20 Lessons from Seth Klarman on What the 2008 Crash can Teach You

Lesson #1: Expect the Unexpected

The classic “expect the unexpected” is true for the market. Take measures to prepare for the worst because the market reality can be worse that what you imagined. Nassim Taleb popularized the term “black swan” based on rare and hard to predict events happening. But it does happen.

 Lesson #2: Too Much of a Good Thing

Watch out when there is too much of a good thing. Markets constantly rising? Loans available to anyone? Interest rates constantly hovering near zero? This environment creates a false sense of security and when things fall back to the mean, it will trigger a crisis.

 Lesson #3: Control Risk First

Don’t try to milk the last drop from your investments. Always consider risk and downside first over potential returns. When entering a crisis, you have to make your positioning conservative and be able to pounce on new opportunities while others are forced to sell.

 Lesson #4: Paying Less is Less Risky

Risk comes from the price you paid for the stock. It isn’t uncertainty or volatility. When there is great uncertainty and it drives prices down, you buy with less risk.

 Lessons #5: Financial Risk Models are Useless

Market risk models done by computers are a waste of time. Reality is impossible to model. Human logic based on actual and real time facts is more accurate than boxed formulas and numbers.

 Lesson #6: Don’t Invest for Short Term Gains

Don’t be tempted to invest for short term gain simply to earn something off cash that’s doing nothing. This is a higher risk strategy which increases the likelihood of losses and illiquidity precisely when the cash is needed.

 Lesson #7: Stock Price is Not an Indicator

The stock price is not the fair value of a stock. People mistake that the stock market is completely efficient. During good and bad times, the stock price is not an indicator.

 Lesson #8: Expand Your Circle of Competence

When a crisis hits, your investment approach has to be flexible. Don’t get too stuck on one method because opportunities can come in many different ways. If your investment approach is too rigid, start to expand your circle of competence.

Lessons #9: Buy When Prices Go Down

Buy when the price is going down. Volume is higher, there is less competition. It’s better to be too early than too late. Don’t be afraid to buy things on sale.

 Lesson #10: New Financial Products are Not For Your Benefit

Be wary of new financial products. They are always created in times of exuberance and never questioned. The subprime loans were the rage as institutions only saw the upside. Then it got killed.

 Lesson #11: Rating Agencies are Useless

Ratings agencies are useless and always a step late. What’s the point in lowering or increasing a rating after it’s happened?

Lesson #12: Illiquid Stocks Come at a Price

Illiquid stocks will cause high opportunity costs. Make sure you are compensated for that illiquidity.

Lesson #13: Public Investments Still Rock

All things being equal, public investments are better than private ones. During a crisis, you have a better change to average down with public investments over private ones.

Lesson #14: Debt is Evil

Stay away from all forms of leverage. Don’t assume a maturing loan can be rolled over since you have no idea what the capital markets will do.

Lesson #15: LBOs Are Disasters Waiting to Happen

LBOs (Leveraged Buyouts) are stupid manmade disasters. If the price paid is too high the equity portion is an out of the money call option.

Lesson #16: Financial Stocks are Risky

Financial stocks are very risky. For example banks are highly leveraged, very competitive and difficult to run businesses. Unless you have deep experience and knowledge of the industry, invest in safer industries that you understand.

Lesson #17: Long Term Clients is Key to an Investment Fund’s Success

If you manage funds, having clients with a long term orientated mindset is crucial. You don’t want investors pulling out their money during a crisis.

Lesson #18: Government Officials Don’t Know Anything

When a government official says that a problem has been “contained”, it’s a contrarian signal. Pay no attention.

Lesson #19: The Government is the Ultimate Short Term Trader

The government is the ultimate short term oriented player. It will do anything to quickly ease the pain with band aid patches on the economy or financial markets without thinking about the implications. If the pain can be deferred to the future, the government will take on huge amounts of risk to do so.

Lesson #20: No One Cares About You More than Yourself

No one is going to take responsibility for the crisis so you have to look out for yourself and manage your risk well. Why? Because no one will take responsibility for making you lose money.

http://www.oldschoolvalue.com/blog/investing-perspective/20-lessons-2008-crash/

Introduction to Valuation by Aswath Damodaran

High Growth = High Return?

High Growth = High Return? It is only true if

1. Higher growth translate to higher value
2. The growth expectation have not been incoporated to the stock price.

How to estimate growth?

• Investors tend to estimate expected growth by looking at its past, or expected growth in earnings in the future.
• This estimation is divorced from the operating details of the firm
• The soundest way is to make it a function of how much a firm reinvests for future growth and the quality of its reinvestment.
• Expected growth rate in Equity income, g = Retention ratio  x Return on Equity (ROE)

Value Creating Growth vs Value Destroying Growth

•  From above Equation
• Retention ratio = g / ROE
• Payout Ratio = 1 - Retention ratio
• Based on Gordon constant dividend growth model,
• Value of Equity = (Net Income x Payout Ratio)/(Cost of Equity - Expected Growth Rate)
• Click here to see the calculation in spreadsheet
• E.g. of A non value creating growth; ROE = 10%, Cost of Equity = 10%, NI = 100M
• If company growth @ 5%, 
• Retention Ratio = g/ROE = 5%/10% = 0.5
• Payout Ratio = 1 - Retention Ratio = 1 - 0.5 = 0.5
• Value of Equity = (100M x 0.5)/(10% - 5%) = 1,000M
• If company not expected to growth at all
• Retention Ratio = 0/10% = 0
• Payout Ratio = 1
• Value of Equity = (100M x 1)/(10% - 0%) = 1,000M
• The growth in this firm doesn’t add value to the shareholders.
• If growth increases earnings, why is it not affecting value?
• E.g. of A value creating growth, ROE = 15% (instead of 10%),  Cost of Equity = 10%, NI = 100M
• If company growth @ 5%, Value of Equity = 1,333 M
• If company not expected to growth at all, Value of Equity = 1,000 M
• The growth now increases the value of equity due to higher ROE than cost of equity.
• E.g. of A value destroying growth, ROE = 6% (instead of 10%),  Cost of Equity = 10%, NI = 100M
• If company growth @ 5%, Value of Equity = 333 M
• If company not expected to growth at all, Value of Equity = 1,000 M
• The growth now reduces the value of equity due to lower ROE than cost of equity.
•  Return of Equity (ROE) vs COE (Cost of Equity)
• ROE > COE will generate value for investors. 
• ROE < COE will destroy value, and at increasing rate as growth accelerates.

 Growth at Reasonable Price

• Even if a company’s growth is expected to be value generating (ROE > COE), its stock may not be a good investment if the market has overpriced growth.
• A stock with higher expected growth rate should sell at a higher valuation. But, how much higher should it be? 
• Refer to the calculation on the google doc,  the present value of a stock will be affected by it's P/E, Growth Rate, and COE
•  
• Company A 
• EPS is RM0.10 
• No Dividend (Retention Rate = 100%) - All earning reinvested to the business with same return
•  Growth 10% a year.
• Says, my COE is 10%, and I am buying to A that selling on P/E 10 (RM0.1 x 10 = RM1.00) . 
• In 5 year times, the EPS growth to RM0.10 * (1+10%)^5 =  RM 0.16 and A's P/E maintain at 10, the share price = RM1.60. 
• The Present Value = RM1.60 / (1+10%)^5 = RM1.00
• Thus, by paying RM1.00 to buy A is buying A at fair value.
•  If you pay 1.50 (PE of 15) - you are paying a high price;
• If you pay 50 sen (PE of 5) - you got a real bargain. 
• Company B
• EPS is RM0.10 
• No Dividend (Retention Rate = 100%) - All earning reinvested to the business with same return
•  Growth 20% a year.
• Says, my COE is 10%, and I am buying to A that selling on P/E 20 (RM0.1 x 20 = RM2.00) . 
• In 5 year times, the EPS growth to RM0.10 * (1+20%)^5 =  RM 0.25 and B's P/E maintain at 20, the share price = RM5.00
•  The Present Value = RM5.00 / (1+10%)^5 = RM3.10
• Thus, by paying RM2.00 to buy B is a bargain - the PV is > 50% the price you pay
• It is justified to pay a higher price for stock B which has a higher growth than A. 
• In view of the consistency of the growth in B, investor may be willing to pay a higher valuation for it 5 years later. 
• If the rate of growth is maintained at 20%, and valuation expanded to a PE of 30, the present value of stock B is worth $4.64. 
• The “growth” is the future expected growth and it is a forecast figure which is very difficult to predict. 
• The high growth rate often does not last long enough to justify high PE. If forecast growth rate is lower than expected (says 15%) and the PE ratio wil be contracted to 15. Then the EPS = 0.10*(1+0.15)^5 = 0.20; Price @ Year 5 = 0.20 x 15 = 3.00; PV = 3.00/(1+0.1)^5 = 1.86
• Even analysts got their forecasts wrong most of the time. So how good is yours?

Conclusion

• Successful growth investing require
• to buy high growth companies with ROE > COE
• at reasonable prices
• A prudent growth investor will consider
• the magnitude of the expected growth 
• the sustainability of this growth rate (there is a tendency for high growth rates to converge towards normal level over time-and the quality of this growth).
• Investors should not only focus on the bottom-line, and pay attention to how efficient the growth is being generated.

References:-

• Growth Baby Grow kcchongnz (private)

P/B ratio as Invesment Strategy

What is P/B ratio?

• It compares the market's valuation of a company to the value of that company as indicated on its financial statements.
• Price to Book = Price per Share/Book Value of Common Equity
• Book value of equity is the difference between the book value of assets (cash, accounts receivable, inventory, equipment, etc.) and the book value of liabilities (loans, accounts payable, mortgages, etc) - if you liquidated a company, this is what the leftover assets would be worth after paying off all the debts.

Low P/B Strategy 

• Low P/B  could signal a stock that is currently undervalued. 
• It is least likely to suffer serious share-price declines in the future
• Research has shown that low P/B stock have less downside risk & tend to outperform the overall market pretty consistently over long periods of time.

Undervalued or Underperformer?

•  A low P/B ratio (<= 1.0) can mean one of two things:
•  The stock is selling at a discount to its fair value - A buying opportunity
• Something is fundamentally wrong with the company - Avoid it like the plague.

Limitation on P/B ratio

• It only work well for companies with a good deal of assets on their books
• Intagible assets are ignored - it may not be very applicable to service firms.
• Acquisition can boost the book value and decrease the P/B ratio as a result
• Share buy back lead to lower book values.

ROE + P/B - Theoretical background

• The financial theory postulated by John Burr Williams in his “The theory of investment value” says the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. The simplest model for this purpose would be the Gordon constant dividend growth model for a stable firm.
• Eq 1: P₀ = DPS₁ / (r-g)  
• P₀ = Value of equity 
• DPS₁ = Expected dividends per share next year 
• r = Required rate of return on equity 
• g = Expected growth rate in dividends (forever)
• Divide both sides of Eq 1 with Book Value of Equity Per Share, BVPS
•  Eq 2 : P₀ / BVPS = (DPS₁ / BVPS) / (r-g)  
• P/B = DPS₁ / EPS₁ *  EPS₁ / BVP / (r-g)
• P/B = Expected Payout Ratio * ROE / (r-g)
• Based on above Eq, the PB ratio will
• Increase - expected growth rate increase
• Decrease - if firm have higher cost of capital
• Increase - if firm have higher ROE (more efficient)
• ROE - A measure of how well a company is using reinvested earnings to generate additional earnings
•  If a company’s ROE has been on the rise, so should its P/B ratio - one should take notice if there is a large discrepancy between the ROE and P/B
• Expected Growth Rate, g = ROE * Reinvestment Rate = ROE * (1- Expected Payout Ratio)
• g/ ROE = 1 - Expected Payout Ratio
• Eq 3: Expected Payout Ratio = 1 - g/ROE
• Substitute Eq 3 to Rq2
• P/B = Expected Payout Ratio * ROE / (r-g)
• P/B = (1 - g/ROE) * ROE / (r-g) = (ROE/ROE - g/ROE) * ROE/(r-g)
• Eq 4: P/B = (ROE - g) /( r - g)
• Based on Eq 4: 
• Growth doesn't look to be a convincing factor for P/B
• We should compare the ROE vs the Cost of Capital

Investing using the low P/B ratio strategy

•  Additional screening criteria for low P/B stock
• P/B < 1.5
• Debt / Capital < 70%
• ROE > 8%

 
References:-

• Low Price-to-Book Investing Strategy  kcchongnz (private)

Warrants

Warrants

• There are 2 types of warrant traded in bursa, i.e. Company Warrants and Structure Warrants
• It is a derivatives whose value depends upon  an underlying share listed in Bursa.
• It serve as tools for hedging, speculating and arbitraging.

Company Warrants

• It is issued by the company to raise money. 
• Normally, it was issued “free” as a "sweetener" for a bond, preferred stock, or rights  offering. 
• It is a right, but not an obligation, to subscribe for new ordinary shares at a specified price during a specified period of time. 
• It have a maturity date (up to 10 years) after which they expire are worthless unless the holder subscribes for the new shares of the company before the maturity date. 
• It generally American style option which can be exercise any time by paying the exercise price and convert to the underlying shares before the expiry of the warrants
• It represent a potential source of equity capital in the future and can thus offer a capital-raising option to companies.

Structure Warrants

• It is a proprietary instruments issued by a third-party issuer (e.g. investment bank).
• It give holders the right, but not the obligation, to buy or sell the underlying instrument in the future for a fixed price.   
• There is no conversion to the underlying share. 
• They are essentially European style option with cash settlements only with the investment bank at expiry date.

The Lingo

•  Strike Price \ Exercise Price, X 
• The price at which an underlying stock can be purchased or sold.
• A stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit.
• It must occur before the expiration date.
•  Premium, P
• The total cost (the price) of a warrant
• It is determined by factors including the stock price, strike price, time value and volatility.
• P = (W + X ) / S – 1
• W = Warrant Price
• X = Exercise Price
• S = Underlying Share Price
• There are 2 components of the premium are the intrinsic value (IV) and the time value (TV), P = IV + TV
• Intrinsic Value is the difference between the underlying share price (S) and the exercise price (X), IV = S – X
• Hence P = (S-X) + TV
• The lower the premium the more valuable the warrant.  
• The more time to expiration, the greater the time value of the warrant. - time increases the likelihood that the position can become profitable. Time value decreases over time and decays to zero at expiration. 

Factor that influence warrant price

• Underlying Share Price
• if the price of the stock is below the strike price of the warrant, there is no reason to exercise the warrant
• Days to Maturity
• It is worth less as time goes on and expiration approaches.
• Time Decay - it will accelerate as expiration approaches if the strike price is above the current price.
• Dividend
• Warrant-holders are not entitled to receive dividends
• The corresponding reduction in the stock price reduces the value of the warrant.
• Interest Rate / Risk Free Rate
• Higher interest rates increase the value of warrants.   
• The influence of this factor is small.
• Volatility, σ
• It is measured by the annual standard deviation of return of the underlying share.
• The higher the volatility or the movement of the underlying share price, the higher the odds that the warrant will eventually be in the money and the higher the value of the warrant will be.
• Dilution
• The exercise of volume will increase company's outstanding shares.
• This adds a twist to valuation that is not present in normal option valuation.
• Restriction on Exercise
• Any restrictions on the exercise of warrants will impact the value of a warrant negatively.
• E.g. the different between American-style and European-style warrants; American-style warrants permit exercise at any time, while the later can only be exercised on the expiration date. 

Why buy warrants instead of underlying share?

• Speculation
• Betting on the movement of a security.
• It is the territory in which the big money is made - and lost. 
• You have to be correct in determining
• The direction of the stock's movement
• The magnitude and the timing of this movement. 
• Leverage
• When you are controlling 1000000 shares of warrants, it doesn't take much of a price movement to generate substantial profits.
• Gearing
• The ratio of the share price to the warrant price
• It reflects how much the price of the warrant changes for a given change in the stock. 
• The higher the gearing, the more valuable the warrant.

Valuing Warrants with the Black-Scholes Model

• This formula is for European-style options and, though American-style options are theoretically worth more, there is not much difference in price in practice.
• The valuation of a warrant is expressed as: W = S N(d₁) - X e^-rT N(d₂)
• W= price of the warrant
• S = price of the underlying stock
• X = option exercise price 
• r = risk-free rate 
• T = time until expiration 
• N() = area under the normal curve
• d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2
•  d2 = d1 - σ T1/2
• Because of the dilution that warrants represent, the value of that call needs to be divided by (1 + q) where q is the ratio of warrants to outstanding shares, assuming each warrant is worth one share. 

References:-

• Company warrants and structure warrants kcchongnz (private)

Value with Momentum

Momentum helps is that it provides an answer one of the biggest issues of value investing, namely the “when will it happen?” question.

• Imagine you’ve found a neglected jewel which you expect that will ultimately capture an upside of, say, 75%...  
• But, when will it happen? In 3 yrs, 5 yrs, 7 yrs..?
• Those periods equate to IRRs of 20.5%, 11.8% and 8.3% pa respectively. 
• Assume a catalyst exists that’s successful in prompting a realization of that full 75% upside within 1 year. That is, of course, a 75% IRR!

 
How to find under-valued, out-of-favour companies at the point when the market is starting to recognize them?

• Discover a group of value stock by examine the price-to-book, price to-cash flow, price-earnings and price-to-sales ratios.
• Ascertain which of them are likely to rebound versus being cheap for a reason, such as being near bankruptcy. 
• Look for sign of momentum
• in terms of price momentum (relative strength) 
•  in terms of improving analyst sentiment and earnings surprises.

 
Some examples of possible catalysts include:

1. Fresh management with new direction 
2. A change in strategy of existing management (e.g. new product strategy, business reorganization  or  cost  reductions)
3. A  disposal  or  purchase  of  a meaningful asset 
4. A recapitalization of the business
5. A  takeover bid, or 
6. Activist shareholders who may put pressure on management to act.

Screen Criteria

1.  At least one of P/B, P/CF, P/E or P/Sale more favourable than the industry
2. 6 month relative strength (% gain vs S&P) > 0
3. 3 month relative strength >= 6 month relative strength
4. Earning suprise by examines three inter-related measures
1. Standard earning surprise - most recent interims vs forecasts
2. Abnormal returns around recent earnings announcement
3. Revision in the analyst consesnsus - now or trending over the last 6 months

Diversification & Portfolio

• No one stock makes > 1.6% of the portfolio
• No single industry make up more than 3% relative to the weight in the corresponding benchmark
• Ruled out stocks than have been public < 2 years

References:-

• Investment Strategy: Buying bargains on the move, Stockopedia

P/E ratio as Invesment Strategy

What is P/E ratio?

• P/E = Stock Price / EPS
• It is the most widely used metric as a measure of how expensive or cheap a stock is. It have been used in valuation reports by stock analysts and investment bankers.
• It vary across sectors - some sectors have high P/E while some have low. 
• Generally, stock trade at low P/E than other stock in same sector must be misprice

Which "EPS"?

• ·         Is it the EPS of the most recent financial year? 
• ·         Is it an undated measure of EPS by adding up the latest four quarters results? 
• ·         Is it the expected EPS for the next financial year? 
• ·         Is it before or after the extra-ordinary items? 
• ·      Is it based on the outstanding number of shares or all shares that will be outstanding when all warrants or ESOS are converted (fully diluted)?

Why different P/E?

•  Every company (even those in the same industries) contain unique variables, e.g.
• growth
• risk 
• cash flow patterns
• Company A and Company B should have same P/E?
• Company A has poor operating efficiencies, no potential growth, a poor balance sheet 
• Company B has superior earnings and cash flow growth, and a healthy balance sheet.
• Company with strong market position in general generates more stable earnings should be accorded with higher P/E ratio.

P/E vs Mr. Market

• P/E ratio serve as proxt to reflect market moods and perceptions 
• This can be viewed as a weakness, especially when markets make systematic errors in valuing entire sectors. 
• Below figuee shows the PE ratio distribution of S&P500 stocks on 31^st December 2013. Most stocks are now trading above a PE of 16. Hence a PE ratio of less than 16 may be good, below 8 will be fantastic, but above 20 may be too expensive. 

• 

 

P/E ratio: Theoretical background

• The financial theory postulated by John Burr Williams in his “The theory of investment value” says the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. The simplest model for this purpose would be the Gordon constant dividend growth model for a stable firm.
• Eq 1: P₀ = DPS₁ / (r-g)  
• P₀ = Value of equity 
• DPS₁ = Expected dividends per share next year 
• r = Required rate of return on equity 
• g = Expected growth rate in dividends (forever)
• Divide Eq 1 by Expected EPS next year, Eq 2: P₀ / EPS₁ = Forward PE = (DPS₁ / EPS₁) / (r – g ) = Expected payout ratio / ( r – g )   Equation 2
• From Eq 2,
•  A higher growth firm should  have higher P/E.
• A higher risk firm having a higher cost of equity ,r , will have a lower P/E ratio
• P/E should increase when the payout ratio increases.
• Firms that are more efficient about generating growth by earning a higher return on equity will trade at higher multiple. 
• Eq 2 only applicable for firm with stable growth, for a high growth company, you would have to estimate the payout ratio, cost of equity and the expected growth rate in the separate phase of high growth and the stable growth period, and summing up the value in these two phases taking the time value of money into consideration. This approach is general enough to be applied to any firm, even one that is not paying dividend right now.

Investing using the low P/E ratio strategy

• Basing on P/E ratio alone is not a desirable way as P/E ratio theoretically depends on a number of factors. 
• Low PE stocks are riskier than average and that the extra return is just a fair compensation for the additional risk, low future growth rates and poor quality earnings. 
• Additional screening criteria for low P/E stock
• Low P/E ratio with respect to the prevailing market, say not more than 12
• Low idiosyncratic risk as measured by 
• debt/capital ratio < 0.6
• current ratio of more than unity
• interest coverage ratio > 3.
• Reasonable expected growth in earnings > 5%
• Historic growth rate in past 5 years > 5%
• Good quality of earnings with reasonable cash flows

Estimating fair PE ratios from fundamentals

• Katsenelson’s absolute P/E method to find a fair value of P/E ratio for a specific firm. 

 

References:-

• Price-to-earnings ratio and its use as an investment strategy kcchongnz (private)