enormously helpful.
-First thing Lu checks is new low list. New low P/Es, P/Bs, etc.
-Does not care where something traded before.
-First looks at valuation. If the valuation doesn’t fit, doesn’t go beyond it.
-If you see a low P/B ratio, ask – What is in the book? How much is the book?
-Encyclopedic knowledge is helpful when looking across different industries.
-Look at pre-tax and pre-interest earnings. Look from an un-leveraged basis. Figure out how much capital is deployed in the business. Look at ROIC.
Example: Timberland
-Start by giving a 5 second look at the business. Timberland. The business is trading around clean book value, consisting mostly of tangible liquid assets, working capital, plus 100M in real estate. Deployed capital is 200M with 100M return.
-Then check why the business fell apart and became cheap. Think if you had owned the entire business at that price.
-At the time, was the height of the Asian Financial Crisis, saw their sales falling off the cliff in Asia. Any thing with exposure to Asia was falling apart. Try to check what other people are thinking about this. You may not listen to their advice but you may want to know what other people are looking at.
-Timberland had no other analysts covering it.
-Why no coverage?
-Look at business across years. Timberland has been growing, pretty profitable, did not need financial markets. Family owned. Owns 40% controlling 98% vote.
-Immediately, that is a turnoff to most people. You can do a quick data search.
-You need to have a curious, active mind to ask questions and find answers.
-Timberland had most of the vote, no analyst coverage, a bunch of shareholder lawsuits. If you were a member of the other 95% of the investment business you might say maybe management is milking the business.
-Download every court document lawsuit. Read it. You NEED a very curious mind to figure out WHAT is happening. Dig every single time. READ EVERYTHING.
-The first time, it takes a couple minutes to look over financials. Then gather questions and do deep research.
-Most lawsuits came from Timberland missing guidance, annoying investors, which annoyed the owner of the business. They decided to stop talking to Wall Street. So it was not about milking the business or fraud. They were not crooks.
-How do you determine if they are good managers? Decent people?
-Act like an investigative journalist. Most business owners leave a trail for you to follow and see how they deal with different situations. Most professional managers would not see this as part of their job, but YOU are part of their 5%.
-Go to their community, visit people they know, their Church, their Synagogue, introduce yourself to their friends and neighbors. It is worth it to spend as much time as possible, to find what these business people have done and what their neighbors say about them to accurately get an idea of their personality.
-The father seemed like a simple, decent guy, just a high school graduate. the son went to business school, was already COO of the company even though he was Lu’s age. Lu saw what boards the son sat on, and noticed that they had a mutual friend. Managed to get himself on the board with the son and became friends quickly. Came to realize these where high quality, very ethical businessmen.
-After all that, saw the stock was still trading low. Decided he did not miss anything. The other 95% may not have done enough research to see this or have some kind of institutional imperative that prevents them from owning.
-If you are not a good analyst, you will never be a good investor.
-But we decide to buy. How much do we buy? Imagine having $900. The other 95% will take tiny positions, 50 basis points. You need to use concentration, a $200 position. Think of how much work you did. Lu visited all the stores to see how margins improved – they had a fad going on where kids wanted the shoes. Their asian business is tiny, reduced earnings by less than 5%.
-Lu put a ton into Timberland. What happened after next 2 years? Stock went up 700%. Propelled by earnings. No real risk – went from trading at 5x earnings to 15x with earnings growing 30% a year. It adds up.
Be a Learning Machine
-When an investment opportunity comes, you have to seize it. Devote day and night so you can act quickly. Do everything complete but do it fast. You have to train yourself to jump on opportunity.
-When opportunity presents itself you can smell it. The only way to do that is by training yourself and reading page after page of financial report.
-Uses S&P manuals for viewing foreign stocks.
-As an owner, don’t think about per share information.
-Use your brain, when looking at stock manuals, each page should really only take 5 minutes. Don’t use calculators. Use mental math.
Example: Korean Company
-60M market cap, pre-tax earnings of 31M, roughly 2x pre-tax earnings.
-Book value of 230M, what constitutes book value? If you are an owner, look at: fixed assets, working capital, don’t count on goodwill.
-Basically you see with 60M in market cap, 30M in pre-tax, $240M in book value ($180M in fixed assets)
-It might be cheap.
-Determine what the earnings is. The book. The working capital.
-Use common sense, common logic and think about the business.
-Most employees never went to business school, Lu finds they are easier to train.
-Of the 70M in current assets, it is all cash
-Of 180M in fixed assets, they own 100% of a hotel, recorded 30M as book. Own 13% of a department store recorded as 30M.
-Look up the department store, it roughly has a market cap of 600M. 13% gives you roughly 80M. So the book value undervalues it by another 50M.
-They own 15% of 3 cable companies and a whole bunch of real estate.
-The department store has exactly the same profile. Trading roughly around cash and investments, good earnings, and own a whole bunch of assets. Turns out they are the second largest cable operator as well
-The department store operates like a hotel, do not take inventory, more like a shopping mall.
-They charge a percentage on the top line of all merchant sales.
-Put it all together: Paying 60M, 70M in net cash, another 100M in stock, 30M in hotel with a value that has not been changed in last 10 years while real estate market has gone up in 10 years. Went to Korea, looked at hotel and department stores.
-Checked recent transaction of properties in neighborhood, value is likely 2-3x what is on the book. But take what is on the book anyway, add 150M. Add that to rest and you get 320M in assets that you are paying 60M for and earning 30M annually from operations.
-Insiders own 50%
-Many factors going in your favor, but you need to look at how local investors see it. They need to be buying it for the price to go up.
-Department store used to trade at 22 went to 100
-This company was at 12 now trades around 70
-each went up 5-6x
Don’t just listen. Do it.
-This type of an approach is not natural to an investor.
-If you decide your personality fits in with the mutated gene pool, that this is something you might be looking to do, there is a lot of money in it — proven by Ben Graham to Buffett
-You have to put in a lot of work into your analysis.
-You can make a lot of money if you are really interested, listening, and actually DOING IT.
-Lu benefited from listening to his value investing class and then actually going out and doing the work required.
-Value investing is not really about theory, it is about what works.
-Young analysts have energy and nothing to lose, so they should go and do the work.
-Before you become a good investor, you need to be a good analyst.
Lu says you need two things to be a good analyst:
1. Provide accurate and complete information. You have to go to an extra length to get it done. Most of the time you will stand alone against everybody else. If you are not competent about what you know, you cannot possibly take conviction positions when things go into free fall and everybody else is laughing at you.
2. Most money is not made in stocks from the examples. They do not provide out-sized returns. You can do the Tweedy Brown/Graham or the Buffett/Munger school. Your returns will come from a handful of stocks. You need tremendous insight by continuous intense curiosity and study.
Investment Mistakes
-Most mistakes come from inaccurate or incomplete information.
-Biggest mistake: most people wanted 2 week or monthly returns. They wanted to go up in down markets.
-Lu’s biggest mistake was straying, was working with Julian Robertson, started shorting — have to think like a trader when you are shorting because your downside can be unlimited. It’s like Charlie Munger says — having your hands tied behind your back while getting into a fight.
-Missed the opportunity to buy a business below cash, even though Lu knew the management and had great insights. The business subsequently went up 50-100x. Could not bring himself to buy it because of his mindset at the time.
-You make a mistake when you have not finished your work but like it enough. You start betting on probabilities instead of real analysis.
Constantly search for ideas
-In your life, you may only have 5-10 key moments of insight. You only get it from continuous learning. Find an American business and then find the Asian counterpart. Some businesses studied for 15 years. You need to know what that business is, how it ticks, so you can swing with conviction. If you cannot do that you will not make huge out-sized returns.
-If you do what Ben Graham or Tweedy Brown does, you will make 15-20% returns but you wont make the huge returns of Buffett.
-The biggest ideas can give 10,000x returns.
-Opportunities are not easy to find. They require a lot of factors to come together – Charlie Munger’s lollapalooza. You need a whole bunch of things working together where you have the insight and are willing to bet.
-This is what drives Lu in business.
-Lu started in physics, mathematics, law, economics, got interested in other subjects. Wife has a PhD in biology, he has learned a lot from her.
-Learn from everything, be intensely curious
-Eventually you will stumble into one big opportunity.
-In the meantime, you will stumble into Timberland style investments which aren’t bad.
-There might be years without opportunities, then years with a lot of opportunities.
-Depends on what becomes available to you.
-They do not come in a steady pace, not like once a week an idea.
-In 6 years, Lu had maybe 3-4 great ideas. But you get progressively better and better, improving the amount of opportunities for you since you will be quicker at your analysis.
-Go through every day by learning something. In a year you have to learn a great deal.
-When Lu reads biology, physics, history, it is all searching for ideas. If one idea jumps out, it is all Lu does. Rest of the time is spent with wife and kids and Lu learns from them too, especially with seeing how human cognition develops which is enormously important.
Li Lu’s Investing Checklist:
1. Is that cheap?
2. Is it a good business?
2. Who is running it?
3. What did I miss?
-Lu goes through the checklist, ‘what did I miss’ is greatly affected by psychology. This kind of cognition happens early on and Lu learns it from interacting with his girls.
Three characteristics of a value investor:
1. Business owner mentality
2. Difference in time horizon
3. Demand a huge margin of safety
Think like a Business Owner
-It all comes from one thing, that you are a business owner. You cannot force management changes, so you demand a margin of safety. You have a long time horizon because you think like an owner.
-But why dabble with stock market? Stock markets are made for people who can dream. That is why 95% of people never buy into value investing. Human nature prevents it.
-You do not belong to the stock market but you have to understand its perspective to position yourself properly. If you are truly think like a business owner, you will eventually leave the asset management business and run a real company. That is why Buffett and Munger left it.
-Or you become a private equity investor.
-The people who the stock market is designed for are fundamentally flawed people. Traders are bound to make mistakes due to fear or greed. They will always make room for value investors.
-Used to be strict about selling with great business. Now, sometimes Lu feels he has insights about the business that allows him to believe the probabilities are in his favor for the business actually improving year after year.
-That is the law of distribution in good businesses. The leaders perform spectacularly well.
-Selling makes you pay a huge amount of tax and you might not get that good buying price again.
-If a business can generate 50-100% ROIC, the mathematics get interesting very quickly.
-Caveat: you have to be very confident. Investment bankers use BS and project into infinity. You cannot project that long. There are only a few opportunities where you can project that long.
-If you are good, and spend your entire lifetime studying, across 50 year career maybe 5-10 opportunities where you can confidently project the next 10-20 years. At that point, you don’t want to sell. By holding you don’t pay the tax on capital gains, so you are really compounding 40% interest free, the business is deploying the capital at 40-100% a year in a tax efficient manner. That is what you do.
-You have to identify businesses that are getting stronger and stronger every year.
-What makes one business more successful than others? Why are they making more and more money compared to others?
-The only way you can find that is by studying the ones that are established.
-Look for great businesses, not just businesses owned by Warren Buffett
Example of a great business: Bloomberg LP
-Product was superior to others, high switching costs
-Bloomberg is a fabulous case study, it came out of no where.
-Gained market share little by little, crossed a milestone point, became a monopoly
-At a certain point, after being highly relied upon for daily work, the switching costs become to high so winner takes all.
-Suppose you have an opportunity to see how an industry evolves early on. At a certain point they cross the line
-Maybe when introduced to all businesses. There is a time when that line gets crossed and a public company is poised to benefit by becoming a monopoly business.
-Why did Microsoft succeed over Apple? Little by little they eroded Apple’s 100% market share.
-Offices were using Windows. Today – do you have a choice of not using Bloomberg?
-Bloomberg visits almost every month and asks what you do, how you use the system. Bloomberg terminals have tens of thousands of functions, they don’t give you a manual
-They want you visually hooked so it is a behavioral connection and you don’t mind paying tens of thousands of years where you don’t have a choice if they raise prices
-They keep coming back to you because they know you are a trader and want to provide you with more services so you are hooked.
-That is why Bloomberg is a fabulous business because you get hooked. Think about switching from that or a competitor coming up with a rival product. How do you compete with that?
-Lu doesn’t know. Suppose you know the inflexion point. Do you want to invest? Lu would invest in Bloomberg at that point.
-You need insight. Study every business. They all have more or less this type of dynamic.
-Your job as a good financial analyst is to study that business ALL THE TIME. Observe those trends.
-Once in your life, maybe you will find that opportunity.
-Why doesn’t Bloomberg want to sell? He doesn’t need to sell.
-When you have a business like that, you don’t need to sell.
-Lu has made many private investments, ex: CapitalIQ, which copies Bloomberg’s business model. Same method with an investment in an engineering service.
-Lu likes to know as much as he can. He likes to be friends with people, with Timberland, the CEO and his son actually became investors in Lu’s fund.
-You can learn and observe from everyday business decisions and learn dynamics.
-Nothing is constant. Everything is changing that is why you have to keep learning.
-Businesses change, Microsoft has threats now.
-You need an active mind, so you are prepared to act and you can seize opportunity due to your insights.
Comment:
Value investors: Distinguishing features (1) You are a business owner. (2) As you own business, nsight (big ideas) into many businesses so that you can bet big when all the factors come together in your favour, a huge wave behind you. With that insight, you will be willing to bet, based on your complete insight.
As you get better and better, you establish a good insight. Continue to learn. You only need less than 5 minutes to smell out a good company.
The market is designed for traders and not designed for value investors. Those who trade will occasionally make mistakes, that is when you as a value investor comes in.
When you have the confidence to project a business earnings into next 10 or 20 years, why do you need to sell? These companies' valuations are usually established and are getting stronger and stronger.
Why is this business getting better and better, making more and more money? Why are some companies making money some years and making less money or not making money other years?
Sometime, companies coming from no where, somehow began to make an in-road into their industries and they become a monopoly. Observe the industry, determine when the threshold is crossed. Having this sort of insight is what you should have. Think Microsoft in its early years ... little by little, it crossed that line. Now with free browser sites, the dynamics affecting Microsoft are different.
Excellent video. Smart and powerful ideas which are very applicable in your investing.
The Hold Decision
Developing the Proper Mind-Set for Profitable Sales
The hold decision often results from an investor's bias toward a positive outlook on the future. This subtle bias can persuade investors to take enormous personal, career and financial risks in pursuit of reward.
Investing in the equity market certainly requires a degree of optimism, but that upward bias must be supported by the fundamentals of the situation, by thoughtful personal judgement and by the judgement of suitable advisors.
It is appropriate for an investor to take some risks in search of the stock that doubles, if that risk is not too high relative to his personal tolerance.
Unfortunately, however, an investment broker makes a living by catering to this investor optimism, which supports the buy bias described above. So investors lose billions of dollars every year because of the optimism they bring to daily living. Money is lost not only to fraudulent too-good-to-be-true, get-rich schemes, but also on the buying and holding sides of legitimate securities transactions.
To offset that tendency, proper buy timing and pricing can help reduce the pressure that inevitably surrounds the selling decision. There is a natural tendency to fall victim to excitement and buy a stock when it is already hot. Only the most disciplined of traders and investors consistently refuse to buy stocks on good news, on stories, or on excited rallies. Instead they demonstrate the self-control to stay with their buy decisions based on their predetermined criteria.
So buying too high on a burst of optimism is the first source of optimism-induced losses for traders and investors. But even greater damage results from holding onto positions because of excessive or unjustified optimism. One major difficulty in overcoming this problem is that declining stocks occasionally do rally. But an occasional burst of countertrend strength in a weak stock does its die-hard owners more harm than good.
The declining stock, by rallying - sometimes for several days in succession and occasionally by a nice point or more - provides positive feedback more recently and certainly more often. Each time the stock turns up, a flicker of hope is kindled. The major problem here is that even bad (declining) stocks have their good days (or weeks).
Not only does the daily price action in the market sometimes renew hope, there can be positive fundamental news as well. A good quarterly earnings report or an optimistic brokerage recommendation can generate the renewal of optimism in the heart of an investor. Every plus wiggle in the stock price, every time the price holds steady against a 15-point drop in the Dow and every good piece of news is a source of positive psychological feedback. Anything that goes right is a vindication of personal judgement.
If the dominant path of the stock is downward, each and every cause for renewed optimism is actually a false signal. In reality, those false signals should be viewed as uninvited distractions from the truth rather than as rays of hope.
When hope springs eternal, the investor must separate the facts of the situation from the fiction. The separation process must include not only the real news background - what is actually true about the company and its industry versus what is rumour and hope - but also the psychological environment in which the investor has linked his state of mind with the company and its stock. Guard against being trapped by a personal, renewed sense of optimism when hope springs eternal.
Using Charts
The best way for an investor to calibrate his state of mind against the market is to rely on stock price charts. Aside from the great debate about the viability of technical analysis, a chart can be useful as an accurate road map of price movement history.
Without any experience in charting techniques, an investor can spot whether the stock is still in a downtrend or whether its price action has overcome negative momentum for the better. Only rarely will it be true to say, "I am not sure, it seems to be right at the point of reversing." If that is true, resolve to look again in a week and make a yes/no decision, refusing to take another time extension.
Above all, do not back into a non-decision by default through the insidious process that consultants called "analysis-paralysis." The market keeps moving with or without an investor. So do not wait open-endedly for just a little more news or technical confirmation. There is never going to be a final answer or a point of total closure. So exercise discipline: make an evaluation and take action accordingly.
If a stock declines and then rallies, take note of a change in personal optimism level. (How do you feel?) Keep a daily notebook in which to write down the stock's price and the feelings that arise about it; then decide whether the revival of optimism for the stock is justified by the facts. Bear in mind that when a declining stock has rallied back to a given price level, it feels better to the owner than when it had earlier fallen to that same price. The more recent feedback creates hope while the earlier move produced fear. Watch the emotional difference, even at the same price.
The price an investor pays for a stock can get in the way of prudent selling because it influences the willingness to sell in terms of both timing and price. So buying well is important but only half of the transaction. The investor also must exit skillfully. Failure to buy well not only puts all the burden on possible net success on the exit execution, but it also colours the holder's thinking in ways that are damaging.
A change of mind soon after a buy is an ego embarrassment because it is an admission of error. Taking a loss is a second ego blow. So it is evident how the time and price of a badly made by render the selling decision more painful and difficult than it is on a big gainer. So both the timing aspect of having bought late (recently) and the price aspect of having suffered a loss are dangers to the investor's financial health.
(The truth is that when it is time to sell before the price goes down, it is time for everyone to sell, no matter what the timing is or what the cost at entry. But human nature seemingly demands that investors factor into the sell decision the stock's initial price. And the less time the stock has been held, the less the investor is willing to switch mental gears and say "sell.")
What should determine the decision is whether the stock seems likely to go down from here and now; if it does, it should be sold as soon as possible. The central question that should decide the hold/sell dilemma is "Would I buy this stock today?" Many investors fail to ask that question at all.
There is no denying that buying better helps most investors cash in more effectively when the right time comes. Most buying mistakes (aside from acquiring inflated "hot" new issues and penny stocks) occur not in buying bad stocks but in buying mediocre stocks too late - again, because investors tend to be crowd followers. They wait for confirmation because they need courage. They are most ready to jump in when the market has already become overbought.
If a stock is held only because of perceived positive potentials for the whole market, it should be sold. "Would I buy today?" A similarly revealing question is whether an investor would sell it here if he had bought better. If there is even a hint of an affirmative answer, he must recognise that cashing in is the right thing to do.
The hold decision often results from an investor's bias toward a positive outlook on the future. This subtle bias can persuade investors to take enormous personal, career and financial risks in pursuit of reward.
Investing in the equity market certainly requires a degree of optimism, but that upward bias must be supported by the fundamentals of the situation, by thoughtful personal judgement and by the judgement of suitable advisors.
It is appropriate for an investor to take some risks in search of the stock that doubles, if that risk is not too high relative to his personal tolerance.
Unfortunately, however, an investment broker makes a living by catering to this investor optimism, which supports the buy bias described above. So investors lose billions of dollars every year because of the optimism they bring to daily living. Money is lost not only to fraudulent too-good-to-be-true, get-rich schemes, but also on the buying and holding sides of legitimate securities transactions.
To offset that tendency, proper buy timing and pricing can help reduce the pressure that inevitably surrounds the selling decision. There is a natural tendency to fall victim to excitement and buy a stock when it is already hot. Only the most disciplined of traders and investors consistently refuse to buy stocks on good news, on stories, or on excited rallies. Instead they demonstrate the self-control to stay with their buy decisions based on their predetermined criteria.
So buying too high on a burst of optimism is the first source of optimism-induced losses for traders and investors. But even greater damage results from holding onto positions because of excessive or unjustified optimism. One major difficulty in overcoming this problem is that declining stocks occasionally do rally. But an occasional burst of countertrend strength in a weak stock does its die-hard owners more harm than good.
The declining stock, by rallying - sometimes for several days in succession and occasionally by a nice point or more - provides positive feedback more recently and certainly more often. Each time the stock turns up, a flicker of hope is kindled. The major problem here is that even bad (declining) stocks have their good days (or weeks).
Not only does the daily price action in the market sometimes renew hope, there can be positive fundamental news as well. A good quarterly earnings report or an optimistic brokerage recommendation can generate the renewal of optimism in the heart of an investor. Every plus wiggle in the stock price, every time the price holds steady against a 15-point drop in the Dow and every good piece of news is a source of positive psychological feedback. Anything that goes right is a vindication of personal judgement.
If the dominant path of the stock is downward, each and every cause for renewed optimism is actually a false signal. In reality, those false signals should be viewed as uninvited distractions from the truth rather than as rays of hope.
When hope springs eternal, the investor must separate the facts of the situation from the fiction. The separation process must include not only the real news background - what is actually true about the company and its industry versus what is rumour and hope - but also the psychological environment in which the investor has linked his state of mind with the company and its stock. Guard against being trapped by a personal, renewed sense of optimism when hope springs eternal.
Using Charts
The best way for an investor to calibrate his state of mind against the market is to rely on stock price charts. Aside from the great debate about the viability of technical analysis, a chart can be useful as an accurate road map of price movement history.
Without any experience in charting techniques, an investor can spot whether the stock is still in a downtrend or whether its price action has overcome negative momentum for the better. Only rarely will it be true to say, "I am not sure, it seems to be right at the point of reversing." If that is true, resolve to look again in a week and make a yes/no decision, refusing to take another time extension.
Above all, do not back into a non-decision by default through the insidious process that consultants called "analysis-paralysis." The market keeps moving with or without an investor. So do not wait open-endedly for just a little more news or technical confirmation. There is never going to be a final answer or a point of total closure. So exercise discipline: make an evaluation and take action accordingly.
If a stock declines and then rallies, take note of a change in personal optimism level. (How do you feel?) Keep a daily notebook in which to write down the stock's price and the feelings that arise about it; then decide whether the revival of optimism for the stock is justified by the facts. Bear in mind that when a declining stock has rallied back to a given price level, it feels better to the owner than when it had earlier fallen to that same price. The more recent feedback creates hope while the earlier move produced fear. Watch the emotional difference, even at the same price.
The price an investor pays for a stock can get in the way of prudent selling because it influences the willingness to sell in terms of both timing and price. So buying well is important but only half of the transaction. The investor also must exit skillfully. Failure to buy well not only puts all the burden on possible net success on the exit execution, but it also colours the holder's thinking in ways that are damaging.
A change of mind soon after a buy is an ego embarrassment because it is an admission of error. Taking a loss is a second ego blow. So it is evident how the time and price of a badly made by render the selling decision more painful and difficult than it is on a big gainer. So both the timing aspect of having bought late (recently) and the price aspect of having suffered a loss are dangers to the investor's financial health.
(The truth is that when it is time to sell before the price goes down, it is time for everyone to sell, no matter what the timing is or what the cost at entry. But human nature seemingly demands that investors factor into the sell decision the stock's initial price. And the less time the stock has been held, the less the investor is willing to switch mental gears and say "sell.")
What should determine the decision is whether the stock seems likely to go down from here and now; if it does, it should be sold as soon as possible. The central question that should decide the hold/sell dilemma is "Would I buy this stock today?" Many investors fail to ask that question at all.
There is no denying that buying better helps most investors cash in more effectively when the right time comes. Most buying mistakes (aside from acquiring inflated "hot" new issues and penny stocks) occur not in buying bad stocks but in buying mediocre stocks too late - again, because investors tend to be crowd followers. They wait for confirmation because they need courage. They are most ready to jump in when the market has already become overbought.
If a stock is held only because of perceived positive potentials for the whole market, it should be sold. "Would I buy today?" A similarly revealing question is whether an investor would sell it here if he had bought better. If there is even a hint of an affirmative answer, he must recognise that cashing in is the right thing to do.
Tuesday 15 June 2010
What if BP is unsuccessful in stopping the oil flow?
This mud flow in Indonesia continues unabated 4 years on.
Sidoarjo mud flow
JaveMud Volcano Still Gushing Four Years On (May 28, 2010)
Sidoarjo mud flow
JaveMud Volcano Still Gushing Four Years On (May 28, 2010)
Thinking of property redevelopment? Here's a checklist
What’s the commercial gain?
Need for an air-tight agreement
What are the tax implications?
“Before you negotiate with a developer, you need to establish the market value of the property you will receive on completion of redevelopment.
This is a better approach than quoting a random figure to the builder that would make them feel short changed or the high amount would make the builder shy on the new project,” says Ashutosh Limaye, associate director (strategic consulting), Jones Lang LaSalle Meghraj.
“Once the builder gives a detailed plan, the society members should consult real estate consultants and the developer about the likely future price. Based on this, the society members have to do some calculations to check on the commercial gains.
This is a better approach than quoting a random figure to the builder that would make them feel short changed or the high amount would make the builder shy on the new project,” says Ashutosh Limaye, associate director (strategic consulting), Jones Lang LaSalle Meghraj.
“Once the builder gives a detailed plan, the society members should consult real estate consultants and the developer about the likely future price. Based on this, the society members have to do some calculations to check on the commercial gains.
Need for an air-tight agreement
You should appoint a lawyer before signing a contract with the builder. The contract should clearly mention the obligations of the builder and the society members and the penalty or consequences of any breach of the contract by either of the parties.
The housing society should insist on a bank guarantee, which would take care of monetary compensation because of a delay in the project.
The agreement should also mention the time of completion of the project, the size of the new houses, the mode and the nature of monetary compensation, if it’s a one-time payment, reimbursement of rent or a mix of both. “It usually takes a year for a builder to convince the society members and take an in-principal approval.
But society members should ensure the timely completion of the project, which is the most important detail to be mentioned in the agreement,” Mr Narain adds. Secondly, it should clearly state the nature of temporary alternate accommodation and mode of rental payment/reimbursement. Finally, it should include member’s choice of new flat, parking, entitled area, etc
The housing society should insist on a bank guarantee, which would take care of monetary compensation because of a delay in the project.
The agreement should also mention the time of completion of the project, the size of the new houses, the mode and the nature of monetary compensation, if it’s a one-time payment, reimbursement of rent or a mix of both. “It usually takes a year for a builder to convince the society members and take an in-principal approval.
But society members should ensure the timely completion of the project, which is the most important detail to be mentioned in the agreement,” Mr Narain adds. Secondly, it should clearly state the nature of temporary alternate accommodation and mode of rental payment/reimbursement. Finally, it should include member’s choice of new flat, parking, entitled area, etc
What are the tax implications?
Unlike buying a home, there are no standard tax guidelines for redevelopment cases. “It depends on the agreement. Ideally, the members of the housing society should show a copy of the agreement to a chartered accountant before preparing the final draft,” says Vaibhav Sankla, executive director, Adroit.
Broadly, there are three main tax issues. One is capital gains tax, which could arise out of exchanging the old house for the new one although the house is built on the same piece of land. Under Section 54, you have to invest the amount of capital gains in a residential house within two years from the date of sale.
Second is the tax treatment of the upfront lump-sum payment. “If that payment is treated as capital receipt, it’s exempted from tax. On the other hand, if it’s treated as revenue receipt, then the amount is taxable in the hands of society members. This again depends on how the compensation is worded in the agreement,” Mr Sankla adds.
Thirdly, there is no clarity on the tax treatment of the rent reimbursed to society members by developers. “There are a number of litigations lying in courts with respect to taxability of monetary compensation and capital gains arising out of redevelopment. Hence, clarity is still awaited as it’s an evolving issue,” he adds.
Broadly, there are three main tax issues. One is capital gains tax, which could arise out of exchanging the old house for the new one although the house is built on the same piece of land. Under Section 54, you have to invest the amount of capital gains in a residential house within two years from the date of sale.
Second is the tax treatment of the upfront lump-sum payment. “If that payment is treated as capital receipt, it’s exempted from tax. On the other hand, if it’s treated as revenue receipt, then the amount is taxable in the hands of society members. This again depends on how the compensation is worded in the agreement,” Mr Sankla adds.
Thirdly, there is no clarity on the tax treatment of the rent reimbursed to society members by developers. “There are a number of litigations lying in courts with respect to taxability of monetary compensation and capital gains arising out of redevelopment. Hence, clarity is still awaited as it’s an evolving issue,” he adds.
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