[Investing] Efficiency Measures in Investing

Just a quick question:

If you have a dollar, would you buy something that is worth 1) $0.90 or 2) $1.10?

My answer is "depends". It depends if I am in a desperate need of that something. It is a question on the word worth, which is also an important element in investing. But if that something happens to be a share, I will definitely choose 2). That way my $1 is well spent! In fact I managed to increase its value by 10%. 

That is a crude way to introduce efficiency. Efficiency is getting the maximum output give fixed resources. In the previous example, my "output", or reward, would be -10% if I choose to buy 1) and +10% if i chose 2).

As you can see, efficiency is a relative measure. It is important as it affects operation costs and also infers the management's capability. In general, if a company is not efficient, it will incur high costs to produce its products or services, which will then be translated to the customers. Unless the company is the price setter, which is not usually the case, customers will stop doing business with them and find alternatives that are cheaper (customers ARE efficient). The company may increase its margin to compensate for the sales lost instead of being efficient, and thereby increase the cost, and continue to lose customers. This cycle will continue until the company realises the need to be efficient, or go bankrupt.

As investors, we want to make sure that our money is used efficiently to benefit the company (to make the company profitable in general) so it will in turn benefit us. I opine that efficiency is the most important factor to assess if a company is worthy investment.

How to assess efficiency then?

Efficiency is a relative measure, hence a single metrics by itself is not meaningful - something has to be measured against another. There are several metrics that can be useful in helping us make investing decisions.

Earnings Per Share (EPS)

While this may not be considered an efficiency measure, EPS is important. The shares do not make the earnings per se, but the EPS infers the earning power, or profitability, of the company. But as with all ratios, it is dependent on the numerator and the numerator. If the number of shares (denominator) is massive, it dilutes the earnings. Imagine having a piece of 16" pizza to go around 10 people. How about 20? 100? 1000? EPS gives us a quick glimpse of how much of that "pizza" are we going to be entitled to. The next question is, how much should we pay for it?

Earnings Yield

This is the proportion of the price paid that can be accounted by the earnings. (Although there is another interpretation, that is, how much earnings is there for every dollar of the shares paid. I find this interpretation a little warpy). This is a measure of how efficient our (the investor) capital can be used. Suppose a stock with EPS $0.20 that is going for $1. The earnings yield is 20%. Obviously, the higher the number, the better.

"Return in" Ratios

There are a number of return ratios, and the Return on Assets (or Capital) are particularly useful. It compares the earnings over the assets of the company. It shows how efficient the company is at deploying its asset in generating earnings.

Turnover Ratios

These are generally used to measure the company's management efficiency. The inventory and receivable turnover ratios are particularly useful if we want to assess if the company is good at managing its inventory and collecting outstanding payments respectively.

~yZhiFa

[Investing] Risks and the Value Investor

Warren Buffett says it in it simplest form: Risk is not knowing what you are doing.

Every form of investment involves guessing the future, but nobody is good in that and therefore there is always a certain degree of uncertainty (or risk) in investing.

Value investing minimizes that risks by evaluating a company, as if you have a share of the company (you do when you eventually bought shares of that company).  In general, a company must be  at least financially strong and consistently profitable. Next, the investor has to use his funds efficiently. I will share my thoughts on efficiency in the next post.

Financially Strong

Some of the measures to determine if the company is financially strong are:

Book Value Per Share: Book value is also the net asset value (or equity - see how confusing things can be?) after minusing the liabilities. The per-share value is commonly used by some investor as the proxy for intrinsic value of a company. For example, if a company's book value is $1 per share, and the share price is at $0.90, it is deemed a bargain, because you are paying a discount of $0.10 for some share of the assets which are valued (in the balance sheet) at $1 per share. However, this is assessment is generally not accurate, because there is more to the intrinsic value of a company. How wonder it would if it is so simple? 

Furthermore, future money, such as Receivables and Payables can be so inflated that it can create a false reality of the financial strength of the company, especially the Receivables since they are considered as assets. 

Current Ratio: The current ratio, current assets/current liabilities, measures how much current assets a company has in excess of the current liabilities. This ensures that the company can fulfill its short-term financial obligations. 

Debt/Equity Ratio: Debt and Equity are capital sources of the company. This ratio can be high or low depending on the business operations. Care must be taken if this ratio is exceptionally high, because the company is either servicing a large amount of debt, or it does not need investors (Equity) after all.

Positive Cashflow: The company must generate cash from its operations to pay debts, dividends, etc. This can be determined from the statement of cashflows. Extra care must be taken when a company promises to pay high dividends but generate negative cashflows.

Profitability

Income Statement: In general, if a company is consistently profitable, it will improve the share price in the long run. The profitability of a company can be determined from the income statement. There are a few basic things to note. Firstly, a increasing trend must be observed. Consistency is the key word here.

Secondly, the sources of income must come largely from its organic business. Most businesses have "sideline" investments nowadays, and I wouldn't be surprised if they have more income from their investments than their core business. However, if that's the case I would rather invest in  a holding company.

Thirdly, beware of goodwill. I honestly do not know why it is in the Income Statement. But goodwills are premiums paid when the company acquired another company, and they are not tangible. Be especially careful if the goodwill is reported in very large amount, relative to the company's assets and liabilities.

EPS: EPS is important because it essentially says how much earnings each shares is "making" Compare this relative to the share price, i.e EPS/Price, we get the Earnings Yield, which is the proportion of the price of the share that is attributed to the earnings. The inverse of this ratio gives the P/E ratio, the very popular ratio for investing, but IMO it must be used with other metrics to be useful.

The idea of value investing is to piece all the information that one could get to tell a story of a company. Some metrics are suggested here, but there could be more. However, too much information can be paralysing and therefore use only what is required.

Next up would be something on efficiency!

Stay tune!

~yZhiFa

[Investing] Compounding - How Wealth and Debt Build Up

There was a time, quite recent actually, where I received a shock from a credit card bill (from a boat-brand bank) - I forgot to pay my credit card balance of $2,389.29 (yes, I have to be this precise). I was topped up with a Late Charge of $60 and an Interest Charge of $145.30, a total of $205.30, not forgetting calls from the company "reminding" me to pay the bill and that they cannot waive the interest charge because of my forgetfulness (this is the first time I forget to pay the credit card bill by the way). I quickly paid the bill, and then closed the account. Well, this account has nice perks, like earning up to 3.5% interest, if you meet some prerequisites, like spending a minimum amount, cashing in your salary, etc. But the interest charge is too much for me. I do not have much money inside that account (heh~).

Not including the Late Payment Fee (as if the interest is not enough), the interest is already at about 6% (145.30/2389.29). Or ~8.6% if I include the Late Charge. This is a 1 month late debt. If I translate it to a per annum value, if I may, it is a 72% interest. To the bank!

What would happen if I continue not paying?

How Debt Accumulates

So I will owe the bank $2,594.59 on the Month 1. If I do not pay I incur yet another $60 and 6%, which becomes $2,810.27 ($2,594.59 *1.06 + $60). This is $420.90, or ~18%,  increase from the original sum owed. What was ~8.6% becomes ~18% in 2 months.

If I continue it for 12 months (assuming I do not get a lawyer's letter from the bank after 3 months), I will have to pay a whopping $5,819.92, 144% increase from the original debt. See the picture below.

The effect of compounding is clearly shown here. Interest is applied on what was owed. And interest charges pile up (or compound) quickly. At 6% interest rate each month (the compounding period) it takes about 12 months to double the amount owed (this is the Rule of 72). 

So the lesson learn is: Do not owe the bank money.

But you might think - but it is not fair, The bank pays us next to nothing (about 0.024%) for the deposits we make and they charge us so much when we owe them money? Well this emphasize the need for investing the savings, to make your savings work harder, and the good news is that we can make use compounding to our advantage too!

How Wealth Accumulates

Now suppose the above example, you are the one receiving the 6% per compounding period. With $2,400 in an investment that gives 6% per month, you will get about $4,800 in 12 months! 

But how does one really make compounding work? Many books I have read do not explicitly say, but I can think of some:

Reinvesting Dividends

This approach consistently buys a share that pays good dividends, and the dividends are used to buy in more shares. By good dividends I mean at least 4%, which is the rate where most blue chip stocks in Singapore are paying.

For example, for an investment of $1,000 in a stock that costs $1/share (hence I would have 1000 shares) and pays 10% dividends, I will receive $100 every year as dividends, which I will use to buy an additional 100 shares. The following year, I will receive $110 which I will buy 110 shares. At the end of the second year, I would have 1210 shares. This means I will have $121 dividends in the third year, and so on.

This is the idea, but in practise it is not that easy to execute namely because:

1. The number of stocks that can be bought is likely to be constrained by the minimum lot size. In Singapore the minimum lot size is 100 shares. If the dividends paid out can buy 1 lot of shares, no problem. The problems lies when we cannot buy 1 lot of shares with the dividends we received - likely due to too little holdings or the dividend yield is too low. The work around could be topping up the difference to buy 1 lot of shares.
2. 1 year is actually a pretty long time frame, relatively speaking. Discipline is required to be consistent. Suppose we are unable to buy 1 lot of shares with the dividends and we opt to wait for the next dividends period (which may be the following year, or may not depending if the company could pay dividends), we might actually forget about this little agreement we made to ourselves. Add in uncertainty, and the dividend next year may not be enough to even supply the balance funds to buy 1 lot of shares, which means waiting another year?  

Reinvesting Capital Gains

This approach is similar to dividend counterpart, but this time the stocks are actually sold, at a profit, and the money is used to buy the same stock or the different stock of the similar yield. Not only this approach has the challenges mentioned in the dividends approach, we have to be an expert in picking stocks that are cheap and we know that it is going to appreciate in the stock price. Definitely a no-no.

Regular Savings Plan (RSP)

RSP are plans that lets you put in say $100 every month to buy a stock or a fund (a unit trusts, ETF, etc). It makes use of dollar-cost-averaging, which the dividends and capital gains approach make use of. You buy more when the price is low, and less when the price is high, but all the value is the same. Except that RSP are generally on autopilot because chances are the funds are managed by professionals. Of course we can set up our own funds (or portfolio) to invest in, we can adopt the Dividends Reinvesting (it is also called Drip Investing) approach to do it. But RSP works only if the time horizon is very long, I would say at least 3 years.

Compounding is a double-edge sword. But understanding it is much more beneficial because it will help us avoid debts and make better investment choices. I have already discussed how a debts can accumulate into a nightmare because of compounding. The contrary is also true, that compounding can help accelerate returns for our investments.

Compounding is dubbed the eighth wonder of the world.

The only outstanding task to do is the execution of the plan, which will be in my future post.

Stay tuned!

~ZF