"Cunning is the art of concealing our own defects, and discovering other people's weaknesses." - William Hazlitt
Saturday, 6 June 2020
Three Categories of Risk to Keep in Mind When Investing
By John Huber
Warren Buffett said there are just two rules of investing: #1-Don’t Lose Money; #2-Don’t forget rule #1.
That’s a tongue in cheek oft used phrase, but worth remembering at all times. But it begs the question: how exactly do you “not lose money”?
One thing to do is create a checklist… this is something that I heard Mohnish Pabrai discuss a couple years ago and I've recently implemented this in my own process, which seems to make the decision making process more efficient, allowing me to discard ideas more quickly. Sometime in the next week or so I’ll post the checklist I use currently. It’s nothing special-just basic common sense factors, but it does help.
3 Areas of Risk
My checklist is guided by three general categories of risk. I think many other value investors use these basic categories, and I think I first read them in something that James Montier wrote, but I'm not sure. But in any event, I've always found it helpful to remember that risk comes from these three areas. Many things can cause businesses to deteriorate or stock prices to fall leading to permanent loss of capital, but they all stem from at least one of these three categories:
1. Valuation Risk
Valuation risk is usually the easiest to quickly identify. You might have the opportunity to invest in a great business that produce high returns on capital with extremely attractive prospects for future growth. This business might produce these returns while employing modest debt, or maybe even little to no debt. But in this case, you might have to pay 30 or 40 times current earnings to buy the business.
Coke was this type of situation in 1998. Microsoft was this type of business in 2000. There are countless of other examples. Investors who bought shares at that time saw their business continue to produce high returns on invested capital. Their businesses continued to grow sales, generate free cash flow, and increased earnings and shareholder net worth year after year. But the stock price went nowhere or even went down.
Amazon is one such example currently. There are even some value investors (Tom Gayner) who have purchase shares. These guys are smarter than I am, and I’m smart enough to know that Amazon is a great business, but I can’t get comfortable with paying 100 times free cash flow for the opportunity to own what might turn out to be much more cash flow later. A lot of things have to go right for that investment to work out in the long term.
To eliminate valuation risk, just simple buy stocks with low multiples to earnings or assets, and make sure the earnings are normalized.
2. Leverage Risk
Leverage risk can come in a variety of different areas, but a couple simple things can be done to ensure you are not taking on leverage risk with the investment you are about to make. This comes right from Ben Graham and Walter Schloss. Check the debt to equity ratio. Try to find companies that “own more than they owe” as Graham said. In most industries, I try to look for debt to equity ratios under .50.
The other thing to quickly check is the current ratio. This is the ratio of current assets to current liabilities. It basically provides a quick measure of the liquidity that the business has. Look for current ratios above 1, preferably higher than that. This means that a company’s current assets (cash, inventory, receivables, etc…) are sufficient to cover all short term liabilities including debt that is currently due. Note that some established businesses like WMT can operate with a current ratio less than one for reasons we’ll discuss another time, but understand these businesses are the exceptions, and not the rule.
Schloss said: “Debt causes problems.” The easiest way to prevent leverage risk is to look for companies with little to no debt. If they have debt, make sure they have assets to support that debt and cash flow to pay the interest payments.
3. Business Risk
While it’s fairly easy to determine if you’re taking on valuation or leverage risk, business risk is much more difficult to figure out. This category includes all of the risks that come from the general business, and it includes macro factors that could impact the business. In 2007, you were taking on leverage risk by investing in financials. You were taking on business risk by investing in housing stocks. These stocks were decimated because of macro factors that caused sales to plummet and losses to occur. It was hard to predict the financial crisis, but one simple question to ask is: Are these earnings “normal” earnings or are they “peak” earnings? You can get a clue by simply looking at 10 or 15 year history on Value Line.
The ability to prevent (or limit) business risk has a lot to do with your ability to understand the business. This is why Buffett is so good- he can quickly identify business risk, and avoid all situations where he’s not comfortable with the long term economics of the business. This style of investing provides a huge margin of safety for him because he can concentrate his investments in businesses within his circle of competence that carry very little business risk.
To find out if you’re taking on business risk, go to GuruFocus, Morningstar, or Value Line and look up the 10 year financial history of the stock. I first like to look at sales growth. If sales are declining steadily, you might have a “melting ice cube” that is operating in a dying industry. It doesn't mean you should eliminate the opportunity, but it is a sign you might be taking on business risk. You can also look for things like returns on capital and margins (are they deteriorating? inconsistent?). If margins and returns are stable it's a great sign. If not, there might be business risk involved.
One of my favourite things to look at is book value per share. Just like an individual person, if a company is growing its net worth over time, they are doing something right. If not, they might be doing something wrong. Every company that went bankrupt because of something other than leverage had book value deterioration at some point.
You can also check things like F Scores and Z Scores, but I prefer to simply glance at the 10 year financials.
To Sum it Up
All risk factors in investing can be traced to three main categories: Valuation Risk, Leverage Risk, and Business Risk. It’s fairly easy to figure out the first two. The third one takes more analysis and subjectivity. But if you eliminate the first two, and stay adequately diversified, you’ll dramatically increase your overall portfolio margin of safety and company specific risk will not hurt you. This is the philosophy of Graham, Schloss, and Greenblatt’s magic formula. It’s the philosophy of the insurance underwriting business.
If you have exceptional investment skills, you can concentrate your portfolio and go for higher returns. There are many ways to approach investing, but it helps to keep these three risk factors in mind at all times.
Keep in mind this post is simply an overview of some simple things to check to determine if you might be taking on risk. If you are concentrating your portfolio, much deeper analysis is required. But these three things provide a great foundation to build a checklist on if that is something that would help your investing.
Warren Buffett said there are just two rules of investing: #1-Don’t Lose Money; #2-Don’t forget rule #1.
That’s a tongue in cheek oft used phrase, but worth remembering at all times. But it begs the question: how exactly do you “not lose money”?
One thing to do is create a checklist… this is something that I heard Mohnish Pabrai discuss a couple years ago and I've recently implemented this in my own process, which seems to make the decision making process more efficient, allowing me to discard ideas more quickly. Sometime in the next week or so I’ll post the checklist I use currently. It’s nothing special-just basic common sense factors, but it does help.
3 Areas of Risk
My checklist is guided by three general categories of risk. I think many other value investors use these basic categories, and I think I first read them in something that James Montier wrote, but I'm not sure. But in any event, I've always found it helpful to remember that risk comes from these three areas. Many things can cause businesses to deteriorate or stock prices to fall leading to permanent loss of capital, but they all stem from at least one of these three categories:
- Valuation Risk
- Leverage Risk
- Business Risk
1. Valuation Risk
Valuation risk is usually the easiest to quickly identify. You might have the opportunity to invest in a great business that produce high returns on capital with extremely attractive prospects for future growth. This business might produce these returns while employing modest debt, or maybe even little to no debt. But in this case, you might have to pay 30 or 40 times current earnings to buy the business.
Coke was this type of situation in 1998. Microsoft was this type of business in 2000. There are countless of other examples. Investors who bought shares at that time saw their business continue to produce high returns on invested capital. Their businesses continued to grow sales, generate free cash flow, and increased earnings and shareholder net worth year after year. But the stock price went nowhere or even went down.
Amazon is one such example currently. There are even some value investors (Tom Gayner) who have purchase shares. These guys are smarter than I am, and I’m smart enough to know that Amazon is a great business, but I can’t get comfortable with paying 100 times free cash flow for the opportunity to own what might turn out to be much more cash flow later. A lot of things have to go right for that investment to work out in the long term.
To eliminate valuation risk, just simple buy stocks with low multiples to earnings or assets, and make sure the earnings are normalized.
2. Leverage Risk
Leverage risk can come in a variety of different areas, but a couple simple things can be done to ensure you are not taking on leverage risk with the investment you are about to make. This comes right from Ben Graham and Walter Schloss. Check the debt to equity ratio. Try to find companies that “own more than they owe” as Graham said. In most industries, I try to look for debt to equity ratios under .50.
The other thing to quickly check is the current ratio. This is the ratio of current assets to current liabilities. It basically provides a quick measure of the liquidity that the business has. Look for current ratios above 1, preferably higher than that. This means that a company’s current assets (cash, inventory, receivables, etc…) are sufficient to cover all short term liabilities including debt that is currently due. Note that some established businesses like WMT can operate with a current ratio less than one for reasons we’ll discuss another time, but understand these businesses are the exceptions, and not the rule.
Schloss said: “Debt causes problems.” The easiest way to prevent leverage risk is to look for companies with little to no debt. If they have debt, make sure they have assets to support that debt and cash flow to pay the interest payments.
3. Business Risk
While it’s fairly easy to determine if you’re taking on valuation or leverage risk, business risk is much more difficult to figure out. This category includes all of the risks that come from the general business, and it includes macro factors that could impact the business. In 2007, you were taking on leverage risk by investing in financials. You were taking on business risk by investing in housing stocks. These stocks were decimated because of macro factors that caused sales to plummet and losses to occur. It was hard to predict the financial crisis, but one simple question to ask is: Are these earnings “normal” earnings or are they “peak” earnings? You can get a clue by simply looking at 10 or 15 year history on Value Line.
The ability to prevent (or limit) business risk has a lot to do with your ability to understand the business. This is why Buffett is so good- he can quickly identify business risk, and avoid all situations where he’s not comfortable with the long term economics of the business. This style of investing provides a huge margin of safety for him because he can concentrate his investments in businesses within his circle of competence that carry very little business risk.
To find out if you’re taking on business risk, go to GuruFocus, Morningstar, or Value Line and look up the 10 year financial history of the stock. I first like to look at sales growth. If sales are declining steadily, you might have a “melting ice cube” that is operating in a dying industry. It doesn't mean you should eliminate the opportunity, but it is a sign you might be taking on business risk. You can also look for things like returns on capital and margins (are they deteriorating? inconsistent?). If margins and returns are stable it's a great sign. If not, there might be business risk involved.
One of my favourite things to look at is book value per share. Just like an individual person, if a company is growing its net worth over time, they are doing something right. If not, they might be doing something wrong. Every company that went bankrupt because of something other than leverage had book value deterioration at some point.
You can also check things like F Scores and Z Scores, but I prefer to simply glance at the 10 year financials.
To Sum it Up
All risk factors in investing can be traced to three main categories: Valuation Risk, Leverage Risk, and Business Risk. It’s fairly easy to figure out the first two. The third one takes more analysis and subjectivity. But if you eliminate the first two, and stay adequately diversified, you’ll dramatically increase your overall portfolio margin of safety and company specific risk will not hurt you. This is the philosophy of Graham, Schloss, and Greenblatt’s magic formula. It’s the philosophy of the insurance underwriting business.
If you have exceptional investment skills, you can concentrate your portfolio and go for higher returns. There are many ways to approach investing, but it helps to keep these three risk factors in mind at all times.
Keep in mind this post is simply an overview of some simple things to check to determine if you might be taking on risk. If you are concentrating your portfolio, much deeper analysis is required. But these three things provide a great foundation to build a checklist on if that is something that would help your investing.
Source: http://basehitinvesting.com/
Friday, 5 June 2020
Quote for the day
"A people without the knowledge of their past history, origin and culture is like a tree without roots." - Marcus Garvey
What's Your Trading Brain Type?
By Kenneth Reid Ph.D
There are five general brain types. Among traders and investors, the three most important brain types are Compulsive, Impulsive and Anxious.
People with Compulsive Brains tend to get stuck in a particular thought about the market. “It’s too high.” “It’s too manipulated.” “It’s too risky.” It’s too…” whatever. People with Compulsive Brains tend to operate entirely on their own terms and are generally not open to feedback or other options.
People with Impulsive Brains are the exact opposite. They are unpredictable and lack impulse control in trading/investing and in daily life. Without much discipline, they start many more projects than they finish. They live for creativity and for what’s possible.
People with Anxious Brains live with a rain cloud overhead. They pay more attention to the obstacles to their own success (or the success of others) than to the ways that something might work. They don’t like to try new things and don’t appreciate novelty.
The fourth type is the Depressed Brain. These people tend to feel victimized by the market. They have a ‘Rodney Dangerfield’ mentality, believing that they never get a break or a fair shake. They blame the Fed, the robots, the news, company management, or whatever for their investing and trading troubles. This type of thinking rationalizes and justifies their pre-existing mood.
The fifth type is a combination of Compulsive and Impulsive. These folks tend to be compulsively impulsive, which may mean that they have an addictive relationship to the market and to trading. They over trade because they are trading-to-trade, like a mouse pressing a lever to generate pleasure signals in their brains.
Free Quiz
If you are curious about your brain type, you may download a free Brain Type Self-Assessment HERE.
People with Compulsive Brains tend to get stuck in a particular thought about the market. “It’s too high.” “It’s too manipulated.” “It’s too risky.” It’s too…” whatever. People with Compulsive Brains tend to operate entirely on their own terms and are generally not open to feedback or other options.
People with Impulsive Brains are the exact opposite. They are unpredictable and lack impulse control in trading/investing and in daily life. Without much discipline, they start many more projects than they finish. They live for creativity and for what’s possible.
People with Anxious Brains live with a rain cloud overhead. They pay more attention to the obstacles to their own success (or the success of others) than to the ways that something might work. They don’t like to try new things and don’t appreciate novelty.
The fourth type is the Depressed Brain. These people tend to feel victimized by the market. They have a ‘Rodney Dangerfield’ mentality, believing that they never get a break or a fair shake. They blame the Fed, the robots, the news, company management, or whatever for their investing and trading troubles. This type of thinking rationalizes and justifies their pre-existing mood.
The fifth type is a combination of Compulsive and Impulsive. These folks tend to be compulsively impulsive, which may mean that they have an addictive relationship to the market and to trading. They over trade because they are trading-to-trade, like a mouse pressing a lever to generate pleasure signals in their brains.
Free Quiz
If you are curious about your brain type, you may download a free Brain Type Self-Assessment HERE.
Source: http://www.traderplanet.com/
Thursday, 4 June 2020
Universal Lessons From Every Investment Discipline
“Wall Street has a few prudent principles; the trouble is that they are always forgotten when they are most needed.” – Benjamin Graham
Just as there are no perfect portfolios, there are no perfect investment philosophies either. Nothing works all the time and every strategy its flaws. Even the most successful investors will under perform the overall market depending on the environment.
Yet each form of investing has lessons that can be used regardless of how you choose to invest.
While I think there are certain investment strategies that increase your probability for success, different styles suit different personality types. And if you think about it, if every investor used the same exact process the markets wouldn't function very well.
Even if you don't use or agree with other investment philosophies, each one has characteristics that can be applied to anyone’s portfolio no matter how its structured.
What follows are some of the most well-known investment disciplines along with a lesson or two from each that every investor should be able to use in their own strategy.
Focused Value Investing: Buying stocks that are under priced in relation to their intrinsic value.
Lesson(s): It’s important to invest from the perspective that stocks represent an ownership interest in a business. You get your share of corporate profits from the stocks you own and over the long-term the value of the business should be reflected in the stock price.
Lesson(s): It’s important to invest from the perspective that stocks represent an ownership interest in a business. You get your share of corporate profits from the stocks you own and over the long-term the value of the business should be reflected in the stock price.
Quantitative Investing: Using a systematic, mathematical approach to make buy and sell decisions within a portfolio.
Lesson(s): A rules-based, objective approach to investing is a great way to take out the emotions which can trip up so many investors and introduce biases into the investment process. Automating good decisions can reduce costly mistakes.
Lesson(s): A rules-based, objective approach to investing is a great way to take out the emotions which can trip up so many investors and introduce biases into the investment process. Automating good decisions can reduce costly mistakes.
Technical Analysis: Studying charts, past prices and volume for security and market analysis by using patterns.
Lesson(s): An understanding of the history of the financial markets is extremely important to be able to define your tolerance for risk and gain the correct perspective on what couldhappen in terms of gains and losses. And at the end of the day markets rise and fall because of supply and demand.
Lesson(s): An understanding of the history of the financial markets is extremely important to be able to define your tolerance for risk and gain the correct perspective on what couldhappen in terms of gains and losses. And at the end of the day markets rise and fall because of supply and demand.
Index Investing: Owning the entire market/index at a low cost.
Lesson(s): Beating the market is hard. Keeping your expenses, activity and turnover to a minimum is a prudent way to earn your fair share of the market’s return over time.
Lesson(s): Beating the market is hard. Keeping your expenses, activity and turnover to a minimum is a prudent way to earn your fair share of the market’s return over time.
Asset Allocation: Investing in a diverse set of asset classes, markets and sub-strategies within each asset class through different portfolio tilts.
Lesson(s): It’s impossible to predict the best performing asset class over shorter time frames so it makes sense to diversify, own them all and periodically rebalance by selling some of your winners and buying some of your losers.
Lesson(s): It’s impossible to predict the best performing asset class over shorter time frames so it makes sense to diversify, own them all and periodically rebalance by selling some of your winners and buying some of your losers.
Trend Following: Using the direction of the markets to make buy or sell decisions by entering when an up trend is established and exiting when that trend is broken.
Lesson(s): There will always be a market, sector or asset class that is performing well and some that are performing poorly. Also, risk management is one of the keys to your long-term survival in the markets.
Lesson(s): There will always be a market, sector or asset class that is performing well and some that are performing poorly. Also, risk management is one of the keys to your long-term survival in the markets.
Risk Parity: Ray Dalio's diversified approach of allocating investments by risk (defined as volatility) to account for different economic scenarios.
Lesson(s): It’s impossible to predict which type of environment we will be in with regards to growth, inflation and interest rates so it makes sense to own different investments that each perform well depending on the economic situation.
Lesson(s): It’s impossible to predict which type of environment we will be in with regards to growth, inflation and interest rates so it makes sense to own different investments that each perform well depending on the economic situation.
Trading: Making short-term bets on the direction of the markets and individual securities.
Lesson(s): Defining your threshold for for losses helps set the proper expectations for downside performance (most traders set acceptable levels of loss in their holdings). Plus, an understanding of the fact that markets can be extremely volatile, as traders try to take advantage of short-term volatility, is something every investor must be aware of to keep their composure.
Lesson(s): Defining your threshold for for losses helps set the proper expectations for downside performance (most traders set acceptable levels of loss in their holdings). Plus, an understanding of the fact that markets can be extremely volatile, as traders try to take advantage of short-term volatility, is something every investor must be aware of to keep their composure.
Source: http://awealthofcommonsense.com/
Quote for the day
"Knowledge which is divorced from justice, may be called cunning rather than wisdom." - Marcus Tullius Cicero
Wednesday, 3 June 2020
Quote for the day
"The greatest test of courage on earth is to bear defeat without losing heart." - Robert Green Ingersoll
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