Investment analysis: company analysis, industry analysis, economic analysis

I just realise I have posted twice on "Laws of Malaysia".
(Wonder what is wrong with the system)
So I edit one of the two posts to this post. :-)

You may see that I have posted more on economy recently.
It is just my personal preference to explore more on economy during this period of turbulence (or financial tsunami). During this period of time, many of the market/business/investment participants are in a "jittery" mode. Many stimulus/rescue packages, businesses asking for rescue, retrenchment, downsizing, debate of economic ideas/policies, volatile reactions, more fear, more greed…. the list goes on.

It is a good time to brush up on economy and economic theories.
However, for investment analysis, it is not only economic analysis.

For investment analysis,
company analysis, industry analysis, economic analysis are all important.
However, their relative importances are debatable.

If we proceed in sequence of company -> industry -> economy, it is called "bottom-up" approach.
If we proceed in sequence of economy ->industry -> company, it is called "top-down" approach.

My personal preference:
I place more importance on company analysis and industry analysis; but I didn’t ignore economic analysis. Need to know effects of economic situation/policies (exchange rate, interest rate change, credit situation, fiscal/monetary policy, state of economy etc..) to the company’s financial position, competitive position, etc. and effects on customers.

I didn’t strictly follow either "bottom-up" or "top-down" approach.
I proactively pick up bits and pieces of information on company, relevant industries (supplier, current industry, customer’s "industry") and relevant economic data;
add on to the "database";
decide based on the "database"..
More like when the three (company, industry, economy) clicks, then I buy or sell.

Company analysis is a must (but is quite a routine task, though may have pitfalls here and there);
I like industry analysis the most :-)

time value of money (2)

2. Discounted cashflow (DCF)

From FV = PV * (1 + r) ^n,
rearranging, we get:
PV = FV/ [(1 + r)^n]

Inversely, using the same examples from previous post,
$105 of 1 year later,
$110.25 of 2 year later,
$115.76 of 3 year later,
$162.89 of 10 year later
are all equivalent to $100, respectively.

It makes future value be able to "discount" back to present value.
If we convert all cashflow that we can get in the future to present,
we are using "discounted cashflow (DCF)".

time value of money (1)

If I’m to choose only one concept that is most important in investment, I will choose the concept of time value of money.

It can be used to elaborate a lot of important concepts in investment.
It is not difficult: its maths is learnt in secondary school.
I really hope this concept of time value of money can be taught in secondary school.

FV = PV * (1 + r) ^n
FV: future value
PV: present value
r: rate
n: number of years

1. Power of Compounding

To illustrate, $100 now, put in bank, at interest rate of 5%.
For
1 year: FV = $100 * (1+ 5%) ^ 1 = $105
2 year: FV = $100 * (1+ 5%) ^ 2 = $110.25
3 year: FV = $100 * (1+ 5%) ^ 3 = $115.76
……
10 year: FV = $100 * (1+ 5%) ^ 10 = $162.89
See how the value increases. This explains the power of "compounding effect".
(to be continued)

7 traits shared by great investors

Read an article by Mark Sellers "So you want to be the next Warren Buffett ? How’s your writing ?"
article
Is a good read !

The article touches on competitive advantage as an investor.
It was said that reading lots of books/magazines/newspaper, getting MBA/CFA/PhD/CPA/MS etc, experience do not guarantee great success as an investor.
The article emphasizes the importance of psychology.

The articles mentioned 7 traits shared by great investors that are true sources of advantage in investment.

Trait #1
Ability to buy stocks while others are panicking and sell stocks while others are euphoric.

Trait #2
Obsessive about playing the game (investment) and wanting to win.

Trait #3
Willingness to learn from past mistakes.

Trait #4
Inherent sense of risk based on common sense.

Trait #5
Have confidence in their own conviction and stick with them, even when facing criticism.

Trait #6
Have both sides of your brain working.

Trait #7
Ability to live through volatility without changing your investment thought process.

Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.

One of Warren Buffett’s famous quote is:
Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1.

Let’s look at to what extent not losing money is important in investment.

To illustrate,
if an investor loses 10%,
how much percentage does he have to earn, to go back to the pre-loss level ?

When he lost 10%, he left with 90% of his initial investment.

To go back to 100%, he will need to earn back the 10% he lost using what he has now, 90%.
Profit% he needs = 10%/90% = 11.11%

To generalise, if he lost x%, profit% he needs, to go back to pre-loss level is x%/ (100% - x%) .

Look at the table and graph.

we will be able to see:
as we lose more, it is more difficult to earn back to pre-loss level.
Just imagine, if we lost 50%, we need profit% of 100% to earn back to pre-loss level !

Therefore, to stress again :
Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1. :-)

Professional Skepticism

Today I will blog on something light-hearted. A story, instead of data or resources.
I like this insightful story very much. I read it in a book titled "Wisdom of Jews" (a chinese book).

One day, a man went to visit a Jewish Rabbi trying to seek on knowledge from the Rabbi.
Below were their conversation:

Rabbi: "This event happened in 12th century in United States of America. One day, two men came down from the same chimney. One’s face was smeared, the other’s face was clean, which one would wash his face first ?"

Man: "The one with a smeared face."

Rabbi: "No. It’s the one with the clean face, as he saw the other man having a smeared face."

Man: "Oh ya. That’s right. I understand now."

Rabbi: : "This event happened in 12th century in United States of America. One day, two men came down from the same chimney. One’s face was smeared, the other’s face was clean, which one would wash his face first ?"

Man (feeling confused): "Of course it’s the one with the clean face, as he saw the other man having a smeared face. Why do you ask again ?"

Rabbi: "You should ask, "Why both men came down from the same chimney, yet one face is clean, the other face is smeared ?""

Insights from the story:
When the man answered the smeared-face man would wash his face,
his scope : the one with smeared face

When the answer is the clean-face man would wash his face,
his scope: both men and their interactions (seeing each other after coming down)
questioning the implicit assumption : the one with smeared-face would wash his face first

When the question is raised about the impossibility of one smeared-face man, one clean-face man,
scope: both men, same chimney
questioning the implicit assumption of: one smeared-face man, one clean-face man, coming down from the same chimney

When we get whatever data/knowledge/model, we would need to know the scope and think hard on its implicit assumption. Be professionally skeptical on data you get !

There is continuation from the story…

Rabbi (asked again): "This event happened in 12th century in United States of America. One day, two men came down from the same chimney. One’s face was smeared, the other’s face was clean, which one would wash his face first ?"

Man (feeling confused again): ……

Think deeply on it… Would you be able to answer the Rabbi’s question ?
(Note: the answer is not: "Why both men came down from the same chimney, yet one face is clean, the other face is smeared ?")
(Hint: Go one more level up…)

Think again before mouse over the following paragraph..
Answer: The event didn’t happen at all. United States of America was non-existent in 12th century. It was founded in 1776.
Scope: the time it happens, 2 men, chimney
questioning the implicit assumption of: what the Rabbi said is true
We need to question the validity of the medium carrying the data/knowledge/model too !