The Wealth Accumulator

How to Get Your Credit Report in Australia

2009-10-18T21:00:00.001+11:00

There are 3 major credit bureaus in the US (Equifax, Experian and TransUnion), but they have a centralized credit report request website AnnualCreditReport.com where consumers can order a free copy of their personal credit report every year.

Australia also has 3 major credit reporting agencies (Veda Advantage, Dun & Bradstreet, and Tasmanian Collection Service), but, unlike in the US, you will have to contact each agency and ask for your credit report (or credit file).

How do I get my credit report in Australia?
Veda Advantage and Dun & Bradstreet will send your credit report free of charge within a couple of weeks of your request. If you pay a fee, they'll speed up processing - but it's an unnecessary expense for most people. For those in Tasmania, the Tasmanian Collection Service appears to charge a fee for their credit report unless your request relates to a refusal of credit or the management of your credit arrangements.

To get your credit report, you will need to write to:

Veda Advantage Public Access
PO Box 964, North Sydney, NSW 2059.
Phone: 1300-762-207.
Fax: (02) 9951-7880.
Email: assist.au@vedaadvantage.com
** Check their website for a list of information you need to include in your letter or fax **

Dun & Bradstreet (Australia)
Public Access Centre, PO Box 7405, St Kilda Road, VIC 3004.
Phone: 132-333.
Fax: (03) 9828-3185.
Email: customerservice@dnb.com.au
** You will need to send this application form to the above address. **

Tasmanian Collection Service
GPO Box 814H, Hobart, TAS 7001.
Phone: (03) 6213-5555.
Fax: (03) 6234-2988.
Email: enquiries@tascol.com.au
** Their website says that you will need to include any applicable fee and a copy of an acceptable photo ID **

Why should I check my credit report?
You should check your credit report to make sure that all information in the report are accurate. You should notify your credit provider and the credit reporting agencies if there are any mistakes. Those mistakes may negatively impact your credit score, which may increase your credit interest rates and the probability that you will be denied credit in the future!

There is also the growing problem of identity theft, both in Australia and around the world. If you see any unauthorized use of your credit in your credit report, you might be a victim of identity theft. So check your credit report regularly and protect your financial identity.

Resources: Government

Office of the Privacy Commissioner: How do I get a copy of my credit report?
ASIC: FIDO: About financial products: Your credit report.

Resources: Frequently Asked Questions (FAQ)

Veda Advantage: Frequently Asked Questions.
Dun & Bradstreet: Frequently Asked Questions - Credit Risk.
Yahoo!7 Finance: Personal Finance: Credit Reports: Frequently Asked Questions.

Security Analysis: Chapter 5: Classification of Securities

2008-12-29T23:00:00.002+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Chapter 5: Classification of Securities.

Securities are customarily divided into the two main groups of bonds and stocks, with the latter subdivided into preferred stocks and common stocks.

Graham opposed the traditional classification of securities because:

Preferred stocks are often bought with the purpose of fixed income and safety of principal, which is more closely resembles the purpose of bond investors.
Bond form is associated with safety - even though the safety depends on the debtor corporation's ability to meet its obligations, rather than the legal protection offered by the bond form.
The proliferation of securities with features that deviate from the standard patterns.

Graham proposed a new classification method as follows:

Securities of the fixed-value type. (e.g. A high-grade bond or preferred stock.)
Senior securities of the variable-value type.

Well-protected issues with profit possibilities. (e.g. A high-grade convertible bond.)
Inadequately protected issues. (e.g. A lower-grade bond or preferred stock.)

Common-stock type. (e.g. A common stock.)

Graham's proposed classification does not depend on the legal form of the security, but, rather, the characteristic of the security.

Securities of the fixed-value type are high-grade bonds or preferred stocks that are expected to maintain their principal value.

Senior securities of the variable-value type is divided into two sub-types. Well-protected issues with profit possibilities can include a high-grade convertible bond or preferred stock. It can also be a high-grade straight bond that has been priced irrationally low by the market, where the investor will expect to make a profit on capital gains. Inadequately protected issues include lower-grade bonds and preferred stock, where the value may rise or fall depending on the financial status of the corporation.

Common-stock type securities include not only common stocks, but senior securities that exhibit common-stock type characteristics. A senior convertible bond selling at 200 would qualify in that you may reasonably suffer capital loss, but may also expect gains from the convertible feature is the company does exceptionally well.

I think Graham's goal is not just for us to reclassify securities, but rather to think about the characteristics of the security and not to make assumptions about the security's characteristics based on its name and legal form.

Security Analysis: Chapter 4: Distinctions Between Investment and Speculation

2008-11-10T04:00:00.004+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Chapter 4: Distinctions Between Investment and Speculation.

Traditionally, people thought: (1) bonds are investments while stocks are speculative; (2) investments are outright purchases while purchasing on margin is speculation; (3) investments are permanent holdings while speculations are temporary holdings; (4) investments are for income while speculations are for profit/capital gain; and, (5) investments are made in "safe" securities while speculations are made in "risky" issues.

Graham argued against traditional thoughts. He explained why investments can be made in stock, using margin, as temporary holding, for profit and income, in "risky" issues.

A Proposed Definition of Investment

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. An investment operation is one that can be justified on both qualitative and quantitative grounds.

Graham redefined investments using the term "investment operation" because there is no such thing as an "investment issue". A company may be "safe", but its bond or stock may be an investment or speculative depending on the price. "Operation" takes into consideration everything relating to investing, including sufficient diversification, the margin of safety in each issue, and the use of margin. Graham also considers arbitrage an investment operation. (Arbitrage in its purest sense is a risk-free operation that does not require any capital. Risk arbitrage [an oxymoron], on the other hand, involves risk and ties up capital.)

By "thorough analysis", Graham means analyzing enough of all available facts using established standards of safety and value. By "promises safety", Graham means the relative safety of principal under normal conditions rather than absolute safety of principal. By "satisfactory return", Graham means the return you (the investor) are willing to accept - this is similar to the discount rate that value investors use (one that is not based on "beta").

An observation: Benjamin Graham operates with a perspective quite different from Nassim Nicholas Taleb (author of "The Black Swan"). Graham operates under the premise of "normal conditions", whereas Taleb operates under the premise of "inevitable black swans". Though Graham did write that "for investments, the future is essentially something to be guarded against rather than to be profited from" - perhaps he was thinking about "black swans". In any case, I think we should follow Graham's method of buying undervalued security with a margin of safety, but Taleb's "Black Swan" idea is useful when we think about risks.

Types of "Investment"
Graham defined various types of "investment" by adding an adjective to it - business investment (money in business), financial investment (or investment generally, referring to securities in general), sheltered investment (low-risk securities), and analyst's investment (investments that fit the definition proposed above).

Types of "Speculation"
Speculation is not all bad - operating a business, no matter how well run, always involve an element of speculation. Intelligent speculation is "the taking of a risks that appears justified after careful weighing of pros and cons". Unintelligent speculation is "risk taking without adequate study of the situation". If we are to speculate, we should speculate intelligently. Unintelligent speculation is the highway to bankruptville.

Investment and speculative components and intrinsic value
When a security's price does not satisfy the Graham's proposed definition of an investment, the value of the security may be split into its investment and speculative components. The investment component is a conservative valuation using past data. The speculative component represents the appraisal of the company's long-term prospects. I'd suggest that the speculative component includes your evaluation of the company's economic moat (competitive advantage) and what additional returns you expect it to bring. The intrinsic value of a security is a combination of its investment value and an intelligently speculated speculative value.

P.S. This post was featured in the 114th Edition of the Festival of Stocks at Fat Pitch Financials.

Security Analysis: Chapter 3: Sources of Information

2008-10-26T16:30:00.004+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Chapter 3: Sources of Information.

It is impossible to discuss or even to list all the sources of information which the analyst may find it profitable to consult at one time or another in his work.

This chapter is useful in getting us to think about where to look for information (including some ideas that I've never thought of before), but some parts are outdated. I will include additional information sources as I see fit.

Unless otherwise indicated "Form ___" refers to SEC forms filed by companies and available via EDGAR. You may want to familiarize yourself with SEC form types and definitions, officially defined in this PDF file.

Data on the Terms of the Issue
Registration statements are the S-series forms - Form S-1 for most securities and S-4 for mergers and exchange offers. Form FWP, for Free Writing Prospectus, may also come in handy. If the issue is a private offering, the issuing firm should give you a prospectus to comply with SEC rules. For foreign issues, you should contact the firm and check with the local regulatory authorities or stock exchange (if it's a listed issue).

If you are analyzing a bond, ask for the indenture (or deed of trust). If you are analyzing the stock issues, ask for the charter (or articles of incorporation) and the by-laws.

Data on the Company
Report to Stockholders (Including Interim News Releases) Regulation FD means that all reports of a material event must be filed in Form 8-K (Current Reports). Earnings guidance (a dangerous game) or profit warnings are filed as Form 8-K. "Important" press releases, such as monthly sales data for consumer retail companies (a good place to see how the consumer/economy is doing) or pre-quarterly report announcements of quarterly results (I don't understand why companies spend time/money doing that), are filed as Form 8-K as well.

Weekly and monthly reports
Railroads and public utility companies usually publish detailed operational results on a monthly or weekly basis. These data are not filed as Form 8-K, but are usually available on the company's investor relations website (e.g. BNSF's weekly intermodal and carload unit reports).

Quarterly and annual reports
Quarterly reports are filed as Form 10-Q, or Form 10-QSB for small business issuers. Annual reports are filed as Form 10-K, or Form 10-KSB for small business issuers. There is also Form ARS for Annual Report to Security holders (i.e. the glossy report with lots of photo, for most companies).

Form 10-K contains much more information than Form 10-Q or ARS and should be read cover-to-cover. Form 10-Q, though containing less information, is useful for checking recent changes to the company's performance.

Annual reports (ARS) usually contain less information than Form 10-K, but "[it] frequently contains remarks—not always illuminating—by the president or the chairman of the board, relating to the past year’s results and to the future outlook", which may help you evaluate the management and the company's prospects.

Income account and balance sheet
Times have changed. I almost couldn't believe it, but back in Graham's days, companies tried to conceal their assets and earning powers. Nowadays, companies can't wait to inflate their assets and reported earnings!

Periodic Reports to Public Agencies
I don't have experience utilizing reports/filings companies make to public agencies, but Graham suggests looking at these filings for information that may be omitted from shareholder reports. I'm not sure what the regulations are now and whether public agency filings still have as much value as they did in Graham's days. Would anyone like to comment about this?

FYI: The "Interstate Commerce Commission" for researching railroad companies was abolished in 1995, with the remaining functions transferred to the "Surface Transportation Board".

Listing Applications, Registration Statements, and Prospectuses
As stated above, Form S-1 is used for registering most securities. You may also find companies using Form FWP, for Free Writing Prospectus. I don't think NYSE or other exchanges still have extensive listing applications that can be viewed by investors - at least there isn't any that I can find online.

Miscellaneous Official Reports
Graham suggests that we look at official reports issued by federal and state commissions, such as the Federal Trade Commission. These reports may contain information not disclosed anywhere else. I, for one, haven't thought about reading these official reports when analyzing companies. One question I have is: How do we know which reports contain information about the companies we're analyzing?

Statistical and Financial Publications
Standard & Poor's, Moody's, and Fitch publish stock and bond manuals. Now, we have Valueline, Bloomberg, Reuters, Morningstar, Google Finance, Yahoo Finance, MSN Money, and tons of other publications and services available to us, some of them free-of-charge. These publications and services should contain condensed and standardized data for us to analyze.

These publications and services are more useful to screen for potential bargains than as our one-stop research shop. There could be errors in their data, and some important information may no be expressed in their concise and standardized format. As Graham warns, we should always go back to read and analyze the original reports.

Request for Direct Information from the Company
Stockholders are owners of the company and the employer of the company's officers. As owners, we are entitled to ask questions and have them answered, unless doing so would be detrimental to the company.

Some investors are adament about interviewing the management before investing. Others say we shouldn't speak to the management because they are incentivized to convince us to buy. I think we should talk to the management if we have any specific questions, but we must be guard against being influenced by them.

Information Regarding the Industry
Industry-wide data are available from the Department of Commerce's Survey of Current Business. Other industry data may be published in trade journals or available from statistical services.

Usefulness of additional sources of information
Though some parts of this chapter is outdated, I think it's a good reminder that there are practically infinite amount of information and data out there that we can find, and some of them from not-so-obvious places. That said, individual investors like me have limited time and resources to obtain and analyze additional information, so I'm not sure how useful these additional sources of information might be for us.

If you have used these additional information, please let us know your experience and how useful do you find these information. If you can suggest other sources of information, please post them here! Thank you!

P.S. I have compiled a list of online resources that I may use from time to time. Please let me know any additional links that should be added. Thank you.

P.P.S. This post was featured in the Festival of Stocks #113 at Old School Value.

Security Analysis: Chapter 2: Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors

2008-10-21T22:00:00.004+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Chapter 2: Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors.

Four Fundamental Elements

In all such questions, four major factors may be said to enter, either expressly or by implication. These are:

The security.

The price.

The time.

The person.

More completely stated, [...] Should security S be bought (or sold, or retained) at price P, at this time T, by individual I?

The Person
A wealthy person who's trained in finance should not invest the same way as a poor person who doesn't have a clue about finance.

You should take into account your financial situation and your risk/volatility tolerance before you invest. I have seen too many people invest more money in the stock market than they should. Get your personal finance in order before you start doing security analysis and investing!

The Time
Security analysis is practiced under the assumption of a "normal" economic environment. But, depending on the economic environment, a security may be attractive at one time and unattractive at another time (e.g. bonds when interest rates are high vs low).

I don't think Graham is advocating timing the market/economy here. Rather, he just wants us to understand that the economic environment is changing constantly and beware of "reversion to mean" (which he discusses later).

The Price
High-grade bonds are usually priced fairly accurately, so price is not as important a factor as for other securities. On the other hand, low-grade/junk bonds, convertible bonds, preferred stocks, common stocks, options and derivatives are much more susceptible to mispricing, so the price is an important factor when considering the purchase of these securities.

The Security: Character of the Enterprise and the Terms of the Commitment
"Character of the enterprise" refers to the business behind the security. "Terms of the commitment" refers to the price, provisions, and status of the security. For common stocks, there aren't much "provisions" to worry about. But for bonds and preferred stocks, the provisions covering a security can significantly affect its attractiveness.

Relative Importance of the Terms of the Commitment and the Character of the Enterprise
Graham argues that it is better to invest in an attractive business on unattractive terms for an untrained buyer. Over a long period, an untrained buyer is less likely to lose money investing in an attractive enterprise, even if he overpaid for it.

As security analysts, we should know better that any security can be attractive at the right price. The risk of buying overpriced security of an excellent enterprise is that expected returns will be below par. In addition, we may have misjudged the attractiveness of the enterprise (think Lehman Brothers, AIG, etc.) because of the problem of "driving by looking through the rear view mirror).

Qualitative and Quantiative Factors in Analysis

Analyzing a security involves an analysis of the business. Such a study could be carried to an unlimited degree of detail; hence practical judgment must be exercised to determine how far the process should go.

I recall reading somewhere that Warren Buffett thought it was "disgusting" how easy it was for Walter Schloss's to earn above average return. If we follow Walter Schloss's approach to buying stocks (i.e. buying hundreds and thousands of statistically cheap stocks until return to fair value), I'd imagine that we can do "less" research than if we follow Warren Buffett's approach (i.e. buying quality stocks at fair prices to hold for the long term).

Graham reminds us that not all data are useful for analysis. We must judge whether the data is relevant or useful - some data may be useful for analyzing one type of businesses and less relevant for the analysis of another type of businesses.

Quantitative vs. Qualitative Elements in Analysis
Quantitative elements are more easily obtained and analyzed. Qualitative elements are harder to come by and is practically impossible to appraise accurately.

Qualitative factor: Nature of business, future prospects, and management
Most people have ideas about what constitute "good business", but the nature of a business and its future prospects are often misjudged. In addition, most people have a hard time judging the quality of the management. These qualitative factors are often double-counted because the effect of a good business and a good management should already be reflected in the company's good operational results!

The Trend of Future Earnings
We should not project earnings trend into the future. Past earnings trend is just that, the past, and does not say anything about the future. When a trend become noticeable, conditions may have become ripe for a change in trend.

Graham's solution is to use past averages as a rough index as to what may be expected in the future. He does not project whether the earnings will be higher or lower in the future.

Qualitative Factors Resist Even Reasonably Accurate Appraisal

Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them. Broadly speaking, he views the business future as a hazard which his conclusions must encounter rather than as the source of his vindication.

Inherent Stability a Major Qualitative Factor
Graham gives the example of a chain groceries store vs a motor company, where, from a period of results (1922-1930), the motor company appears to have far higher (26x) interest coverage compared with the chain store (6x). Even though Graham says that quantitative factors are easier to obtain and analyze, he urges us to look beyond the numbers and consider the inherent characteristics of the businesses, and perhaps why the numbers are the way they are. From the way the businesses operate, the chain store is inherently a more stable business that can afford lower interest coverage. The motor company, despite its high interest coverage for the period covered, is an inherently unstable company and can suffer dramatic changes in earnings. In 1933, the motor company went bankrupt.

Summary

In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favorable decision by the analyst.

P.S. This post was featured in the Festival of Stocks # 112 at The DIV-Net.

Security Analysis: Chapter 1: The Scope and Limitations of Security Analysis. The Concept of Intrinsic Value

2008-10-13T01:30:00.005+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Chapter 1: The Scope and Limitations of Security Analysis. The Concept of Intrinsic Value.

Security analysis is not an exact science. Like law and medicine, individual skills (art) and chance (probabilities) are important factors in determining success or failure. But that doesn't mean you should just give up and invest blindly. Like a doctor who studies medicine and a lawyer who studies law, you must still study security analysis if you want to become a proficient investor.

Three Functions of Security Analysis
1. The Descriptive Function. Gather "the important facts relating to an issue and presenting them in a coherent, readily intelligible manner." This function reminds me of Value Line, Bloomberg, and Morningstar. This is the function of most junior analysts, who gather information for presentation to senior analysts and portfolio managers. Or, for individual investors, this is the first step you take in security analysis.

2. The Selective Function. A security analyst "seeks to determine whether a given issue should be bought, sold, retained, or exchanged for some other" based on his/her evaluation of the intrinsic value of the issue versus the market price. This is the function of portfolio managers and senior analysts that issue buy/sell recommendations. Or, for individual investors, this is what you do with the information you've gathered above.

3. The Critical Function. A security analyst must be critical - in making sure securities have adequate protective provisions and enforce them, in analyzing financial statements and accounting methods, and in all matters of corporate policies. This function reminds me of activist investors. Graham says that it is our job, as security analysts and investors, to hold the management accountable. We need to make sure the management avoid mistakes. We must correct corporate abuses. We must protect those who own the bonds and stocks - we must protect ourselves.

Intrinsic value
The problem with intrinsic value is that it is not a precise number. But you don't need to know the weight of a 500-pound man to know he's fat. Similarly, you don't need to know the exact intrinsic value of a security so long as you knows it's adequate.

Pitfalls
As security analysts, we must recognize and try to avoid the potential pitfalls of security analysis, including (1) inadequate or incorrect data, (2) uncertainties of the future, and (3) irrational behavior of the market.

Value trap
Some stocks may be persistently undervalued (i.e. value trap) or overvalued. Or, the intrinsic value may change over time and reach the market price, thus rendering your analysis invalid. To overcome this problem, in addition to Graham's points on investing in stable situations, popular issues, and investing in "normal" times, I believe the concept of a "catalyst" is also useful. A catalyst will bring the market price to the intrinsic value in a short time, thus helping us avoid the problem of value traps or changing intrinsic value.

The market voting machine

[T]he market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

Analysis and speculation
Security analysis is useful for increasing our odds of winning, but it does not guarantee it. Graham, using a gambling analogy, advocates spreading your bets (diversification) so that your wins will likely outnumber your losses.

P.S. This post was featured in the 111th Festival of Stocks at Dividend Growth Investor.

Security Analysis: Introduction: Problems of Investment Policy

2008-10-06T01:00:00.005+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Introduction: Problems of Investment Policy (Pages 1 - 15)
Security analysis is not a theoretical subject - it is to be used to make investment decisions.

Volatility
The first thing to understand is that the economy and stock market prices are volatile. To think that investments will grow at a steady rate of 10% is just silly - yet that is how most do their financial planning!

A. Investing in high-grade bonds and preferred stocks
You can't just buy high-grade bonds and preferred stocks with your eyes shut and put them away and forget them! You need to worry about these issues:

Safety of interest and principal. Before you buy in, you must determine that the company will be able to pay the interests and repay the principal at maturity. But that's not the end! You must continue to monitor the company's financial health and sell if the issue no longer meets the requirement on safety of interest and principal.
Future interest rates and bond prices. Graham warns about interest rates rising from a persistently low level and its effect on bond prices. An investor may suffer 25% loss in principal in addition to missing out on the higher interest rates available on new issues. On the other hand, the opportunity cost of waiting for a rise in interest rates before investing does not justify such practice.

Graham's solution to this dilemma is to invest in US Savings bonds. Your principal is guaranteed and you can redeem these bonds at your discretion.

An alternative solution is to buy bonds with near-term maturities because (1) these bonds are not as susceptible to a fall in bond prices because of rising interest rates; and (2) you may be able to wait till maturity and redeem your principal with only a small opportunity cost from lower bond yields (versus the higher prevalent interest rates).
The value of the dollar. The purchasing power of bond interests you receive (which is constant) will fall with inflation. If you expect significant inflation, then you should buy stocks and commodities. To balance your risks, you should have at least have a portion of your portfolio in stocks.

B. Speculative bonds and preferred stocks

The broad principles underlying the purchase of speculative senior issues remain, in our opinion, the same as they always were: (1) A risk of principal loss may not be offset by a higher yield alone but must be accompanied by a commensurate chance of principal profit; (2) it is generally sounder to approach these issues as if they were common stocks, but recognizing their limited claims, than it is to consider them as an inferior type of senior security.

The high yield offered by speculative/junk bonds and preferred stocks alone do not justify investment in them. It's a fallacy to think that higher yields (or, for that matter, higher discount rates for common stocks) compensate for higher risks of capital loss.

To make a profitable investment, you must buy speculative bonds and preferred stocks at a sufficient discount so you can participate in capital gains. For someone who bought junk bonds at par and see the company go into bankruptcy, a move of bond prices from 10c on the dollar to 20c won't mean much to him - he still suffers from capital loss. But if you bought the same junk bond at 10c on the dollar, the the move to 20c means you have a capital gain of 100%!

When Graham says to approach this category of investments as common stocks, he means you should not invest in hopes of a large and steady interest income (i.e. focusing on how the company can give you money). You should approach it like a common stock, where you'd want to see the improving financial health, increasing asset values, and increasing ability to generate earnings and cash (i.e. focusing on how the company can make itself "wealthier").

If the company does become financially healthier, the bond prices should rise rapidly towards intrinsic value. The disadvantage of speculative bonds and preferred stocks is that your gain is limited - unlike common stocks, which have unlimited potential. The advantage is that you know what par value is and its intrinsic value is easy to calculate - whereas common stocks is susceptible to irrational exuberance.

C. The problem of common-stock investment
The problem many people have is confusing good companies with good investments and investing with speculation. The qualitative standard of a company is important, but the quantitative standard (i.e. price) of the company is just as important in investing. At one price, a "good" company's stock is ab investment, but at very high price, the same stock may be speculative. Similarly, at one price, a "secondary" (not-so-good) company's stock is speculative, but at a very low price, the same stock may be a good investment. The combination of good companies at fair prices and secondary companies at cheap prices should offer sufficient investment opportunities for investors.

It was little short of nonsense for the stock market to say in 1937 that General Electric Company was worth $1,870,000,000 and almost precisely a year later that it was worth only $784,000,000. Certainly nothing had happened within twelve months’ time to destroy more than half the value of this powerful enterprise, nor did investors even pretend to claim that the falling off in earnings from 1937 to 1938 had any permanent significance for the future of the company. General Electric sold at 64 7/8 because the public was in an optimistic frame of mind and at 27 1/4 because the same people were pessimistic. To speak of these prices as representing “investment values” or the “appraisal of investors” is to do violence either to the English language or to common sense, or both.

Timing the market
Graham argues against timing the market - trying to buy or sell a stock based on technical analysis and "signals". Should any charting method works for a period of time, other will try to follow that method and neutralize the usefulness of that method. With technical analysis, you are always trying to keep one step ahead of everyone else but you have no way of knowing whether you are until you have completed the sale.

If you buy or sell stocks based on an objective standard of value, you are, by definition, ahead of everyone else. You have identified value where others have missed it. If your analysis and valuation is accurate, the time you make money is when you buy. You are robbing the seller by without him realizing by exchanging something of greater value (buying the stock at a discount) with something of lower value (your cash). After that, your selling is just a function of exchanging things of equal value with the buyer (i.e. exchanging stock at intrinsic value with cash).

Conclusions
Investing in investment-grade bonds and preferred stock is a relatively straight forward practice in that you screen companies for their ability to pay interests and repay the principal at maturity. The harder-to-handle issue is future interest rates and inflation.

Investing in speculative bonds and preferred stocks and investing in common stocks are more of a challenge in that you are attempting to place a value based on an uncertain future. I believe that this challenge, if mastered and properly implemented, can put you on the road great wealth.

P.S. This post was featured in the Festival of Stocks #110 at College Analysts.

Security Analysis: Second Edition and First Edition Prefaces

2008-10-05T21:00:00.002+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Preface to the Second Edition (Pages vii - viii)

Background
Graham wrote the second edition against the backdrop of World War II. The war introduced uncertainties (as the credit crisis has now), but Graham says that the foundations and methods of security analysis should not be changed. What we need to do in times of uncertainty is to ensure we have a sufficient margin of safety.

Interest rates
George from Fat Pitch Financials asked about Graham's comment:

The persistence of low interest rates justifies a fresh approach to that subject

on Gannon On Investing's post. I'll attempt to answer that here.

I think George was thinking about the evaluation of common stocks. Low interest rates will affect the risk-free rate for common stock valuations, but we will not approach the practice of security analysis any differently than if the interest rates are high.

On the other hand, bond prices are significantly affected by interest rate changes. Should interest rate rise from its persistently low levels, the bond principal may fall significantly. As described in the Introduction, the solution is buy US Savings Bonds and bonds with near-term maturity.

Preface to the First Edition (Pages ix - x)
Target audience

This book is intended for all those who have a serious interest in security values. It is not addressed to the complete novice, however, for it presupposes some acquaintance with the terminology and the simpler concepts of finance.

I've never had formal training on accounting, finance, or investing, but I have read many books on these subjects. These subjects are interconnected, and I don't yet know how to tell a beginner to start "here" and step-by-step build their knowledge from entry-level to advance-level concepts.

If you are just starting out, you will just have to build your latticework of mental models as you go along. So, if you have any questions about the terminology and concepts when reading the book, please let me know and I will try to point you in the right direction. (Google might be useful too.)

Forecasting

Some matters of vital significance, e.g., the determination of the future prospects of an enterprise, have received little space, because little of definite value can be said on the subject.

If you want to learn how to forecast income to perform discounted cash flow analysis, you are out of luck. Graham deems forecasting to be of little value and, instead, emphasizes the analysis of past performances. Warren Buffett will say that it's analogous to driving by looking in the rear view mirror. I believe Graham understands that we are extremely poor forecasters, thus he emphasizes more on analyzing the past. (Read up on "behavorial finance" to understand why we are such poor forecasters.)

The theory and practice of security analysis
Unlike many university professors, Benjamin Graham was a money manager and practices what he preaches. That's why, he said:

We are concerned chiefly with concepts, methods, standards, principles, and, above all, with logical reasoning. We have stressed theory not for itself alone but for its value in practice. We have tried to avoid prescribing standards which are too stringent to follow, or technical methods which are more trouble than they are worth.

I look forward to learning and practicing security analysis with you as we read this book. If you encounter any problem or question while analyzing a stock now, please leave a comment so we can discuss and learn together!

Book Club: "Security Analysis" by Graham & Dodd

2008-10-05T19:00:00.010+11:00

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

I had previously attempted to read Security Analysis (1951 Third Edition) by Benjamin Graham and David Dodd. It is a tough read. I stopped at around the chapter 40 mark and return the book to the library.

When I saw Geoff Gannon from Gannon On Investing doing a series discussing Security Analysis (1940 Second Edition), I thought it would be a good time for me to start again and attempt to finish the entire book. Geoff seems to have paused the series, but I intend to press on. I hope you will join me in my quest to "conquer" Security Analysis.

The "Security Analysis" Book Club
The purpose of this book club is to:

Help you (and me) read Security Analysis cover-to-cover.
Improve our understanding of the text by discussing what we have read (using the comments section, which you can subscribe to if you comment using a Google/Blogger account).

The principles/rules of this book club are:

Read the chapter before you comment (contribute, don't "leech").
Write a comment after you have read the chapter (to maintain a sense of community and encourage each other to keep pressing on!).
Be nice.
Keep me accountable. E-mail me if I ever stop!
If you have any comments, suggestions, or tips on improving my writing, please e-mail me!

The outcome for members of this book club should be:

To have read "Security Analysis" in its entirety.
To be able to perform security analysis at a satisfactory level.

The Book: "Security Analysis" by Benjamin Graham and David Dodd
If you already have the 1934 First Edition or 1951 Third Edition, you can follow along using those editions. There may be some differences between the editions, but the concepts/themes should be similar.

If you don't yet have a copy, I would recommend buying the 2008 Sixth Edition - it is based on the 1940 Second Edition, which I will be using, but it also includes a forward by Warren E. Buffett and additional commentary by legendary value investors and authors: Seth A. Klarman, James Grant, Jeffrey M. Laderman, Roger Lowenstein, Howard S. Marks, J. Ezra Merkin, Bruce Berkowitz, Glenn H. Greenberg, Bruce Greenwald, and David Abrams. I don't have the sixth edition yet (anyone want to buy me one? ;), but I think the additional commentary is worth paying for.

As Geoff had suggested, if you need to brush up on some basic accounting, you may want to read The Interpretation of Financial Statements by Benjamin Graham and Spencer B. Meredith.

Outbound Links:

Book Club Links:

P.S. This post was featured in the 109th Festival of Stocks at Fat Pitch Financials.

A debate on charitable giving

2008-06-15T03:30:00.001+10:00

Last night, I debated what is the best way to give away our money. Charitable giving is a tough topic to tackle with no right answers, and I invite you to join this debate. I will try to give you all the positions you can take and the rationale for each position. I will tell you my positions and reasons, but I don't claim I am "right" and I may change my positions.

Which causes should you support?
There are many causes, or "themes", that you can support with your money. Here are a selection for you to consider:

The people in need - the poor, sick, and hungry: You need to give money to the poor, sick, and hungry. If you wait another day, they will die. How can you hold back from giving to them when you know they are dying? Do you not have compassion?

Education: You need to invest in education. If we give people education, they can work or build businesses, buy or grow their own food, and learn how to stay healthy. We need to educate doctors to heal the sick, scientist and engineers to create solutions to the world's problems, and teachers to guide our future generations. If we don't educate people, we will forever be stuck in this state. As the saying goes: "Give a man a fish, you feed him for one day. Teach a man to fish, you feed him for a lifetime." Why solve the problem for one day when you can solve the problem for eternity?

Businesses and work: You need to invest in businesses. If we give people work, they can have the money to support themselves while producing goods and services that will help others live a better life. If we don't invest in businesses and give people work, they won't be able to buy food, water, or a house because they don't have money and no one is working to produce them. If we don't invest in businesses and give people work, they won't be able to enjoy life with live music, massages, and other experiences because they don't have the money and there isn't anyone to delivering these services. The side effect of investing in business is you may earn more money and be able to give more in the future. This idea may be pushing the boundaries of what most people think is "charitable giving", but why shouldn't you finance businesses in third world countries so they can improve the economy and lift the society from poverty?

Engineering, science, and technology: You need to invest in engineering, science, and technology so we can solve the world's problems. Imagine what better engineering, science, and technology can bring us: We can grow food in previously non-arable land so people in those areas can feed themselves. We can grow more food per unit of resource (acre of land, ton of water, BTU of energy, etc.) and transport them more efficiently, making it easier to feed the world. We can cure cancer and save billions of people from suffering. We can cure acute diarrheal illness and respiratory infections and spare the lives of millions of children who die each year from these illnesses. If we don't invest in engineering, science, and technology, how can tomorrow's world be any better than what we have today?

Animals: We are one of many living organisms on this planet, yet we have pushed some to extinction and others to over-population by destroying their habitats and causing ecological imbalances. Shouldn't we spend money to help endangered species? Should we (or, do we have the right to) cull over-populated species to restore ecological balance? We need to help the animals because if they all die, we won't be around for much longer either.

Plants: We need to help the plants. We have cut down so many trees and destroyed the environment for many plants to grow, we need to restore them as our duty to this planet. If we don't, we will run out of food to eat and resources to use, so we would die too.

The question, then, is... which cause is more important? Which cause should you contribute to? How much should you contribute to each theme?

My position: I would prefer to give more to education, engineering, science, and technology, with a smaller portion going to help those in need today. Why? (1) It's easy to have the impulse to help the poor, sick, and hungry for today, so many people will help when moved by news stories and charity drives. (2) The self-interest of people will cause them to invest in businesses and those businesses will eventually, directly or indirectly, help the poor, sick, and hungry. (3) There are plenty of environmentalists who have a passion to help the animals and plants, something I don't have as much passion for. (4) If we save the people in need for one day, we will only prolong their current state of suffering. If we solve the root causes of the world's problems, then we will truly improve their lives.

Targeting short-term vs long-term problems
There are problems that we need to solve now, but there are also problems that must be solved over the long-term. Which problems should you tackle with your money?

Short-term problems: People need help immediately. If you don't give them food today, they will die tomorrow. How can you allocate your money for other purposes while you watch these people die? But if we keep trying to solve the problems of today, the world will forever be the same and the problems will forever remain.

Long-term problems: You can change the world over the long-term - the hungry can grow their own food and the sick can be cured of their illness. But what about secondary and tertiary effects? With more people alive, won't we run out of food to feed them or run out of space to live? Or, perhaps there won't be no one around to benefit by the time we realize this better future.

My position: I would prefer to give more money to solve long-term problems and less for short-term problems. As stated above, if we save the people in need for one day, we will only prolong their current state of suffering. If we solve the root causes of the world's problems, then we will truly improve their lives.

Giving money that matter vs money that doesn't
If you have $100 and need $50 to live a comfortable and happy life, you can give away $50 to charity without affecting your life. Should you give away $50? Or should you spend less on yourself and give away more?

Giving money that do matter: There are people in this world who need your money far more than you do. By keeping $50 and giving $50, you are giving yourself the right to enjoy life at their expense. Who are you to say that you have more rights to enjoy life and they don't deserve even the necessities of life? But, if you give away more, what will happen if you encounter a financial emergency or get sick? Will you become a burden for the society?

Giving money that doesn't matter: Some philosophers say the purpose of life is to be happy. You should not deprive yourself of the right to enjoy life. If you need $50 to live a comfortable and happy, then you should keep the $50 you need and give away the other $50. You need to be responsible for your own life and take care of your own financial security before you take care of others.

My position: I believe in we need to first be financially responsible for our own lives. But I also believe in frugal living... we don't need to buy expensive houses, faster cars, or luxury brands to be happy. Beyond the basic necessities for living, what makes our lives enjoyable and worth living are relationships and experiences. While I'm young and alive, I am willing to donate money but I will do so within the bounds of maintaining my financial security. When I'm old and upon my death, however, I won't hesitate to give away most of my money.

Giving now vs later
Warren Buffett made news for giving billions to charities, substantially all of his wealth. Prior to this, his charitable contributions has been limited (which led some to say that he gave for reason of tax deductions rather than for charity), but he said he always intended to give his wealth away. It was only a matter of timing.

Giving now: People need money now. If you don't give now, they will die and there won't be any need for your money in the future.

Giving later: If you are a good compounder of money, then you will be able to give away more if you keep the money now, compound it, and give away multiples more in the future. If you are a poor compounder of money, however, you should give away your money now and put them into greater use.

Say, for example, Joe had $10 million 40 years ago and that was all he ever needed to live by. If he compounds money at 20% p.a. and gave all of his returns away at the end of each year, he would give a total of $80 million over 40 years. If he compounds money at 20% p.a. and gives nothing away until the end of 40 years, he would give away $14.7 billion at the end of 40 years, far more than the alternative even if you take into consideration the effect of inflation.

My position: I would like to think that I'm a good compounder of money, but I can't guarantee that. To hedge my bets, I would give away some money every year but I plan to give the majority in the future.

Giving locally vs widely
Should you give locally, to people close to you, or people you see? Or should you distribute your wealth widely, to people far far away, to people you don't see?

Giving to your family & friends vs others: Most people are willing to give money to help their family and friends, but they are far less willing to help others that don't have a relationship with them. Are you willing to watch your family and friends suffer while you give money to others? On the other hand, do your family and friends have more right to your money just because they are born into the family or just happens to know you? Why shouldn't others be treated equally? Should you be destined for a worry-free life just because you are born into a rich family? Should you be destined for hardship and suffering just because you are born into a poor family?

Giving to stories reported in the news vs others: Sometimes stories about the plight of individuals or groups of people are reported in the news, and those news stories prompt people to donate to these individuals or groups. If you have any shred of compassion in you, will you watch them suffer without doing anything? On the other hand, should you depend on the news to tell you who you should help? What about those who aren't covered in the news because the journalists don't think it would make an interesting story? Does that mean whoever shouts the loudest and is heard most should get the most money? What about those people who are too weak to shout and no journalist take interest in? Do they deserve to suffer because of our ignorance?

Giving to your neighborhood, state, country, and continent vs others: You live in this neighborhood, state, country, and continent, you have a responsibility to your community. If they are in need, you should give to them because you have benefited from them. But what about those who live elsewhere? Should the geographic location you are in determine whether you receive help or not? Perhaps this is why the rich country gets richer while the poor countries stays poor... the rich country wants to help the poor in their own country far more than those in poor countries, and the poor countries want to help themselves but they just don't have the money or the means to do so.

Giving based on age, sex, race, etc. vs others: The young are defenseless so they need help more. But the adults need to survive to take care of the young. Women need to be helped more because they are discriminated against. Men need to be helped so they can do useful work and support the women. Give to the blacks, because they are disadvantaged from the start so we set lower admission standards. Asians are smart, so we set higher standards for them to meet before we help them. Caucasians are rich, so even the poor are doing much better than others. Who are you to judge people base on their age, sex, race, etc.? Why shouldn't everyone have the same rights? Why shouldn't everyone deserve equal opportunities? Do you not deserve help because you are now an adult? Do you not deserve help because you are a man or woman? Do you not deserve help because you are black, Asian, or Caucasian?

My position: I will give to my family and friends if they really need my help, because I believe love and relationships matter. If they have the resource to help themselves, however, then I will help others in need. I will ignore news stories, because I believe news often offer biased views of the world and facts. I will give some money to my community, because I believe I have a responsibility to the community, but the majority should go to those in need the most. I will donate without regard to age, sex, race, etc. because I believe everyone should have the same rights and opportunities to live and succeed in life.

Giving directly vs indirectly
Should you give directly to those in need? Or should you give indirectly through charities, foundation, trusts, non-profit organizations, and non-governmental organization (NGO)?

Giving directly: You should give directly to those in need to reduce agency and frictional transaction costs. You will know for sure where your money is going to and who or what is your money accomplishing. But how do you know you are putting your money to the greatest use? How do you know whether one person is more worthy of receiving your money than the other person? Do you have the knowledge, skills, and resources to allocate your money efficiently?

Giving indirectly: You should give indirectly through charities, foundation, trusts, non-profit organizations, and non-governmental organization (NGO) because they have the knowledge, skills, and means to help more people more efficiently. They are the most efficient allocators of your money. But how do you know where an organization spends your money? How can you be sure they are doing what they claim to do? How do you know corrupt persons in those organizations won't embezzle your money?

My position: I would prefer to give indirectly and delegate the hard work to those who are passionate in the causes I support. From the debate outlined above, I think it's beyond my knowledge and skills to engage directly in this endeavor. My passion and skills are better used elsewhere.

A thought experiment
I first heard about this thought experiment in a speech by Warren Buffett. Say you are about to be conceived in this world. You cannot choose which sperm & egg you will be conceived in (it will be a random event - "the great ovarian lottery", as Warren says), but you can design the society any way you want. How would you design this world you're about to be randomly born into?

I would want a world where everyone will have the same opportunities to live, learn, work, play, and enjoy life. But whether you take advantage of the opportunities is up to you... after all, I believe in free will and free markets/capitalism.

Now, over to you: How would you handle charitable giving? How would you give away your money?

Note: I am voicing different philosophies and viewpoints here so you can evaluate each position yourself. Even though I told you my positions and my reasons, but I'm not advocating them as being "correct" and I may change my positions.

P.S. If you have other topics you would like to debate, tell me! If you have other ideas you would like to add, tell me! I'm always interested in learning and expanding my mind.

Should we combine or separate income & cash flow statements?

2008-06-14T03:30:00.002+10:00

I've been advising some friends on personal finance and investing, and it is harder than I thought. Their familiarity with and willingness learn accounting and finance varies, and those without much knowledge in these subjects want me to guide them step-by-step.

While I refer my friends to my "The Principles of Wealth Accumulation" series for knowledge-building, there are few concrete step-by-step guide to lead a newbie to become financially "ready". So, I am now writing a step-by-step guide to personal financial planning (without the use of a financial adviser)... but I'm stuck on financial statements and budgeting.

The problem
Should we combine or separate personal income statements and cash flow statements? The financial analyst inside me tells me to separate them. But the teacher inside me tells me to combine them and make things easy for the beginner. I am torn on which method should I recommend my friends (and others) do.

The arguments
For separating them: In proper accounting, income statements and cash flow statements are separate. Interests on debts (e.g. mortgages, credit cards, and loans) are expensed, but the borrowing or repayment of debt principals are recorded in the cash flow statement as financing activities. Through operating, financing, and investing activities, we increase or decrease our assets and liabilities on the balance sheet.

For combining them: It is easier to list our debt payments as expenses from the bills without separating principal and interest.

For separating them: If we don't separate principal and interest, we run the risk of double-counting credit card expenses (e.g. counting a movie once as an "entertainment expense", once as "credit card payment").

If we finance a new house with a mortgage, a new asset (house) and a new liability (mortgage) will appear on our balance sheet without explanation. Then, in future years, the liability (mortgage) will decrease mysteriously.

For combining them: We will know about the house purchase even if it's not reflected in our financial statements, and we'll know that we are paying off the mortgage.

If we budget based on debt interest expenses instead of the entire mortgage payment or credit card payment, we run the risk of running out of cash to meet our debt obligations.

For separating them: We can include the required principal repayments in the budget by listing them as cash flow budgets.

The question
What would you recommend others do as they prepare their financial statements and budgets? What are your arguments or reasons?

P.S. This post was featured in the Carnival of Personal Finance #157: Third Anniversary Edition at Consumerism Commentary.

Fooling yourself all of the time

2008-06-02T22:00:00.000+10:00

Wall Street banks fear losing to Allied Capital, they are creating a sequel to David Einhorn's "Fooling some of the people all of the time"... this time, it's called "Fooling yourself all of the time". As usual, it involves accounting that do not reflect reality (Bloomberg has more).

People will buy and sell assets at discounted prices, so asset value should be marked-to-market to manage risks. If you can tough it out without selling the asset, you can mark it back up when the value recovers. But mark-to-market helps you understand and control your risks.

On the liability side, $1 of debt will always be $1. No one will let you get away by paying only $0.50 - they will wrestle the other $0.50 from you at the first opportunity they get. What if you buyback the bonds you issued at $0.50? Well... if you had the financial resources, the bonds probably won't be priced at $0.50 to begin with.

Accounting is meant to reflect the realities of the business. Common sense (and conservatism) should prevail when accounting assumptions and decisions are made. But what did Wall Street do? They threw common sense out of the window!

Oh wait... common sense was never in Wall Street to begin with.

Thinking about growth

2008-06-01T21:15:00.005+10:00

Jae Jun of Old School Value wrote a post valuing K-Tron International, Inc. (KTII). His analysis got me interested in K-Tron, but I was worried when I read "I don't see why it can't grow at 23%." Perhaps I'm just more conservative (or paranoid!) when it comes to forecasting growth. K-Tron's growth for the past few years has very impressive, but is it prudent to forecast similar growth rates into the future?

Growing with the industry
Is K-Tron growing at the industry average or GDP growth rate? Is the company operating in an expanding industry? I don't know the average growth rate, but I suspect K-Tron is growing at an above average rate. If growth exceeds the industry or GDP growth rate, we need to beware of reversion to mean.

Companies have been using materials handling and processing equipments for quite a while to automate their manufacturing plants. If K-Tron is involved in a new and growing industry, a high growth rate may be sustainable (at least while the industry is growing). But I think K-Tron is involved in an existing and stable industry, so the growth in demand for their machines should be dependent on their customer's need for expanding production capacity. A global recession may prompt their customers to cut back on capital spending and expansion. As such, I won't count on a high industry growth rate, so K-Tron's prospects of growing with the industry for the near future is uncertain. So what contributed to K-Tron's growth in the past few years?

Growing by stealing market share
If K-Tron is operating in a stable industry, it's likely that the company is taking market shares from others or making acquisitions.

If the company is taking market share from others, how can it keep doing so? What gives the company the competitive advantage? Does K-Tron have products offering significant advantages over its competitions? Do they have above average marketing and sales? How much market share can K-Tron capture before other companies neutralize its competitive advantages? I do not understand K-Tron or this industry enough to answer these questions... in fact, I don't even know who are K-Tron's direct competitors, not to mention indirect/potential competitors.

Growing by buying
K-Tron seems to grow primarily by acquisitions, but acquisitions don't necessarily create value. Integrating two companies is difficult and the projected synergies may not be realized. If K-Tron acquires business producing similar products (e.g. both companies making pharmaceutical feeders), K-Tron and the acquired company's current customers may not see a need to buy a new product when the old one works just as well. If K-Tron acquires businesses producing adjacent products (e.g. a company making electronics feeders), their current customers may not need those products. If K-Tron acquires business producing upstream or downstream products, there might be more potential for vertical integration, cross-selling, and synergy. No matter what type of acquisition a company makes, brilliant management is usually required to make the most out of it.

I think there are too much uncertainty to forecast growth by acquisition:

There may not be appropriate acquisition targets in the future.
They may not be available at attractive prices.
Expected synergies and value may never be realized.

A word on market cap
The "law of large numbers" implies companies with large market cap, high revenues and earnings will grow at an average rate. A small market cap, however, does not imply a high growth rate. It's just that more growth is possible before the "law of large numbers" sets in. The growth rate that can be achieved, however, is dependent on the economics of the business, the industry and the competition.

Forecasting growth
I believe forecasting past growth into the future on a linear basis is "dangerous", especially when past growth rate has been high. High growth rate is not impossible or unsustainable, but I wouldn't forecast an above average growth rate for an extended period of time until I have a good understanding of the business, the competition, and the economics of the industry. I do not have sufficient understanding of the economics of K-Tron's businesses, so I don't dare to forecast 23% growth as JJun does.

P.S. This post was featured in the 92nd Edition of the Festival of Stocks at Fat Pitch Financials.

Discloure: No position in KTII.

Introduction to insurance

2008-05-29T01:45:00.003+10:00

What is insurance?
Insurance is the transfer of risks of large accidental financial loss from you (the insured) to the insurance company (the insurer) for an affordable premium.

Risk: Harmful or negative events that may or may not occur. Without risks, there is no need for insurance.

Financial loss: The loss must be translated to and quantifiable in dollar terms. The insurance company will not rebuild your burnt-down house, but they can give you the money to rebuild.

Accidental loss: The loss must be accidental and out of the control of the insured or the beneficiary. If the loss is regular or controllable, it cannot be insured.

Large loss: If the potential loss is small, you may be better off keeping the premium and taking the risk. "Large" is relative. If you are poor, a $10,000 loss is large. If you are a multi-billionaire, a $1 million loss may "disappear" into a rounding error.

Affordable Premium: If the premium is so high compared to the cost of the insured event, you may be better off keeping the premium and taking the risk.

What types of insurance are there?
Health insurance: Health insurance covers health risks and makes payments for health problems and associated medical expenses. Many countries have national health insurance programs, but there are usually exemptions ("gaps") that private insurance can cover ("gap coverage").

Disability insurance: Sometimes known as "income insurance". It covers the risk of becoming disabled and unable to work, and usually pays a percentage of your income. "Same occupation" disability insurance will pay you if you lose the ability to work in your current occupation. "Any occupation" disability insurance, however, will only pay you when you lose the ability to work in any occupation. "Same occupation" insurance will protect you better than "any occupation" insurance, but it is also more expensive.

Life insurance: Life insurance covers the risk of death, and will pay your family (or your chosen beneficiary) the insured sum upon your death. The amount of coverage should cover burial and funeral expenses, and, if your family is dependent on your income, provide financial support for your family. If you have no financial dependents, you do not need life insurance. Life insurance may be classified into temporary or permanent insurance. Temporary (term) insurance are, usually, the cheaper and better choice.

Automobile insurance: Also known as "vehicle insurance" or "car insurance". It covers the risks involving your car, and may include damages you caused (third-party liability), damages to your car (collision), and loss of your car and its contents (theft). Third-party liability coverage are compulsory in some countries (such as Taiwan), and I recommend them even if they aren't compulsory (in case you ever crash into a Ferrari or a super-expensive house).

Property insurance: There are insurance coverage for the building (your home) and contents (your furniture and other possessions). There also specialized coverage for damages caused by fire, earthquake, and flood.

Liability insurance: Professional liability insurance are usually advisable for professionals such as doctors, and they cover risks such as malpractice lawsuits. Given that we live in an increasingly litigious society, some professionals will need liability insurance. Liability insurance may also be available for small businesses and the products you sell.

Travel insurance: Travel insurance may cover risks such as medical emergencies, lost luggage, travel delays, etc. Some credit cards, such as the American Express Blue Cash, provide travel insurance for free if you pay with your card.

First steps to buying insurance coverage?
1. Assess and prioritize your risks. What risks do you have? Which risks do you most need protection from? What risks do you already have sufficient protection for?

For example, if you work in a company that provides health and dental plans, have 3 young children, and are the sole financial provider of your household, you may want to buy life insurance first. National health insurance, company's health plans, and worker's compensation from your company may provide sufficient coverage for your health and potential job-related disability.

2. Review your budget and figure out how much insurance you can afford. If you are young, have a fair amount of net worth, and are saving and investing 50% of your gross income, you can probably afford to buy more insurance if you need them. If you don't have much room in your budget for insurance, you need to identify what are your highest priority risks and get insurance for those first.

How much insurance coverage do I need?
There are a few method of determining the level of coverage you need:

1. Expected cost: How much will the expect costs be if the insured risk events occur? This method applies for medical insurance and liability insurance.

2. Replacement cost: How much will it cost to replace what's been insured? This method applies for automobile insurance and property insurance. Don't forget to take into consideration inflation or appreciation from your purchase cost!

3. Discounted cash flow (DCF): How much will it cost to replace your future cash flow? This method applies for life insurance and disability insurance. When calculating how much life insurance coverage you need, you should determine how much you expected to earn in the future, then use DCF to calculate how much those future earnings would equal in present day dollars. If you died today, this amount will allow your financial dependents to live as if you are still alive earning money.

Bonus: How do insurance companies earn money?
From your perspective, it appears that the insurance company took your large risk for a relatively small premium. The insurance company, however, have many other people similar to you buying similar insurance policies (let's just say that you and those people belong to the same "group"). The risk that individuals in the group will suffer from the insured event will approximate the probability of that event occurring (calculated by an actuary). The insurance company is basically taking your premium and spreading your risk with the entire group. In return, the insurance company receives a small portion of the premium for managing your risks.

References:

Wikipedia:

Insurance.

Property insurance.

Get Rich Slowly:

The Simple Dollar: Interesting Insights Into Life Insurance from an Actuary - How He Would Buy Life Insurance.

P.S. This post was featured in the Carnival of Personal Finance #155 — Time With Family at Moolanomy.

Phil Fisher on range-bound investing

2008-05-22T01:50:00.004+10:00

I was first introduced to the idea of the "range-bound market" when I read reviews of "Active Value Investing". But when I read "Conservative Investors Sleep Well", I realized Phil Fisher had brought up the issue of "range-bound market" way before Vitaliy Katsenelson did.

The growth stock
Phil Fisher says that the price of any individual common stock is the result of the financial community's appraisal of that stock. The financial community is usually late to recognizing both the start and end of growth. When a company grows, the financial community may not realize its growth potential and the earnings growth are not reflected in the price, resulting in a low P/E. This is the best time to buy the stock.

The growing stock
As a company grows and the financial community realize its growth potential, the growth in P/E ratio and earnings will cause the stock price to grow far higher than that caused by either earnings growth or change in P/E alone. A high P/E, however, does not necessarily mean you should sell the stock because you can still enjoy earnings growth as the company grows - though you will not get to enjoy the P/E growth.

The maturing stock
As a company matures and approaches its limits to growth, however, you should sell. Eventually, the financial community will recognize the lack of future growth potential and adjust the P/E downwards, such that further earnings growth will not result in increased stock price. If you take into account secondary and tertiary effect of the financial community's appraisal of the stock's industry and sector and on common stocks in general, you will have a P/E and stock price that does not move in tandem with earnings growth.

A real-world stock
When I read what Phil wrote, I recalled one of Vitaliy's articles about Wal-Mart (WMT). For quite a while now, Wal-Mart grew its earnings but its price remained unchanged. The financial community had realized that Wal-Mart was approaching its limits to growth and adjusted its P/E accordingly. The earnings growth that did occur were already discounted into the price, so no further price increase occurred. For the financial community, unless Wal-Mart figures out a way to grow beyond its current limits, they will not price the stock for the same type of growth they experienced decades earlier.

References:
Conservative Investors Sleep Well (First published in 1975)
in Common Stocks and Uncommon Profits and Other Writings (Wiley Investment Classics)
by Philip A. Fisher

Active Value Investing
by Vitaliy N. Katsenelson

Disclosure: Long WMT.

P.S. This post was featured in The Festival of Stocks May 26, 2008 at Circle of Competence.

Estate planning

2008-05-18T16:00:00.001+10:00

Estate planning the use of legal tools to make sure your estate (wealth) is distributed to your intended beneficiaries. Due to frequent changes in estate laws and taxation laws, I recommend consulting your attorney when planning your estate.

Getting started
The first thing you should do is to list all your assets and liabilities and determine your net worth. Your assets should include bank accounts, retirement accounts, insurance policies, real estates, bonds, stocks, mutual funds, and business interests. You should plan which assets will pay off your liabilities and which assets be distributed to whom.

Will
A will lets you decide how you want your estate to be distributed and lets you appoint guardians for your children. If you do not have a will and die intestate, the courts will distribute your estate according to the law, usually between your surviving spouse and children or among your relatives, and your closest adult family member will probably assume guardianship over your children.

If you don't yet have a will, you should have one written now. If you write one when you are old and dying, possibly suffering from mental or communication disabilities, your will may be challenged under the premise that you were subject to undue influence, coercion, or fraud. Get a lawyer to write your will to reduce the probability that the courts will invalidate your will or misinterpret your intentions.

Update your will upon major life, family and wealth changes, such as marriage, divorce, birth of a child, buying a house, or buying a business. Even if you don't have any major changes to your life or family, you should review your will annually and update it if necessary.

Trust
A trust is an arrangement where a trustee manages money or property for the beneficiary under the legal entity of the trust. A trust is useful for placing conditions how and when your assets are distributed, protecting your assets from creditors and lawsuits, and reducing estate and gift taxes. The advantage of a trust over a will is that it avoids probate, remains private, and may reduce estate and gift taxes.

If you decide to use a trust, you will still need a will to pour-over all assets that have not yet been assigned to the trust at your death. You may also assign power of attorney for finances and have your agent transfer your assets to the trust if you become terminally ill.

Before you die
Wills and trusts will distribute your estate according to your wishes when you die. But you should also have a power of attorney and a living will to take care of things while you are alive but incapacitated (unable to communicate or make decisions).

Power of attorney
A power of attorney allows you to appoint an agent (attorney-in-fact) to make decisions and act on your behalf. You should find someone you trust and understands your financial and health care preferences to be your agent.

You should have a power of attorney for finances, so your agent can pay your bills and manage your finances. This is important if you have a trust and want your assets to be transferred to the trust before you die to avoid probate. If you did not assign power of attorney, the court may appoint a conservator to manage your finances when you become incapacitated. If you assign power of attorney to a family or friend, they may serve as your agent free-of-charge. But a court-appointed conservator will charge fees for services rendered.

You should also have a power of attorney for health care, so your agent can help you make decisions on your health care if you become incapacitated. If you don't have one, your spouse or family member will assume the role. However, there may be disputes as to who has your best interest in mind. To save your family from trouble, appoint one person to be your agent.

Living will
A living will allows you to specify what life-sustaining medical interventions you want or don't want if you become terminally ill and incapacitated. Be specific whether you want to be resuscitated or intubated. This will save your agent or family from having to make life-or-death decisions for you.

References:

Wikipedia:

Estate planning.

CNNMoney 101: Lesson 21: Estate Planning.
Free Advice: Estate Planning.

P.S. This post was featured in the Carnival of Personal Finance #153: the Q & A edition at Money and Values.

Understanding basic financial terms

2008-05-13T13:30:00.001+10:00

With so much information available on websites, blogs, newspapers, television programs, magazines, and books, why aren't more people "getting" personal finance? What makes it so hard for people to understand personal finance? I realized why after a chat with a friend over the weekend. The reason many people find finance hard because "financial nerds", like me, made it so by using too many financial jargons.

In any discipline, jargons inevitably develop to help people communicate concisely. Instead of saying "valuable items you own", we say "assets". But if I want to help the "uninitiated" learn about and manage their personal finance, I must use simple everyday language... and I haven't done as well as I should. I hope this post will help you understand some basic financial terms I use.

Income statement (noun): A statement to show how much you earned, spent, and saved over a period of time.

Income (noun): The amount of money that you earn over a period of time. Income is money that comes into your life. Income may be categorized into:

Employment income: Money from your job/career.
Business income: Money from your business (if you are a business owner).
Investment income: Money from your investments (in bonds, stocks, real estate, etc.). Sometimes referred to as "passive income", income that you don't need to actively work for (as opposed to income from job or business that you actively work in).

Expense (noun): The amount of money that you spend over a period of time. Expense is money that goes out of your life. Expenses may be categorized into:

Discretionary expenses: "Wants." Expenses on what you want or desire, but are not necessary for day-to-day survival. Examples: Cable TV, cosmetics, magazines, snacks.
Non-discretionary expenses: "Needs." Expenses on what you need for day-to-day survival, even if you don't want them. Example: Food, rent, taxes.

Net income (noun): The amount of money that you save over a period of time, calculated by deducting expenses from income [Income - expenses = net income]. Net income is money that you keep in your life.

Balance sheet (net worth statement) (noun): A statement to show how much you own and owe at a specific point in time.

Assets (noun): Valuable "items" you own at a specific point in time.

Liabilities (noun): Debts and obligations that you owe at a specific point in time.

Equity (net worth) (noun): The excess value of what you own over what you owe, calculated by deducting liabilities from assets [assets - liabilities = equity or net worth].

Financial statements (noun): The set of statements that describe your financial situation, including your income statement and balance sheet.

Principal (noun): The original amount of debt borrowed or the original amount of money invested in assets.

Interest (noun): The amount paid for borrowing money, usually calculated as a percentage of the debt liability.

Capital (noun): The amount of assets available for use at this moment, including those with claims (liabilities) against them.

Return (noun): The income or profit made from an investment, usually calculated as a percentage of principal (capital invested).

Annualized (adjective): The rate for a period of time expressed in term of a one-year period.

Liquidate (verb): To liquidate an asset is to sell the asset. Liquidation (noun).

Thrifty, frugal (adjective): Economical. Careful and diligent in the use of resources

Tax-advantaged (adjective): Receiving favorable tax treatment. For example, tax-free 401(k) contribution and earnings, but taxed 401(k) withdrawal. Or, after-tax Roth IRA contributions and earnings, but tax-free Roth IRA withdrawal. Or, tax-free interest from municipal bonds.

References:

Asset class: Bonds

2008-05-10T20:00:00.003+10:00

What are bonds?
Bonds are interest-bearing loans to the bond issuers (governmental or corporate entities) that mature on a stated future date. Depending on the time to maturity, bonds are classified as short-term bonds (maturity within 3 years), intermediate-term bonds (maturity in 3-10 year), and long-term bonds (maturity longer than 10 years). Corporate bonds are further categorized into investment grade (lower risk, lower yield) bonds and junk (higher risk, higher yield) bonds. Bonds may offer higher interest rate than cash and cash equivalents, but they can still lose purchasing power to inflation (unless indexed against inflation).

Bonds may be traded or held until maturity. In open market trading, the volatility of bond prices tend to be lower than the volatility of stock prices. The prices of bonds are affected by the prevailing interest rate. When interest rates rise, bond prices fall - 5% bonds are less attractive investments when 6% interest is available, so investors want to pay less for those bonds and, in doing so, achieve the same effective yield as 6%. When interest rates fall, bond prices rise - 5% bonds are more attractive than the 4% interest available, so investors are willing to pay more for those bonds.

Do bonds have lower risk vs stocks?
Bonds are erroneously thought to be lower risk investment vehicles than stocks because (1) open market bond prices have lower volatility than stock prices and (2) bonds are "senior" to stocks, meaning bond obligations must be fulfilled before stock investors can receive any money. The safety of capital does not come from the lower volatility or the seniority of the investment vehicle, but from the ability of the issuer's assets and future earning power to meet its obligations. When companies go bankrupt, both bond and stock holders suffer loss of capital. Even companies that seem too large and too smart can fail and go bankrupt - think Bear Sterns, Enron, Arther Anderson, Worldcom/MCI, Global Crossing, HIH Insurance, LTCM (Long-Term Capital Management), Polaroid, Pan Am, and Penn Central.

Bonds vs stocks
Financially strong corporations that can safely meet bond obligations should also generate returns for equity investors, but bond returns are low and limited, whereas stock returns are potentially unlimited. On the other hand, bonds from financially weak corporations may be just as risky as their stocks, but stock returns for companies that turn around their operations are likely to be far higher than junk bond returns. The risk-reward trade off, for me, favor investment in stocks instead of bonds.

Government bonds
Debts issued by governmental entities generally have lower risks than corporate bonds. Sovereign government bonds are called "government bonds" and are considered risk-less because governments can raise taxes and print money as needed (though not without flow-on effects). "Municipal bonds", on the other hand, are bonds issued by non-sovereign governments (state, county, and city governments) to finance local infrastructures, such as road, bridges, tunnels, waterworks, schools. While municipal bonds are low risk, there are rare instances where local governments default on their bond obligations.

US government bonds are available for purchase from US Treasury Direct, or through local banks and brokers, in the form of Treasury bills, Treasury notes, Treasury bonds, Treasury Inflation-Protected Securities (TIPS), Series EE bonds, and Series I bonds.

Investing in bonds
Generally, I do not recommend investing in corporate bonds because of the risks and limited returns. If you want low risk investments, I recommend investing in government bonds, which are truly risk-free.

If you wish to invest in corporate bonds, I suggest investing through broad market bonds index funds. I do not recommend investing in individual corporate bond issues - you will probably be better off buying a company's common stock than buying the company's bonds. You should only invest in individual bond issues if you know how to value bonds and can find individual issues selling at very attractive prices.

I recommend saving long-term emergency reserve (up to 5 years worth of living expenses) in government bonds, such as Series I US Savings Bonds (I Bonds) or Treasury Inflation Protected Securities (TIPS). Generally, 5 years of living expenses should last you through most broad market cycles. You may consider having the entire "bond" portion of your portfolio invested in risk-free government bonds.

Related posts:

P.S. This post was featured in Money Hacks Carnival #13 — Money Saving Hacks Edition at Moolanomy.

Asset class: Cash and cash equivalents

2008-05-07T13:30:00.003+10:00

Cash and cash equivalents are short-term (readily accessible or mature within one year) and low-risk assets. They may or may not be interest bearing. They have the lowest risk of losing capital (absolute value) but they have the highest risk of losing purchasing power due to inflation.

Cash and cash equivalents are available in the form of currency (cash), bank accounts (e.g. checking account and savings deposit), certificates of deposit (time deposit), Treasury bills, and money market deposit accounts, and money market funds. They are also available in domestic currency and foreign currencies

I recommend saving 1-6 months of living expenses in cash and cash equivalents as emergency cash reserve, but I do not using them as long-term investments.

Currency (cash)
Currencies are the most liquid instrument available, but they are not interest bearing. There is no risk of loss from the market, but there is risk of loss due to physical loss (e.g. theft, degradation).

Bank accounts (checking account and savings account)
Bank accounts, such as checking accounts and savings account, can hold cash for you and may or may not be interest bearing. In US, your money is guaranteed by FDIC for up to $100,000 per individual, so there is no risk of capital loss below the insured amount.

When using bank accounts, watch out for banking fees and charges. Monthly account keeping fee can literally take money away from you until your account balance is zero. Watch out especially for interbank ATM fees - use a bank with ATM in locations you frequent, or the interbank ATM fees will eat away your money every time you make a withdrawal.

Online bank accounts often have no or low bank fees, and give you high interest rates. Now that you can make most bill payments online, you should consider opening and using online bank accounts.

Certificates of deposit (time deposit)
Certificates of deposit (CD, or time deposit) are instruments for depositing money in banks (or other financial institutions, such as credit unions) for a specific period of time at a fixed interest rate. Principal is returned at maturity, while interests may be paid out as accrued or accumulated until maturity. Similar to bank accounts, certificates of deposit are low risk and are covered by FDIC for up to $100,000 per individual.

Treasury bills
Treasury bills are short-term securities issued by the US Treasury. These are the "safest" form of investment because US Treasury bills have the full backing of the government, which can print more money as needed (though not without flow-on effects).

Money market deposit accounts (MMDA)
Money market deposit accounts (MMDA) are deposit accounts with high interest rates. These account usually have more limitations than regular checking or savings account, but the high interest rates may be worth the inconvenience. Money deposited in these accounts are low risk and are insured by FDIC.

Money market funds
Money market funds are mutual funds that invest in money market short-term securities, such as Treasury Bills and commercial paper. Money market funds are not insured by FDIC and can potentially lose value, though they are still considered low risk investments.

Note on foreign currencies
Cash and cash equivalents are also available in foreign currencies, but they have the additional risk of currency exchange rates. Even if the absolute value of the foreign currency remains the same, the equivalent value in domestic currency may be higher or lower depending on the latest currency exchange rate.

Sophisticated investors may invest in foreign currencies and earn profits from their bets, but I do not have sufficient knowledge to comment on the valuation of foreign currencies and how to make correct bets.

Related posts:

References:

Wikipedia:

What is your risk (or volatility) tolerance?

2008-05-04T13:30:00.003+10:00

I am risk averse; I do not want to lose money. I define risk is the probability of permanent capital loss. Most in the financial industry, however, risk is defined as the volatility of the market or the beta of a stock, meaning how far does the value of your investments deviate from the long-term or market return. Volatility is non-directional and refers to both the up and down cycles of volatility, which average out over time. Volatility may cause you to realize capital loss if you sell your investment (e.g. during retirement) at the lows, but volatility can also give you higher gains. I do not worry about higher gains, I only worry about losing money.

Usually, financial advisers will classify your risk tolerance as being "conservative," "moderate," "balanced," "growth," or "aggressive." They then say how much assets should you allocate to domestic stocks markets, international stocks, and bonds. I think these classifications are meaningless and associated asset allocation arbitrary. Everyone should be risk averse; no one should gamble their money.

I believe risk tolerance, or (more accurately) volatility tolerance, is a function of how much volatility in the value of your investments can you tolerate over time without losing money. If you have plenty of time before retirement, a stable income, a few years worth of emergency cash reserve, sufficient insurance coverage, no financial dependents, and not expecting any life changes, you can tolerate high volatility over a long time without realizing capital loss. The most important issues affecting your risk tolerance is the time you have and your financial stability. As long as you have sufficient time and financial stability, you should put all your other assets in stocks and equity investments.

Here's a list of issues affecting your risk/volatility tolerance:

Time: How many years do you have until you need you need to sell your investments (e.g. retirement)? If you are one year away from retirement, negative volatility may force you to sell at a loss. If you have 30 years to invest, volatility should not matter because the positive and negative cycles tend to average out over time.

Income stability: How stable is your income? If you have a stable job and can easily find another job without retraining, volatility of your investments should not affect your finances now. If your job and skills are on the edge of obsolesce, you may be forced to liquidate your investments to survive while you retrain and look for another job.

Emergency cash reserve: How many months of living expense do you have in your emergency cash reserve? If you have plenty of emergency cash reserve, you can live through financial emergencies without tapping into your investments. If you do not have sufficient emergency cash reserve, financial emergencies may force you to sell your investments at a loss.

Insurance: Do you have sufficient medical, disability, and, if necessary, life insurance coverage? This will affect whether you can afford to go through a medical emergency without tapping into your investments and realizing capital loss.

Financial dependents: How many financial dependents do you have? This will affect whether your job stability/availability, emergency cash reserve, and insurance are enough for you to be considered financially stable.

Life changes: What life changes are you expecting? Are you anticipating getting married, having children, needing medical attention, or poorer job prospects? This also affects how you determine whether you are financially stable.

Intrinsic value of investment: What is the intrinsic value of your investment and the risk of capital loss? If you know the market price of your investment is far below its intrinsic value and the risk of permanent capital loss is limited, as long as you don't need to liquidate your investment before the realization of intrinsic value, volatility should not matter.

***

How comfortable are you with volatility? Some argue you need to take into consideration emotional tolerance to volatility. As long as you are financially stable, I would argue that emotional tolerance can be handled by education, by putting a trusted financial adviser between you and your investments to handle your emotions, or by deliberately ignoring your investments. However you handle your emotions, be risk averse and don't lose money.

Clarification: I am writing with my personal bias to value investing in equities. For most investors, they are probably better off investing in broad market index funds and spreading their investment in all asset classes, including stocks, bonds, real estate, commodities, and cash, to achieve low correlation.

Related posts:

References:

Wikipedia:

The Benefits of Low Correlation (by Craig Israelsen).

P.S. This post was featured in the Carnival of Personal Finance #152 at Money Under Thirty.

Introduction to index investing

2008-05-02T01:00:00.005+10:00

What is index investing?
The goal of index investing is to approximate the performance of stock market indexes through index funds. This investment method assumes that the stock markets are generally efficient.

For most individual investors, who do not have the temperament, skill, or time to practice value investing, I recommend investing in no-load low-cost index funds. Warren Buffett and David Swensen, among other famous investors, also recommend index investing for most individual investors.

Why should we invest in index funds?
Better performance: Everyone wants to outperform the market. The market, however, is mostly efficient and it is very difficult to outperform the market over the long term. According to Vanguard, index funds had better returns than 70% of actively manage funds. Some reports claim index funds outperform 80% of actively managed funds before taking fund expenses and taxes into consideration.

Low costs: Index funds do not require expensive fund managers or research staff, allowing them to keep management expenses low. Most index funds have low management expense ratio (MER; 0.09%-0.65%) and do not charge sales commissions (also known as "loads"). On the other hand, actively managed funds usually have higher MER (1-2%) and may charge loads of up to 6%. The high costs of actively managed funds put a drag on investor returns, and they must to outperform the index just to match the investor returns of no-load low-cost index funds. Given that most index funds already outperform actively managed funds before costs, after costs, it is practically impossible for high-cost actively managed funds to beat low-cost index funds.

Low portfolio turnover: Index funds have low portfolio turnover, so they spend less on trading transaction fees, resulting in lower management expenses. Low portfolio turnover also results in higher tax efficiency due to less realized capital gains. By minimizing losses to taxes, we will ensure maximum potential gain.

No "key person" risks: The performance of actively managed fund may critically depend on its fund manager, and the departure of the fund manager may significantly affect the fund's performance. Even with the same manager, Morningstar claims that up to 40% of professional managers deviate from their stated investment styles (this is known as "style drift"), so you may end up with a fund different from what you signed up for. Index funds, by their very nature, do not depend on the talents of a fund manager and will not suffer from style drifts.

Easy to invest and manage: By investing in only a few index funds, you can be instantly diversified across small, medium and large cap stocks, and across domestic and international stocks. You will have fewer things to track and it will take minimal time for you to manage your investments.

What are the potential drawbacks with index funds?
Index funds cannot outperform the index: Index funds aim to approximate the returns of stock market indexes, so they should never outperform the indexes. The maximum return index funds can achieve is the stock market return minus fund expenses. The only reason an index fund may outperform the index is tracking error. As we established earlier, though, it is very difficult for actively managed funds to consistently outperform stock indexes, so index funds outperform most actively managed funds over the long run.

Tracking error: Index funds aim to approximate the returns of stock market indexes, but due to cash holdings and sampling, they may deviate (both positively and negatively) from stock market returns. The tracking errors are generally very low, causing 0.05%-0.40% deviation from index returns, far less than the "beta" (volatility, or deviation from market returns) of actively managed mutual funds.

Market bubbles: Market bubbles are "systemic" and will be reflected in stock market indexes. Because index funds aim to replicate stock market indexes, they will inevitably experience the rise and falls of systemic market bubbles. Actively managed funds may try market timing to buy low, sell high, and avoid market bubbles. Unfortunately, actively managed funds have dismal records at market timing and are often actively involved in market bubbles.

Index composition changes: Stock market index composition may change over time due to changes in company capitalization, mergers and acquisitions, initial public offering (IPO) listings, or liquidations and delistings. These changes are usually announced ahead of time, and the stocks in question may rise or fall with the announcements prior to the composition changes. This can cause slightly higher buying prices and lower selling prices. The losses due to composition changes, however, are relatively small in broad market indexes and do not significantly impact their returns.

Index funds ignore business valuations: Index funds do not take into consideration business valuations when investing in stocks. They merely try to replicate the composition of the index. The assumption of market efficiency require market participants to actively value businesses and trade stocks at their fair values. Since the majority of stock market participants are active investors, for now, the stock markets are still mostly (though not completely) efficient. For professional investors have the temperament, skill, and time to practice value investing, they will be duly rewarded. For most individual investors who do not have the temperament, skill, and time, they will be better off investing in an index fund.

How do I invest in an index fund?
I hope I have convinced you that index investing is better than investing in actively managed funds, and that you are now ready to start investing in index funds. So how can you invest in index funds? There are two options:

Option 1: Regular index funds. Financial institutions, such as Vanguard and Fidelity, offer no-load low-cost index funds. You will need to open an account with them before you can begin investing. They may have a high minimum investment requirement you need to meet before you can open an account, but the requirement may be lowered if you enroll in their automatic investment program. A comforting factor for new investors is that you can speak to a representative before you begin investing.

Option 2: Index fund ETF (exchange-traded funds). ETFs are, as their names suggest, traded on stock exchanges. You can buy them through discount online brokerages to lower your costs. There are plenty of ETF tracking similar indexes, so you will need to do your own research on the management expense ratios and how well they track the indexes. There are no minimum investment requirements, but watch out for high brokerage expenses. You can also trade rather easily with ETF, so you must control your emotions and invest for the long-term.

Related posts:

Financial record keeping for individuals and households

2008-04-28T13:30:00.002+10:00

We need to keep records and documents for various purposes, including tax, legal, emergencies, and references for family. It is important that we know what to keep and for how long. By keeping good records, tax returns, tax audits, legal situations, and emergencies can be handled with less stress. In this post, I will focus primarily on records relating to taxes and finances.

Where and how should I keep the records?
For some legal documents, you should consider placing them in a safety deposit box, with copies at home. But for most records, you can keep them at home. I recommend using softwares to help with bookkeeping, and keep the paper records in folders separated by category. If you have enough records, you may want keep the folders in boxes, separated by year.

What records to keep and for how long?
Generally, tax-related records need to be kept for 3-7 years. I keep them for 7 years just to be safe. For other records, it's really up to you how long you want to keep them. Please refer to IRS Publication 552: Recordkeeping for Individuals for more information, or consult your accountant and attorney for their recommendations.

Tax returns (IRS Form 1040)
The IRS can come back and audit you between 3-7 years after you file a return, unless you commit tax fraud or evasion (for which there's no time limitations).

Income records
You need to keep records on sources of income and whether it is taxable or non-taxable income. Here are some income record examples:

Pay slip: Keep them until you have received the end of year wage and tax statements (IRS Form W-2). Shred them after you have confirmed the statements are correct.
Wage and tax statements (IRS Form W-2): Keep with your tax returns. You may want to keep indefinitely for the protection of your Social Security benefits.
Income as independent contractor (IRS Form 1099).
Income from flow-through entities, such as limited partnerships, S corporation, limited liability companies (IRS Form K-1).
Income from partnerships (IRS Form 1065).

Expense records
You must keep records for expenses for which you claim tax deductions and credits, and retain them for 3-7 years. Generally, you will need to keep invoices, bills, receipts, or other proofs of payment. If you do not claim tax deductions and credits, you do not need to keep them for tax purposes. Here are some expense record examples:

Business expenses: Never mix business expenses with personal expenses. Please refer to IRS Publication 583: Starting a Business and Keeping Records for more information, or consult your accountant and attorney for professional advice.
Charitable donations: Not all donations are tax deductible. If they are tax deductible donations, keep the receipts. Otherwise, you can throw them away.
Medical records: If they aren't used for tax deductions, you do not need to keep them for tax purposes. Your insurance policy, however, may require you to keep longer records, so check with your insurer.
Utilities bills (telephone, gas, electricity, water, etc.): You can dispose of them after payment. I keep them, however, for tracking seasonal variations in utilities expenses (e.g. gas heating in winter, electricity for air conditioner in summer).
Other notes:

Receipt of items under warranty: Keep with product manual and warranty. Dispose with warranties upon expiry.
Most receipts (dining, entertainment, groceries, etc.): Throw them away after you've done your bookkeeping.
Credit card slips: Keep them until you get your credit card statements. If they match up, you can discard them (though I keep them for approximately 3 months before purging).

Financial records

Bank statements (savings, checking, and credit cards): I don't think there's a requirement to keep them, but I keep them for at least 3 years. I think it's good to have some financial history on hand.
Mortgage statements: Keep them for tax purposes.
Credit reports: Order your credit reports annually. You are entitled to a copy each year for free. Check them for accuracy.
Budgets: Keep them for 1-3 years to see how well you keep to budgets.
Personal financial statements (income statement and balance sheet/net worth statement): Keep them for indefinitely to track your financial progress.

Property records
You should keep your property records for 3-7 years from the date of you sell the property. These are important for tax deductions and capital gains for tax returns.

Closing documents.
Purchase and sales invoices.
Proof of payment.
Insurance records.
Mortgage statements.

Investment records
Your records should cover all your investments, including bonds, stocks, and mutual funds. You need to be able to determine your cost basis, expenses, and gain or loss on investments from your records. You should record all "hidden" transactions, such as reinvested dividends, stock splits and dividends, and load charges. Unless otherwise stated, you should keep investment records for 3-7 years after you have sold the investment. Examples of investment records:

Brokerage statements: Though not required, I keep them indefinitely so I can see how I performed with my investments.
Mutual fund statements.
Retirement account statements: Keep these indefinitely, especially if you have a mix of tax-deferred and after-tax retirement accounts. Keep track of whether tax has been paid, or you may accidentally pay taxes twice!
Tax statements for dividends and distributions, interest income, etc. (IRS Form 1099).
Capital gain statements (IRS Form 2439).

Legal documents:

Social Security cards: Retain indefinitely.
Wills and trusts (copy): The originals should be at the attorney's safe, with a copy for your records. Be sure to keep your Wills up-to-date, especially with life changes like marriage and divorce.
Deeds and titles: Retain for 3-7 years after disposal of assets.
Home content inventory: Keep them up-to-date for insurance claims.
Bonds and stock certificates.
U.S. Savings Bonds and U.S. Treasury Securities: Make sure you're still collecting interest on them. If not, redeem then buy new ones.
Rental lease: Retain for the duration of the lease plus 3-7 years. (In Taiwan, renter's rental expenses are tax deductible. Owners need to keep records accordingly, as the tax office will match your rental income to the renter's deductions claimed.)

The principles of value investing

2008-04-26T14:00:00.005+10:00

Many personal finance website recommend investing in index funds, and I also believe that index investing is the best option for most people. The high level of diversification and low cost will ensure that your performance will approximate "the market" (minus management expenses and transaction costs). Most actively managed mutual funds have, over the long term, underperformed the market and no-load low-cost index funds. As WarrenBuffett recommended, for know-nothing investors, they are better of investing in no-load low-cost index funds than an actively managed mutual fund.

As you may have read on my LinkedIn profile, I am the investment manager of a private investment company I setup for my family and relatives. Why do I actively manage investments when I recommended index investing? Because it is possible for those who put in the time and effort and have the right temperament to outperform the market.

I practice value investing because it is the method of investing that seems most logical and rational to me. The concept of value investing is very simple and understandable, though not necessarily easy to execute. While value investing is not the only way to invest actively, I am not convinced by other methods and do not have sufficient knowledge to practice them.

Introduction to value investing
Value investing is investing businesses at a discount to intrinsic value. The intrinsic value of a business can be determined, so the value of securities (stocks), which represent fractional ownership in the business, can be calculated. Basically, value investors want to use fifty cents to buy businesses that are worth one dollar.

Invest for the long-term: "Buy a businesses, don't rent stocks"
Stocks represent fractional ownership in the business behind it, so you should buy stocks with the same approach as you would when buying an entire business. If you buy a business, such as the neighborhood groceries store, you would want to own it for a number of years and let the business earn money for you. Similarly, you should be investing for the long term when you own a stock, rather than renting the stock for a day. As Warren Buffet says, "buy a business, don't rent stocks;" "if you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes."

Circle of Knowledge and Circle of Competence
These concepts are borrowed Warren Buffett. Everyone has a "circle of knowledge", meaning things that they know or have information about. Within that circle of knowledge, we have our "circle of competence" - things that we understand and are competent in doing. We should invest only within our circle of competence. If you want to invest in a business, not only do you need to know or have information about the business, you must also be competent enough to understand and analyze the business.

Invest in great business
Here are some traits of great businesses that value investors look for:

Simple and understandable business: You should be able to understand the company's business model. In layman terms, you should understand what the company does and how it makes money. Everyone can understand how Coca Cola (KO) earns money, but no one understood how Enron earned money (it didn't).

Business operating in a stable industry: It is hard to predict what will happen to a business in fast changing industries, so intrinsic value will be difficult to determine.

Business operating in an industry with good economics: In an industry with good economics, even an average company can earn a lot of money for you. However, in an industry with bad economics, such as the airline industry, brilliant managers are needed just to give the business a fighting chance of maintaining profitability. But, as Warren Buffett said, "when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the the business that remains intact."

Business with favorable long-term prospects: We would, ideally, invest in a business that is going to continue operating and growing. Blockbuster (BBI), for example, is a business with poor long-term prospects - unless they change their business model, Netflix (NFLX) and online movie downloads will put them out of business.

Business with durable economic moats: Economic moats, or competitive advantages, allow businesses to operate with superior margins and returns. The economic moats must to durable, or sustainable, so the business can maintain long-term superior operation. You can think of it as, if you are given $1 billion, how badly can you hurt the business? It's hard for anyone to do serious damage to Coca Cola (KO) with $1 billion.

Business with low capital investment requirements: If a business does not require high capital investments to maintain its size and grow, most of the business's profits can be returned to the shareholders while the business continues to grow. See's Candies, for example, have low capital requirements, so it can pass most of its earnings to Berkshire Hathaway while it continues to grow.

Business that do not require superstar managers: If a business is easy to understand and operates in a stable industry with good economics, even an average manager can earn money for you. If the business require superstar managers, it will be in trouble if the manager leaves and an equally brilliant replacement cannot be found.

Invest with honest and competent management
While stocks represent fractional ownership, similar to partnerships, in a business. But, unlike partnerships, shareholders cannot participate in the day-to-day operations of the business. Shareholders are, essentially, silent partners. For us to be comfortable owning the business while it is managed by someone else, we need to invest with managers who are:

Able and competent: Nowadays, most CEOs and business executives are overpaid. The least we should get in return are able and competent CEOs and executives. Their abilities and competence can be measured by the business's performance (margins and returns, NOT stock price performance). We can also see if their business strategies and the actions they take make sense.

Directors should also be able and competent. Natalie Bancroft, for example, is a director of News Corp., but she does not appear to have sufficient business or industry experience to contribute much to the Board.

Energetic: Energetic leaders can energize the employees and lead the company to do great things; for example, Amazon.com's (AMZN) Jeff Bezos and Apple's (AAPL) Steve Jobs are leading energetic companies. On the other hand, Hewlett-Packard's (HPQ) former CEO, Carly Fiorina, drained the employees' creativity and energy and the company's performance suffered accordingly.

Honest and trustworthy: These are the most important quality of good managers. If they are not honest and trustworthy, investors will suffer from their ability and energy. While it is possible to detect earnings manipulation and similar unethical business behaviors, evaluating people for honesty and trustworthiness are subjective exercises.

Candid with shareholders: Good managers should communicate candidly with shareholders, informing the shareholders of things that they would want to know if their positions were reversed. In his letters to shareholders, WarrenBuffett readily admits his mistakes and shares his concerns and thoughts on Berkshire Hathaway's (BRK.A, BRK.B) businesses.

Rational and resist the institutional imperative: The institutional imperative is the "group think" or lemming-like behavior people and businesses engage in. It's the mindless imitation of what others do, no matter how irrational or self-destructive those behaviors are. Good managers should resist the institutional imperative and, instead, be rational in what they do.

Warren Buffett said it best: "(1) as if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated."

The subprime financial crisis was (partly) caused by the institutional imperative when banks imitated each other and lend excessive amounts of money to people with poor credit history or without proof of income. Rational managers should realize the folly of such behavior and not bother to compete in that business. The few banks that avoided the institutional imperative, such as Wells Fargo (WFC) and JPMorgan Chase (JPM), will come out better and stronger after this crisis has washed out the weak.

Business Valuation
Value investors will run mathematical analysis, while keeping in mind the big picture, to determine the intrinsic value of a business. The process is called "business valuation". There are many ways to value a business, for example, discounted cash flow (DCF) analysis, dividend discount model (DDM), liquidation value, relative valuation, and option valuation. Aswath Damodaran, an NYU professor, generously distributes his class materials on valuation online and I recommend watching his course webcasts (you'll need to have some basic understanding of business and finance, though).

I believe, as Aswath teaches, there are no set Excel templates for valuing a business. Every business is different and you cannot just plug in numbers to a spreadsheet template and expect to come up with an intrinsic value that reflect the true value of the business. That said, Excel templates for various valuation models are good ways to approximate the value of a business.

When valuing a business, you should apply the Pareto Principle and find the small portion of the business data that are critical for determining the company's intrinsic value. Even though Warren Buffett suggests that DCF analysis is the way to measure a company's value, Charlie Munger said he never saw Warren do a calculation. Why? Perhaps, Warren Buffett distilled all the financial data on the business to the critical few pieces of information, then did a simple mental calculations to come up with the intrinsic value of the business.

Invest with a magin of safety
When we have determined that a company is worth one dollar, we will try to buy the company at fifty cents. We want a margin of safety to (1) minimize our potential losses (if we were wrong about the business's value), and (2) maximize our potential gains (if we were right about the business's value). For smaller and unstable businesses, we generally will want to have a larger margin of safety (50% or more). For large and stable businesses, we may be confident of our valuation and positive about the company's future, so we may be willing to accept a smaller margin of safety (say, 25%).

Concentrate investments
Diversification can minimize some investment risks, but the law of large numbers means that, the more you diversify, the closer to average your investment performance will be. Many mutual funds invest in hundreds of companies, and their performance are inevitably closely correlated to the market return. To exceed market returns, investors should invest with conviction and make big bets with ample margin of safety. No matter how sure you are, though, always under-bet the Kelly Formula. Generally, you can limit your portfolio to approximately 20 businesses you truly understand and you would have diversified away most "diversifyable" risks.

Another reason to concentrate investments is so that you can get to truly understand the businesses you invest in. Value investors filter and digest a lot of information before we find a great investment idea, and new information are always flowing from our investment holdings. If you diversify too much and hold too many investments, the information overload may lead to poor decision making and a bad financial outcome.

Recommended reading
I hope you now have a good understanding of the basic principles of value investing. There are much more to value investing that you can learn about. For starters, I recommend "The Intelligent Investor" by Benjamin Graham. My second recommendation is to read all the letters to shareholders and letters to partners by Warren Buffett. Finally, if you have gotten a good grounding in value investing and finance, read "Security Analysis" by Benjamin Graham and David Dodd.

Related posts:

References:

Wikipedia

Index investing.

Damodaran Online.
The Intelligent Investor by Benjamin Graham.
Warren Buffet's Letters:

Security Analysis by Benjamin Graham and David Dodd.

P.S. This post was featured in April 28, 2008 Edition of the Festival of Stocks at Investing Adventures.

Discloure: Long BRK.B, WFC.

Inflation, compounding, and the time value of money

2008-04-24T22:00:00.004+10:00

Inflation and compounding are two basic concepts of economics and finance that you should understand. Together, inflation and compounding will have huge effects on your wealth over your lifetime. Related to inflation and compounding, present value and future value calculations are two basic personal finance formulas you should know. If you understand the concepts and know the formulas, you will be able to solve many time-related money problems.

If you are offered $100 either today or in 10 years, which offer should you accept? Most people will instinctively choose to take it today. But why? How does the value of the offers differ? How do we calculate the value of money over time?

Inflation
Inflation is the rise in general price levels over time, usually measured as the percentage change of the Consumer Price Index (CPI). Inflation will cause the purchasing power of our money to decrease.

What causes inflation?
1. Demand-pull inflation: Prices are often set by supply and demand. For example, you have tickets to a popular sold-out concert but cannot go because of personal matters, so you put it up for auction - the popular demand for the ticket will cause it to be sold at a premium over your purchasing cost. Similarly, when we (individuals, businesses, and governments) buy goods and services, if our demand exceed current supply, prices will rise.

2. Cost-push inflation: When prices rise for producers, they will pass the cost on to their customers so they can maintain their margins and profitability. It may be explicit cost transfers (such as the airfare fuel surcharges) or hidden cost transfers (price increase of McDonald's burgers).

3. Built-in inflation: As we see our groceries costs increase, we will ask for wage increases to cover our increased living expenses, and ask for more, so future price increases will be "covered" by this wage increase. We have priced both current inflation and future inflation into our wage increase. The companies we work for will then increase prices of the products and services so that margins are maintained. The price increase will ripple through the economy and eventually cause the price of our groceries to increase yet again. This is the vicious cycle of price/wage spiral.

Back to the $100 offer. How much purchasing power will the $100 have left in 10 years?

Time value of money: Discounting to present value
To calculate the purchasing power of $100 in 10 years, we will have to put the $100 in the future then "discount" it back to the present at the expected inflation rate (let's assume it as 3% p.a.) to find the purchasing power in present dollar value. The formula is as follows:

Where:

PV is the value at time=0, the Present Value.
FV is the value at time=n, the Future Value.
i is the rate at which the amount will be discounted each period, the discount rate.
n is the number of time periods.

For our example, the values we need to use are: FV = $100, i = 3% p.a., n = 10 years. When we solve the equation, PV = $74.41. This means that, in 10 years, your $100 will have a purchasing power equal to $74.41 today.

Compounding
Compounding is the addition of interest back to the principal, so that interest is earned on interest from that moment on. Instead of the linear growth of principal with simple interest, compounding will cause our principal to grow exponentially.

So what will happen to your $100 if you take it today and invest it for 10 years?

Time value of money: Compounding to future value
To calculate the amount of money $100 will become in 10 years, we will have to compound it at the expected compound growth rate (let's assume it as 6% p.a.) to find out how much money it will become in the future. The formula is as follows:

Where:

PV is the value at time=0, the Present Value.
FV is the value at time=n, the Future Value.
i is the rate at which the amount will be compounded each period, the compound growth rate.
n is the number of time periods.

For our example, the values we need to use are: PV = $100, i = 6% p.a., n = 10 years. When we solve the equation, FV = $179.08. This means that your $100 will grow to $179.08 in 10 years.

Inflation, compounding, and the time value of the $100 offer
Inflation will decrease the value of $100 over time, whereas compounding will increase the value of $100 over time. Now that you have calculated the present value and future value of the $100 offers, rather than relying on gut feelings or instincts, you can compare them and make a rational decision on your offer.

	Take $100 today	Take $100 in 10 years	Difference
Present value	$100.00	$74.41	$25.59
Future value	$179.08	$100.00	$79.08

The effects of inflation and compounding make take the $100 today the better offer, no matter whether you look the present values or the future values of the offers. You will be better off taking the $100 today.

Related post:

Maximize the power of compounding.

Reference:

Wikipedia

P.S. This post was featured in Carnival of Personal Finance #150 at Lazy Man and Money.

The Story of Stuff - Consumerism vs Thrift

2008-04-22T22:00:00.003+10:00

The Story of Stuff (hat tip to Garr Reynolds from Presentation Zen) is a good presentation you should have a look at (you can also read the transcript). You may not agree with everything Annie said (I don't), but the visuals are compelling and she tells a good story. Incidentally, my favorite part is also Garr's favorite part of the presentation:

Marketers and advertisers are very good at motivating us to buy their products and services. They make us feel bad, then tell us we will feel better if we buy their products or services. In addition, television programs and movies often equate a lavish lifestyle to a happy life. Anthony Robbin says pain and pleasure are the strongest forces in life, so the pain-pleasure combination strongly motivate us to shop and spend. What should we do to avoid the urge to spend as they wish us to?

Turn off your television: If you don't watch television, you won't see the advertisements. You will also receive the additional benefit of having more time for productive endeavors. I do not have a television at home. I believe we should learn and improve ourselves constantly, but very few programs on televisions do much more than entertain us. Given that we all have only 24 hours a day, I would rather devote more time to reading and learning. By learning and improving ourselves, we may even increase our income!

Do what advertisers do, in reverse: Clean out all the things you bought but never, or seldom, used and make yourself feel bad for making those purchases. When you throw them out, imagine throwing away cash. Next time when you want to buy things, think long and hard about whether you will find yourself throwing away the cash next time you clean out your "stuff".

Don't succumb to fashion and peer pressure: When certain things are in fashion, remember that fashion go out of style very quickly. There was a time when Japanese digital pet toy was the craze in Taiwan - every child, boy or girl, had it - and I wanted one. I got my wish. After a month or two, everyone lost interest. If someone had wanted my "used" digital pet, I would have given it away for free. Incidentally, the buyer could reset it and it would play as if it was new! I have since realized it is a waste of money to buy into fashion and peer pressure.

Don't fall into the "on sales" trap: When people see the "sales" sign and the 50% off, they think they have a bargain they must buy immediately. But do you absolutely need and will you regularly use the products or services? Don't buy things just because it's a bargain - it's still money you're spending away.

I recall Guy Kawasaki's talk to entrepreneurs: It is your money in the customer's pocket. How do you get your money out of the customer's pocket and into your pocket? Remember that every dollar you spend, whether to buy products or services at a discount or not, is money out of your pocket and into the pocket of the seller. It is your job, as responsible steward of your money, to keep your own money firmly in your own pocket.

Be thrifty, save your money, and you might just help save the world at the same time!

Related posts:

References:

The Story of Stuff (Transcript).
Garr Reynolds - Presentation Zen: The Story of Stuff (and the stuff of story).
Guy Kawasaki - How to Change the World: The Art of the Start Video.

This post was featured in the Festival of Frugality #123 at Sound Money Matters.