Month: January 2015

Different Layers of Margin of Safety

I won’t delve into why there’s such a strong need to prioritize preservation of capital over return on capital since I want to focus on the different ways we can apply margin of safety to an investment decision. Just note that it’s much harder to earn money percentage wise than to lose money (eg. If you lose 33% money you’d need to earn ~50% to earn back that lost money).

The first margin of safety is never investing with money you can’t afford to lose. If you’re forced to liquidate stocks at extremely unattractive prices to deal with emergencies, then volatility (which academics define theoretically as risk) becomes actual realization of risk of permanent loss of capital.

The second margin of safety is your investment philosophy, and to an extension investment strategy. This provides a framework for you on how to act when the market is up, down or stagnant.

The third margin of safety is your emotional discipline. You can have a framework but it’s no good if you can’t stick to it through the good times and bad times.

The fourth margin of safety is price you pay. Never invest when it is over-valued, the reason is obvious. Also never invest when it is fair valued since that requires an extensive amount of knowledge and intuition to accurately predict on how the company will perform in the future. The less you pay, the larger the margin of safety, the more you can afford to be inaccurate.

The fifth margin of safety is knowing the company and industry well. To be able to see what others see but also see much more than what others see, you can understand where the pessimism of certain stocks are coming from and discern if the pessimism is warranted or not.

The sixth margin of safety is buying quality companies. When you buy and you misjudge on valuations, the sustainability of excellent compounded growth of earnings will help compensate over time. When you don’t sell even though the stocks of the quality companies are extremely over-valued, you are punished less than lesser quality companies as the returns will still be okay instead of bad.

The seventh margin of safety is quality companies that pay dividends. Despite being much less tax efficient than quality companies that don’t pay dividends due to double taxation, predictable dividends allow you to make more accurate personal budget forecasts and thus bigger allowance to invest aggressively with your cash reserves and inflow of income and dividends without risking bankruptcy. It also enhances your ability to borrow to invest without going bankrupt.

The eighth margin of safety is to practice some form of diversification. You have to always cater for the extremely minute possibility of your quality company stocks going to total failure just in case it does happen and completely screws you over. Even Charlie Munger who is famous for being ultra-concentrated practices some form of diversification with his investments, by having at least three companies in his portfolio at all times.

The ninth margin of safety is accumulating cash without investing when no quality companies are under-valued. It helps act as a hedge to compensate for risk of holding onto over-valued quality company stocks for too long and provides dry powder to invest aggressively when compelling opportunities are abundant.


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


Before Making Any Investment Decisions, Think Opportunity Cost

I’ve mentioned that I get fidgety whenever I invest, which is why I prefer formula based investment strategies such as Active Indexing, Magic Formula Stocks and NCAV stocks since it helps take out the emotions out of the decision process.

One reason behind being fidgety is the fear of permanent loss of capital. But I realize I’ve been neglecting another reason, which is opportunity cost.

The thought of being locked into an investment for years thus forcing me to miss out on even more lucrative investment opportunities absolutely drives me crazy.

Considering this, it’s best to also consider the necessary amount of time needed for a full cycle of an investment strategy and how much time is needed for you to accumulate the capital to execute an investment strategy that offers even better returns.


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

Relative Valuation Versus Absolute Valuation

In many articles posted here, I’ve always mentioned my uneasiness in passively indexing even if many indications tell me that some index funds are over-valued. This uneasiness also extends to being fully invested in investment strategies such as Magical Formula when the whole stock market is at over-valued territory.

The crux? Relative Valuation.

Relative Valuation is basically valuing an investment that is cheap relative to the general market instead of valuing an investment based on specific parameters. A great example is Walter Schloss’ investing, where he had to shift towards buying low P/B stocks (Relative Valuation) because most NNWC stocks (Absolute Valuation) were in very short supply.

To understand my uneasiness, you need to understand how people profit from investing in stocks, which boils down to one formula: Profit/Loss = (Company Earnings * Earnings Multiple) + Dividends

What the formula summarizes is that you only make money when three variables changes, which is Company Earnings (if increase in Company Earnings offset potential drop in Earnings Multiple, you profit), Earnings Multiple (if increase in Earnings Multiple offset potential drop in Company Earnings, you profit) and Dividends (if Dividends were more than losses caused by Company Earnings * Earnings Multiple, you profit).

Breaking down the formula further, you will realize that profits are driven by both fundamentals and sentiment, fundamentals being Company Earnings and Dividends, while sentiment being Earnings Multiple (essentially how much people are willing to pay for each dollar of earnings).

An example would be P&G, where its revenue, gross profit and net income has been relatively the same from 2010-2014, yet its price (and thus P/E) has been climbing steadily since 2010. If you were to have bought P&G stocks in 2010 and sold it now, you would be profiting mainly through sentiment.

P&G 2010-2014 IncomeRevenue, gross profit and net income of P&G from 2010 to 2014, taken from Morningstar.

P&G 2010-2014 PriceStock price of P&G from 2010 to 2014, taken from Google Finance.

The danger of sentiment is that the stock market could be horribly over-optimistic with how much it is willing to pay for each dollar of earnings. Quoting George Soros’ explanation of Theory of Reflexivity, “Negative feedback brings the participants’ views and the actual situation closer together; positive feedback drives them further apart“, thus the more optimistic the market is, the more detached from reality the market is.

And the more detached from reality an investment is, the less margin of safety, and the higher possibility of a price drop that won’t see prices revert back to its previous peak for a long time.

Going back to the comparison between Relative Valuation versus Absolute Valuation, Relative Valuation’s profitability is much more easily affected by sentiment than by Absolute Valuation, since if stock prices dropped even though I bought at a higher price using an Absolute Valuation, it was still a bargain when I initially purchased it due to Absolute Valuation.

As such, for investment strategies such as Magical Formula which relies heavily on Relative Valuation, there is a strong need to hedge against market over-valuation, and I think a very effective method is to spot the amount of NNWCs available in the stock market you’re investing with Magical Formula with. If there are >20 NNWCs, then I’d be fully invested in a Relative Valuation strategy, but if it drops below 20 then my hedge will be (1 – No. of NNWCs / 20). This is basically emulating what I would do if I were investing NNWCs, which is to never invest more than 5% of my portfolio in any NNWC stock and hold cash if there’s less than 20 NNWCs to invest in.


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

Invert Your Questions! How Can I Be Happy -> What Makes Me Miserable?

I took a long break from work from Jan 1st to Jan 11th this year to get sunshine (which I find helps me get over my winter blues) but also to contemplate on life.

One of the questions that I’ve been asking myself admist winter blues has been, “How can I be happy?” It’s a simple but devastatingly important question that I’m sure many who are going through winter blues would ask themselves.

And it’s a question that I didn’t really have an effective solution for. Light therapy, fish oil, vitamins… I’ve never found any of them to be very helpful.

Then I remembered Charlie Munger’s quote:

“Invert, always invert”

So I inverted the question from “How can I be happy?” to “What makes me miserable?”

And miracles happened. Literally. Like I found my muse and questions dissolved while answers emerged.

Here was my list of things that make me miserable:

  1. Not enough sleep
  2. Stress from work (always seem paralyzed by the stress of tackling monumental tasks)
  3. Stress from finances (always fear being broke and homeless)
  4. Burn out from socializing

And the solutions just seemed so simple:

  1. Not enough sleep
    1. Get minimum 8 hours sleep a day -> Sleep 1st thing after work so I don’t have to plan that out
    2. Always say no to staying up late if you’re not able to get enough sleep within 24 hours
  2. Stress from work
    1. Break down big tasks into a checklist of smaller tasks
    2. Always cross things off of the checklist to visualize progress
  3. Stress from finances
    1. Always maintain 12 months worth of expenses in cash
  4. Burn out from socializing
    1. Always have at least 1 full day to self, spending it in green areas (nature, garden, parks etc.)

Speculation, Illiquidity, Path Dependency, and How They Make Sense Together

As I mentioned in “Revising My Emotional Risk Tolerance v2“, I became very fidgety due to lack of emergency cash. One other detail I forgot to reveal is my cash flow is irregular, which just boosts my stress levels even more when money I can’t afford to lose has potential to be permanently lost.

Considering all these facts, a purely Great Company strategy as proposed in “Revising My Emotional Risk Tolerance v2” is probably not the best solution actually as I risk running into two kinds of problems: High Opportunity Cost and Illiquidity.

High Opportunity Cost comes in the form of missing out returns due to Speculation. Re-reading Chapter 8 of Intelligent Investor made me shamefully admit that I was engaging in market timing rather than price timing, something that would make me miss out returns because I was not fully invested since I can’t have 100% accuracy in market timing.

Illiquidity comes in the form of not knowing when to sell Great Company stocks. Great Companies work well if held for long periods of time, but this strategy causes lots of problems for small investors if they intend to live off of Great Company stocks alone as it requires large sums of cash on hand to survive the time period for Great Company stocks to resume to intrinsic value, and also uncertainty behind the timing of not prematurely selling Great Company stocks would also give me a lot of un-necessary stress if my living costs depended on it.

Active Indexing also just doesn’t make sense because returns aren’t sexy for the amount of capital required to stay invested. Adding the fact that it makes it hard to transition into other higher return investment strategies due to uncertainty of timing (eg. I might need $100,000 HKD to have enough diversity among stocks to kick start an investment strategy, but the index ETFs may drop in value right before I’m about to kick start, delaying plans indefinitely).

This is why difficult Path Dependency of Active Indexing is the nail in the coffin for me, because ultimately I should take advantage of investment strategies that have low competition to increase high returns rather than getting stuck in low return investment strategies indefinitely, since Charlie Munger’s advice for small investors has always been to:

Don’t go after large areas. Don’t try to figure out if Merck‘s pipeline is better than Pfizer’s. 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.

My qualms with jumping directly into a NCAV stock strategy though, was the requirement of a decent chunk of money to diversify among 20+ stocks and the time period needed for profits to materialize (2-3 years). The lack of capital to diversify among 20+ stocks without getting killed in commissions and the cash flow problem I presented in the beginning makes it a problem for me to deal with the illiquidity of NCAV stocks.

I have however realized a way to invest that would be great as a transition between a standstill situation to a fully invested NCAV stock strategy, which is Joel Greenblatt’s Magical Formula strategy.

The similarity in style of buying undervalued stocks and selling it and the similarity in the need for diversification makes it easier to transition as I can rotate into NCAV stocks the more capital I have at my disposal.

Another beauty of the Magical Formula strategy as a transition is the short holding period required (1 year), which means I require much less capital to start investing. This allows me to reduce my cash reserves from the target of 18 months to 12 months since in the event of being laid off, by the time I finish off my 12th month of expenses in cash, my Magical Formula stocks would be liquidated in time to extend the time I can have to find my next job.

My plan of action for now as a result would be to first ensure I have 12 months worth of expenses in cash, and then buy 1 Magic Formula stock / month with at most 2% commission [1]. I will stick to large cap companies during this period of only buying 1 Magic Formula stock / month, to counteract low diversification (Joel Greenblatt recommends at least 20 stocks).

As I have more and more capital, I will aim to buy 2 Magic Formula stock / month before trying to reduce commission to at most 0.50% [2]. Any extra stock I can afford beyond 2 Magic Formula stock / month I will then contemplate on either buying more Magic Formula stocks or NCAV stocks instead.

The reason why I will maintain buying 2 Magic Formula stock / month even after I start buying NCAV stocks is because the strategy only works if I persevere even when it underperforms the market, thus requiring full commitment through cycles of over-performance and under-performance in order to reap the benefits of the Magic Formula strategy instead of foregoing maximum profits prematurely.


[1] The reason why at most 2% commission is because the backtests of Magic Formula shows that it beats the market by 4+% under realistic conditions. I want to make sure I at least make 10+% returns after commissions as I want to still be able to generate better than market returns’ historical average of ~6-9% returns.

[2] 1% management fee is the most I will pay for active managed funds. Two transactions (buy & sell) will make commissions take 1% of my return


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

Revisiting My Emotional Risk Tolerance v2

I’ve been very fidgety these past few weeks.

Everything I thought I was (emotionless against volatility, hold for long term, 100% rational), I wasn’t.

It made me think of a quote from Charlie Munger:

“Each person has to play the game given his own marginal utility considerations and in a way that takes into account his own psychology. If losses are going to make you miserable – and some losses are inevitable – you might be wise to utilize a very conservative patterns of investment and saving all your life. So you have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.”

And I have to admit, paper losses make me miserable. My transactions from The Link REIT (SEHK: 0823) and Wharf Holdings (SEHK: 0004) last year earned me a handsome amount of money, and that felt really good, but seeing my Vanguard ETFs go down in price has made me miserable, even if it has dropped by a mere ~3-4%.

Everyday the commentaries / news of the US stock market being overvalued just bothers me for fear of a global stock market meltdown, and everyday the updates of value investing gurus I respect a lot returning cash to shareholders or accumulating cash makes me very nervous for fear that I’m not maximizing my opportunity cost by holding cash as well to capitalize on future opportunities.

I think I have to revise my plan of action. Even though my strategies (Active Indexing, NCAV Stock, Great Companies) are sound, I think the only strategy that would work with my temperament would be a Great Company stock strategy.

Accumulating cash calms me down, and the prospect of being able to fully focus on reading everything about Great Companies and potentially associating with them during a bear market excites me. And I just love dirt cheap bargains for world class merchandise.

Even though this means giving up returns that only small investors like me could benefit from (such as NCAV stocks), it also means I wouldn’t prematurely quit my investments and incur losses due to inability to withstand volatility, which would be even worse than making less positive returns.

I will be selling all my Vanguard ETF holdings at the average price I bought them in the mean time. The losses I incur shall be the commissions I paid buying and selling, which is negligible to me compared to the potential loss of capital.


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

Hedged Cash In Active Indexing Should Reflect Market Cap

There is a flaw with my current Active Indexing system, where I hedge based on how many ETFs Vanguard Hong Kong offers.

There are two huge problems with this:

  • Vanguard Hong Kong doesn’t offer a US ETF, which means I’m neglecting 50% of the world’s market cap
  • Equal hedge per ETF assumes that all ETFs are equal

The fact is, all ETFs aren’t equal, since some stock markets have a much bigger influence on financial spillover effects than other stock markets, such as US stock markets’ financial spillover effects onto Asia and Latin America during the 2007-2009 financial crisis.

This sounds like market timing, something John Bogle, founder of Vanguard Group, is strongly against, saying that “After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.

But to understand why there’s a need to adopt to macro market conditions, there’s a need to understand about how investors make money off of stocks, namely dividends, company earnings and earnings multiples.

Index funds by nature aren’t very sexy when taking dividends and company earnings into consideration, since most of the time based on dividends and company earnings they can’t be huge bargains due to mass diversification. The realistic way that index funds really bring fortune to investors is through earnings multiples (a.k.a. P/E), where the stock prices of index funds are driven more by sentiment rather than company fundamentals.

Therefore if any investment becomes over-valued, it should be sold to prevent permanent loss of capital and to minimize reduced returns over the long run for holding onto over-valued investments for too long.

And since I have to take sentiment and over-valuation into consideration, I should take the global stock market as a whole into consideration. When North American makes up to 55.30% of the world’s stock market (as of Nov 30th 2014), and it is over-valued based on P/E * P/B versus the earnings yield of AAA grade bonds, then in theory I should hedge 55.30% of my portfolio against such over-valuation.

This might sound drastic, but everything in life is opportunity cost. When I hold cash, I’m essentially making a point that I can use better investment opportunities down the road to compensate for my zero returns for now by guaranteeing the safety of my principal. Considering the fact that QE has pushed interest rates so low, “the opportunity cost of holding liquidity is among the lowest ever, when compared to dividend yields averaging just over 2%.

As such I’m going to change the composition of my current portfolio and edit my Active Indexing strategy plan of action to reflect this.


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