Month: May 2008

In his annual letter to shareholders for the year 2000, Buffet wrote that the principle for valuing an asset for financial gain was established by Aesop in 600 BC and it remains largely unchanged since then. The fable’s moral – a bird in hand is better than two in the bush.

You have to go through Buffet’s explanation several times before it starts making sense but once it does it hits you that the thing is absurdly simple and insightful.  

A bird in hand is the risk free rate of interest that you would get if you bought government securities. So the returns that you are expecting from your investments should be much more lucrative than the risk free rate of interest that you can earn. And to find out whether it is lucrative enough or not you have to look in the bush and answer these three questions:

1. Are there any birds are in the bush?
2. When will the birds emerge and how many would there be?

Put simply would the business ever generate positive cash flows?

When it does generate positive cash flows, would the discounted cash flows be greater than what has been spent in the initial years to be profitable and lucrative?

Buffet stresses upon the fact that ultimately it is the cash generation ability of a business that will decide its true worth. Other factors like P/E Multiple, book value, dividend yield etc. are at best just clues as to how much the business is worth.

I find this particularly interesting because I use P/E multiple quite a bit in deciding whether a stock is selling at a reasonable price or not. However the fallacy is quite obvious, a company which is struggling will have a comparatively lower p/e but that does not make it lucrative. On the other hand a company which has performed sturdily over the years and promises to do the same in the future would have a higher p/e but that doesn’t make it expensive either.

Projecting cash flows for a business isn’t an easy thing to do however it is not a very difficult thing to do either. What an investor needs according to Buffet is a general understanding of business economics and a sense of independent thinking which can help the investor to reach a ‘well founded positive conclusion’.

The projected cash flows should be a range rather than a fixed number so that you get an estimate of the most pessimistic view to the most optimistic. This would help in ironing out any errors in forecasts that may have been made. In industries where technology changes rapidly or in the case of new businesses even getting a range of estimates become difficult and hence Buffet’s advise of investing in businesses that an investor understands.

The concepts that Buffet discusses are quite simple and insightful and though it takes some time to digest and go through them, the simplicity and thoughtfulness really makes sense in the end.

Manshu Verma

The concept of value investing was established by Benjamin Graham and David Dodd who were both Columbia professors. At its core, value investing means buying into securities whose price is lower than their ‘underlying value’. There are various measures to judge the underlying value and primary among them are P/E ratio, price to book ratio, book value, intrinsic value etc.

Value investors look for stocks that are trading at less than what they are actually worth and then buy into such stocks. Typically these situations arise when the market over reacts to a piece of bad news, there is a general down turn in the market or a particular stock gets beaten down more than it deserves and other such situations.

The key, is to understand that valuing a stock is always an inexact science and you need to factor in some margin for error or what has been famously described as Benjamin Graham as margin of safety in whatever price you have given to a security.

Growth investing is the name given to the kind of investment where the investor buys a stock because the company is in a high growth industry. Such companies are expected to grow at a high rate for the next few years and are generally characterized by a high P/E multiple.

This type of investing became popular in the dotcom era. After the dotcom burst though growth investing ceased to be as sexy as before, but the concept is still widely used by analysts. Typically investments in emerging markets, technology stocks and smaller companies are used as vehicles for growth investing.

What investors need to keep in mind is that the P/E multiple is a means to judge the ‘price’ of a stock and by definition most of the ‘growth stocks’ have high earnings multiples.

Therefore the risk on your investment also becomes that much more. However that doesn’t mean that the stocks with high P/E will always be lemons. A lot of investors have made good money on stocks like Apple and Google which typically trade at a higher P/E due to their growth rates. What it means is that if a company doesn’t shine as it was promised to; the fall could be quite steep.  

Most lenders including financial institutions use the value at risk assessment to determine how much risk is involved in a given scenario. Since they are in business to make money, they have to reduce the amount of risk they involve themselves in. Losing money due to people not paying what is owed can result in them going under as well. With the value of risk they can assess the probability of loss that could occur over a given frame of time.

It is commonly referred to as the VaR by many institutions. There are many factors that play into it, so the results can be quite different from one time period to the next. How volatile the market is at a given time will play a huge role in the VaR. There are several different tools that institutions use to calculate the VaR, but all of them will give them similar results.

However, the VaR also gets plenty of criticism in the market. Many complain that such predictions aren’t always a fair indicator of how they will repay what they borrow. Therefore they feel they are being penalized for what has taken place in history rather than based on their own merit.

A rolling settlement is one that you will get your return on after a set period of time. This concept refers to trades that take place with any of the various stock exchange locations. The number of trading days will be known and therefore investors can determine exactly when they will be receiving any funds they have earned on their investments.

This is important because with a rolling settlement there are likely to be investments that are traded each day. This process allows investors to really see how much they have earned for each day, and not as a total over that time frame. It is important to understand that those days may be offset by weekends and holidays. Understanding that can help investors to be accurate about the days in which they can expect to receive payment for their earnings.

You will find that for the past 20 years rolling settlements have been increasingly popular. Due to the high amount of international trades that take place daily, a common ground had to be established for paying out the dividends. That common ground is almost always in the form of a rolling settlement.

Authorised capital is the total dollar amount that a company is legally able to raise through the process of issuing shares of the company. This is often done when they company need to raise capital in order to finance some type of addition or change of direction for the company. The company can choose to offer shares up to the dollar amount of authorize capital.

Generally, they don’t do so if they only need a lower amount of money to work with. Should the company find that they need to access more capital than their limit, they can seek to increase it. This is done through a process that requires the approval of the shareholder’s of the company. They have to vote in favor of that increase in order for it to take place.

Those who buy these shares understand there is some risk involved in the process. If the company isn’t successful in their efforts then the shares won’t be worth anything. However, if they make wise business decisions that result in more revenue then they can make some money from such investments.

Many business owners offer ESOP for their employees to take part in. This is short for Employee Stock Ownership Plan. This is a great way to get employees to take more pride in their work. They will view it as more than just a job as they now know that if the company makes money they will too.

There may be a time frame that the person has to work for the company before they can take part in the ESOP. Generally it is one year after the date of hire. The specifics for the company will be explained to you upon your acceptance of employment. ESOP’s are a great way to make your money grow so consider investing in them if you have the opportunity to do so.

There may be a cap as to how much stock an employee can buy with an ESOP plan. It is also common for there to be a specific period of time in which the employee can’t sell the stock after buying them. Some employers allow their employees to borrow money against the stock they have in their ESOP plan as well. This can be a great way to get access to money you need at a certain point in time.

During a lock in period, an investor is prevented from selling the shares he holds. There are certain types of stocks that a person can buy that have this stipulation attached to them. The amount of time that the person can’t sell the stocks has to be disclosed. That information can’t be hidden and then revealed later on by law. Generally it is at least 90 days though and not more than one year.

Many employers who allow their employees to invest in stock for the company have such guidelines in place. The amount of time that this covers will vary so it is very important to pay attention to it before you buy. After that period of time has passed the individual can sell them if they choose to do so. This is done in order to offer outside investors some sense of security.

For example if a company is doing poorly, it is generally the employees who will know it first. This can result in them rushing to sell their stocks. As a result of that movement the public will do the same because they are following suit. There also won’t be much of a market to buy these stocks. With a lock in period in place though this can’t occur even if the employees do have information that indicates the company isn’t doing so well right now.

There is often a significant risk involved for the holders of bonds when it comes to reinvesting. It is important to understand that the rate of return is going to be less if the rates drop. This is because that process prevents most investors from successfully being about to invest at the assumed rate.

Investors need to be very careful with this when there is a trend of interest rates continuing to drop. Knowing your reinvestment risk rate will help you to calculate the overall risk that is involved with particular types of investments. The fact that the dividends from the initial investment may not be invested at the same or a higher rate is something you will have to be prepared for.

The issue of the reinvestment risk rate pertains more to those that engage in long term bonds than short term investments. This is because they may have to be reinvested after rates have dropped from what the purchase price was. This is one of the main calculations that investors look at when they want to predict what their risk is for a given investment.