How to understand risk reward modelling by Howard marks
The rise of stock market has really coincided with the reduction of interest rates around the world
The concept is simple
Interest rates provide the blanket of risk free rate, basically meaning the guaranteed return by government for you to store money with them
So all investing then becomes risk in relation to other deals
For example if buying us T-bills is giving you 2%
Then to take a larger risk we would need something like 4% to take a bank fixed deposit
Then 8% to buy corporate bonds
Then 10% returns to buy stocks
Etc so on so forth
That is the big mental model here
Same goes in investing in companies
You don't mind getting 3% dividends and returns investing in say pchem and public Bank
Rock solid blue chips with relatively low risk
A commensurate 5-8% investing in REITs with their 90% payout, fixed income
10-20% investing in growth stocks like yinson, serba, kpower, scib etc etc with higher operational risk
50% working at your job, 100% returns investing in a gold mine or franchise business
These are the minimum requirements for your returns for dabbling into risky ventures
If we look at it in relation to the government interest rate
The problem I see with a lot of investors is they do not know how to evaluate risk properly
Take for example this one...
How did this go to 50 billion?
How did it drop to 18 billion?
We need to start by evaluating risk and putting it on the proper world view
How risky is a business for you to invest in that has 200 employees, 300 million in funds, has never made a profit or has yet produced a commercial product and the only reason you are buying is because of a white paper, Volkswagen putting in a 1 billion fund merger and expectations of the future
The risk is very low, if the company was asking 500 million market cap valuation
The risk is astronomical if the company is asking 50 billion market cap valuation
Now looking at palantir, same risk reward analysis
You have an 18 year company with 1 billion in revenues
The relative risk is much lower when the asking price is 25 billion USD, at 14 per share
As it goes higher, the risk pops higher because now you are baking in future growth into it
Now looking at risk free rates, how about a 2 stocks I have begun a position in recently
Wilmar and China mobile
At 44 what am I getting into in China mobile? A company that is earning 100 billion yuan and pays 50 billion yuan in dividends or 7%
With roughly 50% payout
It is 70% of the China market with unicorn 20% and China telecom 10%
So you have to weigh in the lack of huge growth versus the risk free rate for holding the company
Obviously this valuation is only because delisting in USA is causing funds and investors to dump the stock
Buy when everyone is selling
But again... What kind of earnings am I looking at? Did China mobile earnings and revenues drop by half since last year?
The business itself has not changed
Yes it is not a go getter
Or a big growth company
But... The risk reward of the company is very low if you look at the business model, stability of business etc
For Wilmar same thing, boring rock solid companies that has slow growth, but very low risk versus reward rate
Buying this at 4.15, what do I get? A boring agriculture business
... With a huge cooking oil with 70% dominance of China.
The big question to ask is how much ownership of yihai does Wilmar own
And what is the relative valuation
The stock market is always very funny, the sum does not equal the parts
In the case the parts are worth more than Wilmar when it owned 90% of yihai Kerry?
Wilmar 30 billion... Yihai 100 billion
So the thing is here... You don't have to always invest in the new new thing like bitcoin and tech stocks etc for your returns
Sometimes... Boring simple to understand business is best
And what could be easier to understand than 70% market dominance of cooking oil
I hope you learned something new today.
Compliance: I have 5% weightage of Wilmar in my email@example.com, and 5% weightage of China mobile in my portfolio@44. Boring businesses.
This book is the result of the author's many years of experience and observation throughout his 26 years in the stockbroking industry. It was written for general public to learn to invest based on facts and not on fantasies or hearsay....
Yes now you understand the parts are worth more than Insas when it owned 545 million of Inari and everything else inside Insas.