Investing Series Part 1: What is Investing?

To understand successful investing , let's take two quotes from two well-known investors:

"An investment is an operation where upon thoroughly analysis, promises safety of principal and an adequate return" Benjamin Graham

"Investing is simple, but it is not easy" Warren Buffett

Benjamin Graham, the mentor to Warren Buffett, defined an investment as an operation that requires sufficient research to minimize the loss of principal and maximize potential gains. Buffett adds that an investment operation should be simple but not easy. The question now is, how to invest successfully? First, let's first compare investment to speculation to make sure everyone avoids the latter.

Investment vs. Speculation:

Under Graham's investment definition, anyone who takes an outright guess on the future direction of a security price is really speculating. An example is when traders take bets on the direction (long or short) of a stock, bond, currency or commodity. You are not forbid to speculate in anyway and in fact many market participants love the thrill of trying to make short term gains. However, the speculation game is really a zero-sum game because you're hoping that a sucker will be willing to pay a higher price than you paid. Some can profit enormously by speculating but it is not a game average investors should play, especially when you don't have a large time commitment. 

An investment operation differs because you actually analyze the underlying business, not the price trends. A stock is an ownership of business, not a ticker symbol with a price that fluctuates from 9:30am-4:00pm. As famous investor Phil Fischer said: "the stock market is filled with individuals who know the price of everything but the value of nothing". 

What is Value?

Value, more commonly known as "intrinsic value", is determined by the underlying asset's returns. In case of a stock, the value is derived from the underlying business operations and owners (shareholders) should expect returns similar to the profitability of the business. Peter Lynch claimed that in the long run, investors should expect average returns similar to the average earnings (profit) growth of the company despite large swings in the share price. A similar analysis can be used to estimate intrinsic value using a discounted cash flow approach; Buffett said that the value of a business is really just the sum of the discounted cash flows you can get out of the business throughout its life. By analyzing either the earnings power of the company and its future cash flows, investors can have a rough estimate of the actual intrinsic value. Nonetheless, Buffett admits himself that the calculation of intrinsic value is vague and sometimes it's better to think in ranges (or in range of multiples such as 10-12 times earnings) rather than a specific number. I.e. I might calculate the intrinsic value of stock X at $25-$35 and if the stock is trading at $15, I'll buy it. However, if the range is close, i.e. stock Y is trading at $25 while your calculated range is $25-$35, then the investment is not very attractive. Don't worry if the stock price keeps dropping after you buy it. As Graham reminds everyone: "you are neither right nor wrong because the crowd disagree with you, you are right because your data and reasoning are right". Investors are better off analyzing the facts and ignore short term fluctuation because the chances of predicting short term market movements are no better than a simple toss of a coin.

I'll wrap this section up with a Graham quote that nails the point of making successful investment: "investment is most intelligent when it is business-like". Buy the stock as if you were going to buy the underlying business.  

Common Mistake to Avoid:

One common mistake is that investors tend to "buy high and sell low". This sounds pretty counter-intuitive since most investors want to "buy low and sell high." The reality in the real-world is that investors are driven more by their emotions, not by their analysis. As stock prices soar higher and higher, many want to jump in (buy). As a result, many investors buy near the top of a bull market. As the market starts to decline, investors often hold onto their positions tenaciously in hope of breaking even until they finally give up (especially if they see losses over 50%) and sell everything. When everyone sells out, it's usually the end of a bear market. To avoid this mistake, follow Buffett's simple advice: "Be fearful when others are greedy, be greedy when others are fearful".  Buy when there is blood on the street and sell when everyone crowds in the stock market. Be extra cautious if everyone is more worried about missing opportunities than losing money.

Another common mistake is not selling the obvious losers. Investors don't like admitting mistakes so they tend to hold onto losers until they break-even. However, losers tend to decline further and investors often find themselves in a deeper hole than before. A good gut check to decide whether to get rid of these losers is: "If I don't own the stock and I have ample of cash, would I buy the stock today?"  If the answer to that question is a flat "no", then why are you even holding on to that position.

Finally,  don't change your strategy even if others are bragging about their returns. If your friend just made 10% last year while you made only made 9%, do not take more risks because you feel you need to "outperform" your friend.  Also, try to focus less on whether your returns beat the S&P500 or TSX composite (unless you're a professional money manager) and more on whether your investments are making sufficient returns to meet your goals, such as buying a car, home or retirement.

Summary:

I know some may criticize me for suggesting speculation is bad and the focus on the long term is stupid. Everyone is welcome to speculate, but I think the average individual should try to avoid it and only speculate using a very small amount of capital. Thinking long term is not popular, but it works. 

To ensure you can have a long successful investing journey, remember to always to do your homework and avoid getting caught taking on a speculative bet. If you feel you do not want to take additional effort to manage your investments, you can take a more passive approach of putting money in exchange-traded funds (ETFs).  An example is a 50-50 division between equity ETFs (like XIU) and bond ETFs (like ZAG). The use of dollar averaging, the continuation of purchases of an asset over time, helps the passive investor to build a lower cost basis.

Good Luck in your investing journey! As Benjamin Graham would say " in the short run, the market is a voting machine. In the long run, the market is weighing machine. " Try to think a little more long term if you can. (I know it's hard!)

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Other Parts of this Article Series:
Part 2: Intelligent Investing for the Average Investor
part 3: Accounting Frauds, Lessons for investors
Part 4: Understanding Investor Psychology and Improve your Investing Results

To Taper or not to taper, that is the question

Federal Reserve officials are currently trying to figure out whether it is appropriate to reduce the quantitative easing program that began last September (nicknamed QE3). In the meantime, financial markets are fluctuating up and down trying to guess when will the Fed actually taper QE. While some primary dealers (those who trade directly with the Fed) estimate that the Fed will reduce the size of its program by $20 billion as early as the September meeting, consensus is at the October meeting.

In my opinion, it looks like markets may have gotten ahead of itself by pricing in an earlier timing of tapering than would be appropriate given current economic releases. I have no doubt that the Fed will taper but the pace/timing may be slower/later than what markets are currently pricing. Investors must remember that the Fed must comply to its dual mandate of maximum employment and price stability. Let's take a look at recent economic data to see if both criteria merit immediate reduction of QE.

Data on employment:

• Latest May nonfarm payrolls report came in at 175K, below the 200K run-rate most Fed officials would consider appropriate for an economic recovery
• The 6 month moving average improved slightly from 150K in August 2012 (pre-QE3) to 196K currently, but even this average is below the 200K mark
• The labour force participation have dropped to near record lows at 63.3%, far below the 66.0% seen in 2007. This is definitely not a sign of "substantial" improvement of labour markets

Data on prices:

• Latest reading on core PCE (Fed's preferred measure of inflation) stand at a measly 1.1% year-over-year (y/y), far below the informal 2% inflation target adopted in January 2012. The headline PCE is even worse at 0.7% y/y
• Latest reading on CPI shows benign inflation with the headline inflation running at 1.1% y/y and core inflation (ex-food and energy) at 1.7% y/y
• Looking at the breakevens (nominal yields minus real yields as indicated by TIPS), long term inflation expectations reminds stable near 2.2%, far below the 2.8% priced by the market when QE 3 started in September 2012

Hence, looking at the data points above, investors must acknowledge that the economy is gradually improving but a September or even October tapering may be premature. William Dudley of the New York Fed hinted in a speech that the Fed needs at least 4 month of healthy data to consider a  reduction of monetary stimulus. Given that the April-May economic releases are not 100% "healthy", it is likely the Fed will reduce the size of QE3 later than what consensus is currently calling for.

The markets were spooked by the follow statement in the May meeting minutes: " A number of participantsexpressed willingness to adjust the flow of purchases downward as early as the June meeting IF[emphasis added]  the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, VIEWS DIFFFERED [emphasis added] about what evidence would be necessary and the likelihood of that outcome"

Apparently investors only paid attention to the "willingness to adjust flow of purchases as early as the June meeting" instead of "if the economic information received by that time showed evidence of SUFFICENTLY STRONG AND SUSTAINED GROWTH". Also take note that "views differed" so it is likely the committee as a whole may agree on a later date than currently priced in by the market.

Impact on Fixed Income Markets:

Bond markets, which are forward looking in nature, have responded to a possibility of reduced stimulus. The 10-year treasury yield rose over 40bps to 2.29% in the past month while corporate spreads have widen slightly. It is likely that bond markets overreacted to tapering and yields move down in the short term while still gradually increase over the next 1-2 years.

Impact on Equity Markets:

Defensive stocks, which led the rally through the end of April, are likely remain under pressure. Not only due to concerns about tapering but due to rich valuations after gaining over 10% YTD. Cyclical stocks may outperform in the second half of the year as they lagged in the rally so far this year. There is a risk for a short term pull-back in equities from tapering fears but I think tapering would eventually be healthy for the equity market as a whole (see below).

To remind investors, stocks started one of the greatest bull market rallies after the Fed tightened policy in 1983 (after a dreaded double tip recession in the early 80s). Similarly in 1994 when the Fed shocked the market with a 3% rate hike over 12 month, there was some short term volatility but equities continued to advance until 2000.  

Wait, can tapering actually mean good news?

In a interesting piece by bond guru Bill Gross, he argues that tapering is actually good news to the underlying economy despite causing some short term volatility in the financial markets. The commitment to keeping rates low for an extended period of time is like having a slight deflationary effect on the economy. Why would companies be willing to start investing more now when rates are guaranteed to be low for a long time? Why would a bank increase loans to small businesses when the low interest environment is keeping the yield curve so flat? By giving the message that rates will eventually rise, businesses will have more incentive to lock-in today's low rate and increase underlying business investments. By tapering slowly, monetary policy remains accommodative while at the same time, the private sector is reminded that they better increasing businesses investments or else face higher borrowing costs to do so in the future. For the past few years, the economic recovery is due to a pure wealth effect as the Fed's QE programs pushed up asset prices with little effect on the underlying economy. Perhaps, with the Fed passing on the torch to the private sector, underlying GDP growth can move above the sluggish 2% level.

Investments Strategy going forward:

I want to end this piece with a folksy quote from Buffett: "You don't know who's swimming naked until the tide goes out". Thus, we can't know the full implication of slowing down QE until after the Fed actually taper QE. All the guesses made by market participants are really useless for prudent investment decisions, but it is interesting to note that the speculation of tapering increased volatility in the market, which can be a huge opportunity for those patient investors willing to take advantage of the wild mood of the market. Note that in this piece, I did not guess the exact date when the Fed will taper; rather, I provided facts that the probability of a late-tapering is higher than for an early tapering. Guessing macro variables is not a fun game but always remember that "it is better to be approximately right than precisely wrong".

There is no doubt that there will be continued volatility in the next few month but the increased uncertainty also will create opportunities for shrewd investors.

Disclaimer:

The piece is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the report. The author may change his opinion at any time in the future corresponding to new developments and will not be responsible for any capital loss experienced by readers.