8 Pearls of Investment Wisdom for These Volatile Times

These are the words of investment wisdom on those "bear" advertisement posters on the MRT by Aberdeen. You can download the pdf file here.

Volatility is not something to fear, but something to embrace
Why do we fear stock market volatility so much? As an airplane's wings must bend during turbulence to prevent them from snapping, so too must share fluctuate, sometimes gently, other times wildly. Of course, sever turbulence during a flight can be an uncomfortable experience but we have no choice but to sit tight, knowing deep down that we'll reach our destination. But in the world of investing there is little to stop us bailing out at the slightest wobble as our emotions get the better of us. Try then to welcome volatility. Shares do not go up without it.

Think long term
All stock price movements are a combination of unpredictable noise on the one hand and the meaningful pattern of business performance on the other. Over short periods price movements are as good as random, while over long ones business performance dominates. As an investor, you should align your time horizons accordingly. If a factory, for example, is expected to provide at least ten years of returns, so should your shares.

Know the difference between gambling and investing
We all like to have fun once in a while. A trip to the casino is an excuse for a good time, but approach the stock market in the same way and you'll quickly find yourself in trouble. Successful investing is hard and often dull, requiring discipline and lots of study. For that adrenaline rush, few things beat watching the roulette wheel spinning. When it comes to making good investments returns, however, owning the casino itself tends to be more profitable than entering it. Think about it.

Be contrarian
We have a tendency to do or believe something just because others do. It makes us feel normal, part of the group. Occasionally, however, such behaviour is counterproductive and even dangerous. Rush for the exit in a crowded market with everyone else and you risk getting trampled. The same applies to behaviour in the stock market. Selling - or buying - behind everyone else is a sure formula for poor investment performance. Warren Buffet teaches us to "be fearful when others are greedy and greedy only when others are fearful."

Consider the difference between price and value
In the real world, the distinction between price and value is frequently apparent. Given the choice between a $10,000 car and a $10,000 tee shirt, it's pretty clear that the car is better value. In the investing world however, it is much harder to discern the difference. Unlike a car, who economic utility is something we can understand and even evaluate, the value of a company is somewhat intangible and thus a tricky concept to grasp. Guru stock picker Philip Fisher noted that the stock market is filled with individuals who know the price of everything, but the value of nothing.

Be humble, the stock market is smarter than you
Overconfidence might help to secure a job promotion or the attention of others at a nightclub, but in the investing world, an over-inflated opinion of yourself can be disastrous. You may think that you are in a position to predict the direction of the market or a particular stock over the next few months but remember that there are millions of others doing the same thing. Apply a little humility and ask yourself honestly whether you are really smarter than all of them. as the father of modern economics and successful investor John Maynard Keynes noted, "Successful investing is anticipating the anticipations of others."

Avoid things you do not understand
The world is an increasingly complex place and one often finds oneself blinded by science or confused by complicated arguments. With investing, it is important to understand precisely what you are buying, at least so that you can sleep soundly at night. Think about share as you would a book: if you don't understand it, put it down. Peter Lynch recommended that if you cannot summarise in just a few sentences why you are investing in a company, then you're probably looking at too much information.

And finally...
If you place bets proportional to their market odds on every horse in a race, you'll come out slightly down, after the track's take. This is a pointless strategy, particularly if you know more than others about horses. It is important to understand where you have an edge and, when you have one, to use it to your advantage. We never forget Buffett's tip, "Wide diversification is only required when investors do not understand what they are doing."

Equity Risk Premium Model

Ms. Teh Hooi Ling, in "Show Me the Money, Volume 1", recommended the use of Equity Risk Premium model for investment in the equity market.

Equity risk premium (ERP) = Inverse of market PE - risk-free rate

Singapore market
ERP about 350 basis points: market under-valued (Buy signal)
ERP about 60 basis points: market over-valued (Sell signal)

Malaysia market
ERP about 100 bpts (Buy)
ERP about -250 bpts (Sell)

US market
ERP about 100 bpts (Buy)
ERP about -200 bpts (Sell)

Rationale:

ERP is the compensation required by investors for holding risky assets (in this context, equities). Investors demand high returns to be enticed into holding stocks when fear prevails the market. When greed prevails, investors are over-confidence and require very little compensate for taking risks.

= = = = =

In the book, it was mentioned that the average one-year FD rates (1987 - 2002) in Singapore is about 3.9%. This implies:
Buy when market PE = 13.5
Sell when market PE = 22.2

However, our current 1-year FD rate is only a miserable 0.925% (from UOB website). If we are still looking at 60 abd 350 bpts, that means:
Buy when market PE = 22.6
Sell when market PE = 65.6
O_o!!!

= = = = =

Although I think it's clearly a good time to accumulate stocks now, I thought it's interesting to see what the current ERP says.

To estimate FY2008 earnings share for STI stocks, latest full year EPS were used for companies with financial year ended 30 June or 30 September. For companies with financial year ended 31 December, full-year EPS were estimated using:
(FY2007 EPS / 9M FY2007 EPS) * 9M FY2008 EPS
Similarly, companies with financial year ended 31 March, EPS for FY2008 were estimated by:
(FY2007 EPS / HY2007 EPS) * HY2008 EPS

Based on yesterday's (11 December 2008) closing prices, estimated PE for Singapore market works out to be 5.28 which means the earnings yield is about 18.93%.

Using 3.9% as risk-free rate (though I don't know where I can get such good deal now), ERP = a hefty 1503 bpts!

No matter how you look at it, it's a STRONG BUY.

REITs - Glossary

Most important rules for REITs
1. A minimum of 75% of the REIT's total assets must be in qualifying real estate investments.
2. At least 90% of the REIT's taxable income must be paid out through dividends each year.
3. Maximum gearing allowed: 60% (Singapore's context)

The profitability of a property REIT is a function of 2 factors:
1. Economic moat
2. Capital allocation (whether management consistently generate good returns from its asset base)

Capitalization rate: property's net operating income / purchase price

Funds from Operations (FFO)
Net Income (after preferred dividends)
+ Depreciation
+ JV adjustments
- Gains on real estates sold
= Funds from operations

FFO payout ratio = DPU / FFO per unit

Adjusted FFO
AFFO = FFO - capital expenditures - other amortization
A more precise measure of residual cash flow available to unitholders and better predictor of the REIT's future capacity to pay dividends.

Evaluating REITs
1. Type of properties
2. Geography
3. Occupancy trends
4. Tenants concentration
5. Credit rating
6. Lease duration
7. Fee-based income
8. Interest cover

Sources:
"The Ultimate Dividend Playbook" by Josh Peters
http://www.investinreits.com/learn/glossary.cfm

Banks Valuation - Glossary

Equity/assets ratio = Shareholders' equity / assets
A key indicator of solvency and financial strength.

Net interest income: the difference between what a bank earns on its assets and what it pays on its liabilities

Net interest margin = Net interest income / earning assets

Noninterest income: fees for other services (eg. advisory, insurance brokerage)

Noninterest expenses: eg. wages, rent, utilities.

Net revenue: (aka total revenue) net interest income + noninterest income

Efficiency ratio = Noninterest expense / Net revenue
(Banks don't express their income in terms of profit margins. The lower efficiency ratio the better.)

Provision for loan losses: allowance for loan losses
The relative size of this figure to gross loan will convey how prepared a bank is for a deterioration in credit quality.
Loan-loss ratio: allowance for loan losses / total outstanding loans

Charge-off: bad loan amount - collateral's market value
Charge-off ratio = net charge-offs / gross loans
Low charge-off ratio suggest a bank is doing a good job in identifying creditworthy loans

Past-due loans: when borrowers falls behind schedule interest and princial payments (usually reported in footnote)

Nonperforming assets: total value of loans the bank seriously doubts it will be able to collect in full.
(This is not a projection of future losses as loans may be secured with collateral but the more nonperforming assets a bank has, the greater the likelihood that the eventual loss will be higher than what has already been charged off.)

Source: "The Ultimate Dividend Playbook" by Josh Peters

Dividend Drill Return Model

From "The Ultimate Dividend Playbook" by Josh Peters

Stocks, like any investment, only have value because of their ability to return cash to their owners - if not now, then eventually.

Income
We should rely on cashflow from assets, rather than selling of assets, to attain our financial goals.

Insight
Dividends provide signals such as the company's financial health, growth prospects and confidence of the management in the company.

Independence
By managing a portfolio based on dividends, the investors can achieve psychological independence to ride out short-term market volatility.

Dividend Drill Return Model

Dividend rate ($)
divided by: Share price ($)
= dividend yield (%)
---------------------------
Core growth estimate (%)
divided by: ROE (%)
multiplied by: EPS ($)
= Cost of growth
---------------------------
EPS ($)
minus: dividend ($)
minus: cost of growth ($)
= Funding gap ($)
---------------------------
Fundung gap ($)
divided by: Share price ($)
= Share change (%)
---------------------------
Core growth (%)
plus: Share change (%)
= Total dividend growth (%)
----------------------------
Total dividend growth (%)
plus: dividend yield (%)
= Projected total return (%)

Margin of safety: Look for a forward-looking total return prosepect higher than you might be willing to accept if the future was certain.

Assessment of Dividend Safety
1. Are earnings sufficient to cover dividend?
2. Are earnings stable enough to cover the dividend amid short-term variation?
If not, does the company have access to other resources to fund the dividend?
3. Are earnings durable enough to cover the dividend for the foreseeable future?
4. Is the management not only able but willing to maintain current dividend payments when the going gets tough?

Durability implies:

- A firm can take a financial punch in one year and come back swinging the next.

- An earning stream that, if not quite predictable in any one year, can be relied upon over a series of years, during which short-term fluctuations should be averaged out.

Factors affecting durability:
1. Economic moat

2. Long-term demand

3. Liquidity

To know about earning prospects:
1. Management guidance
2. Analysts' consensus
3. Trailing earnings
4. Own forecast

Factors affecting earnings stability:
1. Revenue fluctuation
2. Operating leverage
3. Financial leverage

Warning signs:
1. Unsustainable earning sources
2. Excessive debts
3. Legal problems
4. Peer pressures

It would be easy to invest solely on the basis of historical trends in dividend growth but a changing situation can easily render the past irrelevant.

= = = = =

Simplified Gordan's Dividend Discount Model:

P = Div/(r - g) ; where Div = expected next dividend payment
r = (Div/P) + g

Since sustainable growth, g = (1 - dividend payout) * ROE

Prospective return = expected dividend yield + (retention ratio * ROE)

Stock Selection Criteria - by Mr. Chen Yi

Stumbled across the personal website of Mr. Chen Yi who claims an annual IRR of 34% for his 10 years of investment experience in the stock market. On his website, he listed his 10 criteria for stock-picking.

I shall modify a little and use the list as a guide for my future stock investment.

How to identify a good stock
Track record of profitability:
1. The company does not incur loss in in the last 5 years
2. Net profit should be growing for the last 3 years
Financial health
3. Current liabilities <= current asset
4. Shareholders' fund >=0.5 * total liabilities
5. Total liabilities <=5 * cash balances
Growth prospects
6. Based on what the company is doing, earning is expected to grow over the next few years
7. Annual investment return should be 25% or higher
Annual investment return = E/P + expected annual earning growth rate
Valuation
8. Forward P/E<=10
9. Stock price <=3 * NTA per share
10. Dividend yield >= 4%
Management
11. Good management

What Type of Trader Are You?

Took a personality test from: http://tharptradertest.com/

I am a...

Supportive Trader

You tend to focus on the details of life, seeing what needs to be done and doing it in a conscientious manner. You take your responsibilities very seriously and you are very dependable, practical and realistic. At the same time, you strongly value security and stability. You tend not to be a risk taker, but you could see yourself as an investor as long as you had a structure to work under.

You tend to gather information about people and use it to support them because you make others feel good about themselves. You are very people oriented, and you probably do not like abstract ideas, concepts or theories. However, since trading tends to be an isolated and relatively lonely profession you might find that it's not for you simply because there is not enough social interaction.

You probably have definite values and a clear idea of how things "should be." And when things are not the way you like them to be, you’ll probably tell people. However, you tend to adapt community standards for what is right and wrong, rather than trusting your own internal values. This might be disastrous for you as a trader/investor where being a non-conformist tends to lead to success.

Trading Strengths

1. Your creativity often comes from flashes of insight into the nature of things or the needs of people.
2. You can probably work very effectively among a team of like minded supportive traders.
3. With a careful selection process to help you feel secure, you should be able to work with simple, clear systems that manage risk and don’t aim to go for outsized returns in dynamic conditions. Probably very comfortable with clear, calm all-season trading plans.

Trading Challenges

1. You have an aversion to risk and have trouble taking socially adverse trades, even if it could make you big profits. This could eliminate a lot of options for you in trading.
2. Probably have trouble understanding concepts like how the markets really work and how to evaluate a low risk trading idea.
3. If you have an action oriented part you may jump into the markets too rapidly.

Example Trader: Andrew Carnegie

Andrew Carnegie rose from a poor Scottish immigrant worker to become the second richest man of his era (next to John Rockefeller). He parlayed some wise investments into a $40,000 investment that he used to buy a farm which turned into a million dollar oil landfall the very next year. He invested that fortune in steel and newspapers. His company was eventually bought out by J.P. Morgan and became U.S. Steel. And once Cargnegie retired, he proceeded to give away over $300 million before his death. Here is Carnegie's philosophy:

"Man does not live by bread alone. I have known millionaires starving for lack of the nutriment which alone can sustain all that is human in man, and I know workmen, and many so-called poor men, who revel in luxuries beyond the power of those millionaires to reach. It is the mind that makes the body rich. There is no class so pitiably wretched as that which possesses money and nothing else. Money can only be the useful drudge of things immeasurably higher than itself. My aspirations take a higher flight. Mine be it to have contributed to the enlightenment and the joys of the mind, to the things of the spirit, to all that tends to bring into the lives of the toilers of Pittsburgh sweetness and light. I hold this the noblest possible use of wealth."

In 1908, he commissioned (at no pay) Napoleon Hill, then a journalist, to interview more than 500 high and wealthy achievers to find out the common threads of their success. Hill eventually became a Carnegie collaborator, and their work was published in 1928, after Carnegie's death, in Hill's book The Law of Success and in 1937 in Hill's most successful and enduring work, Think and Grow Rich.

He was generally known to be warm hearted, conscientious, and very cooperative. And you, like Carnegie, want harmony around you and you work hard to accomplish it.