Short term trading may look enticing but it is actually extremely difficult to be a consistently successful short-term trader.
Do you have the mindset of a trader? That’s the advertising catchphrase for an online broker that is marketing aggressively around Raffles Place.
The advertisement makes short-term trading sound like a lucrative and exciting proposition. But in reality, short-term trading is an extremely risky sport. Many factors are working against traders that they more often end up losing money instead.
With the aggressive marketing campaign in the heart of CBD, I thought it would be important to highlight some of the dangers of short-term trading before more people get burnt.
Trading costs
Day traders who trade frequently end up paying much more in commissions than long-term buy and hold investors. These commissions add up over time, especially when short-term traders tend to take profit after only a small percentage gain.
While online trading fees are generally falling, fees can still add up over time. Right from the get-go, traders are already trying to claw back what they lost in fees, making their task of earning money all the more difficult. The difference in the bid and ask further complicates the issue.
Buy and hold investors, on the other hand, pay less in fees and each investment they make can end up becoming multi-baggers, making brokerage fees negligible in the long run.
The use of margin
Typically, day traders use margin to increase the size of their trade. Margin allows traders to earn a higher return on their capital outlay but it also increases the size of a loss.
On top of that, margin calls make trades even riskier. Should the trade position go against the trader and fall below their available funds, the margin call will immediately close their position, realising the loss.
It’s a zero-sum game
Short-term trading is effectively a zero-sum game. For there to be winners in short-term trading, there must also be losers.
In addition, short-term traders are playing the game against professionals, who may have an informational advantage.
This is very different from long-term investing, where a rising stock market creates the opportunity for all investors to make a profit together.
It’s time-consuming
A successful day trader also needs to factor in the time taken to make frequent trades.
Short-term trading requires the constant monitoring of charts, news, and technical indicators. The time and effort to make successful trades may not be dissimilar to that of a full-time job.
The Good Investors’ conclusion
Don’t get taken in by the aggressive marketing campaign to be a short-term trader. While it may seem enticing, short-term traders bear the huge risk of loss. There are so many factors working against short-term trading, that only a small percentage of them are able to make consistent profits.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
2019 has been one of change and challenges. But it has also been a year that has taught me the power of human generosity and to shoot for the moon.
In both my personal and career life, 2019 was one of the more challenging but rewarding years.
The Motley Fool Singapore – what I believe was an excellent portal for investor education in Singapore, and a platform that I had been contributing to – unexpectedly closed down (for commercial reasons); Ser Jing – my fellow Good Investor – and I subsequently decided to launch a fund; we started our blog to share our investing thoughts; we joined a company with an eye on helping the less fortunate in Cambodia; and I finally got engaged!
It was indeed one heck of a year.
With that said, I decided to pen down a few things I learnt along the way.
Don’t underestimate human generosity
The cynic in me used to believe that the majority of people want to see others fail. There’s even a word for it in Germany: Schadenfreude.
But this year I learnt that while there are people who are generally self-serving, many are not. My personal encounters with generous people – people who were willing to share, teach, and help – have made me believe in the innate generosity of human beings.
Setting up a fund is not an easy task, a task which Ser Jing and I could not have imagined doing on our own. Thankfully, throughout the year, we encountered countless people who were willing to take time off from their busy schedules to help in whatever way they could.
Meeting people who didn’t even know us well but who were willing to share insights, give advice, and encourage us, was a truly humbling experience.
Be open to new experiences
I knew that setting up fund was not going to be easy. Compliance needs, regulatory requirements, gaining the trust of investors, legal fees, etc, are all challenges we have to overcome.
But a fund would also be an avenue for Ser Jing and I to help more people prepare for retirement, provide us with a platform for investor education, and to be a guiding light on how funds should charge clients. It could also be a great way to give back to society (as Ser Jing and I have pledged to give back at least 10% of our personal profits from the fund to charity).
Taking a step in the dark can be daunting. But it can also be hugely rewarding.
Even if the fund does not achieve all our goals, there are still many invaluable lessons from what we have done so far.
The friends made, the knowledge gained, and the chance to make a meaningful impact make it all worthwhile.
Surround yourself with the right people
This is a cliche but it is one worth repeating. This year could not have been so fulfilling or rewarding if not for the people who have supported and helped us.
My family not only provided the encouragement to take the leap of faith but also the support that all entrepreneurs really need.
I am also thankful for friends who have placed their trust in Ser Jing and me and have been willing to support our venture so far.
This year has indeed been a messy one; one of change, challenges, and uncertainty, but it has also been one that taught me to treasure my close circle, shoot for the moon, and not to underestimate the generosity of humans. I certainly wouldn’t have had it any other way.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Haidilao is one of the top-performing stocks of 2019. Its surge has propelled its founder to the top of Singapore’s rich list. But is it a good stock to buy?
Haidilao has been one of the top-performing stocks in Hong Kong this year. The premium hot pot restaurant brand’s share price has climbed 79.4% this year, compared to a 10.8% gain for the Hang Seng Index.
But historical share price performance is not necessarily an indicator of future success. With that said, I decided to do a quick analysis of Haidilao’s business. I will use Ser Jing’s six-criteria investment framework to determine if the company is indeed worth buying.
1. Is its revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
This criterion is important because Ser Jing and I want to invest in companies that have the ability to grow. The size of the company’s addressable market, and the speed of the market’s growth, are important determinants of the company’s growth potential.
I think Haidilao ticks this box easily. The hotpot king’s revenues are still tiny compared to its overall addressable market size.
Haidilao, as of 30 June 2019, had a network of 593 restaurants around the world. On the surface that seems like plenty but if you dig deeper a different picture emerges.
First, Haidilao has room to grow in China. The company has 550 restaurants in mainland China. Given that China’s middle-class population (defined by the Chinese government as having an annual income of RMB 60,000 to RMB 500,000) numbers around 420 million people, that translates to just one restaurant for every 763,300 middle-income person in the country.
Comparatively, the largest casual dining chains in the US restaurant industry serve around 200,000 to 500,000 people (including the low-income population) per restaurant.
If we assume Haidilao can penetrate the market at the low end of that range, it can increase its store count by more than 30% just based on the current middle-income population.
On top of that, the middle income population in China is growing – and fast. Mckinsey estimates that the upper-middle-class population (defined by McKinsey as having an annual income of RMB 106,000 RMB to RMB 229,000) will account for 54% of urban households by 2022, up from just 14% in 2012. That loosely translates to a population of 750 million people. The new generation of upper-middle-class is more sophisticated, has more picky taste, and is more loyal to brands.
All of which is good news for Haidilao, which already has an established reputation for good food and impeccable service.
The Mainland China market is not the company’s only avenue for growth. Haidilao has successfully broken into other International markets such as Taiwan, Singapore, Japan, South Korea, Malaysia, Australia, the United Kingdom, Canada, and Vietnam. And it has barely scratched the surface of the International market scene. It only operates 43 restaurants outside of China, leaving it plenty of room for growth. The average spending per guest outside of China is also much higher at RMB 185 per customer, compared to its overall average spend of RMB 104.4 per customer.
The company’s recent financial results also point to its ability to grow. In the 12 months ending 30 June 2019, Haidilao increased its store count by 73.9%, or 252 stores. More importantly, the increase in store numbers had little impact on existing stores, signaling limited cannibalisation. Same-store sales increased by around 4.7% and the average same-store table turnover increased to 5.2 from 5.0.
2. Does Haidilao have a strong balance sheet with minimal or a reasonable amount of debt?
Haidilao is in a great position financially. As of 30 June 2019, the group reported a positive net cash balance of around RMB 2.57 billion. It also had another RMB 1.7 billion in deposits placed with financial institutions. The company generated RMB 1.9 billion in cash from operations in the first six months of 2019; it was more than sufficient to fund capital expenditures for the opening of new restaurants which amounted to RMB 1.7 billion.
It is good to see that Haidilao is using internally-generated cash to expand rather than tapping into its reserves.
3. Does Haidilao’s management team have integrity, capability, and an innovative mindset?
Haidilao has not had a long history as a listed company, but its management seems to be treating existing shareholders fairly for now.
Even though 38% of Haidilao’s suppliers are linked to CEO Zhang Yong and his family, the cost of goods has not increased unreasonably since Haidilao was listed. This is a sign that Zhang Yong is committed to treating Haidilao and its minority shareholders fairly. On top of that, Haidilao has also started to reward shareholders by paying a small dividend for 2018.
Zhang Yong has also proven himself to be a capable leader. Now Singapore’s richest man, Zhang Yong has maintained his commitment to improving the customer experience in his restaurants. He has also overseen the company’s adaptation numerous times, including its expansion into delivery, Haidilao-branded food products and the adoption of artificial intelligence in restaurant operations.
Haidilao is also one of the more innovative businesses in the traditional F&B industry:
The company was one of the first to provide unique manicure and free snack services for customers waiting for a seat.
This year, it deployed intelligent robotic arms and intelligent soup base preparation machines in 3 restaurants. It also introduced AI robot waiters in 179 restaurants.
It has expanded its offering and now offers milk tea under the Haidilao brand. In 2019 alone it introduced 187 new dishes.
It encourages restaurant-level managers to maintain customer service by sending at least 15 mystery diners each year to each restaurant to rate their experience. Their feedback is a key performance indicator for managers.
Restaurant managers are also compensated based on the profitability of the restaurants under their care.
Restaurant managers are encouraged to train mentees and they are then compensated based on the profitability of the restaurants that their mentees manage.
These unique initiatives have helped to create a culture of providing good service and have enabled the company to retain talent more effectively.
4. Are its revenue streams recurring in nature?
A recurring revenue stream is an underrated but beautiful thing to have. It means the company does not have to spend time and money to remake a past sale. This can be achieved through repetitive customer behaviour or long contracts with clients.
In Haidilao’s case, its strong brand and loyal customers make its revenue streams recurring and predictable.
Needless to say, more brand-conscious consumers are loyal to brands that they trust. Haidilao has a strong brand and sticky following with consumers. The long queues in its Singapore outlets are a testament to that.
The number of customers Haidilao serves is also obviously large. In 2018, it served more than 160 million customers! That means it has no customer concentration risk at all.
5. Does Haidilao have a proven ability to grow?
Haidilao was listed only in 2018, and so far, it has shown the ability to grow based on its financials released in its initial public offering prospectus and subsequent earnings updates.
Source: My compilation of data from annual and interim reports
Revenue has compounded by 43% per year from 2015 to 2018 and the growth rate accelerated to 59% in the first half of 2019. Profit has grown at an even faster pace, at a compounded rate of 82% per year from 2015 to 2018. In the first half of 2019, profit increased by 41%.
6. Does Haidilao have a high likelihood of generating a strong and growing stream of free cash flow in the future?
The true value of a company is not based on its profits but on all the cash that it can generate in the future. That is why the sixth criteria of the investment framework is so important.
Based on Haidilao’s recognisable brand, strong customer loyalty, and the management’s determination to keep customer-satisfaction high, I can see customers continuing to frequent the company’s restaurants well into the future.
Haidilao is not only well-positioned to grow its store count, but same-store sales are also growing at mid-single-digits.
Although capital expenditures remain high, likely due to the opening of stores, I foresee that Haidilao could start to generate copious amounts of free cash flow in the future.
Risks
A discussion of a company will not be complete without addressing the potential risks.
Keyman risk is an important concern I have with Haidilao. Zhang Yong is a visionary leader who reinvented the hotpot dining space, through innovative initiatives. He continues to adopt new technologies and has constantly implemented plans to improve his customers’ dining experience.
He is the key reason for the brand’s huge success so far. Zhang Yong is 45 now and I don’t foresee him stepping down anytime soon. Nevertheless, investors should watch this space.
Another risk is that Haidilao continues to source supplies from entities with related-party ownership. Even though these related-party suppliers have so far been fair to Haidilao, there remains a risk that things could change.
Lastly, execution risk is another concern. The company’s growth is dependent on it expanding the number of stores without affecting its existing business. Store-location choice is an important determinant of whether new restaurants succeed.
On top of that, while size improves economies of scale, it can also become increasingly difficult to maintain food quality, food safety, and the quality of the customer experience.
Valuation
What is a good price to pay for Haidilao? As with any company, I think this requires a reasonable amount of judgment and estimation.
The company recorded revenue of RMB 10.6 billion in China in the first half of 2019. Based on the addressable market size, I think the mainland Chinese market can easily absorb 1,500 Haidilao restaurants. That’s a three-fold increase.
The international market is a bit harder to estimate. But I do think Haidilao can easily increase its store count in geographies with large Chinese populations such as Taiwan, Singapore, Malaysia, Australia, United States, and Hong Kong. For simplicity’s sake, let’s assume it can increase its current international store count of 43 by three times to 129.
We will also leave out the growth in delivery sales for now.
Based on these assumptions, Haidilao can achieve an annual profit (assuming net profit margin remains the same) to shareholders of around RMB5.5 billion.
If we attach a multiple of 30 times to that figure, we can estimate a reasonable future market capitalisation. Based on this rough estimation, the company’s future market capitalisation should be around RMB 164 billion.
I think that Haidilao, at the current rate it is expanding its network, can realistically hit that level of profit in eight to 10 years.
If I want to achieve an annualised return of 10%, the most I would pay for the company would be RMB 76.5 billion.
At its current share price, it has a market capitalisation of RMB 154.8 billion, which is around 74 times trailing earnings. The company’s current market cap is twice the amount I would be willing to pay based on my calculations.
Although the numbers I used for my estimation may be conservative, the current market cap seems inflated and leaves investors exposed to huge risk should the company fail to achieve the anticipated growth.
The Good Investors’ conclusion
Haidilao ticks all six criteria of Ser Jing’s investment framework and is certainly a good business with great prospects. I think my estimates of the potential addressable market are fairly conservative, and the company could easily grow faster and bigger than I predicted. The addressable market could also grow much more as the Haidilao brand could penetrate the International market more deeply.
But despite all that, from a valuation perspective, the company’s share price is a little too expensive for my liking. It leaves very little room for execution error. Should Haidilao fail to deliver my projected growth, its stock might also risk valuation-compression.
As such, even though Haidilao is a solid growth company, it is only on my watchlist.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The Mawer Global Equity Fund and Fundsmith Equity Fund have handsomely outperformed the market since their inception. Here’s how they did it.
If you thought that professional investors can easily beat an unmanaged basket of stocks, think again.
According to an article on CNBC, 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the broad US-market index.
Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.
Given how such few funds consistently beat the market, I tend to take notice when one does.
Two funds, in particular, have caught my eye. They are the Fundsmith Equity Fund and the Mawer Global Equity Fund. Both funds have global investment mandates and have beaten their respective indexes by a wide margin.
Fundsmith has an impressive annualised return of 18.3% as of 31 October 2019 since its inception nine years ago. It is well ahead of the annualised 11.7% return of the global equities market.
The Mawer Global Equity Fund has also done really well since its inception in 2009. As of 30 September, it has a compounded annual return of 13.1%, compared to an 11.4% return from the global equity benchmark.
So what is the secret behind their success?
Low portfolio turnover
Needless to say, careful selection of high-quality stocks is one of the key ingredients to their success.
But another thing that stands out is that both Fundsmith and Mawer Global Equity Fund have extremely low portfolio turnover. Portfolio turnover is a way to measure the average holding period for a stock in a fund.
In 2018, Fundsmith and the Mawer Global Equity Fund had an annualised portfolio turnover of 13.4% and 16% respectively. In essence, that means the average holding period for stocks in their portfolios was more than 6 years each.
So why is this important? Terry Smith, founder and manager of Fundsmith, explained in his annual letter to shareholders that a low portfolio turnover “helps to minimise costs and minimising the costs of investment is vital contribution to achieving a satisfactory outcome as an investor.”
Besides reducing the costs of transactions, staying invested in high-quality stocks gives investors the opportunity to participate in the immense compounding effect of the stock market.
Morgan Housel, currently a partner in Collaborative Fund, wrote in one of his past columns for the Motley Fool:
“There have been 20,798 trading sessions between 1928 and today (2011). During that time, the Dow went from 240 to 12,500, or an average annual growth rate of 5% (this doesn’t include dividends). If you missed just 20 of the best days during that period, annual returns fall to 2.6%. In other words, half of the compounded gains took place during 0.09% of days.”
Hence, a low portfolio turnover not only reduces transaction fees but increases the chance that investors do not miss out on the best trading sessions, which form a large portion of the market’s returns.
Low management fees
Actively managed funds have been known to charge notoriously high fees. This is one of the reasons why active funds find it difficult to outperform their low-cost index-tracking counterparts.
However, both Fundsmith and Mawer Global Equity Fund buck this trend. Both funds have relatively low management fees and do not have a performance fee. Fundsmith’s management fee ranges from 0.9% to 1.5%, while Mawer Global Equity Fund has a management expense ratio of around 1.3%.
The Good Investors’ Conclusion
When Warren Buffett was the manager of the Buffett Partnership some 50 years ago, he noted that earning a few percentage points more than the market average per year can be hugely rewarding. He said:
“It is always startling to see how a relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”
Actively-managed funds that can consistently outperform the market over a long time frame are a dime a dozen. But if you find one, it definitely pays to invest in it.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
I revisited some of the annual letters Warren Buffett wrote when he was a fund manager some 50 years ago. Buffett’s teachings then are still relevant today.
And his track record was, unsurprisingly, phenomenal.
According to his fund’s investor letter in 1969, his partnership produced an annual compounded return of 31.6%, compared to the Dow’s 9.1%.
Net of fees, limited partners (investors in the fund) gained a cumulative return of 1,403% in just 12 years, or 25.3% per year. Not bad.
Despite being written more than 50 years ago, Buffett’s teachings in his fund’s investor letters are still relevant today.
Here are five things I learnt from the great man’s writings.
Don’t time the market
The market will swing in the short term. But over a long time frame, you can bet your last dollar that it will be up. Buffett wrote:
“I am certainly not going to predict what general business or the stock market are going to do in the next year or two since I don’t have the faintest idea. I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few years when it is minus on the same order, and a majority when it is in between. I haven’t any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor.”
Today, many hedge funds and financial advisors try to manage their clients’ money to reduce near-term volatility. But timing the market is a fool’s game.
Buffett’s right-hand man, Charlie Munger certainly agrees, saying, “Time in the market is more important than timing the market.”
It is notoriously difficult to beat the stock market index
When Buffett started his fund, he set the goal of beating the Dow Jones Industrial Average, which at that time was the most widely followed stock market index in the US.
If you thought this was easy to achieve, think again. In his 1961 annual letter, Buffett noted that out of 70 funds listed in Arthur Wiesenberger’s book with a continuous record since 1946, only seven outperformed the Dow. And those that did were superior by just a few percentage points.
Today the story is no different. Bob Pisani, wrote in an article on CNBC earlier this year that 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the index.
Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.
The joys of compounding
A few percentage points can really add up when compounding. Buffett observed:
“It is always startling to see how relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”
Buffett added the table below to show how much more you would make if you compounded a $100,000 investment at 15% instead of 10% or 5%. The results were indeed staggering, and also demonstrates that the difference in absolute returns mushrooms the longer the investment compounds.
Source: Buffett Partnership annual letter
Individual thinking is important
In his annual letter in 1962, Buffett warned that it is not safe to simply follow what others are doing. Individual thinking is essential. He wrote:
“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you.
In many quarters the simultaneous occurrence of the two above factors is enough to make a course of actions meet the test of conservatism.”
He added:
“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”
Making bigger bets on high-conviction stocks
While modern portfolio theory suggests ample diversification, Buffett had a somewhat less conventional style. His fund had the mandate to invest up to 40% of its assets in a single stock!
In his 1965 letter, Buffett reasoned:
“Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation of achieving performances surpassing the Dow by, say, fifteen percentage points per annum.”
But he adds:
“It doesn’t work that way. We have to work extremely hard to find just a few attractive investment situations. Such a situation by definition is one where my expectation of performance is at least ten percentage points per annum superior to the Dow.”
Because of that, Buffett does not mind allocating a larger chunk of his portfolio to stocks that he expects to outperform the index and has a very low probability of loss.
Based on his track record, its clear this strategy has done really well for him.
The Good Investors’ Conclusion
Even at a young age (he was just 25 when he started), Warren Buffett was already a great investor. His performance as manager of the Buffett Partnership all those years ago speaks for itself.
More importantly, for investors today, his writings back then are still relevant today. If you want to read more of Buffett’s annual letters during his time at Buffett Partnership, you can head here.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Risk management is an essential component of investing. We can try to reduce the risk of permanent loss by investing in low-risk stocks.
Risk management is essential when building a stock portfolio. But it is impossible to remove risk completely. Instead, we should find ways to reduce risk in our investment portfolio, while maintaining a good chance for high returns.
With that in mind, here is a simple framework for picking low-risk stocks.
How to find low-risk businesses?
A low-risk business should have a strong balance sheet and an ability to consistently generate cash. Ideally, I look for companies with six qualities that should indicate it has a resilient business.
1. A manageable debt load and low-interest expenses
The company should be able to easily service its interest expense and to pay back its debts when they’re due. The company should have both a high-interest coverage ratio (how easily it can pay back its interest expenses using profits or free cash flow) and a low debt-to-equity ratio.
2. Consistent free cash flow generation
Cash is the lifeblood of a company. It is what the company needs to pay its creditors and suppliers. A company that is able to generate cash after paying off all its expenses and capital requirements (free cash flow to equity) is then able to reward shareholders through dividends, share buybacks, or reinvesting in the business.
3. Predictable and recurring sales
In order to generate cash consistently, a company needs recurring sales. A low-risk business should have recurring and fairly predictable revenue. This can come in the form of repetitive customer behaviour or long-term contracts.
4. Low customer concentration
The business should also have a varied pool of customers. A high customer concentration might cause wild fluctuations in sales and profits.
5. A diversified business
Similarly, the business should ideally not rely on a single revenue source. A business that has multiple revenue streams is more resistant to technological changes disrupting a single core focus.
6. A long track record
Finally, a low-risk business should have a reasonably long track record of all the above qualities. The track record should ideally span years, if not, decades. Businesses that have such an admirable track record demonstrate resilience and management’s adaptability to technological disruptions.
How to find stocks that will not suffer from valuation compression?
Besides investing in stocks that have resilient businesses, we should also consider the risk of valuation-compression.
A valuation compression occurs when a company’s market value declines permanently despite sustained earnings growth. This happens usually because the starting valuation is too high. If the purchase price is too steep, a good business may still end up becoming a bad investment.
The most common metrics that are used to value a stock are the earnings, cash flow, and book value.
Another metric that I like to use is the enterprise value to EBITDA (earnings before interest, tax, depreciation, and amortisation). The metric is also known conveniently as EV-to-EBITDA.
The enterprise value, or EV, strips out the company’s net cash from its market cap. Companies whose cash make up a large proportion of their market caps are prime acquisition targets. In addition, the net cash balance could also act as a support for which the company’s market cap will likely not fall under.
I also look for companies whose earnings are likely to grow faster or longer than the market expects. This requires a reasonable amount of judgment. But stocks that eventually exhibit such sustained growth are unlikely to see a compression in their valuation.
The Good Investors’ Conclusion
If you’ve been avoiding stocks because of the fear of the risk of loss, don’t.
Warren Buffett says that “risk comes from not knowing what you are doing.”
If we pick stocks wisely, the risk of permanent loss becomes small. On top of investing in stocks that exhibit low-risk qualities, investors should also consider diversifying their portfolio. Diversification reduces the risk that a single mistake or an unforeseen circumstance will be detrimental to our overall portfolio.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Investing can be hugely rewarding. But we need to be able to navigate behavioural tendencies that may cause poor investing decisions.
Taking control of your own finances can be hugely rewarding. But it is also permeated with investing mine traps that could potentially derail your returns.
Even seasoned investors and professional portfolio managers are not immune to these pitfalls.
Many of these are innate behavioral human tendencies that create delusions and lead to investment errors.
Jason Zweig, the author of the best selling book, Your Money and Your Brain, said, “Humankind evolved to seek rewards and avoid risks, but not to invest wisely. To do that. You’ll have to outwit your impulses – especially the greedy and fearful ones.”
With that said, here are three common human tendencies that may impact our investing.
Making gross generalisations
The human brain makes sense of the world by recognising patterns. But when it comes to investing, assuming a pattern when there really isn’t one could be detrimental.
Carolyn Gowen, a well-respected financial advisor, recently wrote in her blog that “in investing, we often mistake random noise for what appears to be a non-random sequence.”
To lower the chance that we mistake a random sequence for a pattern, we should look for real economic reasons behind a correlation.
Second, never rely on short-term data. Investing should be viewed in decades, rather than months or years.
Herd mentality
Humans are social creatures. We want to be included and accepted. It is, therefore, not surprising that herd instinct is a common phenomenon in investing.
Investors need positive reinforcement to make decisions. We want to be verified by advice and what others are doing.
The end result is an investment decision that is not the result of individual choice. The tulip mania is a classic example of herd mentality. Towards the end of the 16th century, the demand for Dutch tulips skyrocketed. Investors, eyeing a quick buck, flocked in to buy tulip futures. The price of tulips skyrocketed before the bubble finally burst in 1937.
John Huber, manager of the Saber Capital Fund said, “My observation is that independent thought is extremely rate, which makes it valuable… Understanding this reality and being aware of our own human tendencies is probably a necessary condition to investment success in the long run.”
Self-serving bias
The self-serving bias is a common cognitive bias that distorts an investor’s thinking. In essence, the self-serving bias leads us to credit ourselves for successes but blame failures on other causes.
This delusion perpetuates poor investing decisions and limits our ability to learn. Not knowing what you don’t know is probably the single most dangerous flaw in investing.
The best defense against this cognitive bias is to review each investment decision and see if your investment thesis had played out in the first place. Were your investment successes built around solid fundamental reasoning or was it pure luck?
Keeping an investing journal can help us keep track and review our investing decisions.
The Good Investors’ Conclusion
Billionaire hedge fund manager, Seth Klarman, once observed:
“So if the entire country became security analysts, memorized Ben Graham’s Intelligent Investor, and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies, and investment fads.
Even if they somehow managed to be long-term value investors with a portion of their capital, people would still find it tempting to day-trade and perform technical analysis of stock charts. People would, in short, still be attracted to short-term, get-rich-quick schemes.”
Being rational is easier said than done. We humans are built in a way that has helped us survive for thousands of years by making decisions based on fear and greed. So going against these human emotions is innately difficult.
But to be good investors, we need to appreciate and overcome these human emotions and biases. By overcoming our emotions and biases in investing, we are more likely to make sound investing decisions that give us the best chance of long-term investing success.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
REITs are a popular investment vehicle that provide regular cash flow. But REIT managers may pursue goals that end up harming investor returns.
Real Estate Investment Trusts (REITs) are increasingly popular in Singapore. Besides providing exposure to real estate at a low starting capital outlay, REITs also offer portfolio diversification, enjoy tax incentives, and offer relatively high yields.
One flaw is that some REITs’ managers may not be specifically incentivised to increase their REITs’ distribution per unit- the metric that is most important to unitholders.
Because of this misalignment in interest, REIT managers may be tempted to pursue goals that end up harming unitholders. I did a quick review of some REITs in Singapore to compare how their managers are incentivised.
Misaligned interests?
For instance, Frasers Logistics and Industrial Trust’s manager is paid a performance fee that is 5% percent of the REIT’s annual distributable income. Mapletree Industrial Trust and Keppel REIT’s managers are paid a performance fee of 3.6% and 3% of the net property income, respectively.
At first glance, investors may think this is a fair practice, since it encourages the managers to grow their respective REITs’ distributable income and net property income. But the reality is that an increase in either of these may not actually result in an increase in distribution per unit (DPU).
In some cases, the net property income and distributable income may rise because of the issuance of new units to buy new properties, without actually increasing DPU.
Keppel REIT is a prime example of a REIT whose unitholders have suffered declining DPU in the past while its manager enjoyed high fees.
Performance fees aligned with unitholders
That said, there are REITs that have good performance fee structures.
For instance, Sasseur REIT and EC World REIT’s managers are paid a performance fee based on 25% of the difference in the DPU in a financial year with the DPU in the preceding year. In this way, they are only paid a performance fee if the DPU increases.
ESR-REIT has an even more favourable performance fee structure. They are paid 25% of the difference between this year’s DPU and the highest DPU ever achieved.
Base fees
We should also discuss base fee incentives. Besides performance fees, REIT managers are also typically paid a base fee.
The base fee may be pegged to asset value, distributable income, or net property income. The base fee helps the manager cover the cost of its operation. A base fee pegged to the size of the assets makes sense since a larger portfolio requires more manpower and overheads to maintain.
In my opinion, the base fee should be there to help cover the cost of managing the REIT, while the performance fee should be the main incentives for the REIT managers.
Based on a quick study of base fees, ESR-REIT and Mapletree Industrial Trust are two REITs that pay their managers a relatively high base fee of 0.5% of the deposited asset value. Sasseur and EC World REIT’s managers are paid a base fee structure based on 10% of distributable income.
Typically, investors should look for REITs that pay their manager a low base fee, which in turn incentivises the manager to strive to achieve its performance fees.
Conflicts of interests
As you can see, managers and minority unitholders of REITs may end up with conflicts of interests simply because of the way REIT managers are remunerated. If a manager is incentivised based solely on net property income, it may be tempted to pursue growth at all costs, even though the all-important DPU may decline.
On top of that, REIT managers’ are also often owned by the REIT’s sponsor. This might result in an additional conflict of interests between sponsors and REIT minority holders.
But having said all that, conflicts of interests may not always end up being bad for investors. Even if remuneration structures and interests are not aligned, an honest and fair sponsor might still feel obliged to treat minority unitholders fairly.
The Good Investors’ Conclusion
As retail investors, we have little power over the decision-making processes in a REIT. We depend almost entirely on the REIT manager. It is, therefore, essential that we invest in REITs who have managers that we trust will do what is right for us. So how do we do that?
The first step is to study the REIT’s manager’s remuneration package. Ideally, the REIT manager should be remunerated based on DPU growth. If the manager has poorly-aligned interests, you then need to assess if it has a track record of making honest decisions. Look at the REIT’s DPU history. Has it allocated capital efficiently and in a way that maximises DPU?
Too often investors overlook how important it is to have a manager that has the interests of minority unitholders at heart. Hopefully, this article brings to light the importance of having a good and honest sponsor and manager.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Frasers Logistics and Industrial Trust is proposing to acquire Frasers Commercial Trust. Here’s a breakdown on possible scenarios and what actions to take.
Frasers Logistics and Industrial Trust has proposed to acquire Frasers Commercial Trust in a shares plus cash deal. In essence, Frasers Commercial Trust unitholders will receive 1.233 Frasers Logistics and Industrial Trust units and S$0.151 in cash for every unit of Frasers Commercial Trust they own.
In light of the proposed deal, I had previously shared my thoughts on what it means for Frasers Logistics and Industrial Trust’s unitholders. Below are my thoughts on what the merger means for Frasers Commercial Trust’s unitholders.
Scenario 1: The proposed deal goes through
Existing unitholders of Frasers Commercial Trust can accept the offer tabled to them. In exchange, they will receive cash and units of the new REIT. This outcome could be fairly rewarding.
For one, there are reasons to believe that the new REIT can provide solid returns for unitholders. If the deal does go through, Frasers Commercial Trust unitholders will be able to participate in the new REIT’s potential upside.
The new REIT is expected to provide a 6% distribution yield (if you consider the market price at the time of writing of S$1.23 per unit). The enlarged REIT will benefit from a diversified portfolio with the potential to grow its rental income organically.
The deal will also enable Frasers Commercial Trust’s unitholders to cash out a portion of their holdings, due to the cash portion of the acquisition.
Scenario 2: The proposed deal gets rejected
If the deal gets rejected by either party, it will not go through. In that case, Frasers Commercial Trust unitholders get to keep their stake in the existing REIT.
I think the main reason why Frasers Commercial Trust unitholders may reject the deal is that they may not view the purchase price to be high enough. They will also be receiving new units of the enlarged REIT at fairly high prices. Based on current market prices, the new units will be issued at a 29% premium to book value.
Scenario 3: Unitholders can sell their units now
Unitholders of Frasers Commercial Trust can also sell their units before the results of the deal. By selling your units, you can get the cash out immediately and reinvest elsewhere.
This option is for unitholders of Frasers Commercial Trust who do not want to hold on to the units of the newly formed REIT.
This is a reasonable action to take if you have found an investment that is better suited for your portfolio.
Scenario 4: Looking for arbitrage opportunities
The fourth option is to make use of the deal as an arbitrage opportunity.
Although I encourage long-term, buy-and-hold investing, mispricings in the market, especially after a deal has been proposed, can result in the opportunity to make an immediate profit.
To understand how to do this, we must first look at the mechanics of the deal. Frasers Commercial Trust unitholders will be getting 1.233 Frasers Logistics and Industrial Trust units plus 15.1 Singapore cents.
At the time of writing, Frasers Logistics and Industrial Trust shares trade at $1.23 per unit. As a result, the market value of what Frasers Commercial Trust unitholders will receive ($1.667 per unit) is slightly lower than the current market price of $1.67.
As such, investors can instead choose to sell their holdings in Frasers Commercial Trust and purchase Frasers Logistics and Industrial Trust. Of course, they should factor in whether it still makes sense after including any transaction costs (it might not, depending on the broker you use).
The Good Investors’ Conclusion
The proposed acquisition of Frasers Commercial Trust has given its unitholders a lot to think about. Should you simply wait for the deal to pass and enjoy the upside of the enlarged REIT? Or should investors take active steps to achieve a better return by seizing the current arbitrage opportunity? The risk of trying to maximise returns through arbitrage is that the deal falls through.
Additionally, unitholders who do not want a stake in the enlarged REIT can also choose to encash their units now.
Personally, I think trying to make an arbitrage profit is too much effort for too small of an upside (this may change if either REIT’s unit price moves dramatically, which is unlikely as arbitragers will force the price to equilibrate). So for now, I think it is best for Frasers Commercial Trust unitholders to simply wait for the outcome of the deal.
There are potential pros and cons to either outcome. If the deal goes through, exiting Frasers Commercial Trust unitholders can enjoy distribution per unit-accretion, if they reinvest the cash portion of the deal into Frasers Logistics and Industrial Trust. The new trust will also enjoy potential economies of scale, access to cheaper debt, and potentially trade at higher valuations. The downside is that the new units are being issued at a fairly high valuation of 1.29 times book value and the purchase price is fairly low.
Conversely, if the deal falls through, unitholders will continue to hold onto their Frasers Commercial Trust units, which also has a good portfolio of properties, low gearing, and could potentially pay out higher distribution per unit in the future. However, unitholders will miss out on the yield-accretion and the potential to participate in the growth opportunity of a larger, more liquid REIT with access to cheaper debt and equity.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
John Huber’s fund has more than doubled the S&P500 index. Here’s a compilation of three investing lessons from his annual letters and blog posts.
John Huber is one of the top-performing fund managers of the decade. His Saber Investment fund has achieved a gross annualised return of 20.66% since 2014. That puts his fund well ahead of the S&P 500 which has annualised at 10.89%.
I spent my weekend studying some of Huber’s letters to shareholders and blog posts. Here are three investing lessons from his writings.
Time is a valuable edge
Fund managers often get asked the question, “what is your edge”? The two main responses that institutional investors look for are some sort of “information” or “analytical” edge.
However, Huber believes that in an era of easily-accessible information, both these edges do not exist anymore. Huber explains:
“I’ve observed over the years that whatever information an investor believes to be unique is almost always understood by many other market participants, and thus is not valuable.
The mispricing is not in the stock itself, but in the investor’s own perception of the value of information: it’s worth far less than they believe it is. Information is now a commodity, and like the unit price of computing power that provides it, the value has steadily fallen as the supply and access to it has skyrocketed.”
But the absence of an “informational” or “analytical” edge does not mean stock pickers cannot outperform the market. Huber believes that the “time horizon” edge is still alive and kicking.
The “time horizon” edge is formed because today’s market participants are more interested in short-term gains over the long-term. Huber notes that many investment firms today make investing decisions based entirely on short-term stock price movements. These decisions have nothing to do with long-term value.
This creates a huge pricing mismatch between a stock’s long-term value and the current stock price. In turn, it creates a massive opportunity for long-term investors to outperform the market.
But the “time horizon” edge does come with its price. Huber explains:
“The price of gaining this edge is the volatility that could occur in the near term. You have to be willing to accept the possibility that your stock will go down before it goes up. Very few investors are willing to pay that price, which is why even large-cap stocks can become disconnected from their long term fair values.”
Don’t be afraid to say, “I don’t know”
Huber wrote a great article on one of Warren Buffett’s underrated investment attributes: His ability to recognize when a situation is outside of his well-defined circle of competence.
Buffett has been able to do extremely well in the stock market simply by focusing on more-certain bets and resisting everything else.
The ability to say “no” has enabled Buffett to have very few major mistakes on his record.
More impressively, Buffett is also humble enough to admit when he is wrong. For example, his ability to realise his mistakes led him to make smart investment exits in IBM, Tesco, and Freddie Mac. Huber wrote:
“I think the vast majority of investment mistakes can be traced back to the inability to be honest about your own knowledge or level of understanding about a subject matter.
It’s hard for smart people who have spent their lives being right far more often than they are wrong to admit to themselves that something is too challenging.
It is even harder to admit that their original assessment was completely wrong. So I think intellectual honesty can be a source of a powerful edge for those who can harness it to their advantage.”
Individual thought is essential
Huber also explains that one of the biggest risks in investing is allowing others to indirectly make your investment decisions.
Too often investors rely on outside advisors to make an investment decision. But the advice may be based on different economic interests, investment horizons, or goals.
Investors also tend to copy high-profile investors. However, high-profile investors can also occasionally make mistakes.
Theranos, one of the most high profile fraud cases of the decade, managed to secure billions in funding before it was eventually found out. Its early investors were some of the most respected business people of our time. They included the likes of Carlos Slim, Robert Kraft, Larry Ellison, Rupert Murdoch, and the Walton family. Huber notes:
“My observation is that independent thought is extremely rare, which makes it very valuable.
On the other hand, outsourced thinking appears to be pervasive in the investment community, and because of how we’re wired, this dynamic is unlikely to change. Regardless of how convincing the facts are, we are just more comfortable if we can mold our opinion around the opinion of others.
Understanding this reality and being aware of our own human tendencies is probably a necessary condition to investment success in the long run.”
