A few thoughts on investing

I remember Jingyang told me before that my blog entries seem like book reviews... on books like The New Buffettology and The ABCs of gold investing. Well, it most certainly isn't plagiarism... but it may have created a misunderstanding because I did not properly qualify my opinions or express doubts to certain theories in the books. (well, it's obvious in this case I don't really have any major disapproval with the books' content in general) Anyway, I wish to express my thoughts clearly in this entry so that my friends can find out how I really view topics on investments and maybe even share their opinions on this matter.

I have recently read up a bit on Warren Buffet's investment strategies and therefore would also naturally find out the root of his ideas - Benjamin Graham. I would like to clarify certain ideas first on investment. I strongly feel that investing is NOT speculating. I guess our experiences with investing would be from TV dramas showing stockbrokers shouting across the floor or newspaper articles announcing yet another case of massive losses and bankruptcies following a stock market crash. However, as all things are, the form may not be the substance. What I mean is that these seemingly complex trading methods (futures trading, options trading, index arbitrage) are creative innovations (people get excited with new ideas with big names) of financial banks and institutions which have little to do with investing at all... basically people bet on a future scenario using past and current technical trends (mostly on stock prices) which sometimes is a win all or lose all scenario. (Sounds very much like playing blackjack or poker right?) Investing is in fact making business sense, which means you look at the stocks as an ownership of a business instead of commodities which are traded on the basis of price. (Surprisingly, many people still view investing as buying or selling shares just because your stockbroker called and tell you that the price is rising steadily and the prospects of the market is good, btw your stockbroker also earns a commission on every transaction you make)

Benjamin Graham believes in value investing like Warren. However, he does not invest selectively in good businesses with a durable competitive advantage like Warren did. Instead, his main motivation for investing in any company is the price of its stocks... if its stocks are selling way below the intrinsic value of the business he would consider buying. Now, I'm not exactly very sure what is his definition of intrinsic value too because he uses many factors and a series of complex calculations to determine the intrinsic value and the safety margin. (the difference between the price and the intrinsic value, which should be more if he expects the invetment to be risky) However, some people believe that the intrinsic value is the book value of the company. (the total capital that a company can work with which includes plants, machineries, cash reserves, also known as assets minus liabilities) Their rationale is that this is the value of a company if it is liquidated, hence if price is just trading slightly above this value it means that it is likely to go up cause you pay almost what you will get if the company is forced to shut down. Warren believes that the intrinsic value is the total projected annual compounded rate of return for the next 10 years or so discounted to the current government bonds (for example) rate. Afterall, you wouldn't want to be paying more than what the business can earn you in total.

Anyway, I feel that it is important to understand why certain ideas are expounded and this doesn't mean I totally ignore the view of intrinsic value being the book value, because it serves to remind me of the consequences if it is trading at book value or even the liquid cash value of a company. As I said earlier, Graham determines whether a particular stock is worth buying by calculating the intrinsic value of a business and at the same time determining if the price is sufficiently below this value. Warren first picks the companies he has an interest in, then he lets the price determine whether he should buy it. Graham isn't all that interested in the economics of a business, (however later he implements certain safeguard procedures such as requiring the company's earnings to grow at a steady rate) rather he lets price be the main motivating force behind every investment. He is not speculating, because he has a theory that any business will eventually reach its intrinsic value after some time and he will sell it for the gain. However, the problem lies in the fact that the longer the time it requires for the price of the stock to reach the intrinsic value, the lower the returns would be. Also, what if it never reaches this value? Graham follows a strict system of selling these stocks that fail to perform in 2 to 3 years time because he believes they either never will or the rate of return would be too diminished. Another point to note is that even if it works, the profits often are erroded away significantly by capital gains tax. Graham also owns a portfolio of very diversified stocks (often more than a hundred) while Warren owns a very concentrated porfolio with stocks of companies in his circle of confidence. Graham has to do that because there will be losses on some stocks which fail to reach their intrinsic value while Warren can do with just a few stocks because he is confident that these stocks will perform to his expectations. In fact, Warren even once said that diversification is only for people to protect themselves from their own stupidity. (I also wish to give my views on diversification but in a later entry perhaps because this entry is becoming extremely long and boring)

My purpose in writing such entries is not to glorify certain knowledge or praise Warren to the skies. Rather, I feel that together with all "intellectual" arguments, (pardon me for this expression but this is the common term used for such discussions) we are trying to sell our logic to people and hopefully get some opinions on our logic. It is just like arguing whether the price increase in public transport is fair to us, or whether the job environment is upbeat enough for you to demand a raise or job hop. And I feel that this topic on investment is relevant enough to many people, as investing is one of the main methods to achieve financial independence (which I believe everyone should aim for such a goal to varying degrees) because as I said before no one would want to be financially desperate on top of being poor. Well, my hope is that after reading this entry if you have anything to contribute or discuss please leave a note or talk to me about it. In this way, I can also benefit from your logic and learn to be a better investor. : )