Why “Shareholder value” Is Often A Lie

“Shareholder” – The over-simplified Term

We often hear that businesses are supposed to maximize shareholder value. It certainly sounds reasonable to beginners, but once you get to know more about stocks, you will find shareholders are rarely a single group with some common interests.

Instead, we can usually identify 5 groups of shareholders:

1. Operators/Management.

Management are the operators of the business. They manage and control the business’s daily activities. Although they don’t have the ultimate control of the business, they have strong enough influence to the business and board of directors.

For sure, management are often shareholders as well, but their interests also come from being able to draw compensation on a long term basis. When they have enough influence to the board, they could also treat the company as an unlimited source of cash flows for themselves.

Besides getting long term compensation, there is also pride, love, and sense of power involved. The job itself might be rewarding enough, so much that it is beyond the financial interests a regular shareholder would have.

By nature, management are the ones who interact daily with employees, so they might have natural attachment to employees or at least try to avoid confrontation at a minimum.

For all these reasons, management rarely have the same interests as the other shareholders:

  • They don’t like to lose control. It is often a matter of pride and sense of power.
  • They like to draw as much compensation from the company as possible.
  • They don’t like to sell the company even when given a good offer.
  • They don’t like to do restructurings and lay off people, even when it is really needed.
  • They don’t like to liquidate an unprofitable business even when they believe it is hopeless (think Berkshire Hathaway’s textile mill)

2. Controlling Owners.

Controlling owners are the large shareholders who actually control the board. Some have close to majority shares, while others have different class of shares with more voting power (such as class B shares with 10 times voting power).

Controlling owners sometimes have more aligned interests with long term shareholders, but they are rarely the same. This is because controlling owners have both control and insider information.

Insider information covers the past and present status of a company, giving them more certainty to predict the future.

“Control” is even more powerful, since it gives them certainty about future actions and potential changes that could happen to the company.

Because of these two advantages, controlling owners could also play tricks against minority shareholders. For example, there are quite a few Hong Kong companies that play the same type of tricks over and over to dilute minority shareholders in a big way.

Just recently, Landing International (HK: 0582) announced a pro-rata share offering at HK$0.05 per share for 102 billion shares (yes, you read it right, it is not “million”). The current share base has 20 billion shares outstanding. So this is 500% dilution. To understand the offering price, I should mention that the share was traded at HK$0.10 just the day before the announcement and HK$0.20 just one month ago. The company’s book value is HK$0.50 per share.

The company also has HK$5.2 billion cash and about HK$4 billion debt. So it has net cash to begin with, why does it need so much dilution and so much capital (HK$5 billion capital injection)? The controlling owner declares this is to pay off the loan made by the controlling owner himself.

I should also mention that this is not the first time they dilute shareholders in such dramatic matter, it is the 3rd time they do it since they acquired control in 2013.

Some people might think this is a “fair” offer because it is pro-rata. In theory, it might sound right, but again, people tend to forget that it is the controlling owner who has the control and insider information here. If you are one of those minority shareholders, do you want to put more money into this apparently suspicious company? Do you know how many insider dealings they could have later on? Do you really trust their accounting books?

So the mere action and announcement would already scare away the minority shareholders, leaving them 500% diluted at unbelievably low prices relative to their costs and the company’s book value.

3. Short term shareholders.

Short term shareholders don’t intend to hold the shares for many years. They want to take a “free-ride” and prepared to jump off the wagon at any time.

To them, the so-called DCF value (discounted cash flow) is a joke. They only care about the market value and how much and how fast they can sell.

With this purpose in mind, they would like a company which can make numbers and produce a stable trend. They like companies which can tip them off at the expense of other shareholders. They like companies which will sell at a premium to the highest bidder tomorrow no matter if the bid is below or above the long term intrinsic value. They like companies which care about short term earnings than long term returns and don’t want to make any real long term investments (unless the investment could make the “story” more attractive). And they like the company to buy back shares no matter what the price is since it would boost the short term share prices.

Many activists are also in this type. Although they claim that they represent the shareholders’ interests, they tend to be short term oriented, and their solution could be conflicting with the company’s long term interests.

4. Long term shareholders.

For long term shareholders, DCF makes more sense, at least theoretically. Even in this case though, “value” is still only meaningful in a relative sense. For example, since nobody knows what discounted rate should be used, we can never tell whether someone should prefer $3 for 10 years later or $1 for now.

Also, how much cash a company should hold and how much leverage a company should use is really a subjective decision, which depends on the personality of the decision maker.

5. Options holder.

Since management and employees usually hold a lot of long term options, this type of shareholders is also important to consider. Since they only hold options without any cash flow needed to excise them until many years later, their downside is practically zero at the moment they get the options, and their upside is infinite.

Naturally, options would encourage them to be very aggressive to pursuit growth and leverage regardless of the risk and downside. The limited time window of options would also encourage them to be more short term oriented.

When it comes to paying dividend vs. buying back stocks, options holder would by all means favor buybacks, no matter how high the stock price is. After all, dividends have nothing to do with them.

Implications

To be fair, there are a lot of common interests among all the shareholders too, but as you can see, the real picture is much more complicated than what you would usually read in the news media. It is also hard to argue what is right and what is wrong, plus what can you do even if you could tell? (unless you are the regulators)

Therefore, for investors, it is critical to understand who you are and what role you play, and try to find a shareholder base that meets your needs.

For example, if you are one of those long term shareholders, you would want to partner with some good controlling owners or a management who has long term shareholder’s interests in mind, those who would treat other minority shareholders fairly, and think about the company’s long term future.

On the other hand, if you are one of the short term investors, you might want to find a management that knows how to do promotions and tries their best to make the wall street happy.

Overall, people of the same type can usually get along. If a stock is dominated by short term investors, the absence of a long term oriented CEO or controlling owner can be a good thing, but collectively, they might lead the company to do something harmful to the long term performance.

On the other hand, a long term oriented company with long term investors as its shareholder base could be “unfriendly” to short term investors who have no patience for long term fundamental returns.

In any case, no matter whether you are a long term or short term investor, you have to be careful about any powerful management or controlling owners who behaved unfriendly to minority shareholders. Studying their history and the company’s history is an important part of due diligence. To do that, just reading all the past annual reports is far from enough, since that material is too official and strongly biased. Instead, you should look at the cash flows, value returned to shareholders, online reviews and investors’ past discussions.

Conclusion

Just as “value” is an over-simplified term, “shareholder” is also an over-simplified term. Experienced investors know what to look for beneath the surface. So next time when you hear people talking about “maximizing shareholder value”, you might want to silently ask yourself: which shareholder are they talking about?

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The Economics Of Buying Your First Home

I have always told my friends that not everyone needs to learn advanced Math, but almost everyone should take two classes when they are in high school: Psychology and Finance.

All our education, taking so many years, and getting so competitive, are mainly to prepare some workers to be used by large or small businesses. The goal seems to be making enough money and make a good living. Money is certainly useful, but it is more like a weapon, it is powerful, it is needed, and it could help you, but it could hurt you too (if you don’t know how to use it properly).

That is why we need to learn Psychology, to understand what makes us happier.

What about Finance? People spent so much time on learning and worked so hard everyday, but most of them only spent very little time on learning how to invest the money they earned. Gambling on stock market without the know-how, or being too conservative can and did cost them a lot.

One basic lesson for Finance for everyone is that regular people (layman) usually makes money on real estate investing, but loses (or gains much less) money on stocks. It doesn’t have to be the case, but it has been the case for decades. One main reason for this is that stocks have businesses behind them and these businesses are very complicated for regular folks to understand well. The stock market also has a lot more short term fluctuations than the real estate market, which is used/produced/taken advantage of by the sharks or wolves of wall street.

On the other hand, real estate is much simpler (relatively), with much less short term fluctuation (long term cycle is still there though), and more importantly it is a “non-scalable” strategy. “Non-scalable” means people who have a lot of money can’t use the same strategy, since finding a real estate deal requires a lot of time searching it, it may also require extended knowledge about a local area, and each transaction is separate, all of these require personal care.

Of course, stocks have its advantage too, such as more diversification, global reach, and not require a large sum of money. But to invest in stocks, you need a lot of time to study it, follow it, or you need to find a trustable expert to do it for you.

So real estate investing is better for regular folks, but the “crown jewel” here is buying your first home. And I will explain why that is the case.

Suppose there is a betting game, which requires you to bet $50k, and you have 90% chance to double your money, but 10% chance to lose all that bet, and you only need to pay $10k out of your own pocket (you can borrow $40k from “the house”, and you don’t have to pay it back if you lose!), and best of all, there is no income tax for your profit, would you do it?   (When you think about it, if you don’t have to pay back the money you borrowed if you lose, the upside is 500% with 90% probability, and downside is 100% with 10% probability. )

It certainly sounds too good to be true. But that is what you get when you buy your first home. To get your vote, and encourage home ownership, government has sweeten the deal a lot, to the point that it really sounds too good to be true (to investment experts). I will list out the benefits here:

  1. 20% downpayment without any liability to pay it back, and no forced liquidation as long as you can pay the mortgage every month.

Leveraged investing is not something new. You can borrow money to invest in pretty much everything, but if you are “under water”, say if your stock goes down 20% when you leverage 5 times, your portfolio will be liquidated and you will be on hook to pay anything left to pay if the liquidation doesn’t pay back all the loans.

You don’t get the same treatment with your first home. In 2008, so many people defaulted, and still get to walk away without having to pay anything back – they even got to live in the house for one year without any payment before the foreclosure finally happened.

Essentially, the bank or government (most mortgage loans are bought by the government even though it might be originated by the banks) is on the hook when lending money to you.

2. The loan interest rate is ultra-low, so low that you can’t get the money in any other way.

When we borrow a mortgage, we often find that the interest rate is so low, often just 1% above what the bank pays us for the CD deposit. How can the interest rate go so low?

When we put it together, “high leverage and long term loan with no terms attached” + “no liability for the loan other than losing some of your credit” + “ultra low interest rate” are truly unbelievable treats, but this is all built on top of two credit systems:

The first is your own credit. The salary you have is a stable income source (your “credit”), and it should be used to make some borrowing against it and not wasted. And the loan is collateralized, meaning your house will be taken away if you can’t pay mortgage.

The second is the government’s credit. When government buys the mortgage from the banks and later sells it to investors, it has an implicit loan guarantee on it. Investors are willing to accept this “agency” debt (“agency” like Fannie Mae which represents the US government) for very low interest rate because it is virtually risk free. If anything happens (another 2008 for example), you can bet on government to pay it back. What if government can’t pay it back? That almost will never happen, we have yet to see one government to default on a loan made in its  own currency (Yes, Greece wouldn’t have had default if it had borrowed loans in its own currency), since the worst that would happen is just printing more money.

So this is a “benefit” given by the government, but government is not a person, it is an entity owned by all of us. Essentially, this “free lunch” is provided by all the rest of us who don’t buy a house. It is not our choices to not provide that “free lunch” to other first time home buyers, but not taking it for those who need and can afford a home under such a favorable term would seem unwise.

3. Real estate generally goes up over long term.

Like any other financial assets, real estate will also have a boom and bust cycle, although it is generally a very long cycle and has relatively stable trends in the short/mid term. However, over even longer term, such as 10 – 20 years, real estate generally goes up, unless the country had a big bubble in the past, or local economy is in deep trouble.

It goes up because of inflation and city growth. Chances are the place people find more jobs is exactly the place that real estate will go up faster.

4. No income tax (or capital gain tax) on profit up to $500k per couple.

Again, almost no other investing can avoid tax except buying your first home. And that could make a big difference. This is another benefit our government gives to home buyers on behalf of all the other tax payers.

With all the good things, does this mean this “free lunch” is risk-free? It is certainly not, just like other investments, it would have some risks, but I would say much less risks. You just need to be careful on some of these points:

  1. Generally, you should NOT time the market when buying your first home, unless the bubble is too big and too unbelievable. (Usually I define a bubble as being at least 3 times of its fair value, but it also depends on the growth rate of the country and local economy.)
  2. One major benefit of buying first home is to save on the rent expense. So if the mortgage payment has to be many times more than the rent for the same house, you might need to be more careful. (If the mortgage is twice of the rent, it is not ideal, but still not too bad. If you wonder why that is the case, it is because part of mortgage is to pay  down the loan over time, and the mortgage doesn’t go up over many years, but your rent would go up over time.)
  3. You might need some cash in hand, so you wouldn’t go default when you lose your jobs for 1-2 years.
  4. Housing price is tied to local economy, so if you expect foreseeable big trouble in local economy, you might need to be more careful.
  5. The benefits listed above only apply to the first home purchase. For investment homes, generally it is still a favorable investment, but the things will get a lot more complicated than the first home.

Many first home buyers in an up-trend face this dilemma: it looks too expensive to buy, especially when you compare it with the last few years. As a result, they often try to time the market and hope to catch it when it drops back, only to find that it continues to go up for many following years, and not enjoying the benefit of their first home in the process. This is because they failed to understand the economics behind the first home purchase. It is a very good deal for most people, of course it could get better when the price drops, but you may not want to bet on that to happen.

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Liquidity and Ponzi Scheme

Every time, when I saw some news talking about how investors lost hundreds of billions of dollars because index dropped 3% in a day, I can’t stop thinking that this kind of news is designed to get attention of the unwary public.

Theoretically, the value of stocks is the share price times the number of shares. But that calculation totally ignores the liquidity factor. Just because some crazy guy is willing to pay 10 times of what the share is worth, it doesn’t make every shareholder 10 times richer. This is because the shares being traded is only a tiny percentage of all the outstanding shares.

However, this is exactly how the manipulators design the game. If the shares are being traded in a price range, it gives a misleading impression that the shares are worth that much. After all, the market is efficient, right? In reality, it is far from the truth. Otherwise, try to explain those bubbles in the history.

In some sense, Ponzi Scheme is using this liquidity factor to fool people. At any given moment, as long as the people who demand redemption is only a small percentage, or the people who seek redemption (sellers) are less than the people who get sucked into this game (buyers), the manipulators (or call them the game designers) will have no problem to keep this game going. However, when all the existing stockholders want to seek redemption, you can be pretty sure that there is no way it can still be able to maintain the same or similar price.

Perhaps this is not news to many experienced investors/traders, but what is more interesting is that many investors/traders are participants of this Ponzi Scheme when they have already knownthis is a Ponzi Scheme!

This actually happens quite often in the stock market for those momentum players. Some of them are the unwary public, but many of them do know that the stocks are not worth much. But as long as it can keep on going up, why don’t enjoy the ride? Last year, the Chinese stock market had a crazy run from March to June when many stock traders, including many who just joined the market for the first time don’t really believe there is much value in those stocks. Yet, most of them think they can get out before others do, and there is plenty of money to be made during this crazy bull run.

What happened to them eventually? Well, I don’t know individually, but collectively, you know for sure that they are determined to lose in a big way.

This brings another paradox of the market efficiency theory. Something clearly not “efficient” to those fundamental investors can become efficient for some other market participants. Even though you know this is a ponzi scheme, it doesn’t mean there is no money to be made here. In fact, the FANG stocks are still the best stocks in this weak market, right? (Other than Google, I believe the other 3 are all much overvalued.)

But when you factor in the liquidity factor, it is not that hard to see where the bubble stocks are. Why did you see a big value gap last year between the valuation of BABA (BABA) and Soft Bank (SFTBY)? Can Netflix (NFLX) raise new equity capital easily at today’s valuation, or maybe that is why it has to get more debt instead? What about LNKD (LNKD) dropping 45% in a day?

That is also the reason why companies with bubble stocks like to use the stock as a currency for acquisitions or stock based compensation. These transactions are both non-cash, and also hide the fact that there isn’t much real liquidity for investment purposes at that high valuation.

What is more interesting here is that it is actually a “win-win” situation for almost all stakeholders. For the acquirer’s management, they just expanded their empire, gaining more power and better pay. For the acquirer’s short term investors, the acquisition will show higher growth rates without affecting earnings or FCF, and therefore may bring more premium on valuation. For the acquirer’s long term investors, using expensive stocks as a currency is creating value for them.

What about the company being acquired? They get some premium (usually 30% or more) during the transaction, but what if the shares are 3 times overvalued? Don’t they lose eventually? Well, that really depends on their size and time horizon. Also, if this game can continue for long enough, the acquirer may gain enough “value” to make the overvalued stocks to be really worth that much, which is exactly what happened in 1960’s conglomerate scandal. (Even though the conglomerate was overvalued at the moment, if it can continue to use overvalued stock to exchange for many fairly valued smaller businesses, the value created from this process could later make it worth the price at that particular moment!)

How can “value” be created in this zero-sum game and make every player happier than before? That is the “magic” of Ponzi Scheme. Before the music stops, you really don’t know who the loser is, and all the “current” participants could all be winners if there are enough losers joining this game later, but you also know that collectively, there will be a lot losers for sure.

Ideally though, these companies also like to raise equity capital when the stocks are overvalued, but that is much harder to do because it is too much risk for the investors to take so much stock at such a high valuation (again, the liquidity factor is in play). So the best they can do is often just some convertible bonds or warrants. (After all, day dreams are only worth that much.)

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The Double-Agency Problem In Investing

In investment, the “agency problem” is commonly known, which refers to the fact that the management of a company usually acts on their own interests, at the shareholders’ expense.

There many examples of such problems:

1. Expensive Acquisitions.

Among all the bad actions, expensive acquisitions are the most damaging ones. Managers often come up with all kinds of excuses to show shareholders why this is a good deal, and how much synergies they could achieve after this deal. The reality is their pay/bonus is often proportional to the size of the company. Even without the financial reward, they surely enjoy the increased power as the company becomes bigger.

2. Large bonus and stock based compensation.

It is quite often that the bonus for a CEO or CFO is much larger than his/her base salary. I have often seen CEO taken a bonus at 0.5% or 1% of the market cap every year, sometimes even when the company is having a bad performance or losing big!

Well, 0.5% or 1% may not sound like a lot, but if that 1% is saved and added back to income, it will transfer to a big proportion relative to the earnings.  So if the company if valued at P/E 20, the earning is 5% of the market cap. Adding 0.5% on top of that, it translate to 10% extra earning, or at the same P/E multiple, it will give 10% more share price.

This is just the bonus of top management, not counting the bonus of all the executives and board. Very few small investors would go and check proxy statements for these details.

Besides taking bonus, they are also very good at boosting their return on options, and dressing up their financials.

First, by not issuing dividend or issuing a smaller dividend, they could buy back shares instead. What is the difference? Regular dividend doesn’t increase the value of options, but share buyback does. So without moving a finger or delivering extra real operating performance, just by buying back shares (no matter how high the price is), they can make good gains on their options.

The ironic thing is that shareholders actually like to see share buybacks. It just shows how pitiful the shareholders are in the mercy of the management. They like share buybacks because quite often there is the other even worse alternative: they can find out that the management is using the cash on balance to make an expensive acquisition, or mess up the business and eventually go under, which means there is no return at all for shareholders, ever.

Even if there is no expensive acquisition, cash hoarding makes the management feel safer, but makes investors poorer simply because the cash is sitting there without being deployed. The time value of money is lost, and no compounding returns on that cash at all. This kind of hidden value destruction is not to be overlooked, but not obvious to all the small investors. At the end of the day, a manager good at capital allocation and act on shareholder’s interest can be even more valuable sometimes than a manager very good at operations.

Adding insult to injury, after taking millions or even hundreds of millions in stock options, management often want investors to ignore that cost completely. They emphasize on EBITDA, Free Cash Flow or non-GAAP earning figures which don’t contain any charge on options/stock related expense, because those are “non-cash” charges. A simple word “non-cash” wipes out all the dilution effect they have created consistently year after year.

This is what they often do: they dress up the earnings by wiping out the “non-cash” stock based compensation, showing a better earning, and use the “cash” to buy back some shares to eliminate the dilution effects created by the stock based compensation, effectively moving the cash from operating cash flow to the financing cash flow, boosting both operating cash flow and free cash flow. And after all this, they call that share buybacks as “returning” to shareholders.

Not only the small investors who don’t understand the trick get cheated, even the knowledgable professional analysts on buy side and sell side often forget about the tricks when they do the valuations.

It is also not just some of the companies, virtually all the high-tech companies routinely and traditionally come up their non-GAAP figures, with analysts helping their course: all the earnings forecasts are non-GAAP earnings, and forward P/E is using non-GAAP earnings for calculation. Another trap for small investors. For many high tech companies, such as Google, Tesla, or Netflix, just the options/stocks based expense could make a huge difference on their P/E calculations.

3. Accounting manipulations.

The more I learn about investment, the more accounting tricks I could find. And eventually I found out that the accounting manipulations are actually the “norm”, not just for the “criminals”.

To be fair, most of them are relatively mild, such as taking up revenue earlier, or recording a one-time charge-off in order to boost up the following quarters’ earnings. These are smoothing out the earnings, but not having a huge long term effects. People tend to focus on the kind of financial fraud like Enron did, hiding huge losses in off-balancesheet entities, but the type of earning manipulations I just talked about can be damaging to small investors as well, since they often misjudge the stability of the earnings, or get surprised by a sudden change of the business fundamentals. As a result, they tend to sell at the worst moment, and buy at the worst moment.

In the case that the company’s fraud does get discovered, and get fined, guess who suffers? It is the company who pays the fine, or the shareholders who pay the bill! At the mean time, managers’ legal costs are often covered by the legal insurance the company (shareholders) purchased for them!

4. Shares with different voting power.

Suppose a “friend” comes to you and ask you to invest in his company.

He says: “you can own 90% of my company if you put in 90% of the capital. Oh, BTW, forget about the fact that I only put in 1% of capital, based on the current (manipulated) earning power, my company is worth 10 times of the book value now. So my 1% of capital is worth 10% of the company now. After you get 90% of my company, you will be entitled to enjoy the 90% of the earnings. However, you will own the class B stocks, and I own class A stocks, since my class A share have 10 times of voting power than your class B share, despite the fact that you are the 90% owner of the company, I am still the controlling owner, and I can decide whatever I want to do with the company and its earnings, and pay however big the bonus to myself, including giving myself any type of stock based compensations. In another word, I will eat the “meat”, but you are entitled to 90% of all the leftovers, if there is any. Oh, don’t worry, there could be some dividend at some point, when I want to throw some bones to investors to boost up the share price so I can get a new round of share offerings at a high price.”

Now, does that sound like a good deal to you? But you should thank your friend, because he told you everything you are supposed to know. Not like most of the IPOs, although this kind of facts are included in the SEC documents they have to file, they (and the investment bankers they hired) would tell you none of such things when they sell your their version of the stories.

5. Poison pills and entrenched positions.

You might think managers are more like employees, and shareholders are the true owners. Theoretically, that is true. But practically, the management knows how to get an entrenched position, putting their friends on the board, and putting “poison pills” in the “change of control” contingencies.

Because shareholders are scattered and often not knowledgable enough, they often feel powerless to fight the management. Even when they do, it often results in a long struggle, causing distraction to day-to-day business (which often means deteriorating business) and distress on share price for the uncertainty (unless most shareholders are too angry at the management). Once you invited the wolves in (or tried to own a share of that wolf den), it is hard to get rid of them…

6. Misleading investors.

Some of the problems listed above such as expensive acquisitions can be prevented if the management has significant stake in the company. So if the CEO and chairman own 20% – 30% of the company, it is unlikely that they would intentionally make an expensive acquisition to sacrifice the shareholders’ interest. However, even in that case, it won’t prevent them from hiding the bad news or staying over-bullish to mislead investors. To be fair, the CEO should be bullish about the company, and they actually have a job to maintain the company’s public image. However, there is a grey area between staying optimistic and protecting the company’s reputation vs. giving false or misleading presentations to misguide investors.

Any over-bullish statement or attempt to hide the worrisome facts would mislead the investors and make them overpay for the stocks. Obviously, this problem doesn’t exist when the investors actively manages the company themselves. Therefore, it is another type of agency problems.

Ok. Those are some of the agency problems. It means that small investors have to find a trustable management who cares about them, but they are often not empowered by the knowledge and skill to tell who is trustable. What about just buy a mutual fund and rely on those professional money managers?

That is the second “agency problem” I want to talk about here, which is not as widely known.

People bought mutual fund either because they don’t have the knowledge to pick stocks, or because that is the only choices in their 401ks (401k often doesn’t allow investing in individual stocks directly).

So does mutual fund help in this case? The answer is “no” for most funds.

Just take a look at the cost structure of mutual fund. Usually it charges 1% of the total balance no matter what the performance is. So the money managers get paid no matter what the performance is.

Looking at this, most people don’t ask the question like: why do they even get paid when they don’t achieve a good performance? For their labor? Do I even know how many hours they have put in their work? And how much for one hour?

The second question is: if they get paid for the same amount, what is their incentive of delivering a better performance?

Some might argue that if they are not doing well, they get penalized because people will choose a different fund. That is neglecting the fact that it usually takes a long time to tell how good the performance is. Also, quite often, the number of people that would buy a mutual fund depends more on marketing and relationship related deals, than just performance.If you can get the news media to sell your version of the story, it would work more than a charm. If you can persuade your partners to carry your fund as the only choice in the 401k plan, you don’t care too much about your performance as long as it is not too bad.

That is exactly what money managers are seeking. They don’t need to get a very good performance, but they want to make sure it is not too bad, relative to the index or general market. In other words, they care more about the relative performance, than the absolute performance.

The result of this is that they won’t buy when market is cheaper, and won’t sell when market is more expensive, they just tag along the general market. But that is actually not true, it is actually just the opposite, for an open-ended mutual fund: they buy more when the market is more expensive because they get more money flowing in during a bull market (everyone want to catch the good trend), and they will sell more when the market is down and getting cheaper because more money is flowing out their fund during a bear market (forced redeeming). That is why some mutual fund managers are forced to sell at the very panic moment of the market in October 2008. Some of them don’t even know how to choose which one to sell, so they sell in alphabetic orders! They sell stocks with symbols from A to N today, N to Z tomorrow! The net effect is that they end up buying back the same thing they sold at a much lower price! Although it may be unfair to blame the money managers for this action (since it is the individual investors who made the bad decision), it does add to the transaction costs of the mutual fund.

Now, what about buying a fund that was performing well? Many friends told me that they would check the 10 year performance of a fund, if it is going up steadily (Good return with low volatility, essentially higher sharpe ratio), it should be a good choice.

That sounds reasonable right? But it is actually very deceiving. To understand this, I need to tell an old trick first. If you send out 1000 mails to 1000 people recommending different stocks, predicting a stock will rise in the next week, natually, half of them will work, half of them will not. Then you select the 500 people who got the predictions that happened to have worked, and send them some new recommendations again. After repeating this trick 6 times, you will have 15 customers left who got recommendations that worked 6 times in a row. For those customers, they would believe you are the “oracle” since it is very hard to get right 6 times in a row (only 1.5% possibility in statistics). And chances are they would trust you as their money managers.

Many investment firms use exactly the same trick: they don’t own just one fund, they start many different funds with different investment strategies. Some will work well, some will not. Over the years, they close out the funds that didn’t work well (which naturally should have lost most of its customers anyways), and only brag about the ones what worked well. This is a basic “survivorship bias” at work.

So given the double-agency problem, how can a small investor choose? Maybe they should get away from the stock markets and not invest at all?

The answer is “no”.

While stocks could have all kinds of problems, we must remember that it is often the highest return and most flexible investment vehicle regular people can have access to. People could invest on other things like real estate, but that also requires some good knowledge, large amount of capital and often come in limited choices (limited in local area and subject to local property tax policies).

Holding cash is not a solution, as the government often tries to steal from savers by printing money in a non-responsible (and invisible) way. Despite all the uncertainties in the stock market, the damage caused by inflation when you only hold cash is a “certain” way to lose.

Also, we must not ignore the compounding power of investment. At 10% return a year, 50 years would turn $10,000 to $1,170,000.  As Charlie Munger said, if we have some basic investment skills and stay rationale, we will be “determined” to be very rich eventually.

I would often put “compounding” and “diversification” as the two most powerful magic tricks in finance.

So small investors should definitely consider stock investments, but need to follow the right approach. There 4 choices I can think of:

1. Learn a lot about investment, and be an expert at it.

This approach will pay back in a big way eventually, but certainly not for the majority. They simply don’t have the time and the interest to get the expertise.

2. Learn some basics about investment, and invest with good temperament.

This should work fairly well for most of the novice value investors. But small investors usually don’t have good temperament. So it is not realistic for the majority either.

3. Buy a low cost passive index mutual fund.

This is the method Buffett suggested. If done consistently over many years, it should yield fairly good result due to the compounding power of any investment. If you are not so sure about the economy of US, you can also buy a diversified index fund over the entire world.

4. “If you don’t know jewelry, at least know your jeweler.”

It is much easier to know your jeweler than try to be an expert at jewelry. So if you know a good money manager, you can just trust him/her and rely on his/her skills.

It might be difficult for small investors to access a good hedge fund, but there are still some mutual funds with good managers. Also, some investment companies like Berkshire Hathaway are essentially working like a fund, although it is not as tax efficient as a fund (but still pretty good if it owns business directly or not selling stock investment until after many years).

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Tesla: A Checklist Of Bearish And Bullish Points

The Euphoria of Growth Stocks

The last 3 years have been a very good time for the growth stocks. For many of the star companies, the old conservative valuation models based on book value and earnings yield are being replaced by the growth rate and future potential. The high P/S (Price to Sales) ratio shows that investors have many optimistic projections of the future growth.

As the history shows, investors tend to have very short memory about the financial history, and the euphoria of growth stocks often signals the end of a bull market.

Among all the growth stories, the story of Tesla (NASDAQ:TSLA) is one of my favorites, since I truly believe Tesla is likely to be a successful disruptor and may eventually take over the world. This is partly because there were no disruptors in the automobile industry in the past decades, and the existing players got too big and too slow on innovations.

However, investors often confuse the ultimate success of the company with a successful investment. Due to competition, the history shows many, many times that glamour companies often turn out to be bad investments, simply because the good story, if well known, will bring in even higher bids than its intrinsic value. Also, things rarely happen in the same way as expected.

The human brain has limited capacity, and it tends to focus on a couple of things at a time. The manic depression symptoms found in Mr. Market and the investors are understandable because our mind tends to focus on the recent news or a narrow perspective of the fundamentals at different times. When a story appears and focuses on the good side, people tend to be bullish and bid the price up. But when the recent news turns bad, they suddenly turn to the bearish side and take a loss quickly in order to sleep better.

That said, it is not a simple accusation to the other investors, because I am one of them. I have been guilty of swinging between the two extremes myself. For this reason, it has been important for me to keep a checklist of the high level bullish and bearish points, something I can check on at any time before I make a purchase/sale decision.

The Good Side

Let’s start with the good news first:

1. Take over the world.

As I mentioned above, I truly believe Tesla will likely “take over the world”. Although this doesn’t mean that Tesla will become the largest car company in the world, I do think it is likely to have the most loved car and the company will eventually get to the size of BMW, with about $100 billion revenue.

The innovative ideas and enthusiasm in the model design and all the advanced technologies, the innovative direct sales model, the efficiency in the manufacturing process, and the laser focus on user experience all give Tesla a huge competitive advantage. Other companies can be copy-cats, but it is very hard for them to match Tesla. This is mostly because the automobile industry is full of old players who are usually very slow on moving forward.

This industry has significant economies of scale too, in terms of the R&D needed and the brand name recognition required. It is also a capital intensive industry, as we have seen in the poor ROA (return on assets) of the industry. Ford, GM and BMW only have 3% – 5% ROA. Their ROE may reach 10% or more for now, but that is based on a good economy, low interest rate, stable revenue and loose credit. When these conditions no longer hold, we may find the growth of these mighty car companies are only destroying shareholder value. The more they grow, the more value they destroy.

All these mean that it is very hard for new entrants to enter. In fact, the only reason Tesla exists today is because it was not profit-seeking when it was founded! (Elon Musk estimated that there was only 10% chance of success when Tesla was founded.)

One relatively new player and close competitor is BYD in China. I have been a shareholder of BYD in the past too. The CEO of BYD (Chuanfu Wang) is very smart and had some great achievements too. However, in my own opinion, BYD is still not a match to Tesla in terms of innovation and model design. It is great in its own way, and it has easy access to the cheap human capital in China, but so far it doesn’t seem to be a threat to Tesla yet.

2. Direct Sales Model and Low Working Capital.

Tesla’s innovation goes to the sales model too. The direct sales model not only saves the distribution cost, but also reduces the working capital. The whole system also becomes much more efficient. In the US, I believe the regular consumer experience with car dealerships can be ranged from poor to awful. So it actually helps on improving the customer experience too.

Dell’s success mainly came from the direct sales model, and it actually had negative working capital because of this. This advantage may not reflect on earnings, but small investors usually don’t know that in terms of investment returns, this difference is huge. In other words, the cost of any capital (whether it is current assets or fixed assets) is not to be ignored.

3. New innovations and ventures.

When Apple first announced the iPod, people who liked it would use iPod and Mac sales to value the company. In hindsight, we know that valuation would have greatly undervalued the company because they should have considered the possibility of further new product releases, such as the huge successes we have later witnessed in iphone and ipad.

Similarly, Tesla may not stop at EV. The opportunity at autonomous cars, batteries, and who knows what other technology could be some pleasant surprises to investors later.

4. No demand problem in the long term.

Despite the fact that Elon Musk continuously said Tesla has no demand problem, many speculators always worry about the potential demand saturation. In my opinion, Tesla doesn’t have a demand problem right now, since it still has a lot of tools it hasn’t used to boost demand, such as advertisement. Also, the hesitation of the wealthy is related to the lack of charging stations which are being built up gradually. The information diffusion also takes some time to reach its peaks (this translate to Tesla not yet being seen as a “fashion” product in many areas.)

Eventually, the luxury car sales will saturate at some point, but by that time, we may have the 3rd generation model coming out. The price/value ratio with that model will be hugely attractive to the average consumers, and it would be a time for Tesla to really take over the world.

Right now, Tesla only have two hurdles: price and charging. The 3rd generation model will address the first problem, and the charging network are gradually being built up. This is a classic “network effect” problem, as more charging stations will allow more EVs and more EVs will bring in more charging stations. The adoption of EVs are already picking up in the US. We may soon reach the tipping point of that network effect.

Saying “no demand problem” doesn’t mean the demand will always keep up with the pace of the production growth, or there will be no short term demand problems at all. From time to time, we may see the demand doesn’t keep up with the expectation or production, but in the long term, it is likely that the peak demand is large enough to allow Tesla to reach the $100 billion revenue mark.

5. Better Economies Of Scale.

While Tesla has already reached a certain scale, as it increases the scale even further, there may be additional cost savings and possible margin expansion. It is hard to provide an accurate analysis on this, but a couple percentage points of margin expansion could cause a big change in the valuation.

The Bad Side

1. Capital intensive industry.

I have seen arguments like Tesla should be classified as a high-tech company because it mainly focuses on R&D. While this argument is not completely unreasonable, we have to be aware that the high tech companies could have quite different economics.

The key difference between the high-tech world and traditional industries is the difference on variable cost and capital needed for fixed assets.

Traditional industry (manufacturing industry) produces goods with raw materials. So the gross margin is low, and variable cost is high. It also tends to require significant up-front investment in fixed assets, such as factories and distribution infrastructure.

On the other hand, for the high-tech industries like the software industry, the variable cost is low: selling one more software license or installation CD costs almost nothing. The up-front investment is mainly on R&D in the software industry, which is certainly a significant cost, but both the gross margin and the profit margin are very high, once the company has reached a certain scale.

Comparing to the software industry, the high-tech hardware companies such as Apple tend to have lower gross margins, but Apple outsources much of the manufacturing to the third party suppliers. Therefore it doesn’t need a lot of investment on factories, which makes it easy to scale up and scale down.

On the other hand, if the hardware company is producing regular PCs like HP or Dell, once the product becomes a commodity, it looks more like a traditional industry than a high tech industry.

In this sense, although Tesla’s success mainly comes from its focus on R&D, the capital intensive nature and low margin nature do not change much. It requires huge fixed asset investments on manufacturing facilities, battery factories, and charging stations. Therefore, although Tesla is quite different from the other car companies, it should still be classified as in the traditional auto industry.

So far, Tesla has $2.6 billion in fixed assets, mainly in factories, charging stations, service and retail centers. Based on what I have seen from BMW, the fixed assets are close to its annual sales. If so, a 10% profit margin means the return on assets is roughly 10% too. This is certainly much less attractive than the most companies in the high tech industries.

To be fair, Tesla may be more efficient than BMW in terms of the manufacturing process, so maybe it can achieve better ROA and ROIC (Return On Invested Capital), but it may not be a lot better.

In fact, we have to assume its ROA is better than 10%, because otherwise, the growth will not provide any economic value at all, assuming the average cost of capital is 10%.

The following question would be: where will the capital come from? If it is growing fast at 30% – 40% a year, the profit generated internally will not be enough. If it is from the share issuance, it will have a dilution effect. As long as the shares are traded at the current level, it is not very damaging, but a company usually has a hard time to find money when it needs it most. There is no assurance that the company can get the same valuation on its stocks when it needs the money to fund its future growth.

If it finances mainly by debt, it is certainly possible, as other auto companies already did it, but it puts the company into a greater risk.

In terms of working capital, it may be close to zero right now. (Although there appears to be about $1 billion working capital on the balance sheet, much of it may be just some reserve cash for the future capex.) I am not sure if this will continue though. If it has to rely on dealers later, it may need to increase the working capital.

2. Past fast growth in an overvalued market.

Yes, you didn’t hear me wrong. The past fast growth in the last 3 years could be a bad thing!

Of course, just by itself, the fast growth in the past is always a good thing. However, when the market is overvalued, a fast growing company with great awareness among small investors can get highly overvalued.

The only possible relief is the high short ratio. So it is possible that shorts are keeping the pressure on the share price. This force balances the potential over-optimistic valuation, and becomes a good thing instead.

Of course, it is unfair to say a company may be overvalued without giving a valuation first (I will give a valuation under various assumptions later), but at least it is a warning sign.

In fact, that optimism has already affected the CEO Elon Musk himself. As he mentioned recently, he thinks Tesla could pass Apple in market cap by 2025.

Even if we assume Tesla can continue to grow 50% a year for 11 years by the end of 2025, reaching a revenue more than double what GM has this year, for a 10% net profit margin, it requires a P/E of over 20 to pass Apple’s $700 billion market cap. At least for me, a P/E in that range for such a big company is pretty hard to imagine. Even Apple, with much better ROIC, a lot of cash, and a short term earnings boost could not reach that P/E in this overvalued market.

Now, growing 50% a year for 11 years is also going to be extremely difficult to achieve. It may be OK to grow 50% in 2014 or 2015, but this kind of exponential growth has to face a much bigger base later. If Tesla can’t deliver model X and 3rd generation EV on schedule, why would investors believe it will deliver 50% growth without any interruption for the next 11 years? Even if production can grow that fast, we don’t know if the demand will keep up the pace. Unlike solving an engineering problem, economic forecast is very hard to be accurate. There are simply too many moving parts in play to be fairly confident to bet on something in the next 11 years.

Since Musk got a lot of fans right now, a lot of admirers really trust his words. Given the so-believed potential of getting to the size of Apple without significant dilution, it could be particularly damaging if these people are willing to pay whatever the high price for the stock, and eventually get really disappointed by a reality check. I don’t think Musk had realized this, but he may have unintentionally reinforced the confirmatory bias of the shareholders.

Frankly, this kind of over-optimism can be very damaging based on what we have seen in the history, and even a great person like Musk would not be an exception.

3. Competition.

Yes, I just mentioned that competitors are no match for Tesla. However, it is simply not right to ignore competition completely. After all, there are so many auto companies in this world, many of them are good copy-cats and some of them are fairly good at innovation too.

Of course, the success of any competitor doesn’t mean the failure of Tesla, since the potential EV market is huge. In fact, since the networking effect of charging stations is obvious, the success of other EVs may actually help Tesla at the early stage.

Still, it is important to keep competition in mind and remember that things may not be really smooth over the next 5 – 10 years.

4. Non-Profit-Seeking.

Tesla is a for-profit company, but Elon Musk is not a for-profit leader.

It is kind of ironic to me that investors have worried so much about all those managers seeking profits for themselves at the investors’ expense, but now they have to worry about managers not so interested in profits at all.

This is certainly a “new” problem to investors, with not many precedents in history!

Although I am a big fan of Musk and fully admire his intention to help mankind, objectively as an investor, the non-profit-seeking nature could bring in a conflict of interests later. So far, we haven’t seen this as a big problem yet. The patents he gave up may not be that critical, plus it may bring in more goodwill and enthusiasm.

Just as an example, if Musk later finds that demand is not as strong as he expected, he might still choose to push on and invest in capex aggressively, simply because he is not concerned much about the risk. Also, since he said he would personally bet on getting to Apple’s market cap in 10 years, he may have more “commitment bias” and gets more aggressive on growth.

5. Key personnel risk

Elon Musk has showed his intention to leave the company once the 3rd generation car is ramped up to a certain point. Certainly, his contribution has been critical to the company. No other person will likely be an equal replacement.

6. The decline of oil price

Since shale oil has been growing fast and comes at a lower cost than the other non-conventional oil, and the demand has not been growing very fast recently, OPEC has decided to keep production volume without controlling the oil price any more.

While some people may think this is declaring war to US Shale Oil, we have to keep in mind that OPEC’s historical price manipulation was an anomaly in the commodities industry.

If their market share has not been enough to allow them to keep doing that, it will be a fundamental shift in the industry.

While $45 oil may not last long, it is also likely that oil price may just stay in the $60 – $70 range for the long term, which is just enough to keep Shale oil from growing too fast.

This certainly changes some of the economics of EVs. However, I don’t think this is a big problem in the next few years for Tesla, since I believe many more people bought Tesla because of its other innovations and features, rather than to save money on gas. (Those who just want to save money would not buy a much more expensive Model S.)

For the 3rd generation model, the low oil price may reduce the peak demand though. If the 3rd generation EV can save $1500 per year on gas price, this saving is going to be reduced by $400. This may translate to 10% higher cost for a $35,000 car. For regular folks who care about the features and the bills at the same time, it will reduce the eventual peak demand.

7. Short term challenges.

There are many short term challenges. Although they sound very serious, they don’t seem to be big problems in the big picture to me:

I. Strong USD.

The strong dollar has put pressure on all the export companies. It will do the same for Tesla. However, this is not a huge problem in the long term. In this race of currency devaluation, nobody knows what will happen later, and the force balances itself too (more trade imbalance will devalue US dollar).

II. Delay of Model X.

This should have been expected to happen. A delay of a project schedule happens a lot more often than delivering a project on time.

III. Demand from China was not as big as Musk expected.

This is not a long term problem either. It may take some time to get visibility and become another “fashion” product in China, but the ultimate demand is determined by the value of the product. Also, as mentioned above, since the two hurdles are “price” and “charging”, it is expected to get more early adoptors in a rich and small country. Places like HongKong seems to be the ideal target.

Valuation

One thing that is common for the stock market is that the variation of the valuation is much more significant than the change of the fundamental.

Investors tend to buy/sell based on the mood of the day, rather than trying to quantify everything based on the facts.

So it is important to do a reality check by putting everything into numbers with reasonable and clearly documented assumptions.

Below you will find the basic assumptions of my valuation:

1. Tesla will not get serious challenges from its competitors.

2. Tesla will not have long term problems with demand.

3. Tesla will not have serious long term problems with scaling up the production. However, the speed of scaling up may vary.

4. Tesla may work on newer technology not related to EV, but this potential will not be included in the valuation, since it is hard to stay objective with fantasies or day dreams. It is also hard to quantify the potential in those areas.

5. Once reaching a certain scale, Tesla’s growth will slow down, so that we can use a constant P/E model to estimate its terminal value.

6. We assume the capital needs will be mainly financed by internal profits and external debts. We assume there will be 10 million shares dilution (about $2 billion capital in today’s price), and 4 million shares of stock options.

7. We will use a discount rate of 10% per year.

I certainly don’t claim these assumptions are right or safe, but any valuation has to be based on some assumptions. It is important to clearly document these assumptions and check whether the assumptions are still sensible from time to time.

Variable assumptions:

1. Growth rate and years of growth.

This factor will have the most effect on value. We will try two growth rates: 30% or 40%, and years of constant growth at that rate for 7 years or 10 years. If the company grows 40% for 10 years, its sales will be $89 billion, which is 10% more than BMW’s sales.

2. Profit margin.

Considering that BMW has 20% gross margin and 7.5% profit margin, since Tesla has 26% gross margin right now, we assume the profit margin will be 10%.

Although better economies of scale may improve the margin, we also have to keep in mind that the 3rd generation models will be in higher volume and may have a lower gross margin than the luxury models. The EV credits may not last forever either (currently it is 4% of gross margin).

Also, since we assumed that it will rely mainly on debt financing for its capital needs, the high debt ratio will give higher risk, which also justifies a lower P/E ratio.

3. Terminal P/E multiple.

As I mentioned before, the variation on valuation is often the main source of capital gains/losses. Even if we assume the company has fairly stable earnings and growth, what P/E should we use for the valuation?

The long term return rate of an investment is usually somewhere between the current earnings yield and the ROIC, assuming the company doesn’t invest more capital than its earnings. Whether it is closer to the current earnings yield or ROIC, it depends on the potential market capacity, whether it can constantly win that market over its competitors, and how much it reinvests its earnings. Since we have assumed that Tesla will enter a slow growth phase after 7-10 years, a P/E of 15 makes sense given its large size, high debt ratio and slower long term growth.

Given the current sales of $3.1 billion, if we assume 40% growth for 10 years, 10% profit margin, a P/E of 15, 10% discount rate, 125 million shares outstanding and 12% shares dilution, the fair value is:

3.1 * 1.4^10 * 0.1 * 15 / (1.1 ^ 10) / (0.125 * 1.12) = $370 per share.

Here, we have all numbers in billions, and the formula is the following:

sales * (1+growth rate)^period * margin * PE / (1 + discount rate)^period / (number of shares * (1 + dilution)) = value per share

If we change it to be 30% growth for 10 years, it becomes:

3.1 * 1.3^10 * 0.1 * 15 / (1.1 ^ 10) / (0.125 * 1.12) = $177

Under the assumption of 40% growth for 7 years, it is:

3.1 * 1.4^7 * 0.1 * 15 / (1.1 ^ 7) / (0.125 * 1.12) = $180

Under the assumption of 30% growth for 7 years, it is:

3.1 * 1.3^7 * 0.1 * 15 / (1.1 ^ 7) / (0.125 * 1.12) = $107

Conclusion

Although the valuations I did above show more upside ($370) than the downside ($107), we have to keep in mind that the valuation is based on the optimistic basic assumptions, and those assumptions may simply be wrong.

The bulls may argue that Tesla deserves a higher terminal P/E after 7 or 10 years since it may maintain higher growth for a much longer time, and may even pass GM in sales. That is certainly possible, but it is more like a speculation than the current optimistic assumptions I have already made. For BMW, even in a bull market, it is still being traded at P/E 13 right now.

Clearly, the fair value for high growth stocks is a very wide range. This is mainly because of the difficulty of forecasting the potential growth rates for many years. In the past, not many people have been good forecasters, so it is always better to be on the cautious side.

So what does this article say? Is Tesla a good buy at the current price?

Investors tend to reach conclusions too fast. And value investors tend to assign a fair value to everything.

For high growth stocks like Tesla, the fair value is such a wide range that it is not easy to say what price gives a reasonable entry point. From all the points above, I believe a conservative entry point is around $130. That said, it may be OK to build a very small starting position at a price below $200.

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New Federal Fund Rate Projection and Its Implications

The New Projections

A rising short term interest rate is not any news to the market. The only thing people don’t know is when and how fast it would happen. To the surprise of many market participants, the schedule of the potential Federal Fund Rate hike is accelerated in today’s release compared to the last meeting’s projections.

Screen Shot 2014-09-17 at 2.57.31 PM

As we can see in the projections above, although there are widely different opinions among FOMC members, the average interest rate projections have been increased compared to the release in June, 2014. In average, the interest rate is roughly 1.375% for 2015, 2.75% for 2016, and 3.75% for 2017.

Also, in the last two meetings, there were no projections for year 2017. We only knew that the interest rate for the long term is expected to be stabilized around 3.75%. However, today’s projection shows that the majority of the FOMC members expect the interest rate to go beyond 3% in 2017, or 3 years from now.

Some Implications On Stock Investments

In history, we can find that the yield curve tends to be flattened when the short term interest rate goes up. This will severely impact those companies that “borrowed short and invested long” (borrowed short term loans like credit facilities and invested in long term assets, while getting profits from the yield spread between the long term interest rate and the short term interest rate). Certainly, anyone can do this without much experience and still make a lot of money. In fact, a lot of companies have been doing this for quite long now. Obviously, there is no free lunch in this world. The catch here is that once the short term interest rate goes up, their profit will vaporize or even turn to a big loss. By definition, the long term assets are not flexible since they are long term commitments. Once the short term rate goes up, these companies will be forced to pay a higher interest expense, but still obligated to accept the same long term interest income as before.

For example, a REIT company can borrow short term loans through credit facilities, leveraging up 6-8 times, and invest on long term mortgages (such as 30 years Mortgage Backed Securities). Because there is a 3% interest rate spread and it is leveraged up 7 times, they could easily earn 20% over equity in this way. Also, in the past few years, when interest rate decreased, the fair value of the long term MBS increased and boosted the book value. So on surface, we have seen these companies with increasing book value, very attractive earnings and generous dividends, but once the short term interest rate starts to go up, it will be a completely different or even entirely opposite scenario.

For professionals, all these are not big news. However, I still see a lot of headline news around saying the insurance companies will be benefited by the rising short term interest rates. That statement alone is correct, in the long term. However, in the short term, you will see their book value and comprehensive income getting reduced significantly, since a higher interest rate means lower bond value on their books. Therefore, people who valued insurance companies based on their book value or comprehensive income may actually see a decline in share price in the short term. That said, in general, I do agree a rising interest rate is a good thing for insurance companies, especially when they have shorter maturity bonds in the assets. So essentially, after we balance the effects of a declining book value and a potentially higher future income, a fast rising short term interest rate will benefit the insurance companies with shorter duration assets a lot more than those with longer duration assets.

Another thing investors need to pay attention to is the leverage of their invested companies. For those companies heavily on debt, and financed primarily on short term loans like credit facilities, a higher interest rate means less profit. It may even get to a point of turning profits into losses. Also, some people were talking about coverage ratios calculated from the interest payments on short term loans. Obviously, that can be very misleading. While the long term interest rate could double in a bad scenario, the interest rate on short term loans could go up more than 5 times from here. Therefore, even a good coverage ratio of 5 is not that good if it is calculated from the short term loan’s interest payments in the past few years.

In addition, since many unsophisticated investors primarily focused only on P/E, these high leverage companies’ stocks have enjoyed much on lower capital cost on short term debts in the past. This is unlikely to continue for long.

Take Advantage of The Low Rates for Personal Finance

For personal finance, if one is buying a home, he/she could still enjoy good mortgage rates for now, but perhaps not for long. I have been recommending many of my friends to get mortgages even if they can afford to pay down more mortgages by cash. Many of them felt it is hard to understand, especially when the stock market is inflated, and we suffer from the lack of good alternative investment options at the moment. There are 4 reasons behind this recommendation:

1. Additional liquidity is handy during bad times and we should be prepared. The liquidity also offers flexibility when good opportunities in real estate or stock market come along.
2. In the long term, buying many big cap value stocks right now would still give a return much higher than the current mortgage rates. Also, in 3 years, even the 1 year bank CD has a good chance to give a yield higher than today’s 30 year mortgage rate. There could also be many other good long term corporate bonds that would offer much better yields 2-3 years later.
3. Since interest rate is much more likely to go down than up, some people might consider shorting long term bonds right now. Essentially, getting a mortgage is like shorting a long term bond. However, shorting bond requires capital to support the leverage and also subjects to margin calls. On the other hand, there is no margin call to borrow a mortgage; it requires no equity to support the leverage; its interest payment is often tax deductible, and it reduces the potential maximum liabilities for unforeseen disasters like major earthquakes.
4. Inflation still remains one big threat for the financial market and personal investments. While some people may suggest to hold gold or commodity assets as a hedge against inflation, borrowing a mortgage is a good or maybe better hedge too.

When being asked recently on what can still be a good investment in today’s market, Buffett mentioned that if he is a small investor, he might try to find a real estate property in a still distressed area and borrow 30 years mortgage to invest on it.

Conclusion

Certainly I can not accurate predict what will happen to the interest rates, and everything above is not very meaningful if the interest rates don’t go up or only go up very slowly, but given the obvious trend and the official projections, we should be prepared to avoid the potential risks and seize the opportunity while it still lasts.

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Thinking as a business owner – part II

As I said in my previous post, in theory, we, as long term investors, should all think as business owners. As the teaching of Ben Graham and Warren Buffett, it is right to think we own a piece of a business, instead of own a piece of paper with a price that crawls up and down on the wall street stock chart.

However, I would also argue there are reasons for regular investor who can’t think a business owner. And there are mainly two reasons: lack of information, and lack of control.

First, only a small part of information was disclosed. Sometimes it is to prevent a leak of business secrets and giving advantages to competitors, but more often it is to avoid scaring the investors. However, without complete information, investors are becoming more scared, as we all know the most scary thing is always the “unknown”. Once you get complete knowledge, you can handle it.

Managers often blame wall street analysts (representatives of investors) care quarter-to-quarter results too much. Why do they care so much about quarter-to-quarter fluctuations? Did they know that the business is never meant to have stable straight-line growth every 3 months? It is only because investors are constantly live in fear (generally), and they are prepared to run if things don’t feel right and hopefully they can run faster/earlier than the other longs.

If their knowledge level is comparable to insiders, they wouldn’t be so scared. Sometimes, even after the management told the investors about certain facts, they still get scared, because they don’t fully trust the words of management, since they get cheated from time to time.

Lack of information is one thing, but even if they have all the information, they are not in charge. Can they really stop management from doing stupid or selfish things when the board is on the side of management? (They often have relationships with management, and plus they are getting paid by management.)

So what is the answer to these questions? I think this brings something not many long term investors have carefully thought about. Although these are fundamental issues, we do have ways to mitigate the risks.

1. We have to trust the management before we invest.

If you don’t know the management, or don’t have confidence in management, then you probably shouldn’t invest in that company at all, at least not a big investment. Or we may call it speculation, not investment.

It is hard to really know the management, especially for a small company. But we can always find as much information as we can. Check what the management said and did. If they rewarded investors, cautious on making predictions, not afraid of talking negative things and stay with their words, you can trust them.

With a good management, there will be plenty of pleasant surprises since the managers were cautious to begin with and didn’t set up too much false expectations. On the other hand, with a bad management, it is like sleeping with a bunch of rats, you never know what is going to get left afterwards. (Just think about Bank Of America in 2008)

Buffett said a good business works well even with a bad management, so many people only pay attention to the business, not the management. I think at least half of the bet should be on the management, since good business may survive an incompetent management, but it will not survive a management without integrity, always thinking about stealing from shareholders for their own benefits.

Although I like management to talk about the negative views or their mistakes in public, we shouldn’t take it too far and make it a mandatory requirement before invest in a company. Not everyone wants to directly admit their mistakes, and management’s public statement often has a material impact on the business. For the sake of business reputation, sometimes they are required to stay bullish. This is not intended to fool investors. However, if there are signs of too much hype, or too many failed promises, we should stay away.

One example is Sears’ Lampert. Investors all have to guess what he really wanted to do. Did he really want to turn around this hard-bleeding retailer? Or he wants to slowly liquidate the company? Or he wants to split it to parts, so he can reward the investors in some degree, and yet keep the main company afloat as long as he can, so he don’t have to be irresponsible for 250,000 employees. Maybe he wants to tell investors, but he can’t because that is too much impact to the business, the morale and to the partners/suppliers. In that case, I can understand him not being so straight forward, and I don’t doubt his integrity just because he wasn’t entirely open.

Still, if management is very honest, not shy to admit his/her mistakes, and very conservatives on promises and accounting, that is a huge plus! A P/E of 30 from an honest and conservative management might be equivalent to a P/E of 10 from an all-hype management.

If the management is competent, honest and conservative, you really don’t need to have control and full information on the company. All you need to do is to listen to what management says and act accordingly.

Unfortunately, that is probably asking too much. If we have to invest on a company with mediocre integrity, we have to spend a lot of time to monitor everything, verify what management says against facts, and adjust the expectation accordingly. The whole process is tiring and risk is significantly higher, but may still be worth doing if the value is very appealing. For bad management, you may need to require 4 times more value and still only able to commit a small speculative position.

In a private investment, we wouldn’t entrust a big trunk of money with a friend who is not completely trustable, perhaps we should do the same with stocks too.

2. Make sure the company has a board that represents shareholders’ interest.

If the manager owns a lot of shares, that is a very good sign. If not, at least the board directors should own a lot of shares, or they represent the people who own a big stake. In this way, managers will be monitored and influenced by shareholders.

3. Have enough due-diligent research.

Although a lot of information is not released to public, there is still a lot that is. From 10-K, internet reviews, forums, youtube, investor presentations, and information from competitors, you can find a lot of information that is not easily noticeable by other investors. Without a thorough understanding of the business, certainly there is no way to think like a business owner.

4. Don’t deal with companies that are too hard to understand.

If you feel the company is too hard to understand, or its financial statements are too complex, or its 10-K didn’t disclose a very important piece of information, you may need to stay away from it, or at least mark it as a big risk and give it a big discount. However, if you really trust the management, and strong believe their integrity and their words, you may give complete control to them, and let them take it over from you. In another word, invest solely based on their words and projections.

 

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