Author: Tan KW   |   Latest post: Wed, 13 Feb 2019, 09:38 AM


Wall of Ideas - safalniveshak

Author: Tan KW   |  Publish date: Wed, 13 Feb 2019, 09:38 AM

Welcome to Safal Niveshak’s Wall of Ideas, where I present hand-drawn illustrations of a few of my thoughts on investing, learning, decision-making, and living.

The permanent home of these illustrations lies here, where all my future updates will happen.

If you like what you see below, please share your love in the Comments section of this post. Also share your ideas for future such illustrations.

Sharing the illustrations socially – Twitter, Facebook, LinkedIn, etc. – would also help spread the word. Thank you!

Wall of Ideas


How to Get Wealthy


What You Control


Abnormal Distribution

Becoming A Full Time Investor

Reading Spectrum

Full Time Investing

Bull Markets' Three Silent Killers

Warren Buffett Secrets

Wisdom Tree


Three Iron Rules

Process Vs Outcome

Broker Reports

Ego is the Enemy


Regret Minimization Framework

Business Quality Growth Matrix

Feynman Technique

Business Analysis the Sherlock Holmes Way

When to Sell A Stock

Circle of Competence

Stock Selection Process

Capital Allocation 101

Octopus Model

Barriers to Good Decision making

Teaching Investing to A ChildHow to Be Happy


Being Human

Brain and Business TV

Is Investing Science or Art

Learning Compounds

Demons of Investing

Financial Shenanigans

Financial Red Flags

J Curve

Knowledge Pie

Happiness Curve


Qualities of Investment Advisors


Career Advice



Advice from A Tree


Investing Checklist


How to Get Rich

Socrates' Triple Filter Test


Way Out is In



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January 2019 Data Update 8: Dividends and Buybacks - Fact and Fiction - Aswath Damodaran

Author: Tan KW   |  Publish date: Sat, 9 Feb 2019, 09:45 PM

Friday, February 8, 2019

In my series of data posts, I had always planned to get to dividends and buybacks, the two mechanisms that companies have for returning cash to stockholders, at this point, but an op ed on buybacks by Senators Schumer and Sanders this week, in the New York Times, will undoubtedly make this post seem reactive. The senators argue that the hundreds of billions of dollars that US companies have expended buying back their own shares could have been put to better use, if it had been reinvested back in their businesses or used to increase wages for their employees, and offer a preview of legislation that they plan to introduce to counter the menace. Like the senators, I am concerned about the declining manufacturing base and income inequality in the US, but I believe that their legislative proposal is built on premises that are at war with the data, and has the potential for making things worse, not better.

The Buyback Effect: Benign Phenomenon, Managerial Short-termism or Corporate Malignancy?
'The very mention of buybacks often creates heated debate, because people seem to have very different views on its causes and consequences. All too often, at the end of debate, each side walks away with its views of buybacks intact, completely unpersuaded by the arguments of the other. The reason, I believe is that our views on buybacks are a function of how we think companies act, what the motives of managers are and what it is that investors price into stocks.
a. Buybacks are benign
If companies are run sensibly, the cash that they return to shareholders should reflect a residual cash flow, making the cash return decision, in terms of sequence, the final step in the process. 

If companies follow this process, buybacks are just another way of returning cash to stockholders, benign in their impact, because they are not coming at the expense of good investments, at least with good defined as investments that generate more than their hurdle rates. In fact, putting restrictions on how much cash companies can return, can harm not only stockholders (by depriving them of their claim on residual  cash flows) but also the economy, because capital will now be tied up in businesses that don't need them, rather than find its way to good ones.
b. Buybacks are short term
The benign view of stock buybacks is built on the presumption that managers make decisions at publicly traded companies with an eye on maximizing value, and since value is a function of expected cash flows over the life of the company, that they have a long term perspective. That view is at odds with evidence that managers often put short term gains ahead of long term value, and if investors are also short term, in pricing stocks, you can get a different picture of what drives buybacks and the consequences:
In effect, managers buy back stock, often with borrowed money, because it reduces share count and increases earnings per shares, and markets reward the company with a higher stock price, because investors don't consider the impact of lost growth and/or the risk of more debt. The argument that buybacks are driven by short term interests is strengthened if management compensation takes the form of equity in the company (options or restricted stock), because managers will be personally rewarded then for buybacks that, while damaging to the company's value (which reflects the long term), push up stock prices in the short term. With this view of the world, buybacks can create damage, especially at companies with good long term projects, run by managers who feel the need to meet short term earnings per share targets.
c. Buybacks are malignant
There is a third view of buybacks, where buybacks are not just motivated by the desire to push up earnings per share and stock prices, but become the central purpose of the firm. With this view, companies try to do whatever they can to generate more cash for buybacks, including crimping on worker wages, turning away good investments and borrowing more, even if that borrowing can put their survival at risk.
This picture captures almost all of the arguments that detractors of buybacks have used, including the ones that Senators Schumer and Sanders present in their article. If buybacks are the drivers of all other corporate actions, instead of being a residual cash flow, the “buyback binge” can be held responsible for a trifecta of America's most pressing economic problems: stagnant wages for workers, the drop in capital expenditures at US companies and the rise in debt on balance sheets. If this buyback shift is being driven by activist shareholders and a subset of "short term" institutional investors, as many argue that it is, you have a populist dream cast of good (workers, small stockholders, consumers) and evil (activists, wealthy shareholders and bankers). If you buy into this description of corporate and investor behavior, and it is not an implausible picture, it stands to reason that restricting or even stopping companies from buying back stock should alleviate and even solve the resulting problems. 
Picking a perspective
The reason debates about buybacks very quickly bog down is because proponents not only come in very different perspectives of corporate behavior, but they use anecdotal evidence, where they point to a specific company that behaves in a way that backs their perspective, and say "I told you so". The truth is that the real world is a messy place, with some companies buying back stocks for the right reasons (i.e., because they have no good investments and their stockholders prefer cash returns in this form), some companies buying back stock for short term price gains (to take advantage of markets which are myopic) and some companies focusing on buying back stock at the expense of their employees, lenders and own long term interests. 

Moneyball with Buybacks
The question of which side of this debate you will come down on, will depend on which of the perspectives outlined above comes closest to describing how companies and markets actually behave. Since that is an empirical question, not a political, idealogical or a theoretical one, I think it makes sense to look at the numbers on dividends and buybacks, not just in the US, but across the world, and I will do so with a series of data-driven statements.

1. More companies are buying back stock, and more cash is being returned in buybacks
Are US companies returning more and more cash in the form of buybacks? Yes, they are, and it represents a trend that saw its beginnings, not ten years ago, but in the 1980s. In the graph below, I look at the aggregate dividends and buybacks from firms in the S&P 500 since 1986, and also report on the percentage of cash returned that takes the form of buybacks, each year:
Starting at a base in the early 1980s, where buybacks were uncommon and dividends represented almost all cash return, you can see buybacks climb through the 1980s and 1990s, both in dollar value terms and as a percentage of overall cash return. That trend has only accelerated in this century, with the 2008 crisis putting a brief crimp on it. In 2018, more than 60% of the cash returned by S&P 500 companies was in the form of buybacks, amounting to almost $700 billion.
2. Cash Returns are rising as a percent of earnings, and it looks like companies are reinvesting less back into their own businesses
If you look at the graph above, you can see that the rise in buybacks has been accompanied by a stagnation in dividends, with growth rates in dividends substantially falling short of growth in buybacks. This shift has had consequences for two widely used measures of cash return, dividend yield, which looks at dividends as a percent of market capitalization or stock prices and the dividend payout ratio, a measure of the proportion of earnings as dividends. The declining role of dividends, as a form of cash return, has meant that a more relevant measure of cash return has to incorporate stock buybacks, resulting in a broader definition of cash yield and cash payout ratio measures:
  • Cash Yield = (Dividends + Buybacks) / Market Capitalization
  • Cash Payout Ratio = (Dividends + Buybacks)/ Net Income
The push back that you will get from dividend devotees that while dividends go to all shareholders, buybacks put cash only in the pockets of those stockholder who sell back, but that argument ignores the reality that the it is still shareholders who are getting the cash from buybacks. (As a thought experiment, imaging that you own all of the shares in a company and consider whether you notice a difference between dividends and buybacks, other than for tax purposes.) Calculating both dividend and cash measures of yield and payout over time, we observe the following for the companies in the S&P 500:
S&P 500: Dividends, Buybacks, Mkt Cap and Net Income
This table reinforces the message from the previous graph, which is that both dividends and buybacks have to be considered in any assessment of cash return. That is why I think that the handwringing over how low dividend yields have become over the last two decades misses the point. The cash yield for US companies, which includes both dividends and buybacks, is much more indicative of what companies are returning to shareholders and that  number has remained relatively stable over time. Using the same logic that I used to argue that cash yields were better indicators of cash returned to shareholders than dividend yields, I computed cash payout ratios, by adding buybacks to dividends, before dividing by net income in the table in the last section, and it does show a disquieting pattern. In fundamental analysis, analysts give weight to the payout ratio and its twin measure, the retention ratio (1- payout ratio) as a measure of how much a company is reinvesting into its own business, in order to grow.  The cash returned to shareholders exceeded net income in 2015 and 2016, and remains high, at 92.12% of net income, and that statistic seems to support the proposition that US companies are reinvesting less.
3. The drop in reinvestment may be real, but it could also be a reflection of accounting inconsistencies and failure to see the full picture on cash return
It is true that companies are returning more of their net income, as measured by accountants, to stockholders in dividends and buybacks, with the latter accounting for the lion's share of the return. Before we conclude that this is proof that companies are reinvesting less, there are two flaws in the numbers that need fixing:
  1. Stock Issuances: If we count stock buybacks as returning cash to shareholders, we should also be counting stock issuances as cash being invested by these same shareholders. Thus, the more relevant measure of cash return would net out stock issuances from stock buybacks, before adding dividends. While this is a lesser issue with the S&P 500 companies, which tend to be larger and more mature companies, less dependent of stock issuances, it can be a larger one for the entire market, where initial public offerings can augment seasoned equity issues, especially for smaller, higher growth companies.
  2. Accounting Inconsistencies: Over the last few decades, the percentage of S&P 500 companies that are in technology and health care has risen, and that rise has laid bare an accounting inconsistency on capital expenditures. If a key characteristic of capital expenditures is that money spent on them provide benefits for many years, accounting does a reasonable job in categorizing capital expenditures in manufacturing firms, where it takes the form of plant and equipment, but it does a woeful job of doing the same at firms that derive the bulk of their value from intangible assets. In particular, it treats R&D, the primary capital expenditure for technology and health care firms, brand name advertising, a key investment for the long term for consumer product companies, and customer acquisition costs, central for growth in subscriber/user driven companies as operating expenses, depressing earnings and rendering book value meaningless. In effect, companies on the S&P 500 are having their earnings measured using different rules, with the earnings for GM and 3M reflecting the correct recognition that money spent on investments designed to create benefits over many years should not be expensed, but the earnings for Microsoft and Apple being calculated after netting those same types of investments. As with the treatment of leases, I refuse to wait for accountants to come to their senses on this question, and I have been capitalizing R&D for all companies and adjusting their earnings accordingly. 
In the table below, I bring in stock issues and R&D into the picture, looking across all US stocks, not just the S&P 500:
All US publicly traded companies; S&P Capital IQ
While the trend towards buybacks is still visible, bringing in new stock issuances tempers some of the most extreme findings. In 2018, for instance, the net cash return (with issuances netted out from dividends and buybacks) represented about 46% of adjusted net profit (with R&D added back), well below the gross cash return.  In fact, there is no discernible decline in reinvestment over time, barring 2008 and 2009, the years around the last crisis. Capital expenditures have grown slowly, but an increasing percentage of reinvestment, especially in the last 5 years, has taken the form of R&D and acquisitions. 

4. Buybacks cut across sectors, size classes and growth categories, but the biggest cash returners are larger, more mature companies.
Before we decide that buybacks are ravaging the economy and should be restricted or even banned, it is also worth taking a look at what types of companies are buying back the most stock.  Staying with US stocks, I looked at buybacks and dividends of companies, broken  down by industry grouping. The full table is at the end of this post, but based upon the dollar value of buybacks, the ten industries that bought back the least stock and the ten that bought back the most are highlighted below:
Dividends and Buybacks: By Industry for US
It should come as no surprise that the industries where you see buybacks used the least tend to be industries which have a history of large dividend payments, with utilities, metals and mining and real estate making the list. Looking at the industries that are the biggest buyers of their own stock, the list is dominated by companies that derive their value from intangible assets, with technology and pharmaceuticals accounting for seven of the ten top spots. While that may surprise some, since these are viewed as high growth businesses, some of the biggest players in both technology and pharmaceuticals are now middle aged or older, using my corporate life cycle structure.
Given that there are often wide differences in size and growth, within each industry grouping, I also broke companies down by market cap size, to see if smaller companies behave differently than larger ones, when it comes to buybacks:
Market capitalization, as of 12/31/18
It is not surprising that the largest companies account for the bulk of buybacks, but you can also see that they return far more in buybacks, as a percent of their market capitalizations, then smaller firms do. 
Finally, I categorized companies based upon expected growth in the future, to see if companies that expect high growth behave differently from ones that expect low growth.
Expected revenue growth in the next two years
While companies in every growth class have jumped on the buyback bandwagon, the biggest buybacks in absolute and relative terms are for companies that have the lowest expected growth in revenues, returning 4-5% of their market capitalization in buybacks each year. Companies in the highest growth class, in contrast, return only 0.95% of their buybacks. That said, there are companies in higher growth classes that are buying back stock, when they should not be, perhaps for short term pricing reasons, but they represent only a small portion of the market, accounting collectively for only 10.56% of overall market capitalization.
I may be guilty of letting my priors guide my reading of these tables, but as I see it, the buyback boom in the United States is being driven by large non-manufacturing firms, with low growth prospects. If you restrict buybacks, expecting that this to unleash a new era of manufacturing growth and factory jobs, I am afraid that you will be disappointed. The workers at the firms that buy back the most stock, tend to be already among the better paid in the economy, and tying buybacks to higher wages for these workers will not help those who are at the bottom of the pay scale.
5. Investing back into businesses is not always better than returning cash to shareholders, when it comes to jobs, economic growth and prosperity.
Implicit in the Schumer-Sanders proposal to restrict buy backs is the belief that while shareholders may benefit from buybacks, the economy overall will be more prosperous, and workers will be better served, if the cash that is returned to shareholders is invested back in the businesses instead. Incidentally, this seems to be a shared delusion for both ends of the political spectrum, since one of the biggest sales pitches for the tax reform act, passed in 2017, was that the cash trapped overseas by bad US tax law, would, once released, be invested into new factories and manufacturing capacity in the US. I believe that both sides are operating from a false premise, since investing money back into bad businesses can make both economies and workers worse off. In a prior post, I defined a bad business as one where it is difficult to generate a return that is higher than the risk adjusted rate that you need to make to break even on your investment. 
Data Update 6 on excess returns
Using the return on capital, a flawed but still useful measure, as a measure of return and the cost of capital, with all of the caveats about measurement error, I found that approximately 60% of companies, both globally and in the US, earn less than their cost of capital. Forcing these companies to reinvest their earnings, rather than letting them pay it out, will only put more more money into bad businesses and create what I call "walking dead" companies, tying up capital that could be used more productively, if it were paid out to shareholders, who then can find better businesses to invest in. 
6. Some companies may be funding buybacks with debt, but the bulk of buybacks are still funded with equity cash flows
The narrative about stock buybacks that its detractors tell is that US companies have borrowed money and used that debt to fund buybacks, creating, at least in the narrative, sky-high debt ratios and  rising default risk. While there is certainly anecdotal evidence that you can offer for this proposition, there is evidence that we have looked at already that should lead you to question this narrative. Looking across sectors, we noted that the technology and pharmaceutical companies are on the list of biggest buyers of their own stock, and neither group is in the top ten or even twenty, when it comes to debt ratios.
Taking the naysayers at their word, I broke US companies down, based upon their debt loads, using Debt/EBITDA as the measure, from lowest to highest, to see if there is a relationship between buybacks and debt loads:
Debt to EBITDA at the end of 2018
The bulk of the buybacks are coming from firms with low to moderate debt ratios, falling in the second and third quintiles of debt ratios.  It is true that the firms with the highest debt load, buy back the most stock, at least as a percent of their market capitalization. As with the growth data, you can view this as evidence of either short-term thinking or worse, but note that the second and third quintiles together account for 61% of overall market capitalization, suggesting that if buybacks are skewing debt upwards at some firms, it is more at the margins than at the center of the market. 
7. Buybacks are now a global phenomenon
It is true that stock buybacks, at least in the form that you see them today, as cash return to stockholders, had their origins in the United States in the 1980s and it is also true that for a long time after that, much of the rest of the world either stayed with dividends and many countries had severe constraints on the use of buybacks. In the last decade, though, the dam seems to have broken and stock buybacks can now be seen in every part of the world, as can be seen in the table below:

US companies still lead the world in buybacks, but Canadian companies are playing catch up and you are seeing buybacks pick up in Europe. Asia, Eastern Europe and Latin America remain holdouts, though it is unclear how much of the reluctance to buy back stock is due to poor corporate governance. 

The Follow Up
I agree that wage stagnation and an unwillingness to invest into the industrial base are significant problems for US companies, but I think that buybacks are more a symptom of global economic changes, than a cause. In particular, globalization has made it more difficult for companies to generate sustained returns on investments,  and has made earnings more volatile for all businesses.  The lower returns on investments has led to more cash being returned, and the fear of earnings volatility has tilted companies away from dividends, which are viewed as more difficult to back out of, to buybacks. In conjunction, a shift from an Industrial Age economy to the economies of today has meant that our biggest businesses are less capital intensive and more dependent on investments in intangible assets, a trend that accounting has not been able to keep up with.  You can ban or restrict buybacks, but that will not make investment projects more lucrative and earnings more predictable, and it certainly is not going to create a new industrial age.
If you came into this article with a strong bias against buybacks it is unlikely that I will be able to convince you that buybacks are benign, and it is very likely that you will be in favor, like Senators Schumer and Sanders, on restricting not just buybacks, but cash returns (including dividends), in general. Playing devil’s advocate, let’s assume that you succeed and play out what the effects of these restrictions will be on how much companies invest collectively and employee wages.
  • On the investment front, it is true that companies that used to buy back large numbers of their own shares will now have more cash to invest, but in what? It could be in more internal investments or projects, but given that many of these companies were buying back stock because they could not find good projects in the first place, it would have to be in projects that don’t earn a high enough returns to cover their hurdle rates. Perhaps, it will be in acquisitions, and while that will make M&A deal makers happy, the corporate track record is woeful. In either case, you will have more reinvestment in the wrong segments of the economy, at the expense of investments in the segments that need them more.
  • On the wage front, the consequences will be even messier. It is possible that tying buybacks to employee wages, as Senators Schumer and Sanders propose, will cause some companies to raise wages for existing employees, but with what consequences? Since they will now be paying much higher wages than their competitors, my guess is that these same companies will  be quicker to shift to automation and will have smaller workforces in the future, and that those at the low end of the pay scale will be most hurt by this substitution. 
Illustrating my point about anecdotal evidence, the senators use Walmart and Harley Davidson to make their case, arguing that both companies should not have expended the money that they did on buybacks, and taken investments or raised wages instead. 
  • Assuming that Walmart had followed their advice and not bought back stock and invested instead, it is unlikely that Walmart would have opened more stores in the United States, a saturated market, but would have opened them instead in other countries, and I don’t believe that the senators would view more stores being built in Indonesia or India as the outcome they were hoping for. As for Harley Davidson, a company that serves a loyal, but niche market, building another factory may have created more jobs for the moment, but it is not at all clear that the demand exists for the bikes that would roll out.
  • Would Walmart have raised wages, if they had not bought back stock? In a retail landscape, where Amazon lays waste to any competitor with a higher cost structure, that would have been suicidal, and accelerated the flow of customers to Amazon, allowing that company to become even more dominant. In a world where people complain about how the FANG stocks are taking over the world, you would be playing into their hands, by handcuffing their brick and mortar competitors, with buyback legislation.
In short, restricting buybacks may lead to more reinvestment, but much of it will be in bad businesses, acquisitions of existing entities and often in other countries. Tying buybacks to employee wage levels may boost the pay for existing employees, but will lead to fewer new hires, increasing automation and smaller workforces over time. In short, the ills that the Schumer-Sanders bill tries to cure will get worse, as a result of their efforts, rather than better.
I believe that the shift to buybacks reflects fundamental shifts in competition and earnings risk, but I don't wear rose colored glasses, when looking at the phenomenon. There are clearly some firms that are buying back stock, when they clearly should not be, paying out cash that could be better used on paying down debt, especially in the aftermath of the reduction of tax benefits of debt, or taking investments that can generate returns that exceed their hurdle rates. You may consider me naive, but I believe that the market, while it may be fooled for the moment, will catch on and punish these firms. Also, the data suggests that these bad players are more the exception than the rule, and banning all buybacks or writing in restrictions on buybacks for all companies strikes me as overkill, especially since the promised benefits of higher capital investment and wages are likely to be illusory or transitory. If you are tempted to back these restrictions, because you believe they are well intentioned, it is worth remembering that history is full of well intentioned legislation delivering perverse results. 
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The Low-Priced Way to Lose Money in the Stock Market - safalniveshak

Author: Tan KW   |  Publish date: Thu, 7 Feb 2019, 11:26 PM

Once upon a time, I used to recommend stocks. I did that for a living.

One of the most common questions I received when I recommended a stock priced in three or four digits was this – “What is the point of buying a stock this expensive? Recommend something under Rs 100, or better, Rs 10, or better, Rs 5.”

The reasoning was simple – “It’s easier for a Rs 10 stock to go Rs 100, than for a Rs 1,000 stock to go to Rs 10,000.”

At the start of my career, this reasoning sounded reasonable. But it turned out to be one of the biggest misconceptions I’ve ever had in my career as a stock analyst and investor. Thankfully, I got over that misconception early.

Of course, a car that sells at Rs 20 lac may be more expensive than one that sells at Rs 5 lac, even when you discount for better features etc. But a stock that sells for Rs 2,000 or even Rs 20,000 is “not” more expensive than a stock that sells for Rs 20 or Rs 200, just because of its price tag.

In fact, it’s never about the price in stock investing. It’s always about the price-to-value offered, or price-to-underlying business quality.

The stock of Asian Paint, for instance, is priced at Rs 1,460 as I write this. The stock of MRF if priced at Rs 60,000. Now, if I were to go purely by stock prices, MRF certainly looks like a much bigger company or a more expensive stock as compared to Asian Paints.

But, consider this. While Asian Paints’ stock price is just 2.5% of MRF’s stock price, the former’s market capitalization of Rs 140,000 crore (stock price multiplied by number of shares) is 560% (or 5.6 times) of the latter’s Rs 25,000 crore.

What is more, if I were to consider the price-to-earnings multiples, Asian Paint’s P/E of 65x is 300% (or 3 times) of MRF’s P/E of 21x.

That makes MRF’s stock, priced at Rs 60,000, much cheaper than Asian Paints’ stock, priced at Rs 1,460.

Now consider the most expensively “priced” stock in the world, that of Warren Buffett’s Berkshire Hathaway. Its current price is US$ 308,810 (Rs 2.2 crore, per share!). Market cap is US$ 500 billion, or 25% of the total market cap of all listed stocks on the Bombay Stock Exchange. This makes the stock look so-so expensive, right?



Now, what’s Berkshire’s P/E? As per Yahoo Finance, it’s 8.2x. This makes the stock much cheaper than the cheapest of large companies in India. We are not going into details of what makes Berkshire’s P/E so low. But you got the point, right?


It is that the stock price alone never tells you whether a company’s shares are expensive or not. To know that, you must relate the price to something in the denominator, like sales, earnings, and book value (even these don’t tell much about a stock’s cheapness or expensiveness but are reasonable indicators). You must also assess the underlying quality and economics of the business. An Infosys at 10x P/E is cheap. A Tata Steel at 10x P/E may not be so (commodity stocks trade at low P/Es due to cyclicality).

Let’s look at one more example. Suzlon Energy’s stock is priced at under Rs 4 now. Its market cap is Rs 2,100 crore. An investor looking just at these numbers would say, “Isn’t it easy for Rs 4 to go to Rs 20? That would make it a 5-bagger!”

My dear friend, that’s one way to look at it. But isn’t Rs 4 closer to Rs 0 than to Rs 10 or Rs 20? What stops Suzlon from going to zero? The stock is anyways down 99% from its peak of 2008.

Here, one common misconception a lot of people have is – “The stock has already fallen by 99%. How much more can it fall?”


Well, a stock that falls 99%, first fell 90%, and then 90%. What stops it from falling another 90%?

Yes, it happens sometimes that some low-priced stocks double and triple in quick time? But you won’t like the reason why this happens most of the time.

Low-priced stocks, especially the ones from the small and penny cap spaces tend to be thinly traded. So, they can skyrocket briefly on a news release or a recommendation or plain rumour, and then plunge just as quickly. Not to forget the fraud and market manipulation rampant in such stocks that ultimately cause massive losses to the gullible investors who wander into this swamp.

Of course, fraud and manipulation – business wise or in the stock market – is also seen in stocks from the more established mid and large-cap spaces, as we saw in a few cases recently. But low-priced stocks, especially from the small and penny cap spaces, are hotbeds of such evils. The base rate of succeeding here is very poor.

All in all, it comes back to the same cardinal rule that you must stop looking at stock prices while making your investment decisions.

A low price does not automatically mean cheapness and guarantees future greatness, like a high price does not automatically mean expensiveness and guarantees future mediocrity.

As a quick thumb rule, look at the P/E ratio of the stock you are studying to find out whether it’s cheap or expensive. Take the current stock price as ‘P’ and last 12-months earnings per share as ‘E’. Better, take last 3-5 years’ average earnings per share. Compare this P/E with P/E of other stocks in the industry and with the stock’s own past P/E track record.

If the stock’s P/E is lower than its peers’ or from its past, explore the reasons. Maybe the business is worse than its peers or has deteriorated in terms of sales and profit growth, or the profit margin or return on capital has come down, or maybe the debt level has increased.

If you find nothing wrong with the business’s fundamentals, the stock deserves a deeper look, for its relative undervaluation. Study that.

But, again, never ever count on a stock’s price to tell you that it is cheap or expensive, in an absolute or relative basis.

Doing that is not just lazy, but silly.





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A Cheat Sheet To Avoid Stock Market Ruin - safalniveshak

Author: Tan KW   |  Publish date: Tue, 5 Feb 2019, 07:36 PM

February 5, 2019 

In his latest book, Skin in the Game, Nassim Taleb runs an interesting thought experiment where he talks about two cases of playing the casino.

Equate the first case with ‘stock market trading’ in general –

…one hundred people go to a casino to gamble a certain set amount each over a set period of time, and have complimentary gin and tonic. Some may lose, some may win, and we can infer at the end of the day what the “edge” is, that is, calculate the returns simply by counting the money left in the wallets of the people who return. We can thus figure out if the casino is properly pricing the odds.

Now assume that gambler number 28 goes bust. Will gambler number 29 be affected? No.

You can safely calculate, from your sample, that about 1 percent of the gamblers will go bust. And if you keep playing and playing, you will be expected to have about the same ratio, 1 percent of gamblers going bust, on average, over that same time window.

Now consider the second case in the thought experiment. Equate this with an ‘individual’ trading the stock market –

One person, your cousin…goes to the casino a hundred days in a row, starting with a set amount. On day 28, your cousin is bust. Will there be day 29? No…there is ‘no game no more.’

No matter how good or alert your cousin is, you can safely calculate that he has a 100 percent probability of eventually going bust. The probabilities of success from a collection of people do not apply to your cousin.

Now, you may blame the disastrous outcome of your cousin on, well, your cousin. He may have been foolish, you may think, who did not understand that the longer you play in a casino the more you stand to lose (the house always wins).

But what Taleb writes about is a nice mental model to remember when you are reading finance books or are being recommended stocks based on the long-term returns of the market. How your cousin behaved in the above thought experiment is how most people, old or new, behave in the stock market when they play the game as if it were a casino (trading, speculating, etc.).

Remember that you or me are not the market. Earning the long-term returns of the market, of the past or the future, is not in our control. Managing our risks and avoiding ruin, mostly is.

“Rationality is avoidance of systemic ruin,” Taleb writes.

Trying to avoid the ruin the stock market system enforces upon people who disregard its workings is rational. Believing that you can beat the system at it, by playing the game mindlessly, isn’t.

Someone wise once said –

People destroy themselves in unique interesting ways. Systems destroy people in uniform boring ways.

Now the problem with beating the system for some time is that we get a swelled head. We start believing that if the stock we have invested in has earned us magnificent returns over the past 2-3 months or years, it was entirely an element of our skill and no luck. Yes, that’s how the mind behaves and makes us believe.

But then, as Jesse Livermore, one of the world’s best speculators, who committed suicide after going bankrupt the fourth time, reminds us –

A great many smashes by brilliant men can be traced directly to the swelled head — an expensive disease everywhere to everybody, but particularly…to a speculator.

Now, if that’s not all, consider path dependence that in simple terms explains how history really matters – where we have been in the past determines where we currently are and where we can go in future.

As Taleb writes in Skin in the Game

Assume that your capital is around one million dollars and you are involved in speculation. Apply path dependence to the reasoning.

Making a million dollars first, then losing it, is markedly different from losing a million dollars first then making it.

The first path (make-lose) leaves you intact; the second (lose) makes you bankrupt, insolvent, maimed, traumatized and more generally unable to stay in the game, thus unable to benefit from the second part of the sequence. There is no ‘make’ after the ‘lose.’

Anyways, ultimately, the lessons?

First, you are not the market. So, stop looking at market returns. Don’t yield into the false promise that “in the long term, you will earn a minimum of 15% because that’s what the market has earned in the past.”

Second, don’t speculate, again because you are not the market made up of people who may seem to be doing well (for some time) speculating. Also, stocks are pieces of underlying businesses. Respect that and you have a great chance of doing well over the long run. Remember Warren Buffett who said – “If you’re even a slightly above average investor who spends less than you earn, over a lifetime you cannot help but get very wealthy – if you’re patient.”

Third, if you really wish to speculate (but never with other people’s money), first earn at least a million (through hard work at your place of work, and investing) and then speculate with a small part of it so that you don’t end up in total ruin. Call this money you use for speculation as ‘sin money,’ so that mentally prohibits you from committing a lot of sins. Remember that smoking a single cigarette, like speculating just once and with a small amount of money, is benign. But their constant repetition (“just one more time”) takes you closer towards ruin.

Fourth, the only way to do well in investing is to survive. As Peter Bernstein writes in his brilliant book Against the Gods“Survival is the only road to riches. Let me say that again: Survival is the only road to riches.”

In life and investing, I wish you survival.

Because if you survive, you will be rich, my friend.





  wwwcomment likes this.
calvintaneng Good one!
All must read and take heed!!
05/02/2019 22:30
wwwcomment Not fully understand it but Love it.
06/02/2019 10:17
speakup https://malaysia.news.yahoo.com/deputy-minister-marzuki-reveals-did-124917446.html
like that speakup also can speakup say went to Oxford U! but never study in Oxford U.
this Bersatu want to tipu only!
07/02/2019 09:29
stockraider Again a template is set to avoid over paying...!!

Thanks sifu calvin for the posting
08/02/2019 19:30

January 2019 Data Update 7: Debt, neither poison nor nectar! - Aswath Damodaran

Author: Tan KW   |  Publish date: Tue, 5 Feb 2019, 07:35 PM

Tuesday, February 5, 2019

Debt is a hot button issue, viewed as destructive to businesses by some at one end of the spectrum and an easy value creator by some at the other. The truth, as is usually the case, falls in the middle. In this post, I will look not only at how debt loads vary across companies, regions and industries, but also at how they have changed over the last year. That is because last year should have been a consequential one for financial leverage, especially for US companies, since the corporate tax rate was reduced from close to 40% to approximately 25%. I will also put leases under the microscope, converting lease commitments to debt, as I have been doing for close to two decades, and look at the effect on  profit margins and returns, offering a precursor to changes in 2019, when both IFRS and GAAP will finally do the right thing, and start treating leases as debt.
The Debt Trade Off
Debt is neither an unmixed good nor an unmitigated disaster. In fact, there are good and bad reasons for companies to borrow money, to fund operations, and in this section, I will look at the trade off, and look at the implications for what types of businesses should be the biggest users of debt, and which ones, the smallest.
The Pluses and Minuses
There are only two ways you can raise capital to fund a business. One is to use owner funds, which can of course range from personal savings in a small start up to issuing shares to the market, for a public company. The other is to borrow money, again ranging from a loan from a family member or friend to bank debt to corporate bonds. The debt equity trade off then boils down to what debt brings to the process, relative to equity, in both good and bad ways.
The two big elements driving whether a company should borrow money are the tax code, and how heavily it is tilted towards debt, on the good side and the increased exposure to default and distress, that it also creates, on the bad side. Simply put, companies with stable and predictable earnings streams operating in countries, with high corporate tax rates should borrow more money than companies with unstable earnings or which operate in countries that either have low tax rates or do not allow for interest tax deductions. For financial service firms, the decision on debt is more complex, since debt is less source of capital and more raw material to a bank. As a consequence, I will look at only non-financial service firms in this post, but I plan to do a post dedicate to just financial service firms.
US Tax Reform - Effect on Debt
If one of the key drivers of how much you borrow is the corporate tax code, last year was an opportunity to see this force in action, at least in the US. At the start of 2018, the US tax code was changed in two ways that should have affected the tax benefits of debt:
  1. The federal corporate tax rate was lowered from 35% to 21%. Adding state and local taxes to this, the overall corporate tax rate dropped from close to 40% to about 25%.
  2. Restrictions were put on the deductibility of interest expenses, with amounts exceeding 30% of taxable income no longer receiving the tax benefit.
Since there were no significant changes to bankruptcy laws or costs, these tax code changes make debt less attractive, relative to equity, for all US companies. In fact, as I argued in this post at the start of 2018, if US companies are weighing the pros and cons correctly, they should have reduced their debt exposure during the course of 2018.

While I have data only through through the end of the third quarter of 2018, I look at the change in total debt, both gross and net, at non-financial service US companies, over the year (by comparing to the debt at the end of the third quarter of 2017).
Download debt change, by industry
In the aggregate, US non-financial service companies did not reduce debt, but instead added $434 billion to their debt load, increasing their total debt from $6,931 billion to $7,365 billion between September 2017 and September 2018. That represented only a 6.26% increase over the year, and was accompanied by a decline in debt as a percent of market capitalization, but that increase is still surprising, given the drop in the marginal tax rate and the ensuing loss of tax benefits from borrowing. There are three possible explanations:
  1. Inertia: One of the strongest forces in corporate finance is inertia, where companies continue to do what they have always done, even when the reasons for doing so have long since disappeared. It is possible that it will be years before companies wake up to the changed tax environment and start borrowing less.
  2. Uncertainty about future tax rates: It is also possible that companies view the current tax code as a temporary phase and that the drop in corporate tax rates will be reversed by future administrations.
  3. Illusory and Transient Benefits: Many companies perceive benefits in debt that I term illusory, because they create value, only if you ignore the full consequences of borrowing. I have captured these illusory benefits in the table below: Put simply, the notion that debt will lower your cost of capital, just because it is lower than your cost of equity, is widely held, but just not true, and while using debt will generally increase your return on equity, it will also proportionately increase your cost of equity.
I will continue tracking debt levels through the coming years, and assuming no bounce back in corporate tax rates, we should get confirmation as to whether the tax hypothesis holds.
Debt: Definition
The tax law changed the dynamics of the debt/equity tradeoff, but there is an accounting change coming this year, which will have a significant impact on the debt that you see reported on corporate balance sheets around the world, and since this is the debt that most companies and data services use in measuring financial leverage. Specifically, accountants and their rule writers are finally going to come to their senses and plan to start treating lease commitments as debt, plugging what I have always believed is the biggest source of off balance sheet debt.
Debt: Definition
In my financing construct for a business, I argue that there are two ways that a business, debt (bank loans, corporate bonds) and equity (owner's funds), but to get a sense of how the two sources of capital vary, I looked at the differences:

Specifically, there are two characteristics that set debt apart from equity. The first is that debt creates a contractual or fixed claim that the firm is obligated to meet, in good and bad times, whereas equity gives rise to a residual claim, where the firm has the flexibility not to make any payments, in bad times. The second is that with debt, a failure to meet a contractual commitment, will lead to a loss of control of the firm and perhaps default, whereas with equity, a failure to meet an expected commitment (like paying dividends) can lead to a drop in market value but not to distress. Finally, in liquidation, debt holders get first claim on the assets and equity gets whatever, if any, is left over. Using this definition of debt, we can navigate through a balance sheet and work out what should be included in debt and what should not. If the defining features for debt are contractual commitments, with a loss of control and default flowing from a failure to meet them, it follows that all interest bearing debt, short term as well as long term, bank loans and corporate bonds, are debt. Staying on the balance sheet, though, there are items that fall in a gray area:
  1. Accounts Payable and Supplier Credit:  There can be no denying that a company has to pay back supplier credit and honor its accounts payable, to be a continuing business, but these liabilities often have no explicit interest costs. That said, the notion that they are free is misplaced, since they come with an implicit cost. To make use of supplier credit, for instance, you have to give up discounts that you could have obtained if you paid on delivery. The bottom line in valuation and corporate finance is simple. If you can estimate these implicit expenses (discounts lost) and treat them as actual interest expenses, thus altering your operating income and net income, you can treat these items as debt. If you find that task impossible or onerous, since it is often difficult to back out of financial reports, you should not consider these items debt, but instead include them as working capital (which affects cash flows).
  2. Underfunded Pension and Health Care Obligations: Accounting rules around the world have moved towards requiring companies to report whether their defined-benefit pension plans or health care obligations are underfunded, and to show that underfunding as a liability on balance sheets. In some countries, this disclosure comes with legal consequences, where the company has to set aside funds to cover these obligations, akin to debt payments, and if this is the case, they should be treated as debt. In much of the world, including the United States, the disclosure is more for informational purposes and while companies are encouraged to cover them, there is no legal obligation that follows. In these cases, you should not consider these underfunded obligations to be debt, though you may still net them out of firm value to get to equity value.
The table below provides the breakdown of debt for non-financial service companies around the world.
Debt Details, by Industry (US)
As you browse this table, please keep in mind that disclosure on the details of debt varies widely across companies, and this table cannot plug in holes created by non-disclosure. To the extent that company disclosures are complete, you can see that there are differences in debt type across regions, with a greater reliance on short term debt in Asia, a higher percent of unsecured and fixed rate debt in Japan and more variable rate, secured debt in Africa, India and Latin America than in Europe or the US. You can get the debt details, by industry, for regional breakdowns at the link at the end of this post.

Debt Load: Balance Sheet Debt
Using all interest bearing debt as debt in looking at companies, we can raise and answer fundamental questions about leverage at companies. Broadly speaking, the debt load at a company can be scaled to either the value of the company or to its earnings and cash flows. Both measures are useful, though they measure different aspects of debt load:

a. Debt and Value
Earlier, I noted that there are two ways you can fund a business, debt and equity, and a logical measure of financial leverage that follows is to look at how much debt a firm uses, relative to its equity. That said, there are two competing measures of value, and especially for equity, the divergence can be wide.
  • The first is the book value, which is the accountant's estimate of how much a business and its equity are worth. While value investors attach significant weight to this number, it reflects all of the weaknesses that accounting brings to the table, a failure to adjust for time value of money, an unwillingness to consider the value for current market conditions and an inability to deal with investments in intangible assets. 
  • The second is market value, which is the market's estimate, with all of the pluses and minuses that go with that value. It is updated constantly, with no artificial lines drawn between tangible and intangible assets, but it is also volatile, and reflects the pricing game that sometimes can lead prices away from intrinsic value.
In the graph below, I look at debt as a percent of capital, first using book values for debt and equity, and next using market value.
Debt ratios, by industry (US)
In the table below, I break out debt as a percent of overall value (debt + equity) using both book value and market value numbers, and look at the distribution of these ratios globally:

Embedded in the chart is a regional breakdown of debt ratios, and even with these simple measures of debt loads, you can see how someone with a strong  prior point of view on debt, pro or con, can find a number to back that view. Thus, if you want to argue as some have that the Fed (which is blamed for almost everything that happens under the sun), low interest rates and stock buybacks have led US companies to become over levered, you will undoubtedly point to book debt ratios to make your case. In contrast, if you have a more sanguine view of financial leverage in the US, you will point to market debt ratios and perhaps to the earnings and cash flow ratios that I will report in the next section. On this debate, at least, I think that those who use book value ratios to make their case hold a weak hand, since book values, at least in the US and for almost every sector other than financial, have lost relevance as measures of anything, other than accounting ineptitude.
b. Debt and Earnings/Cashflows
Debt creates contractual obligations in the form of interest and principal payments, and these payments have to be covered by earnings and cash flows. Thus, it is sensible to measure how much buffer, or how little, a firm has by scaling debt payments to earnings and cash flows, and here are two measures:
  • Debt to EBITDA: It is true that EBITDA is an intermediate cash flow, not a final one, since you still have to pay taxes and invest in growth, before you get a residual cash flow. That said, it is a proxy for how much cash flow is being generated by existing investments, and dividing the total debt by EBITDA is a measure of overall debt load, with lower numbers translating into less onerous loads.
  • Interest Coverage Ratio: Dividing the operating income (EBIT) by interest expenses, gives us a different measure of safety, one that is more immediately tied to default risk and cost of debt than debt to EBITDA. Firms that generate substantial operating income, relative to interest expenses, are safer, other things remaining equal, than firms that operate with lower interest coverage ratios. 
In the table below, I look at the distributions of both these numbers, again broken down by region of the world:
Debt ratios, by industry (US)
Again, the story you tell can be very different, based upon which number you look at. Chinese companies have the most debt in the world, if you define debt as gross debt, but look close to average, when you look at net debt. Indian companies look lightly levered, if you look at Debt to EBITDA multiples, but have the most exposure to debt, if you use interest coverage ratios to measure debt load.
Operating Leases: The Accounting Netherworld
Going back to the definition of debt as financing that comes with contractually set obligations, where failure to meet these obligations can lead to loss of control and default, it is clear that focusing on only the balance sheet (as we have so far) is dangerous, since there are other claims that companies create that meet these conditions. Consider lease agreements, where a retailer or a restaurant business enters into a multi-year agreement to make lease payments, in return for using a store front or building. The lease payments are clearly set out by contract, and failing to make these payments will lead to loss of that site, and the income from it. You can argue that leases providing more flexibility that a bank loan and that defaulting on a lease is less onerous, because the claims are against a specific location and not the business, but those are arguments about whether leases are more like unsecured debt than secured debt, and not whether leases should be treated as debt. For much of accounting history, though, accountants have followed a different path, treating only a small subset of leases as debt and bringing them on to the balance sheet as capital leases, while allowing the bulk of lease expenses as operating expenses and ignoring future lease commitments on balance sheets. The only consolation prize is that both IFRS and GAAP have required companies to show these lease commitments as footnotes to balance sheets.

In my experience, waiting for accountants to do the right thing will leave you twisting in the wind, since it seems to take decades for common sense to prevail. Consequently, I have been treating leases as debt for more than three decades in valuation, and the process for doing so is neither complicated nor novel. In fact, it is the same process that accountants use right now with capital leases and it involves the following steps:
  1. Estimate a current cost of borrowing or pre-tax cost of debt for the company today, given its default risk and current interest rates (and default spreads).
  2. Starting with the lease commitment table that is included in the footnotes today, discount each lease commitment back to today, using the pre-tax cost of debt as your discount rate (since the lease commitments are pre-tax). Most companies provide only a lump-sum value for commitments after year 5, and while you can act as if this entire amount will come due in year 6, it makes more sense to convert it into an annuity, before discounting.
  3. The sum total of the present value of lease commitments will be the lease debt that will now show up on your balance sheet, but to keep the balance sheet balanced, you will have to create a counter asset. 
  4. To the extent that the accounting has treated the current year's lease expense as an operating expense, you have to recompute the operating income, reflecting your treatment of leases as debt:
Adjusted Operating Income = Stated Operating Income + Current year's lease expense - Depreciation on the leased asset

Capitalizing leases will have large consequences for not just debt ratios at companies (pushing them for companies with significant lease commitments) but also for operating profitability measures (like operating margin) and returns on invested capital (since both operating income and invested capital will be changed). The effects on net margin and return on equity should either be much smaller or non-existent, because equity income is after both operating and capital expenses, and moving leases from one grouping to another has muted consequences. In the table below, I report on debt ratio, operating margin and return on capital. before and after the lease adjustment :
Lease Effect, by Industry, for US
You can download the effects, by industry, for different regions, by using the links at the bottom of this post.  Keep in mind, though, that there are parts of the world where lease commitments, though they exist, are not disclosed in financial statements, and as a consequence, I will understate the else effect, While the effect is modest across all companies, the lease effect is larger in sectors that use leases liberally in operations, and to see which sectors are most and least affected, I looked at the ten   sectors, among US companies, and not counting financial service firms, that saw the biggest percentage increases in debt ratios and the ten sectors that saw the smallest in the table below:
Lease Effect, by Industry, for US
Note that there are a large number of retail groupings that rank among the most affected sectors, though a few technology companies also make the cut. As I noted at the start of this post, this year will be a consequential one, since both GAAP and IFRS will start requiring companies to capitalize leases and showing them as debt. While I applaud the dawning of sanity, there are many investors (and equity research analysts) who are convinced that this step will be catastrophic for companies in lease-heavy sectors, since it will be uncover how levered they are. I am less concerned, because markets, unlike accountants, have not been in denial for decades and market prices, for the most part and for most companies, already reflect the reality that leases are debt. 
Debt: Final Thoughts
One of the biggest impediments to any rational discussion of debt's place in capital is the emotional baggage that we bring to that discussion. Debt is neither poison, as some detractors claim it to be, nor is a nectar, as its biggest promoters describe it. It is a source of capital that comes with fixed commitments and the risk of default, good for some companies and bad for others, and when it does create value, it is because the tax code it tilted towards it. It is true that some companies and investors, especially those playing the leverage game, over estimate its benefits and under estimate its side costs, but they will learn their lessons the hard way. It is also true that other companies and investors, in the name of prudence, think that less debt is always better than more debt, and no debt is optimal, and they too are leaving money on the table, by being too conservative.

YouTube Video

  1. Debt Change, by Industry Group for US companies, in 2019
  2. Debt Details, by Industry Group in 2019 for US, Europe, Emerging Markets, Japan, Australia & Canada, India and China
  3. Debt Ratios, by Industry Group in 2019 for USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
  4. Lease Capitalization Effects, by Industry Group in 2019 for USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China




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Ben Graham: Just Plain Lucky? - safalniveshak

Author: Tan KW   |  Publish date: Wed, 30 Jan 2019, 02:23 PM

Remember Ben Graham, the guy who wrote The Intelligent Investor? And who taught Warren Buffett to become Warren Buffett?

Well, if you really know who Graham was, you also know that he is associated with buying something cheap (one dollar worth at fifty cents) and then selling it when it reaches a value that reflects what it’s worth.

A very copybook, calculated approach, right? Like what a Rahul Dravid would do in cricket.

But, for once, go back and read the postscript of The Intelligent Investor (Pg. 532), where Graham shares a story of some other kind. He starts by describing two partners of an investment firm who –

…combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results.

In short, these were conservative, well-diversified investors who played it very safe with their and other people’s money. Like Graham is known to have always advocated.

Anyhow, somewhere in 1948, these partners found an opportunity to purchase around 50% of a growing business. They were so impressed by this opportunity that they broke their rule and invested around 25% of the assets they managed into this single stock.

This was, Graham wrote, “…a highly unusual departure for the conservative managers, who normally diversified widely and seldom invested more than 5% or so in any one holding.”

Anyways, over years, this stock went up more than 200-times, and the partners didn’t sell it, again breaking their rule of selling stocks when they reached fair values. This was even though they couldn’t justify keeping it based on their strict standards of valuation and margin of safety they otherwise practiced.

Graham added in the Postscript –

Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

In cricketing parlance, these partners who had always played their game like Rahul Dravid, pinch-hit a big one like Virendra Sehwag, and succeeded massively at that.

“Are there morals to this story of value to the intelligent investor?” asks Graham, and then provides an answer –

…one lucky break, or one supremely shrewd decision – can we tell them apart? – may count for more than a lifetime of journeyman efforts.

Remember these words of the father of value investing when you find a fund manager boasting about how skillful he is at picking stocks.

Well, to spill the beans, one of the abovementioned partners was Graham himself (yes, Graham himself!). The stock was the insurance company GEICO, and Graham credited much of this phenomenal success to luck alone.

How big the success it really was? Graham’s fund’s $712,500 investment in GEICO turned to more than $400 million in 25 years. In Peter Lynch parlance, Graham had hit upon a 500 bagger!

Graham suggested that he got tremendously lucky with GEICO. But was that just luck? No!

As he added to the Postscript –

…behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them.

Ultimately, what’s the moral of the story of Graham’s tryst with GEICO?

We investors tend to think it’s easy to be a successful investor. The ultra-successful, even though they are few, have an outsized effect on us. We believe we can succeed because they did, and ignore the role of luck in their success.

Investing in a game of probabilities. Uncertainty rules the roost here. And thus, luck plays an important part in separating winners from losers.

Unfortunately, even if the achievement is purely random, as in coin flipping or in stock investing, we usually look back and credit the successful individual with great skill for having accomplished it. We make many mistakes of this type, attributing skill to a person who had only luck.

Our tendency to base decisions on observed success, while ignoring unobserved failure, is called the survivorship bias. Graham wouldn’t have been known to us if he had failed in his big bet on GEICO. Or he may have been known as just another “successful” fund manager who attributed his success entirely to his skill in identifying the stock early. Like he is quoted as saying this in 1976 –

In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people.

The world of investing, like most things in life, produces success stories and failures. It’s human nature to wish to copy success. However, the ironic truth is this: To accept success at face value without acknowledging the role of luck is a strategy for failure. Graham, in being lucky with GEICO, knew this well.

But it’s also important to note that luck, like love, is a verb. It requires dedication and effort and the conviction and courage to act. Like Graham wrote –

…behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity.

Another key lesson here is that of not selling your winning stock just because you think it has reached fair value or has gotten overpriced. Thank Graham for breaking this rule that he had himself practiced so strictly. GEICO started off as a value investment, but as the business grew, Graham held on and reaped the benefits over a 25-year period.

In fact, the reason Graham deliberately concentrated in GEICO was that his analysis showed it was undervalued and provided an asymmetric outcome. He played down this very important ‘skill’ part in the entire process of making money on GEICO.

The way to win in the stock market, according to Charlie Munger, is to work, work, work, work and hope to have a few insights. The question is – how many insights do you need in your investing lifetime?

Not many, as Munger says (and Graham proved with GEICO) –

…you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man — Warren’s a lot more able than I am and very disciplined—devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying, that most of the money came from ten insights.

…you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.

To conclude, here is a formula, derived from Graham’s investment in GEICO, to create wealth from stock market investing over time – Be prepared and wait for a high-quality business at reasonable price, stick with it over time till the business does well, then be humble to credit luck more than your skill for whatever success you achieve, and repeat this process if you get another fat pitch. Rest of the time, don’t act much. That will be your true skill.

And yes, please read The Intelligent Investor.



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qqq3 good article, less people think to be a rubbish collector with margin of safety is the way to go.......

the word margin of safety has no place in equity investments, IMO.....

s= Qr....if the r is good and the Q is good, u ride the story for what it is.....
30/01/2019 14:42
qqq3 cigar butts investing is not the way to go
30/01/2019 16:13
qqq3 neither is trying to arbitrage your valuations vs market valuations.....

people who regularly go do such arbitrage have egos bigger than their brains....that is all......
30/01/2019 16:16
3iii Graham’s investment in GEICO, to create wealth from stock market investing over time – Be prepared and wait for a high-quality business at reasonable price, stick with it over time till the business does well, then be humble to credit luck more than your skill for whatever success you achieve, and repeat this process if you get another fat pitch. Rest of the time, don’t act much. That will be your true skill.
30/01/2019 16:38
3iii The way to win in the stock market, according to Charlie Munger, is to work, work, work, work and hope to have a few insights. The question is – how many insights do you need in your investing lifetime?

Not many, as Munger says (and Graham proved with GEICO) –

…you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man — Warren’s a lot more able than I am and very disciplined—devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying, that most of the money came from ten insights.

…you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.
30/01/2019 16:38
deMusangking dun quote another person's idea lah!! where is ur idea?
30/01/2019 16:45
3iii Another key lesson here is that of not selling your winning stock just because you think it has reached fair value or has gotten overpriced. Thank Graham for breaking this rule that he had himself practiced so strictly. GEICO started off as a value investment, but as the business grew, Graham held on and reaped the benefits over a 25-year period.
30/01/2019 17:09
geary Some people don't anyhow said things...U know GEICO nearly gone bankrupt n the owner committed suicide...Well why Graham n Buffett invested so much in it...n the rest is history. They are well prepared n disciplined...n did bought with huge Margin of Safety...n it started to grow again under a new CEO. Good luck...!!!
30/01/2019 17:26
stockraider Don forget Ben Graham says he is lucky loh....!!

The author also acknowledge that is luck too mah...!!

Remember General Raider also did the samething too on hengyuan loh....!!

Bought Rm 3.00 hengyuan and the stock shoot up to Rm 19.00 raider has been calling for bullish all the way in its rise mah, in fact raider decide to hold on the wonderful gain and even call for further buy at rm 15.00, bcos the financial further support tp of rm 45.00, but unlike graham Geico, raider not so lucky holding on hengyuan, as earnings disappointment subsequently set in, the stock tumble to rm 13.00, raider quickly call for a sell & lari kuat kuat loh...!!

This is not following MOS rules loh...!!

However, Luckily loh....raider skillful to call for sell rm 13.00 hengyuan, as price stop is trigger loh, if not alot of people will die standing mah....!!

That is the benefit of General raider, can move forward, stop and reverse not like soochai 3iii and philip know only drive forward loh...!!

This means even raider divert from MOS rules to achieve higher gain but raider know how to set safeguard mah...!!

Don listen to soochai 3iii, breaking the MOS rules is dangerous, especially driver like 3iii & philip who only know how to go fwd but do not know how to brake & reverse car loh...!!

Posted by 3iii > Jan 30, 2019 04:38 PM | Report Abuse

Graham’s investment in GEICO, to create wealth from stock market investing over time – Be prepared and wait for a high-quality business at reasonable price, stick with it over time till the business does well, then be humble to credit luck more than your skill for whatever success you achieve, and repeat this process if you get another fat pitch. Rest of the time, don’t act much. That will be your true skill.

Posted by 3iii > Jan 30, 2019 05:09 PM | Report Abuse

Another key lesson here is that of not selling your winning stock just because you think it has reached fair value or has gotten overpriced. Thank Graham for breaking this rule that he had himself practiced so strictly. GEICO started off as a value investment, but as the business grew, Graham held on and reaped the benefits over a 25-year period.
30/01/2019 17:30


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