Investment Thoughts Four Years On

OK, I know this is probably another lousy title, but it was tough for me to think of what to call this post, which basically sums up my reflections and thoughts as an investor after blogging for 4 years. I guess you can call it an “investment style update”, one of many which I have over the months (the last one was in Nov 2010 in this post). Every now and then, I take the opportunity to crystallize my thoughts on investments, businesses and personal finance as part of my journey (the blog is, after all, “Musicwhiz’s Journey”) towards financial freedom. For now, it remains decidedly elusive, but that does not detract me from my eventual goal of reaching this summit. Many will remark that goalposts may change as you age and your personal circumstances change, and I do agree; but as times change, my investment style and knowledge has also evolved to prepare myself for the next 10-20 years, and hopefully my experience, reading, analysis and research can put me in good standing to tackle these challenges in life.

This blog actually acts as an investment diary and journal, as I use it to collect my thoughts and opinions in one central location. I formally started blogging back in 2006, though that was an on “immature” basis if you check out the posts back then. I only started blogging about investing and personal finance more seriously in May 2007. Since then, it has been four years and I never would have expected (back then) to be able to achieve the level of portfolio that I had achieved now, or the passive income generation. It is indeed a pleasant surprise to me to know that even though I may not be hugely successful (i.e. joining the ranks of a millionaire or the financially free), I had indeed improved my passive income generation ability and also greatly matured as an investor. This alone gives me a profound sense of satisfaction, even though it may not translate into tangible financial results. Remember: it is the process as much as the results which I enjoy, so for detractors who may remark that I am spending way too much time generating way too little returns, I must emphasize that investing is more than just a hobby – it is the passion of discovering how companies are run, what makes them tick and also how fascinating it can be to dissect numbers and make sense of them.

I usually must stop myself before I get too carried away and end up being long-winded again, so here are some of the lessons learnt since my post last November. Note that this list is far from exhaustive:-

1) Avoiding dud and mediocre companies is as important as finding undervalued gems – Interestingly, many people tend to talk about finding “The Next Google” or “The Next Facebook”, symbolic of the next great investment idea which could reap them tons of (seemingly effortless) money. Much attention is focused on finding great companies even before they become great, and funds tend to flow towards the next big idea (Artivision, it seems, as I type this). But the true essence of investing is not just about finding a great undervalued company with all the right characteristics for investment; it is also about learning to avoid the mediocre companies and the dud companies. Over these 4 years, it has become somewhat easier to identify the duds almost immediately, as I have developed automatic mental screens when I look at the financials of a company and study its business model. The greater danger, however, is in finding so-called “Value Traps”, companies which seem great but turn out to be painfully mediocre. These companies attempt to “ensnare” you with good numbers and a (seemingly) strong business model and competitive moat, but if one is not careful, they may see these “strengths” being rapidly eroded away as competitors flood in, regulations change and the industry evolves. Therefore, one has to be ever vigilant on the risks such companies may harbor, in the knowledge that it is better to avoid such companies before they turn out be a major pain in the ass.

2) The Erosion of Gross Margins – This was meant to take up a whole separate post, but I thought there would probably not be enough content so decided to slot it in here instead. While thinking through various companies’ business models, operating environment and unique characteristics, one metric which stood out is how often the gross margin can foretell things to come. Gross margin, for the uninitiated, simply means the gross profit (revenues less cost to acquire these goods) divided by revenue; and this measures how much profit you obtain from each dollar of sales, before factoring in expenses such as depreciation, staff costs and marketing/distribution costs. A careful study of gross margins for the last 5-8 years of any company can throw up some very interesting insights, and this is what I have been doing for quite a while on my investment journey. Erosion of gross margin is often the first tell-tale sign that something bad is going to happen, sort of like the first sign of trouble before the true rot causes a massive cave-in. Companies in industries which compete on prices normally experience a steady decline in gross margin, while other companies may suffer from stronger competitive forces which push down gross margins. One recent example was Tat Hong (which I divested about 3 months back). Their gross margins were steadily declining over the years, and this signaled that competitive forces were making it difficult for the Company to price its products as profitably as before, resulting in not just lower gross profits but also a lower market share over time. Companies which suffer from constant and chronic gross margin erosion should be avoided or sold off because it is often an early sign of deteriorating fundamentals. Well, seeing that I do have quite a bit to say on this, perhaps in future (if readers request it) I may do a full posting (along with examples) on this topic.

3) The importance of Purchasing Insurance – I know this is unrelated to investing per se, but since insurance is an important aspect of personal finance, I have decided to talk a bit about this. Recently, my daughter was admitted to hospital for about 17 days, and the significance of purchasing not just insurance, but the right insurance with the proper coverage, hit me hard. Fortunately for me, I had my daughter fully covered for all classes of wards up to private hospitals, which meant I could let her stay in a single room in a private hospital. The bill came up to close to $20,000 including medications, procedures and doctors’ visits; and fortunately this was fully reimbursable (though you have to pay upfront first then claim back later from Great Eastern – my insurer). In addition, there is also a clause which says that any hospital stay past 8 days entitles me to an additional claim of $500. If I had not purchased insurance, I would be staring at a massive financial hole of $20,000 which would seriously drain my reserves. So for all readers out there, do review your family’s insurance plans and coverage and make sure you are adequately covered for H&S and other emergencies (including Accident, Disability Income if necessary).

4) The Curious Case of the Disappearing Cash (for S-Chips) – I guess enough has probably been said in the newspapers about the status and reputation of S-Chips in general, so I will try to be brief. You would think that cash was one of the harder things to fake on a Balance Sheet, but so many S-Chips have done a “Satyam” that it really seems as if Chinese companies have an inherent knack for doctoring the cash numbers. After a particularly damning report issued by KPMG for China Milk Products (which has been suspended since 2009), it has brought to light exactly how onerous it is for special auditors (and forensic auditors) to gather sufficient relevant information on the financial activities of such dubious companies. Past cases with China Sun Bio-Chem and Sino-Environment have been equally daunting for the auditors, and shareholders can more or less kiss their entire investment goodbye as the Management and associated rogues have probably absconded with the money a long time ago! While the most recent cases still fresh in people’s minds were those of China Hongxing, Hongwei Technologies and Sino Techfibre (all still suspended pending further news and updates), there have been other suspicious S-Chips which seem to be sending out signals that something is wrong, yet no full-blown investigation has been conducted into their affairs. A case in point is Dapai Holdings, a backpack and luggage manufacturer. Despite having RMB 539 million (S$102.87 million) cash in its books as at March 31, 2011, the Company has announced a rights issue of 1 for 4 shares at $0.08 per share (a heavy discount to last done share price of 14 cents) to raise a paltry sum of S$19.3 million. This is purportedly for an acquisition but if the acquisition does not go through then the money will be used for “general working capital purposes”. It is quite inconceivable for a Company to raise such little money using such an EPS-dilutive method when it has a large cash hoard sitting around. Unless they have massive capex plans for that S$102.87 million which I am unaware of, I would say this exercise seems highly suspicious.

5) Reading up on Bond Investing – This is one of the more interesting major topics which I have been reading up on, and at the same time, I am also studying and observing what is happening in the real world of bond issues. Bonds are fixed income instruments which has a role to play in balancing one’s portfolio as one ages, and from my readings on portfolio re-balancing, I know that bonds are a security which one should start to introduce into one’s portfolio as one gets older. Though equities are known to trump bonds hands down in terms of long-term returns, the issue here is whether one can outlast a long bear market if one is at a more advanced age. Bonds (especially blue-chip, high-quality ones) provide good protection against downside as coupons are a compulsory feature, unlike dividends which can be (severely) cut in times of recession or economic upheaval. There is some argument over whether bonds should be a staple in an investors’ portfolio, it’s just the percentage allocation which should be tweaked. The Intelligent Investor by Benjamin Graham recommends that when one is young, it should be 25% bonds to 75% equities; but he also mentions that this proportion can be adjusted according to bullish or bearish markets, though it’s far from easy to be able to do it with ease. Considering the amount of information on bonds alone, I guess I will have to dedicate a separate post on this as well another time. In the meantime, I will continue to look for sources of reliable and dependable information on bonds and how to invest in them, in order to broaden my investment sphere.

That about summarizes my thoughts on investing at the moment, and covers some of the more current topics on my mind as I seek to better myself as an investor. It takes a lot more knowledge, reading and experience before I can say I am an all-rounded, confident investor. Considering my investment history is only about 6.5 years old (since Dec 2004), and the fact that I have not had a very consistent track record until I embraced value investing in late 2007, I think there is a ton more to learn and absorb in order to improve myself. Keeping humble is also an important attribute as I feel humility lets you have a better feel of your mistakes and prevents you from getting swell-headed and complacent. A ten-year track record of consistent returns would be something I can look forward to, and if you take end-2007 as the starting point, then I am not even halfway there!