Businessman Investor

Touching base with the rational business psyche of stock market investors

Tuesday, October 18, 2011

Astonishing Role of Capitalism in Passive Wealth Building

Capitalism has astonishingly imposed and facilitated our preferred, ideal setup—Chemrez’s management doing its job of running the company, taking care of the technical burden for us, while we, being investors, duly reaping the economic rewards, expecting and passively enjoying fundamentally-grounded returns for as long as we would like.
This is Part 7 of a Series. Go to Part 6: Acquisition Moves and Exploitation of Market Misalignments

The following is a portion of a letter addressing my partners which states, clarifies, and addresses the operating principle behind that private investment partnership (i.e. hedge fund) I began. I would recommend that you start your reading at the beginning.

Rare are situations where you have excellent firms posting double-digit returns for a good run of years yet are selling inexpensively; we paid attention, decided, and took action. Relative to equity value, we have effectively become part-owners of Chemrez for free, being able to strike a great discount around 14%. As such, we have the luxury of watching our fortune in book value terms, taking comfort in each increase as an enhancement of wealth, conservatively subscribing to the idea that our rate of return approximates the underlying company’s return on equity regardless of the market’s schizophrenic mood. Capitalism has astonishingly imposed and facilitated our preferred, ideal setup—Chemrez’s management doing its job of running the company, taking care of the technical burden for us, while we, being investors, duly reaping the economic rewards, expecting and passively enjoying fundamentally-grounded returns for as long as we would like.

Monday, October 17, 2011

Acquisition Moves and Exploitation of Market Misalignments

One of the chief reasons which have prompted our purchase of Chemrez shares was due to a market anomaly which I often exploit—particularly, companies selling below their equity or book value. 
This is Part 6 of a Series. Go to Part 5: Reporting Hedge Fund Performance

The following is a portion of a letter addressing my partners which states, clarifies, and addresses the operating principle behind that private investment partnership (i.e. hedge fund) I began. I would recommend that you start your reading at the beginning.


Our first move has been the acquisition of some shares in a corporation called Chemrez Technologies, Inc. (ticker symbol: COAT), a business which has positioned for growth by branching out from powder-coating operations to the lucrative business of biodiesel, oleochemicals, resins, and other specialty chemicals. We are generally confident on how well this business shall achieve considering the economic potential and long-term sustainability of biodiesel.

Sunday, October 16, 2011

Reporting Hedge Fund Performance

Great investment operations endure the test of time, spanning decades of consistently compounding money. Along these lines, we strongly maintain and attempt to be the same and consistently reach double digits growth on an annual-basis. 
This is Part 5 of a Series. Go to Part 4: Accounting as the Language of Business

The following is a portion of a letter addressing my partners which states, clarifies, and addresses the operating principle behind that private investment partnership (i.e. hedge fund) I began. I would recommend that you start your reading at the beginning.

Noting performance, our aggregate partners’ equity increased 2.82% from its inception on November 22, 2010—the date of approval of our proposed Articles of Partnership and registration with the Securities and Exchange Commission (SEC)—up to 2010’s yearend. This translates to an effective annual rate of return of 26.42% (computed as 2.82% multiplied by 365/39 days).

Saturday, October 15, 2011

Accounting as the Language of Business

We, as passive investors should be shrewd businessmen, having the technical operations of the business delegated but still mindful and prudently watchful of the state of our assets. 
This is Part 4 of a Series. Go to Part 3: Conservative Expectation on Rate of Return

The following is a portion of a letter addressing my partners which states, clarifies, and addresses the operating principle behind that private investment partnership (i.e. hedge fund) I began. I would recommend that you start your reading at the beginning.

I’m sure none of us are strangers to the basic dynamics of how a business works financially. Generally, we are faced to lay out some cash, depending on the industry, to allot for initial working capital (e.g. inventory, revolving fund, etc.) or to spend on capital expenditures (e.g. fixtures, equipments, etc.) hoping the venture would payback these outlays later on; transactions are inevitable when conducting the affairs of a business.

Friday, October 14, 2011

Conservative Expectation on Rate of Return

We shall have a more conservative expectation on our rate of return, limiting it and not being excessively optimistic in our prospect than what our underlying held companies, in their operational and financial capacities as real businesses, can realistically achieve.
This is Part 3 of a Series. Go to Part 2: Business Perspective Attitude and Owner Mentality

Note: The following is a portion of a letter addressing my partners which states, clarifies, and addresses the operating principle behind that private investment partnership (i.e. hedge fund) I began. I would recommend that you start your reading at the beginning.

Consequently, we shall have a more conservative expectation on our rate of return, limiting it and not being excessively optimistic in our prospect than what our underlying held companies, in their operational and financial capacities as real businesses, can realistically achieve.

Thursday, October 13, 2011

Business Perspective Attitude and Owner Mentality

Stocks, by their very nature, are long-term; evaluating them, as true businessmen do, takes into consideration the years it commonly takes to recoup initial outlay, conservatively vouching on the cash-generating economics of the venture.
This is Part 2 of a Series. Go to Part 1: A Filipino Hedge Fund

Note: The following is a portion of a letter addressing my partners which states, clarifies, and addresses the operating principle behind that private investment partnership (i.e. hedge fund) I began. I would recommend that you start your reading at the beginning.

With this business-perspective attitude and owner mentality towards our partnership’s investments—treating them as real businesses with operating realities and not merely paper assets whose value wiggles daily—we naturally take the position of being long-term investors, buying firms and holding them indefinitely. It is only intuitive that we follow this long-term approach if we really want to take advantage of their true compounding power.

Wednesday, October 12, 2011

A Filipino Hedge Fund

Legally, our fund is a private investment firm organized as a limited partnership (wherein you are the limited capitalist partners, and I am, while also being a contributing capitalist partner, the designated general industrial partner) whose primary purpose is to invest in various investment instruments, particularly shares of corporate stocks, without acting as a dealer in securities.
This is Part 1 of a Series.

When I started that hedge fund which I first mentioned here, I wrote my partners a preliminary letter trying to state and address the operating principles behind the private investment partnership. Below is that letter which I would like to share to everyone. I come back reading it from time to time just to remind psyching myself into that rational business paradigm behind the stock market.

January 6, 2011

DEAR FELLOW PARTNERS:

While it is too early to talk about fund returns and performance, I write and send this letter (along attached financial reports) to ground-break our partnership’s investing operations—to start this capitalist tradition of wealth-consciousness, transparency, and passion for business-perspective investing.

Tuesday, October 4, 2011

The Uncertainty of Bottom-Fishing Versus the Certainty of Striking the Bargain Deal Now

Bargain! What are you waiting for? You can never be so sure when the bottom is coming.  That's the uncertainty. You can, however, assess the bargain deal now, and strike it now. That's the certainty.
This is Part 2 of a Series. Go to Part 1: The Uncertainty of Price Movement Versus the Certainty of Underlying Value in Bear Markets

The following was my response to an online forum inquiry regarding bottom-fishing and timing the exact, opportune moment of getting into the bear market.

Timing (or rather, precision timing) isn't really so everything...

Once a bargain price is established, we won't necessarily have to fish for the bottom—because what matters is that the purchase has already been done and executed at a bargain price regardless whether the price further dives or not.

The Uncertainty of Price Movement Versus the Certainty of Underlying Value in Bear Markets

The Age of the Bear. There's no guarantee the stock will stop falling despite buying it at a bargain. But never mind that, because the intent anyway is to capture gains not necessarily through stock price appreciation but through consistent, predictable underlying value.
This is Part 1 of a Series.

The following was my response to an online forum inquiry regarding bottom-fishing and timing the exact, opportune moment of getting into the bear market.

While bargains even during a bull market are possible, a bear market, such as what we're experiencing now, offers the best opportunity for fire sale stocks. You can never be so certain when the stock price will stop falling. You can only be certain, nonetheless, that the stock is already a bargain relative to some underlying value.

Sunday, September 25, 2011

Republic Cement as an Equity Bond with an Expanding Coupon

It's just a cement bag. No! For me, it's an equity bond with a powerful compounding/expanding coupon!
This is Part 2 of a Series. Go to Part 1: How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

We turn ourselves to Republic Cement (PSE: RCM), a company I was able to purchase three years back then (and still holding) when it was still selling below book value.

Fast facts: It’s been in the business of manufacturing and selling cement for decades. It’s currently the market leader; majority holder is that worldwide leading French cement company called Lafarge. Catastrophe risk is almost minimal.

So let’s try to apply the simple appraisal steps noted earlier...

How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

Foresight? In stocks, hindsight is clearer and easier. While we know by hindsight what the excellent business is capable of performing, we downplay our prospects of it, and content ourselves with the more likely, easily achievable, conservative scenario.
This is Part 1 of a Series.

I’m starting to be more inclined towards fast but very conservative approaches in rate of return and intrinsic value appraisals. Because no matter how detailed, elaborate, or complex our models are, if the assumptions, programming, or the projections themselves are too optimistic and aggressive, then the likelihood of achieving these forecasts would be thinner. And the same thing goes with achieving superior returns.

What we simply want to do is downplay our prospects, minimize our expectations, and be happy and content ourselves with the safe, very achievable, conservative scenario, and pay a reasonable price for that—all these despite knowing by hindsight that the business is much more capable and can offer more!

Thursday, September 22, 2011

BIR Tax Legality, PSE Administrative Impossibility, Logistical Burden, Illiquidity Tendencies

This is Part 2 of a Series. Go to Part 1: The Philippine Stock Exchange Tax Dilemma—Clarifying the ½ of 1% Stock Transaction Tax and the 5 to 10% Capital Gains Tax

The Ayala Tower One & Exchange Plaza: seat of the Philippine Stock Exchange (PSE) in Makati. Implementation of the capital gains tax rule on traded stocks through the local exchange is problematic legal-wise, and poses administrative issues. It may actually deter liquidity than improve it.
Problematic Legal-wise. I still have my reservations on the applicability of the 5 to 10% CGT on traded shares of listed firms primarily because there’s no provision in our National Internal Revenue Code (NIRC) saying that when a listed firm falls below the MPO requirement, it should be subject to the CGT. Under Sec. 127 (A), the tax code was very clear and particular that shares traded through the local stock exchange shall be subject to a final ½ of 1% STT.

The 5 to 10% CGT stipulated under Sec. 24 (C) of the tax code, on the other hand, is actually intended for shares not traded in the stock exchange, and not for those traded through the local stock exchange. So even if the BIR issues a Revenue Regulation ordering and outlining the implementing guidelines, this would conflict against the provisions of the tax code. I’m not a lawyer, but by the rule of law, it’s going to seem null and void. The only way to put it into effect legally is to revise the tax code, and the tax code is law. Revision of law requires involvement, consent, and action of our legislature—the Congress and the Senate.

The Philippine Stock Exchange Tax Dilemma—Clarifying the ½ of 1% Stock Transaction Tax and the 5 to 10% Capital Gains Tax

This is Part 1 of a Series.

The Bureau of Internal Revenue Main Building. While the ½ of 1% stock transaction tax is applied on the gross selling amount, the 5 to 10% capital gains tax is imposed on, well, just capital gains, and not on the whole gross selling amount.
There seems to have a revived stir among Philippine Stock Exchange (PSE) investors on the insistence of the Bureau of Internal Revenue (BIR)—with the backing of the Department of Finance (DOF)—that a 5 to 10% capital gains tax (CGT) be imposed for traded stocks of listed firms that failed to comply the PSE minimum public ownership (MPO) requirement of 10 to 33% (depending on the company's market capitalization). It has been revived particularly because of recent news articles (e.g. that one from the Philippine Daily Inquirer) having a seemingly confirming tone that this ruling is already scheduled for implementation.

Currently, the tax being imposed on traded stocks in the local exchange is the ½ of 1% stock transaction tax (STT). Consequently, most have initially perceived that the CGT, being 5 to 10%, immediately leads to higher tax costs because at first sight, it does indeed seem that way (5 to 10% > ½ of 1%).

Yet these assumptions should be clarified. Because while the STT is applied on the gross selling amount (i.e. Selling price x no. of shares sold), the CGT is actually applied only on capital gains (i.e. Gross selling amount – gross purchase amount)—that is, 5% on the first Php100k capital gains, and 10% on capital gains in excess of the first Php100k.

Tuesday, September 20, 2011

The Purpose of the Margin of Safety is to Render Forecast Unnecessary

This is Part 8 of a Series. Go to Part 7: Phil Fisher-Type Growth Company at a Ben Graham-Like Price

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

Question from an Audience: I'm kind of interested in the scratch notes that you were talking about ... If someone who was very quantitatively-oriented and knows excel looked at that and put it into a model, do you think he could understand what's going on inside Warren's head when he's trying to value a company, and actually replicate that?

Alice Schroeder: There's a saying, let me call it to mind... I think it's from the Intelligent Investor: “The purpose of the margin of safety is to render forecast unnecessary.”
Yes. What you would see is a column that said sales, and a column that said expenses, and a column that said profits, and it would have Kentucky plant, Lulaville plant, Kansas City Plant, this plant, that plant, and it would have 1st quarter, 2nd quarter, 3rd quarter, 4th quarter, 1958, etc., and then it would end with the last quarter that was reported...

That's what it is.

That's all this is. And the difference from a model is that it would not add the quarters up, and it would not project anything into the future, nothing. In other words he looked at what had been reported, and he said they've earned a million in sales; they've earned this many thousands. I want this much. They earned this, I want this, can they do it? Yes/no? That's the decision.

Phil Fisher-Type Growth Company at a Ben Graham-Like Price

This is Part 7 of a Series. Go to Part 6: Buffett’s “Discounted Cash Flow Model”

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

And that was typical. I gave you this example in part because it was that other time, apart from Geico that he got a Phil Fisher-type growth company at a Ben Graham-like price. It was the most vivid example of that that I found. But it was a private investment and there's not a lot of public information about it available.
And he ended up putting $60,000 of his personal non-partnership money into this company which was about 20% of his net worth at the time. He got 16% of the company stock plus some subordinated notes. And the way he thought about it was really simple. It was a one-step decision. He looked at historical data, then he had this generic return that he wants on everything, it was a very easy decision for him, and he relied totally on historical figures with no projections. I think that's a really interesting way to look at it because I saw him do it over and over on different investments.

So what happened? Well, the company changed its name to Data Documents. he owned the investment for 18 years. He ended up putting up another million dollars over time. It was bought out by Dictograph in 1979 and he earned a 33% compounded return over the 18 years that he owned the investment. So it was not too bad.

Buffett’s “Discounted Cash Flow Model”

This is Part 6 of a Series. Go to Part 5: Handicapping—The One or Two Factors that Could Make the Horse Succeed or Fail

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

Okay, so what he did is, he incorporated his whole earnings model and compounding discounted cash flow into that one sentence: I want 15% on 2 million of sales. Why 15%? Because Warren's not greedy. He always wants a mere 15% day one return on investment and then it compounds from there. That's what all he ever wanted, he's happy with that.
And then he took all the historical data, quarter-by-quarter, for every single plant; he got this similar information as best he could from every competitor they had and he filled pages with little hand scratches of all this information and he studied that information and then he made a yes/no decision. He looked at it: they were getting 36% margins, they were growing over 70% a year on a million of sales. So that's where he looked at the historic numbers in great detail, just like a horse handicapper studying the tip sheet. And then he said to himself: I want a 15% rate of return on 2 million of sales. And then he said: Yeah I can get that.

Okay, so what he did is, he incorporated his whole earnings model and compounding discounted cash flow into that one sentence: I want 15% on 2 million of sales. Why 15%? Because Warren's not greedy. He always wants a mere 15% day one return on investment and then it compounds from there. That's what all he ever wanted, he's happy with that.

Handicapping—The One or Two Factors that Could Make the Horse Succeed or Fail

This is Part 5 of a Series. Go to Part 4: Assessing Catastrophe Risk—A Quick Way to Say Yes or No

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

Everybody that I know or knew as an analyst would have created a model for this company and would have projected out earnings and would have looked at its return on investment in the future. Warren didn't do that, in fact in going through hundreds of his files, I've never seen anything that resembled a model. What he did is: he did what you would do to a horse. He figured out the one or two factors that could make the horse succeed or fail. And on this case, it was sales growth and making the cost advantage continue to work.
Okay, so now, Warren is interested. Because the catastrophe risk element of the equation is gone. They are competing successfully against IBM. So he asked them the numbers and they explained to him that they were turning their capital over seven times a year. So a Carroll press costs $78,000. Every time they run off a set of cards through and turned their capital over, they’re making over $ 11,000. So basically, their gross profit a year on a press is enough to buy another printing press.

At this point, Warren’s very interested. Their net profit margins are 40%. It’s like the most profitable business that he’s ever had the opportunity to invest in. Notably, people are now bringing Warren special deals. It’s 1959. He’s been in the business two and a half years running the partnership. Why are they doing that? It’s not because they know he’s a great stock picker. They don’t know that. He hasn’t yet made that record. It’s because he knows so much about business, and because he started so early that he has a lot of money. So this is something interesting about Warren Buffett. By 1959, people are already bringing him special deals like what they’re still doing today with Goldman and G.E.

Assessing Catastrophe Risk—A Quick Way to Say Yes or No

This is Part 4 of a Series. Go to Part 3: Handicapping, Compounding, and the Margin of Safety—Alice Schroeder’s Take on Buffett’s Approach

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

He didn’t say no because it was a technology company. He said no because he went to the first step in his investing process. And this is where I think, what he does is very automatic and isn’t well understood. He acted like a horse handicapper. And the first step in his investing process is always to say: what are the odds that this business can be subject to any catastrophe risk that could make it just fail?
Before computers were digital, they actually read off of punch cards, they were called mark-sense cards, and these were big deck of cards that had holes punched in them and they would be stuck in the computer and, being non-electronic, they were sent mechanically through the computer. So this company was formed because IBM had to divest off this business. It was an incredibly profitable business. In fact, because these cards were trivial compared to the mainframe computers that IBM sold, it marked them up to get more than a 50% profit margin. This was IBM’s most profitable business.

So Wayne Eaves and John Cleary, two friends of Warren, saw that IBM was going to have to divest in this business and they thought they’re going to buy a Carroll press which was the press that makes these cards. They’re going to compete with IBM because they’re based in the Midwest; they can ship faster, and provide better service. They went to Warren and said: should we invest in this company and would you come in with us? And Warren said no.

Handicapping, Compounding, and the Margin of Safety—Alice Schroeder’s Take on Buffett’s Approach

This is Part 3 of a Series. Go to Part 2: The Margin of Safety Mentality—A Cornerstone of Value Investing

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

But there are three other factors to his success that I would like to talk about and focus a little bit differently than he normally explains the way he invests. That is, handicapping, compounding, and the margin of safety. These are three concepts that work together. He uses them in a slightly different way than he would think of describing them publicly
I think everybody, or everyone who’s read the Snowball knows, how hard Warren Buffett has worked and how much learning he’s done. But there are three other factors to his success that I would like to talk about and focus a little bit differently than he normally explains the way he invests. That is:

  • Handicapping
  • Compounding
  • The Margin of Safety

These are three concepts that work together. He uses them in a slightly different way than he would think of describing them publicly; they’re all discussed in the book.

I’d like to take you through a case study on an investment called Mid-Continent Tab Card Co. This was a private investment that he did in his personal portfolio and this kind of shows you how I saw him invest based on his personal files and what he actually does, and I’ll update that up to the present day.

The Margin of Safety Mentality—A Cornerstone of Value Investing

This is Part 2 of a Series. Go to Part 1: The Quantitative Principle of the Margin of Safety

The Margin of Safety as a Conservative Mentality or Attitude. It's all about managing your expectations, toning them down, and being realistic about them.
A different way of viewing the margin of safety principle is to think of it as a qualitative concept—an attitude or mentality, if you may. It is that mentality of being bias towards conservative approaches of intrinsic value appraisal which would guarantee protection from permanent capital loss but at the same time exposure to that bonus of rational potency of earnings.

It is that attitude towards using conservative assumptions even if you know the underlying business is much more capable. It’s somewhat intentionally downplaying the growth prospects not because you don’t believe the company won’t grow or boom, but that you’d rather bank on something that can be easily ascertained/achieved by the proven earning capacity of the business, and content yourself with that. Because while you know there’s much more into the investment, you’d rather not delve into complex forecasts, since, after all, if it’s really that good, actual earnings and free cash flows will take care of themselves.

The Quantitative Principle of the Margin of Safety

Margin of Safety as a Percentage Discount. Say the intrinsic value estimate is Php100, a 50% margin of safety would net Php50, the safe price to buy the stock.
This is Part 1 of a Series.

I’ve been blabbering about capital preservation and rational potency of earnings lately. And while watching a Value Investing Conference 2008 video of Alice Schroeder (author of The Snowball: Warren Buffett and the Business of Life) talking about Buffett’s simple thought process in investing, I was particularly struck when she said: “The purpose of the margin of safety is to render forecast unnecessary.” It was a golden nutshell statement which succeeded elegantly in trying to communicate what I intended to point out when I wrote somewhat extensively about capital preservation and rational potency of earnings.

She described that most analysts would rely on a model that would forecast future cash flows then discount them at an appropriate rate. Surprisingly, Schroeder points out that Warren never bothered with financial models. What?! His thought process puts great emphasis, instead, on analyzing historical data in great detail (i.e. sales, expenses, profits in each plant, quarter-by-quarter) then he’d have this generic required rate of return of 15%, and glean whether the business is capable of achieving it or not. He compares—they earned this much, I want this much... Can they do it? Yes/No. It was a very simple decision.

Friday, September 16, 2011

Capital Preservation and Rational Potency of Earnings

This is Part 2 of a Series. Go to Part 1: On Discount Rates, Required Rate of Return, and Conservative Purchase Price.

The idea behind capital preservation is defensively allocating capital in a safe investment position (thus, preserving your money’s worth) but at the same time exposing it to the prospect of profits (or capital gains)—Simply, it is earning without risking losing money. The cardinal concern shouldn’t really be profits—it should first be preserving capital. Profits only come secondary after making sure we don’t lose money. If we start concerning ourselves on this primary consideration, then we’d undoubtedly be diligent and be very cautious in our allocations.

Earning without risking losing money. Capital preservation should remain top priority, with earning profits only being an afterthought.
So if that be the case, then why not just easily opt to hold hard cash, you may think? Well that’s hardly the solution. Complacently leaving your cash lying in the room or under your bed or pillow would diminish its worth because of that value-sucking animal called inflation—the real enemy. Capital preservation is therefore achieved only through placements in value-enhancing instruments which, at the least, beats inflation.

In the realm of stocks, capital preservation can be ascertained by banking on very conservative assumptions of underlying value. Why underlying value? Because that can only be your best bet towards consistency and predictability. If you rely on market value, you’d be subjecting yourself to the whims, emotions, and ups-and-downs of the market. And that would certainly not preserve capital. (An aside though: take note that this is only true if we exempt arbitrage plays; in arbitrage scenarios, the pursuit of value is not found on the underlying business, but rather on the difference between prevailing market price and the publicly declared market tender offer—the arbitrageur viewing the discrepancy as his source of value gain). Nonetheless, certainty is key.

On Discount Rates, Required Rate of Return, and Conservative Purchase Price

Why do we discount something? We discount a future value because we want to know the right price to pay now to achieve that discount rate as our required rate of return. Or maybe we don't necessarily want to accurately achieve our target rate; we just want, at least, to estimate a conservative purchase price that will preserve capital and put some potential earnings exposure, leaving most of the actual returns to chance... Just maybe.
This is Part 1 of a Series

Discount rates often seem too complicated when they should be not. Because the idea behind them is similar to an interest rate. Interest rates, for most of us, are easier to comprehend because of their familiarity in everyday practical use. Say we have Php100 and a bank deposit placement offers a 10% interest rate per annum. Should we decide to put it there and hold it for a year, our Php100 will be Php110 [Php100 x (1+10%)]. It’s very straightforward and helps to answer the question: How much money will we get in the end? Or algebraically, the unknown being sought is FV (future value):

FV = PV x (1+i)^n

By contrast, if what is known and offered to us, instead, is a future value amount, the question now is: How much are we willing to pay for it now? Algebraically, after transposing the variables, our unknown this time is PV (present value):

PV = FV / (1+i)^n

So if we are offered Php110 and we want to achieve a 10% rate of return after a year, we should be paying Php100 [Php110/ (1+10%)]. The interest rate and discount rate are thus one of the same nature. The difference can be attributed to the circumstance—that is, the term interest rate is used if we’re talking about finding the future value of a principal amount we would want to invest now. The term discount rate, on the other hand, is spoken if we’re talking about finding a present value we would be willing to pay now provided we know what the future value outcome would be.

Wednesday, September 14, 2011

On Realizing Gains, Compounding Value, and Equity Perpetuity

This is Part 2 of a Series. Go to Part 1: On Price, Value, Value Investors, and Equity Perpetuity

The following are excerpts from a discourse I had with a fellow investor with regards to realizing gains, compounding value, and equity perpetuity. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Realizing profits versus compounding value. On one hand, the impulse and instant gratification of realizing profits ironically brings you back to that burden of finding another bargain; on the other, you may have just held onto that stock and let compounding do its magic.
On realizing profits: If the intention is to compound value and amass net worth (i.e. to be rich), then you wouldn't worry about not realizing capital gains. That's the irony in selling stocks—on one hand, by impulse, you just want to realize your paper profits. Realizing your capital gains, however, would again bring you back to that burdening position of finding another bargain (and exposes you to taxes) if you intend to reinvest and further create value. On the other, you may have just indefinitely held onto that stock as long as the underlying business takes care of itself (which in turn takes care of the price). And what is easier and which I personally prefer is the latter case wherein you let the value compound within the business, i.e. that's why I prefer non-paying dividend companies able to retain earnings and compound them at sustainable high rates than businesses paying out all their earnings in dividends (which again exposes you to taxes) at the expense of growth.

On Price, Value, Value Investors, and Equity Perpetuity

This is Part 1 of a Series

The following are excerpts from a discourse I had with a fellow investor with regards to future price projection, focusing on business value, and the usefulness/relevance of the equity perpetuity theory. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Value investors don't project price, they project value. It should always be some underlying value you're anticipating to get. The difference maybe subtle, even trivial, but in my view, crucial and vital.
The whole intent behind the equity perpetuity concept is to find a safe purchase price (for an excellent business) to achieve your required rate of return. The intention is not to project a target sell price or predict the market. The intention, primarily is capital preservation (through sound business/fundamental basis as represented by forecasted flat earnings/cash profits—you can never rely on market swings/movements to preserve capital anyway) and exposure to rational potency of earnings. And that's primarily the focus and intent of value investing.

Indeed, the principle of value investing is purchasing excellent businesses at bargain prices and not to forecast a future stock price or predict what the market will do. And that being the case, value investors are first and foremost, naturally conscious and very focused on not losing money (that's why all the fuzz on buying a bargain price)—that is, capital preservation—but with the added benefit of exposure to rational potency of earnings (i.e. because of buying into a defensive stock position with an underlying profitable business).

Anticipating a future stock price should never be explicit. Because once you start throwing off some stock price projection tool, the focus tends to be just that: market price forecasting. And there's the peril of neglect where value comes in the first place—the underlying business.

Sunday, September 4, 2011

Rate of Return on Equity Perpetuity: Dividend Yield and Free Cash Flow Yield

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and the Equity Perpetuity Theory

If we start to think of stocks as perpetuities (i.e. if we intend to be passively enriched as the "equity" perpetuity unendingly pays us flat dough—regardless what the market is schizophrenically doing) then we might as well identify which "equity" annual payments we’d be considering and discounting. Once we identify these, we'll discover that the rate of return on our equity perpetuity is nothing more than two familiar, often used (but also often misunderstood) measures: the dividend yield and free cash flow yield.

Return Measures of the Equity Perpetuity. When we conservatively assume a stock is a perpetuity and try to derive a rate of return, we're mathematically bound to eventually use the Dividend Yield and Free Cash Flow Yield.
If we choose cash dividend payments, then we’re effectively using the dividend yield. If a stock has recently paid out dividends of Php100 and we assume that it’s gonna issue dividends year after year (since it’s been doing that for years already) and we also assume these will be flat, then we'd have to discount Php100 at a rate we'd want to achieve (i.e. 15%). Using this conservative frame of mind, the stock, obviously, has got to be worth Php666.67 (Php100/15%). On a flipside, if the same stock’s trading at Php500 and we bought it at that price level, then perpetuity-wise (i.e. assuming flat payments forever), our rate of return shall conservatively be 20% (imagine: that is regardless whether the market shuts down or commits suicide—you’re just relying on the fundamental dividend-paying capacity of the underlying business). The dividend yield shall be that equity perpetuity yield from a dividend-conscious perspective. Isn't the Dividend Yield more meaningful if taken from a flat-dividend-paying perpetuity standpoint?

Intrinsic Value and the Equity Perpetuity Theory

This is Part 1 of a Series

Flat cash payments into infinity. To think of stocks as "equity" perpetuities can be a useful, conservative mindset to quickly assess a reasonable purchase price. Despite projecting perpetual annual cash payments, they're still assumed, nonetheless, flat!
Thanks to that contemplation on how relevant and useful the P/E Ratio and Earnings Yields are, I’ve been thinking about perpetuities often these days. And because of that, I’m starting to think of stocks as perpetuities. It’s reasonable, after all, if you intend to indefinitely hold on to an excellent business which would continuously and unendingly generate you bucks passively year after year after year (and beyond). And the great thing about perpetuities is that, they’re conservative! They’re conservative primarily because of their flat or fixed annual payments assumption. We do all know that a good company shall be able to expand or grow its cash profits year after year. So if we’re going to assume flat earnings, then that’s definitely being conservative, don’t you agree? To think of stocks as perpetuities shall be a conservative, appropriate mindset, for a prospecting, long-term rational investor conscious of a reasonable purchase price.

Friday, September 2, 2011

Squeezing the Rationale Behind the Price/Earnings Ratio... or at least its Twin, the Earnings Yield

I’m not really a fan of the Price/Earnings (P/E) Ratio.Why would you want to divide the stock price by its earnings, anyway? Have we even really thought what kind of information we'll get from that? Or are we using it just because everyone else is. Let’s be honest.

P/E Ratio & Earnings Yield. The P/E Ratio personally doesn't appeal to my reason. Its reciprocal, the Earnings Yield, however, seems to be more logical. It's very reminiscent of the rate of return of a perpetuity annuity!
Well, I’ve been thinking about it... And the immediate, most seemingly logical explanation I can muster (to justify its use) is this: It essentially computes the breakeven period (in years) it would take to recover that stock price you’d be paying assuming the company continues to flatly produce the same earnings. Doesn’t it make sense from this stand point? But why would you want to know that, anyway?

The only way I can think of to make sense of the P/E ratio is by taking its reciprocal—that is, instead of dividing the stock price by its earnings, we do the opposite—divide earnings by the stock price. Thus, we get the Earnings Yield, P/E’s reciprocal twin. I have to admit I had my initial reservations on using this ratio. But after going through several valuation techniques and further pondering on the DCF approach/analysis, the simplistic rationale behind the earnings yield suddenly lit up!

Tuesday, August 30, 2011

Scalability and Predictability of Investing

The premises of the trader and the investor with regards to how each views their gains, are distinct from each other. These significantly impact each of their buying and selling behaviors.

All in for predictability of business gains. The consistency inherent in excellent companies makes owning them bankable and scalable worthy of an investor committing and tying serious amounts of money indefinitely.
On one hand, a trader takes on the perspective that his returns are ultimately dictated by stock market capital gains (i.e. trading gains), and therefore, it shall only be necessary to buy and sell (i.e. trade) a stock position. The activity necessitates active management of cash/liquidity; naturally, the trader is concerned of being liquid in the end of the day (or week, or depending on his trade plan)—that is, being able to eventually close his stock positions and have them in liquid cash at his disposal to execute new trades. It is a relentless pursuit. That being the case, the trader cannot help but be always reluctant of committing serious amounts of money when executing a certain trade or play, because of the unpredictability of the schizophrenic market that is driven by the emotions of fear and greed.

Sunday, August 28, 2011

Enabler Which Makes Stocks Passive: A Management In Place

Let Management do the heavy-lifting. Publicly-listed companies already have that bonus of having management teams run the business. An owner/entrepreneur should aspire the same thing for his private business to free him up from the day-to-day grind of operations, and make him focus more on being an investor concerned of profitably allocating capital.
How many times have we seen thriving businesses which come to be just that—small businesses? The owner/entrepreneur's time has been so caught up with active involvement in the day-to-day operations that overlooked are the possibilities of automation and delegation. Other opportunities of profit-making ventures are neglected, too.

Virtues of industry and hardwork are important. But if one intends to make a business expand, prosper and make a lot of dough in the process, there should also be that added element of delegation. One can be business-minded, conscious, and concerned about his company's operating realities, but it does not mean he has to be necessarily actively and always engaged in its day-to-day operations.

Because while businesses are alive, operating entities, they eventually ought to run by themselves and be passive—we can’t call it a money machine anyway if your toil and labor involvement are always required! While we are businessmen, we are also an investors, and that being the case, we should aim to focus and allot more of our time on profitable capital allocations as our founded/acquired businesses run by themselves...

Friday, August 26, 2011

Money-Weighted Rate of Return: It's All About Absolute, Actual Returns

This is Part 3 of a Series. Go to Part 2: Time-Weighted Rate of Return: It's All About Relative, Simple Yields

Note: The following is a letter addressing my partners which clarifies the money-weighted (MW) and time-weighted (TW) measures of performance. I would recommend that you read first the earlier letter before proceeding.

March 6, 2011

TO MY PARTNERS:

The Money-Weighted Rate of Return. This rational measure of performance tries to capture the internal rate of return (IRR) of the portfolio. It is therefore sensitive to the timing and size of cash inflows (outflows) and accurately depicts absolute returns per actual fund results.
My January 12, 2011 letter presented how my personal portfolio has yielded since its inception in 2008. My number-crunching, while honest and innocent, failed to mention two ways in which fund returns maybe measured: the money-weighted (MW) and time-weighted (TW) approaches. For everyone’s information, the 17.15% rate of return previously presented considered the time-weighted method. Through this letter, I intend to further delve into this issue of measuring performance. I cannot overemphasize the importance of this matter to the investing partner; although I have to apologize in advance should this presentation be too technical.

Essentially, TW captures this scenario: had I started the fund with a pioneer partner in 2008 and that partner did not make any deposits to and withdrawals from the fund, he should be earning a 17.15% compounded annually. In reality, however, this may often not be the case: he may be making additions or withdrawals (these can dramatically magnify his profits or losses depending on how the fund performed after the additions/withdrawals)—this is the essence of the MW approach; it captures and weighs the timing and money amounts committed for any given period and pinpoints the real absolute returns per actual fund results.

Time-Weighted Rate of Return: It's All About Relative, Simple Yields

This is Part 2 of a Series. Go to Part 1: Measuring Portfolio Performance: The Market-Conscious Side of the Rational Investor

The Time-Weighted Rate of Return. This rational measure tries to capture the fund performance in terms of simple, periodic returns, discrediting the distorting effects of infusions and withdrawals.
Late last year, I began a private investment partnership (in common parlance, a hedge fund) with some friends and family members. Although the original plan for the partnership was to carry it on indefinitely as a going-concern, my partners and I were forced to liquidate it just recently because of personal constraints (this is another story). What follows are two letters addressing my partners on the subject of measuring performance. The first letter tries to explain my personal fund’s time-weighted performance (although it didn't explicitly tell I was using TW; I still had then the faintest idea of using the MW approach and thought that TW is the only correct way of presenting and measuring returns). The second letter explains the MW approach; there, I tried to explain and reconcile the differences between both approaches.

Note: For privacy and other reasons, while my portfolio's starting capital is presented below to be Php100,000, this isn’t the exact, actual amount; accordingly, succeeding deposits (withdrawals) and gains (losses) are proportionately adjusted.

Measuring Portfolio Performance: The Market-Conscious Side of the Rational Investor

Rational Measures of Portfolio Performance. The Time-Weighted and Money-Weighted rates of return are two standard rational measures of portfolio return.
This Part 1 of a Series.

It was sometime early this year when I finally decided to bring unto myself the task of measuring the rate of return achieved by my personal portfolio. The whole idea intrigued me—I knew it's making some money, but knowing how much money—well, that really captivated my imagination.

I know the exercise was somewhat hypocritical... I preach business perspective investing which always focus on the financial performance of the stock based on its merits as a true, performing business, and give little or no value to how its stock market price performed.

While I admit I measure my portfolio’s returns based on stock price performance, and that this is my yardstick as a market-conscious fund manager, I likewise admit and insist (and I don’t see any inconsistency in saying) that in my career as a rational investor, my focus, nonetheless has still been and always will be the virtues of the underlying business. Further, I see that using and practicing value investing principles in managing my portfolio is an experiment and a profitable endeavor altogether. It is an experiment which tests whether this premise is true: "that the market may take an inconveniently long time to adjust to a rational valuation; (we) don’t know what the mechanism is, but (we) can tell that in our experience, it usually does readjust eventually" – Benjamin Graham on the market being rational (taken from the book Warren Buffett: An Illustrated Biography of the World’s Most Successful Investor).

Monday, August 22, 2011

Intrinsic Value and the Equity Bond Theory

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and Bond Valuation

Equity Bond. A stock can likewise be thought of as a bond whose worth is just the sum of all its discounted free cash flows. The difference from your regular bond being: the equity bond yields expanding coupons!
Following the line of rational thinking usually applied in bond valuation, a business, in the same manner, is only worth all the discounted future cash flows it can provide. A business, therefore, can be thought of as an “equity” bond. The question now is: which cash flows should we consider and discount?

An extreme take on this paradigm is the Dividend Discount model. Taking on the assumption that the significant cash flows are only those dividends actually paid to the shareholders, the model intends to value a stock based only on these dividends. The immediate problem on this extreme view is how detached it is from the real, internal cash-generating capacity of the business. For one, it can be deceptive since dividends by themselves say nothing of the operating realities of the underlying asset—they can even be financed through externally sourced debt at the immediate pleasure of naive, detached “owners”, but at the immense detriment of long-term, business sustainability. Another reason is that, there's also those companies which are really good at making money but are not in the habit of disbursing them as cash dividends. It's not that they don't want to share the profits, but that even the board of directors and the shareholders favor income retention because management is capable of further deploying these profits in investments that would further compound wealth.

Intrinsic Value and Bond Valuation

This is Part 1 of a Series

The intrinsic value of an asset is only worth the sum of the present values of all the future cash flows it provides. This is the assumption of bond analysis and valuation. When you buy a bond, you are offered interest or coupon payments which you receive in varying intervals (e.g. monthly, quarterly, semi-annually, annually, etc.). You pay upfront for the principal, receive interest payments, and finally receive that principal you initially paid for upon maturity (i.e. expiration date of the bond).

Coupon Bonds. In bond analysis, a bond is only worth the sum of the present values of all its coupon payments and principal upon maturity.
What is Present Value? It is the discounted value of a cash you’d be receiving in the future. It is based on the premise that as rational capitalists, we give more value to cash we can hold, spend, or invest now (at the present time) than the same cash amount we would receive in the future. It does make sense if we observe an extreme example: were you offered a million pesos, would you rather have it now or have it 10 years later? Most definitely, that Php1M is worth more to you now than it is (at the same amount) 10 years after!

How about Discounting? Discounting is a technical, finance-slang term akin to your more familiar, layman’s interest rate. Say you have a Php100 and you offered it to me as a loan with 10% interest per annum. After a year, assuming I stay true and make good our original terms, your Php100 would be worth Php110.

Sunday, August 21, 2011

FEU’s Cash Hoard. And They Said School is Boring...

This is Part 3 of a Series. Go to Part 2: So Where Have All Those Free Cash Flow Gone?

Majestic Campus. FEU is one of those few quality businesses that routinely produce and hoard free cash for the wealth enrichment of its owners.
I can’t blame anyone who thinks school is boring. Be it on what one may have experienced back in high school or college (e.g. boring classes and teachers/professors), or in stocks (i.e. boring, illiquid issues that hardly move in the market). But let’s take on the shoes of a prospecting investor interested in the fundamental cash-generating dynamics of a school as a business.

Disclosure: I'm currently a shareholder of Far Eastern University—yes, it is listed in the Philippine Stock Exchange (PSE: FEU).

Grasping the core business model of a school seems easy. Schools teach and prepare students for the real world, and in return collect tuition fees for this education service. As many are aware, they collect these fees upfront; before a student can walk into a classroom to learn, he must first pay the registrar a visit and write the accounting department a check. Not mentioning its other sidelines (such as leasing certain properties owned and deploying excess cash into other non-core business investments), that's how a school primarily makes its money.

Friday, August 19, 2011

So Where Have All Those Free Cash Flow Gone?

This is Part 2 of a series. Go to Part 1: The Corporate Cash Hoard Theory

Flow Accumulation. Doesn't the thought of where free cash flow has been accumulating merit contemplation?
A company’s cash hoard is similar to the idea of accounting profits being accumulated in equity’s retained earnings. In this case, however, we're talking money—that is, cold hard cash, not booked accruals, or capitalized expenses. If one is so conscious about observing free cash flow and one subscribes to the idea of it being the true measure of cash profits, the more so should be with how and where it accumulates. That is, that “free cash equity” base where all those free cash has accumulated.

Remember that free cash flow tracks internally-generated earnings realized in cash. That being so, it does not give any bearing or value to booked receivable sales, booked payable expenses, externally sourced cash, as well as prepaid expenses, inventory, and capex assets which are all actual cash outlays. Following this bias on internally-generated cash, the balance sheet accounts can appropriately be reclassified as follows:

ASSET SIDE
  • Free Cash Assets – they include cash & cash equivalents and non-core business investments (stocks, bonds, real estate, etc.)—these are the primary free cash flow outlets—the asset base of cash hoard.
  • Capex Assets – while these are investments on enterprise infrastructures, these are actual cash outlays.
  • Trade Assets – these are accounts receivables (accrued sales which are yet to be collected), and prepaid expenses and deferred tax assets (actual cash outlays).

Disclaimer

The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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