Value Investing Recap Part 2 – Psychology and Temperament

Part 2 of my investing recap will focus on the psychological, mental and emotional aspects of investing, which are arguably just as important (if not more) than the quantitative and qualitative aspects of analysis into a Company and its business model. This is because having the wrong psychology can often scuttle an investor’s best intentions, even if he is a certified expert in analysis. The inability to control and master destructive emotions can cause significant losses for an investor and result in him not being able to preserve capital. Behavioural Finance is a very new field which combines finance theories with psychology to come up with models of investor behaviour which deviate from the rational and logical “standard” model. I will be touching on aspects of behavioural finance research with quotes and simple examples from the book “Investing and the Irrational Mind” by Robert Koppel. At the same time, I will also elaborate on some of the emotional and psychological attributes necessary for an investor to be successful in achieving a decent long-run return.

Patience, Discipline and Fortitude

The above attributes relate to the mental state of the investor as he observes Mr. Market’s erratic price fluctuations. It also embodies the attitude an investor should have when confronting investments which may look attractive from an analytical standpoint, but unattractive from a valuation standpoint. Patience is a key trait which investors should have, as there is always the temptation to swing for the fences even though one may not be prepared. Impetuous behaviour often leads to grief, and the ability to stand still while others are moving like whirling dervishes shows the strength of one’s conviction.

Discipline is needed to ensure that one stays true to investment principles and philosophies, and does not stray off the well-trodden path. Often, Mr. Market’s exciting gyrations will entice the unwary investor to cross over to the gilded path of speculation, wherein he may feel that it is harmless enough to commit a small portion of his wealth to speculative activities; all in the name of feeling the pulse of the market and to experience the adrenaline rush which comes from placing a gamble. In order to cultivate discipline, one must shut out the noise and “advice” which comes daily in the form of recommendations, exhortations and forecasts. To be disciplined also means strictly following your original plan for investment and not deviating from it, as this may mean an erosion of capital.

Fortitude is defined as the “mental and emotional strength in facing difficulty, adversity, danger or temptation”. This is probably the hardest mental and emotional quality to have as a paper loss can feel extremely painful due to the human tendency for loss aversion. Having fortitude means being able to overcome the mental anguish that you may have made a bad decision and to soldier on even though the odds seem against you. It is a character trait which is honed through many years of being in the market and getting used to Mr. Market’s manic mood swings. By focusing on the business of the Company, one can build up fortitude and be more emotionally resistant to such adversities and difficulties.

Calm, Rational and Realistic

An investor needs to maintain a calm attitude when approaching investing, and not get unduly excited, panicky or exuberant. Calmness helps one to think more objectively and to evaluate possible courses of action in a rational manner. This trait also means that one should logically think through all potential outcomes, including the so-called “Black Swan” ones, and be mentally prepared for significant losses should these events come to pass. If one is certain of committing capital, then the calm investor should proceed to do so only after considering all the possibilities.

A rational investor is more likely to react more calmly should any unexpected events occur, as he can maintain his sense of balance amid turbulence and uncertainty. In order to remain rational and objective, it is necessary to cultivate a mindset which does not react adversely to sporadic and unexpected events which most certainly will crop up in an investor’s lifetime, be they a sudden terror attack, a large drop in earnings or a natural disaster just to name a few.

Finally, an investor must learn to be realistic about companies. In the world of business, nothing is certain and sometimes the best laid plans and strategies may be fruitless if a new competitor or complementary technology/product is introduced. Hence, an investor must learn not to be too optimistic – according higher valuations to a company which is supposedly the next big growth engine or with the next new groundbreaking product or technology. Neither should the investor be unduly pessimistic and see only dark clouds ahead, which may cause him to unnecessarily divest of his holdings when the setback may just be temporary or transitional. These extreme emotions should be tempered by realism and business sense, which would allow an investor to logically and rationally assess the business prospects of the companies within his portfolio.

Behavioural Finance – Heuristics, Biases, Fallacies and Illusions

Now we come to the area of behavioural finance, which in recent years has been the subject of extensive and groundbreaking research. This is because it is a new field which can determine investors’ behaviour outside of the standard economic model of rational behaviour and profit maximization. Apparently, a lot of what we do actually runs counter to common sense and some of it even actively destroys our wealth! I shall not go in depth into the above four aspects but will just touch briefly on them. My reference is Robert Koppel’s book “Investing and The Irrational Mind”.

Heuristics simply refers to rules of thumb – shortcuts which our mind uses to arrive at conclusions. In any activity (investing included), our brains are hardwired to look for shortcuts which would make like easier and make decision-making quicker (though not necessarily more efficient!). For investing, we need to ensure that we rely on the correct and accurate heuristics in order to support our conclusions, and must actively avoid shortcuts which may results in flawed decisions.

Biases are cognitive and psychological in nature, and refer to a particular form of behaviour which arises due to personality traits inherent in human beings. Examples are over-reaction bias, endowment effects, hindsight bias and anchoring bias just to name a few. Over-reaction bias exaggerates the effects of bad news and makes us over-react to events, thus bad news is magnified in terms of emotional impact while the effects of positive news is muted. Endowment effects make it seem like what we own is more valuable than what we do not own, and is usually used to describe the fact that once one owns shares in a company, they would seem more valuable to him than an outsider viewing the same shares. Hindsight bias is one of the most pernicious and common biases and relates to people thinking that they would know what was going to happen, after the fact! This fools people into believing that they could predict what was going to occur. Finally, anchoring bias causes our minds to anchor on a specific price or event and we tend to use this as a benchmark even after it is long obsolete or irrelevant. For more info, please borrow or buy Robert Koppel’s book.

Fallacies are misconceptions resulting from incorrect reasoning that often triggers an emotional response (Koppel, 2011). Some of those discussed in the book include the Fallacy of Accident (Black Swan Theory), Gambler’s Fallacy and Psychologist’s Fallacy. The Fallacy of Accident is a fallacy based on the faulty logic of a generalization that disregards exceptions, thus this applies to assessment of companies without considering scenarios which seem too “impossible” to occur, even though there may be a reasonable chance of it occurring. Gambler’s Fallacy was discussed before in one of my posts, and I shall not dwell on this further. Psychologists Fallacy is interesting because it is the case where the observer assumes that others have the same information and perceptions of the world as he does, and thus he bases his assumptions and logic based on this.

Illusions are pretty interesting phenomena, and this was the first time I had stumbled upon such an extensive array of illusions which can play tricks on our minds. Basically, an illusion is defined as perceptions which differ from objective reality. There are several discussed in the book, but the two worth mentioning (in my opinion) are “jumping to conclusions” and “clustering illusion”. Jumping to conclusions is a case where one believes they possess superior knowledge, therefore they take shortcuts with respect to decision-making, which may end up costing them an arm and a leg. Clustering illusion is the belief in the existence of patterns where none exist, and can usually be found among chart readers who swear by a certain pattern, though nothing may actually exist. I liken this to seeing picture of animals or familiar shapes in clouds, whereas everyone knows clouds are just random collections of water droplets.

Conclusion

The above is a very summarized list of the psychological and mental attributes which an investor should strive to possess in order to manage the “softer” aspects of investing. While having a firm foundation for analysis is important, it is also equally important that the investor does not neglect the emotional aspect of investing. This is because as humans, we do not always behave rationally and with cold logic (like a computer), therefore it is important to understand these emotions and harness them to make better investment decisions.

My next post (my second-last post) will focus on my four and a half year investment journey, and what I had learnt along the way, mistakes made and lessons learnt. I will also pay tribute to value investors who had inspired me as well as people (including bloggers) who had taught me about life, personal finance, wealth building and money management.

Value Investing Recap Part 1 – Research and Analysis

As part of my concluding posts for this month, I shall be doing two major recaps on value investing and will be focusing on two major aspects which I feel are equally important if an investor wishes to obtain a successful, consistent and decent return on investment. These two sections shall be split into “Research and Analysis” which gives a revision on what one should focus on with regards to the numbers, financials and operating statistics; and “Behavioural Finance and Temperament” which sums up the emotional fortitude and attitude an investor should have when he approaches investing and the stock market. I guess readers can take these two posts as a final culmination of my 4.5 years of blogging and intensive thinking and analysis on various companies. I shall give my best attempt to distil my current knowledge and understanding of the proper concepts of investing into these two posts.

Note that following these two posts, there will be another final post on my investment journey and (this) journal, which will essentially sum up my personal thoughts and feelings on my investment journey through these years, and how I have grown and matured as an investor. No doubt the input of many other esteemed value investors was also taken into consideration in making me who I am today, as well as a list of very established authors and articles which I had read (and absorbed) over the years. I wish to thank these people in advance for enriching my life and journey and making it more meaningful and fruitful.

The Research Process

This involves preliminary research and gathering relevant and useful information about a potential investment opportunity. The research process is often rather time-consuming and tedious as multiple sources of information would have to be found in order to move on to the next stage – the Compilation Stage. An investor can usually start out with the most basic source – the Company’s Annual Reports for the last ten years. This should be followed up by recent corporate announcements, and then any industry reports if applicable.

Research should attempt to be as broad-based as possible, and to include all pertinent and relevant sources of information which may assist in the decision-making process. Most of the information obtained will be from public sources, but it does not hurt to go direct to the source if possible and set up and interview with either the Operations Manager, CFO or even CEO. This is truly a case of Phil Fisher’s “Scuttlebutt” technique, where the investor “gets his hands dirty” in gathering information directly from the Management themselves. Of course, such information is necessarily biased, and the investor should objectively assess the information to ensure he is not unduly influenced by Management’s expected optimism.

The Compilation Process

Compilation is a process which collates and aggregates the information, either on a Word document or an Excel spreadsheet. This enables the investor to better make sense of the huge influx of information which he must have obtained from the previous process of research, and also to summarize and make sense of the information in a meaningful manner. Compilation may take quite some time as the facts need to be arranged in a logical sequence, which could includes (but is not limited to) chronological sequence of events, arrangement of inter-connected facts and figures (examples, setup of new business divisions and their associated operating margins) and year-on-year comparisons of key ratios and metrics (like ROE, margins etc).

At this juncture, perhaps I should mention that the way the information and data is compiled has quite a heavy bearing on the next process, which is analysis. If the information is not compiled in a logical manner which makes it easy for the investor to trace the fortunes of the Company over the years, then he is likely to be either unable to make a conclusion on the investment worthiness of the Company, or worse still, may make an erroneous conclusion which may result in permanent loss of capital. Generally, the “proper” and sound way of compiling information is to ensure that one moves through the Company logically, from quantitative to qualitative; from business divisions to strategy, and so on. It can be argued that the substance of what is compiled is more important than the form, but I would insist that the presentation of the information also be coherent to an outside reader such that the investor and him would be able to glean the same insights using the same sets of data.

The Analysis Process

The analysis process can be described as the most difficult aspect of investing as everyone may look at the same data or information, yet come up with completely different conclusions. This is where the “skill set” of the investor comes into play, as he must draw on multiple disciplines (as mentioned by Charlie Munger, Warren Buffett’s business partner) in order to form a mental model of whether an investment looks attractive. Numerical and quantitative data must be assessed and analyzed to identify trends or spots of competitive advantage which differentiate one company from another; and the same investor must also be alert to potential danger signals or “red flags” within the numbers (e.g. inventory levels, receivables days, declining gross margins) in order to identify potential weaknesses. Suffice to say that the investor requires a very keen eye and an even sharper mind in order to make sense of the voluminous amount of information and draw meaningful and logical conclusions.

Numbers aside, analysis also involves areas of business analysis (as shares are, after all, part-ownership of a business) such as marketing, corporate strategy, management, human resource (staffing), operations and administration. Obviously, one cannot be knowledgeable in all aspects of a business, but it is important to at least have some awareness of how major decisions in these key areas influence a company and affect its competitive advantage, growth prospects and stakeholders. Porter’s Five Forces come in handy and some investors also take it upon themselves to do a SWOT analysis to enhance their understanding of where a Company stands. Other types of analysis which may be employed would also include (but is not limited to) a PEST analysis.

The final and possibly most important (yet somewhat nebulous) aspect of analysis is that of the integrity and character of key Management personnel and Directors. This aspect can only be independently assessed if the investor undertakes to personally visit and interview the Management and/or Directors. A very good opportunity usually arises by attending the AGM or EGM of the Company, whether as a minor shareholder (e.g. buy 1 lot to be invited to the AGM) or as an observer. Subtle cues can be picked up to see if Management is evasive, upfront, candid or simply cannot resist the so-called “institutional imperative”.

The Decision Process

The decision process would immediately follow the analysis phase, and is a validation of the analysis process. Once the all-clear is given in terms of the analysis portion, meaning there is green light to go ahead, the only “hurdle” left would be to determine a suitable valuation to purchase. This is the tricky part where one has to assess metrics such as P/B, PER or use a rudimentary form of DCF analysis with assumptions in order to “model” a fair value for the Company. While Buffett uses “intrinsic value” to encompass the entire business and its characteristics (including intangibles such as goodwill, patents and trademarks), this concept would imply a value which is in excess of the sum total of the net assets on the Balance Sheet, and therefore is difficult to pinpoint with precision. Hence, being approximately right in obtaining a value and purchasing at a margin of safety is much better than being precisely wrong.

Conclusion

The above pointers are just a brief summary of the research, compilation, analysis and decision-making process which has now become an integral part of my stock selection process. My criteria has been mentioned before in previous posts and I will not repeat them here again, but this post is just to collate my final thoughts on this topic and to provide a summary of how to go about the often tedious, but ultimately rewarding process of finding and purchasing an excellent company.

In my next post (third-last post), I shall weigh in on the psychological, mental and emotional aspects of investing, which I feel are as important as the business analysis portion.

How To Think About Yield

After my previous post on how to think about valuations, this can be considered a “follow-up” post on how to think about yield. Oftentimes, I read about comments in forums or the newspapers which mention how attractive some yields are for certain companies, REITs or business trusts. I also hear of friends, peers and colleagues talking excitedly about high yields and how easy it would be to beat the dismal 0.05% interest rate which DBS is giving on its savings accounts. But what most people may fail to realize or consider is that higher yield is usually accompanied by higher risk – both in terms of the business model of the underlying company/trust and the sustainability of the yield. In other instances, computation of yields is also not conservative as most people make use of past yields to justify purchase decisions by implicitly assuming that yields will carry on being high without adequate consideration for the future. These actions have dangerous implications on one’s portfolio as they may lull an investor into a false sense of security, as he would rely on high yield as a “cushion” or buffer for his investment and expect that he would be able to weather a downturn. The reality is much starker – during economic recessions a myriad of factors may lead to yields being slashed and capital values declining, and that will lead to a double whammy when it comes to an investor trying to beat inflation and also preserve his original investment value.

High Yield from Business Model

There are many instances of high yields to be found in the current stock market environment, with many REITs and Business Trusts advertising yields of 8% to >10%. This in inherently tied to the business model of the underlying assets and the investor has to be astute and take a very keen look at the said business model to ensure that the yield is able to sustain. While many REITs can boast high yields, one should also observe that most are highly leveraged and this could be an issue if a credit crunch of severe downturn hits. To add to this, the risks of a property downturn (leading to a fall in rental rates once rents are due for renewal) could also hit the revenues of many REITs. Yet another factor is the increase in borrowing costs for REITs once their loans are due for roll-over. Perhaps an investor can learn some lessons from the previous credit crunch of 2008-2009 to know that high yields from such securitization of assets is not always guaranteed, and that a fall in capital values of the underlying assets (due to revaluation, no doubt) could also have a devastating effect on the yields being provided by said assets. Not to mention, of course, that capital losses could also offset many years of future yield, as in the case of Babcock and Brown Structured Finance Fund (BBSFF).

High Yield Sustainability from Business Operations

Assuming a steady state business which is of a going concern and which does not involve depreciating assets with finite lives (as in the case of business trusts which hold assets with a finite concession like K-Green Trust), high yield should be viewed from the perspective of ongoing business operations and whether it can be sustained as such. To explain this further (I apologize if it sounds rather lengthy and dry), one should focus on the free-cash-flow generation history of the Company and its consistency to determine if the business can withstand downturns and recessions and still be able to pay out a decent dividend, thus forming the “core” part of the expected yield. As businesses grow and mature over time, they will build up a larger customer base and also forge stronger customer relationships, thus a large part of the revenues and orders may be sustained even if there is a major downturn, unless the Company has an illusory moat or one which cannot be maintained. An ideal business is, of course, one which is able to increase dividend payout ratio as profits trend upward over time, and this demonstrates the classic case of the company with excellent economics and an almost unassailable moat.

In reality, however, most companies do suffer from dips in their earnings, and consequently their cash flows. Hence, in order to portray a realistic picture of the yield from a Company, one should do a 10-year analysis and pick the worst 2-3 years and observe the cash flows during those years. If the Company is still able to generate free cash flows during periods of great economic distress and upheaval, and the business has not suffered long-term and permanent deterioration or setbacks; and if the Company has still maintained its dividend policy throughout that period, then there is a good chance of getting a fairly decent yield which is sustainable. Using this dividend as a benchmark, compute the expected yield based on extremely bearish and pessimistic conditions, and see if it still manages 2-3%. If so, then the Company can be said to be resilient and worth collecting as it may either have superior economic characteristics (e.g. strong, stable moat and repeat customers) or require very little additional capital to function efficiently. Either condition would make the Company suitable for consideration in a value investment portfolio.

Computation of Yield – Pitfalls and Perils

The most common mistake I notice when I speak to investors regarding yield is that they always tend to use last year’s dividend payout as a basis for computing expected yield. This not only assumes that history would always repeat itself, but also makes the mistake of ignoring economic cycles and their (probable) detrimental impact on the business. The perils of computing yield based on historical payouts is that as the business cycle moves, the fortunes of the Company may fluctuate as well. A Company may have good years and bad years, or it could also be a one-off disposal/divestment of an asset or a business division which saw a large inflow of cash and hence the declaration of a special dividend. So investors must be cautious and conservative in their calculation and remove all effects of special dividends, no matter how consistent they seem to be. One example which immediately comes to mind is that of bellweather stock SPH. In its latest FY 2011 results, it declared a final dividend of 9 cents/share and a special dividend of 8 cents/share. In the prior year, there was a final dividend of also 9 cents/share and a special dividend of 11 cents/share. Even though SPH has been paying a special dividend since FY 2002, I feel that an investor still cannot take it for granted that it is a given that this trend will continue, unless he assesses that the business is stable/growing and NOT declining. To be very conservative, one should simply take the interim + final dividend as the total dividend and divide it by the last done share price to compute the expected yield.

Another example in my own stable of companies is Boustead, which had also paid out special dividends in the last two financial years. For FY 2010 (ended March 31, 2010), it paid out a special dividend of 1.5 cents/share while for FY 2011, it paid out a special dividend of 3 cents/share. But core dividend for full-year remains at 4 cents/share for FY 2011 (2 cents interim, 2 cents final) and thus yield should be computed based on this, and not the full 7 cents/share. If special dividend is counted in, it would distort the yield.

Another pitfall often seen is that investors tend to over-estimate company performance and project increasing dividends over the years, even if there is no objective or reasonable basis for doing so. In other words, investors may purchase a Company with the assumption that the yield can either sustain or improve, which may be a fallacious assumption. Margin of safety (for yield) may end up being illusory if the Company suddenly cuts its dividend or announces huge capex to replace old machinery/assets. Business conditions may also force a company to scale back on dividends and divert more cash to fund working capital requirements.

The Illusory Yield "Cushion"

I would say that one of the more dangerous assumptions one can have when investing in companies is to assume that yield can act as a “cushion” should capital values plummet. When speaking to different people, I get the sense that those who invest in assets with high yields are basically assuming that the high yield can somehow compensate for any losses in capital values due to either asset deterioration or a declining market value. While it is true to a certain extent that high yields (high being defined by myself as anything exceeding 7%) can offer some measure of protection against a temporary decline in market prices, it cannot hope to offer a long-term “buffer” against declining business or a major shake-up relating to the underlying asset.

A good and rather recent example would relate to the shipping trusts back in 2008-2009. Yields of >8% were touted back then for FSL Trust, with stable, locked-in charters and a 100%-payout policy (which was to prove not just unsustainable on hindsight, but overly aggressive as well). However, when the underlying asset value (of the ships) began to plunge, many hitherto unknown clauses were triggered (such as loan convenant ratios) and the Trust suffered major hiccups and setbacks. Suffice to say that the touted high yield was unsustainable and the share price drop was massive in order to reflect the new realities after the shipping crash. The permanent and irreversible drop in share price more than offset any quarterly dividends received, and is a prime example of how unprepared one can be for such events and how yield can eventually prove to be both illusory and unsustainable.

Seeking Comfortable, Sustainable Yields

After going through the experience (and heartache) of abruptly plummeting yields, I believe it is better to focus instead on obtaining yields which are lower than the often-touted 8-12%. Good businesses which are generating decent cash flows and maintaining or growing their market share should theoretically be paying about 5-6% yield, with the exception of major market depressing moods which temporarily cause stock prices to plunge (and hence yields to rise sharply).Sustainability should be the focus of an investor seeking yield, rather than going for eye-poppingly “high” yields which can usually be associated with higher risks. Some of these risks may not be readily apparent as the Company or REIT/Trust may not have undergone a baptism of fire and emerged unscathed, thus investors (most with short memories) may not be aware of the potential perils of investing in such securities.

While I do admit there are occasional good deals in which companies can sustain an inordinately high yield, my experience thus far has been one of scepticism and caution. Most companies may seem to pay out high historical yields but the all-important question would be whether these are sustainable moving forward. If not, as an investor I would rather stick to a company with a lower yield (but still higher than inflation) which I feel would be consistent and sustainable over time.

Conclusion

The issue of yields is as thorny as my previous post on valuations, because after all, nothing in the stock market is cast in stone. One has to continually review and analyze the facts on a case-by-case basis and form their own conclusions based on objective data, instead if relying on “preset formulae” when making investment decisions. The best investors have always used a mix of personal experience, business knowledge and theoretical foundations (plus throw in emotional resilience and control) in order to earn consistent returns for themselves without losing money (capital preservation), thus holding true to the mantra of value investing as espoused by Benjamin Graham. Any aspiring value investor out there (including myself) would be doing himself a favour to follow their footsteps and to seek continuous improvement in their methods, techniques and processes.

How To Think About Valuations

At this juncture, and after all the thinking, mulling and silent contemplation on the trains and buses, I thought it timely for me to write down my thoughts on valuations and how I approach this slippery topic. With stock markets around the world going into a violent tailspin in the last 8 weeks, perhaps it is also a good time to revisit this topic and to deliberate on exactly how one should think about valuations. The reason for this is that valuations do not exist in a vacuum (unlike what analysts would love for you to believe) and are constantly in flux, changing as often as business conditions change (which is, to say, virtually all the time). Pinning down an exact valuation and projecting it into the future is always difficult, but during volatile and turbulent times this becomes even more of an impossibility. So how should an investor navigate the frigid waters of corporate valuations to find some semblance of dry land? Can he firmly root his feet on the dry sand or will he quickly find out that he is standing, instead, on quicksand?

Valuation as a function of historical corporate profitability (business model approach)

Companies which have been operating for many years (or decades) and which have a track record of steady and growing profitability and stable cash flows should see valuations which are somewhat high as compared to companies which are just starting out and have yet to find their niche. From this standpoint, valuations should be assessed based on a company’s business model and how efficiently it can continue to generate profits and cash flows through good times and bad. As such, recognized blue chips tend to trade at higher valuations even during recessionary periods because of their ability to generate consistent profits throughout all economic cycles, but this has not always been shown to be true.

A conservative and prudent investor should thus assess each company on its own merit, and dissect its business model to see if it is able to function as efficiently through all business cycles. History may not always be able to foretell the future, and there have been numerous cases of companies which had succumbed to new technologies or advances which completed changed the industry landscape and eroded their (seemingly) impenetrable competitive advantage.

Hence, after a review of the business and its underlying prospects and characteristics, one should make a rational assessment of whether it deserves to be accorded high valuations (for a superior and adaptable business model which has a long-lasting impact and can shield the company from the vagaries of the economy), or whether it should be given lower valuations for possible risks (whether perceived or real). This is possibly the most difficult aspect of investing.

Valuation based on economic cycles

Coupled with the above, one should also account for valuations with respect to the stage of the economic cycle. Since the stock market normally precedes the real economy by about six to nine months, it is therefore no easy feat to assign valuations to companies based on economic cycles; but one can use a very rough approximation to cushion for possible error (the proverbial margin of safety so to speak). So let me give a simple illustration:-

As the economy expands and grows, all companies benefit from increased demand for their goods and services, and accordingly these companies will grow, hire staff, expand and earn higher profits and generate better cash flows for their shareholders. Valuations at this stage are thus moderate to high as expectations of growth will rest on a wave of optimism for the future. An investor thus has to temper his expectations of growth in this regard in order not to get carried away on the sea of optimism and hope. Conversely, when the economy is faltering and sputtering and there is trouble left and right (as is the case currently), then valuations would accordingly be much lower as it is expected that companies would suffer from a drop in demand and hence earn lower profits and cash flows. Valuations will therefore be correspondingly lower, and this is something the investor has to accept as part of the economic cycle.

The idea, of course, is to effectively marry the two aspects I mentioned – economic cycles and business characteristics, to be able to determine an approximate level of valuation which is acceptable to the conservative investor. For some companies go into decline, their valuations hit a trough, but they never are able to pick themselves back up and resume their previous growth trajectory. Other companies may prove more resilient and spring back from adversity; thus this underscores the importance of not just financial analysis but also business analysis from a quantitative and qualitative perspective. There is no right or wrong answer, and the investor has to take it upon himself to search for a level of valuation which he feels gives good value and provides adequate justification for his purchase of shares. [Yield does come into the picture, which I will elaborate more on in a separate post.]

Valuation Metrics – Price-Earnings and Price-To-Book

A rather pertinent question one may ask is what kind of valuation metric one should use to determine if valuations are indeed fair, demanding or bargain. The two most common ones which I use and which I feel are relevant to investment decisions are the price-earnings (PE) and Price to Book (PB). PE is essentially how much premium one pays for the earnings of a company, and is the most commonly used metric to gauge valuation. PE can be rather deceiving as it may not apply to all types of companies (e.g. property companies and companies with “lumpy” revenues). Other times, a one-off event may also distort PE and may something look cheap when it is actually expensive. PE should not be used in isolation to weigh valuation but should be used in conjunction with other metrics like ratios as well as yield (also factoring in, of course, the qualitative characteristics of the Company in question).

PB is usually only applicable in cases when earnings are either not stabilized, or when the company has a strong asset base with low earnings. Book value is, very simply, the liquidation value of a company, minus any fire-sale conditions which may result in a haircut discount given to fixed assets and marketable securities. I note that PB is generally used by analysts during protracted bear markets as earnings cannot be reliably predicted during such periods of economic turbulence.

An important note which I have to emphasize (sometimes repeatedly) is that these valuation metrics should not be used in isolation to determine if a company is “cheap”. There are a myriad factors to consider and PE and PB are just two of them. Life (and investing) is certainly much more complex than that!

Relative (Peer-to-Peer) Valuations

One final method I can think of offhand is using peer to peer valuations as a quick rough and dirty method of determining if a Company may be cheap or expensive. Of course, this method is rather rudimentary and requires a lot more in-depth research and refinement, but by itself it should at least offer the investor a glimpse into whether a Company is lagging or leading its competition.

The use of competitors within the same industry ensures that an “apple to apple” comparison can be made. However, one risk of using this apparently simple method is that the industry as a whole may be in decline, thus everything would seem “cheap”. Thus, the conclusion cannot be made using peer valuation in isolation, but should be used in conjunction with Porter’s Five Forces analysis and industry analysis.

Conclusion - how to think about valuations

To conclude, valuations are a rather tricky business as there is no hard and fast rule as to what constitutes cheap or expensive valuations. It depends a lot on not just the economic cycle but also the operating characteristics of the Company in question. During periods of recession and economic slowdown, investors should get used to lower valuations in general, as Mr. Market is feeling pessimistic and is unable to forecast a bright future with much certainty. Investors would then adjust their expectations for future growth accordingly and demand their requisite margin of safety.

Conversely, during periods of economic prosperity (during a boom), valuations will be correspondingly higher; and it is up to the prudent and wary investor to be sceptical of such high valuations and to ensure he is emotionally unaffected by the euphoria and optimism. Of course, this is all easier said than done, but it’s good to have the theoretical foundation as a starting point.

The Annual General Meeting (AGM) Part 2

Part 2 of the AGM series will shed some light on the AGM itself, decorum to observe and who to approach. Please note that this is all narrated from a personal perspective, as I have been attending AGM for quite a few years now and have, over time, picked up some cues on who to approach and what to ask from experience. None of this is cast in stone, however, and therefore readers are free to modify any of the suggestions below to suit their own personal preferences.

For information, the experiences detailed below are a result of the compilation and culmination of attendances at the following AGM/EGMs: Ezra, MIIF, Swiber, Tat Hong, China Fishery, FSL Trust, Boustead, Kingsmen Creatives, MTQ and Suntec REIT. Since almost all AGMs are held on working days, be prepared to take leave in order to attend (unless you are a retiree with time to kill).

Mechanics of AGMs

An AGM is usually held at a hotel function room or if the Company is keen on saving money, then it will be held at the Company’s premises (for info: Boustead and Kingsmen AGMs are held at premises, while MTQ and SIA Engineering hold theirs at a hotel). You should bring along your identity card as well as a copy of the Annual Report and any documents which came along with it, as well as a pen and your prepared list of questions and notes. At the counter area, register your name with the staff and they will hand you a sticker (colour varies) to paste on your clothing. Some AGMs will hand you a poll slip stating the resolution to be voted on, and this will state your name, IC number and the number of shares held in the Company. These poll slips will be used for tallying in cases where voting is done by poll instead of a show of hands.

Assuming you are early, there will usually be time to find a good seat and to interact and mingle informally with Management (and other shareholders). The section below will focus on the proper behaviour and decorum to be observed at such meetings, in order to create a good impression and be able to gather the information required to make an informed assessment of the Company and its prospects.

The CEO will be in charge of reading through each resolution and asking for a proposer and seconder (a basic formality). There will usually be a pause before asking for a show of hands, as the BOD and Management would allow questions to be asked before putting the resolution to a vote. Once all questions have been posed and answered satisfactorily (and this includes both formal and informal questions), the resolution will be put to the vote. Unless there are violent objections, most resolutions will be passed without much fanfare.

Decorum, Etiquette and Behaviour

I can’t stress more on the importance of proper behaviour at the AGM proper. After all, it is a corporate meeting and therefore one is expected to at least dress presentably and behave in a civil and cordial manner. For myself, I treat the AGM as a business meeting and therefore I will usually dress up in corporate wear, with long/short-sleeve shirt, long pants and socks/shoes. I have seen retirees who are dressed much more casually, but no one comes in a singlet and sandles (obviously). Dressing well also gives a good impression to Management that you are a serious investor and assuming you approach them with the right attitude and armed with the requisite knowledge, you may leave a deep impression on them. There are reasons for this which I shall go into shortly.

In term of decorum, it is only polite to ensure one does not interrupt the proper proceedings of the meeting, and to save most of the questions till after the meeting proper (to be taken “offline” as it commonly referred to). When invited to formally ask questions (usually by standing in front of a microphone), one should be civil and polite when posing the question. I have personally witnessed cases where shareholders get agitated over some perceived grievance and decide to air their frustrations through the microphone for all to hear. Management may take quite a while to placate the incensed individual and normally, when one is caught up in that frame of mind, nothing useful ends up being discussed and everyone’s time is wasted. Indecorous behaviour is normally tolerated as the BOD and Management strive to be professional, but there have been cases where sarcasm is thinly veiled and where Management has been known to admonish the shareholder (so that they feel some measure of chagrin or mortification, hopefully).

My style is often a non-confrontational one – I will arm myself with the questions and approach Management after the meeting proper by asking if they are free for a discussion. They are usually quite pleased to engage shareholders, though what they say and proclaim is usually coloured by personal bias and unbridled optimism (most of them own part of the company, and are therefore loathe to admit anything bad about it). The personnel of importance to approach include the Chairman, CEO, CFO and any divisional heads; all others can only give a rather one-sided view of things which may not be useful; and they may literally rattle on and not give you the chance to extricate yourself from the idle chatter.

For accounting and finance –related matters (e.g. sales, revenues, margins, loans, debt, gearing and ROE), approach the CFO or the Finance Director. For strategy-related matters, industry prospects and plans for the future, it is better to speak directly to the CEO and/or Chairman. For the record, I have personally spoken to Benedict Soh (CEO) of Kingsmen Creatives, FF Wong of Boustead (Chairman and CEO) and Mr. Kuah Boon Wee (CEO) and Mr. Dominic Siu (CFO) of MTQ. For other matters pertaining to the Annual Report or other news-related queries, it will be useful to approach the IR contact, but make sure they are internal personnel and not staff from an IR company. Some examples would be Keith Chu from Boustead and Andrew Cheng of Kingsmen Creatives who are the designated IR spokesperson from their respective companies.

There are also no hard and fast rules as to how to approach each person. Generally, a smile and a warm handshake (coupled with an introduction) would suffice. The next section will discuss on how to ask the right questions (and also how to avoid potentially embarrassing ones) and to dig out the required information in order to make your personal trip worthwhile.

Fact-Finding and Questioning

An AGM is to be viewed as a fact-finding “mission” for the enterprising investor, and if one is well-prepared with a list of questions (see Part 1) and equipped with the requisite knowledge of the Company (e.g. divisions, margins, plans and other pertinent details), it will make the discussion much easier and more casual. If not, it can sometimes resemble an interrogation session whereby shareholders will ask inane and inappropriate questions and make Management wince and grimace. I have yet to see the BOD or CEO recoil in horror, but the way some shareholders ask questions (combative tone, threatening demeanour) makes me feel quite a measure of pity for the one being questioned.

It is usually good to start off with some casual and general remarks or questions before one digs deeper. Leading questions and statements could include commenting on the company’s excellent performance before delving into an aspect which requires attention, or to congratulate the CEO for a good financial year before questioning him on his plans and strategies. As part of human relations, it is important to blunt any impact of difficult questions and try to wrap your tongue around the question to make it sound more palatable. A good example might be querying the Management on why debts have increased by so much in the Balance Sheet. Instead of asking the question point-blank (which may elicit a defensive response), it may be better to para-phrase it to sound something like – I understand debt has gone up significantly, but was this for a planned acquisition or was it already part of Management’s budget? Phrasing a question to sound politically-correct may make it seem like you are being superficial, but unless you are on friendly terms with the Management, it is better not to put them on guard; for this may also frustrate further attempts at digging out important nuggets of information.

Also avoid asking loaded questions which “corner” the person and leave him with little room or choice to manoeuvre or reply. Examples of loaded questions would be “Do you think the company can only do better this year?” - this essentially forces a response in the positive, for no Management would like to paint the company in a bad light. Ask open-ended questions instead of those requiring a “Yes” or “No” absolute reply.

Another irksome area is that of vague questions. Some questions are so general that Management is given room to answer almost anything. There is the problem of not being focused enough to be able to obtain the answers you seek, and this wastes time and effort. Try to support each question with some facts of your own or numbers; this will give the impression that you know your stuff and Management will feel less inclined to hoodwink you. You could perhaps say – I heard that the oil and gas industry is poised to dip into the doldrums, what is your take on this? Or on a question on margins, you could say – I noted from my analysis that operating margins for XX division were only XX% compared to YY% a year ago, may I know the reason for this and what is Management doing to address this? Being focused and drilling into details also forces Management to ruminate and think on the problem in order to give you their best answer (though some answers may be spur of the moment types intended to cover their ignorance of the situation!).

The last area I must talk about is that of silly questions. These probably take the cake in terms of being not just irritating but also a complete waste of time. I can, offhand, quote two of the most common silly questions I have heard at almost every AGM/EGM. One of them is the classic “dividend” question – Will the BOD be paying higher dividends next year? I mean, hey, no one can even forecast their results in the next quarter, much less a year later! The second most irritating question would be – Why is the share price so low? Can Management do something about this? Obviously, the hapless shareholder should know better than to burden Management with something as trivial as the share price when he should be focusing his energy and effort on understanding the business better! These questions almost invariably draw a polite (sometimes forced) smile and the standard reply that it is not Management’s duty to track the share price and there is nothing they can do to manipulate it, other than (of course) running the business well and growing it. It’s about time that shareholders realize - if the business does well, the share price will naturally follow.

Conclusion

An AGM is a very rich source of information for investors and therefore, I feel it is a must for all investors to attend. After all, it is only once a year that you get the chance to rub shoulders with senior Management and the Board of Directors and also get to question them on various corporate actions and strategies. By sizing them up in person, an investor can also pick up subtle cues from their body language which may signal a lack of confidence, or at the opposite end of the spectrum, hubris. Face to face interaction is important as Management is less able to hide behind the computer screen to type away on a prepared email response, and they will be far less dismissive as compared to talking over the phone (where they may also be reading from a script). One can literally test how Management and the BOD react to “awkward” questions and accusations and to see how they (stoutly) defend themselves, or if they have a proper and reasonable response to a pointed question.

Part 3 will focus on the aftermath of the AGM – how one should organize their notes and thoughts, the impression which they take home after meeting the Management and BOD face to face, as well as the essential follow-up which must be done as part of the on-going due diligence as an enterprising investor.

The Annual General Meeting (AGM) Part 1

After attending more than my fair share of AGMs, I thought it strange that I did not write a generic post on how I usually prepare for an AGM, or how I go about extracting information and conducting due diligence during an actual AGM. It’s interesting because the process often involves not just being ready with the questions which you have prepared, but one should also carry with them the willingness to warmly engage Management in discussions on the Company’s prospects and strategies. It’s as much a human relations exercise as it is an exercise in financial and corporate (business) analysis. Of course, it can be argued that one gets better over time as one attends more of such AGMs and gets to meet their fair share of interesting and varied personalities, ranging from the downright unfriendly to the exceptionally warm. This post serves to highlight the preparatory efforts which I undertake before an AGM, an account of what to do during the AGM, as well as the follow-up required after the AGM to verify facts, collate information and glean valuable insights.

Part 1 will discuss mainly on the Annual Report, how to go through it, and what information to glean from it; as well as the preparation of questions and pointers to be brought up during the AGM. Part 2 will focus more on the AGM itself, including the proper decorum to observe, things to do and people to approach. Part 3 will wrap up with a discussion on the aftermath of the AGM and any follow-ups required, as well as how to analyze, collate and make sense of the information gathered in order to glean knowledge from it.

Preparatory Work – Receiving the Annual Report

Obviously, one could argue that the very first step towards preparing for the AGM proper consists of reading and downloading the Company’s latest full-year financial results from SGXNet. This is usually within a window period of 60 days from the date of year-end for the Company. For example, in the case of Boustead, their year-end was March 31, 2011 and results were released on May 26, 2011 (within 60 days) on SGXNet. The AGM, though, is usually held about 2 months after the release of the results; in this case for Boustead it will be held on July 29, 2011 (Friday). This means that four (4) months would have elapsed from the date of release of the full-year results till the actual date of the AGM. Note too that the AGM is almost always held on a weekday, therefore in order to attend, one must take leave if one is engaged in full-time employment. I try to do so as much as I can as this is a once-a-year affair.

For the Annual Report, however, it will usually be issued two (2) weeks before the date of the AGM. In my case, I received Boustead’s Annual Report in my mailbox on July 18, 2011 (Monday) but the online soft copy version was already available on the Company’s website as early as July 15, 2011 (Friday).

Obviously, one will not have the luxury of time to peruse through the Annual Report, as there are only about 12-14 days between the time of receipt of the Report, till the date of the AGM. Below are some pointers on the salient aspects to look out for in the Annual Report to cut down time taken for analysis.

Preparatory Work – Digging Deep into the Annual Report

The Annual Report (AR) is usually perceived as a rather daunting document, as thick as a small encyclopedia and filled with glossy pages lauding the Company’s achievements. Essentially, though, it has two main sections. I call them the marketing section and the financial section. Marketing section consists of full-page, mostly glossy photographs of the Company’s projects, products or premises, while the financial section is chock-full of numbers, tables, explanations and (obtuse) accounting facts and estimates. Most people who are not accounting-trained would tend to shift their focus almost exclusively to the marketing section, as the pages there are easy to read, usually in full-colour, presented in columnar format (for easy comparison) and the English used is not too archaic. For example, using Boustead’s FY 2011 AR as an example, the Group’s four divisions are clearly segregated and explained, and tables are used to summarize major projects and milestones for each division. There is a Chairman’s Statement which is 4 pages long, as well as a financial summary showing five years of revenue, profits and dividends. While I do not deny that this section can be used as the basis for questions, it is usually the stuffy numbers in the financial section which should be scrutinized up-close, and for a person without accounting knowledge this task would seem like a mammoth one. Therefore, I would strongly encourage readers to acquire a basic understanding of accounting by reading books such as “Value Investing for Dummies” which explains the key concepts involved in the three financial statements, as well as some other accounting concepts.

It would be a good starting point to concentrate on the numbers which “stand out”, meaning any big changes in profit margins, revenues or anything which is an aberration and not quite “normal”. What these are will, of course, vary from report to report, but they generally centre on the following:-

1) Significant Events - These include acquisitions and divestments during the financial year, and their effects would have been described in notes such as Goodwill, Subsidiaries, Associated Companies or Investment/Investment Properties.

2) Receivables - Bad debts being written off, more being provided for. A note on Receivables will usually contain a summary of these by ageing profile, and under Risk Management the auditors will also assess the fair value of receivables to ensure no (further) impairment is required.

3) Debts - This note can be pretty detailed for a company with significant loans, and will include comprehensive conditions on each loan, repayment amount, interest rates (usually Cost of Funds + Spread), currency and repayment period. These can give an indication of whether the Company needs to refinance soon, as well as give an idea of the finance costs for the coming year.

4) Subsequent Events - These include significant events which occurred after the financial statements were released but before the printing of the AR. Some of these may have a material impact on future financial periods and may give rise to questioning.

5) Investments and Investment Properties - For those analyzing an asset play, this note would be very useful. The market value of properties may exceed their book value and thus hidden value may be present in the properties which a Company has.

6) Commitments (Contingent and Capital) - These include potential liabilities which have yet to crystallize due to uncertainties such as lawsuits or corporate guarantees; as well as commitments for capital expenditure in the next financial year which may give a sneak peak as to how much cash needs to be channelled to these purchases.

There are, of course, other aspects which need to be looked at on a case by case basis, but the above is a simple laundry list of the more important notes to look out for when browsing through the AR.

Preparatory Work – Taking Notes

As one peruses through the AR, one should continually jot down notes on a separate piece of paper (or type it out if you wish) in order to organize your thoughts on what you wish to be clarified. Structure and focus your questions to make sure you tackle the crux of the issue and not just to scratch the surface. For example, a question on debt may require you to query on why borrowings had to increase so much when cash flows were actually healthy and seemingly sufficient, and at the same time, one can also ask about the cost of debt if Management is willing to reveal the blended yield for the Group.

Formulating A List of Questions

After reading through the AR and making notes, I will usually compile a more detailed list of questions for the AGM. These are categorized into business strategies, business divisions, financials and plans/prospects; but readers are free to choose a format which they are comfortable with. The key is to make sure you cover the points you wish to raise systematically, and to ensure you organize your thoughts well. This is because you will seldom be able to keep glancing at your list during face-to-face interactions as it may be construed as rude (more on this and other etiquette in Part 2). Try to remember key information such as net margins, important debt amounts, and other numbers such as revenue growth, profit growth, projections, numerical forecasts and dividend yields. This is not so much to impress Management but it also allows you to flow more smoothly from one question to another should you receive a reply which allows you to do so. Since questioning and fact-finding can be a fluid affair it is important to have some facts and figures at your fingertips in order to make the process a whole lot more efficient and effective. Remember too that Management has limited time to interact with shareholders and may have to rush off for some important meeting or do what they do best – work to grow the Company to greater heights!

Part 2 shall delve into the AGM proper as you arm yourself with your list of questions. It also describes basic behaviour to be observed, dos and don’ts and what else you should bring along.

Period of Contemplation

The title of this post was actually meant to reflect my thoughts on the time required to mull over and consider a potential investment. It is also meant to be a “break” from the heavy analyses going on in prior posts on MTQ and SIA Engineering. There is another analysis coming up and planned for Boustead’s FY 2011 results. This post is to summarize some of the thoughts I have gone through while taking bus/MRT recently, and follows closely on my previous post on “Pace of Research”. I guess you can say that I would recommend reading both posts back to back, as this post is sort of a “follow-up” to the previous one.

So what exactly does the title mean? While pace of research was meant to assess how dedicated one should be while researching a company, to the extent of whether he can allocate sufficient time to dig deep into a company’s financials, stakeholders and business model; period of contemplation addresses the issue of how long one should study a company before deciding if sufficient research and study had been taken. This would naturally translate into a reasoned decision to purchase shares in the Company. The problem is that different companies have different characteristics, and I admit that some do require a lot more monitoring and following up than others, purely due to not just the nature of the business but also the way the company is run. Add to that strategic management decisions, varied management styles and an evolving business model and you get some very subjective views on how long one should evaluate a company before committing. I will now attempt to state, broadly, how much time one should adequately devote before making an informed decision.

Note that the default conditions for investment will be required, such as good margins, good and consistent free cash flow, steady earnings and decent ROE. What differs is the nature of the business and the type of industry the Company is in, as I shall elaborate.

Cyclical Companies

For companies in cyclical industries, one has to at least observe one entire economic cycle relating to that industry before deciding when, or whether, to buy some shares. Examples would be companies in construction or property like Tat Hong or Capitaland, where the housing boom/bust cycle would determine if valuations are demanding or not. Therefore, the period one should take should stretch into years if one wishes to fully understand the business cycle and determine when to make a purchase. Of course, history can always serve as a guide but the future may not always repeat itself in the same way. I would think these companies are best avoided unless you can time the cycle very well and go in at the point of lowest valuation, and just before the economic uptick.

Cash-Rich Companies in declining industries

Companies such as GRP would qualify, as they are very cash-heavy but are mired in a business which is declining and competitive. One should observe such companies to the extent that they actually plan to do something with the cash hoard, or if they undertake actions (e.g. M&A) to improve the business model. Alternatively, the investor could also study the company as a yield play, with potential to generate good FCF even in a declining industry. The time period in this case could be anything from a few months (for research) to perhaps one or two years to observe and study Management’s decisions.

Companies in new industries with low barriers to entry (many new entrants)

These are companies which have had a first-mover advantage with respect to a new and emerging industry; and therefore are enjoying supernormal profits, margins and very good cash flow. Some examples may include palm oil, bio-fuels and solar panels which are at the cutting edge of technology. However, more time needs to be spent observing such companies as many new entrants, seeing the huge profits being made by the incumbent, may scramble to grab a piece of the pie as well. The ever-changing economics and dynamics within the industry would require a longer-term study before any commitment is made. In addition, there is also not much history to fall back on as these industries may be relatively new.

Fast Growth Companies

Fast growth companies are those which are aggressively expanding, conquering new territories, opening new offices in new countries, and generally engaging in active M&A or corporate actions. They usually do not pay a dividend as profits are reinvested to grow the business. For such companies, one should observe only as long as one should in order to gain comfort on their plans, and current growth strategy. Once an understanding is formed, a position could be taken up without waiting for too long. Of course, one should also watch out for valuations – growth companies usually trade at higher valuations as a lot of potential future growth is already factored in. Investors may wish to discount for this growth in order to maintain some margin of safety.

Stalwarts and Stable Conglomerates

The final category of companies which I would like to comment on are the stalwarts, or stable blue-chips, as well as conglomerates. These would include ST Engineering and SingTel for the former and Keppel Corporation for the latter. SIA Engineering would also probably fall into this category. This type of companies probably require the least amount of monitoring and observation, as they already have an entrenched market position, steady earnings and decent cash flows. One would simply need to understand the business and be comfortable with the financials and numbers before deciding to invest, and this should not take a whole lot of time.

To summarize, the length of time taken should not be inordinately long, otherwise one may miss out of very good opportunities to accumulate shares in well-run companies, as well as miss out on the compounding effects of their investments growing over the years. Yet, one should not be unduly hasty in committing to a purchase before one has done sufficient research, otherwise the consequences could be disastrous and detrimental to one’s wealth.

The Quest for Higher Yields

Originally, the title was intended to read “The Chase for Higher Yields”, but I thought that the word “chase” conveyed an element of desperation. Although “desperation” would adequately and concisely reflect the current ground sentiment in that everyone (i.e. the man on the street) is looking for higher yields than what pathetic bank deposits have to offer, I thought “quest” may be more appropriate to describe a large swath of educated, knowledgeable investors who have yet to find the Holy Grail of high yields – a stable bastion of companies or securities which can guarantee a (almost) lifetime of dividends and passive income. And so this post will discuss some of the more recent attempts by companies to not only shore up their Balance Sheet, but to raise funds using very opportunistic methods which attempt to not just capitalize on the public’s hunger for yield, but also to reduce their cost of raising such funds significantly.

Preference Shares

I think enough has been said on the most recent Hyflux issue of Cumulative, non-Convertible, Non-Voting Preference Shares at 6% yield (issued at S$100 per share, “CPS”). Many finance blogs have been abuzz with the CPS as the key characteristic of these CPS are that they are cumulative, which means dividends accrue over the periods if they are not paid out, so that they “accumulate” until they are eventually paid out. This does not, however, mean that they are guaranteed, a point which the corporate brochure took pains to highlight. Many other websites have pointed out the merits and demerits of the CPS, so I will not go into details on that as it has probably been debated to death.

What I would like to do is to highlight salient risks in investing in such securities, and whether an investor should have a much clearer understanding of the underlying risks before taking the plunge. For any firm which issues securities, whether it be equity-based or debt-linked, an investor should read through all prospectuses and comb through the financials of that company as if he were reviewing it to buy its common shares; as the process for screening is essentially the same even though the subordination of the security may be different when it comes to liquidation.

So in the case of securities such as CPS which are a hybrid between equity and debt, one should ask the following pertinent questions:-

1) Why is the company choosing to issue CPS instead of relying on debt financing or a secondary placement? Are there issues with issuance of debt due to existing high gearing and a weak Balance Sheet? For secondary placements, one has to question the attractiveness of a company selling more ordinary shares vis-à-vis the attractiveness of issuing CPS or some other form of preference shares.

2) What are the chances of the company being able to honour its dividend obligations? A close scrutiny of the Company’s Cash Flow Statement (over 5 years, no doubt), mode of business, business model, recent news, industry, competitiveness and market share/position, and future prospects and plans are required in order to make an informed decision. If a company has problems paying a good dividend yield to its ordinary shareholders, then it may likely default on its preference share dividend. Whether this is cumulative or not should not matter – if a company cannot pay then no amount of accumulation will mean anything to the shareholder.

3) Liquidity – Preference shares are usually less liquid as compared to ordinary shares, and therefore the bid-ask spread may be much wider. Poor liquidity is also a result of our stock exchange not being as sophisticated as that of the USA, and may hinder one’s ability to cash out quickly should one need to.

There is probably a longer laundry list of issues to be looked into when it comes to investing in preference shares, but I will leave those for the comments section and move on.

Corporate Bonds for Retail Investors

There has been a recent spate of issuance of corporate bonds catered to retail investors, and this is a surprising development considering bonds were previously reserved for either institutional investors, or accredited (i.e. high net-worth) investors. It all started with Singapore Airlines Limited (“SIA”) issuing S$300 million worth of 5-year bonds paying a coupon rate of 2.15% payable semi-annually back in September 2010. Investors would be able to purchase the bonds in denominations of S$1,000 and the minimum subscription amount is $10,000, which is generally affordable to the masses who are seeking stable, higher yields. At the time, however, the SIA bond was perceived to be paying too low a coupon rate as compared to other investment vehicles such as blue chip dividend yields (around 3-4%) and REITs (which pay on average 5-6%). The issue was a resounding success nonetheless due to SIA’s blue-chip status and paved the way for other companies to issue bonds for the retail public too.

Next up was an underwritten bond offering by another blue-chip company Fraser & Neave Limited (“F&N”); and this was announced on March 16, 2011. This consisted of S$150 million worth of 5-year bonds paying 2.48% per annum (out of which S$50 million was for the public tranche) and S$150 million worth of 7-year bonds paying 3.15% per annum (out of which S$50 million was for the public too). Notice here that the coupon rate for the 5-year bonds is 33 basis points (i.e. 0.33%) higher than those issued by SIA just six months ago, and reflects the fact that the public may require a higher coupon rate to incentivize them to subscribe for the bonds. It could also be due to the fact that more of such issuances were coming up and investors would then be “spoilt for choice”, hence the decision to price the bonds as such. Whatever the case, this still represented extremely cheap debt for both SIA and F&N as the cost of debt was still below 3%. By way of comparison, the dividend yield for F&N on its ordinary shares for FY 2010 was 2.58% (using 17 cents full-year dividend against S$6.58 closing price on November 12, 2010 when it announced its FY 2010 results), so this makes the 5-year bonds slightly cheaper than the cost of equity.

The crux of the issue here is that investors have become so sick of the ultra-low interest rates which banks are offering that they have even turned to such “safe” bonds issued by blue chip companies. These investments can be deemed to be secure enough as the companies involved most likely will be able to honour their coupon obligations, but the investor has to do himself a favour to look for better yields which can exceed inflation (around 4-5%) as the bonds paying less than 3% do not achieve this goal.

Real Estate Investment Trusts (REIT)

In an era of low interest rates such as the present (in fact, all-time low as the SIBOR recently hit 0.33%), investors will have a tendency to flock to REITs as a way of getting higher yield on their investments. These vehicles will traditionally use cheap debt to fund the purchase of properties which have a stable tenant base, thus generating stable (and arguably predictable) cash flows of which a high percentage (usually 80% to 90%) is paid out as dividends to unit-holders. Many REITs will also periodically revalue their properties and in an environment where real-estate prices are rising, this will make the Balance Sheet look good. This combination of low interest rates and rising property values makes REITs very attractive to those looking for high yield investing and many REITs have also issued rights and placed out shares in recent months to capitalize on the low interest rate environment to raise capital to refinance their loans. Other REITs have also proudly proclaimed that they have “locked in” higher tenancy rates for the next 2-3 years, thereby almost guaranteeing the distributions which they have forecast as the debt has no need to be refinanced and hence no extraneous expenses will be incurred.

The problems will, of course, start to pile up once interest rates head north (as they must surely do as part of the reversion to the long-term mean). When interest rates rise, REITs which have to refinance their debt will have to do so at higher interest rates, therefore there will be a need to retain more money to fund such interest payments, leading to lower payouts for unit-holders. Rising interest rates also impact property prices and companies will be more hesitant to borrow to purchase land and build property as the cost of borrowing will increase, and this leads to property values falling. Assuming a steady decrease in asset value, there is always a possibility of being in negative equity. REITs may then have to shore up their Balance Sheets through rights issues, but if their share price is languishing then the dilutive impact to DPU would be even more pronounced, and with tenancy rates falling in a falling market, this could exacerbate the problems.

Thus, while REITs are traditionally seen as “safe havens” for investors to park their money for high yield, do note that there are risks involved as well.

Conclusion

So the quest for higher yield often seems more elusive than attainable, especially in the light of risk factors which may derail the consistent and predictable payments which a security has to offer. As investors, we have to be constantly watchful and wary of where we place our money, for high yield most often does come with associated higher risks. For myself, I opt for decent yield which is sustainable through investing in companies which have a stable business model and a good history of increasing dividends on ordinary shares.

Pace of Research

As I sit here facing the new year with a mixture of delight and trepidation, I begin to muse over the financial resolutions I had made at the close of the previous year, 2010. One of them was to engage in research and reading in order to unearth more companies to invest in, and I had mentioned that I would devote more time to this pursuit. However, a friend of mine told me the other day about the importance of family time and values; and to be honest, my wife has been complaining incessantly about my time spent at the computer doing research and reading of annual reports. This made me think about what was truly important in my life – making money and financial freedom, or previous time with my loved ones including my daughter. I guess it’s no point being financially free if your family is fragmenting before your very eyes!

Which brings me to the point of this post – that research into potential companies to invest in need not be undertaken in a hasty, rushed manner. My previous detailed research into SIA Engineering company was done in a mere two weeks, and involved a lot of late nights poring over annual reports, compiling numbers and reading and crunching facts and figures. One of the main reasons for the rush job was because I was hasty to deploy some capital, which resulted in some fatigue and perhaps some biasness towards accepting the data and information gathered (commonly known as selective retention in marketing literature). Part of me was also afraid that valuations would continue to climb higher, thereby making a purchase difficult due to the decreased margin of safety. As it was, valuations were already not exactly cheap for SIAEC as it was a blue chip, but further dragging of feet could have resulted in valuations which were even more demanding. Hence, there was a concerted effort undertaken by myself to hurry up on my research to produce a credible report on which I could base my investment decision on.

I now realize that this logic is rather flawed, because if valuations are demanding then the purchase decision should be postponed, and the company can be placed under a “tracking” or “watch” list, to be purchased only when there is a market crash or if valuations become depressed for some reason. The idea of being an investor is being able to wait for the big fat pitch, and then swing when it comes along. To this end, patience should be an enduring virtue possessed by the successful investor; and I realize I may have lacked this when I did my SIAEC research. The pace of research should be slow and relaxed, as one needs time to absorb, digest and analyze disparate pieces of information gathered from various sources, in order to collate them into a coherent investment thesis. The investor’s job is to make sure the business he is researching is understandable and simple enough to digest, and he should ensure he gives himself enough time to read and understand the business model. By giving yourself enough time and space to understand and appreciate the inner workings of the business, as well as possibly arranging for a meeting with the Management and Directors to further delve into the corporate aspects, one can have a more holistic view of whether or not to invest your money in that company for the medium-term.

Now when I think deeper on this issue, I realize that many companies can sit on the backburner for at least a couple of years while one monitors and tracks the business growth of the Company. This is especially so for the newcomers (i.e. IPOs) which may not have much of a track record. The idea of investing is to ensure you are sufficiently comfortable with the track record of a company and the consistency of revenues and earnings in order to be able to place some money on it. With more time on your hands, you can safely assess companies to see if they conform to your investing criteria in terms of growth, ROE and other metrics; and whether Management has delivered on their promises over the years. Therefore, it is absolutely all right to slow down your pace of research and identify good companies, yet not invest in them immediately. Right now, I am in the process of compiling a list of very good companies which have decent prospects, are able to weather a significant downturn, have strong Balance Sheets and good cash flow generation. Obviously, some of these companies will not be trading at attractive valuations as the economic recovery had already taken place, pushing valuations up higher as compared to during the Great Recession. The idea, then, is to build up a decent laundry list of companies with which you will swoop down on and scoop up significant amounts of shares when their share prices are forced down in a market crash or economic downturn. Of course, the usual requirements of controlling your fear and greed are always applicable, as it takes a strong stomach to purchase shares during a market crash. However, it does get easier over time as you adjust yourself to a value mindset and adopt the mentality of a business owner. If one thinks this one, one will be immune to the daily fluctuations caused by Mr. Market and able to act quickly and decisively to purchase shares.

One final point to note is that one should also continue to research and read up on companies already existing in one’s portfolio, as these will also be prime candidates for further investment should their share prices drop like a rock during the next downturn. Since you purchased them in the first place, it is assumed that they had already passed the initial intensive screening and will remain as good investment candidates unless something drastic occurs to upset their status as being worthy investments. It is of paramount importance that one assess the investment worthiness of the companies you already own from an objective perspective (though in essence this is nearly impossible as you are already vested), in order to assure yourself that they remain investment worthy.

Can Value Investing be considered a Gamble?

Interestingly, the above question was posed recently on the Value Buddies forum, and attracted considerable interest and wide-ranging views from a variety of participants. The question above was posed from the standpoint that value investing (or any kind of investing, for that matter) can be considered a gamble as it may take a long time for the market price of a security to rise to its intrinsic value. Thus, there is an element of chance and perhaps even luck and is no different from blackjack or slot machines at the casino.

I found this to be a somewhat interesting topic as the subject matter raised was one which many investors would have asked themselves countless times when their investments are stagnant and not doing well. Value investing, by its very nature, requires an investor to purchase part-ownership of a company and hold its shares for more than a few years, in order for business growth to make the company more valuable. If he chose the right company, there would also be a return on his investment in the form of dividends, which come from the cash flows generated by the Company. But to classify an investment as a gamble is somewhat wrong, as I feel that any event which has a probabilistic outcome amid uncertainty qualifies as a “gamble”. However, it must be stressed that value investors will “gamble” with the factors in their favour, in order to increase the odds of success, and reduce the chances of failure.

The proper definition of a gamble is – “any matter or thing involving risk or hazardous uncertainty” (from dictionary.com). While it is generally acknowledged that investment carries risks and uncertainties, value investing, by its very nature, seeks to adequately address the uncertainties while at the same time, mitigating the risks. Uncertainties can be smoothed out through an understanding of the industry in which a company is operating in, and also by studying its long-term track record using ten-year financial analyses (plot this using MS Excel and you can see the trend of revenues, profits and dividends). Though one can argue that uncertainties in terms of economies and industry cycles can never be completely understood or predicted, one can use history as a somewhat reliable guide and factor in a suitable discount to computed intrinsic value as a margin of safety. In terms of risks, these are mitigated when an investor gains a thorough understanding of the business, including what drives it, its business model, prospects, plans and Management quality. Of course, this entails a lot of reading, research, fact-finding and some even go to the extent of visiting the premises and plants/factories to gain a better appreciation of how the business is run from an operational and tactical standpoint. To further mitigate and control risk, an investor can “go the distance” and use Phil Fisher’s “Scuttlebutt” technique of visiting Management and conducting interviews with them on various aspects of the business. Usually, however, being a minority shareholder means that the Management will not allocate time to entertain you, as they have more pressing matters at hand (like running the business day-to-day!). However, some companies have excellent IR personnel who will respond to queries and provide appropriate updates, news and facts when requested to do so.

So back to the question of whether value investing is considered a gamble. Yes it is if you go by the strict definition given by the dictionary; but then again everything in life can then be termed a gamble, from what you choose to study in University, who you marry, which job you take up and which friends you decide to associate with. After all, all these events involve uncertainty and some of them carry a fair amount of risk as well; but we still have to move on and make decisions which seem best under the circumstances. So my assertion is that we all take daily “gambles”, it’s simply the impact which differs for each of these actions that’s all.

From my limited and short experience (less than 4 years) as a value investor, I did note that valuations will normally revert back to the long-term mean, and that if an investor purchased shares in a company whose valuation is trading at a discount to the mean, and the Company is doing well in terms of business growth and cash flows, then one can reasonably expect a reversion to intrinsic value as time goes by. But after going through one complete bull/bear cycle, I have to categorically state that it is by no means easy to spot whether valuations are “cheap” or “expensive” as these terms can be relative, depending on the state of earnings and economic growth in general. One must learn to be flexible and adaptive in assessing valuations and to keep an open mind.

Ultimately, as investors we have to make an intelligent gamble, with the odds tilting in our favour. That’s basically what investing is about, and when the odds are strongly in our favour, then learn to bet larger amounts. If there are too many uncertainties and risks, then an investor should be prudent and only commit a small amount of capital. In other words, we should do position sizing based on our comfort level with a certain company, and this is something which I believe all investors practise. After all, when it comes to the crunch, I dare say a value investor will still do much better than a gambler at a casino playing cards because in the former case, we are talking about business growth and the management of uncertainty; whereas in the latter case, there is the “house advantage” which is an artificially created additional layer of mathematical uncertainty out to sabotage the gambler!

Can One Expand Their Circle of Competence?

This has always been a very intriguing question for me, more so since I started on my journey on value investing. It is well-known by now that Warren Buffett has strong knowledge of the insurance industry, which is why he focused his efforts on GEICO and this is also how Berkshire Hathaway is able to obtain so much insurance “float” with which to invest. Outside of insurance, it is useful to note too that Buffett had somehow acquired a keen insight into the businesses of furniture (Nebraska Furniture Mart), soft drinks (Coca-Cola) and credit cards (American Express). So the question now begs to be asked – how does one go about expanding his circle of competence on businesses he may not know or know well enough? Is this even possible and should an investor even attempt to do so?

Each individual has their own unique expertise and knowledge culled from years of either working in a particular industry, or because of his profession, has access to industry knowledge which others may not be privy to. To give an example, an oil rig engineer may understand the inner workings of oil rigs and the O&G industry very well, while an IT technician or software programmer would be more in tune with the rapid technological advancements in the realm of software design or hardware configuration. One’s profession and area of study also bestows knowledge of certain aspects of businesses; an engineer is more likely to understand an engineering company while a quantity surveyor would understand the property development process more intimately. As the above examples demonstrate, one can already have latent knowledge of a particular industry or business unit based on one’s education or work experience; and this will form the backbone of his understanding with respect to businesses when he embarks on his investing journey.

Armed with this knowledge, investors will then seek out investments which fall within their respective areas of comfort, suitably termed “circle of competence”. The fringes of this circle must be very clearly defined as there could possibly be overlaps in certain industries or companies which may cause unfamiliarity to the investor, so even though he may proclaim that he “knows” an industry, he may be unaware of the minute aspects which could escape his attention. I guess the worst feeling one could have is a false sense of security, which is why I keep stressing on the importance of really knowing an industry before committing your funds to it. If an investor can have intimate knowledge of an industry which not many people are familiar with, this is a distinct advantage as he can then invest with lower risk and higher certainty as compared to other investors who may not be equipped with such knowledge.

So can one expand this knowledge? The most obvious method would be through intensive reading of the said industry, for example for O&G industry, one could delve into articles written on the O&G industry, industry reports, brokerage reports compiled for that industry, as well as news articles and commentaries on the industry itself. One should start to familiarize with the terminology and jargon used in the O&G industry, such as E&P (Exploration and Production) and BOP (Blow-out preventers). Another method one could use is to speak to executives and management to find out more about the intricate business aspects of an industry and how a company within the industry works. Yet another method is to closely observe and study some of the companies within the industry over a couple of quarters, in order to build up the requisite knowledge and understanding of the business cycle present (if any) and the industry dynamics. In short, one needs to conduct intensive research, undergo diligent studying and have patience and perseverance to expand his circle of competence.

I myself started out as a novice investor who was not familiar with any particular industry. Over time, my reading and intensive research have enabled me to understand the O&G industry, MRO industry and the cranes and heavy equipment industry; though of course it is still not as well as I would like. But the knowledge was sufficient for me to feel confident enough to make an investment in MTQ, SIAEC and Tat Hong respectively. For Boustead’s case, I read up extensively on water and wastewater treatment and margins (including the CEO’s interviews), and also on real estate (as Boustead has a real estate solutions division headed by Boustead Projects). So to summarize, I would say I had managed to increase my circle of competence fairly significantly compared to when I first started out.

Of course, one should only expand the circle as far as one feels comfortable. I acknowledge that there may be certain industries which are difficult to understand for certain people, so one should prod and find your “resistance” level to such information, and to seek out information which best suits one’s character and temperament. To put it in another way, seek out what you feel comfortable with and feel confident on engaging, and you will find that you are able to slowly (but surely) expand that circle of competence.

So, in short, the answer is yes – you can expand the circle through reading, research and talking to people. But this will require time and patience and cannot simply be achieved in say, a couple of months. So if you are just starting out as an investor, take your time to read intensively and gather knowledge for at least 9 months to a year before you commit any money to companies trading on the Stock Exchange.

The Essence of Investing

After the trials and tribulations over the past 4.5 years, I admit I do spend an inordinate amount of time doing self-reflection, and at the same time, reading up on value investing and doing some independent thinking and analysis of my past mistakes; and how I can always improve on my investing techniques and stock selection process. Close to my heart is Benjamin Graham’s definition of investing, which bears repeating: “An investment operation is one which upon thorough analysis, guarantees safety of principle and an adequate return. Operations not meeting these requirements are speculative.” Notice that the man does not define investment in terms of making lots of money, and he also does not specify any time frame with which one should practice the above. This has led me, in recent months, to truly define and ask myself what is my purpose for investing; and what I would eventually like to achieve from it. The answer was quite clear and simple – my purpose for investing is not to “strike it rich”, but to obtain an adequate return on my invested capital which is higher than inflation. With that in mind, I focused on capital preservation and margin of safety, concepts which most readers are familiar with by now but I will discuss these two concepts from a slightly different perspective this time. In particular, the concept of margin of safety is not cast in stone and its definition is subject to interpretation by the practitioner.

Capital preservation is a concept which is not fully appreciated in the stock market. In fact, I dare say it is often downright neglected! This is because of the human being’s propensity to lunge after profits and gains, and to let the greedy side take over (I call it the “Dark Side of the Force”); while the prudent and conservative side of his brain takes a back seat. As veteran investors in the stock market probably know, NOT losing money is already quite an achievement, much less making a pile. Hence, the overarching principle involved in investing should be to protect your principle at all costs; and this can be done by undertaking a rigorous and painstaking research process to protect your downside. Before you even consider purchasing a security, ask yourself if the business can continue to grow or remain stagnant, if competition can erode the competitive advantage which a company has, or if the company has debt levels which you are not comfortable with. In other words, pre-empt yourself for the downside, instead of looking at glittering profits which are non-existent. This is the mindset which an investor should adopt if he wishes to generate a consistent and sustainable gain in the stock market. By protecting your downside, you would be able to sleep well and let your money compound. Please also do note that yield counts as part of capital preservation, as it acts as a return ON investment (not return OF investment). One should aim to preserve capital ex-dividend, meaning the value of the company should remain or even increase the same regardless of dividends being paid out, as a company is supposed to be continually generating cash flows and profits to keep its equity base constant.

The above concept of capital preservation can only be fully appreciated in a bear market, when the market prices of securities tumble like rocks falling off a cliff dragged down by the force of gravity. With corporate fundamentals acting as a cushion, one need not be afraid of declines in market price in the face of the Mr. Market’s desperation. For Graham was right when he said we should not let a certified lunatic with wild mood swings decide the right value of companies in which we own shares of. To quote a simple, yet effective example, imagine a company was worth S$50 million (net worth – assets minus all liabilities), would you accept a price of S$20 million for the company, which is a 60% discount to its true net worth? Stated as such, it would seem obvious to both a casual observer (with average intelligence) and a reasonable man that a huge bargain was at hand and up for grabs. However, in reality, a mish-mash of emotions and cognitive + psychological biases serve to confuse and confound investors into buying high, and selling low. As investors, we have to constantly be aware of these biases and be mindful of their pervasive effect on our investing behaviour, lest we let ourselves suffer from the cardinal sin of losing our precious capital.

The traditional definition for “Margin of safety” would indicate that the investor has some leeway in being wrong in estimating the intrinsic value of a security, and this margin would provide a cushion to ensure that he preserves his capital, or else loses as little of it as possible. But margin of safety can be a notoriously elusive and subjective concept, so much so that two veteran investors may not see eye to eye on the required margin of safety for a particular security; or even whether it has any margin at all! Each of us has a unique ability to read into a company’s financials and business situation cum model, and form our own conclusions as to the attractiveness of the business with which to invest in. Consequently, the margin of safety demanded should also be commensurate with our risk tolerance as individuals, based both on personal circumstances (e.g. age, presence of child, aged parents to support etc.), and asset allocation (some investors may choose to “diversify” into different asset classes, hence he would require less margin of safety as he has parked limited funds in equities). Hence, my point is that the margin of safety is a fluid concept which is not cast in stone, but is subject to interpretation and personal observation and deduction. Furthermore, as a company evolves through time and grows or declines, one should also adjust their view of required margin of safety accordingly; or if there is no longer a margin of safety, the investor may consider divesting his stake to preserve capital for channeling into other more promising securities.

To conclude, the essence of investing is very basic and simple; but somehow human beings have a strange and inexplicable tendency to make simple things complex. The two most basic tenets should be capital preservation and margin of safety; and together these two powerful concepts will guide an investor through all kinds of markets, and allow him to screen through all types of companies for suitable ones. I believe that if one is armed with this knowledge and practices it faithfully, he/she will not get a bad result in his investments.