The Lean Investor

Corporate Governance: Do Microcap Stocks Do Wrong by Shareholders? - Small vs. Young - Gannon On Investing - Gannon On Investing

2010-10-18T15:48:00.001+01:00

A post worth reading if you're thinking of getting into small & micro caps.

Corporate Governance: Do Microcap Stocks Do Wrong by Shareholders? - Small vs. Young - Gannon On Investing - Gannon On Investing: "

"...microcap frauds tend to be in more speculative and young companies rather than purely small companies. A lot of small companies are also young so people get the two confused. Old microcaps are often like old big caps and young microcaps are often like young big caps..."

Goals of the Investment Plan

2010-08-29T15:51:00.001+01:00

What I want to develop is a framework for investing that allows for the following three outcomes:

Preservation of capital
Income
Capital growth

I believe that all three can be achieved through a careful and thoughtful process that is backed by a disciplined and patient behaviour. Too many times I have seen (and experienced) jumping into a situation at the wrong time because of a lack of discipline caused by some other external factor.

So how am I going to go about achieving my three goals? Basically, the only real way I have experienced that has demonstrated any sort of robust results is one that views each company as a long term investment where the short term price shows a mismatch with the long term value of the company. Moreover, only when the short term prospects are largely ignored can the longer term prospects be understood. And at this point, we start to get a far clearer picture of the true intrinsic value of the business.

In fact, focussing on the short term prospects of a business is too difficult to get right in the broad majority of cases. This is where the visibility is highest and thus, the most information is reflected in the price. As I see it, market efficiency certainly exists - in the short term. In the long term, where business prospects are less certain, yet can be understood within a bounded range, pricing inefficiency is far higher.

However, taking this view is far harder to achieve than one may think. Sadly, the investment world is hell bent on achieving "outperformance" from month to month, quarter to quarter, and year to year. As soon as the focus moves to month to month and quarter to quarter the chances of out performance starts to diminish rapidly. Here, it is the short term market noise that becomes important rather than the true economic characteristics of a business. As the time horizon increases, so do the chances of market beating returns.

One of the key disciplines I'm hoping to achieve is not losing sight of what an investment really is. In fact, it would be safe to say that an investment is one that:

Protects the original investment
Gives some sort of income either through returning dividends or reinvesting back into the business at an attractive rate of return.
Shows an increasing output as the company grows over time.

This all seems very much like the goals for the framework I'm trying to achieve. In fact, this framework is just another way of articulating a set of steps for successful investing. So how will this be achieved? In short, the plan is to approach this whole thing in a systematic way that reflects a total purchase of the company. This is what could be called "the total purchase basis". As an approach to investment, this is where things start to get interesting as it forces the view of looking at each investment in a more business like fashion. What will I get out of the business, what are the prospects, and what am I going to pay?

Pretty quickly, it can be seen that the view of each business starts to resemble a true economic investment. There is little difference from buying a business with publicly listed stock and buying a business that is closely held. In the favour of the investor in publicly listed shares, prices are quoted daily and they may represent an undervalued, fair, or overvalued valuation.

This last point is important because it forms the basis for achieving the selection of investment candidates with the original three investment outcomes in mind. Companies that are cheap should see better yields, should see a better opportunity for preserving the original investment, and they should see better chances for capital appreciation as their prices move back to a fair valuation.

It is patently obvious that buying low and selling high is the foundation of most investment. Right? However, in practice this is easier said than done despite the fact that it offers some real an understandable way of achieving the three investment outcomes. For this reason, this methodology will focus on understanding the intrinsic value of each investment as a way of understanding the real position of each investment and the overall portfolio. In fact, it could be said that intrinsic value is the center of the process. If there is an understanding of roughly what something is worth then there is a rough understanding where the risk is. In abstract terms, could it be any simpler than this?

The Process of Investment

2010-08-28T09:46:00.009+01:00

Now it's time to start developing a framework for investing. I've been meaning to do this for a few months now as I think I've now come far enough to see that there is a real need for a set of boundaries from which to operate within. What I will try to do is write down a set of overall principles and then expand on those principles as I go along. This is a totally iterative process that I intend to develop over time. It may not be right first time around but with numerous iterations I hope to get closer to the goal of something that is both cohesive and structured.

There are five general themes that I hope to expand upon:

Goals
Investment selection and disposal
Risk Management
Emotions
Academic & real world theories

These five themes provide enough of a breakdown for an end to end process of managing a well rounded portfolio designed to achieve its investment goals. This is not an over reaching, step by step set of hard rules, rather it is based on a set of principles that can be adapted to each individual situation spanning market caps and asset classes.

Like most plans, the best place to start is by defining the goals which being worked towards and at what point these goals are being successfully met. Capital appreciation, income, preservation of principle. Whatever it is, by setting an overall target the development of the plan is obviously far easier. This is probably not far off comon sense. I personally look first for preservation of principle over the long run with capital appreciation and income in between. Because of this, I'll write with these goals in mind.

Investment is a funny game because it plays with your emotions more than I could have ever imagined. It always feels like everyone has an opinion that they are happy to give and the market is apparently "always right". Brokers, colleagues, analysts, the press. It's always easy to let these external influences shape your investment thesis for better or for worse making true investment difficult in all but the best cases.

Having experienced the academic side of investing, it's striking how large the difference between academic investing and real world investing really is. In fact, I can see that the practicalities of academic studies are limited at best if they are not used to simply gain some sort of general insight into the workings of the world. There is a reason why Post Earnings Announcement Drift and the Price to Book value anomalies exist. Would you really want to invest in a company purely because it has beaten consensus forecasts or would you really want invest your pension fund into a basket of low Price to book value stocks despite the stocks having a low ROIC or being less than financially sound? In many cases this is not practical. However, these anomalies do provided an excellent place to start thinking about where to start looking for potential investment candidates.

Obviously, we also have the actual investment selection. This can only really be done in the light of the a holistic process the takes into account end to end thought and care. This is where a careful analysis of each investment case is done with the overall portfolio goals in mind. Here, we need to distinguish between investment and speculation along with what the investment gives you that you don't already have.

Often the focus is purely on what to buy rather than what (and when) to sell. I'm not a big fan of buying and selling for the sake of it as I often think the only ones to win out of this strategy are the brokers. However, at what point have we introduced too much risk into the portfolio through not selling out when the market cap has advanced too far. It could be argues that holding onto an over valued stock is the same as buying an overvalued stock.

Finally, tying all of this together is the risk management process which I believe should be at the center of the whole portfolio. Are we looking to preserve capital, build capital, or a combination of both? How is this going to be done and with what type of assets? How diversified will we be and what do we need to achieve our returns? These are all basic questions that need a set of principles from which we can work within. Once this part of the management process starts to break down then not only will the portfolio start to take on unwanted risk but the portfolio will start to resemble a set of random bets on success.

Of the five areas of this methodology, no one area can be used without the others. Understanding these five areas should create a holistic process for investment and investment management. At the end of the day, this process aims to create a way to allow for investment that is "business like" in order to achieve its goals.

The Problem With Being Qualitative

2010-08-28T09:27:00.002+01:00

Qualitative analysis forms an important component of the analysis process however it should not be the start point. The problem with the qualitative factors is that there is no measurable way to determine just how much each factor is worth to the overall investment value. Adding to this, it needs to be asked just how much of the qualitative facts are already factored into the current price. This is impossible to accurately say.

One of the real problems with qualitative (as compared to quantitative) analysis is that an accurate appraisal can only be given after taking in all the influences on the business. In reality, this may prove to be impossible due to the unpredictability of everyday life and the lack of accurate comparators between different opinions. Quantitative analysis on the other hand takes given, measurable inputs to help evaluate any given model. By comparison, these inputs are far simpler to digest and model than what can be provided by qualitative factors alone.

Quantitative data is easier to obtain, easier to measure and compare, and there is less of it. Once the thorough quantitative analysis has been done can a qualitative analysis really only take place. In all cases of investment, an investor is looking to measure the value of an investment in way that can be compared and easily understood.

In fact, the numbers can probably tell a lot about the qualitative factors of a business. A good example of this is companies that have demonstrated a high return on capital over a number of years (long term). This is probably quite a good indication of a business that has some sort of competitive/strategic advantage over its competitors. Could a qualitative analysis show this? Most likely but it would not show the magnitude of the advantage. This is where I think many people go wrong. They attach too much to the qualitative factors without taking into consideration that these factors are already in the numbers contained within the accounts.

So where does the qualitative come on? One answer may be that they can be used to help gain understanding of how the situation could change going forward. How durable is the advantage and where will it come from in the future? What is management trying to achieve and are their ideas workable? What could destroy the advantage? Only when taken in this context does qualitative analysis begin to be useful for investment. Moreover, in many cases it is pretty difficult to put any value on the qualitative factors above and beyond what you've read in the financial statements.

Margin of Safety

2009-07-05T22:35:00.000+01:00

The margin of safety is a concept tightly linked to the concept of intrinsic value. Without an intrinsic value, there can be no way to determine how large (or small) your margin of safety is. Understanding this relationship is important when trying to minimise risk in security investments.

Intrinsic Value
Intrinsic value is true value of an underlying investment based on factual information. Warren Buffet defined intrinsic value as "the current discounted value of the future cash flows that can be taken out of a business" whilst Ben Graham defined it as "the value which is justified by....assets, earnings, dividends and definite prospects".

Margin of Safety
Without an understanding of intrinsic value then this difficult to determine. This can be defined as the spread between the purchase price per share and the actual calculated underlying value per share. The wider this spread, the greater the buffer the investor has against downturns in the market and bad investment decisions brought about by the difficulties in evaluating businesses.

Simply, if you can't work out the intrinsic value for your business then how will you know what price to pay?

Random Nature

2009-03-01T13:23:00.003Z

It's been a long time since I wrote my last post. I've been settling in at a new job, wrapping my mind around a whole new area, and getting life back on track after the last year of study. There has been a lot of changes in the markets since my last post (obviously) so it's interesting to reflect back on what has been happening and what it really shows. It turns out that even the main man, Warren E. Buffett, has made some bad calls. Undoubtedly he is still the king but it goes to show the random nature of the world we live in and how little we really know of what we are dealing with. Certainly, what is quite clear from all of this is that we have an incomplete understanding of randomness and its role in investment returns. Food for thought.

And again...

2009-03-01T13:21:00.002Z

OK, I'm going to have another shot at this. I'm finding that I've got so many things going on that the last thing I want to do is sit in front of the computer in the evenings. Nonetheless, I'll try.

Indexes 2

2008-01-08T17:56:00.002Z

Another way that I think about an index is just as another investment manager. Remember that the index is not the average, it's the point that the average would like to beat. The index follows a simple investment strategy that most other managers just can't beat. The realised results of the average investment manager are probably the best that can be expected when managing many billions within an institutional framework. With restrictions on the degree of activity and with the pressures to preform it may be nothing but expected. But why is the "index manager" so good and why does the average active manager have so much trouble keeping up? (note that something like 80% of funds under perform the benchmark). Clearly consistently beating benchmark is incredibly difficult but there may be some reasons which start to answer why this is.

I get the feeling that most investment managers are more interested in building their business rather than focusing on their profession (of achieving investor returns). As with any business, if you get the process right then over the long run everything else will fall into place in time. There will be less chance of mistakes and the business will find life much easier. Remember that a process is just a way of defining your average result. Instead, as I understand it, most managers are focused too heavily on their benchmark tracking error which deviates thinking away from the long term average and focuses it on the short term. To paraphrase Keynes, many investors focus on predicting the market's psychology (speculation) rather than predicting long term return on investments (enterprise).

Why is it that the index manager, who has a simple criterion such as market capitalisation, price or a simple set of fundamental metrics, so powerful? Looking at the behaviour of these managers might lead to some clues. Indexes generally have very low turnover (which translates into low costs) and they have no pressure to outperform. In other words they have a simple buy and hold strategy. Yet despite their lack of detailed analysis and skill they still outperform.

The low turnover point is important. The returns from the stock market do not follow a normal distribution- the returns have fatter tails and many more smaller fluctuations. In other words we are looking at a leptokurtic distribution (i.e. excess kurtosis). I was reading the other day how the returns from the S&P from 1978 to 2005 were 9.6% (annualised) . If we knocked out the worst 50 days our returns would be 18.4%. If we knocked out the best 50 days our returns would have been just 2.2%. So I decided to run a similar test using the daily returns of the FTSE All Share from 10-Jan-1977 to 4-Jan-2008. The results I got were pretty similar. I had an actual annualised gain of 10.2%. If I knocked out the worst 50 days I got a return of 17.6%. If I knocked out the best 50 days I got only 4.3%.

This makes it pretty clear that the tail events have a lot of impact on returns and it highlights how important a longer term holding period is in order to catch all of the tail events. I'm not sure exactly how this will impact many of the standard pricing models but I would imagine that as they assume a normal distribution they could be problematic because they only work "most of the time". It seems that the tail events have a lot more to answer for than what I am told.

BTW, if you're interested in the spread sheet then just ask and I'll send it over.

Indexes

2007-12-27T21:44:00.001Z

When thinking about performance, it’s interesting to note what we are trying to compete against. In most cases our benchmark is some kind of index or basket of indexes. So how are the constituents of an index chosen? For example the FTSE All Share index is basically a market capitalisation weighted index of the largest 350 stocks trading on the London Stock Exchange. There is low turnover and no human decision. The S&P 500 is determined based on several non human factors such as Liquidity, Four Quarters of Positive Net Income, Market Cap, Sector Representation and Lack of Representation. However, despite their simplicity the majority of fund managers have trouble beating these benchmarks. Which leads me t ask, are we doing something wrong and if so what is it?

To me, the idea of placing too much emphasis on benchmarking in the short term is ill founded and adds to informational noise which in turn causes irrational behaviour. Trying to magically outperform something that is uncontrollable over the short term kind of signals to me that there are some serious misunderstandings in what is trying to be achieved. In the short term it is inevitable that we may underperform the market and it should be expected. Until we can accept this can we then, and only then start to understand how to beat the market. As I have written before, an investment process is one which works over the long term by the fact that the process is weighing the probabilities in the user’s favour. As with the coin flipping example in the “Process vs Outcome” post, it is only once we give the process a chance can we start to realise the probabilities associated with the process - over the long term.

Process vs. Outcome

2007-12-25T20:15:00.000Z

Enterprise software development is a discipline in which process is often a deciding factor between success and failure. In my experience, more often than not projects run over time and over budget which I would put down primarily to one thing, focussing on the outcome of the project rather than focussing on the process of achieving the outcome. Through desperation, most managers falsely believe that adding more developers will help. Instead deadlines slip further. Getting developers to work longer. Instead deadlines slip further. Emergency measures whatever they may be. Yet deadlines still slip further. In other words, most software projects are conquered with brute force rather than careful thought and finesse. Instead of concentrating on eating the carrot, why not first work out how to get the carrot.
As anyone who has thought about software development for what it is can tell you, the complex relationships between understanding client requirements and technical complexity are difficult. Only when the actual process of the software development process is addressed are development teams enabled to start building malleable and flexible software that meets business and technical requirements. What needs to be understood is how software that is malleable and flexible in its design is cheaper to maintain, easier to build and less problematic overall. Only with a disciplined process can this result be achieved. Unfortunately, the brute force approach nearly always creates software that is late, over budget, barely satisfies the business requirements. Moreover, a long term legacy of difficult and expensive maintenance is born. This approach of focussing on the outcome rather than the process behind the final outcome comes down to our need for instant gratification regardless of long term results. It’s the feel good factor that drives us. When projects are faced with challenges a well defined process does not instantly lead to better results but in aggregate it does and this is why most people continue to carry on with the brute force approach. It’s the average speed, not maximum speed that counts.
To me, it is pretty clear that investing is not much different from software development in its need for process. Process brings to the table a set of disciplines that are not available with a “gut feeling” approach. To consistently repeat logical decisions a well defined process must be in place. Sustainability of execution is the all important. However, it is important to realise that even with a “superior” process we will not be guaranteed against failure. What we will see is a lower chance of failure. We are just moving the odds further into our favour. Over the long term, we will see an stronger aggregate result.
We are seriously limiting our chance of success by focussing on the short term. As investing is a probabilistic endeavour it can not reasonably be expected that a process will lead to a desired result every time. Coin tossing is a useful analogy of how long term results revert back to a process mean. A toss of a fair coin obviously has a 50% chance of heads and a 50% chance of tails. If coin is flipped twice is this going to be an indicative of these probabilities? The chances of flipping two heads or two tail are pretty high (25%). However the more times the coin is flipped the closer our results will be 50% heads, 50% tails. This is the mean of our process and over an extended set of outcomes it can logically be assumed. In other words, this is “the law of large numbers”.
An investment process is exactly the same. If you only give it a limited chance to work then the chances that you will be disappointed are high. You are not moving the odds into your favour because you are forgetting about the law of larger numbers. Accepting that there will be periods of under performance and that the aggregate results are what count. There is no such thing as “the law of small numbers”.

Moving From Target Returns to Expected Returns

2007-12-07T18:49:00.000Z

Investing is really just a probabilistic endeavour not unlike gambling. Lets think about that for a moment. Like gambling, investing has a set of expected outcomes and like gambling, the only certainty is that there is no certainty. However, despite this lack of certainty we need to act.

For precise prediction, we rarely have the required information and by adding more information we do not necessarily obtain more accurate results. To counter this we need to look at decision making as a set of probabilistic outcomes. By calculating a probability distribution we can arrive at an expected value which takes into account probable chances of loss. In other words the chance of an adverse result. In total this will enable us to calculate an expected return rather than a target return. This is no different from producing a decision tree of probabilistic outcomes.

By expressing opinions in expected value terms we are admitting that there may be a chance of a negative result. By reviewing all of the scenarios (good, bad and neutral, etc) we can start to think of the payoffs and the probabilities of those payoffs. It removes the risk of focusing too much on particular scenarios (often the positive ones). In behavioural finance this is known as "anchoring"- if we start to think of the target return for of a certain stock we start to look for evidence that will support that target whilst dismissing contrary information.

By considering multiple scenarios, we are enabled psychologically to consider all the available information. This allows us to enter into the investment position with the idea that there may be an unfavourable result. In other words, we can be wrong without a fear of failure.

So what does all of this mean? Lets take a look at an example.

Stock exceeds earnings target. 25% probability. Stock rises by 3%
Stock meets earnings target. 50% probability. Stock rises by 1%
Stock misses earnings target. 25% probability. Stock falls by 4%

(0.25 x 3% + 0.50 x 1% + 0.25 x -4%) = 0.25%

We can see here that our expected return is not really all that favourable, even though the probability is clearly in favour of a positive result. Lets look at an even more illustrative example.

Stock exceeds earnings target. 25% probability. Stock rises by 3%
Stock meets earnings target. 65% probability. Stock rises by 0.5%
Stock misses earnings target. 10% probability. Stock falls by 10%

(0.15 x 3% + 0.65 x 0.5% + 0.20 x -10%) = -1.225%

This is clearly a bullish outlook but the expected return is negative. So what should we do? Short sell?

Now lets look at a typical stock which is facing some problems. Each piece of bad information gives us a small reduction in the price but any positive information has a big impact (upwards) on the price. Lets look at an example:

Stock exceeds earnings target. 25% probability. Stock rises by 15%
Stock meets earnings target. 50% probability. Stock rises by 0.5%
Stock misses earnings target. 25% probability. Stock falls by 2%

(0.25 x 15% + 0.35 x -0.5% + 0.50 x -2%) = 2.575%

Again, the odds are not in favour of a positive outcome but the expected value is positive. Look past the frequency of success and start thinking about the expected value. It's not the frequency of being correct that matters; it's the magnitude of being correct that matters. These are simple examples just used to illustrate a point but remember that through investing, we are dealing in a probabilistic endeavour so it needs to be asked "are target returns really that relevant"?

Blogging is Simple But Not Easy

2007-11-19T21:23:00.001Z

I haven't written anything for a while. Actually, I haven't written for months. I was pretty busy with my wedding late this summer and the start of the course has been pretty hectic.

Blogging has actually been pretty good. By trying to articulate my ideas I've found that I have developed a much stronger understanding of the things I've written about. But I'm going to try and pump out some more posts over the next months.

Speculation vs. Investment

2007-07-02T23:29:00.000+01:00

"An investment operation is one which, upon thorough analysis, promises safety of principle 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." Security Analysis, Graham & Dodd, 1951 Edition

Defining the term investment is somewhat difficult as most people have their own understanding of what it means to invest their money. As a simple example, we probably can all agree that investing £50,000 in a business and subsequently receiving an annual income from the business of £10,000 can be classed as an investment. In the world of financial markets the definition of an investment is not as clear cut. It is quite clear that there is often no real distinction between speculation and investment in this arena.

Generally speaking, speculation could be defined as bad and investment could be defined as good. When looking at these definition in such simple terms the distinction between the two becomes far more obvious. However in financial markets how can we tell what is good and what is bad? Before going any further, it would be fair to say that before an investor starts to invest his money this is a distinction that should be clearly understood. In any case, the failure of investors to understand this difference is what caused the disastrous dot com mania and its subsequent crash.

Keep in mind that just because a security may be seen as low risk does not mean that it is not possible to speculate. For example, on one hand take the large purchase of a particular bond issue in anticipation of a quick rise in price. This speculative behaviour turns an otherwise "safe" investment into something more risky. On the other hand, just because a security is perceived as a higher risk does not mean that it can not be classed as an investment. Take for instance the purchase of a relatively smaller cap stock trading at below its intrinsic value. The very fact that the stock trades below its calculated intrinsic value creates a price buffer, associated with the purchase at that price. This price buffer is otherwise known as a margin of safety and serves to somewhat protect the investor against large losses associated with the purchase.

It is this margin of safety that offers an indication to the definition of what could be termed as an investment. Using the two previous examples, this concept can only really be useful when the purchase of a security is done using more than psychological factors. What is needed in the purchase of an investment is a set of repeatable standards that can assist the investor gauge the amount of safety associated any given opportunity. It is important to realise that for any given security, the purchase may be classed as an investment at one price but not at another. Again, understanding the margin of safety principle makes this obvious.

Although not investments, a basic everyday analogy is the purchase of an article of clothing in the week before Christmas compared to the week after Christmas when the sales are on. We are paying two completely different prices for exactly the same product. This shows that when the price is right we obviously get better value for our money. Investing is no different. It's all about buying at the right price.

Determining the investment worth of any given security is not a precise science. Moreover, it is something that, even with careful analysis, is different for every situation. It will however still offer reasonable protection against loss under all "likely" conditions. What is important is that the definition of the process that is used determine the real worth of a security, and whether to go ahead with the investment, is backed up with a well defined yet flexible valuation strategy. Taking into account the price and the quality of security is all part of this strategy.

As the level of chance in a given investment increases, the value of analysis starts to decrease. One of the underlying problems with speculative investments is that they are susceptible to sudden price corrections. Even though the intrinsic value of an investment of less speculation can change before it is reflected in the market price, this problem becomes even more pronounced as an investment becomes more speculative.

To quote Graham and Dodd's 1951 edition of Security Analysis, investments can be broken down into four different types:

Business investment - Referring to money held in a business.
Financial investment or investments generally - Referring to securities generally.
Sheltered investment - Referring to securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon adequate taxing power.
Analyst's investment - Referring to operations that, upon thorough study, promise safety of principal and an adequate return.

Additionally, to quote Security Analysis further, speculations can be broken down into two types:

Intelligent speculation - the taking of a risk that appears justified after careful weighing of the pros and cons.
Unintelligent speculation - risk taking without adequate study of the situation.

This break down offers a simple description of the differences between the various types of investments and speculations. Clearly the two forms of speculation
are very different and I think that it should be immediate that the second form could be likened to gambling. When investing, we would ultimately be aiming to ensure that the investments that we do make fall under the category of being analyst's investments. Otherwise, money not held under this category could arguably be classed as one of the two forms of speculation.

Real Estate

2007-06-22T11:09:00.000+01:00

Consider the current economic environment where interest rates have recently been slowly increasing and may continue to do so in the foreseeable future. They may go down but it's unlikely. Now imagine borrowing £1,000 at 10% to buy a bond selling at a premium yielding 9% hoping that the 1% you are losing in interest payments will be offset by appreciation of the bond price in subsequent years due to what you hope will be lower future interest rates. Keep in mind that as interest rates go up, bond prices go down in order to create a higher yield to match the interest rate. Would you do it?

This is just a made up scenario that to me seems both speculative and risky. I don't think that any rational and well advised retail investor would ever do something like this. The risk reward ratio would just not be worth it. However, in my opinion this route is similar to the one which many property investors here in the UK have decided to take.

I recently heard about someone who has taken out an interest only mortgage on an "investment" property where the monthly rental income falls £25 per month short of the monthly mortgage repayments. And this is not including any capital expenditures. Not only is there is a highly leveraged position, some the bank's interest charges out of this person's own pocket just to keep the investment alive under the false premise that property prices will continue rising forever. Keep in mind there is an interest only mortgage which is not amortising the loan. As I’m told, because there is a leveraged position in the investment, any price appreciation will magnify any gains on the initial investment but I think there are two things being missed:

Leverage cuts both ways. Borrowing five times the deposit will see a 10% rise in the market price return a 50% return on the investment. On the flip side, a 10% drop in the investment will give a 50% drop in the investment.
Vitally, she is not receiving any productive economic benefit from this "investment". Instead she sees the speculative appreciation in the property price. Isn’t this the same as hoping to gain from trading commodities? Read more here

It's true that rent inflation will see the £25 monthly deficit disappear within a couple of years however this may take longer than anticipated if interest rates continue to increase. Moreover, if interest rates do continue to rise then that puts pressure on market price appreciation- the entire point of this investment.

There is nothing wrong with real estate as an investment as the old adage "safe as houses" still holds true in my opinion. However this style of "investment" is incredibly sensitive to any market down turn. The strange thing is that my colleague feels perfectly comfortable with the situation. I wonder what the feeling will be if, heaven forbid, the market slowed and declined enough to see her "investment" fall into a negative equity situation. What if prices were to stagnate for 10 years? What if there was forced sale? If one can afford to ride out any market storms then they will be OK in the long run but whether they will be wealthier for it I can not say. Without amortising the loan there is an even greater risk of seeing negative equity in the purchase.

I want to finish this post by citing one interesting comment made by Warren Buffet which went along the lines of "one of the characteristics of a price bubble is that investors start to invest in assets based on price appreciation alone and forget about the income generated by the asset". I think that pretty much sums it up.

Commodities Are Not Investments.

2007-06-18T21:49:00.000+01:00

It's not hard to believe the strong economic case for the growth in commodity prices in the years ahead. With emerging economies like China and India coming online the world's supply of various raw materials to support their development is under pressure, hence pushing commodity prices up. I certainly see the reasoning behind it and I believe that it will happen.

However, I don't want to invest in commodities even though I believe in the story behind them. Why? Because commodities are not investments. They are links to economic production. They have no cash flows so they create no value related to any future productive enterprise. Also, as there is no possibility of any future cash flows how can I discount their value back to a present value today? Other than discounting the final cash flow when it comes time to sell there is no real value created to me as an investor that makes them difficult to value. Obviously the only real way to make money on a commodity transaction is if the price has gone up when it comes time to sell. But there is no way to really place a value on how much and how this price will occur.

Of course, this argument is not isolated to commodities. I would not class derivatives (futures, swaps, forwards, options etc, etc) and currencies as investments because, like commodities, they do not create any future value. They merely shift wealth from one side to the other. In other words, there is no win-win situation; there is only a win-lose situation where one person "wins" a pound at the expense of another person losing a pound. As an example, Stocks on the other can create wealth for all those involved. Consumers receive a marginal benefit from the products they purchase, employees receive benefit through their salary and investors receive a benefit through economic profit.

However commodities, derivatives and currencies do have their place in the area of risk managment. This was was the original motivation behind many derivative products. For an example read more here

So if the purchase of a commodity is not an investment then what is it? I can only conclude that commodity purchases are merely speculative- no matter how much research and thought go into the decision to buy (or sell). Commodity purchases can really only rely on macro economic information which is general at best and pricing information which is provided by the general sentiment of the market (which as any investor who has experienced a market correction knows this can change quickly). How can an investor have any fair degree of confidence to reasonably predict where the intrinsic value and margin of safety lies when we have nothing to quantify against?

As an someone who works at a large commodity hedge fund in London told me, the January 2007 commodity market recorrection was the most stressful periods of his life. Not a very nice way to spend a skiing holiday in France. Maybe if the nature of his "investments" were a little more like real investments then maybe he wouldn't have had as much to worry about.

Tulipmania and Mr. Market

2007-06-16T18:17:00.000+01:00

First lets start with Mr Market, a classic investment analogy first explained in Bejamin Graham's book, The Intelligent Investor. The story goes something like this:

Imagine you own part of a business in partnership with a person named Mr. Market. Every day he tells you what your share of the business is worth and offers to buy your portion of the business or sell you an additional interest in the business. His views on the business swing from an incredible optimism to an overwhelming pessimism and anywhere in between. With this in mind the prices that he offers you gyrate as often as his moods do. When Mr Market quotes an incredibly high price, you might sell some of your stake in the business (or all of it if the price is right) whereas if the price he quotes you is low enough, you might decided to buy some of his stake (or all of it). However, any time the price is not right you don't have to do anything other than wait until he quotes you a price you are satisfied with based on your own ideas of what the business is worth.

This is such a simple explanation of the investment environment that we are in yet I wonder why so many investors fail to take this advice? Why any investor would sell a holding based on a declining stock price (i.e. stop losses) when the underlying "story" behind the investment has not really changed is hard to understand from a logical perspective. I often wonder whether this is because investors do not really understand what they are investing in and why.

However, I do understand that loss aversion and the games that it plays with your mind can get pretty intense at times. Even in the best case scenario, when there is a strong criteria driven business reason behind the investment, the thought of a declining stock price can make you want to sell. On the other hand, when there are a less than sound criteria behind an investment decision, a declining stock price can be hard to stomach.

Think about any investment where you felt there was a larger than normal element of speculation involved in the decision. When the price goes down on these speculative investments the first reaction is to SELL! The natural instinct against loss aversion starts to kick in. Without a set of real quantifiable investment criteria there is no way to measure the investment's price action against market events. Having this set of criteria will help to allow you to avoid investing based on emotions, tips, rumours and other psychological based biases. in other words, not knowing the underlying story behind a business and it's fundamentals gives an you very little psychological cushioning for seeing the investment through to the point where you realise the original reason for the investment in the first place.

To illustrate my point further, here’s a classic story about investor irrationality during the 1600s and the sad consequences for many of those involved. It kind of rings like the euphoric mania behind the internet stock bubble.

Tulipmania

Value

2007-06-07T23:19:00.001+01:00

Value investing - the disciplined practice of buying assets that trade for less than their intrinsic value in an effort to gain from their long term performance. Intrinsic value? This could basically be defined as the current discounted value of the future cash flows of a business.

As an investment style, I think that value investing can be defined by the following:

An understanding of how markets are efficient
In reality only 50% of investors can beat the market so it is important to understand that by and large markets are "generally" efficient. By understanding and recognising irrational investor behaviours an investor can begin to understand how to succeed in stock market investing. However, it is fair to say that markets are not totally efficient as can be simply displayed by the periodic market corrections that we are all so familiar with.

An ability to invest with long term investment horizons
To paraphrase Ben Graham, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." Understanding this simple principle enables an investor to ride out the stock market gyrations thrown at us by Mr Market. It is probably fair to say that in the short run the stock market is pretty efficient. However as most investors have relatively short term investment views, this opens up the gate to long term pricing inefficenies which can be found by investors who are prepared to wait for the market to catch up.

An ability to understand the intrinsic value of a business and to buy into that business at a realisable discount to that value
Being able to evaluate the real fundamental intrinsic value underpinning a business and then finding the opportunity to pay well below this value in order to own a piece of the business creates what is commonly known as a margin of safety. Think of it as buying £2 for £1. Moreover, an investor must have some way of searching for this value out of the universe of available investments. It would be far too time consuming for an investor to search through everything so there must be a way to screen stocks to narrow down this universe.

In combination I think these three elements give an investor a powerful set of "tools" in which to make investment decisions. However, I can't see how any one of these three skills is particularly effective when used in isolation. The old adage "fail to plan, plan to fail", is particularly important here. By producing some sort systematic methodology for investment an investor may more than likely satisfactory returns. Unfortunatly there is no exact science to it so in the beginning a lot of it is going to come down to trial and error.

Lean Investing

2007-06-07T20:14:00.000+01:00

"Lean" is a theory that has revolutionised how many organisations manage their processes. The origins of lean thinking started with Toyota, the japanese auto manufacturer. During the 1940's, the company needed a way a way to cheaply manufacture cars - After the war, people did not have much money, let alone money for expensive cars. The question for Toyota was how could they keep production volumes low whilst at the same time keeping the cars as cheap as mass-produced cars?

From this dilemma emerged the ideas that formed the foundations of the Toyota Production System (TPS) that forms the basis of the lean models that we have today. The basic ideas behind being lean are simple- eliminate waste and concentrate on what works.

Toyota was able to greatly reduce lead times and cost using the TPS, while improving quality at the same time. Moreover, lean has enabled Toyota to become one of the ten largest companies in the world. It is currently as profitable as all the other car companies combined and Toyota became the world's largest car manufacturer in 2007. Lean has also been used with great success in the software development world so it is viable for more than just manufacturing cars. For a more information on the beginnings of lean see:

Wikipedia Page on the TPS
Mary Poppendieck's Articles on Lean

What has lean got to do with investing and asset management? When taking a holistic view of the investment management process, from the asset manager to the end client, lean may be an effective way to increase the profits for the portfolio manager whilst continuing to be ethical and loyal to the end client.

As a discipline and by its very nature, value investing lends itself very well to the ideas behind lean. For example the ideas of infrequent trading and portfolio concentration are both ideas that reduce the problems associated with market timing, stock selection/analysis costs, transaction costs. As an investment manager, costs equal waste so this is a natural area to address. Although simplistic, this may form the basis for possible appications of lean principles in investment management.

The Lean Investor

2007-06-07T13:52:00.000+01:00

This blog has been started as a simple way to document and arrange my thoughts on investing whilst at the same time putting my thoughts up for public scrutiny. The main topics which will be covered are:

Value
Portfolio concentration, longer term investment horizons, margin of safety.

Small/Micro Cap Companies
Generally companies trading on London's Plus and AIM exchanges. These companies are often illiquid and perceived as risky due to their large standard deviation of returns.

Special Situations
Companies undergoing significant structural changes. For example, spin-offs, restructurings, mergers, bankruptcies, etc.

Market Inefficiencies
Pricing anomilies. The price of the asset is below what would normally be expected.

I'm afraid I won't be offering any stock tips or market commentaries as I feel a blog is not really the appropriate place for such information.