Month: December 2012

Distinguish Between a “Want” and a “Need”

During this festive season, many of us indulge in shopping to “spruce” up our lives. Buying the luxurious Louis Vuitton handbag, a luxurious watch or the latest gadget are some ways of how people enhance their lives. However, let’s take a step back and decide if we really need those things. Is the latest watch a “want” or a “need”? What will happen if we did not buy that watch? Will our lives be worst off?

A want is something that is good to have. If you do not have it, it doesn’t make you worst off. A need is something that you have to have. If you do not have it, it might make you worst off. Examples of wants  include a new watch even if you already have a working one, the latest smartphone, a car (yes, this is a want for most people) and many more. Even your daily fix of Starbucks coffee is a want. Examples of needs are the basic human needs like a shelter over your head, water, food, basic health care and hygiene products and clothes (not those fancy type but functional ones).

I mentioned car in the list of wants. In Singapore, with almost all the locations well-connected through public transport, a car can be a superfluous purchase. I think a taxi ride to all locations might cost lesser than servicing the car loan, paying for petrol, parking, etc. However, for those in the delivery business, it might be a need. Taking public transport for them might be a hassle as they need to delivery food or goods.

Once we know the difference between a want and a need, we have to distinguish if the item we long for is a want or a need. By doing so, we can budget our money properly and channel them into things that will provide us for the long-term. An example would be instead of buying the latest expensive watch that will set you back by a thousand grand, you can save up the money and once you have accumulated enough from other wants that you had chosen not to purchase, you can invest the money in a fundamentally strong stock. $5000 compounded for five years at 10% per annum gives u a cool $8000 at the end of five years. Isn’t that more enticing than buying those unwanted wants that will only give you satisfaction for a few weeks, or months at the most?

For myself, before I purchase anything, I distinguish if the purchase is a want or a need. Just today, I wanted to buy a new soccer boots and a vintage Manchester United jersey. After much thought, I decided not to buy them as I do not need them but they are just good to have.

Having said that, I do not mean we should not enjoy the finer things in life. It is alright to buy something that is a want once in a while to reward ourselves. It just should not become the norm and cloud our judgement, making us think that something that is actually a want is a need. In extreme cases, it can put us in a spiraling debt. Making us buy more and more on credit those things we do not need.

In conclusion, before purchasing the latest gadget or anything for the matter, we should identify if the purchase is a want or a need. Remember, a want is something that is nice to have. If you do not have it, it doesn’t make you worst off. A need is something that you have to have. If you do not have it, it might make you worst off. There should always always be a balance between our wants and needs. We can indulge in wants once in a while but we should make sure that we do not over-indulge in them!

Different Scores to Filter Companies

We can filter companies using various scores such as Piotroski F-score, Altman Z-score, Beneish M-score and Montier C-score. In this post, we will look into the scores to identify certain companies.

Piotroski F-score

F-score was developed by Joseph Piotroski. It is used to spot turnaround companies fast and also to identify the healthiest company among a basket of stocks. It involves nine variables from a company’s financial statements. In a research paper by Piotroski entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers“, it was shown that by investing in the top performers over a 20-year test period from 1976 through 1996 that “the mean return earned by a high book-to-market investor can be increased by at least 7.5% annually”. On top of that, he found that buying the top stocks in the market and shorting those that got the worst scores would have resulted in 23% annualized gains. Also, weak stocks, scoring two points or less, were five times more likely to either go bankrupt or delist due to financial problems.

There are nine variables in the F-score, split into three groups. Points are awarded in a simple binary fashion, 1 for yes, 0 for no. The variables are as follows:

A. Profitability Signals

1.     Net Income – Score 1 if there is positive net income in the current year.

2.     Operating Cash Flow – Score 1 if there is positive cashflow from operations in the current year.

3.     Return on Assets – Score 1 if the ROA is higher in the current period compared to  the previous year.

4.     Quality of Earnings – Score 1 if the cash flow from operations exceeds net income before extraordinary items.

B. Leverage, Liquidity and Source of Funds

5.     Decrease in leverage – Score 1 if there is a lower ratio of long-term debt to in the current period compared value in the previous year .

6.     Increase in liquidity – Score 1 if there is a higher current ratio this year compared to the previous year.

7.     Absence of Dilution – Score 1 if the Firm did not issue new shares/equity in the preceding year.

C. Operating Efficiency

8.     Score 1 if there is a higher gross margin compared to the previous year.

9.     Asset Turnover – Score 1 if there is a higher asset turnover ratio year on year (as a measure of productivity).

Altman Z-score

The Z-score is used to identify risky stocks. It was developed by Edward Altman. Any Z-score above 2.99 is considered to be a safe company and any companies with a score less than 1.8 is shown to have a significant risk of financial distress within two years. This formula can also predict bankruptcy of a company.

The original Z-score formula is as follows:

Z = 0.012T1 + 0.014T2 + 0.033T3 + 0.006T4 + 0.009T5.

T1 = Working Capital / Total Assets. Measures liquid assets in relation to the size of the company.

T2 = Retained Earnings / Total Assets. Measures profitability that reflects the company’s age and earning power.

T3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

T4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

T5 = Sales/ Total Assets. Standard measure for total asset turnover (varies greatly from industry to industry).

Beneish M-score

The M-score was developed by Messod D. Beneish and it helps to uncover companies that are manipulating its earnings. An M-score above 2.22 highlights companies that may be inflating their earnings artificially. This increases the probability that they will have to report lower earnings in the future. In his research paper entitled “The Detection of Earnings Manipulation“, Beneish has stated that the percentage of correctly classified manipulators ranges from 58 to 76%, while the percentage of incorrectly classified non-manipulators ranges from 7.6% to 17.5%. An interesting note is that students from Cornell University used the M-score to identify Enron as an earnings manipulator before its collapse.

M Score = -4.840 + 0.920 x DSRI + 0.528 x GMI + 0.404 x AQ + 0.892 x SGI + 0.115 x DEPI – 0.172 x SGAI – 0.327 x LVGI + 4.697 x TATA

Where:

Days Receivable Index (DSRI) is:
DSRI = (Net Receivablest / Salest) / Net Receivablest-1 / Salest-1)

Gross Margin Index (GMI) is:
GMI = [(Salest-1 – COGSt-1) / Salest-1] / [(Salest – COGSt) / Salest]

Asset Quality Index (AQI) is:
AQI = [1 – (Current Assetst + PP&Et + Securitiest) / Total Assetst] / [1 – ((Current Assetst-1 + PP&Et-1 + Securitiest-1) / Total Assetst-1)]

Sales Growth Index (SGI) is:
SGI = Salest / Salest-1

Depreciation Index (DEPI) is:
DEPI = (Depreciationt-1/ (PP&Et-1 + Depreciationt-1)) / (Depreciationt / (PP&Et + Depreciationt))

SG&A Expense Index (SGAI) is:
SGAI = (SG&A Expenset / Salest) / (SG&A Expenset-1 / Salest-1)

Leverage index (LVGI) is:
LVGI = [(Current Liabilitiest + Total Long Term Debtt) / Total Assetst] / [(Current Liabilitiest-1 + Total Long Term Debtt-1) / Total Assetst-1]

Total Accruals to Total Assets (TATA) is:
TATA = (Income from Continuing Operationst – Cash Flows from Operationst) / Total Assetst

Montier C-score

The C-Score was developed by James Montier and is used to identify companies that cook the books and then short them in the process. It is almost similar to the M-score. A point system of 1 is given for yes and 0 for no. These scores are then summed up to give a final C-score ranging from 0 (no evidence of earnings manipulation) to 6 (all red flags are present). The areas tested are:

  1. Is there a growing divergence between net income and operating cash-flow?
  2. Are Days Sales Outstanding (DSO) increasing? This means that the “accounts receivable” are growing faster than sales and this may be a sign of channel stuffing.
  3. Are days sales of inventory (DSI) increasing? If so, this may suggest slowing sales. This certainly is a bearish sign.
  4. Are other current assets increasing vs revenues? The DSO and/or DSI are usually closely watched so some Chief Financial Officers may use this catch-all line item to help hide things
  5. Are there declines in depreciation relative to gross property plant and equipment? This protects firms altering their estimate of useful asset life to beat earnings estimates.
  6. Is total asset growth high? Some firms are serial acquirers and use their acquisitions to distort their earnings.

References:

http://www.stockopedia.co.uk/content/the-piotroski-f-score-a-fundamental-screen-for-value-stocks-55711/

http://en.wikipedia.org/wiki/Altman_Z-score

http://ycharts.com/glossary/terms/beneish_m_score

http://www.stockopedia.co.uk/content/montiers-c-score-are-your-favourite-stocks-cooking-the-books-63863/

Book Review – “Building Wealth through REITs” by Bobby Jayaraman

“Building Wealth through REITs” is a local book by Bobby Jayaraman which touches on the overview of real estate investment trusts (REITs) found in Singapore, how to read the financial statements of REITs and also how to value the REITs, among others. The book also includes interviews with the Chief Executive Officers of six REITs listed in Singapore. The interview section in itself is worth the money. I learnt a lot from the interviews alone.

I came across Bobby’s articles on REITs in the now-defunct Pulses magazine in 2010. The articles were well-written and I learnt a lot from those articles when I was just starting out on learning about REITs. This book actually takes readers a step further in looking into REITs. However, beginners need not fret as this book also divulges on the basics of REITs like the structure of REITs and how they grow.

There are only a handful of local books on REITs and this definitely is a must-read for all who want to know more about REITs and how to invest in them prudently. I feel beginners and advanced investors will equally learn a lot from this book.

What is Contrarian Investing?

Let’s say you were to fall sick and visit a doctor. He prescribes you some medicine. Suppose you are unhappy with this doctor’s diagnosis and wanting a second opinion. Thus, you visit another doctor who gives an identical diagnosis and prescribes the same medicine. Still not satisfied, assume you visit eight more doctors and all prescribe the same course of medicine. What should you do under these circumstances? The logical course for you will be to take the prescribed medicine. Doing anything else is likely to be foolish as you would be jeopardizing your health. If all doctors agree on the proper medicine for you, then it is logical that you should take that medicine.

Now let’s change the circumstances. Suppose you were to visit ten investment gurus and all agree that you should buy a particular stock. What should you do under these circumstances? Here, the rational thing to do will be to avoid that stock because if all ten investment gurus recommend that stock at the same time, it’s likely that its price is too high because it already reflects the optimism of the professionals. You may end up losing money chasing the hot stock.

Below is an awesome quote by legendary investor, John Templeton:

“It is crucial to understand, and very few people do, that attaining superior investment performance has nothing at all in common with succeeding in 99% of other occupations. If you were building bridges and a dozen consulting engineers experienced in bridge building all gave you the same advice, you’d be stupid not to build your bridge their way. In all probability, if the experts all agree, their way is the right way to do it. You’d build a better bridge at lower cost if you followed their advice. But the very nature of investment selection process turns that scenario topsy-turvy. Let’s assume that every securities analyst you see says, “That’s the stock to buy!” You might think that if all the experts are saying “buy,” you should. But you couldn’t be more wrong. To begin with, if they all want it, they’ll all buy it and the price will build up enormously, probably to unrealistic levels. By the same token, if all the experts say, “It’s not the stock to buy,” they won’t buy it and the price will go down. It’s then, if your research and common sense tell you the stock does have potential, that you might pick up a bargain. That’s the very nature of the operation. It’s quite simple; if everybody else is buying, you ought to be thinking of selling. But that type of thinking is so peculiar to this field that hardly anybody realises how valid it is. They say: “I know you’re supposed to look where other people aren’t looking,” but very few people actually understand what that means.”

Therefore, it can be seen from the quotes and examples above that investing is unlike most of what we do in our daily lives. The best time to buy a stock is at the point of maximum pessimism and the best time to sell a stock is at the point of maximum optimism. This is contrarian investing. Warren Buffett sums it up best when he quipped, “Be fearful when others are greedy and be greedy when others are fearful”.

The Book That Started Me off on This Journey…

2012-12-19_10-34-49_512My journey into the world of personal finance and investing started around October 2007 when I was in National Service (NS). I was 19 years old then. I was just promoted to be a Third Sergeant and wanted to learn how to budget my extra allowance prudently to prevent overspending. I made a trip to Popular bookstore to purchase some books on budgeting.

As I strolled into Popular bookstore, to my left stood a section called “Popular Bestsellers”. Perched on it was a book that caught my eyes instantly. The book was entitled “Rich Dad, Poor Dad” and it was by Robert Kiyosaki. The title was interesting so I picked it up to read the blurb on the back page and it seemed interesting. The blurb did not talk much about how the book could help me to budget my money but I bought the book anyway.

Reading the book was a life-changing experience for me. I never saw money the same way again. The concepts revealed in the book were just mind-blowing. One example is that the house we are living in is actually not an asset but a liability. We have been all trained to think otherwise since young. There were many instances of “Aha” moments as I read the book. Anyone who is interested in personal finance and investing should read this book. I have not looked back since…