Why some gain and others lose?

Morgan Kelly in his research (1997) entitled, Do Noise Traders Influence Stock Prices?, identified three types of investors: smart-money traders, noise traders and passive traders.

Smart-money traders always behave rationally whereas noise traders always buy high and sell low. Passive traders do not actively participate in the market most of the time.

According to Kelly, the probability of being a noise trader declines with income. As a result of higher income, smart-money traders can acquire more reliable research reports to help them in investment decisions.

Noise traders, being in the lower income group as well as lacking critical information and having wrong information, end up losing money in the stock market most of the time. Their aim to recoup losses lead to more losses. Nevertheless, the presence of this group of traders makes it possible for smart-money traders to make money.

In general, noise traders are always affected by emotion and past experience. They rush to sell when prices fall and buy when prices go up because they believe the current trend will continue into the future.

As a result of over-confidence and lack of self-control, they are unable to act rationally. Furthermore, due to a lack of financial training and limited capacity to process information, they tend to misinterpret economic and market information.
Most of the time they put faith in the information they want to hear and if that contradicts what they have done, they will “bend'' the information to confirm their actions.

Some noise traders rely on heuristics and rules of thumb to make decisions.
Heuristic refers to the process whereby investors develop their investment rules by trial and error. These will later develop into their own rules of thumb.

An example of the rule of thumb is buying stocks when the market transacted volume falls to 100 million a day and selling when the market volume surges beyond one billion a day. However, this rule of thumb has changed of late.

With the implementation of one board lot of 100 shares, we notice that the lowest daily market volume is about 400 million to 500 million. A daily market volume of one billion shares may not imply a sell signal. Given that there is no empirical evidence to verify the effectiveness of these heuristics, noise traders tend to commit systematic forecasting errors.

Apart from the above, noise traders also like to follow others in making investment decisions. This situation is called information cascading where investors make their decisions based on the observations of others’ previous actions. They will try to gather information available from the history of previous action choices.

For example, we choose restaurants that are full of customers than otherwise, without knowing how the food tastes.

Most day traders select stocks showing higher gains and bigger market volume. They may not know the exact reason for the strong buying interest in the stocks but they believe certain people may have certain private information.

However, when the private information on these stocks is not consistent with the value of the stocks, this can cause a heavy sell-down. The sudden reversal of an information cascade is called information avalanche.

Hence, noise trading keeps us from knowing the expected return on a stock.
Smart-money traders always maintain unbiased expectations and make rational decisions. Due to the inaction of passive investors, this may help to slow the decline of a stock.

Investors need to constantly upgrade their investment skills by reading up on stock market investment or attending courses on investment.

·Ooi Kok Hwa is a licensed investment adviser and managing partner of MRR Consulting.

Source: TheStar

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Investing for the longer term

Shares that we intend to hold for the long term should have the Four “Ps'' and have enough margin of safety. We need to be patient and wait for the right time to invest, says Ooi Kok Hwa, a licensed investment and management partner of MRR Consulting.

Q: Are we able to find the next “Public Bank” that can make us millionaires after holding it for 40 years?

In Public Bank's recent AGM, founder Tan Sri Teh Hong Piow mentioned that a shareholder of 1,000 Public Bank shares in 1967 would now be owner of 129,720 Public Bank shares worth RM1.55mil (including all gross dividends)!

This represented a compounded annual return of 20% for each of the 39 years.

A lot of investors have been searching for the next “Public Bank” stock. Given the present stock market level, identifying cheap stocks is a little bit like treasure hunting.

According to Warren Buffett’s letter to Berkshire Hathaway Inc. shareholders, he said he was currently searching for companies with the following characteristics (i) large purchases; (ii) demonstrate consistent earnings power; (iii) earning good returns on equity with little or no debt; (iv) good management in place; (v) simple businesses; (vi) an offering price.

In Malaysia, not many companies are able to meet the above criteria.

According to Michael Moe on his book, “Finding the Next Starbucks”, we need to focus on Four Ps, namely People, Product, Potential and Predictability.

“People” refers to the quality of management, especially the quality of leadership.

For “Product”, we need to invest in a company that is an industry leader with substantial market share through its products.

Next, the company should have a great market “Potential”. It is really not easy to identify a high growth company with consistent high growth in business and performance.

Finally, the company should have “Predictability” in its business model and operating results. Given the current high stock market level, we have companies having the above four Ps, but they may not be able to provide the margin of safety (MOS).


Margin of Safety (MOS)

Apart from the above four Ps, we should not ignore the price that we pay for a stock. MOS, which is widely used by Benjamin Graham, refers to the remotest chance of a stock losing its market value.

It is the discount at which the stock is trading below its minimum intrinsic value.

If Company A's share is selling at RM2.00 each and its minimum intrinsic value is computed at RM3.00, so the MOS will be RM1.00. It is the difference between the intrinsic value of RM3.00 versus its market price of RM2.00.

The intrinsic value that is computed by an analyst is a rough estimation of a company's value.

According to Warren Buffett, the real intrinsic value could never be precisely calculated.

As a result, he suggested that either we purchase companies with businesses that are simple and stable in character or there must be a MOS between the market value and the computed intrinsic value.

As future events are always impossible to ascertain, MOS provides a cushion to the potential margin of error in the intrinsic value computation.

According to Graham, there are two possible situations when MOS will be available to an investor.

One is when market sentiment is weak and most stocks are selling at depressive price levels, while another one is even when the general market is not particularly low.

Under normal market conditions, a suitable MOS depends more on the expected earning power than the asset value of a company.


Q: I sold most of my stocks after the Chinese New Year. But the market has gone up much higher than my previous selling level. Should I come back in?

Since the sell-off right after Chinese New Year, the market has recovered about 200 points to the current 1,300-point level.

A lot of investors have started to feel uneasy over missing the opportunity of making the extra 200 points. Most of them are currently sitting on a lot of cash.

Buffett said: “When there’s nothing to do, do nothing”.

For long-term investing, we need to be patient in order to find a stock that can meet the above four Ps coupled with a reasonable MOS. However, many retailers always feel that they have to be doing something in the market at all times.

Thus, if you regret missing the opportunity of selling your shares before Chinese New Year, you may want to consider locking in your gains now.

Source: TheStar

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Defensive way of investing

In view of the uncertainties of the stock market outlook, how to invest now?

Even though the market rebounded lately, a lot of retailers are still cautious. They still recall clearly their bad experience on how the market wiped out all their gains within a short period of time.

Despite the Government’s efforts to make Malaysia a better place to invest, our market cannot escape from potential negative external risks like the yen carry trade, the threats of possible US economic recession or the volatility in the US or Shanghai markets. Thus, retailers need to adopt a more defensive way of investing amid the current market situation.

Benjamin Graham developed a method called defensive value investing, which uses a few strict quantitative guidelines for the stock-screening process.

According to Graham, a defensive investor is one who places great emphasis on avoiding serious mistakes or losses. As he explained in his book The Intelligent Investor, the serious investor is someone who is looking for “safety and freedom from bother”. This approach emphasises the avoidance of serious mistakes but, at the same time, provides satisfactory returns.

Graham’s defensive investor screen


Adequate size of the enterprise
Graham considered this the most important factor. He recommended [in 1970] that an industrial company should have at least US$100mil of annual sales and a public utility company should have no less than US$50mil in total assets.

This was because smaller companies tended to have a more volatile performance compared with bigger corporations. As a result of the adjustment on inflation and the different industry structures of different countries, we think selecting large companies that have a market share of at least 10% in the industry should be a fair guide today.


A sufficiently strong financial condition

Graham proposed that we should select companies with a sufficiently strong financial condition – with a current asset ratio of more than two times. Also, the company’s long-term debt should be less than the net current assets (or working capital), and the debt-to-equity ratio should be less than 0.5 time.

Cash-rich companies with little borrowings would be able to fulfil these requirements. Graham’s student, Warren Buffett, did mention in his 1987 letter to shareholders that “Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage”.


Earnings growth and stability
The company should not have incurred any losses over the past 10 years and its earnings per share should have grown by one-third in the same period. Hence, companies in cyclical business may find it difficultto meet these requirements.


Dividend growth
The dividend returns are always the most important form of reward for an investor. According to Graham, the company should have a continuous record of dividend payments for at least 20 years. In Malaysia, only a handful of companies can fulfil this requirement.

Moderate price-to-earnings ratio (PER)
To safeguard investors from paying too high a price, the current price of a stock should not exceed 15 times of its average earnings for the past three years. Based on our estimation, the current market PER is selling about 15 times. There are still a lot of good fundamental stocks selling at PERs of less than 15 times. Nevertheless, they may not be able to match the above earnings and dividend requirements.

Moderate ratio of price-to-assets
Graham suggested that a defensive investor should not pay more than 1.5 times of the company’s net asset value. This acts as a safeguard against overpaying for a company. Most property companies may be able to meet these criteria, however, they may find difficulties in fulfilling guideline 2 (strong financial condition requirement) as most of them have high financial gearing.

Even though Graham did warn that many of the above might become obsolete with the passage of time, I believe some of the principles can still be applied today, given the high uncertainties in future market movements.

Source: TheStar

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To buy or to sell stocks?

WHY did our stock market crash?

Investors need to understand that the stock market normally takes a longer time to go up than to go down,

When the market drops, as a result of fear and panic, it just cannot move down gradually.

In the recent market crash the KL Composite Index (KLCI) tumbled from a high of 1,283.47 on Feb 23 to a low of 1,110.69 on March 5, plummeting 173 points in six trading days.

The reasons behind the crash were attributed to the sharp drop of 8.8% on the Shanghai Composite Index, the unwinding of the yen carry trades as well as worries over a rapid slowdown in the US economy.

In addition, our own market correction after the KLCI's sharp rise of about 400 points without any major pullback – from 886.48 points on June 15, 2006 to the recent peak of 1,283.47 – also contributed to the downturn.

Hence, we should be aware that the KLCI took 8 months to put on 400 points, but needed only six days to lose 44% of those gains.

Apart from the China market, other regional major stock markets like Hong Kong, Japan and Singapore as well as the US market also made big losses over the past two weeks. We are not surprised by the losses, given that these markets have been making large gains over the past 8 months.

Rachel Campbell, Kees Koedijk and Paul Kofman in their research titled Increased Correlation in Bear Markets, found evidence of significantly increased correlation in international equity returns during the bear markets.

As a result of the international contagion, a big crash in any one market could lead to major crashes in other financial markets.

Hence, apart from monitoring changes in our KLCI, retailers need to keep track of movements on other major indices like the Shanghai Index, Hang Seng Index, Dow Jones Industrial Average Index and Nikkei 225.

Some traders even track the movement of the yen versus the US dollar in view of worries over yen carry trade.

Should I cut my losses now?

Some retailers tend to invest at the wrong time. Every time there is a bull market, the moment they start getting excited about the stocks and start to invest, the market collapses a few weeks after that.

In this recent market rally, we believe that a lot of retailers only started to invest one to two weeks before the Chinese New Year (CNY).

As a result of the market crash one week after the CNY, most retailers gave back all their gains while some even incurred losses.

According to Benjamin Graham, the word “intelligence” in intelligent investor “is a trait more of the character than of the brain”.

It has more to do with how investors control emotions when investing.

They must have the courage to take profit in a bull market and have the discipline to cut losses when the investment drops below a certain acceptable level.

At the beginning of the market crash, most retailers were reluctant to sell their stocks because the prices went below their recent highs.

For example, even though their cost of stock A was only at RM1.00, they did not want to sell the stock at RM1.70 because the stock's recent high was RM2.00.

To them, selling at RM1.70 means they are incurring a “loss” of 30 sen. In actual fact, they have already made 70% profit, given that their original cost was only RM1.00!

These investors, however, panic and want to sell when the market crashes further and when the stock price trades nearer to their original cost of RM1.00.

As a result, most retailers were unable to make money from the stock market because they bought and sold at the wrong time.

Is it a good time to buy now?

After a market crashes it needs to go through a period of consolidation before gathering the momentum to turn around.

Nobody can tell when the consolidation period will be over. In our local market, the recent low of 1,110.69 on March 5 may be the lowest level of the recent pullback. Ooi Kok Hwa, a licensed investment adviser and the managing partner of MRR Consulting, gives some advise on buying and selling of stocks

If the market goes against our view and starts to move up, we should not continue to be bearish if we have sold out all stocks. We must be then be prepared to buy them back.

Hence, we need to constantly monitor our country's economic development as well as the global economic outlook.

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How to select growth firms

Lately, companies that reported strong growth in sales and profits were rewarded with higher stock prices. Hence, analysts and investors are currently paying close attention to the latest financial results announcements, hoping to catch those stocks early at a low price.

Benjamin Graham defined a growth company as a company that has performed better than the industry average over a period of years and is expected to continue to do so in the future. As earnings potential is the primary driving force in stock prices, our focus will be on the potential growth in earnings, which has yet to be reflected in the current price.

When investors invest in growth companies, they are hoping to invest in companies with products or services that are in high demand and have an edge over the competition.

According to W. Chan Kim and Renée Mauborgne in their famous book, “Blue Ocean Strategy'', companies in blue oceans, where there is still ample untapped market space, have the highest opportunities for demand creation and profitable growth. Normally, they tend to be the best among their industry peers and place equal emphasis on value creation and innovation.

According to Warren Buffett, growth companies have long-term pricing power and sustainable moat. The long-term pricing power refers to the ability to increase prices even when product demand is flat or the ability to achieve large volume increases with only small additional capital investment.

A sustainable moat is regarded as the entry barrier that current competitors and potential entrants find impossible to break. Companies with the above two characteristics will normally show high growth in sales and good profit margin.

Recently, companies with great businesses and fast growth were traded at price levels that might not be unsustainable. Investors need to pay attention to the price that they pay and the expectation of future growth. In reality, it is impossible for a true growth company to exist for an infinite time period in a relatively competitive economy.

Therefore, the entry price for a growth stock is crucial. The time to purchase is when it is still on sale, and not when it’s already at the peak where everyone seems to own a piece of it.

How do I know whether this stock is considered a growth company?

One of the common methods used by analysts for identifying growth companies is by tracking the company’s quarterly financial results. Again, strong sales and profit growth are the two most important characteristics of a growth company. If a company is able to show consistent growth in sales, this implies that it is expanding its production capacity and activities.

The table shows the quarterly financial results of Tong Herr Resources Bhd. Over the past three quarters, from Q106 to Q406, it reported strong growth in sales and profits on a quarter-on-quarter basis as well as year-on-year basis.


As a result of lower profits reported in Q205, Q305 and Q405, its stock prices tumbled from a high of RM4.30 in early 2005 to a low of RM2.30 in February 2006. Since then, due to the strong growth in sales and profits, its share price has recovered to the RM4-level again recently.

Investors need to study a company’s financial performance to determine whether the potential of future growth has been fully reflected in its current stock price.

As a result of the extrapolation of the recent performance, when the market is already high, our analysis will tend to be over-confident, which would lead to the decision to buy or sell stocks at the wrong time.

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Relating earnings to stock price

Consistent growth in sales and profits reflects strong earnings power of a company. Investors need to check the company's financial performance before selling a stock.

How do I determine the earning power of a company?

As a result of higher investor confidence and stock prices, the market capitalisation of certain blue-chip stocks has surged to new highs.

Some analysts have started to revise upwards the target prices of these companies as a result of higher market valuation. It appears that the prospects of these companies have “suddenly” improved within a short period of time.

When we analyse their fundamentals, their sales, earnings or production capacity are about the same compared with the previous year's. Although certain companies may have shown better prospects due to some merger and acquisition activities, most of them have shown little change in their fundamentals. Yet, their stock prices have surged by more than 100% in less than a year!

We will not pay RM5,000 for a hand phone that is worth only RM1,000. However, we are willing to pay 5 to 10 times above the intrinsic value of a company during a bull market.

This may be attributed to our expectation of the future prospects of these companies. We may be able to judge the real value of a hand phone, but we have difficulty determining with certainty the future prospects of these companies.

Intrinsic value of the company
The fair price we need to pay for a stock will depend on the intrinsic value of the company. An investor needs to know the intrinsic value before making any purchase. According to Benjamin Graham in his book entitled Security Analysis, intrinsic value is an elusive concept.

He defined it as the price at which a stock should be sold if properly priced in a normal market and the value being justified by the facts, for example, the assets, earnings, dividends and definite prospects.

He also said the intrinsic value of a company could be determined by its earning power but admitted that it was very difficult to establish with precision a stock’s real earning power.

We can only provide an approximation on whether the value is adequate compared with its market price. However, we are unable to determine the exact intrinsic value.

Graham defined earning power as a combination of actual earnings, shown over a number of years, with a reasonable expectation that these will be approximated in the future. A company's strong earning power will imply that it has the potential to generate higher sales and earnings in future.

If the stock price of a company is highly correlated with its earnings, improved earnings will contribute to higher stock prices. If the current stock price does not reflect the strong earnings potential of the company, buying the stock at the current price can contribute to higher capital gain.

Method to determine the earning power

The following is one of the quantitative methods in determining the earning power of a company suggested by Graham. From the earlier definition, in order to check a company's potential earning power, we may need to trace its historical earning and sales performance.

The table shows the historical earnings of Transmile Group Bhd.


The consistent growth in sales and profits in the table reflects Transmile's strong earning power over the past six years.

Its stock price has also surged from the average price of RM1.81 in FY01 to RM12.45 in FY06. Any investor who had bought this stock at an average price of RM1.81 in FY01 should have made a handsome gain of 588% within a five-year period.

Unfortunately, most retailers would have sold this stock at around RM5.00 in FY04 as not many investors were able to resist the temptation of locking in their gains.

Given that most investors seldom check on the actual financial performance of a company, the decision to sell a stock would always depend on its original purchase price rather than the earning power of the company.

As a result, they usually miss the golden chance of making handsome returns from good fundamental stocks.

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Fundamentals key to sustain share price

Retailers are tempted to lock in their gains following the recent run-up in stock prices. They should not worry that higher prices would mean the stocks are due for a fall. It is the fundamentals of a company that determine the sustainability of its share price, writes Ooi Kok Hwa of MRR Consulting.

I have made very good returns on certain stocks. Should I lock in my gains now?

When to sell is always the toughest decision to make in investing.

Over the past week, as a result of some pull-backs on Bursa Malaysia, investors have started to wonder whether this is the right time to lock in their gains, given that the market has surged by more than 30% since the low in the middle of June 2006.

Most investors will have a sense of regret when the price of a stock that they have just sold goes up further.

To an investor who has sold Genting Bhd at around the RM25.00-level versus his original purchase price of only RM15.00, a return of 67% is supposed to be considered as a very handsome one. However, instead of feeling good about it, he may feel the other way around if the stock is currently selling at the RM38.00-level.

To him, he has missed an opportunity gain of 52% if he compares the current price of RM38.00 with his disposal price of only RM25.00. He would have earned an extra 52% if he had continued to hold the stock.

Do not sell just because the stock price has gone up

In his letters to Berkshire Hathaway shareholders, Warren Buffett said: “We need to emphasise, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time”.

He would only recommend a sell if the stock’s quality deteriorates or if the price rises far above the demonstrable value, or when a better opportunity arises. Except for the above three reasons, he would never sell a business whose intrinsic value continues to increase at a satisfactory rate and the current price is only temporarily above intrinsic value.

According to Buffett, the maxim that “you can’t go broke taking a profit” is a foolish premise on which to sell a good company’s stock.

Investors may miss out on the potential of greater gains if they do not have the patience to hold on to their winners for a longer period of time, as a good stock can sometimes increase 10- or 20-fold in value.

Investors get worried when there is a drop in the stock market. As they follow closely their winners’ stock prices, the chances are high that they will regret selling the stocks too early.

Sometimes, certain investors who seldom follow stock prices can sell at a better price than active investors who closely monitor the market's movements.

Hence, we should always remember that “just because a stock price has increased, does not mean it is due for a fall – the fundamentals are the determining factor, not stock price history”. (Peter Lynch)

Need to know the intrinsic value of the company

Nevertheless, it is always not easy to determine the intrinsic value of a stock.

Normal investors with limited financial training will find it difficult to determine the point at which a stock becomes fairly valued.

John Neff in his book entitled John Neff on Investing said: “Successful stocks don’t tell you when it’s time to sell them”.

In order to judge the intrinsic value of a company, investors need to know the earning power and the sustainable earnings of the company. We need to check whether the current market price has gone far beyond the company's fundamentals.

Some investors have tried to predict short-term price movements. They sell a good stock when the price appears to be too high with the expectation of buying it back at a cheaper price later.

Instead, the stock price goes up even higher after the disposal. If the fundamentals of the stock remain intact and promising, they should buy back the stock.

Unfortunately, in most instances, investors seldom buy back at a higher price when they realise that their prediction did not come true.

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