Finance Learning - Show Me The Money Volume I - part 1

From Show Me the Money I by Teh Hooi Ling

1. How to Exit The Rat Race Early
invest... invest...and let your hard-earned money grow...

2. Before You Invest Your Money

3. Time To Pile Into Stocks Now?
4. Time To Overcome Your Greed and Fear
5. It's All About Timing, Believe It OR Not
Equity risk premium - the compensation investors require for holding stocks.

using historical data, the equity risk premium by taking inverse of market price earnings ratio - or earnings yield - minus the risk-free rate.

Market PE ratios were obtaned from Thomson Financial Datastream and one-year deposit rates were taken as risk-free rates.

Every time the risk premium measured in basis points - hit 350, it was an indication of under-valuation of equities. On the other hand, a drop to about 60 points suggested that the market was over-valued.

without data from thomson financial datastream,
All one has to do is tally up the most recent year earnings of the 45 companies which made up the Straits Times Index(STI). Also add up their market capitalisation. Dividing the combined market cap of STI index stocks with the combined earnings will give you the average PER for STI.
Taking the inverse of the PER and deducting the one-year fixed deposit rate will give you the estimate of equity risk premium.
The combined net profits figure would stay pretty constant for much of the year. The one-year fixed deposit rates, too, move infrequently. Market cap, however, will fluctuate every day as the stock prices of the index stocks move up and down.

6. How to Detect Lower Earnings Quality
The acconting discretion granted to managers is potentially valuable, because it allows them to reflect inside information in reported financial statements. However, since investors view profits as a measure of managers' performance, managers have an incentive to use their accounting discretin to distort reported profits by making biased assumptions.
In other words, mangers can use accounting flexibility to either communicate their firm's economic situation or hide its true performance.

While asset allocation will determine a large part of the variability of a portfolio's returns, stock selection can and do enhance the portfolio's performance. And there is no short cut to that extra returns. Understanding a company's industry characteristics, its own competitivie strategy to ascertain its key success factors and risks is a major part. To gain that understanding, you have to gather information from various sources, chief among them the company's annucal reports.

some common red flags are:
- unexplained changes in accounting, especially when performance is poor.
- a disproportionate increase in accounts receivables in relation to sales increase.
- a growing gap between a company's reported earnings and its cash flow from operating activities.
- unusual increases in inventories vis-a-vis sales increases.
- unexpected large asset write-offs.
- large fourth-quarter adjustments.

Other helpful hints to detecting earnings quality declines are:
- inclusion of profits from past periods in the current period, such as a reversal of a reserve.
- under-provision of future expenses associated with current sales, such as bad debts, warranty obligations, etc;
- increasing reliance of earnings sources not central to the company's principal business activity and strategy.

market generally value growth stocks at a higher multiple to earnings.


7. Looking For Red Flags In Accounts
One of the most common red flags investors should look for is a growing gap between a company's reported earnings and its cash flow from operating activities.

Cash flow from operations, or CFO, is the actual cash generated by the business that will be used to pay interest on bank loans, or repay principal and to finace new investment. It excludes depreciation charges of assets - an accounting number. That's why it is usually higher than the net earnings figures.
Obviously, you want cash flow to be higher than net earnings, as it is a measure of a company's ability to self-finance. There usually is a steady relationship between the two if the company's accounting policies remain the same.
A growing gap may suggest aggressive recognition of revenuse which has not materialised into cash for the company.
Another red flag that analysts look out for is a disproportionate increase in accounts receivables in relation to sales increase. This may suggest that the company is relaxing its credit policies or stuffing iits distribution channels to recordd revenues in the current period.
If credit policies are relaxed unduly, the firm may face receivable write-offs going forward as a result of customer defaults.
Another tell-tale sign of unsustainability of earnings growth is when net earnings is expanding at a much faster rate than sales.
see charts.

8.How To Read The signals That Companies Give Out
Meanwhile, new plants must be built to make the new product, so capital must be raised. The company can borrow the money or it can sell new shares to raise the funds.
If it issues more new shares, then the claim of existing shareholders(including the management) on the future earnings of the company will be diluted. In other words, future explosive earnings from the new product will have to be shared with the new shareholders.
And with more shares in the market, the company's stock price will not appreciate as much as it would have if the management had not issued any new shares when the share price was much lower.

if company has good prospects, it will not issue more new shares, as the earnings of the company will be diluted. Therefore, one would expect a firm with very favourable prospects to try to avoid selling stock but to raise any requied new capital by other means including debt. With debts, the company needs only to meet the fixed obligation of interest payments. Any excess returns from the investments will accrue entirely to the shareholders.

A firm with unfavourable prospects would want to sell stock, which would mean bringing in new investors to cushion existing investors against future adverse developments.


So, in short, the announcement of a stock offering is generally taken as a signal that the company's prospects as seen by its management are not bright. Consequently, when a company announces a new stock offering, more often than not, the price of its stock will decline.

Investors here generally prefer debt-free companies. But as can be seen above, the announcement of a debt issue can signal better things to come.

Furthermore, debt is a cheaper form of capital than equity. This stems from the fact that interest expense on debt is tax-deductible.

debt provides a leverage effect that can significantly boost a company's earnings in good times. ( affects EPS )
debt can be a double-edged sword with the leverage effect going the other way. ( see e.g. in book, page 35 )

9. Lessons in Buffet's Focus Investing
Academics define risk as price volatility, and to counter that risk, they recommend holding a diversified portfolio.

But to Mr Buffet, risk is the intrinsic value risk of a business, not the price behaviour of its stock. And intrinsic value risk, he says, coms from misjudgement of a company's prospects.

You should have the courage and conviction to put at least 10 per cent of your net worth into each investment you make, he says.

In other words, by pruposely focusing on just a few select companies, you are better able to study them closely and understand their intrinsic value. And the more knowledge you have about a company, the less risk your are likely to be taking.

Such focus investing can, no doubt, only be employed by those who have absolute conviction of their analysis - and the fortitude to hold steady during any short-term market gyrations.
"Diversification serves as protection against ignorance'. It's a good strategy for a know-nothing investor, but the price is an average return.

4 primary factors to ascertain the probability of achieving a return on one's investment
1. The certainty with which the long-term economic characteristics of a business can be evaluated.
- is the business simple and understandable;
- does it have a consistent operating history;
- does it have a favourable long-term prospects.
2. The certainty with which fmanagement can be evaluated, in terms of its ability to realise the full potential of its business and wisely employ the cash flows
- is management rational?
- is it candid with shareholders?
- does it resist the institutional imperative?
3.The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself
- focus on return on equity, not earnings per share;
- look for companies with high profit margins;
- for every dollar retained, make sure a company has created at least one dollar market value.

In terms of valuation, investors should do some homework to arrive at the value of the business and ask if the business can be pruchased at a significant discount to its value.

Followers of Mr Buffet must be willing to make big bets when they encounter a strong opportunity or a high probability event. And they must be patient. Mr Buffet thinks that risk is inextricably linked to an investor's time horizon. One mustn't panic over price changes. The volatility of one's portfolio is a necessary by-product of focus investing. To be a Buffett follower, you have to steel yourself against bumps and not act rashly in response to the vagaries of the market. Mr Buffet views price weakness as an opportunity to buy more of a godd company.

10. Crucial To Hold A diversified Portfolio.
Two types of risks. One is the non-systematic risk, or risk which is unique to each individual company. The second riks is systematic risk. The market only rewards systematic risk. Non-systematic or unique risks are not rewarded because they can be diversified away.

Diversification - in the same fashion that insurnace companies diversify risks by writing a large number of policies, investors can diversify risks by holding a large number of securities.

stocks with low correlation to STI are Want Want, Delgro, hong Kong Land, SembCorp Marine, Dairy Farm and Keppel Corp.