Tuesday, June 24, 2014

A value investment course that is simple to understand and simple to execute

Alvin first communicated with me after I wrote a eulogy on his late teacher (Dennis Ng). He wrote books on trading and published interviews with Singapore Trading Gurus. Today, he conducts a value investment course. It is good to be open-minded and flexible. There are many ways to make money from financial markets. Without being exposed to the different ways, it is difficult for a person to pick the best one that is suited to his temperament.

Alvin asked me if I would like to attend his course. I had always been a lone operator in investing and never attended any course except read books and paying school fees to Mr Market (I lost lots of money as a newbie and it is more beneficial to share such experiences than boast about winnings). As I preferred to remain anonymous, I refused his request but offered to review his course based on his training materials. Since I am not paid, I am free to write negative stuff, if any.

I do not know how Alvin is like as a trainer. I have never met him in person but I like his intellectual honesty.

It is inevitable to pay school fees to Mr Market along the way. A prerequisite to benefiting from the school fees is to admit your mistakes and take the blame on yourself. Don't blame unfair practices like market manipulation, insider trading, bad advice from brokers etc. Blame yourself because ultimately, the buy and sell decisions are yours to make. I was very impressed with Alvin's honesty when he revealed that he blew up SGD100k in his trading account. Potential students of his value investment course may ask ... why would I want to learn from a loser? Most of us will lose big at some point (me included) no matter how prepared. The loser has a better chance of becoming a winner in future if he is honest about it to himself and family who are affected by the loss. I have reservations in a guru of an investment course who spends more time harping on his winnings than sharing the lessons from his losses. You cannot learn much from someone who boasts about his achievements but you can learn much from someone who reflects on his past mistakes. 

I doubt Alvin's training style would be to impress, boast about past achievements to appeal to the greed of newbies who want to get rich quick. If he is which I doubt so, I apologize for writing this positive article on his course.

The CNAV strategy that will be taught in the course involves buying stocks at prices way below their conservatively estimated net asset value. Suppose you buy a company with net assets worth $100 on its balance sheet at $50. Your downside is well-protected. If the company is liquidated today, it is quite unlikely to sell below $50 because of the asset backing. In addition, given that the asset base has adequately compensated the investor for the price paid, he is getting the earning power of the company for free. The company need not be a growth stock or highly profitable as long as its operations are not burning cash. In fact, any profits will be a bonus to the investor.

A few things to note is the quality of the assets. For this kind of asset play which is probably low growth, high quality assets are those that are easy to value and hard to defraud. Cash, marketable securities, real estate fall into this category. Assets whose values are hard to estimate should be discounted heavily to be conservative. Almost 4 years ago, I wrote an article which describes a case study using a method similar to the one employed in Alvin's course.

One problem with this method is the risk of stumbling onto value traps. After all, when something is too cheap to be true, it probably is. To reduce the risk of stumbling onto minefields, Piotroski score is added as an additional screening criteria as taught in the course. A Piotroski score of at least 7 would be good enough.

Every investment strategy has its pros and cons. The problem with the CNAV method is that the stocks uncovered tend to be illiquid and few. A bad scenario will sound like this. Someone runs the CNAV screens and uncovers only 4 stocks. He puts his entire capital into these 4 stocks. Something goes wrong with 2 of them. He tries to cut his losses but the stocks are too illiquid for him to run. There are a few things to note to counter the weaknesses of this strategy. Using the CNAV strategy, does today's market generate enough stocks to provide adequate diversification? If no, the investor needs to watch his position size in each individual stock. It should not be so large that he cannot cut his losses fast enough if something goes wrong later. Fortunately, these problems are less of a concern to the small retail investor as his capital is small.

The CNAV strategy is not suitable for investors with large amounts to invest. This is bad for the big institutional investors but good for small retail investors. Because CNAV stocks are illiquid, they are not worth the attention of the big players. It is because of this neglect that they become so cheap for retail investors who do not mind the illiquidity to pick. Since CNAV is not a scalable strategy, retail investors will need to look for other strategies after they have become successful. That is a good problem to have.

What I like about this course is that it is highly focused on a single concept that is simple to understand and simple to execute. Value investing is simple to understand. What is so hard to understand about the concept of buying something worth $1 and paying $0.50 for it? What is really difficult is its execution. How do you really know it is worth $1.00? The problem gets even more complicated when the investor tries to project future earnings and cashflow. The CNAV strategy has nothing to do with the future. No projection. The investor only needs to know how to read the balance sheet to extract net asset value and apply a discount. A one day course is quite sufficient.

The course costs only SGD98. It is too cheap for the trainers to make meaningful profits. Therefore, it is quite fair that other products/services will be promoted during the course. I cannot review on this aspect because I did not attend the course.

PS: This is not a paid advertising post. Nobody knows my real identity except my wife. I like to share good financial products/services, particularly from fellow Singaporeans. Other similar posts are (Link) and (Link) and (Link)

Sunday, June 2, 2013

Stocks versus property. Why I prefer stocks over property.

Singaporeans love the property market. The fact that it took our government seven anti-speculative measures to dampen Singaporeans' love affair with property since 2007 is evidence that it is very hard to break this strong love. In the meantime, the lack of success is not exactly bad news to the government. They have made 1 billion in tax revenues from the property curbs.

There is substantial anecdotal evidence that more Singaporeans made more money from property than stocks. Just ask and look around. Our parents' generation who dared to invest in property have secured their retirement. It is small wonder the next generation will do the same thing since property investments have worked for decades for so many people.

I have peers who took the plunge and invested a second property 5 years ago. I am sure they are doing quite well. Some have urged me to stop hoarding my money and take a plunge into the property market. Another told me I will never become rich because of my steadfast refusal to take the risk to buy a second property. I probably look stupid to these people. However, I think it is fine to look stupid for good reasons which will be explained here. 

In one sentence why I refused to buy an investment property - I cannot control risk with property investments with the same ease as stocks.

Given the very high property prices in Singapore and my own financial resources, I only have enough money to buy 1 property for investment.  Only 1. What can be more concentrated than that? The lack of diversification makes it hard to manage risk. With stocks, I can construct a portfolio of 30 stocks with not a single one taking up more than 5% of my net-worth. I can afford to make several mistakes without facing financial ruin. Can the same be said with a concentrated property portfolio consisting of only 1 property? To make matters worse, this single property has to be bought with leverage. How many Singaporeans can buy a property with cash? When an investor uses leverage, his margin of error is greatly reduced. The mortgage debt is usually quite substantial because it can take 20-30 years to repay with today's high property prices. It is quite common to pay 25% cash with the rest using borrowed money to purchase a property. The investor loses 20% when the property drops 5%. Leverage introduces the risk of margin call. Although banks seldom ask borrowers to top up their mortgage loan when property price drops, they are legally allowed to do so. If the borrower misses the interest payment because he loses his job, the bank may foreclose and force-sell his property in a battered-down market at a lousy price. With stocks, there is no need to use leverage. One can build a diversified portfolio with as little as SGD30000 with cash.

Value investors tend to steer clear of bubbles. I do not shun participation in a bubble if the underlying asset is liquid. The end period of a stock bubble is historically characterized by a parabolic rise of stocks in a short time. Being out of the market at this stage means missing out the opportunity to make lots of money in a short time. Thus, I will join in the crowd despite knowing that it is a stock bubble, although only a manageable portion of the net-worth will be inside the market. (Don't try this if you are a newbie in the stock market, particularly if you have yet to suffer gut-wrenching losses) The reason why I dare to join the bubble is that stocks are liquid. The moment danger is sensed, one can get the hell out in a single trading day. This is one of the advantages of being a retail investor with a small fund to manage. It makes risk management much easier. Properties are illiquid with high transaction costs. Unlike an equity investor, there is no way for a property investor to get the hell out even if he desperately wants to because of property's illiquid nature.

If a hired fund manager shows me a portfolio with a highly leveraged, super-concentrated and illiquid portfolio, I will sack him straightaway so that I can sleep better. How to manage risk with a portfolio like that? Middle-class Singaporeans who took on a 20-year mortgage to buy an investment property are doing just that.

Besides the inability to manage risk, there is another good reason to avoid property investments. I hate debt intensely. The only time I overcame this hate was to buy my first residential HDB Singapore flat so that I can marry the love of my life. While this article frowns on property investment, a HDB flat is highly desirable. One motivation foreigners convert to become a Singapore citizen is to have the privilege to buy our HDB flats. Particularly for Singaporeans who have sacrificed for National Service, don't ever miss your privilege to buy a HDB flat. It is almost a sure-win as it is subsidized by the government. Besides, everyone needs a roof over our heads that provides the stability for us to marry and start a family.

Buying an investment property today usually involves taking on a huge debt that requires at least 20 years to repay. This makes a person a financial slave. If the goal of investment is to be financially free, then does it make sense to take on so much debt for an investment that it risk making one a slave for the next 20 years? It is not just money anymore. It is freedom. With a heavy debt, a person has to tolerate bullies at work. It is easy to slip into mental depression if a person has to drag his feet every day to work in an environment that drives him crazy. Although my present workplace is wonderful and I am working with and for pleasant and smarter people at the moment, there is no guarantee that this can continue. The advantage of investing and saving hard is to accumulate enough "fuck-you" money to have the freedom to show the middle finger and quit when faced with unreasonable behavior at work. Buying a second property at this point will take away all the "fuck-you" money that I have painstakingly accumulated over the years.

For high net-worth individuals with enough money to buy up multiple properties with cash, property is an appropriate component in this investment portfolio. It is easier for the rich to manage risk in their property portfolio. For the majority of middle-class Singaporeans like me, I think they should think twice before committing to a highly leveraged, concentrated and illiquid investment that can potentially make a slave out of them for the next 20 years.

Saturday, April 13, 2013

Characteristics of a good fund manager

I have a theory about hiring smart people to work for you. Once you hire people with the right talent, you can just sit back, relax and wait for good results as long as you drive him with the right incentives. On the other hand, if you drive him with the wrong incentives, he will destroy you despite paying him top dollars. We have seen this phenomenon happened in Wall Street and this almost destroyed the world financial system in 2008. Closer to home, would it serve Singapore better if our smart civil servants were incentivized to raise the inflation-adjusted median income of all Singaporeans instead of raise the GDP? By focusing on absolute growth, the government took the easy way out to grow GDP by importing foreigners without considering the quality of growth. Quality of growth should raise the purchasing power of the masses. Today's unequal world delivered great wealth mainly to the top richest 1% who already have more than they ever need even if they live up to 150 years old at the expense of the rest who have to suffer rising cost of living.

The lesson from Wall Street is that smart people with wrong incentives will destroy. Therefore, when choosing the right fund manager to manage my money, I will first focus on the incentives that drive him, then on his ability.

First and foremost, fund managers should not charge you fees if he loses your money. This means rejecting the standard fee on asset under management(AUM) . This is exactly the kind of incentive that drives intelligent fund managers to harm their clients. Bigger fund size kills investment performance. It is easier to make investment gains of 15% with $200k than $200m. With $200b, it is virtually impossible. How to find investment opportunities that yield 15% if the fund size is a substantial percentage of the economy when the economy itself is mature and slowing down? If the host is not growing, how can the "parasite"? When fund managers are focused on growing their asset size, they are not acting in their clients' interest. Unfortunately, such bad behavior is the norm in the fund management industry. This is not the person's fault but the system's fault (bad incentives). Instead of spending money on core investment activities, they spend money on marketing to grow their asset under management (which leads to poorer performance). For fund start-ups, they may even take excessive risk to have a great year so that they can market the hell out of it next year. Then, once the marketing succeeds and the asset size grows large enough to throw up comfortable cashflow to the fund managers, they start to become risk-averse, be contented with mediocre results as long as they do not underperform the benchmark.

The safest and perhaps most rewarding strategy on a risk-adjusted basis (career risk, not investment risk) for an established fund manager to pursue is to follow the crowd. If they follow the crowd and get it wrong, clients are more forgiving. If they go against the crowd and get it wrong, clients flee and the managers will earn lesser management fees or even get fired. If you want to hire a fund manager, would you want him to focus him to focus on his own career risk or on the actual investment risk which will determine how much money he makes or loses for you? The standard fee on AUM is the culprit for this sort of undesirable anti-client behavior.

Secondly, fund managers should eat their own cooking. In other words, they should invest in their own fund substantially. Preferably, they should invest so much of their net-worth into the fund that if they cause pain to their client by losing money, they should feel the same pain multiplied by 10. This will discourage the kind of short-term risk-taking behavior in Wall Street that led to 2008 financial crisis. Of course, the same euphoria from making money will be felt by them multiplied by 10 and clients will be more than happy to congratulate them. Let's make money together. This way, fund managers will concentrate on the risk and opportunities that really matter in the investment process.

Thirdly, the performance target should be set reasonably high but not unreasonably too high. In other words, fund managers should have a high watermark. The watermark is a performance target that has to be exceeded before the fund manager gets paid a bonus. This ensures clients do not pay for under-performance. The watermark should not be set too high as this could lead to two undesirable outcomes (1) Close down the fund and open a new one to reset the watermark after a series of bad losing years (2) Take excessive risk to hit the watermark. This is not likely to happen if fund managers eat their own cooking.

One Singaporean fund which meets my criteria of a good fund manager is Aggregate Asset Management. They first caught my attention on Business Times as a fund that does not charge any management fee. Zero AUM fees. When I had a brief exchange with Mr Eric Kong on fund managers not being well-regarded because most of them under-perform their benchmark and still charge their customers management fees, he honestly admitted so. This is also one reason why he has decided not to charge any management fees for his hedge fund. I think this is not only ethical but it also makes business sense. Clients of hedge funds are unlikely to be fools, otherwise they could not become rich. They will not remain as suckers for long and will opt for a better and fairer deal for themselves, if there is such an option. Aggregate Asset Management has started the ball rolling.

The founders do not get paid unless they deliver results to their clients. Meanwhile, the administrative cost of running a fund are borne entirely by the founders. They make a strong impression when you compare them to the robbers who committed the biggest bank robbery in banking history on Wall Street in 2008 (robbers being the banksters themselves).

Aggregate Asset Management has a high water mark mechanism (read the FAQ) which demands that the fund managers earn an absolute profit for their clients before they start to earn the first dollar from their clients. This is far superior to the current (and dominant) payment scheme in which fund managers charge their clients management fees on top of the losses they heap on the clients during bad years.

The Founders and their close circle of friends/family have put $3 million into the fund. Although I am not sure what percentage of their net-worth is invested in the fund (the more the better), the fact that their loved ones have entrusted their money with them is reassuring. Once a person is comfortably rich, family relationships become more precious than mere dollars and cents. There is little risk that the fund managers will take unreasonable risks with their clients' money. It is not just money now.

Right incentives alone are not enough. The next ingredient is ability. Mr Kong's personal portfolio return was 17.8% a year between May 2005 and June 2012. This is certainly impressive performance in an 8-year period which covered a business cycle that included the worst global financial crisis for the past 50 years. However, it is not likely that the same performance can be repeated in a much larger-sized portfolio. To the founders' credit, they have humbly and honestly lowered their target to 12% annual return which is still highly desirable. I wish I could match their lowered targets.

(Source: Business Times Nov14 2012 article. Also available from fund website)

Apart from a good performance record, the amount of risks taken to attain the good performance is even more important. High gains achieved as a result of high risks is luck. High gains achieved despite taking on low risks is skill. Would you prefer someone who employs a concentrated portfolio to achieve 17% annual gain or someone who uses a diversified portfolio to achieve the same result? I would prefer the diversified approach because it is lower risk. Aggregate Asset Management employs a diversified strategy.

There is no right or wrong as to which approach(diversified or concentrated) is better. Advocates of the concentrated strategy will say that it is better to focus your funds on your ten best investment ideas than to spread it across 100 ideas. Since it is your best ideas, the probability of getting it wrong is lower. However, as Mr Eric Kong mentions, when a stock occupies a substantial percentage of the portfolio, an investor may get emotionally attached which distorts his judgment. When facts point that he may be wrong, the investor may be too proud to admit it or find it too painful to make the cut. This is a lesser issue in a diversified portfolio which enables the investor to be more objective. I would like to add further that there is such a thing as bad luck. You can be right in your analysis, in your judgment of character, in everything but still lose money when bad luck hits. Good risk management means good damage control when bad luck strikes. An investor who puts all his eggs in one basket and diligently watch the basket very carefully is still not protected from bad luck. Without further elaboration, I have had more than my fair share of bad luck. Hence, I am allergic to a concentrated (and leveraged) portfolio.

I wish Aggregate Asset Management a good start to their investing year in 2013. Unfortunately, I will not be able to share in the prosperity because I am not qualified to be their client.

PS: This is not a paid advertising post. Nobody knows my real identity except my wife. I like to share good financial products/services, particularly from fellow Singaporeans. Other similar posts are (Link) and (Link)