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The 4 Dimensions Of Value Investing

Summary Value investing can be much more than just calculating the intrinsic value of a business. The more traditional value investing tends to focus only on quantitative metrics, such as P/E, P/B, EV/EBIT or EV to maintenance cash flow. Buffett and his followers introduced a new value investing approach which is more scalable and in longer term, which I call “quality-value investing”. Besides quantitative metrics and qualitative factors, there is the 3rd dimension: the certainty or the information edge. Finally, the 4th dimension is not about monetary gains, but about the emotional gains in the investment process, as well as an investment in the investor himself/herself. The Two Camps in Value Investing When Benjamin Graham wrote his famous book “The Security Analysis” 82 years ago, he built the foundation of value investing approach. This book became a timeless piece, and is still being followed everyday by many famous value investors. Interestingly, although all the value investors seem to be under the same title of “value investment”, their approaches could be dramatically different. One major and obvious difference is the focus on quality. Graham had his deep belief that any forecast is unreliable, and therefore we should always fallback to the “facts”, which are the numbers we have seen in the past. Apparently, this is a pure quantitative approach. On the other hand, Buffett and his followers started to deviate from Graham’s traditional approach, and started to focus on the quality side of the business. As Buffett said, he would rather invest in a great business at a fair price, than invest in a fair business at a great price. In reality, deep value investors (Graham’s followers) would not only invest in a fair business, but also often invest in a poor business with a poor management. Another difference is on the time horizon. While value investors are usually the long term investors, and have much longer time horizon than the other market participants, Buffett usually has even longer time horizon than the deep value investors. As he said, his favorite holding period is “forever”. However, many famous deep value investors clearly said they would sell when the stock price reaches its intrinsic value. Some of these deep value investors even criticized Buffett’s saying, or at least didn’t really understand the logic behind it. In my understanding, this difference comes from the roots of different focus. Deep value focus on pure quantitative metrics, such as P/B, P/E, EV/FCF, EV to maintenance cash flow, current ratio, debt ratio, growth rates, and dividend yield. There are two benefits of this kind of pure quantitative approaches: 1. It is objective. In investing, one of the biggest enemies of investors is their emotion, or their behavioral bias. Not only we are emotionally influenced by the price actions, the changes of fundamentals and recent events can also have a great influence on the perception of investors. Because of this influence, investors tend to focus more on the recent events, or more on the outlooks, and less on the historical facts. This kind of over-reaction or behavioral bias is often the reason why deep value investing worked. There are numerous research papers which showed that simple quantitative metrics such as P/B or P/E can generate a significant edge for investors. The pure quantitative approach is not limited to Graham’s formulas either. The famous “Magic Formula” only had two quantitative metrics in it: P/E and ROE. 2. It is easy to be well diversified. Since it is a pure quantitative approach, it doesn’t really need to analyze the business or understand the industry. Therefore, it is very easy to pick many different stocks and achieve high diversification. While I acknowledge the merits of deep value investing, it is also my belief that the pure quantitative approaches will be less effective in the future. This is because information is more available today, and there are more quantitative algorithms being created by backtesting the historical data. It is also easier to implement these investment approaches in an automated algorithm, which takes emotions completely out of the game. In other words, the competition on the deep value approach will be more intensive, and any deep value investment opportunity you can find is more likely to be a value trap, especially when that stock is a large cap or mid-cap. That said, Graham’s basic philosophy is still valid today: we have to focus on facts and avoid any over-confidence in our ability to forecast. This fact makes the first dimension (the quantitative metrics) to be the most important and most basic element of value investment. Without these metrics, we should not talk about “value” at all. While the quantitative metrics are important, we should also not underestimate the importance of qualitative factors (the 2nd dimension), such as the competitive advantages, the management’s ability and integrity, the pricing power of a business, and the industry outlooks. Not only these qualitative factors can give us more assurance of the business’ future, it also makes an exit strategy less important. As we all know, it takes a lot of work to understand an industry and a business. If we have to constantly find new opportunities after exiting the previous investment, it could be very tiring and it also increases the risks of misunderstanding the new opportunity. Beyond that, there is also the impact of taxes when you realize the capital gains. That is why Buffett said his favorite holding period is forever. After all, it is very hard to find a really good investment opportunity, and it takes a lot of effort to truly understand it. Plus, if you know you have to find the best exiting point, you will be tempted to sell too soon. When you increase your investment time horizon, it can also help to create a more scalable strategy, since you only need to slowly build the positions, and not worry too much about the need of liquidating the position with the best timing, or responding to any events quickly. The longer time horizon can also make qualitative factors much more important than quantitative factors. For example, if a stock is being traded at P/E 5, a deep value investor might get it and fetch a quick 100% gain within 1-2 years when the sentiment recovers. However, when you have to hold onto a poor business for 10 years, the poor business, even if it is not bleeding (losing money) every year, could be destroying value by reinvesting earnings with very low ROIC. So over a long period of time, any discount can be superficial and eventually get wiped out by the poor economics or poor management of the business. That is why when Buffett said “if you don’t want to hold it for 10 years, you shouldn’t hold it for 10 minutes”, many deep value investors couldn’t agree, simply because that philosophy doesn’t really apply to many deep value cases. On the other hand, for a good business with a good manager, even if you have to pay some premium for it, because of the good ROIC and high growth, your “sin” will often be more than covered by the good economics of the business when you hold it for many years. For example, a lot of investors were hesitating to buy Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) 20 – 30 years ago, when its P/B was more than 2. But at least in retrospect, that seemingly overpayment would be more than paid off later. The same thing can be said for many great businesses in their early stages, such as Microsoft (NASDAQ: MSFT ), Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), and Wal-Mart (NYSE: WMT ). Even today, when Berkshire Hathaway is already too big to grow very fast, the smart capital allocation along with many high quality world class businesses in its holdings make it an attractive investment for people who seek stable growth. Therefore, I believe it still deserves some premium in its valuation. For sure, today’s deep value investment can be much more than just a pure quantitative strategy. Deep value investors do often understand the business very well, and they often pay attention to the quality factors as well. However, their primary focus is still on the quantitative metrics, and they don’t require the business being a high quality business and don’t often require the business having a good management. Furthermore, even Buffett himself still invested in some low quality businesses from time to time. For example, after he had remained pessimistic on newspaper industry for many years, he still purchased many small newspaper businesses a couple of years ago, knowing that these businesses would slowly decline and could eventually die. Still, when the valuation was attractive from a discounted cash flow perspective, he felt that was a sensible thing to do. The 3rd Dimension: Certainty and Edge If the quantitative metrics can give us a view of the past, the qualitative factors should give us a “flavor” of the future (of course, investment is all about estimating the future). However, these two views can be totally unreliable if we don’t know enough about the business and the industry, and all our calculations could be based on imagination rather than facts. That is why we need the 3rd dimension: the certainty and the information edge. Every investment thesis is about finding and filling-in the missing pieces of a big puzzle. Investment, like any other business, is also highly competitive. Good businesses are unlikely to be sold cheap, and cheap ones are very likely to be value traps. The key about solving this big puzzle is about collecting as much information as you can. It is also about interpreting the basic information you collected, which requires some insights of the economics and the industry. In order to beat the market, we should also have an information edge, some unique insight or deep understanding that can help us to find the value discrepancy, and help us to maintain the confidence when facing emotional challenges. Buffett likes to call this as “The Circle of Competence”. It is a field where we can have an edge, a field where we can have more certainty than the other investors. After all, the term “uncertainty” is not equivalent to “true randomness”. When you try to guess the color of a ball in a box, that color is not a “true” random variable, since it is already fixed and known to some people, but just not known to you because you don’t have that information. Therefore, “certainty” is directly related to how much information we have. One obvious question following this is: how can we invest if we don’t have any circle of competence? Or what if all the stocks in my circle of competence are too expensive? I think there are several answers to this question: The first and the most important method to tackle this problem is to learn as much as you can. After all, nobody started with a circle of competence. It is all about constant learning over one’s lifetime. Learning has also become increasingly easier in this internet era as more and more information becomes easily available online. If we don’t have time to learn a new field, we could also simply wait until the opportunity shows in our existing circle of competence. Or try to copy a “superinvestor”, but I am not sure if that approach really works or not. Finally, less certainty in an investment means that we need to rely more on diversification, which again falls back to the more quantitative approach I have mentioned above. As I said, this approach may still work, but I would expect its effectiveness gets weaken over time. The 4th Dimension: Emotional Rewards While investors are normally only concerned about the potential monetary rewards in any investment, there is another hidden element in the investment process which is just as important: the emotional rewards. As a human being, the ultimate goal an investor seeks or should seek is always the “happiness”. While the investment profits can help us to get more happiness, we shouldn’t forget that much of our happiness is not related to money at all. Much of our pleasure directly comes from a constructive process. Much like a businessman who enjoys building his/her business, investors like to find the next gold mine or solve the next grand puzzle. It is a game they love. But beyond that, investors are also partners in a business. They are the owners of a business, even if they may only own a small fraction of it, and may not have any control on the business decisions. Nevertheless, just like a fan of a NBA team, the investors can enjoy seeing the business growing, and enjoy seeing the constructive process of building a business. This also makes a “quality-value” approach more attractive than a deep value approach. When you invest in a high quality business with a good manager, you often end up being happier in your investment life. You would worry less about management cheating on you or destroying value. There are less uphill battles against a deteriorating industry trend, or poor economics of the business. There is less energy spent on a proxy fight with a bad management. Besides the emotional rewards, there is another important side effect coming out of happy investing: when you truly like a business or a industry (not just because of the potential profits), you will spend a lot more time to learn about that business and industry. This will boost your edge in the 3rd dimension: your information edge. More importantly, this will become a very rewarding learning process that will be beneficial in the long run. In other words, when you invest on something that is truly interesting to you, you also invest in yourself by increasing your expertise in that industry. This benefit can be as significant as any monetary gains you could get from the investment itself, because just as Buffett said, “the best investment is always investing in yourself, it is the investment in education.” Summary The reason I call these 4 elements as 4 dimensions is that they are mostly uncorrelated factors. As investors are busy hunting their next best opportunity every day, it is also important to sit back and think through the process on a very high level. After all, it is more important to head in the right direction than moving at an amazing speed.

China Stumbles But Does Not Fall: ETFs To Play The ‘Chinese Century’

The Chinese government has the will and resources to create national wealth while helping smooth economic bumps and market volatility. Chinese ‘B’ shares trade at a PE of 21.6 (‘A’ shares trade at 16.7x), comparable with the S&P 500. FXI (iShares) is the largest China ETF, while Vanguard’s VWO is 27% invested in China. China’s stock market has been on a roller-coaster ride in 2015, with the largest China ETF, the iShares China Large-Cap ETF ( FXI), down 8% YTD. Recently, China’s market has been in the news, first for its huge run-up, then for its dramatic decline. I wanted to share some perceptions on the strength of China, and its internal resolve, that I think provides some perspective on the long-term opportunities in the Middle Kingdom. (click to enlarge) Source: Yahoo! I recently had the privilege of attending a conference in Miami sponsored by the Financial Times- ‘Trade Links With The New Latin America.’ While I learned a tremendous amount regarding the resource, political and financial/structural issues regarding trade with Latin America, my biggest takeaways were about China. A discussion regarding China is especially timely, as that country’s recent stock market meltdown, government response and growth forecasts have been in the news in recent months. Below I will discuss several of the more interesting observations; many of the observations will be directly attributable to Charles Tang, Chairman, China-Brazil Chamber of Commerce & Industry. Mr. Tang is not formally a part of the Chinese government, but spoke as if he was representing the views of his government, and equally as important, was thought by other panelist and conference participants to be representing the views of the Chinese government. Non quotes are my perception of comments by Mr. Tang and other participants at the conference (bankers, scholars, businesspeople and government representatives). I will start with the summary observations, and support with examples throughout the article. 1) China views the US as a competitor eager to keep the growing country down, 2) China has literally trillions of dollars saved to support its economy, help its friends and to secure its goals, 3) China is generous with its friends and does not (think it) attach moralistic strings to its aid/deals. 4) China will do what it takes to gain power, influence and respect. A very frank and telling quote, “The current administration will not be successful in dealing with China.” My initial thought was, are we (the US) playing the same game (as the Chinese)? It is well-known that we tend to view events and actions through our own prism. The conference brought into stark focus how actions can be viewed very differently depending on your ‘side.’ For example, actions by the US (and the West in general), that may be thought as motivated to help our partners or our economy are viewed by the Chinese as structured to isolate (China). The Trans Pacific Partnership (“TPP”), while controversial in the US for a variety of domestic reasons is viewed in China as a tool to exclude and isolate that country. While not a primary motivator, I think the Chinese, at least perceptually, have a point. A quote was, because the TPP excludes China “it will be difficult to be very successful.” The International Monetary Fund (“IMF”) is well known as the agency that tries to help troubled economies. From China’s perspective, it has been excluded from participation; ironic to China as it is the great creditor nation (and those that have the most say at the IMF are big debtors- bad at running their own economies!). Having successfully kept China out of the leadership of the IMF, the country decided to start its own development bank, the Asian Infrastructure Investment Bank (“AIIB”). Despite heavy lobbying by the US against joining the bank, the UK was the first western country to join; the headline in the New York Times summed up the situation: “Stampeded to Join China’s Bank Stuns Even Its Founder.” China’s success in getting the AIIB off the ground promises to increase the country’s stature and influence. Unfortunately (for the US), China’s gain is at the expense of the US. Poorly played by the US; the lack of influence (with heavy lobbying) is a real sign of diminished US influence. China wants its currency, the Renminbi, to be a trade and reserve currency, like the US Dollar and (to a lesser extent) the Euro. China’s attempts at currency control and manipulation have hurt itself in this regard. However, as conference attendees demonstrated, banks such as Commerzbank ( OTCPK:CRZBY ) are eager to facilitate Renminbi transactions (as opposed to having a transaction conducted in US Dollars or Euros); it appears almost inevitable that China will eventually succeed in having its currency join the US dollar as a trading and (later) a reserve currency. China will need to remove most capital controls before the currency can truly be a reserve currency. China is not “on the rocks.” While tacitly acknowledging some clumsiness in dealing with the stock market situation, the real point emphasized was that China has $4 trillion (with a ‘T’) to play with. Interesting quotes included: (the first part partially in jest), “China is not going broke . . . it has tremendous financial depth.” And, there have been “a few hick-ups” in transitioning China to a consumer economy. Also, “China was a slight cold . . . the US has had pneumonia for the last 16 years.” Note the confidence, arrogance and (by being arrogant) lack of confidence. In talking about the financial situation, it was noted that almost none of Chinese property is subject to a property tax. The imposition of a property tax was noted as a lever that could be used to support indebted regions. From a practical point of view, China feels, instead of exploiting Africa as the colonial powers (or the post-colonial rulers) did, they have “transformed Africa into a continent of hope.” After hearing this quote, I did realize there was a certain ‘Alice in Wonderland’ feel to the perspectives of the Chinese and the West. However, China feels its investments in Latin America are a counter-point to the historically more exploitive investments of the US. Coincidently, on September 3, the Financial Times reported that China had made a $5 billion loan to beleaguered Venezuela. While risky from a credit point of view, China is clearly buying influence with money (even at the risk of default) and securing supplies of commodities (in this case oil). China also continues to invest in Brazil, though more cautiously as the Petrobras (NYSE: PBR ) scandal has made the money-for-influence transaction more challenging (who know who will be in power in six months). However, never one to miss a good crisis, China is “taking advantage of opportunities to buy assets” in Brazil. Like Donald Trump, you have to admire the straightforward audacity of the Chinese even if you do not respect the underlying morals/motivations. Frankly, lending when all others have left is a great way to gain favors and bargains. Another interesting quote regarding investment, “Chinese money has no conditions.” Of course Chinese money has conditions, just not the moral conditions or requirements used to satisfy local political constituents (e.g. unions) in the US. While I don’t know if anything I heard was entirely new. What was new to me was the blunt, forthright and unapologetic way the Chinese perspective was presented; hearing a direct Chinese justification was certainly different than a Western interpretation. My takeaways are: China is buying assets and influence on the cheap. China is amoral and guided by enhancing security and stature. China views the US as attempting to isolate the country; China’s response is to create parallel institutions that will ultimately weaken US influence. The US would be better to compromise (in some areas) than compete. China’s $4 trillion war chest gives it flexibility and a long-term perspective the US (and the West) cannot match. A parallel thought is the impact to the US if China stops buying US Treasury bonds (he who has the gold . . .). China’s arrogance and insecurity will cause it to waste a good portion of its war chest (e.g. Japan in the 1990’s). The influence China’s money will buy, will be somewhat like what the old Soviet Union used to buy. Effective, but generally in areas where ideology trumps economics. China’s no-strings attached money come with ‘other’ strings (see: Godfather Part I). The US is wasting goodwill and money in threatening the Chinese; the Chinese are proud, determined to be respected and will create a lose-lose situation if necessary (e.g. Creation of the AIIB). The lack of a well-articulated and consistently applied economic policy is hurting the US vis a vis the Chinese. I would regard any commitments the Chinese make with respect to climate change as credible as the commitments the Iranians make on nuclear weapons (probably well-intentioned when made, but not likely to be adhered to in the long term). I mention this topic as it is one where the US would likely make concessions in international agreements in order to get cooperation from the Chinese. While much of the above was not directly about the stock market, much of it has a direct impact. In short, China is playing the long-game to enhance its financial and strategic power. The government will do what is necessary for stability. From a market perspective, that means investors benefit from the government’s desire to increase overall national wealth and use its resources to smooth bumps and minimize market volatility. The macro growth of 7% (or even 5% or 6%) is a strong tailwind. Last week’s announcement changing the one-child policy is a new (with a nine-month lag ) tailwind. The Shanghai Stock Exchange reports an average PE ratios of 16.7x and 21.6x for ‘A’ shares (those available for purchase by mainland Chinese) and ‘B’ shares, respectively. By comparison, the S&P 500 currently trades at a 21.9x PE ratio. While confidence in earnings reported by Chinese firms is not as high as those reported by US firms, the valuations provide a sense of relative value. Despite recent volatility, given Chinese tailwinds, valuation does not seem excessive. From a long-term perspective, China should be considered a part of a well-diversified portfolio. FXI is the largest ETF (0.74% expense ratio), though eight other China ETF’s exist with assets of more than $100 million (see the ETF database for more information). Personally, I participate in China via the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) (0.15% expense ratio). VWO’s portfolio is 27% China.

Should We Fear Debt?

Summary Avoiding an indebted investment is short-sighted, because data shows that debt levels and returns aren’t always negatively correlated. By tilting to the segments that are more sensitive to movements in credit spreads, investors must be willing to accept the greater influence of the equity markets. Look at the data before you believe a strategist who encourages you to avoid indebted companies. By Chris Philips Late last year, Josh Barrickman, head of bond indexing at Vanguard, blogged about the smart beta movement in fixed income. Josh challenged the notion that a company or country could flood the market with debt, which would invariably harm market cap-focused investors. You’ve probably heard it before: “Why would anyone want to invest in the most indebted companies or countries? It’s just throwing good money after bad.” While this premise may seem logical and intuitive on the surface, as with many things we see or hear, a bit of logic and perspective can diffuse superficial arguments. First, some perspective from a unique source. I’ve been catching up on some reading, and one piece in particular stuck with me – an article referencing a story about astronomer Carl Sagan. When presented with “evidence” of alien abductions in the form of an individual who was convinced beyond doubt of having been abducted, the astronomer responded: ” To be taken seriously, you need physical evidence… But there’s no [evidence]. All there are, are stories .” So, should we believe the stories and fear debt? The answer is, it depends. But as a general practice, avoiding an investment simply because of its level of debt is short-sighted. For example, see Figure 1, which shows the relationship between a country’s debt-to-GDP level and the returns of that country’s bond market. Included is a mixture of developed and emerging market countries, with a requirement that each country report a debt-to-GDP ratio and 10 years of bond returns. I’ve highlighted two “groups” of countries – those that have seen low returns over the last 10 years and those with higher returns. Notably, there’s no apparent relationship within each group or across groups. Higher debt levels didn’t always lead to lower returns, and low debt levels didn’t always lead to higher returns. So, rather than take intuition at face value, as investors we must ask ourselves: “What causes one country with a low debt-to-GDP ratio to return 1.5% per year, another to return 4% per year, and yet another to return 7.5% per year?” Clearly, market participants are taking many more factors into consideration than just the perception that debt is scary and should therefore be avoided. Figure 1. Another consideration involves the actual portfolio ramifications of focusing on debt levels as a screening metric. The easiest strategy with which to evaluate the impact of debt involves weighting an index according to a country’s GDP instead of to its bond market. And if we compare the Barclays Global Aggregate Bond Index to the GDP-weighted Global Aggregate Bond Index, we see an immediate attraction: Duration is reduced marginally from 6.47 to 6.33, but the yield increases by close to 20% – from 1.72% to 2.06% – by moving to the GDP-weighted index.¹ Less risk and greater return? Free lunch alert! However, if we closely examine Figure 2, we can clearly see what’s going on. By moving away from market cap, you underweight the U.S. and Japan and overweight various emerging market segments. After all, the U.S. and Japan both fit the profile of the most indebted countries. One implication is that while both indexes are considered investment-grade, the GDP-weighted version has a noticeable tilt towards lower-quality bonds. Figure 2. Why is this important? Because as much as we’d like them, free lunches do not exist. Case in point: From January 1, 2008 through February 28, 2009 (the last notable equity bear market), the Aaa segment of the Global Aggregate Bond Index returned 0.2%. The Aa segment returned 5.8%, the A segment returned -17.1% and the Baa segment returned -14.0%.¹ In other words, by tilting to the segments that may be more sensitive to movements in the credit spreads, investors must be willing to accept the greater influence of the equity markets, particularly during really bad times. What’s more – and what’s important – is that a primary motivation for holding fixed income (at least in our opinion) as a consistent and meaningful diversifier for equity market risk may be marginalized (see: Reducing bonds? Proceed with caution ). My advice? Next time you hear a strategist, sales executive, or portfolio manager encouraging you to avoid indebted countries or companies, ask yourself whether you should buy into the hype. Indeed, as Sagan is famous for stating: “Precisely because of human fallibility, extraordinary claims require extraordinary evidence.” So, let’s all take a deep breath and repeat: “I’m not afraid of debt, I’m not afraid of debt.” Source: Barclays Global Aggregate Bond Index. Notes: All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Securities of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.