SYWBS Part 2: So you still wanna buy shares...

This is a continuation to the first part of the series of writings on my views as to how we can break down the logic and rational of investing in shares, especially for the very first time.

In the previous post, I shared my belief that:
1. Share price move based on expectations of making profit
2. People invest with the expectations to make profits
3. The starting point of investment is pitch black and there are thousands of choices and noises in the market.
4. Expectations are elusive and unpredictable, sometimes (most of the times) it defies logic and reason.
5. Most of people starting out have limited capital, so best to first see the surrounding, the battlefield, before making any move. That distinguishes between the brave and the idiot (while not forgetting idiots do have some luck sometimes).
6. One of the ways, by which we can try to 'see' in the dark  or feel the surrounding, systematically is by a top down approach.
7. Top down approach starts with industries within the country. Actually you can even go higher with which country, but i will explain this on if anybody asks. For the time being, we shall keep it local.

So lets continue with the top down approach and look at industry.

A country's economy is divided by industries and each industry has its own 'health'. The health of the industry depends on many things, internal and external. I am not going to explain how to assess the industry here, like the Porter's Five Forces etc, but sufficient for us to understand that we need to find out which industry harbors the most expectation to be prosperous.

Why do we need to find this out? The logic behind this is that the industry that is prosperous would give more chances for the companies within it to be prosperous. Therefore, as the company prosper, the shareholders would prosper alongside it too. That is the general nature or logic of the human brain.

The need to to have the ability to systematically/ logically narrow down choices above is further enhanced by the fact that the human beings are limited by capital and brain power.  Capital is limited in a sense that it is no one person / organization has enough capital to be invested everywhere. Choices has to be made as to where be to invest in. More importantly, in general, the decision making process of investments are done by humans and the ability to have a multiple lateral analysis is very limited.

As I have argued before, the prices of shares are determined by expectations of trading profits. It is not determined by fundamental or analytical calculations. If someone had carried out a fundamental or analytical calculations and comes out with a price, that price is not going to be force fed into the market / system.  They can't do that; they can't determine the price. Otherwise how do we explain all the price targets? If the prices of shares are determined by these calculations there will be no price targets as the next price will be set at that.

In my eyes, the fundamental (FA) and analytical analysis (TA), calculations and outcomes feeds into the expectation of the share concerned. And the magnitude of this expectations depends on the visibility of the shares and how much people believe in it.  Take for example a share which is trading at $1.00 each. We did our own FA or TA and arrived at a price target of $2.00 each. GREAT! Really? Not really.

Our price target above are not visible to others. That means that others does not share our price target hence the magnitude of that expectation that the price will increase to $2.00 has only the strength of whatever capital we have.

But if an analyst comes out with his/her own calculations and sets the price target to $0.50 and that target is then published in the newspaper, it would have an impact on the share price of the company as the visibility of this opinion would affect the expectations of many more investors.

You could probably be right  and the analyst wrong, but since the price is determined by expectations, the price would more probably be swayed by the much larger expectations generated by the analysts.

This also explains how can one share have multiple target prices from multiple credible analysts. Each analyst may have been correct in arriving at their target price calculations but the actual price movement is determined by how much and how many people believed in the upside (of 50%, 20% or even 100%).

So back to the industry selection above, it is important for us to identify the industry that is most visible for the right reason. The more visible the industry is the more investors will be looking at the companies within the industry.

Take for example the oil and gas industry. For the past few years there has been many good news about the industry, mainly that the oil price is at a very high and profitable level. That made it stand out and make people believe that there is more likelihood of success for the companies involved in this industry. And the investing public expects that it is going to generate more and more attention and hence attract more investing money.

In general, the expectations on making a profit in oil and gas companies should be high because  most of the factors that would be fed into the the expectations of rising share prices are all there. The fundamental calculations should be looking good as the industry is doing well. And as sentiment translates into positive share price movements, the TA would also be showing a good sign.

So first, pick your industry or industries.

But before we can make our pick, we need to know how to identify which industry is doing well. The first obvious source would be the newspapers and and other sources of economic outlook, including analyst reports. Look at how the industry is being reported in the news and around us.

You can also look at the indices representing these industries. What has been the trend and whether the indices has been growing in line with all the positive news out there. Comparing the indices against good news about the industry is a good way to gauge the level of visibility of the industry in the eyes of the investing public; whether the investors are paying attention the companies within that industry.

- to be continued-

Next: how do the fund managers usually narrows down which company to buy within a particular the industry.

Next next: How fund managers build equity portfolio and how you can do it with the combination of ETF and shares.

SYWBS Part 1: So you wanna buy shares...

So you have decided to buy some shares on the stock market.

So, where do you start?

I guess you may have read other blogs and articles about investing, and if you had done so, then some of the things I am going to say here would be a repeat.

1. Objective: Why do you want to do this?
To make money or profit. To exit more than you had before. You don't buy shares so that you can participate in setting the right price for shares. That would be stupid. You want to buy and trade in shares so that you make more money than you had before.

Simple objective but not so simple way to do it.

2. Why is it so difficult to make money on the stock market then?
Everyone has the same objective. And since it is a zero sum game (save for the dividend), you have to lose for them to win, and vice versa.

You are most probably quite insignificant (especially when you are starting). This is in terms of capital. The entire market is way to big for you to influence and worse some of the other players play dirty. They are significant enough to manipulate the share price, commonly known as goreng sampai hangus..You wanna get on the 'goreng'  part and leave before you 'hangus'.

The share price of a company is almost unpredictable, especially if you do not have the technical or fundamental tools. It would be like walking blind without a stick even to guide your way. The share price is subject to the expectations of everyone else and since you cannot read their minds, you would not know. Therefore, without any knowledge on how to 'feel the surrounding' you are basically gambling. You could win with almost equal luck as a flip of a coin (I vaguely remember reading a study done on this).

3. The first thing is to know yourself
Like I said earlier, buying shares is not unlike going into a battle (of wits). And as with any battle, you gotta to have to things, a great deal of knowledge about yourself and a plan.

You already know what is you objective is: to make money. However, here you would need to be a bit more specific. Do you need to make profit everyday, every month or once a year maybe. This is determined by your cash need and how long can you go without the cash you are using to invest. There is no right or wrong answer, as there is no guarantee that you can make any profit any day, month or year. But this would determine the kind of time you need to be monitoring the market and the kind of shares you can buy.

In my case, I cannot be stuck on the screen every minute, so I guess I need to make my profit on a monthly basis. Not that I need the profit for my monthly expenses, rather for the purpose of discipline. I can go for at least one year without the capital back in my pocket.

Risk level? The moment you decided to buy shares that means you are on the above average risk takers already, daring and brave. The only thing right now is to not make ourselves foolish instead, or even stupid.


4. The second thing to do is to 'un-blind' yourself systematically
A fool falls down a lot, mostly for the stupidest reasons. That is akin to being blind and refusing to learn how to feel with your other senses. Well, the 'brave' also falls down sometimes, it hurts just as much, but as he are able to feel the surrounding, he would fall less (usually a lot less) than a fool.

There are many ways to learn about the or feel the stock market. Two of them are 'top down' and 'bottom up' approaches. I like the top down approach in general as a systematic way to feel the market.

First we start with the entire market, hundreds and hundreds of companies with hundreds and hundreds of shares. It is not uncommon for first timers to then quickly look at the most active counters as a guide for the choice of shares to invest in. I don't go for that because usually by the time the counter gets on that list, the meat is already gone. Meaning the price is already stabilizing, coming down or about to come down.

If you have lots and lots of money and you do not know at all what to buy, you could buy the entire market, meaning you would buy ever types of shares there are in the market or more realistically, the shares in the indices. That way you will be taking the market  risk and return. You will make profit when the whole market makes profit.

Does it mean you need to have millions to to this? The answer is: not anymore.

You can 'buy' the exposure to the entire market by buying ETF from as low as a couple of hundred ringgit. For more details on ETF and how it works, you may visit my earlier posting here.

But if we want to take a higher risk and hope for a higher return (or have enough money for just one or two stocks), then we have to narrow down our selection further.

The entire market is then dividend by industries. Oil and Gas, construction, banking and such. Within these industries are companies (and shares) that does business; some more profitable than others and some loses money.

The natural thing to do is to pick an industry that is gathering most positive attention from other investors. Remember, share price moves based on expectation and expectations can sometimes be totally different than the reality of the fundamentals.

How do we find this out? Which industry is getting the attention? Well, we need to read the newspapers, trading forums and the likes and judge which industry is getting the most airtime. It could be oil and gas, it could be banking it could be property or plantation. You make your call.

- to be continued-

SPAC, a view post QA

REMINDER/ DISCLAIMER: THIS IS NOT A RECOMMENDATION TO BUY OR SELL HIBISCUS OR ANY SPAC OR ANY SHARES. IT IS INTENDED TO EDUCATIONAL AND DISCUSSION PURPOSE WITH A VIEW TO PROMOTE MORE ANALYTICAL INVESTING AND LESS GAMBLING.
 
I decided to continue to share more of my understanding of SPAC due to the very encouraging responses I received on the previous two postings on SPAC, the first which discussed on the nature and understanding of SPAC and the second one which talked about the enigma of trying to grapple with the valuation of  SPACs.

I started by listing down all the SPAC in Malaysia again. While the imeediate number that came to my mind was 3, I stopped writing after the names Sona and Cliq. I hesitated to include Hibiscus as i recalled that it had completed its qualifying acquisition (QA).

The question that I had to answer was: was Hibiscus still a SPAC or should I now consider it as an oil and gas company? The answer to this question it only then would I be able to appropriately understand, assess and evaluate the company.

The first thing I checked was the Bursa Malaysia classification. Nope, Hibiscus is no longer classified as a SPAC. How about Bloomberg? When I checked on 7 June 2013, it is stated as Sector: Financials; Industry: Specialty Finance. Sounds like SPAC to me. Well now we have two different 'market experts' with two different opinions on the nature of the beast entity.

But the nature of the company is not as simple as a reclassification on the board. In the actual sense, it should be determined by its business model.

As I had argued in previous posting, I view a SPAC before the QA as a private equity fund. The question is whether post QA, does a SPAC cease to be a private equity company and become a normal operating company or does it continue to be a private equity company. The answer will change the perspective in which I view a SPAC, the risk assessment and the evaluation (some may say valuation).

Let me try to explain why. A private equity company makes money from buying, investing and finally exiting the investment. Cashing in from the dividends and proceeds of the sale of the investee company. It does not need to hold a majority stake as it is more interested in the ability to groom and sell the company later rather than managing and living of the profits and cashflow of the company. The proceeds of the sale of the initial investment will be used to find another acquisition which it will try to replicate the success with the initial investments. The value of the investment in the private equity will grow  based on the size of the assets it has and the quality of the private equity will depend on the liquidity or ability to convert those assets into cash.

A normal operating company, especially a normal operating company listed on an exchange has to have a business model and business operations that are in perpetuity. The operations must be on going concern basis and the company must have control over the assets (most importantly cashflow) and the business direction of the operations and assets, particularly when it comes to paying dividends. In other words, the company must have an identifiable core business. And to be listed, the core business must be able to satisfy the listing requirements of the exchange. If this is the business model, then the evaluation and valuation will be done on the fundamental of the company in the same manner as all the other companies operating in the same industry, which in this case the oil and gas industry with the likes of Yinson, SapuraKencana, UMWO&G, Bumi Armada and others.

So, where do I put Hibiscus as? As a private equity or a normal operating company? The only way I can objectively  put my mind at ease is to look at the equity guidelines of the Securities Commission Malaysia to see if Hibiscus would have made it as it is to the exchange.

Under 'Profit Test' an applicant needs to have a core business, defined as "the business which provides the principal source of operating revenue or after-tax profit to a corporation and which comprises the principal activities of the corporation and its subsidiary companies". Well, assuming we take the QA of Hibiscus as the 'core business', it may have passed this test if it provided the principal source of revenue and profit for Hibiscus. But that is only because Hibiscus bought and now owns 35% stake in Lime, which allowed for equity accounting. It does not come across as a typical core business in a normal IPO where ususally we would see the listing company owning 100% of the core business via direct ownership of the assets and operation or the operating company. Well, if not 100%, then a majority control is more familiar to us. In other words, no matter how big Lime grows into, the stake is only 35% (Lets not get into the RM20 million requirement and track record.)

Why is the majority control of core business is important to me? It is because if i were to treat the company as a perpetuity, I must have the comfort that it can determine the perpetuity itself, independently and without any hindrance. If I were to own less than 50% of a company, I have a much restricted rights and say on this matter. I am a minority shareholder. I mean if we were to put, size aside, the control over the core contributor of profit between Hibiscus and SapuraKencana, UMWOG or Yinson, we would able able to see the difference there.

Is it wrong? NO. Remember, the purpose i made this comparison is just to put the business model in the proper perspective according to my views. I do this so that I can try to make sense of the valuation and pricing of the shares of Hibiscus. The 35% stake in Lime has some value, and in some cases it could be more valuable than 100% of other company. 

However, lets assume all is good and lets take one common valuation indicator, the PE ratio. Based on the following, the PE for 2013 was 66.80 times! Really? That is way higher than SapuraKencana or even UMWOG, let alone the industry average of approximately 13 times.
Stock Price : 1.75 (2013-12-31)
EPS : 2.62
P/E Ratio: 66.80

How else could I make sense of all this? Well, another possible way for me to look at the price is to assume a different business model for the company.

A private equity model usually values the 'assets' on piecemeal basis. They are valued based on the a view to exit. From there, we would be able to arrive at the value of the private equity fund by adding on all the pieces of investments together. Interestingly enough, I stumbled upon a research report by a local institution that did exactly just that for Hibiscus: valuation based on the sum of parts. And the stock price of RM1.75 was within their range of estimated worth of the company.

Well, what is the takeaway here? Well, in my opinion, price is different from the value, as I have discussed previously. The demand for shares depends on the expectations of profits to be made from the movements of the shares and expectations are a function of how the investors view the company.

 If I had assumed that a SPAC post acquisition is a typical oil and gas company, I would have been baffled as to why the demand was so high compared to the fundamental of the company. However, it feels that the price makes more sense when I view the company as still a private equity venture: something that carries a high potential (hence expectations) together with an equally high amount of risk.

REMINDER/ DISCLAIMER: THIS IS NOT A RECOMMENDATION TO BUY OR SELL HIBISCUS OR ANY SPAC OR ANY SHARES. IT IS INTENDED TO EDUCATIONAL AND DISCUSSION PURPOSE WITH A VIEW TO PROMOTE MORE ANALYTICAL INVESTING AND LESS GAMBLING.

Share price: demand, supply and expectation

The price of a share is indeed an interesting item. It had brought joy to many and brought tears to just as many (if not more) investors.

Why is it interesting? To me it is interesting because the 'behaviour' of the price is unique. While it uses the same platform of demand, supply and price equilibrium mechanics of a commodity (sugar, rice, coffee etc), the characteristics could not be more different.

Understanding the characteristics and behavior of  the share price is so important that it would either place the investors as a clairvoyant, a gambler or a buffoon. 

Share price is the equilibrium price at any point of time when a buyer and seller agreed to buy and sell an amount of shares.

The above would immediately make us think of the supply and demand curves that determine the prices of commodities like sugar and rice. The price of commodities are also determined by the the intersection between the supply and demand curves. A typical demand and supply curves of a commodity would like an 'X' where the demand is higher as the price gets lower (indicating people will consume more) and the supply gets higher as the price gets higher (indicating people will produce and sell more).

But then there is a major difference between the commodity and share. Commodities are purchased to be consumed, shares are purchased to be sold back again (let's ignore dividend for the time being). You cannot chew on the share certificates or even bring it to the neighborhood grocer to buy fish (unless he trades in shares too). Generally, it has to be sold and converted into cash at the end of the day. Therefore, shares are bought with the EXPECTATION to make profit by selling the shares.

Therefore, in my opinion, the demand curve for shares are not driven by actual price but rather expectation of profit or future price. Therefore, that would explain why sometimes, as the price of the share increases, the more demand it seemed to attract. Until at one point when the expectation of further profit is nil, then the demand starts to fall.

Same with the supply side, instead of the supply being driven by the price of the shares, it is actually being driven by the expectation of future price and profit (or losses). If the expectation of the profit increases, the supply would be less as people would hang on to the shares to expect more profit.

However, we have to remember that on the supply side, there is another important factor which is realization of profit, i.e converting cash into shares or cashing in on the opportunity. This is sometimes, especially for institutional investors, may be insensitive to price or expectation as they would be set at an arbitrary figure for example 'sell when share price makes 30% gain for example". While the demand side may have this rule, it is less prevalent.

The effect of expectations on share price, in my opinion, explains a lot of things.

It explains the frustrations of investors trading on fundamental analysis and valuation as to why sometimes despite the wonderful fundamental results, the share price does not budge, or worse drops. In my book, that is because it failed to increase expectations.

Expectations are a function of the number of investors and their expectation level.

If the shares are not known to many investors, in other words they are below the radar, then any fundamental result would have a minimal effect on the shares simply because there are not going to be many investor affected by it. That is why research reports and newspaper highlights are crucial. That is why investor relationship are vital for any publicly listed company.

If we have discovered a gem of a share based on our own fundamental analysis, no matter how accurate our calculations were, it would mean nothing if our expectations are not shared by others. Not that we are wrong or anything, it is simply that other are not aware (or worse not interested or not in their mandate).

Similarly, if we were to conduct a technical analysis of a certain share, we might seem to believe that the share had turned a corner and is expected to rise. But again, if this is not known to others the price would not budge until a significant number starts to see the same thing and have the same expectations. And since the trend of a technical chart is built upon the actual historical prices of the share itself (sort of a self fulfilling prophecy),  the absence of a large number of people believing in the prophecy would then render it unfulfilled.

But this does not mean fundamental analysis or technical analysis is not important, just that we have to remember that a correct analysis does not guarantee you a profit in the stock market. It simply gives you a chance at making a profit when everyone else catches up with your findings AND you have enough staying power to wait when they do.

What should be the objective of your business?

You might be running your own business or you might be managing someone's business. I am sure plenty of people would have come up to you saying what would be the objective of your business, what would be your driving force, your business' aim in order to be successful.

So what is the objective of your business?Is it to maximise market share?
...maximise revenue?
...maximise profit?

Well, let's take a look shall we?

If the objective of your firm is to maximize the market share, what is the best way to generate market share? Marketing?
Advertising?
No. The best way to maximise market share is to give your products and services fro FREE. You will have loads of market share, but you will not be making any money.

Okay, what is the objective is to maximize revenue?Well, you could maximize your revenue by selling it as cheaply as possible, regardless of how much it costs. In the end, you could be raking in the revenue but not making money at all?

Okay, then let's target maximizing profit as the goal. That should be it. In order to make profit, you would have to take revenue and cost into consideration, hence that would be a good goal for your business. I say no to this too.

It is because the best way to make profit is to sell all products on very long credits or no collection at all. Everyone will be buying from you at whatever price you would be selling if they know you are (or your staff ) not going to collect it. You profit will balloon but so would your accounts receivable and provision for bad debt.

In corporate finance, it makes sense to say that the objective of the firm is to maximise the value of the firm by making three rights decisions about:

1. Investment
2. Financing; and
3. Dividends.

Comments and questions are welcomed.

---Friendly notice---

Yazdi occasionally holds and runs corporate finance workshops, where you could gather the financial sense required to succeed in business or at your workplace. His past participants included senior managements (including a CEO or two) and executives of financial industry (including fund managers, analysts) as well as business practitioners.

If you would like to know more about his upcoming workshop of corporate finance in general, please free to drop your email at this link, here. We will not spam your mailbox - let's keep that personal between us. We appreciate your support and if you could share this with whoever you think might benefit from this (like friends or colleagues), we thank you a gazillion times.

Making strategic decisions

Every business, big or small, would have a strategy (or more). I found the following strategy action tree very helpful in trying to make sense of the decisions that needed to be made or making sense of decision made by others.

Hope it helps you too. If you have any question, please feel free to post it in the comment box. I will get back to you as soon as possible.

---Friendly notice---

Yazdi occasionally holds and runs corporate finance workshops, where you could gather the financial sense required to succeed in business or at your workplace. His past participants included senior managements (including a CEO or two) and executives of financial industry (including fund managers, analysts) as well is business practitioners.

If you would like to know more about his upcoming workshop, please free to drop your email at this link, here. We will not spam your mailbox - let's keep it personal between us. We appreciate your support and if you could share this with whoever you think might benefit from this (like friends or colleagues), we thank you a gazillion times.