Passive Investing Versus Active Investing

As one grows older, one’s financial needs change and evolve. Many financial experts and planners have advocated different allocations for one’s funds according to one’s age bracket, and this post is to discuss the options available to one as one ages and nears retirement (assuming this word actually exists in Singapore !). My thoughts had centred on the concept of passive investing, as defined by Benjamin Graham as the “defensive” investor; versus active investing, or the “enterprising” investor. I shall elaborate on the two concepts below and discuss the salient points for each as well as deliberate on the pros and cons.

Passive investing involves methods such as purchasing into index funds or buying blue chips which are “guaranteed” to survive recessions, and in Singapore’s context some examples would be SingTel, DBS and UOB. There is a lot less thought and analysis to be put into such decisions and in effect you are just “buying the market”, or coming close to that effect. Passive investors do not have to take the time and effort to devote to careful analysis of individual companies, and they also do not need to bother about under or over-valuation as they simply need to pick an index fund which tracks the long-term returns offered by being vested in equities. The idea of “passivity” is further extended to not really needing to keep track of one’s portfolio as one should be reasonably certain of favourable long-term returns, assuming one has not committed oneself during periods of irrational exuberance. Perhaps there ought to be a disclaimer here: one can only be reasonably assured of a decent return on investment through the passive method if one purchases during a recession or sharp downturn (as we are in now), where general price levels and valuations are low. If one makes the mistake of buying into index funds during periods of irrational exuberance, then it may still take many years before one can break even on their investment; passive though this strategy may be. Therefore, it is critically important for a passive investor to have some rudimentary knowledge of economics and stock market dynamics; as well as some general feel of market psychology, in order to ascertain a proper and conservative entry point. Perhaps some indications can be derived from the sentiments of the general public, where the herd normally stampedes, one may find it wise to act in a contrarian fashion. Note though that this method does not necessarily work for the active investor, as I shall elaborate below.

Active investing, as the name implies, literally means one has to get low-down and dirty in dissecting the numbers and analysing the facts, in order to delve deeper into the investment merits of individual companies. It’s a lot of hard work involving blood, sweat and tears; and the problem is after all the effort, one may still not be able to beat the indices and trump the “passive” method of investing. Thus, many argue – why bother to do all the analysis yourself when one can just get a market rate of return from buying an index fund ? Several reasons are offered for this:-

1) One’s age profile and time constraints - Index investing is suitable for those without too many family or personal commitments and who have time to visit companies to attend AGM, and also to pore through thick and boring annual reports to spot little known facts. If one has a family with 3 kids, suffice to say it may be better to rely on passive investing.

2) Knowledge and Analytical Skill – Let’s face it, some basic accounting knowledge is required to analyze financial statements; as well as skill in interpreting the numbers and having a holistic view of a company. Some people may not be properly equipped with such skills to undertake a rigorous study of a company; so they let analysts do this job. Passive investing may be more suitable if one does not have the proper skills.

3) Psychological Strain – Passive investing removes the emotions from investing as you just buy into an index fund or several well-established blue chip companies. Active investing requires some monitoring of the stock market to ensure one has a decent margin of safety and does not over-pay, and one also has to monitor in case one’s company becomes too over-valued, such that one may be compelled to sell and switch into another under-valued company. Such stock market monitoring would inadvertently place psychological strain on the active investor, and even though Benjamin Graham’s advice is to ignore Mr. Market, part of us which is human would still be unable to be completely detached from his emotional mood swings.

4) Satisfied with Market Return – For investors who are content with achieving a market rate of return, then they should be contented with passive investing as it achieves just that. Someone did mention that for an active investor, the reason why he is into active investing in the first place is the belief that he can achieve returns which are better than market averages. Otherwise, why bother?

With the arguments for and against passive and active investing, the question now is to ask oneself which method suits your skills, knowledge and temperament more. There is definitely no right or wrong and one has to select the style which suits him best. But please note that this discussion is just confined to investment in equities; I have not included other forms of investment such as unit trusts, bonds and derivatives.

For myself, as an active investor, it’s not just a matter of getting better returns than the market which drives me (and I have yet to demonstrably achieve this, by the way), it’s also the passion for analysis and my interest in reading up on companies which spurs me on. Investing is a constant journey of learning and it never stops till the day you pass on, which is why it makes for such an intruiging journey filled with ups and downs. Since I took up the value investing mantle, I have learnt so much more about companies and have increased my knowledge many times over compared to when I first started out in 2004 as a “newbie”.

Time In The Market, or Timing The Market

The topic above has probably been debated to death, and there are many studies and so-called research and material dug out from the historical annals of the stock market which can either support one theory or the other. In case readers may not understand the meaning of the title above, let me give a little background. Time in the market simply means “Buy and Hold” as it implies you are spending time staying vested in the stock market (i.e. the companies whose shares you purchased). Timing the market, on the other hand, is the practise of trying to enter and exit periodically and maximizing one’s gains through this method.

This post is more to compare and contrast the two methods rather than to pass judgement on which method is “right” or “wrong”. Of course, this is a value investment blog and I am a practitioner and advocate of value investment, which belongs to the “buy and hold” camp. Still, keeping an open mind is important and I recognize that this style may not be suitable for everyone as one’s investment style is intensely personal. Basically, as long as a particular style suits you, then whether it is time in the market or timing the markets, one should be able to profit consistently from it over the long-term.

Proponents of timing the market are of the opinion that as long as a long-term trend can be established, it is relatively safe and low-risk to enter the market and either ride it up or down. Others may also rely on charts, graphs and trendlines to determine support and resistance areas, and use these as price points for determining their entry and exit. I would assume that obviously if one thinks that they can time the market successfully, that they would be able to do so consistently and profitably. What one must always remember by using this method is that frequent trading will erode profits and magnify losses as frictional costs such as brokerage come in. Even if one were to trade, the trade should be infrequent and one should maximize the gains while cutting the losses short. This strategy requires, of course, much discipline and fortitude and is much easier said than done. The reasons why 95% of traders lose money is not due to the lack of a system of cutting loss or taking profit; in fact it is actually due to the inability to properly control their emotions of fear and greed. A trader who does not adhere strictly to this system will likely not be able to enjoy long-term success, so do not be fooled by the myriad advertisements in the newspaper claiming easy profits through trading “systems”. Trading is as intensely personal as investing, and each person should have their own style and risk tolerance level, as well as way of observing the stock market and reading charts. There is no one size fits all, and I will explain how this applies to investing as well.

Investing is more of an art than a science, which is what I concluded after being invested in the Singapore Stock Market for the last 5 years. Why do I say so ? This is because aside from the numbers, financials, tangible products and one’s concrete understanding of a business, there are still a lot of “grey” areas which make up a business and determine its attractiveness. Aspects such as corporate governance, quality and integrity of Management, goodwill, brand equity are impossible to quantify and measure; and risk factors such as those associated with S-Shares in the past few months are but some of the factors to consider when making an investment decision. I can almost consider myself lucky that none of the companies I own have seen anything dishonest associated with them (touch wood !), but continuing to remain vigilant is important and one must also ensure one does not harbour blind faith in the Company and ignore any warning signs.

Having said that, time in the market means one should control their emotions of greed and fear as well, similar to what traders have to go through. The problem with being vested throughout is that one must mentally tune out the noise and rubbish which filters through the news every day, in order to make sense of what’s important. The news is responsible for propagating half-truths, as the media tends to expound on certain news which is more prominent, while neglecting other aspects. This gives one a very skewed perspective of the “truth” and may make one either panic or get too greedy (depending on the nature of the news). Investing is not just emotional control, but consists of intense objective analysis of companies too, which is why it is not easy to get consistent returns.

I guess I may have veered a little off-topic, so let’s get back to the issue of time, versus timing. Timing is a fine strategy as long as one is emotionally disciplined, and has a very strict and rigid set of rules for cutting losses/taking profits. This also requires one to be in tune with the markets, economic news and the psychology of the market. Though I have yet to see someone I know personally consistently make money through timing, I have no doubt that there are such people out there (they simply choose to keep quiet about it). As for time in the market, this is a strategy which is more suited to my temperament and character; as well as utilizes my analytical abilities.

So dear reader, please use whichever method is more comfortable for you; but for this blog, I can only give advice on “time in the markets”, and not “timing the markets”.

Stakeholder Influences on a Company

For want of a better title, this post is about how stakeholders affect a company even though the company itself may be fundamentally strong. The truth is this recession and sudden sharp downturn has revealed to me that companies which were once “strong” can quickly see their fortunes reversed due to many factors, some of which are beyond their control. As investors, even though we are unable to predict exactly how bad things can get to the extent of how adverse the economic environment can degenerate to, we should nonetheless be aware of risk factors which may crop up now and then to make us more careful before we put our money down.

I would like to explore several aspects of stakeholder influence on a company which may cause concerns once the economic environment worsens. These are by no means an end to itself and it may open up a can of worms as readers may wish to comment on other aspects which make a company “vulnerable” as well. But my motive is to highlight some aspects which I think have been revealed in the recent recession and which I feel may have a bearing on out investment decision-making going forward. After all, it’s supposed to be continuous learning and learning from others’ mistakes is a good way to avoid committing the same ones yourself.

CUSTOMERS – The loss of a major customer due to bankruptcy, or inability to pay in a timely manner can severely affect the future of a business. In the semi-conductor industry, Chartered faced problems when main customer Motorola saw a drop in orders, which in turn tricked down to lower demand for Chartered’s products. Heavy reliance on one customer is risky as most of the revenues will be hinged on that one customer, and even if a company has a good Balance Sheet; it may be affected by the customer who cannot pay in time. This would have a bearing on the Cash Flow Statement of the company and may lead to severe cash burn. Some companies are able to recover from this but others may either file for bankruptcy or be forced to raise funds through a dilutive rights issue (as in Chartered’s case).

SUPPLIERS – On the flip side, the financial problems affecting a major supplier can also have a huge and adverse impact on a company. To give a hypothetical example, imagine if a dumpling company’s supplier ran into trouble and could not supply most of the pork and flour required for their dumplings. Assuming the company only had one major supplier, this would mean they are vulnerable to “supply shocks” and thus would have problem fulfilling customer orders. Hence, it is risky for a company to rely solely on one supplier or even one major supplier for its raw materials. Even if a company was perfectly healthy, a collapse in one or more of its suppliers could spell big trouble unless it can quickly look for substitutes. In specialized industries, this is made tougher than for commodity industries.

FINANCIAL INSTITUTIONS – With the severity of the sub-prime crisis, once untouchable banks in the USA are now falling like a house of cards. Once lauded as the largest bank in the world by market capitalization, Citigroup has been reduced to tatters and now requires a few rounds of Government bailout in order to stay alive. The health of a financial institution is instrumental in determining if a company can obtain sufficient financing. This problem is difficult to mitigate, however, as the current crisis has shown that almost ALL banks have been hit and financing has more than dried up. This has taught me to watch out for highly leveraged companies as this means it gets harder to refinance short term debt. A case in point in Ferrochina which had a leverage of about 300%. I will comment more on this in a separate post on gearing, debt and leverage for companies.

MAJOR SHAREHOLDERS – By now, most people would have read the cases of major shareholders of the company pledging their shares to obtain personal loans. With the advent of the financial crisis, these stakes have been forced sold due to margin calls on the shareholders’ personal loans, thereby causing chaos with respect to the ownership of the company. The latest victim of this is Sino-Environment which has seen the founder’s stake reduced to a mere 6+% as a result of many rounds of forced sale of shares. I feel that this can be mitigated if SGX publishes which companies’ shares are being pledged for loans; but so far this is still not a mandatory requirement.

The list above shows some of the ways in which one can get “tripped up” even though one has analysed the company from top to bottom. Stakeholders have a major influence on a company and thus we cannot avoid studying these influences in order to arrive at a fair conclusion as to the risks and rewards relating to a potential investment.

Confessions of an S-Share CEO

Recently, it came to my attention that an anonymous letter had been penned and circulated to various parties regarding “confessions” made by a (supposed) CEO of a Singapore-listed S-Share company. This letter was supposed to be written to let the whole world know about the shady insider dealings in relation to the IPOs of China Companies listed on the Singapore Bourse, as well as to reveal the inner machinations which went on “behind the scenes” which enabled many parties to get rich; but which ultimately left the retail investor “holding the baby”.

While the authenticity of such a “confession” can be debated, what was written (yes, I do have the full copy of the text but it would be too lengthy to post it here, so please follow this link ) constitutes a peek into the shady and dubious world of deal-making, private equity and the eventual listing. Even Ms. Teh Hooi Ling of the Business Times wrote an article on this in yesterday’s Business Times commenting on various aspects of such deals and how these companies can be hyped up, marketed and eventually sold to the public. It is not unlike the heydays of the dot.com IPO boom which led many new companies to aggressively sell their shares to unwary investors, all with the promise of growing revenues and soaring profits. I would like to use this article to illustrate some aspects of IPOs and deal-making which I feel can be learnt and which are significant to retail investors like myself.

It was mentioned in the article that if you pumped enough money into a company, it could look very much more “alive” than it really is. This was alluding to the fact that if one wished to “promote” a company, all one needed to do was to find some private equity investors (“angel” investors), put money in, aggressively spend on capex and new products; then push them to customers all on credit, all the while booking in the revenues but not collecting the cash. Such an accounting “trick” is widespread in commodity businesses (the letter stated that it was a “chemical fibre” business in the textile industry, which led some to speculate that it may be the recently suspended Fibrechem). Barriers to entry are low and as margins are thin, so introducing new products and investing in technology is risky especially if customers are not willing to take up the new products. Hence, the deal-maker (Mr. D in the article) is the one responsible for making a mountain out of a molehill (figuratively speaking) and transforming the company to something much bigger than it actually was. In other words, mediocrity was perceived as quality based on a change in appearances.

The article also highlights the fact that in most IPOs, the ones who benefited the most are the original people who pumped money into the company at very low valuations (perhaps 1-2X PER), and which later filed an application to list under bullish conditions, thereby garnering gains of 5 to 20 times of their initial investment. Since companies could be “dressed up” to look very nice, the numbers may not be heavily scrutinized by the general public prior to IPO, and anyway everyone knows that IPOs are hot during bull markets as everyone wishes to “stag” it on its first trading day. This is probably one reason why IPO stands for “It’s Probably Over-priced” ! Companies will choose to sell their shares during periods when their shares can command the highest valuations, as this means they can raise the maximum amount of money possible, even if they don’t need it ! IPOs are sometimes also mechanisms for the existing owners to cash out and get filthy rich in a short period of time.

Investors who buy into such growth stories have to be wary of the people pushing the IPOs, as the article clearly states that everyone in the IPO-cycle benefits in some way from the listing – except the retail investor. A very noteworthy paragraph which I will reproduce here states as such:

“Everyone got what they wanted. The Chinese companies got their money to expand their business (which at a later stage, no one is really sure which company really had any business to start with), the entrepreneurs were handsomely rewarded for the risks they undertook, the deal makers got their fees, the angels made their killings, the bankers collected their fees and dished out new loans, the lawyers and accountants recruited more young graduates to cope with the record work volume, the stock exchange got their “new mandate as the second board of the Chinese companies”, the investors got their hot-and-sizzling China concept stocks and above all, the rich and the influential members of the “invisible clubs” were all happily enriching their own pockets”.

I think the above is self-explanatory and only serves to reinforce the fact that everyone has a part to play to push through an IPO as there is a lot of money to be made even before a company gets listed. Investors have to spend time separating the wheat from the chaff and this is admittedly not easy; but one easy thing to note is that the quality of IPO companies drops as the bull market gets hotter and hotter, and valuations get more and more crazy.

One final point I wish to highlight is that the bubble eventually HAS to burst, just as it did for the dot.com companies in 2000. The immense hype, easy money and over-leveraging were the perfect storm for a crash and the subsequent bust. Even in 2006 and 2007, when S-Shares were touted as the next big thing, there was already an element of “bubbling” as the China growth story was pushed and touted again and again by a myriad of analysts. Everyone wanted the party to last and indeed, everyone acted like Cinderella dancing in a room without clocks. When midnight struck, everything was reduced to pumpkins and mice. This is a lesson for me and other investors too – beware of hype and slick marketing; don’t leave your brains at the door when evaluating companies. It takes a very clear, sharp, objective, rational and analytical mind to see through the thick coat of gloss which covers the true prospects and financial situations of many a company.

Avoiding the Duds

I realize that so much emphasis has been placed on the choices that one has made in relation to companies that one had bought, that almost no one mentioned about those that one had correctly avoided ! I guess I could not think of a more appropriate title, hence "avoiding the duds" sounded reasonable enough. The same logic applies to mistakes as we can classify them according to "omission" and "commission". Commission means purchasing a company which is a dud and later makes you lose tons of money; while omission means NOT purchasing a company which later turns out to be a star, thus it is mainly opportunity costs.

If we turn the tables around, the same logic also applies. If one consistently avoids buying the "dud" or "over-hyped" companies, one can indeed prevent a substantial loss of wealth. Remember that preserving capital is also one good way of building wealth, as Warren Buffett advises us to "Never Lose Money". Even though cynical readers may point out that I have "lost money" due to this bear market and sharp recession, my argument is that over the long-term, I am confident of adhering to the mantra of "not losing money". This is because I feel that aside from choosing the right companies to take a stake in, it is also important to spot the danger signs for dud companies which may later implode.

Just to give some examples of the companies which I had considered but rejected, they fall into a few broad categories. One of them is "wrong business model", which is what happens when I first review a company's basic business model and decide that it cannot possibly sustain a competitive edge. Either that or the business model seems flawed, risky or inherently unsound. One of the more recent cases which comes to mind is the company GEMS TV, which was listed a few years back. This is a company which sells gemstones through television (akin to TV Marketing) and they had penetrated the UK and USA market. Back after its IPO, it was trading at around $1.50 and analysts were fervently touting for target prices as high as $3 (yes, you heard me right - I still have that report !). By studying the underlying business model, I decided that buying jewellery is a personal process and most people would rather go down to stores to try them out. Moreover, advertising is an expensive business and would require huge upfront capex with limited chances of success (it's a retail operation, not a contract-based business). Hence my decision to avoid the company even though analysts were bullish then. The benefit of omission has saved me a ton of money as the company has gone on to announce 4 consecutive quarters of losses and is now trading at 3 cents per share. It remains to be seen if the company can pick itself back up to its glory days when it IPO-ed.

Another category of companies which I will avoid are those with razor-thin margins. Some industries are effectively commoditized like semi-conductors and PCB Boards so the margin is extremely thin (close to 2-3% or maybe less). This means that a small escalation of costs from suppliers would trickle down into an avalanche for the company, who may have problems raising prices due to lack of pricing power. Some examples would include Chartered Semiconductor (which recently did a rights issue) and Jurong Technologies. The former has seen massive losses due to the plunge in worldwide chip demand while Jurong Tech has been suspended pending the outcome of judicial management proceedings as it was served statutory demands from several banks. Other companies which I have noticed with very think margins are Surface Mount Tech and also Olam* (surprisingly, this "blue chip" has margins of about 0.5-1% only).

*A Note here: If one had purchased Olam during its 2005 IPO at a price of 62 cents, one would still be sitting on nearly a 100% gain (more if you include dividends over the years). This was mainly due to its aggressive M&A strategy which saw many acquisitions (through gearing) over the last few years. These have been driving earnings in the near term. However, I am focusing on the margins which I am not comfortable with. The Company DOES have a sustainable competitive advantage in its total SCM business model, though.

A last category of companies I choose to avoid are - the over-hyped ones ! The hype can be done through various ways, either through analysts strongly pushing the company without taking a close look at the business model, operating risks, cash flow generation, capex and gearing; or else over-hyped on the basis of valuations alone (e.g. 20-30x PER meaning you need 20-30 years to recover your capital !). I guess most of the S-Shares would fall into the over-hyped category, as I remember the heydays back in 2006 and early 2007 when so many China-based companies came here to list. Gosh, there was almost one listing per month that time and if you got in at IPO it was almost guaranteed to make you money if you "stag" it. Such was the immense hype surrounding the "China Growth Story".

Of course, 2 years later, valuations have come down to 1-2x and a slew of scandals have hit S-Shares, notably in companies like Fibrechem, Oriental Century, China Sun and China Printing and Dyeing. This once over-hyped segment has faced almost a total collapse in confidence as investors flee S-Shares as if they were the plague. This situation sort of reminds me of the hype surrounding the dot.com companies during the dot.com bubble in 1999 before the eventual painful crash. Some examples I can think of for companies which I avoided include Synear Foods (trading at 30x PER back then - $2.00 and still being pushed by analysts), China Energy (their DME technology was touted as an emerging technology and valuations were pushed to stratospheric levels) as well as China New Town (ok, this was a dud to begin with, I don't know how SGX managed to get them to list here !).

So after all has been said and done, please do remember to give yourself a pat on the back for the companies that you correctly avoided ! Most people like to tell you about their winners or blue chips, but if you probe further they tell you in a quiet voice about the duds they had bought donkey years ago and are STILL holding on to them. In an environment where making the correct decision can greatly influence your chances of growing wealth, I would think a lot more due diligence should be demanded of the retail investor, or he may risk seeing his capital evaporate like puddles on a hot summer day.

Can Minority Shareholders influence Management ?

As a minority shareholder myself in several companies, the question which has always popped up in my mind is the extent of influence which minority shareholders have on the Management of the companies which one owns. After all, as part-owners of a company, minority shareholders should have some influence or say on the running of the business, besides just showing up to attend AGM and voting on perfunctory matters. However, let's explore how this could be done in a more constructive way, and whether Management actually responds in ways which would enhance shareholder value.

In the kind of economic environment we are in now, companies have started bombarding (yeah, carpet bombing) shareholders with rights issues. Hapless minority shareholders have to choose between forking out cash or else get diluted (sometimes massively so). So can this be taken as a sign that Management has ignored the plight of minority shareholders and went ahead with such issues due to the backing of the majority shareholder (in most cases, it's Temasek). How can aggrieved minority shareholders voice their displeasure and disappointment ? It would seem that there are currently no proper channels or avenues besides the EGM; and even then the majority shareholders' votes would more than negate the small voices of a majority of the minority shareholders. This is indeed worrying and should be properly addressed by SGX.

Another avenue which shareholders can make themselves heard is through the so-called IR department (an abbrieviation for Investor Relations). Some companies have their own IR department while others engage a PR firm as their IR contact. Shareholders can call in to ask questions about the business or to request annual reports (I've done so myself). However, the flip side is that the person whom you're asking is unlikely to be the top Management or someone from the Board of Directors; which means the answer you probably will get is a standard one. Since companies do not like to disclose price-sensitive information, you may just get a curt reply that they are not in a position to comment further. Companies hiring the PR firms are more "marketing" by nature - they tend to use nicer language in press releases and to phrase things more positively. Nothing wrong with that, but sometimes the truth is the truth so let's just call a spade a spade. Companies I own which engage such PR firms are Ezra (Oaktree Advisors) and Swiber (August Consulting). Companies such as Boustead and Tat Hong have their own IR department.

A more effective way of getting your views heard by top management is, of course, to attend the AGM and/or EGM. I've always found that I can engage the top management in conversation to ask about the latest developments surrounding the company, as well as to find out about the company's plans for the future. Most companies have Management teams which patiently entertain all shareholder queries, which is a very good thing indeed. However, whether any suggestions by shareholders on how to run the business are taken seriously or not is in question, as minority shareholders are not assumed to know enough about the business to be able to contribute anything constructive. This I am fully aware of, but I feel that during such unprecedented times, Management should remain open to constructive suggestions and filter out the bad ones; as they themselves may be facing problems in growing their business.

As a shareholder who studies the business intently, I would very much hope that any suggestions which I make can be seriously considered so that Management can take the best measures to enhance shareholder value. This would indeed be a synergistic co-operative effort by both Management, Directors and Shareholders !

Survivorship Bias - Is the Index indicative ?

It was with much interest that I read about the recent revamp of the Straits Times Index (FTSTI) in March 2009 and that the Index would be reviewed and revamped twice a year in March and September to ensure a fair and true representation of stocks listed on the Stock Exchange of Singapore. The latest revision removed 2 property companies - Yanlord Land and Keppel Land; while adding two transport operators - ComfortDelgro and SMRT. Interestingly enough, the reason given was that property was in a slump and that the market capitalization of Yanlord and Keppel Land was lower than that of the 2 transport companies, thus removing them from the index would ensure a better representation as transportation was seen as a more "resilient" industry.

This brings us to the very obvious conclusion that the Index seems to be "revamped" every other time such that the components are switched for other companies. The issue of survivorship bias will certainly be raised - this bias can be explained by the fact that the index continues to persist and climb higher over time not because shares on the whole keep rising, but because the components in the Index are substituted with stronger companies over time, while leaving out the laggard companies which do not perform. This is especially pervasive if you consider the fact that bellweather companies such as Creative used to make up the index until they were dropped due to declining sales and profits.

To cut a long story short, what I am trying to say is that if one uses an Index as a benchmark for stock market performance, one is likely to get results which are highly skewed due to this bias. When weak companies are dropped in favour of good ones, isn't it very obvious even to the layman that the index will continue to rise in future instead of stagnating or even falling behind over time ? Thus, the many articles written about stock markets always returning about 6-8% per annum may not be totally 100% true after all, if we account for this bias and the fact that the index is simply NOT representative from one period to another. For simplicity sake, I will confine my discussion to the Singapore Stock Market as some may point out that the Dow Jones Industrial Index (DJIA) had so many switches in its components since its inception that the Index is almost a totally different animal today than it once was 70 years ago.

This begs the question - how representative is an Index of the broad market and should investors rely on such indices to gauge market sentiment and relative price levels ? Some points to ponder on:-

1) The high weightage of the three local banks (DBS, UOB and OCBC) plus SingTel skews the Index towards these 4 companies. In fact, the rise and fall of just these 4 companies can have a drastic and sharp effect on the Index even though other index components ma not fluctuate much. My argument here is that the weightage is skewed too much towards financial stocks currently.

2) The usage of just 30 stocks to represent a universe of about 700+ companies seems to undermine the representative strength of the index. In the USA, though the DJIA is the bellweather Index which is still used by a broad array of investors, there are also two other important indices - the NASDAQ and the S&P 500. Of the 2, the S&P 500 is considered to be the most representative index because it includes 500 companies in it - this obviously makes it more representative than the DJIA which only includes 30 blue-chip companies (some of which are not so "blue-chip" any longer). My suggestion is for Singapore to have such an index incorporating about 40-50% of the companies on the 2 Boards, in order to show a more representative sample.

3) There are many other indices as mentioned by SGX in their press release some days ago, such as the FTSE ST Mid-Cap Index, Small-Cap Index, Fledgling Index and even an ST China Index. However, all these indices are not prominent enough and are usually not even mentioned by commentators or news reports (with the exception of the China Index since S-Shares seem to be taking a severe battering these couple of weeks). I was hoping SGX could come up with more useful indices which are better recognized rather than the existing ones which seem (to me) to be rather defunct.

4) How are dividends accounted for in terms of computing the returns on an Index ? Besides the fact that an index suffers from survivorship bias, another problem is also that of dividends which are declared and paid out by index constituents over the years. Are these accounted for by the Index ? I doubt so. There are researchers, however, who assume the dividends are reinvested into the Index and compute a median return for that. Suffice to say that such literature remains buried amongst the scholarly and those who study the stock market for a living, and has yet to be mentioned in a mainstream media article or given due attention.

All the above seek to highlight the problems with STI and indices in general. I would appreciate opinions on this issue as well as it is also quite a new area for me to blog on, and I will approach this subject again in the near future should I discover new insights.

Corporate Complexity

In the entire world of companies and businesses, a quick glance would immediately tell a casual observer that some companies are simpler than others. By the use of the term “simple”, I imply that some companies have business models and structures which are relatively easier to comprehend than others, and so are easier to subject themselves to comprehension and scrutiny in order to assess if it is a viable investment target. These companies are often producers or providers of a type of product or service respectively, as compared to global conglomerates who may be providing multi-industry products and services. As we shall see next, this can have positive and negative impacts on one’s investment thought process as well.

Using just the examples of Singapore-listed companies, one can find many companies which are focused on just one main type of business. For example, Capitaland is dealing in property development, SPC is doing oil refining and DBS is providing retail and corporate banking. To slot these companies into defined categories is easy due to the specialized nature of their principle activities and also based on the fact that they operate within popularly categorized industries such as property, oil and gas as well as financial companies. Of course, things start to get a little hazy and complicated when we observe companies which have multiple units or are into multiple industries and/or business segments. One example would be Keppel Corp, whose main business is in the building and provision of oil rigs for major oil companies. At the same time, it also has a property arm (Keppel Land) and it also owns part of SPC as well. Another pertinent example is one of the companies I own – Boustead Holdings. It has operations spanning oil and gas, real estate, water and wastewater as well as Geo-Spatial Services.

When we broaden our horizons further past Singapore and look to USA companies, one can easily find companies which are multi-industry conglomerates. Take 2 components of the Dow Jones Industrial Average for example – 3M and General Electric. These companies manufacture everything from post-its to electrical appliances to doing financing for loans (just check out their respective websites). These companies have a worldwide presence and their intangible goodwill probably values them far above their current market capitalization. So the question to pose here is: how does one go about analyzing companies of such complexity ?

Companies which are operating in a single industry often are much easier to analyze as there are peer comparisons to be made, and the business itself is also easier to comprehend. However, that said, the brand name may not be synonymous with the common man at all, and thus there may not be a premium to be paid in terms of brand recognition for the products sold by the company. Famous brand names such as Proctor and Gamble, Coca-Cola and Gilette are very specialized companies which produce a very specific product or set of products, but still manage to retain worldwide recognition.

If we turn our attention to conglomerates and companies in multiple industries (e.g. General Electric), most of the time, sum-of-the-parts analysis is used to”break-up” the company into its constituent parts, where they are then separately analyzed. A PER valuation is assigned to each component, which is then weighted according to the stake held by the parent company (e.g. 50% or 20% stake). These individual values are then added up to give a final “value” for the entire firm. While this approach is not wrong per se, it fails to take into account synergies and intangibles between the separate components of the Group. This would usually mean under-stating the true value of the conglomerate if we just base it on the individual sum of parts. Similarly, disparate business units may also not have much synergies and thus a discount ought be factored in. Hence, corporate complexity may be a hindrance when one tries to analyze and value the company as there are so many factors to account for, while one may also not realize or be aware of potential synergies within or among the business units.

That said, in my current investment journey, I have not yet ventured to value such complex entities with global reputations and reach. The closest I have come is to owning Boustead which is multi-industry but since they only have 4 distinct divisions which are quite separate from one another, this job is somewhat easier. If readers have tried analyzing a complex conglomerate for potential investment before, please do share your thoughts on the process and the factors one should look out for.

Investing Like an Ox

Let me take the opportunity to wish all Chinese readers a very Happy Lunar New Year, and to usher in the Year of the Ox ! It's somewhat appropriate that this year happens to be the year of the Ox, as I seek to revisit some of the classic investment and wealth-accumulation principles which has served generations of human beings, and will continue to act as a guiding light for investors during times of darkness and gloom. In Lord of The Rings terminology, it simply means the Light will eventually conquer Mordor and the Ring of Power will be forever destroyed !

So what is it about the Ox which has traits for us to learn and emulate ? For starters, the Ox symbolises patience, (good old) hard work and discipline. Along with those attributes, the Ox also conveys steadiness, resilience (as in "Resilience Package" - the name of this year's Singapore Budget !), dependability, calmness, being methodical, tirelessness, perserverence and the capability to endure hardships. One would argue that these are old-fashioned axioms which our fore-fathers would have smiled upon, as they hark back to the olden days even before computers and handphones existed. This is what investing should be about, and I shall elaborate more in the subsequent sections.

Of utmost importance is patience and perserverence in the face of adversity. The Ox is known as a beast of burden and is put to work in fields under the hot sun, toiling day and night. It is only with lots of patience and perserverence that the Ox is able to complete its task, all the while unhurried and unruffled. As investors, we need to absorb this aspect of the patient Ox, to be able to wait for our investments to bear fruit and also to have the patience to wait for an appropriate opportunity to invest in a good company. To perservere through hard times such as these is not easy, but resilience is important for us to be able to bounce back once the crisis is over, and to remain relatively unscathed. The idea is not to make major investment mistakes which would substantially wipe out almost all our capital. If this happens, then it might be extremely difficult to claw our way back to our original positions.

Another important trait to emulate is that of hard work and discipline. The days of easy credit and easy money are over with the near collapse of the USA and UK Banking system. Punters and speculators who used to ride on the wave of easy money from following the bull trend now have to go back to basics and work hard for their returns. For investors, it's a total back to basics formula as the seemingly easy returns of the bull market have all but evaporated. Even in other aspects of life, one has to rely on hard work and discipline (in saving a portion of income) for one to be able to grow wealth slowly but surely. Wealth accumulation is a slow but steady process and the Ox is a symbol of steadiness as it stands unflinching amidst the turmoil. Only through consistent savings and the power of compounding can we begin to see the effects on our wealth, and this will take time to realize.

Finally, I would like to touch on the virtues of calmness and being methodical. We should develop a sort of inner peace within us which shields us from the daily reports of more "calamities" and companies laying people off or banks needing more government bailouts. Calmness helps in soothing the mind and tuning out the unwanted noise which permeates our daily lives. Of course, one knows that this is easier said than done ! We are living in a world where we are constantly "assaulted" by the media, which never fails to constantly remind us of the global gloom and recession through a barrage of news reports and updates. I myself am finding it difficult to stay focused amid the monstrous surge of news reports, 99% of which are negative and pessimistic. In order for an investor to be successful, he must be able to remain calm and rational. As human beings, this can be difficult but with effort, one can adopt selective retention and retain only the news which assists us in our investment decisions, and filter out the rest of the "pollution". For example, retaining knowledge of the Singapore Budget 2009 is helpful as one can know which industries are being directly affected by the Budget's measures (such as fiscal stimuli for example).

Being methodical means going through one's investment methodology in a systematic, uninterrupted fashion. This can be more difficult than it sounds. As investors, we are all prone to taking short cuts or to gloss over certain investment criteria in order to make a potential purchase look more attractive than it really is. I think I have been guilty of such behaviour myself and this can be traced to "confirmation bias", which is another behavioural finance aspect where we seek only information which confirms our beliefs, and tend to reject information which does not conform to what we seek to believe in. This can lead to the dangerous conclusion of giving an investment the "OK" when it is not worthy in the first place. Being methodical would ensure one goes through all the relevant screens before a decision is made, and enables the process to be more foolproof.

As the year of the Ox gets underway, I wish all investors good luck for their investments and most importantly, to remain in good health and good spirits !

Bernard Madoff - Where Integrity crumbled in the Face of Greed

Most readers here should be familiar with the case of the rogue hedge fund manager Bernard Madoff, who appeared in the news after admitting to running a Ponzi scheme of unprecedented scale. He is allegedly the mastermind of the world's largest Ponzi scheme (valued at US$50 billion and counting) and who had been duping investors for quite some years before everything began falling apart like a house of cards. Much has been reported in the news (CNN, CNBC, Time, Reuters and Forbes), each with their own views on the case and also different commentaries about what happened and why it happened. Perhaps I can take the time to dissect some aspects of the case so that we can all learn a lesson about honesty, integrity and greed.

Leaving aside the details of how Madoff managed to fool investors (and amazingly, the SEC) for so long, we delve into the fundamental reason for his deviant behaviour. It all simply boils down to - GREED. Greed of course is simplifying the whole issue, since arrogance, failure to accept losses and probably even self-denial came into the picture somewhere along the way, but the penultimate driving force should have been greed (for money and reputation) because it is like lifeblood for some people - it keeps them going and it fills them with a sense of self-importance. Were investors to know that Madoff had lost money in certain years and opened his fund more judiciously to outsiders, he would then have lost that "awe" which he commanded in his loyal followers. It was precisely because of this hero-worshipping that got so many "sophisticated" investors into deep trouble. Madoff was a man hungry for power and status, and the recognition which came with it. If he had admitted being anything less than infallible, his demi-god status in the hedge fund circles would have been instantly shattered.

The most important thing in investing (and, in fact, all other aspects of life too), I feel, is to have integrity and honesty. Warren Buffett did mention that it takes almost a lifetime to build up a solid reputation but just 5 minutes to ruin it totally, and this is oddly reflected in the way Madoff totally blew everything in just under 3 minutes by confessing to his sons that he was "finished" and had been running a massive Ponzi Scheme all these years. I value integrity more than making money, and would gladly admit to all my investment mistakes, missteps and failures rather than delude myself and others that I am always doing well (and making money). Because once people lose that trust (and consequently, their respect for you), it can almost never be recovered and it's like tying a noose round your neck and releasing the trap door.

Another point I would like to grouse about is the apparent lack of controls and procedures in regulating these hedge funds. The SEC was given ample warnings over the years over Madoff's operations, yet chose not to pursue these leads further. This makes one wonder if the current body in charge of oversight and policing these funds is sufficiently equipped to handle their role competently; or has there been a conflict of interest in allowing Madoff to get too close to them; such that independence has been compromised, allowing familiarity to breed into complacency which then led to the loss of the life savings of so many individuals and retirees. The SEC is probably in need of some soul-searching and after this scandal has been fully investigated, needs to undergo a radical overhaul to ensure this kind of nonsense does not occur again. If necessary, President-Elect Obama could even suggest the setting up of a separate body to regulate the SEC, so that the 2 bodies act as counter-balancing weights such that neither gets too cosy or dominant in terms of influencing decisions which could have a life-changing consequence.

The promise of 1% returns per month consistently through good times and bad stinks of impossibility, as even Warren Buffett (arguably the greatest investor who ever lived) had periods of severe under-performance as the economy and stock market went into periods of extreme volatility. One would have suspected that if something is indeed too good to be true, it sometimes isn't ! Ponzi schemes are perpetuated on the fact that human beings are gullible and will let their guard down when they are greedy for supernormal returns. This also applies to expert investors as much as novices, because we are all subject to human emotions which can cause us to make flawed investment decisions.

What is the purpose of a Stock Exchange ?

It seems with the daily barrage of news, forecasts, predictions and commentaries by pundits, professionals and "sooth-sayers", perhaps no one has really realized the purpose of having a stock exchange in the first place ! The way the newspapers and publications go about it, you would not be blamed for mistaking the stock market as some national lottery game or gambling den, or even some fast-paced high-octane game where "The Winner Takes It All" (as ABBA sang it so succinctly some 30 years ago).

Nothing could be further from the truth though. The stock exchange's true purpose is for purely business reasons and it is merely one method which companies can use to raise funds for business expansion. Let's examine the main reasons in more detail:-

1) Private Companies sell shares to the public to raise funds for business expansion, using the stock exchange as a platform. They thus become "public" or "listed" companies from then on.

The main purpose of the stock market is to let aspiring companies sell shares to the general public in order to raise funds to expand their business. These are also known as "Initial Public Offerings" or IPO. A company needs to have some track record usually (3 years of consecutive revenue and profit growth) as well as fulfill several other conditions before it is allowed to list. Note that this is just ONE of the methods which a company can utilize to raise funds, others will include bank borrowings or issuance of debentures (bonds or notes) which are a form of debt. Listing on an exchange is a way of raising funds through equity, and it involves an expansion of a company's share capital. In a way, one can argue that it dilutes the stakes of existing owners but it also makes the company's shares liquid, thereby ascribing a market value to them almost as soon as the shares begin to trade.

2) Secondary Offering - Additional funds raised through a secondary offering of shares using the stock exchange as a medium

Even after being listed, companies can utilize the stock exchange (called the "capital markets") to issue more shares to raise even more funds for future business expansion, assuming there are buyers to take up the additional shares. This is known as a secondary offering and is most popular when share prices are HIGH, therefore this method is very common during a bull market. When share prices are high, companies can raise higher amounts of money through the issuance of less shares, thereby raising more capital with less dilution to existing shareholders. Notice now in the current bear market, no company is using a secondary offering to raise funds ? At the most, we hear of companies doing rights issues which ensures proportional participation in the company's fund raising and ownership.

3) A listing status may raise the profile of companies which may enable them to widen their scope of business expansion and get better recognition from suppliers/banks.

An intangible benefit of being listed (on the Singapore Stock Exchange at least) is that it confers to companies a certain status which is recognized by suppliers, customers, banks and other stakeholders. Knowing that the requirements for being listed are pretty stringent, this would imply that the company has "what it takes" to make it as a listed entity, and thus it would accorded a fair amount of respect. This would enable it to raise its profile and use its listed status as a "marketing" tool to reach out to more potential customers and to expand its business. Of course, one must also recognize that the quality of listing aspirants drops drastically as the market goes on a bull run, up to the point where the quality of those listed just at the apex of the bull market really gets very questionable ! I won't pinpoint names but suffice to say that certain China companies (S-Shares) fall under this dubious category.

4) A stock exchange gives the intelligent investor the opportunity to be a part-owner of companies.

This is the part I love best about the stock exchange. Aside from the hullabaloo and nonsense being spouted daily about the stock market and whether it is going up or down, the intelligent investor need only be concerned about one thing - the ownership of good companies at reasonable prices for the long-term. The stock exchange is a medium which makes this possible, as it allows sellers and buyers to transact. Without this medium, investors would not be able to partake in the profits and growth of companies (which is actually partaking in the growth of a slice of the economy). Provided one researches companies well and does not overpay for a piece of a wonderful business, one can enjoy many good long years of fabulous returns (much higher than the bank FD rate, trust me !) with little or no risk. One may argue that blue chips are a sure way of achieving this, but be aware that in the current economic crisis, the USA has proven that even blue chips may not be that "blue" after all and can be prone to total collapse (like AIG, Fannie Mae, Lehman Brothers). Thus, it is always prudent to do a thorough analysis of any investment before purchasing it, whether it is small-cap, mid-cap or blue chip.

And so I hope that the rationale for a stock exchange has been adequately explained in the above 4 points. Anyone who has more to add, please feel free to use the comments box or to discuss/debate over the 4 points which I brought up.

Predicting the Market Bottom - An Exercise in Futility ?

With the recent unprecedented volatility dogging the stock markets around the globe, and with the economic crisis fully under-way, more and more people have been congregating together to ask the mother of all stock market questions - where will the market bottom be ? To expand this question a little, it's actually a little more complex, being divided into events like "where will the bottom be", "when will it happen", "will there be another bottom" and the no-brainer "have we already missed the bottom and the boat has left" ?

Interestingly, there are no lack of experts and market analysts making predictions on the stock market, as they have been doing for the past few decades. The funny thing is that when retail investors jump in to offer their "psychic" views on what's going to be happen, then it gets truly hilarious. Everyone knows that market bottoms cannot be timed, yet people persist in trying. There is something perverse about human beings that likes to make simple things complex; and this is about one of the most complex things one can ever attempt to achieve. As mentioned, the stock market is a complex adaptive system, which means that there are a myriad of factors which determine how prices move on any given day, and thus far there is no predictable pattern for these random movements. Yet, almost everyone loves to chip in to try to predict what's going to happen next, and where the market is going to go. It's becoming a national pastime, akin to a game show, where people try to outdo and outsmart one another to be the first to "guess" the right answer. It strikes me as being silly and a waste of effort. Why ? Read on.....

The point of investing is to ensure one gets a fair return on his investment in sound companies over time. The purpose of a stock market is for companies to float their shares so as to raise funds for business expansion. Most people seem to have forgotten the two golden rules above, which is why the stock market has turned into a game, a contest and to some, a sort of battleground to test their wits and dexterity. I must emphasize that my view of the stock market is one whereby I can park my money in shares belonging to a good company which can grow steadily over the years, and eventually my stake in the company will be worth more by virtue of its business growth. This represents a way for the retail investor to grow his money in a slow and steady way. The problem is that many people are impatient for quick gains and thus engage in the speculative "game" of market timing, which ultimately results in futility as their efforts to discern patterns in stock prices usually end in failure.

Trying to pick a bottom in the stock market is the same as trying to guess when the top is here (in a bull market) so that you will know when to sell out all your shares and stay in 100% cash. There are a few flaws to this logic which many people do not notice:-

1) Assuming the bottom is coming (i.e. not here yet), how can one devise a way to properly anticipate this and be able time it exactly so that one can purchase shares at the bottom ?

2) Assuming the bottom has already past, many people will still be waiting for the bottom to arrive so that they can buy at lower prices; while the stock market may just march onwards and leave them in the cold;

3) The bottom for the stock index may not always signal a bottom for individual stock prices; so one who tracks the index closely looking for a bottom may fail to capture appropriate opportunities in individual securities as he too focused on the forest to notice the trees;

4) "Hindsight Investing", the bane of market timers, always results in one thinking that he will know exactly when to sell out and exactly when to buy back. I need not say too much more about this as I have often mentioned how silly a concept hindsight investing is.

5) Pattern-seeking human beings will always discern patterns in past data, clearly because they are available and not because they form any part of a larger picture of what's going to occur in the future. Correlation is not equal to causation; and what caused a market bottom in previous cycles may not always lead to one in the current cycle, as each economic crisis is different. So people who postulate based on past data are simply trying to anchor their expectations of the future based on information which may not be representative of what's currently going on.

The conclusion to all this rambling is that market timing is simply an exercise in futility, and my advice to readers would be to conveniently ignore the bunch of forecasters and analysts out there who are forever trying to predict the bottom. Time can be spent more constructively on sieving out good bargains in terms of corporate valuations in the current bearish environment instead of reading tons of commentaries by "experts" and "gurus" who think they know better. Thinking indepedently is one of the traits of a successful investor, but at the same time, be open to opinions about your companies which are objective and may be of value to your assessment of a company's potential.

Stock Markets - Predictors of the Future ?

As I was journeying on the bus and the MRT, I was thinking of how accurate the stock market is as a predictor of things to come. The market started its bear run in Oct 2007, and now Singapore is in a technical recession because of 2Q and 3Q 2008 GDP. So in a way, the stock market decline was able to "predict" the recession coming up and price it into share prices. This must be why people say that the stock market is a leading indicator, as it tends to react to future news and expectations even before they materialize and become apparent to the man on the street.

The reason for this uncanny ability of the stock market to anticipate economic slowdowns and recessions is due to the fact that most forward-looking news is incorporated into the price through investors/traders expectations of the future. Of course, there are some who argue that it might be a self-fulfilling loop created, whereby people's expectations of others' expectations forms either a positive feedback loop to push prices up or a vicious cycle (like what we are witnessing) to force prices lower. The analogy which Benjamin Graham used of Mister Market is extremely apt as stock markets are the collective actions of millions of participants, al trying to maximize their own gain and all thinking that they are (somehow) smarter than the guy next to them.

Normally, all this frenetic activity prices stocks very reasonably and fairly; and on "normal" days the market price can be said to be an accurate reflection of a company's intrinsic value. However, during periods of economic prosperity or depressive gloom, there is a tendency for the market price to over-shoot and land up too high or too low. Let me elaborate on this with respect to the current prevailing sentiment in the world. With the USA in constant fear of being "in a recession" and the rest of the world also afraid of tumbling into a long, deep recession; this has caused market prices to reflect the most pessimistic scenario, whereby many companies are priced as if they were better off dead than alive (below NAV !). This kind of weird asset pricing occurs in extreme conditions (admittedly, current conditions are unprecedented) and acts as a barometer of sentiment about the future (or the lack of one !).

The fear and trepidation is quite apparent in the last 3 weeks as the crisis has spiralled into something of an avalanche instead of being just a tiny snowball. On my blog alone, the number of visits has increased to more than 300+ daily (compared to 100-200 during the bull market and on normal market days). There are also seemingly more people acting sarcastic or cynical, which I may attribute to acute stress as a result of the sudden plunge in the value of their shareholdings. After some thinking and reflection, I realized that this is the PERFECT opportunity to purchase more shares in companies which I am confident in, and which can emerge from this crisis stronger. As a value investor, the idea is to own shares in good and growing companies, instead of relying on hindsight investing to tell if one should sell at the peak and buy back at cheaper prices (incidentally, anyone can be a hindsight investor by looking at a historical chart and sounding intelligent when they point out when you should have bought and sold; but try doing that in real time hehe). So the crux of the matter is to own shares in companies that will do well 3-5 years from now; the short-term price fluctuations do NOT matter as there is no intention to sell anyway.

Based on the above observation of the predictive abilities of the stock market, what I can say for sure is that the market will almost ALWAYS start moving up about 6 to 12 months from the recovery of an economy. This means that almost no one can accurately time the bottom as no one will know how long or deep the current recession will last. Stock prices are useful future indicators of how the economy will turn out; and investors who wish to own a piece of a great company should make use of this rare window of opportunity to purchase to his heart's content. Just make sure you leave enough funds for emergencies !

A Value Investor's Test of Resolve

I shall type this post purely from scratch and this is based on the thoughts that I had rationalized over the last week as the stock market had taken probably the worst slide in the last 21 years (since the 1987 market crash). I intend to cover a few areas so please bear with me if the post seems haphazard, I am trying to organize my thoughts as I type and if there are some ideas which seem disjointed, it's because this is a rather "ad-hoc" posting.

What we have witnessed in the past 2 weeks is probably the worst rout in the history of stock markets, and for some time to come no doubt. I shall not go into the details as every major newspaper and website would have covered the events to death, sounding more doom and gloom to an already panicky cauldron of potent witchbrew. Mr. Market has shown time and again that he can be extremely emotional; as one year ago he was irrationally exuberant and bidded up the share prices of companies to lofty valuations. Now, exactly a year later, he is ferociously thrashing every one who made him look like a fool for being such an eternal optimist. I was reminded of some sections of the "Intelligent Investor" which stated that in a bull market, you'd worry about not making as much money as your neighbour; in a bear market, you just worried about whether your money will dwindled to absolutely nothing as the value of your portfolio dips by 50-60%. But I digress.

I am here to categorically state that as I am HUMAN too, I was affected by the emotional roller-coaster unleashed by a manic Mr. Market, and I was rather distressed throughout the whole week. This being my first true bear market (and a savage one at that), the severity, intensity and consistency of selling has truly amazed me. Reading books on such selling is one thing; actually witnessing it is an altogether different experience, one that I certainly won't like to experience too many times in my life. However, I would like to state that I did NOT capitulate and sell all my shares in a panic, even though the recent news on Ferrochina's bankruptcy and China Printing and Dyeing's scandal have further exacerbated my lingering worries about the financial health of my companies.

Being an aspiring value investor, I think the most rational and prudent thing to do would be to do a quick review on the underlying health of my companies:-

1) Ezra - I had sent the IR department an email on their loans and whether refinancing was needed or would be a problem. I also clarified if they were going ahead with their MSFV plans as industry conditions are more uncertain now. The reply was that they had no problems with their business as they had secured long-term charters with National Oil companies and International Oil majors (lower counter-party risk), while the Group had built up strong branding and relationship with their bankers over the years and there was no risk of the banks "pulling the plug".

2) Swiber - Some indications of their financial health are the consistent share buy-backs which Management is making, and also the recently sealed third sale-and-leaseback deal. Do recall that not too long ago in March 2008, the company raised S$100 million in bonds (at 4% interest rate) which have a 3-year maturity (maturing in FY 2011). As there is currently no announcement of their Equatorial Driller, this means that the company will not proceed to build it as yet and therefore does not need to pay a deposit to the yard, thereby saving more cash. I have also personally spoken to the Management, CEO and BOD and found them to be intelligent businessmen who know how to run a company; and they all have rich experience in oil and gas industry. Some Management also consist of talents such as Mr. Glen Olivera who has many years of offshore drilling experience; thus he would know how to properly run the ODS division.

3) Boustead - Off the cuff, I recall that Boustead had a cash hoard of about S$150 million as at 1Q 2009, and this will probably be boosted further by the sale of a property announced earlier in the calender year. All their projects are proceeding smoothly including the many projects Boustead Projects won in FY 2008, as well as the Al Marj township contract in Libya and the various O&G contracts too. With their strong net cash position, this is the company I'd worry about the least; and Boustead may also be on the quiet prowl for a suitable acquisition target which they can acquire cheaply as a result of the global turmoil. In addition, the company has been using its cash hoard to buy-back shares cheaply at prices which can be deemed under-valued, as a way of enhancing shareholder value.

4) Pacific Andes (PAH) and China Fishery (CFG) - It is true that these 2 companies are highly-geared, and are at risk in such a credit crunch. Of the 2, I would think Pacific Andes is more at risk than China Fishery because PAH operates on a very low net margin but with high gearing nonetheless. The good news is that most of the capex and financing is needed by CFG and not PAH, and many of PAH loans will not be due till late CY 2009. CFG has strong operating cash inflows and their balance sheet, though geared, has many assets (e.g. permits, fishing vessels) as collaterals to the banks so I don't see a problem where banks will pull the plug. Also, note that CFG, unlike Ferrochina, does not intend to incur significant capex to expand since they had already done this in FY 2007 with the acquisition of the Peruvian fishmeal operatons. In fact, Chairman Ng Joo Siang said in CFG's FY 2007 AGM that they intend to be prudent and keep cash. That was back in April 2008; so I don't think they will be reckless and over-extend. I trust in Management's capability as CFG, PAH and PAIH have been around for at least 10 years.
5) FSL Trust - After attending the EGM, I am of course not happy to learn that the DPU will probably have to be cut as a result of the dividend reinvestment scheme. But at least FSLT does not have a vessel pipeline coming up and they do not have to scramble for funds to pay for these vessels. Their aim now is to preserve cash and maintain their portfolio, rather than grow which is impossible as they cannot tap the frozen debt markets and the depressed equity markets. Hence, although FLST's yield will probably fall in the coming quarters, at least I can be assured of some cash flows and that there is no danger of them imploding. *Note too that the USD:SGD rate has actually risen to nearly 1.48 in recent weeks, therefore this may offset the effect of the lower USD DPU (recall the previous 2Q 2008 DPU was based on an exchange rate of 1.41+).

6) Suntec REIT - The recent collapse of a Japanese REIT has raised renewed fears of REITS being unable to refinance their huge borrowings to acquire real estate assets. Suntec had just secured financing for a bridging loan to acquire the 1/3 stake in ORQ, and this will be a 3-year loan at competitive spreads. The press release also states that Suntec REIT WILL NOT have any refinancing to be done in FY 2008 and FY 2009, thus only by FY 2010 will it need to refinance its loans. Thus, though DPU and yield may be affected, I do not see any further danger to the REIT as a going concern.

7) Tat Hong - I bought this company recently due to its strong operating cash flows from 12-18 month locked-in leases and its cash balance was S$79 million for 1Q 2009. The Company has also been buying-back shares from the market and I don't think the Management will be silly enough to buy back shares when they have loans to refinance. Their gearing is 0.38 and though they spend quite a bit on capex, note that they have FCF to back them up, and that the CEO Roland Ng has said that with the impending slowdown, they will build up their cash reserves by selling inventory. Note that when times are bad, people rent (they don't buy). Tat Hong's aim is to become a rental company and as computed in Part 2 of my analysis of Purchase for Tat Hong, gross margins for crawler crane rental can go as high as 60-65%.

After this objective review of my companies which has calmed my jangled nerves somewhat, it is time to comment on some of the remarks, suggestions and reponses I had on my blog (and through private messages on forums which I visit). These range from the good (encouraging), the bad (how could you have let all your profits evaporate and be in a net loss position ?) and the ugly ("I told you so !"). The thing to do, of course, is to ignore the callous and those who are in the position to gloat on my "failure". For at least I can hold my head high and say I invested with proper prudence, research and I had done my homework. Even if I were to lose money, I lose it with full knowledge that I had made an error and I will seek to modify my value investment style to accommodate the error. Moreover, my horizon is 3-5 years for the companies I own, and I see this recession as a setback to their growth, but it will not make them topple like bowling pins.

As the title of this post states, this vicious bear market is the ultimate test of a value investor's resolve and how he stands up to repeated criticisms on his style. Advocates of market timing suddenly pop up to point fingers and tell value investors that they should have timed the top to sell and then bought back at the bottom, not realizing that this is 100% hindsight investing, isn't it ? To have conviction is to be steady and not falter even when everyone around you is losing confidence in you, and is the most difficult test of all. Those who are more diplomatic have stated that I ought to be more "flexible" to accommodate the future (i.e. the credit crunch); but no one could have guessed it would have snowballed to this acute extent. I do concede, however, that I need to improve on my analysis in order to be a better investor, and that there are still more things to be learnt in order to be a more rigorous value investor. I still reject the idea of market timing as I don't think someone can get it right over and over consistently. My aim, I reiterate, is to own well-run companies which can give consistent returns, and I shall NOT deviate from this philosophy whether it is a raging bull market, or a depressing bear market.

Lastly, I would advise those who post comments to be diplomatic and tactful. I will not hesitate to delete comments which I think are rude, tactless, insulting or blatantly deragotory.

Caveat Emptor - Understand What you Invest In !

With the recent bankruptcy of Lehman Brothers, there has been much controversy over the structured products which have been sold (through various financial institutions and brokerages) to retail investors. One of them is the DBS High-Notes, while another contentious product are the Lehman Brothers Mini-Bond Series. When a major event such as a credit event occurs, these products are rendered virtually useless for the retail investor and many are now questioning the amount of risk they took up (unknowingly) and whether there was any mis-representation on the part of bank officers who sold them such products.

Deep in the heart of such controversy lies the term "Caveat Emptor", which means "buyer beware" in Latin. Essentially, it means that purchasers of securities and investment products should understand what they are buying before they plunge in, or suffer the consequences of their lack of understanding. While the flip side for this argument is that the "pushers" if such securities ought to be more informed and provide better clarity on the structure of such products; the reality is that sometimes the sellers of such products themselves may not fully understand the consequences or ramifications of obscure events such as "credit events" or "default".

If sufficient appropriate disclosure of risks had been made, perhaps the issue would not have blown up in the media to the extent that it is (in Hong Kong, and now in Singapore). I have read reports that showed retirees who invested their life savings (6-digit sum) into such derivative products, believing that the risk was low and that the product was principal-guaranteed. THe 5% interest rate seemed a little too good to be true, as bank savings rate was only a paltry 0.25% ! I guess as the saying goes - if something is too good to be true, then sometimes it isn't true. Apparently, such high returns were a form of "insurance premium" which the banks paid to ensure that there was no default on any of the underlying securities; and the retail investors were the ones who had to pay out the "insurance" when one of the firms went bust. Essentially, these investors were in the dark about being used as vehicles for insurance, while the issuer of such securities paid off these premiums to them every year. Though the risk of default at the time of issuance was low, this does not preclude the fact that the product was in itself risky and complex.

The Edge Magazine's Personal Wealth section reported that even Mr. Leong Sze Hian (who is president of the Society of Financial Service Professionals in Singapore and has 4 Masters Degrees) had problems understanding the inner workings of such products. He had to read it a few times and in depth before he could unravel the risks and characteristics of such products. So the irony is that if such an accomplished and experienced professional such as Mr. Leong finds it hard to understand such products, what about the uneducated retail investor who simply seeks a safe haven to park their retirement monies ? The banks and brokerages have a fiduciary duty to the general public to ensure that ALL the risks and rewards of ALL the products they offer are clearly and explicitly stated, and not just using glossy marketing brochures to advertise the rewards in large fonts while keeping the risks portion at font size 6.

The reason why I feel strongly about this issue even though I do not know anyone personally affected by this saga is because I feel for the people who have "invested" their life savings into such risky products, all the while thinking that their retirement nest egg was safe, only to be told now that almost all their money will go up in smoke. It could happen to your parents, uncle, aunt or a relative; so imagine the number of extra years one has to slog just to make back the money - and all because of salespeople who may be pushing the wrong product and not being able to explain such products clearly enough.

I welcome comments from readers who have something to say about this saga, and to voice your opinions on how you think this can be prevented in future.

Capitulation ? An opportunity for Value Investors

Investopedia defines the word "capitulation" as the act of surrendering or giving up in the stock market. Investors try to sell equities in an effort to get out of the market and into less risky investments such as bonds or commodities. True capitulation usually involves extremely high volumes and sharp declines and it a symptom of panic selling. In other words, it can be said that people totally ABANDON hope that they can recover their losses and just painfully sell and take their losses. This kind of behaviour is akin to surrendering yourself to the whims of Mr. Market and totally giving in to his pervasive influence.

In the past week, we have seen an upheaval of sorts. The collapse of Lehman Brothers, the bailout of AIG by the Federal Reserve (using US$85 billion) as well as the merging of Merril Lynch into BoA and the subsequent sharp share price declines for both Morgan Stanley and Goldman Sachs; all point to a massive shift in the financial landscape which makes up corporate America, and Wall Street. Once great names, these companies were brought to their knees as a result of years od excesses and re-packaging of "risk", thus creating a bubble of complacency which ultimately led to their financial doom. This issue has probably been debated to death in the financial press and even books have started to be written about the sub-prime crisis, so I shall not delve too much into it myself.

In the most recent news, the USA Government has asked Congress to approve a plan to buy up US$700 Billion worth of toxic mortgages, in what is turning out to be the largest financial bailout since the Great Depression era of 1929. In the 2-year plan (in which details have yet to be worked out as at the time of writing this post), the Government would assist firms with toxic debt to relieve the financial strain off financial institutions and help them to resume lending. Of course, some detractors argue that it's like throwing a pail of water into a raging fire; but proponents of this rescue package say that such a co-ordinated effort would bring further stability to the system and prevent the whole financial system from "seizing up" due to a crisis of confidence and distrust which is now rampant on Wall Street.

As a result of all this, we have seen something akin to capitulation on Thursday morning on SGX, where the STI dipped to as low as 2,304 before staging a massive recovery when this news broke out. On Friday, as further feel-good effects seeped in, the index climbed close to 6% to recover quickly to the 2,500 level. The capitulative effects after three days of massive selling (Monday to Wednesday) opened up a good window of opportunity for value investors who seek a good margin of safety, as Mr. Market has battered down prices to such extents that they are becoming nothing short of ridiculous. A rumour about Macquaries drove Macquarie shares listed on SGX down to amazing levels, while any other quick rumour (about AIG's stakes in MP REIT and FSL Trust) was enough to cause a significant dive in the price of the shares. Such is Mr. Market's manic disposition and his emotionally-charged actions result in blatant mis-pricing of asset values.

I took the opportunity to purchase shares in Tat Hong Holdings Limited on Thursday morning as a result of Mr. Market's depressive mood, as I had been doing research on the company for about a month and found it a suitable target for long-term investment. The purchase was made at an average price of S$1.055 per share. More details of my research process and why I found it a suitable investment will be posted in due time, and I will include this in my September 2008 month-end portfolio review.

So to conclude, if one senses that capitulative effects are being manifested in the market, one can take advantage of this by purchasing shares in a company which one has been eyeing (and which one has done research on),

The Pendulum Swings from Irrational Optimism to Brooding Pessimism

We have now come to a stage in the economic cycle which can best be described as "unbridled pessimism", if such a term actually exists. A few investing blogs such as Jeflin's have written about such events and how it has translated into pervasive fear in the stock markets. One would recall that not too long ago (perhaps just more than a year back), pundits and commentators were extremely positive about the global outlook and were thumping themselves on the back for predicting "explosive global growth". The same bunch of people are now falling over themselves to proclaim, in no uncertain terms, that we are in the worst financial crisis to befall us since the Great Depression. Not exactly a case of being very accurate and mystical, considering their lack of forecasting skill. But I will elaborate on the mechanism of pendulum swings and how it applies to capitalistic economies.

As readers may know, a pendulum is a device which swings from one extreme (left) to the other extreme (right) and back again to left. This is known as one wavelength in physics and the swing of a pendulum can be likened to one complete revolution. Applying this to economies, one extreme of the pendulum would signify irrational optimism about the economy's future prospects - the belief that economies in capitalistic nations will continue to grow without stopping at a steady, constant rate. This view necessarily espouses the theory that excesses which are built into the system will be "flushed out" naturally by the process of competition and that equilibrium will be achieved in a smooth, sustained manner. However, from what has been observed in past boom/bust cycles and if you include the current sub-prime mess, it is rather apparent that excesses in a system do not automatically clean themselves out in a tidy way; but often leave a big mess and a substantial trail of devastation which knocks the economy out of whack for a short period of time. Take the dot.com bubble, Asian Financial Crisis and the LTCM debacle and you will notice a pattern emerging for such "catastrophic" events. They all started out with excesses and ended up with a bust so painful that the most of the world thought that the capitalistic world (as we know it) was coming to an end.

Somehow, this process has been rinsed and repeated yet again in our most recent episode of sub-prime; namely that another shock wave has rippled through the economy and caused the collapse of notable names like Bear Stearnes and (probably) Lehman Brothers. I would argue that in any capitalistic society, such booms and busts are a necessary part of "cleansing the system" of bubbles and exuberance. Hence, back to the pendulum analogy, we find that it will begin to swing rather precipitously from one extreme to the other extreme. This can take a very short span of time (as evidenced by previous boom to bust incidences) and in our case, took less than a year and a half (since June 2007) for the full effects of the sub-prime mess to seep into every aspect of the financial system.

So now that the pendulum has swung to extreme pessimism, the question is when will it swing back again, and how long will it take ? This question has probably been tackled to death by the financial media and every guru and pundit has some view on it; so I won't go into details and bore the readers out there. Instead, if I looked at this from a different perspective, I would say that as long as the excesses have been cleared (i.e. all write-downs and write-offs have been completed) and when confidence is again restored, the pendulum will then start to swing back to the left again towards optimism. The point to note is that human emotion and psychology is probably the hardest to accurately predict, and so the eventual recovery of the economy, of confidence and of the markets will probably be a slow, gradual healing of a deep wound rather than a quick "stitch" to seal the crack. I am more of the opinion that the pendulum will swing slowly from right to left and that it will not be in a hurry to accelerate - which implies that I believe in a long, protracted slump until confidence returns to the system.

Of course, my opinion is but an opinion, and does not matter much in the grand scheme of things. What matters most to the retail investor is how he processes the information at hand to make decisions which will help him to maximise his wealth, and to beat inflation (at the very least). By being invested in good companies which can weather the economic storm, one stands a chance of preserving his capital and earning a decent return on his investment. An investor should follow a disciplined approach of looking at companies to determine if they are suitable investments for the long-term, and temper this with knowledge about economic cycles and the boom/bust model. Only the fittest survive a storm, and only a consistent investor who can adapt to changing times will be able to churn up consistent returns over time.

Economic Effects of a Bear Market on Companies

I think by now, any normal man on the street will be all too aware of the effects of an economic slowdown coming to our shores, as well as feel the effects of heightened inflation. The newspaper has been blaring the news out almost every day in a non-stop stomach-churning litany of bad news, contributing to the ever-increasing gloomy sentiment prevailing in the stock markets. But an investor should ask the all-important question: How will these economic events impact on the companies I own ? I would like to address some of these issues here:-

1) Slowing Demand for Goods and Services - With any economic downturn or recession, people will tend to cut down on their spending and conserve cash for a rainy day. This will translate into slowing demand for goods and services across most sectors, but particularly for consumer goods such as electronic goods, cars and restaurant dining. Thus, during a downturn, such consumer-related companies typically feel the effects first-hand as consumers may spend less and eat more at home. Ironically, it is the spending effect which helps to grow GDP for a country (though it may not be good for an individual's wallet or personal finances, but that's another story !). There will be higher unemployment, more retrenchments and even pay cuts/freezes which will make people tighten their wallets further. All these contribute to the contractionary effect on the economy.

2) Higher Cost of Goods - Inflationary pressures and the global commodity boom has raised the cost of goods for many companies. These include the prices of tin, steel, wheat, rice as well as oil. Even though oil prices have come down somewhat to the current US$106 per barrel, they are still much higher than a year ago and the inflationary impact can be felt across the globe. Many companies which rely on oil as an important component of their costs (e.g. airlines, plastics industry and semi-conductor companies) are facing an uphill battle in controlling their COGS while maintaining their gross margins. Food companies also face rising cost of materials as the prices of rice, flour and other raw materials has risen tremendously, while they are unable to fully pass on the effects to final consumers as there is a limit to how high they can raise prices without affecting demand adversely. It should be noted that many companies in the food industries have reported lower protfits, with some reporting losses. The inflation rate was 6.5% in July 2008, down from 7.5% for April-June 2008, and estimates are that it will stabilize around 4-5% for the FY 2008.

3) Difficulty in Raising Equity - With the current economic turmoil and risk aversion, companies which require funds for expansion are unable to turn to the equity markets as the demand for IPO has almost dried up in the last 12 months. Most companies have to resort to pulling the plug on the IPO as the valuations they are garnering are not attractive enough for fund raising, while subscription rate may also be dismal, leading the under-writer to have to mop up the rest of the shares. Rather than subject themselves to such conditions, most companies would rather seek alternative methods for raising funds, while waiting for equity markets to recover their footing.

4) Difficulty in Raising Debt - The sub-prime crisis which erupted in the USA since June 2007 has contributed to this phenomenon. Not only are companies "squeezed"when it comes to raising equity, but now even debt is hard to raise as banks are suffering massive write-downs and a liquidity crisis because of weakened balance sheets; thus they are unable to lend as per normal conditions and will screen each potential borrower more stringently. Interest rates are also apt to be higher and the cost of financing may be prohibitive for some companies. Thus, all in all companies may find it increasingly difficult to either re-finance their debt, or to obtain fresh funds for expansion. In this respect, highly-leveraged firms with poor operating cash inflows are more at risk of getting into big trouble, as they have no other source of cash besides financing.

5) Cash Conservation and Heightened Risk Aversion for M&A - More companies will start to conserve cash as a result of points 3 and 4, and this would mean dividends may be cut or not paid at all in order for companies to preserve cash for operations. M&A activity will also lessen as there is higher risk aversion because companies are not willing to pay premiums to acquire in the current climate. A lessening of such M&A activity points to a sluggish economy and may lead to a vicious cycle of even more risk aversion, until some large company dares to step up the fore and declare a major acquisition. Recently, Coca-Cola announced the acquisition of China-based Huiyuan, in one of their largest acquisitions to date. However, such news these days are more the exception rather than the norm. Ironically, it is this period of uncertainty which makes valuations more compelling for acquirors, and companies such as Boustead with a huge cash hoard can take advantage of such conditions to acquire cheaply.

It has to be noted that I have covered the general aspects of an economic slowdown, high inflation, high commodity prices and also the sub-prime crisis. These are the main events dogging companies now as they struggle to grow their businesses and their profits. Some industries are described as "recession-proof" such as luxury goods and staples such as basic food products; but even these will be indirectly affected by a slowdown.

Suffice to say that no company can escaped totally unscathed from these effects, except those with pricing power, market leadership and prudent expenses control. Booms and busts are part of the economic cycle and all companies should be prepared for such cycles. It is the company which can weather the storm which may turn out to be a big future winner, and who knows, maybe even the next blue chip ?