How to invest

This is a guest post by the author of ValueFolio a new value investing blog

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These days when someone mentions “stocks” it results in negative connotations. Rightly so, however, considering the majority of individuals investing in stocks do so with little to no discipline and are seeking short-term gains. The most common negative connotations from the word “stocks” are:

• Too risky
• Gambling
• Confusing

But when the word “business” is used in place of “stock,” these negative connotations seem to fade. The reason this has happened is because there are really two types of people who buy and sell stocks:

1. Speculators: Those who try to profit from the movement of stock prices
2. Investors: Those who try to buy great businesses at good prices to realize a gain in the long run.

Speculators are not investors at all. They focus on the stocks. Investors, on the other hand, focus on the business. When you read books that imply negative connotations toward investing in stocks, without distinguishing between speculators and investors–the author is either (1) not aware of the difference between the two or (2) is ignorant of how significantly different they are.

When I first learned finance I was taught that investing in individual stocks is gambling and you should instead invest in mutual funds that are highly diversified so you can earn the returns of the market. This is an ignorant understanding of finance. The reason people quickly make these assumptions regarding stocks is because they haven’t done enough study to realize that speculators and investors are drastically different.

Benjamin Graham, often referred to as the Father of Value Investing, was one of the first individuals make sense out of investing in stocks. Let’s look at his definition of investment.

Investment: An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

If this is true, then anyone who invests without considering the intrinsic value of the business is a speculator. Let’s stop and explain what we mean by some of these investing terms.

Intrinsic value: the real value of the business derived from fundamental analysis.

Fundamental analysis: the analysis of profitability, tangible assets, and cash flow derived from financial statements, SEC filings, and other facts regarding the business (income statements, balance sheets, and cash flow statements etc.) to assess the intrinsic value of a business.

Let’s explain this as an example. If you wanted to buy a rental property you would want to know what your buying, right? If you are a smart investor you would take a look at the neighborhood, history of what renters have paid for rent in the past, history of what renters are paying for houses nearby, the number of rentals that are not occupied nearby, and the tangible value of your house: walls, rooms, fixtures, condition, basement, etc. You would most likely consider many other factors as well. This is fundamental analysis.

On the other hand, what if you approached buying your rental from a speculative approach? There are many speculative approaches, but let’s consider a few:

1. Buy a rental property based on the fact that the selling price of the property has been rising faster than other houses over the last last 2 years.
2. Buy a rental property because the price is 30% lower than it was last year.
3. Buy a property because you speculate that the city is going to eventually buy the property from you at a high price to develop commercial space for the city.

None of these reasons, by themselves, take into consideration the intrinsic value of the property. And without taking the intrinsic value into consideration, how can you ensure “safety of principal and an adequate return?” It’s impossible. You need to know the value of what your buying. Maybe the price has shot up over the past two years, but maybe this was simply because buyers were simply overpaying. Maybe the price is 30% lower this year than it was last, but maybe this was simply because the basement was flooded, severely damaging the foundation of the house. Maybe it is possible that the city will eventually purchase the property for a higher price than what you paid for it, but if it doesn’t, and you never did your fundamental analysis, there is the possibility that you overpaid for the property and could incur a serious loss.

The same goes for stocks. Think of it as if you are buying a business as a whole. You would search for a great business, analyze the facts, and then estimate its intrinsic value. Then, because of the time value of money and because not everything always goes as predicted you would only purchase at a discount to fair value, allowing for a margin of safety.

When you buy a stock you are simply buying a share of a business right? Why then, would you approach the purchase of stocks any differently than the approach of buying businesses as a whole? I doubt it is very often that someone buys an entire business for speculative reasons. They most likely gather all the facts, do fundamental analysis, estimate intrinsic value, and offer to buy the business at a price that seems like they will receive true value for the price they paid to protect their principal and ensure an adequate return.

Investing this way takes discipline and patience. Most people are satisfied to remain ignorant, keeping it simple: “investing in individual stocks is risky,” “mutual funds are diversified and will keep you from loosing your money like you could in stocks,” “investing in individual stocks is gambling.”

In conclusion, whether or not investing in stocks is gambling depends on whether or not the investor is a true investor or a speculator.

While I continue finalizing the 2011 update for the intrinsic value spreadsheets, updating the 2010 screen and my portfolio results, I’ve got a great guest piece for you today.

A short paper on risk and uncertainty written by my good friend Ernie. He also brought you How to Invest: Research and Valuation Process.

I believe this paper is his first revision, but it leads the reader into understanding the concept of risk and uncertainty applied to investing. I like it because it is very different to how main street and wall street define risk and uncertainty. To most, it is the same, but you and I know that it isn’t.

Here are some other posts related to risk you may also be interested in.

• Reward-Risk or Risk-Reward?
• Low Risk = High Return ?
• Different Types of Risk

A Short Paper on Risk & Uncertainty by Ernie

Risk

Risk as it relates to investing is an event that unfolds to induce impairment or loss of capital.

There are many types of risk. To name a few, there are financial, market, economic, systemic and portfolio risk. Generally speaking, risk causes volatility in the stock market, but it doesn’t necessarily result in permanent loss of capital.

The risk that causes permanent loss of capital is the concentrated risk where multiple events combine together to form a negative lollapalooza. Much like a person carrying too many things with too much weight on his or her shoulders, sooner or later, they will fall to their knees impaired.

In the stock market, there are always two sides of the trade, one side will be right and the other will be wrong. There is always a reason why the seller on the other side of the trade is selling to the buyer. Both will assess risk to the investment differently so this means one will be right.

When a transaction takes place from a seller to the buyer, in effect, the seller is transferring risk to the buyer based on their own criteria of risk.

In other words, the seller is really thinking that “I cannot manage the risk anymore so I am transferring it to the buyer who thinks they can manage the risk better in this investment”. It is up to buyer to decide with their own sound reasoning and judgment that the risk can be managed to a profit.

The seller’s criteria of risk can be based on beta, some singular mandate or some flaw in their analysis and valuation which forces them to sell. The important thing to do is to differentiate the risk that causes volatility and the risk that causes permanent loss which is concentrated risk.

Uncertainty

Not far from concentrated risk is uncertainty.

Uncertainty as it relates to investing is the inability to assess the magnitude of a given outcome in which an event can take place.

Every event that unfolds has an outcome. These outcomes have varying levels of results because there are many different events that can transpire.

Uncertainty has a high and low.

When the strength of an outcome of an event can be fairly predicted, it is said that uncertainty is low. When uncertainty is low, capital has a very high probability of returning safely.

When the strength of an outcome of an event cannot be fairly predicted, then it is said that uncertainty becomes very high. When uncertainty is very high, capital has a very low probability of returning safely.

When concentrated risk is identified, bracing for uncertainty must be done. To brace for uncertainty, one has to take reliable information and reason out the possible outcomes using a kind of sensitivity analysis.

The kind of sensitivity analysis preferred is more of a qualitative than quantitative approach where a best case, base case and worst case scenario are determined. The point of doing a sensitivity analysis is to know generally what the security will be worth in each of these scenarios if concentrated risk that is identified were to play out.

In my opinion, risk and uncertainty cannot and should not be quantified. Risk and uncertainty should only be reasoned out based on sound judgment backed by information that has been reduced down to the reliable.

Risk and uncertainty go hand in hand, which means that both need to be managed together. The ability to identify concentrations of risk and knowing the magnitude of any outcome should profitably reward the investor for taking low risk.

When it comes to risk and uncertainty, there truly are no extra points for degree of difficulty.

The extra points go to those who don’t lose money since compounding works for them powerfully. It is absolutely imperative not to have a down year because the time value of money will go against you and you will lose the compounding power of your cash outlay.

It is far better to go for the easy money by stepping over the one foot bars and be rewarded handsomely than stepping over ten foot bars and be punished for it.

With regard to taking profit, it is absolutely imperative to understand that it is okay to leave some money on the table as long as this money is at the near top of the total move in a stock price. The reason being is that you are leaving it for someone else to take the last bit of profit for taking higher risk.

That person who pays a higher price for the last bit of profit has a higher probability of losing it all.

This is a guest post by Andrei from AQ Value. Andrei and I have invested in many of the same companies but he has had far more success with bankrupt investments. I turn it over to Andrei for his latest distressed investment idea – MMPIQ. Let’s get the discussion under way.

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I am very pleased to announce that we have another awesome post by Daniel Rudewicz, who is the co-founder of Furlong Samex LLC, a deep value investment partnership based on the principles of Benjamin Graham.

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Martin Whitman is a legendary value investor and manager of the Third Avenue Value Fund (TAVFX). While his fund has suffered in 2008, his long-track record and expertise in distress investing make it worthwhile to try to figure out why he holds the investments he does.

In his 2009 Second Quarter Shareholder letter he lists several Hong Kong Stocks currently owned by the fund and their respective Net Asset Values (NAVs). In this column we attempt to reverse engineer his Wheelock Group position.

Please note, it will not be a perfect glimpse into his buying behavior since the position is not new.

Wheelock & Co Reported NAV

Wheelock and Company Limited (referred throughout the article as Wheelock Group) is a listed investment holding company headquartered in Hong Kong. The company is led by Chairman and owner of 59% of Wheelock’s common, Peter Woo. Wheelock Group’s holdings can be broken down into three main operating companies:

1. Wharf Holdings Limited (50.02% owned by Wheelock Group)
2. Wheelock Properties (74% owned by Wheelock Group)
3. The Wheelock Company and Other Operating Assets (100% owned by Wheelock Group)

As shown in Third Ave’s 2Q letter, the reported NAV/share for the Wheelock Group is $28.91 (HK$). The diagram below illustrates the holdings of Wheelock Group and includes the negative value of the unassigned Corporate Items.

(CTRL+Click to Enlarge and open in new window)

The current stock price is trading at a 48% discount to the reported NAV of Wheelock Group. Since book value does not always equal the intrinsic value of a company, it warrants further review. In international accounting (IAS/IFRS) real estate properties are revalued each accounting period to reflect the current market value, not the original recorded cost. This allows an investor to be confident in the reported balance sheet value of the investment properties. Further, note 12d to the year end financial statements reads:

12 d) Properties revaluation
The Group’s investment properties were revalued as at 31 December 2008 by Knight Frank Petty Limited and CB Richard Ellis (Pte) Ltd, independent firms of property consultants, who have appropriate qualifications and experience in the valuation of properties in the relevant locations, on an open market value basis, after taking into consideration the net rental income allowing for reversionary potential and the redevelopment potential of the properties where appropriate.

Adjusted NAV Valuation

In his book Value Investing: A Balanced Approach, Martin Whitman provides an example of how he values Toyoda Automatic Loom Works Ltd.

He shows an illustration of an adjusted balance sheet. He uses 6X and 8x multiples of operating income to determine the operating assets value. He then adds the market value of the Toyota Motor Common and Marketable Securities on the balance sheet to arrive at the adjusted NAV.

We attempt to do the same for Wheelock group.

For simplicity purposes, we have assigned a $0 value to many other items that likely have a higher true worth. In addition, due to the ownership structure of Wharf and Wheelock Properties, the assets below are reported at 100% and the minority interest is removed at the end. We use the same minority interest percentage reported in the 12/31/2008 balance sheet as an estimate. A more precise value would involve finding an adjusted NAV for Wharf and taking 50.02%, finding an adjusted NAV for Wheelock Properties and taking 74%, and finding the remaining adjusted NAV of Wheelock Group and adding them all together.

Close End Fund Valuation

Since both Wharf Holdings LTD (WARFF.PK) and Wheelock Properties (WLKPF.PK) are publicly traded securities, and account for over 90% of Wheelock Group’s reported NAV, Wheelock Group could be valued as a Closed End Fund. The diagram below determines Wharf Holdings’ and Wheelock Properties market value based on the most recent stock price and uses reported NAV for the Corporate Items and The Company and Its Other Subsidiaries.

According to the above diagram, Wheelock group trades at an 18% discount. If an investor assumes that the liabilities of the Corporate Items (which represent net debt of the Company and its wholly-owned subsidiaries.) will not increase any time soon, there is an arbitrage opportunity there for him or her.

Since Wharf Holdings and Wheelock Properties both appear to be trading at a discount to reported NAV, an investor may be better off simply holding Wheelock Group.

Disclosure: A family member of the author owns shares in Third Avenue Fund, which in turn holds positions in Wheelock Group and Wharf Holdings Ltd.

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If you enjoyed this article and have any questions, you can reach the author at rudewicz@furlongsamex.com. Visit the website at

After my post on when to sell stocks last week, we have a guest post from fellow reader Tim du Toit, the editor of EuroShareLab, to discuss his methods of selling. Since selling is a difficult aspect of investing, I encourage you to read the following post by Tim.

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Introduction

I always thought of myself as a long term buy and hold investor. Buying good companies and holding through thick and thin thinking that overall my investment performance will be acceptable. But looking at my portfolio over time I realized that I developed the tendency of selling winners and hanging onto losers. Try as I may, I found it really hard to rationally break away from this tendency.

After a lot of research I developed a strict selling strategy which has helped me a lot and I hope it helps you too. If nothing else I hope this article prompts you to think about your approach to selling and how it can be improved.

Important Points

• You should have a selling strategy
• You should have it written down
• You must review it regularly
• You have to force yourself to follow it

Why is it important to limit losses?

Limiting losses is very important as the gains required to recover the loss grows exponentially as the loss gets larger.

The following table and graph show the relationship between a loss and the recovery visually.

Whatever approach you take to selling, this is the most important principle to bear in mind, irrespective of how positive you are on the recovery probability when it comes to the losing investment in your portfolio.

Behavioral aspect of selling

Fear and regret play a large role in investors failing to sell a stock that has declined. Sometimes when a stock falls, it’s a great opportunity to increase the investment at an even more attractive price. But in cases where investors have made an obvious mistake, and logically should sell immediately, behavioral research shows that they will often hang on, thus suffering even greater losses.

Why is this?

By selling, they have permanently locked in the loss, and then have to confront the pain and regret of having made a bad investment, including the potential embarrassment of disclosing the loss to others.

Somehow, in our minds, we think that our ownership of something increases its value. This is incorrect. For example, just after placing bets, punters at the racetrack become much more confident about their horse’s chance of winning the race. Similarly, lottery ticket buyers tend to buy more frequently if they are allowed to choose their own numbers. Investing in shares is no different.

So what can we do to avoid costly and annoying errors?

• Approach investment decisions from as neutral a position as possible
• Ignore all sunk costs by ignoring the cost of the investment when reviewing your portfolio
• Accept it as inevitable that you will make mistakes in your buying decisions
• You will face tremendous pressure that will tempt you to rationalize your mistakes and not correct them
• You will tend to protect the status quo by inventing new reasons to hold on to a bad investment
  • This will be especially true when your original buying decision is known to many other people who are important to you, as it will hurt you to acknowledge this to them, and to yourself.
  • It will be difficult for you to correct the mistake because you will attach more importance to saving face by appearing to be consistent with your past commitments.
• Don’t overvalue your current positions. Pretend that you don’t own them, and ask, “If I didn’t own this stock today, would I buy it?” If the answer is no, you should think hard about selling.
• Don’t compound past mistakes for fear of embarrassment. In the end, the best advice is to learn from mistakes and move on.

Selling Stocks to Realize a Gain

1. Movement of the share in the ranking

If you buy stocks based on a ranking or a mechanical strategy, such as a low price to earnings ratio, low price to book ratio, or high dividend yield, the movement of the stock from cheap to expensive through the ranking can be used to determine the selling point.

2. When your premise is fulfilled

This is what it is all about – selecting a share because of a reasoned, well-thought investment premise, and things work out exactly like you expected, or better. When this happens you have every right to feel confident and take your well earned profits.

3. After a substantial rise in price

Another reason for selling is when you think the stock has become more valuable than it should be. Unfortunately, for many of us, the realization that a stock price has increased too much comes long after the price has already peaked and started to fall.

4. When it doubles

An old adage in the market is that you should sell half your holdings when a stock doubles. This is a purely emotional reason to sell a stock. It allows you to feel like you have received all of your money back and that the money you now have in the share is pure profit or “house money”. The concept of “house money” is purely emotional as all the money, including the gain, is always all yours.

Selling Stocks to Limit a Loss

1. Your reason for making the investment

Once you have done your homework on a company, write down your concise reason for buying.

Should you use this selling strategy, you may want to implement a strict rule that if you were wrong about the reason for investing, you should exit the position with no questions asked. Never invent new reasons to hold a position when the original reasons are no longer applicable.

Holding onto a position simply to recover your initial capital is usually a recipe for even greater losses.

2. Leave emotions out of it

Should it happen that management really makes you angry, you may want to put the investment away for a while and not do anything. Try not to take action just because of your emotions.

If you take action because of an emotional reaction, it is likely that a lot of other investors are thinking exactly the same. This means that everyone is abandoning the investment at exactly the same time. I have found it better to wait a while, even if I am still angry.

3. When your nerves can’t take it any more

Have you ever bought a stock that has taken you for an emotional roller-coaster ride? Instead of increasing in value the price dips and bounces every day. If holding the stock makes you so uncomfortable that you can’t sleep and you only worry about how much money you have lost or made in a single day, you are being distracted.

4. Percentage drop in price

This strategy is the simplest of all, but also much more difficult to implement than it looks. Sell after a fixed percentage decline in price. This level can be set by looking at the recovery table mentioned above, or can arbitrarily be set according your pain threshold.

My Approach (Tim’s)

Below is a diagram of my approach to selling. It’s a combination of the many considerations mentioned above.

Click to enlarge

The loss and gain levels are arbitrary, but they are ones I feel comfortable with. You can use it as a basis to build your own selling strategy. Even though I have developed it and feel comfortable with the arguments and values, I still find it difficult to stick to. The toughest decision is to sell according to the model when I think the share is down due to a negative day for the stock market overall, or negative industry news. The most frustrating is when I did not sell at a 25% loss and the loss then increased to 33% or more.

How the Stock Selling Model Works

Loss of more than 16%

If the share price declines more than 16%, I first ask if I have already added to the position. If not, I redo the analysis. If the business has not deteriorated in one of the five factors mentioned, then I buy more after selling the position to make use of any tax losses. The position is never a hold – either I buy more as the investment has become more compelling, or if it has not, I sell.

Should I have increased my position, the loss on the new total position would have decreased as my average purchase price has declined.

Should my loss again exceed 16% after I have bought more shares, I ask a friend or fellow investor to redo the analysis. I use this objective review to determine if I have missed anything in my analysis. Should the independent evaluation come to the conclusion that it is a good investment, I may buy more or I may just hold, depending on the size of the position in my portfolio.

Loss of more than 25%

In order for a loss to exceed 25%, I would have had to go though my own, and an independent, review of the position when the loss got to 16%. At this point I cut my losses. I may be wrong in selling but I can always buy the shares again.

Selling at this point has enabled me to get out of a position where it has later shown that something was happening in the market or with the company, that I did not understand.

Gain of more than 50%

Should my gain on the investment exceed 50%, I also review the position. If the investment was a “Cigar butt”, a description Benjamin Graham gave to cheap, bad quality businesses, I exit the position as the lowest risk gains have been made.

If the investment is a high quality business, I determine if the gain has been purely price-based with no change in the earnings of the business. Should the former be the case, I may sell right away, or may still hold if the valuation is lower than the market or peer group based on price to earnings ratio, for example.

Should the earnings of the investment have increased along with the price, I will hold the shares.

As you can see, my approach to selling is mainly sticking to the “rules”, but it allows some decision freedom. What I really try to stick to is the hard rule of selling out at a 25% loss.

An Example

About a month after I bought Dell Inc., the share price fell 17%.

The following day I looked at my financial analysis and made sure there were no updated financial or recent news I was not aware of. I found nothing, apart from uncertainty around worldwide computer shipments in the coming year. I added to my position.

This lowered my loss to 11%, as my average purchase price was lowered by the additional shares. About six weeks later my loss again exceeded 16%.

This time I asked a friend to work through my financial analysis to see if he found the company an attractive investment. Apart from a few points he also thought it an attractive investment. I decided to hold the position and not buy additional shares.

Three weeks later my loss on Dell exceeded 25% and I sold the position. From what I could gather the share price decline was caused by weak sales results by Lenovo Group, one of Dell’s competitors. Having sold the share I was in the position to objectively and unemotionally evaluate what I wanted to do from there going forward – repurchase the share after waiting for the situation to stabilize, or look for alternative investments.

What happen?

Dell’s share price recovered slightly after I sold, but subsequently went on to lose a further 20%.

The sale thus had a good outcome, but even if the share had recovered I would have been pleased as it limited my losses and gave me complete emotional freedom to evaluate my options.

Summary and Conclusion

The goal of  this article is to show that it is important to think about your selling strategy in advance of making your investments, and to make it clear that selling is a lot more difficult than it looks.

To summarize the most important points in this article:

1. Have your selling strategy written down.
2. Look at it often.
3. Make changes as you gain additional insight.
4. Stick to your selling strategy – no exceptions!

I wish you all the best with your investment endeavors.

Tim du Toit

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The purpose of EuroShareLab is to share knowledge and ideas gained in over 20 years of investing experience and continuous learning to help other self directed investors on their investment journey.

Visit EuroShareLab, browse through past content and sign up for our free weekly newsletter. Do something for your financial future today.

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Our guest post today is courtesy of Manshu Verma from OneMint, a website with the vision of “creating wealth for everyone”. If you like this article and wish to read more about the economy, stocks, investing, credit cards or other topics on personal finance, please consider subscribing to this feed.

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A lot of people invest in commodity mutual funds and ETFs because of the convenience these funds offer. A large number of investors use these funds as a proxy for holding the commodity itself. After all, how many of you want to hold barrels of oil in your backyard?

If you own a commodity fund and expect that fund to hold the underlying physical asset — this may not always be true. There are different type of Commodity ETFs that track the price of the underlying assets in different ways.

Funds that Own the Physical Assets

ETFs like iShares SLV own the physical quantity of silver that the fund represents. These type of funds actually own physical silver, gold, oil etc. and then issue units against those.

If you are buying a commodity fund only because you don’t want to directly own the underlying asset — these type of funds offer you the closest proxy.

Funds that Own Futures Contracts

ETFs like the Power Shares DB Funds don’t own the physical underlying commodity at all. These funds enter into Futures Contracts and create strategies such that the price of the fund behaves in sync with the price of the underlying asset. Normally, such funds track the movement of an underlying Index, which in turn is designed to track the movement of the prices of the underlying asset itself.

These funds hold short term credit instruments and US Treasury units in addition to the futures contracts. Such instruments enable them to earn interest income which can be then used to cover their expenses.

Funds that Own Mining Stocks

Then there are ETFs that hold stocks of companies that deal in the underlying assets. These are funds that own stocks of gold mining companies or steel mills etc. They don’t own any physical asset at all and are purely invested in stocks of the underlying companies.

Exchange Traded Notes

ETNs are often mis-understood to be an equity instrument, these are really debt instruments and depend on the solvency of the bank or financial institution that issues them.

Proxy for Physical Assets

If you are just looking at buying a fund that holds the physical quantity of the underlying asset for you — then you should get into the first category of funds described here.

Personally, those are the only funds that I prefer. Why pay someone else for a futures contract that I myself can enter into and why pay someone else for owning a stock that I can buy directly? As for ETNs, they are not an equity instrument at all, so the question of being a proxy for physical assets is really remote.

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