The Magic Formula

As mentioned in the previous post, we will take a look at how some other people do their investments so that they get a better-than-market return.

Just before I return the "The Little Book that Beats The Market" (NLB Call No.: 332.63228 GRE-[BIZ]) back to the library, I will have a quick summary of how the little book intends to do just that - give a return that is better than the market.

Most people have the belief that a system that can make money from the Stock Market must necessarily be complicated enough. How else would this explain the need for all those mutual funds and unit trust managers?

The author does exactly the opposite. He shares a method so easy to apply that you wonder if he was bluffing.

In the book, he proposes a method which in essence utilizes 2 financial ratios and by ranking all the companies in such a manner. As a close approximation, these 2 ratios are Return on Assets (ROA) and the commonly used Price Earnings (P/E). He contends that by ranking companies based on these 2 ratios, we will be able to have a list of top performing companies.

The ROA shows how much the company earns with respect to the investment which it pumped in. For example, if a shopfront costs $100 to set up and the profits the shopkeeper gets is $10, the ROA would be 10%. The higher the ROA the better.

P/E shows us how much does a particular stock costs in the Market with respect to the Earnings per Share (EPS) of the company. The lower this number, the better. But not too low. A P/E of less than 5 signifies something abnormal in the past year's results.

By ranking companies according to the ratio, the author is trying to find companies which show a high yield at a relatively low market price.

Of course, profits can change from year to year. But it is assumed that a company with a high ROA has some competitive advantage from its peers that allows it to have a higher return and that this advantage remains for the company.

Pitfalls of this method? It might take 3 to 5 years before the returns starts to show in your portfolio. Another point is that you need to hold 5-8 stocks which ranks high on both ratios. Seems like all investment books from US assumes that the investor has at least US$100,000. This is especially true for books on technical analysis.

But what can a "poor" investor do to maximise returns on his meagre sum of money? Assuming he is a long term investor and won't be needing the money soon, he can:

1. Hide it under the pillow and sleep on it.

2. Leave it in a reputable bank to earn a pathetic interest. This can be 0.25% p.a. if you are not looking hard enough.

3. Pay your life insurance premium to get a "wonderful" annualised return of 5-6% which you'll probably get back when you're 60.

4. Throw the money into a mutual fund and let the fund managers worry for you. If they do good, you get more money and pay them a fee for being such a great help. If they do bad, you curse at them and still pay them the same fee for messing it all up for you.

5. Try buying into an index fund. This is also known as an Exchange Traded Fund (ETF) which allows you to buy indexes as if they are stocks.

Currently, option 5 sounds the most viable. We shall take a look at the past performance and returns of the various indexes around the world and decide which suits our appetite. Till next time!

P.S:
Financial ratios used to describe a company should be intepreted with care. If you think about it, it's not different from using ratios to describe how big an elephant is. Some people use Weight/Height, while others prefer the more interesting trunk length/tail length!

Financial Ratios

Today, I shall talk about some of the financial ratios which you might have heard of but have no idea what they really mean. Not that I know all of them, I'm still learning. I shall update this page when I understand more relevant ratios in fundamental analysis.

Financial ratios are an easy way for us to access the strength/weakness of a company. They help us look into areas such as solvency, operational efficiency and profitability. In short, it's supposed to help us in making our investment decisions in common stocks.

Of course, these ratios mean absolutely nothing if creative accounting was used in the first place. So make sure it's a reputable company you're looking at! It's not worth the effort to calculate ratios if it's not credible.


We shall start off with something common. Most people here should have heard about the

Price Earnings Ratio = (Price/Adjusted EPS)

The P/E ratio shows the amount of times over its earnings that an investor is willing to pay for that share. A good indicator, but do take note that it varies across the different industries. Although a high P/E ratio might mean speculation, it might also mean that investors have a high expectation that the company's earnings will improve in the future.


Next up,

Adjusted EPS ($) = (Earnings/Latest No. of Shares)

EPS is Earnings Per Share. It shows the profitability of a company and is one of the most popular financial ratios. Simply put, if the EPS of a company is $1, it means that the company have earned $1 for every share you hold in that company. Naturally, we want this value to be as high as possible.


Following which, we have the

Adjusted NAV ($) = (Shareholders' Equity/Latest No. of Shares)

NAV means Net Asset Value and is used to describe the value of an entity's assets less the value of its liabilities. Try to buy shares at a price below this value! This is especially easy in bear markets when sentiments are very negative, or so I heard.


Also very important for your investments is the

Return On Equity (%) = (Net Income/Equity)

This determines the rate of return for your investment in the business. By comparing this ratio against the ratio of other companies in the same or similar industry, we can get an idea of whether this company is making enough profits to keep itself afloat.

Alright, time's up. Stay tuned for my next posting where I will share with you how Joel Greenblatt goes about beating the market by making average annualized returns of 40% for over 20 years. Meanwhile, earn and save all you can so that you can capitalise on this method (But only if you want to).

Loss Aversion

It is true. Without realising it myself, I am no better than the normal irrational investor. Not that I believe I'm smarter than most people. I know I am very much the average Joe.

I was casually browsing through the book "The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy" when I came upon the chapter of The Psychology of Investing. In it, Loss Aversion was mentioned. I hereby reproduce it below:

According to behaviorists, the pain of a loss is far greater than the enjoyment of a gain. Many experiments, by Thaler and others, have demonstrated that people need twice as much positive to overcome a negative. On a 50/50 bet, with precisely even odds, most people will not risk anything unless the potential gain is twice as high as the potential loss.

This is known as asymmetric loss aversion: the downside has a greater impact than the upside, and it is a fundamental bit of human psychology. Applied to the stock market, it means that investors feel twice as bad about losing money as they feel good about picking a winner. This line of reasoning can be found in macroeconomic theory, which points out that during boom times, consumers typically increase their purchases by an extra three-and-a-half cents for every dollar of wealth creation. But during economic slides, consumers will actually reduce their spending by almost twice that amount (six cents) for every dollar lost in the market.

The impact of loss aversion on investment decisions is obvious and profound. We all want to believe we made good decisions. To preserve our good opinion of ourselves, we hold onto bad choices far too long, in the vague hope that things will turn around. By not selling our losers, we never have to confront our failures.

This aversion to loss makes investors unduly conservative. Participants in 401(k) plans, whose time horizon is decades, still keep as much as 30 to 40 percent of their money invested in the bond market. Why? Only a deeply felt aversion to loss would make anyone allocate funds so conservatively. But loss aversion can affect you in a more immediate way, by making you irrationally hold onto losing stocks. No one wants to admit making a mistake. But if you don't sell a mistake, you are potentially giving up a gain that you could earn by reinvesting smartly.

I cannot agree more. I am holding to some stocks which will not see significant capital appreciation in the short term. However, I am unwilling to cut my losses and invest in other stocks which are garnering more attention from investors (such as in the property and construction sector). So in short, I am not selling my mistake, hence forgoing my chance of a better return on other stocks.

I keep giving reasons (excuses...) to myself that this stock has a large float, is defensive, and gives dividends (even though it's just about S$0.005 per share before taxes and I only got it once since it was listed in May 2006).

Which brings me to another point. I used to like stocks that give dividends. But now, I think I'll sell the stock at a price where the dividend is factored in. It just isn't worth it to wait for the dividends. The government takes away 20% of it in taxes and it didn't even undertake any risks! At least capital gains from stocks are not taxed here in Singapore (as far as I know).

For the 2 years I've been in the stock market as a novice, my profit/loss statement doesn't record any loss, precisely because I hold onto the stock until it rises above my buying price before selling off!

I am a very conservative investor. My principle is capital preservation. No money, and worse, no guts to do contra trading or sell short. Probably that's why I still haven't managed to be as profitable as other people. But I shall use this to my fullest advantage. I'm sure there's an investment strategy that suits me and lets me earn comfortable amounts of money while I'm at it.

Hobbies and Interest

The other day, I attended class at the university. As usual, there were some get-to-know each other kind of ice-breaker. We were required to ask our partners some questions. How big their family is and some background information about themselves.

"What are your hobbies and interests?", my partner asked.

"Making money," I told her straight in the face.

I don't know why, but she just gave me a smile, the kind which you give when you hear a bad joke but it's just too rude not to feel tickled by it.

And so she told the class that my hobby is making money. The whole class just burst into laughter. I wonder what's wrong. What can be so funny about making money? The lack of money is defintely not a laughing matter to me.

I think the only person polite enough not to laugh was the module coordinator. He said, "So we have a budding entrepreneur here?". This guy here has been through 2 start-ups in his life. The first one failed miserably as he put it. But the second one has been around since the 80s, which is quite something.

What I find interesting is that after his first failure, he got involved into some marketing team for other company. That seems to fit in what the book "Automatic Wealth" talked about having financially valuable skills. With such skills, you'll never have to starve, or so it claimed.

I am inclined to believe that this is true. My personal experiences with other people tells me the simple fact which I saw happening around me, but could not pin-point what it exactly was.

I really wasn't joking when I said that my hobby is making money. Maybe that is not totally correct. I like to find ways to make money.

A lot more to learn

Despite reading up on the topic of stocks for the past 2 years, I realise I am not any better than the average man on the street.

I've read up topics relating to both fundamental and technical analysis. I must say that my approach is a pretty common one - research everything I can find about the company and when the time comes for me to buy, I attempt to be a part-time technician.

My first buy into the stock market took me 3 months before I sold off at a profit of about $200. That was when I learnt what a "laggard" was.

Subsequent tries saw some profits as well but it was also over a relatively long time span. It hardly qualifies as speculation!

Just two days ago, I had the chance to let go of a stock at a premium price. However, I stopped short of executing the trade. Now the stock is down by 6% with a possibility of slipping lower when the SGX opens in the morning. I lost the chance of locking in the returns yet again.

Simply put, I have no idea when is the optimism overflowing and what should be the right price to let go. I don't think I should set myself some arbitrary targets since it's groundless and I may be cutting the flowers prematurely.

Has anyone a good idea on how to tackle the problem?

Personal Net Worth

I read a book titled "Automatic Wealth" by Michael Masterson (NLB Call No.: 332.02401 MAS-[BIZ]) recently. I find the book quite practical judging from what is written, unlike some other authors with more than 1 dad.

Of the 6 steps it recommends to financial independence, one of them involves calculating your net worth. I'm sure most of you smarts guys know it by now. The formula for net worth is

Net Worth = Net Assets - Net Liabilities

Net Asset include everything that you have in your banks, insurance products, stocks, bonds, mutual funds etc. Whenever there is a discrepancy between the value of the item, take the lower value for a more conservative estimate.

Net Liabilities would be any debts which you have to service at the moment. This will encompass any housing loans you have taken or credit card debts which are still unpaid. For me, the only liability I have at the moment is my tuition fees at the university. Living with my parents means that I have no housing loans as of yet. Credit cards are good ideas when approriated correctly, but being a full time student means that banks will not let me sign up for one.

I wasn't very surprised when I calculated that I have an negative net worth. The tuition fee is a really big component. But I am determined to increase my net worth every month I check the balance sheet. I will do this my means of prudent saving, stocks investing and probably housing investments when I reach a critical value. Foreign currencies is also another avenue. I will also keep my eyes open for any possible income-generating ideas.

However, through some exposure with the local stock market, I know that I am very conservative in my investments. Hence, I do not think I will put money in places where I think there is high risk, no returns.

On a side note, I found an abandoned supermarket trolley on my way there yesterday. So I decided to wheel it back and add $1 to my current net worth!