Month: December 2014

How Amateur Investors Can Reduce Competition To A Minimum

In Howard Marks’ memo called “Risk Revisited“, he mentions the idea that to outperform the market, you must be contrarian or face getting average or below average results. He then goes onto mention that the ways one can be contrarian is to take on four types of risks, namely credit risk, illiquidity risk, concentration risk and leverage risk.

Another thing that’s very contrarian in the modern day stock market is investment horizon, where the average holding period of stocks has been decreasing over the years to less than a year holding period. In the words of Andrei Kolodovski, “It becomes harder and harder to make money in a short-term, but easier in the long term.” For me, that would be impatience risk, the risk of being impatient and doing too much trading as a result.

This is one of the reasons why I’ve always said it makes perfect sense to invest in NCAV stocks as an amateur investor (“If you’re not professional, you are thus an amateur” – Warren Buffett), since it’s illiquid, which in turn scares away lots of competition.

However, the beauty of Charlie Munger’s “Sit on your ass investing” style is that compared to only illiquidity risk of NCAV stocks, I have the option to also take up concentration risk, leverage risk and impatience risk as well.

When offered a big fat pitch (eg. bear market), most retail and institutional investors are forced to sell thus making me take up illiquidity risk as I would be buying stocks that would be very hard to sell immediately, and also I would be tying up cash into stocks thus increasing my own illiquidity risk. At that critical moment of time, I can also safely leverage up to a maximum and go into only a concentrated few of the greatest companies in the world. The fact that the companies I would invest in are the best of the best reduces the probability of them blowing up while offering spectacular returns if held for a long time.

Another situation where you eliminate almost all competition is to invest in distressed debt during a bear market, since by then you would be taking up credit risk as well besides illiquidity risk, concentration risk and leverage risk, but unfortunately not impatience risk as the strategy involves selling bonds after reaching ideal value. That is something that most amateur investors (eg. me) don’t have the expertise in unfortunately, so I’ll be sticking with great companies for now.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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Making Sure Your Co-Investors’ Financial Health Is Great

If you co-invest or plan to co-invest, make sure your co-investor’s financial health is great.

Reasons? Simple:

  • Ability to track expenses means awareness of one’s financial situation
  • The will to save up cash worth months of expenses shows one’s discipline
  • Being able to afford emergencies increases one’s survivability
  • Having cash on hand during bear markets helps one keep their rationality

All these 4 reasons are for your co-investor and your best interests.

Think about it, the purpose of co-investing is to maximize returns for both your co-investor and you. The best way to maximize returns is to stick to an investment strategy through thick and thin, especially during bear markets where bargains are everywhere. To stick to an investment strategy through thick and thin, you will need to stay rational through the ordeal, you need to be able to survive the bear market so you don’t have to liquidate investments prematurely, you have to have the discipline to stick to the investment strategy and keep pumping money into it, and you need to be aware of how much money you need to pump, what returns you are expecting, and how long it will take to get to your financial goals.

If your potential or current co-investor can’t display attributes shown in the 4 reasons above, then you might want to consider not co-investing with them, since not being able to stick to an investment strategy through thick and thin will cause much trouble for all parties involved.

So what constitutes great financial health? I think it’s comparable to investing in great companies, thus the benchmark is 1.5 Current Ratio and 0.5 Debt:Equity Ratio, with 1.0 Current Ratio being the minimum and >0.5 Debt:Equity Ratio allowed if debt interest rate is below inflation rate.

Not only is this benchmark what Warren Buffett demands from his investments, it just makes a lot of sense personally.

1.5 Current Ratio in personal finance terms is having 1.5 years / 18 months worth of expenses in liquid assets. 18 months worth of expenses in liquid assets is ideal since by observation, on average, most of my college friends found a job within 1 year, but a minority could only find a job after around 1.5 years of job searching, while a few outliers are still without a job after more than 1.5 years of job searching. It would be crazy to prepare for all scenarios that happen within 6 standard deviations (99.99966% of all scenarios), but it’s not unrealistic to prepare for all scenarios that happen roughly within 3 standard deviations (99.7% of all scenarios) That’s why I prepare for the 1.5 year duration needed scenario.

The 1.0 Current Ratio being minimum is just because it’s the most cost-effective way to insure yourself of a job loss situation, since 1 year’s worth of expenses in liquid assets can help insure you roughly 2 standard deviations (95% of all scenarios). It is then better to build your way up to 1.5+ Current Ratio by having liquid assets be 25% of your Net Worth, so that as you build your Net Worth you build your Current Ratio as well.

The 0.5 Debt:Equity Ratio in personal finance terms is the ratio of Total Debt to your Net Worth (Total Assets – Total Debt). 0.5 Debt:Equity Ratio means that for every $1 Debt you have you have $3 in Assets (eg. if Net Worth is $100 and Debt:Equity Ratio is 0.5, then you have $50 Total Debt and $150 Total Assets), which is a good ratio since it means that if you were to pay off all your debt today, you can afford it comfortably, reducing your probability of going bankrupt.

The reason why >0.5 Debt:Equity Ratio can be tolerated when debt interest rate is below inflation rate is because your debt is basically free money by having inflation rate gobble up the real value of your debt interest rate. It makes sense to not rush paying off such debt to fully utilize this free money phenomenon, which is what I’m doing with my student debt interest rate at a mere 1.395%.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

How To Make Active Indexing Work With Buy More Sell Less

I think I’ve found the answer to the question posed in the article “Active Indexing Doesn’t Work With Lump Sums“.

The problem I had with the Active Indexing strategy was the need to constantly re-balance, which would increase frequency of trades through forced liquidation of positions, thus increasing unnecessary commissions that kill returns.

What if the monthly monitoring of how much cash is needed to hedge against each index fund was more of a high watermark rather than a non-compromise decision making mechanism? In other words, to halt all buying and selling until the portfolio accumulates enough cash to meet the amount of cash needed to hedge against each index fund.

This means I’m willing to deviate from perfect allocation between cash hedge and index fund shares as signaled by the index funds’ fundamentals & price versus 2/3 of Earnings Yield of AAA grade Bonds.

The reason why this works is because you basically only liquidate positions under two conditions: 1) Have the amount of cash needed to hedge OR 2) Index fund’s Earnings Yield is less than 2/3 of Earnings Yield of AAA grade Bonds

So when 1) happens, the holdings of index funds are still undervalued, thus there’s no need to panic and rotate funds to more undervalued index funds, which causes unnecessary commissions. When 2) happens, you should be liquidating the positions anyways since it’s “overvalued”, thus freeing up funds to flow to other undervalued index funds and re-balance back to perfect allocation.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

Active Indexing Doesn’t Work With Lump Sums

I’ve found an answer to the problem presented in this article, the answer can be found in the article “How To Make Active Indexing Work With Buy More Sell Less“.

John Bogle once mentioned that he didn’t like the idea of ETFs since it made it easier for people to trade it, something that goes against his long term buy and hold strategy that works much better with mutual funds due to difficulty to trade frequently [1].

And that is exactly what I’m doing, trading ETFs, increasing commissions and killing returns. It’s very frustrating.

I outlined in the article “Earnings Yield of AAA Bonds Needs a Margin of Safety” a strategy to beat a passive indexing strategy which involved rotating funds from more expensive index funds to cheaper ones while maintaining a margin of safety based on earnings yield of AAA Bonds.

The key to this strategy’s success was overlooked though, which is the need for constant influx of new money that’s large enough to smooth out the deviations of cash required to hedge against each index fund.

What happens when you’re dealing with lump sums or influx of new money that’s too minute in amount is that small changes in AAA Bond Earnings Yield, prices of index funds and fundamentals (P/E * P/B) of index funds means that in certain months you might buy or sell a lot.

This caught me by surprise because I thought the degree re-balancing required would be much less and thus more commission-friendly.

So now that I’ve realized I don’t have the constant influx of new money required to see this strategy through, what do I do? Even though it’s painful, I’m going to exit all my index fund positions, stay idle with cash and bet aggressively into great companies I have in mind when a bear market hits. That will be the way I generate enough money to execute a NCAV stock strategy.

The question that remains, when do I exit? Exit all positions now at a loss (all positions have dropped in price since bought)? Or wait until it rises back to buying price?

[Footnotes]

[1] https://www.youtube.com/watch?v=n_bPmNUT0XA

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

The Role of Concentration for Cost Disadvantage of Extremely Small Sums of Money

This is a followup article to “The Role of Margin of Safety for Cost Disadvantage of Extremely Small Sums of Money“.

Just to recap, I define extremely small sums of money as not having enough money to generate low variable commission fees due to minimum commission fees (eg. Minimum commission fee = $18 USD / trade for 1st 1,000 shares of trade, therefore the larger the trade the lower the average commission fee).

The role of margin of safety in the last article helped minimize this problem by ensuring that the price I pay for stock & commission is still undervalued, thus making the commission fees not as painful.

That however is all bliss when dealing with index funds, but extremely painful when dealing with NCAV stocks , which is the next step that I plan to invest in after I accumulate 18 months worth of expenses in liquid assets.

The reason why dealing with NCAV stocks with extremely small sums of money is painful is because the nature of NCAV stocks (extremely unpopular stocks) requires diversification in order to pull off the strategy successfully. Unfortunately, diversification means buying into many stocks, which reduces the amount of money available to invest for each stock, and thus invites high average commission fees due to minimum commission fees.

To deal with this, I think concentrated investments makes the most sense to generate enough money to pursue NCAV stocks with low average commission fees, which means either investing in Great Companies or Active Indexing.

The reasons why concentrated investments only lie among Great Companies and Active Indexing is because, Great Companies by definition get better over an investing lifetime and thus have less chance of going bust, while it’s very rare that the whole stock market of regions all go bankrupt at the same time.

As for how what my signal is for buying great company stocks at discount, it would be where I can get at least a 20% return after deducting commission fees by the P/E I enter at and the ROIC it can generate and maintain.

The reason the investment hurdle rate is 20% is because that’s the minimum investment return I expect from pursuing a NCAV stock strategy, and because great companies require compounding over a time period (minimum ~5 years) in order to generate such returns, that’s the minimum return demanded from great company stocks if I were to invest in it as I expect the money to be locked up during the period that its earnings are compounded, which would otherwise have been used to compound money through NCAV stocks.

I will also sell 50% of my great company stocks if it doubles in value to provide liquidity to save up for pursuing NCAV stocks in later stages, and also to make sure I reduce the cost basis of my great company stock to zero (selling 50% of doubled stock value = purchase price) while I let it continue to generate 20% returns until perpetuity or until it’s not able to anymore.

The moment I stop pursuing Great Companies and Active Indexing is when I can fully pursue a NCAV stock strategy with at most 1% commission fees. The reason why at most 1% commission fees is because with careful selection of NCAV stocks, I expect to generate 20+% returns, which would leave me at least 20% returns after deducting commission fees.

As for why I don’t pursue a Great Company strategy from the get go if I can generate 20% returns from it, it’s because I’m only using it out of necessity rather than desire.

If given the opportunity I much rather invest in NCAV stocks until I’m no longer able to since there’s much less room for error and less skills required compared to accurately deciphering the durability of competitive advantage and earnings growth of great companies. It is ideal to invest in areas where competition is low (eg. illiquid stocks such as NCAV stocks) as Charlie Munger mentioned to investors with small sums of money to “Don’t go after large areas. Don’t try to figure out if Merck’s pipeline is better than Pfizers. It’s too hard. Go to where there are market inefficiencies. You need an edge. To succeed, you need to go where the competition is low. That’s the best advice I can give to small investors.

But for now, great companies and index funds will have to do until I get enough money to fully implement the “Small Sums of Money Phase” strategy.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)