Ratios That Give Staying Power AND Profitability

I mentioned in my previous post that “I’ve tied up significant capital already in HSBC stocks [in]… 2 months… I might not be able to get even cheaper bargains if HSBC stock prices continue to slide”.

And that was exactly what happened.

But it wasn’t because I didn’t have enough cash to spare. It was simply because I wasn’t willing to tie in even more capital into stocks, let alone a stock that isn’t even a great company that’s worth holding until perpetuity.

And that’s because I want to maintain staying power.

Staying power is the ability to keep all operations in your life going on regardless of optimistic or pessimistic external conditions, eg. I can continue to hold onto my investments for the full duration required for the investment’s price to rise and match fair value regardless if I lose my job, get a pay cut, or a bear market happens

That is something I really treasure, as I want to dictate how I live my life on my own terms as much as possible.

As such, there are two financial ratios (in descending order of importance) that I think is really important to follow very strictly to ensure I continue to maintain staying power:

  • Current Ratio (a.k.a. How long can you survive without any income?): Just like in any company where high Current Ratios are favorable, it is favorable for individuals to have high current ratios too to prevent being forced to engage in activities that solves short term survival by sacrificing long term profits.
    • Preston Pysh mentions that Warren Buffett invests in companies with Current Ratio of >=1.5. I believe a Current Ratio of >=1.5 should be the golden standard that every individual should aim for as well
    • My formula for Current Ratio is different than conventional definitions, namely I believe Current Ratio should = Cash + 50% of Debit + 50% of Investment. Cash retains its nominal value practically all the time, but debit (what people owe you) and investments could lose up to 50% value at any given moment
    • I think Current Ratio can be split into 3 stages, namely (Surviving – 0.5 Current Ratio, Good – 1.0 Current Ratio, Excellent – >=1.5 Current Ratio). If Current Ratio is below 0.5, all financial activities should be focused on making sure it rises above 0.5 before focusing on other aspects (eg. debt repayment, investing or luxury spending)
  • Debt to Equity Ratio (a.k.a. Ratio of how much of your assets are funded by debt or personal net worth): A low Debt to Equity ratio is favorable to ensuring a company doesn’t go bankrupt due to having too much debt, the same is true for individuals:
    • Preston Pysh mentions that Warren Buffett invests in companies with Debt to Equity Ratio of <=0.5. I believe a Debt to Equity Ratio of <=0.5 should be the golden standard that every individual should aim for as well
    • I think Debt to Equity Ratio can be split into 3 stages as well, namely (Surviving – 1.5 Debt to Equity Ratio, Good – 1.0 Debt to Equity Ratio, Excellent – <=-0.5 Debt to Equity Ratio). If Debt to Equity Ratio is above 1.5, and Current Ratio is above 0.5, then all financial activities should be focused on making sure Debt to Equity Ratio drop below 1.5 before focusing on other aspects (eg. investing or luxury spending)

It’s important to have staying power, but it’s also important not to be obsessed with squeaky clean financial health and forego the ability to maximize long term profitability from investing.

According to Ray Dalio, debt is good if you can increase income faster than debt (eg. post-tax investment returns > post-tax debt interest). But everyone knows that debt is dangerous as well, since the positive magnified effects of leveraged return can only be reaped if you have stable income or liquid assets that can meet short term debt repayments while you hold onto investments for the full duration it needs to have prices rise to fair value.

So how to balance between staying power and potential profitability from leverage? I believe long term market timing is required.

As opposed to short term market timing that provides guidance to specific investment decisions (eg. shorting S&P 500), long term market timing reaps the benefits of hedging against falls and profiting against rises by providing guidance to asset allocation decisions while avoiding the need for 100% accuracy on predicting when the market falls or rises.

The idea is to hedge the portfolio with cash during bull markets and to leverage the portfolio with debt during bear markets.

It combines the idea of Mohnish Pabrai’s lesson that “the correct lesson to learn from 2008-2009 was to hold cash. And I didn’t have cash at the time…” instead of always being fully invested just in case a bear market comes along, and the idea that Warren Buffett’s great Berkshire Hathaway returns was contributed by using debt to invest in the form of float.

So going back to my comment on using long term market timing, the indicator that I use is an average of Shiller P/E and Total Market Index (Total US Market Cap / US GNP). The reason why I use US stock market indicators is because 1) If the US stock market crashes, most if not all other global markets crash. No other stock market in the world holds equivalent amount of influence 2) I’m primarily interested in investing in US stocks. The reason why I use an average of both indicators is because reliance on only one indicator alone may provide excess optimism or pessimism for guidance to my asset allocation decision.

In practice, two financial ratios come to play depending on whether the average of Shiller P/E and Total Market Index is over-valued or under-valued:

  • If Shiller P/E and Total Market Index is over-valued, I will rely on the Cash to Asset Ratio. The Cash to Asset Ratio will be equivalent to what % the Shiller P/E and Total Market Index is over-valued (eg. If average of both indicators is 40% over-valued, then my Cash to Asset Ratio will be 40%).
  • If Shiller P/E and Total Market Index is under-valued, I will rely on the Debt to Asset Ratio. The Debt to Asset Ratio will be equivalent to what % Shiller P/E and Total Market Index is under-valued (eg. If average of both indicators is 40% under-valued, then my Debt to Asset Ratio will be 40%).

There are however two important things to consider when doing long term market timing:

  • NEVER EVER let Debt to Asset Ratio increase above 1. The purpose of using debt is to magnify your returns through leverage, but never use it to the extent that you could get realistically get bankrupt with it. A Debt to Asset Ratio implies that if all hell breaks loose, you can still manage to have positive net worth after liquidating all assets to pay debt. Thankfully, since you’re using an average of two indicators, the probability that the average results of both indicators telling you to go above 1 in Debt to Asset Ratio is almost impossible.
  • Allow plus or minus 5% wiggle room with your portfolio allocation. The average of both indicators will constantly shift, so to buy or sell constantly to perfectly match your asset allocation to the average of both indicators will kill your returns due to all the taxes and commissions incurred. Learn from passive index fund investors when it comes to re-balancing as they always have to balance following an asset allocation plan and minimizing costs in doing so.

As for what investments should be made when using debt… that’s a completely different blog post in itself. I’ll write about it in the future.

[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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