Balance Sheet

The Balance Sheet

The balance sheet tells you how much a company owns in its assets, how much it owes in its liabilities, and the difference will be equity. Equity represents the value of money the shareholders have pumped into the company.

Assets - Liabilities = Equity

Current Assets

Current Assets are used up or converted into cash within one business cycle which is usually one year. The major portions of this category are cash and equivalents, short term investment, accounts receivables and inventories. Cash and equivalents and short term investments refer to items which can be liquidated quickly into cash. Short term investments is similar to cash such as bond with less than a year to maturity and earn a higher rate of return than cash.

Accounts Receivables are bills that the company has not collected but expects to be paid soon. If accounts receivables rise faster than sales, the firm is trying to get sales but relaxing its payment terms. When you see an "Allowance for Bad Debts" is the company's estimate of how much money is owed by customers which is unlikely to be paid.

Inventories include raw materials which has not been made into finished product. Inventories are important to monitor for manufacturing and retail companies. Inventories require cash which will deprive the company from other opportunities to make profit. The less time cash is tied to inventory will have a larger impact on profitability.

Non-current Assets

Noncurrent assets are assets that are not expected to be converted into cash or consumed within reporting period. This section consist of property, plant and equipment (PP&E), investments and intangible assets. Property, plant and equipment are long term assets which consist of land, buildings, factories, furniture, equipment and machinery. Investments is money invested into long term bonds or other companies. Intangible assets consist of goodwill which is accounted for when one company acquires another.  Goodwill is the difference between the price the acquiring company pays and tangible value of the target company. Goodwill is the area to scrutinize, very often company overpay their target acquisition.

Current Liabilities

Current liabilities are money the company expects to pay out within a year. You should focus on accounts payable and short-term borrowings/payables.

Accounts Payable are bills the company owes to somebody else and are due to be paid within a year. Large companies can delay paying their subcontractors or suppliers which means holding on to their cash longer which is better for cash flow management. Short-Term borrowings/ payables refers to money the company has borrowed for a term of less than a year to meet short term requirement. This can lead to financial crisis if the company does not have sufficient cash or means to refinance.

Non-current Liabilities

Noncurrent liabilities are money the company owes one year or more in the future. The key is long term debt which represents money the company has borrowed by issuing bonds or from bank which does not need to pay back for a few years.

Shareholders' Equity

The only account worth looking at is retained earnings which basically records the amount of capital a company has generated over its lifetime minus dividend and stock buybacks. Retained earnings is a cumulative account, each year when the company makes money and does not pay it all out as dividends, retained earnings increase. If company loses money over time, retained earnings can turn negative and become "accumulated deficit".

Annual Reports

Reading Annual Reports

A company's financial reports are akin to a medical report of a person, it will display the health status. The financial reports consist a lot information which involved the management team and financial statements. Financial reports help the investor to make the decision whether the company is still worthwhile to invest in or it is time to take flight.

Potential investors of a company can download the annual report from SGX website or company website's investor relations page. The annual report is released after financial year and there will be quarterly interim reports for investors to monitor the business.

The corporate profile shows the business the company is involved in, it will describe the various business segment and business outlook. The financial highlights will provide a summary of the key financial metrics on revenue, profit and dividend payouts. This will show to investors how well the company has performed over the past few years.

On Chairman's statement, it will be prudent to read through past years statements to see whether there is a consist message on the business plans. If the company mention that they are doing a turnaround strategy then you can understand the actions taken and whether it is on track or some how it has been derailed. A change of tone will show whether the business has became more optimistic or pessimistic.

We will focus on the financial statements in the next post as this is the crux of the annual report. The three main sections consist of Consolidated Income Statement, Balance Sheets and Consolidated Statement of Cash Flows. It is important to look at the notes below each page of the financial statements. They show detailed explanations on how the figures are derived and assumptions made during the compilations.

In conclusion, when you download the annual reports of interested or invested company in the future, do spend time to decipher the documents. There are a trove of treasures hidden in each annual report.

Prudent Investing

Do you buy stocks based on what your friends, relatives or stock analysts recommend? Prudent investing is a mindset and philosophy of investors. Successful investing is accumulation of shares in a good business. The business grows or deteriorate on a daily basis but the share price tickers will fluctuate on a daily basis more than the actual business condition. This is what Ben Graham coined as Mr Market will visit day in day out and present a different price to the investors. Mr Market can be rationale on certain days and behave irrationally on other days.

You need to weave this together with the mindset to support your temperament and individual skill sets. You need to pass the sleep-at-night test, with a sound investing process and compliment with the investor's temperament, psyche and skill sets. Then can only the investor sleep at night without the worry of short term changes in price of his stocks.

Prudent investing involves fundamental analysis of the business, sleep soundly at night and adopt a mix of investment philosophies to curtail his investment strategy. Prudent investing involves studying the business, the management and potential future growth story, study the financial statements and determine the intrinsic value of the business and have the right psychology. The crux of prudent investing is to buy businesses selling below its intrinsic value. It focus on fundamental analysis instead of using technical analysis. Prudent investing has no regards to price fluctuations and set a long time horizon to hold the stock of the business.

Risk

During the crisis in 1997, 2000 and 2007, a lot of Singaporeans lost their entire life savings in the stock market and they brand investing equivalent to gambling. Investing is not risky if you know what you are doing. It is just like driving, if you know the rules and has been on the road, you will know how to reduce the risk to minimum. You need to have the comprehension, courage and conviction of the business which you are going to acquire and will not deviate from your decision in trying times. In the academic finance literature, beta is a measure of volatility of a security. High beta equates to high risk but high beta presents better buying opportunity. For instance, ABC Company has intrinsic value of $25 but is trading at $20, this may seems attractive but if the stock drops further to $10, the stock is more volatile but will become a more attractive investment due to larger bargain.

Investment needs a business approach to evaluate the company. There is a business behind the stock price, business takes time to flourish and fundamentals do not change overnight, unlike a stock price. Business has its business cycle, it will achieve stellar growth during its infant stage and reaches a plateau slow growth in its mature stage. Stock price is not equivalent to the value of the business. In short term, the stock market is a voting machine and long term is a weighing machine. Price of the stock does not represent the value of the business in the short term. In the long term, both price and value will converge.

How prudent investing works

The share price of a company increase when investors expect stronger future earnings. Prudent investors look for future growth driver which will increase the share price of the stock. Future growth drivers of a company include expansion of business, increase in product varieties and innovating the products.

Rebalancing

Rebalancing is a powerful strategy

Rebalancing is the process of buying and selling to bring your portfolio back to your target allocation. Your portfolio's components will change overtime due to market forces, some will do better than others, those that done well will take up a higher percentage of the portfolio. You need to readjust to bring the portfolio back to the original balance. Rebalancing is about risk management to ensure that your portfolio is not dependent on a single asset class to succeed or fail. If your risk profile has change, then you need to revise your asset allocation according to risk appetite.

Rebalancing helps you to reap the full rewards from diversification, by scaling down on your winner, you will free up your resources and reposition them to your laggard. Rebalancing helps to remove the psychological factor of investor in the market cycle.

How to Do That?

Step 1 Set your target portfolio mix

Firstly, you need to determine all you asset classes and fix on the investment styles which will lead you to your investment goal. For instance, Jason has $100,000 to invest. He decides to invest 50% ($50,000) to stocks, 20% ($20,000) to bond, 10% ($10,000) to gold and remaining 20% ($20,000) to cash. This is the opening balance and he will like to remain in this portfolio mix.                          

Step 2 What is the difference?

Compare your target component to your present component. Then determine where your investments are not performing. Do you have a larger stake in a riskier company stock? Then consider your sector exposure, this is to ensure you will not have over exposure in particular industry. Then look at your investment to understand which one has performed the best. Continuing from previous example of Jason, at the end of the year, his stocks has grown to $75,000 , his bond has drop to $15,000 , gold has drop to $5,000 and cash remains the same. Total portfolio value is (75,000 + 15,000 + 5,000 + 20,000 = 115,000). The percent of stocks to his total portfolio values will be approximately 65%, bond to portfolio value will be 13%, gold will be 4% and cash will be 17%.

Step 3 Readjust

Then it is time to bring components of portfolio which has grown and direct the money to the investment which have not.

In this situation, Jason needs to sell his stocks and bring it back to 50%, so he need to sell to a level of approximate $57,500. This will bring some of his cash position to 20% which is $23,000 and the rest will be used to purchase additional bond and gold.

When do you need to rebalance?

You should conduct a thorough check on your portfolio once a year but only rebalance when it is not within your target. For example, you might rebalance when your allocation of stocks has exceeded 60% before you need to make changes. Hands off investors can set a higher limit by another 10% relative to their targets.

Costs of Rebalancing

During rebalancing, you need to cater for transaction costs to execute and process the trades, there will be commission, stock exchange fees, and taxes. For mutual funds, costs will include purchase or redemption fees. This will incur time on your side and if you engage a professional investment manager, you will incur administrative and management fees. If there is an increase in transactions, over the long run, it will affect your returns.

Strategies of Rebalancing

The portfolio can be rebalanced on a time-only strategy, it can be rebalanced daily, monthly or yearly basis. The second strategy will be on the limit of portfolio, you can predetermine rebalancing threshold such as 1%, 5% or 10%. The third strategy is to combine time and threshold. Rebalancing with dividends, interest payments, realized capital gains or new contributions can help investors exercise risk control and reduce the cost of rebalancing.

Conclusion

Rebalancing helps you to maintain your desired original asset allocation, allow you to fine tune according to your risk profile and remove emotions during investing.

Margin - Double Edge Sword

Introduction

Investment using margin is also known as leverage. Leverage is always a double edged sword and it can bring you faster to attain your financial goal or it can lead to your financial downfall. Margin is a high risk strategy that can yield huge return if executed well. However, if you do not know how to use margin, it can go against you. Hence, I strongly recommend that margin is meant for the seasonal investor.

Buying stock on margin is to borrow the stock from your broker, it allows you to buy more than your usual limit. However, this requires you to pledge either cash or stocks. Your broker will require you to sign a legal contract to open a margin account. For Lim & Tan, you need to pledge at least $5,000 of cash or $10,000 worth of stocks. It is important to know that you do not need to margin all the way, you can borrow less, say 10% or 25%.

In addition, there is an interest charge on the loan amount. Over time, the interest expenses may become larger than your stock appreciation, this will result in a loss. If your debt increases, the interest charges will increase. When you sell the stock in margin account, the proceeds go to your broker until it is fully paid and redeemed. In addition, there is a maintenance amount which is the minimum amount that you need to have before your broker will force you to top up in cash or force sell your stock. This is known as margin call. Not all the stocks will be qualified for margin, you need to check with your broker and there is a limit to the each individual counter depending on the quality of the company.

An Example

For instance, you deposit $10,000 in your margin account. In Lim & Tan, cash deposit allows up to 3.5 times purchase power and for shares collateral allows up to 2.5 times purchase power. Hence, this allows you to purchase shares up to $35,000. If you buy $5,000 worth of stock, you still have $30,000 in buying power. You have enough cash to cover this transaction and has not tapped into your margin, you start the borrowing process when you purchase more than $10,000.

What is margin call?

The initial margin is the initial amount you can borrow and the maintenance margin is the amount you need to maintain. For Lim & Tan,  the maintenance margin is at 40%. If the equity of your account falls below the maintenance margin, the brokerage firm will issue a "margin call". A margin call forces the investor to either liquidate his position or top up with more cash in the account.

For instance, you purchase $35,000 worth of securities by securities by paying $10,000 of yourself and borrow $25,000. If the market value of securities drops to $30,000, the equity in your account falls to $5,000 ($30,000 - $25,000 = $5,000). Assuming a maintenance margin requirement of 40%, you must top up additional $2,000 to meet $12,000   (40% x 30,000 = $12,000). The brokerage will issue you a margin call. If the brokerage firm sells your stock, you will not have control over which stock is sold to cover the margin call. It is imperative to read the terms and conditions of the margin contract you signed to understand thoroughly the calculation of interest, the collateral of the loan and repayment of the loan.

The advantage of margin

Companies borrow money to invest in projects, people borrow money to buy properties, investor borrow money to buy stocks.  By having more money through margin, you can either trade or hold for long term position. Assume you borrow $20,000 worth to purchase securities of Super Group shares which is trading at $1 and you feel it will rise dramatically. You have only pump in $10,000 of cash and leverage 50%. Normally with $10,000 of cash you can only purchase 10,000 shares (10000 x $1), with margin, you can purchase 20,000 shares. If the company announce strong performance in performance, the share price double to $2, your investment is worth $40,000 (20000 x $2). After paying back $10,000, you still have $30,000 which is equivalent to $20,000 of profit. This example excludes commissions and interest to simplify the illustration. Similarly, the losses will be amplified if the share price drops.

Margin for the young investors

Young investors in their early 20s with just a few thousand dollars in the market will not have very much diversification and they are underinvest in the market for the first 25 years of their working life. The only way for young investors to have more exposure to the market is to deploy a little leverage. You can deploy 2 to 1. When go to 3 to 1 or higher will make leveraging more expensive, the power of diversification will be eroded due to cost of borrowing. The increased market exposure when young allows you to have less exposure later on, market in the long run will recover any short term losses and bull market is always longer than bear market. However, if the young investors have credit-card debt, then they should clear their debts first before moving to margin.

Conclusion

Investors regardless of age need to be educated financially and need to be disciplined when deploying margin to buy stock to reduce and control risk to succeed in purchasing stocks with margin.

Your house is not an asset

Is your house an asset?

People think that owning a house is an asset. As rich dad poor dad author Robert Kiyosaki pointed out in his book Rich Dad Poor Dad a house is a liability until it is fully paid for then it becomes an asset.  Some thinks that the only to save money is to park it in properties. My definition of an asset is when the house produces cash flow for you. Do note that in Singapore, even the resale public housing can cost up to $700,000 for 5 room flat in Clementi. You will get your flat fully paid off when you are old. Who wants to wait until they are old to have money?

A house is a highly leverage tool, with 20% of down payment, you can leverage up to 80% of the property price by loaning from the bank. This is good if the property price is on an upward trend. However, leverage is a double edge sword, if property price is on downward trend, there is a possibility of margin call by the bank if it drops more than your initial 20% down payment.

The house much like an university education is over hyped has been fed to you by parents. However, our parents bought their house when Singapore is developing and the house is cheap. It works for our parents but old ways of doing things are not viable in this generation. It is a middle class myth perpetuated by outdated thinking, politicians and mass media.

Is renting always a waste of money?

Why will you pay rent to the landlord when you can buy? You may argue that the money that you spend on the rental every month can be used to pay the deposit of your house. Firstly, people rent because they can be mobile and nimble. Mobility is a great thing in today's world. A lot of parents rent a place near their desired primary school for their children.

When you are renting, you are renting space that has no future value. When you buy, you are still renting, you are renting money. The money you rent are used to pay mortgage and a house which depreciates for you to live in. However, there is interest based on the principal you loan.

For simple illustration, there are two brothers Zhixiang the owner and Zhixiong the renter. Both have assets of $100,000 each, liabilities of $0 and net worth of $100,000 each at the start. Zhixiang bought a $500,000 house. He paid $100,000 as down payment. He took a loan of $400,000 and incur stamp duties, legal fees, insurance, fees etc for an amount of $30,000. Hence, his current situation is Assets of $500,000, Liabilities of $430,000, new Net Worth is $70,000. Zhixiong found an identical house next door which rent for $2000 per month. His assets and net worth is still the same as before. However, his Net Worth is higher than his brother Zhixiang. Now we look at Zhixiang the owner, say he took a 3% fixed rate mortgage for 30 years, total monthly payment will be $1,686 and the total interest paid will be $207,109. If we add other charges, the monthly fees will probably be close or slightly lesser than $2000. However, Zhixiang will need to continue to pay for the interest of more than $200,000 whereas Zhixiong can use the additional cash flow to invest in shares which gives cash dividend and appreciation over the long run.

The difference at the end of 20 years ultimately depends on whether Zhixiong can save the differences and also house owner needs to be mindful of the impact of transaction costs of buying and selling houses too often. Real world fluctuations can throw your projection out of the window. Hence, it will be wise to project modestly and not take on too much debt. It makes a lot of sense to buy a modest house to live in so that you will have money left over to invest as well.

Ponzi Scheme 101

What is a Ponzi Scheme?

It is a scheme which investors are paid from money collected from new investors. This continues to work as long as there are new investors keep coming in to feed the previous batches. Ponzi schemes are honoured after Charles Ponzi, an Italian who promised investors in the US and Canada that his clients will be paid 50 per cent profit in 45 days through buying postal reply coupons in other countries and redeem at face value in US through arbitrage. Ponzi continued to pay the promised returns to his clients through collection of money from other investors. His scheme caused investors to lose $20 million in 1920.

Modus Operandi

Ponzi scheme is usually promise of exceptionally high returns to investors, often they will get to be paid in installment and first few installments will be paid but investors will not see their principal. Recently, I met someone during a networking event and he shared with me a fix two years campaign promising 15% return each year for 2 years with guarantee principal through insurance. In addition, there is a referral fee of 1-3% if you introduce an investor. In financial terms, this means there is no volatility and higher return than the S&P!

Ponzi schemes are marketed very aggressively and use a network of agents who are offered high commissions. After looking at the video below, you will be surprised of the entire Madoff chronicle and how he cheated the crowd.

The principle of volatility

The guru always says "High Risk High Return", this is linked to the theory of volatility. There are no such thing as "guarantee" high return products and your principal is protected. If an investor is risk adverse and does not want any volatility, it is as good as putting your money below the pillow. This method does not take the eroding effect of inflation into account. Investors requires a higher return value due to the risk premium in order to justify the risk taken. If you wish to be a long term investor, you need to brace yourself for events when your portfolio may drop by more than 30%.

Updates to Ponzi Schemes in Singapore (26th March 2016)

Ponzi companies guarantee the principal and return of 8.5% to 15%. Some companies highlight that the principal will be protected by insurance. The insurance may cover up to say USD 1 m and looking at the above examples, they are above 1m and when the companies fold, who do you get the coverage from? It pays if you are not the last participant and the company has fresh blood. It pays to be financially literate.