Teachings of Warren Buffett

MBA Talk
Part 1
Part 2
Part 3
Part 4
Part 5
Part 6
Part 7 
Part 8
Part 9
Part 10

Key notes:

On Japan
- Not many fantastic companies

On LTCM
- "To make $ that they didn't have and didn't need, they risk what they did have and did need."
- it is foolish to risk something important for something not important, whatever the odds may be.
- Beta of a stock doesn't tell you anything about the risk of the stock.

On Life
- Don't borrow $
- Work for passion not $

On choosing companies
- Choose a business that you understand and you know how it will look like 10 years from now.
- has a moat, esp one that is widening (eg. low cost, brand)
- honest, able management

Global Financial Crisis

Views from one of my Prof.

Causes - 3 imbalance of the U.S

1) Real sector & Financial sector imbalance

The imbalance results in over leverage in the financial system, creation of a shadow banking systems where liabilities were taken off the balance sheet, coupled with weak regulations and wall street lobbying.

2) Income & Wealth imbalance

This results in

- majority under-savings, ended up taking on debts to finance their spending, leading to a debt bubble.

- minority over-savings, ended up chasing for ever higher yields, leading to an asset bubble.

3) Current Account imbalance

This leads to erosion of confidence in the economy of U.S, and fear feed upon itself.


Why Asian Economies are impacted

1) Reliance on exports
2) Lack of domestic financial systems resulting in instability due to currency and debt maturity mismatch

Solution

1) Build up domestic demand
2) Build up domestic/regional financial system

Key take aways from Asian Financial Crisis

Extracted from one of the lectures.

1. Massive capital inflows attracted into the region during 1990s because of:
1. capital market liberalization in industrialized countries
2. Low interest rates in U.S. and Japan
3. High economic growth in region
4. Financial deregulation in region but not accompanied by adequate supervision (esp in Thailand)
5. Pegged nominal exchange rates reduced perceived risks for investors
6. Governments encourage foreign borrowings through tax incentives on income earned from foreign exchange loans
2. Signs that Crisis was Unpredicted
1. Capital flows remain strong through 96 till mid 97 (only exception were equity markets in Thailand and Korea
2. Risk premia on loans were low
3. Credit rating agencies did not signal risk until onset of crisis itself
4. Even Goldman Sachs did not signal a problem
5. IMF gave no indication of potential of crisis in region. October 97 WEO even predicted 6% growth for Korea in 1998, 7.4 % for developing Asia
6. Stock prices provide the only indication of growing concern. Thai and Seoul markets fell since Jan 1996. Malaysian market began to turn down in March 97, and Indonesian market show continued confidence til mid 97
3. Why unpredicted - Sound macroeconomic management
1. Budget balance
2. Inflation below 10% across region in 90s
3. Sovereign debt at prudent levels
4. Domestic saving and investment rates were high, implying that even if capital flow slowed robust growth could continue  
5. CA deficits were large but capital inflows larger so foreign reserves were actually growing across most of the region
6. Foreign exchange reserves at end of 1996 were well over four months of imports in each country except for S. Korea (2.8 months). In Thailand, reserves were $38.6 billion at end of 96, equivalent to 7 months of imports.
7. World interest rates low so the burden of repaying foreign obligations not onerous 
8. U.S. economy, a major market for most of Asia’s exports, robust
4. Signs of growing vulnerability
1. Growing current account deficit
2. Overvalued currencies (90‐97(I): real appreciation in all five countries
3. Slowing export growth (export growth fell sharply between 96 and 97)
4. Rapid expansion of commercial bank credit (much went into real estate markets)
5. Growing short term debt (currency mismatches plus loan maturity mismatches)—e.g. Indonesia, Korea and Thailand had ratios of short term debt to foreign reserves exceeding 1.0.
5. Triggering Events
1. bankruptcy in a decade); followed by Sammi Steel and Kia Motors. They put pressure on banks thro whom foreign borrowings flow through.
2. Samprasong Land missed payments in Feb. In next 6 months Bank of Thailand (BOT) lend $6b to distressed financial institutions. BOT also committed half its liquid assets to fight speculators acting against the Baht. Late 97, Thai govt removed support from Finance One (a major financial institution)—this led to withdrawal of foreign funds and prompted currency depreciation July 2. This caused the contagion effect on the rest of Asia.
6. Impact of Capital Outflow
1. Withdrawal of foreign funds triggered a chain reaction leading to financial panic
2. Exchange rate depreciation sparked new withdrawals
3. Few firms in Asia hedged their position as they were used to pegged exchange rates.
4. Withdrawals set off liquidity squeeze and sharp rise interest rates.
5. Sharp fall in stock markets further erode capital base of banks
7. IMF's Policy
1. Fiscal policy: to tighten in order to support monetary contraction and defend exchange rate and provide funds for injection into financial system
2. Bank closures: Thailand financial institutions 58/91, Indonesia closed down 16 banks, Korea 14/30 merchant banks suspended—to send strong signal of government’s intention to reform banking system
3. Enforcement of capital adequacy standards
4. Tight domestic credit: To raise interest rates to defend exchange rate
5. Debt repayment: Full payment of foreign debt obligations, backed by IMF mobilized bail‐out funds
6. Non‐financial structural changes: Reducing tariffs, opening up sectors for foreign investment, and reducing monopoly powers
8. IMF's Mistakes
1. The great speed of bank closures required led to exacerbation of credit freeze in the system
2. Tightening the quantity of money trigger a panic by short term creditors who come to doubt the ability and willingness of central bank to provide liquidity.
3. The higher interest rate that result did not stabilize the exchange rate but instead cause output contraction, rising unemployment and civil unrest (IMF predicted wrongly that rising interest rate would stabilize the exchange rate and the benefits of that would outweigh the social costs of output contraction)
9. Cause
Sudden massive capital outflow was the cause: Net inflow of $92.8b in 1996 to net outflow of $12.1 b in 1997! The $105b turnaround in one year is about 11% of Asian‐5
1. And not fundamental flaws in Asian economies such as ’crony capitalism”, widespread corruption, macroeconomic imbalances, weak financial institutions.
2. These problems exist but overstated. They have been known for years but yet they have attracted $211 b of capital inflows between 1994 and 1996.
2. Speculative capital flow reversal was the result of financial liberalization in 1980s and mismatch of short term foreign loans to long term domestic investments
1. On eve of crisis, Asian‐5 had a combined debt to foreign banks of $274b, 64% of which in short term obligations.
2. Depreciation of currency increases the cost of debt servicing. Once a currency depreciates, it does not take much to set off panic and rush for exits, especially when central banks do not have a high level of foreign reserves relative the short term debts. Foreign lenders refuse to renew the short term loans and the downward spiral continues.
10. Solution
1. rollover short term debts into loan term loans
2. to have a banker of last resort

High Yield REITS is Best REITS?

Answer is:
- depends on whether the high dividend yield is sustainable

The gap between the dividend yield of a REIT and the yield on newly issued 10yr govt bonds is commonly used to gauge the risk premium of REIT stocks. Typically, a fair value would be 2% over the govt bonds.

Sometimes, the high yield could be achieved via the following financial engineering:

1. Purchase price of the properties under the REIT to be paid over several installments. Such deferred payments make the yield attractive initially. However, the payment would eventually catch up.
2. REIT sponsors and managers may elect to pay the fees and price of the assets in units of the REIT instead of cash. This allows more cash to be given out as dividends initially, but the new units would eventually dilute the shareholders.
3. Usage of "step-up interest rate swaps" where lower cash interest payments in early years and higher cash interest payments in later year. This is usually done to match potential increase in rental income, but if such expected increase did not materialise, the REIT will be burdened by the higher interest rates.
4. Usage of "distribution entitlement waiver" that waive all or part of the distributions due to them (sponsors and managers) for a limited period.

Another thing to take note off is the remaining leasehold of the properties in the REITs.

Here is a good link to understand REITs: http://home.howstuffworks.com/real-estate/reit1.htm

Investment Banks - Goldman Sachs

The concern with Goldman Sachs

US Government may pass a law to ensure that Investment Banks are split out from Commerical Banks. What this probably entails is that only Commercial Banks will continue to enjoy protection from the government and thus preserve their AAA, AA ratings.

Investment Banks (the likes of Goldman) may lose the implicit government protection and thus results in a rating drop to A. This will increase their cost of capital by 10-80 basis points (comparing treasury bills with A rated bonds).

Looking at their capital base (total liability) of nearly 800b, an increase of 80 basis points will mean an increase in 6.4b interest expenses.

This will reduce their 13b profits to 7b.

Macro Economics

BRIC

China is the key growth engine of the four, through its investment and spending in its infrastructure and its entry into WTO.

With China's economy powering up, India also started up its own growth engine and positioned itself as the 2nd engine.

Brazil and Russia looks more like a commodity trade, benefiting from the growth of China and India.

Thus, the risk of this emerging market play is the collapse of China, and to a smaller extend, the collapse of India


Alpha vs Beta Trade

During the recovery movement from Mar 2009 till Apr 2010, it is more of a "beta trade", as most stocks rise due to the rebound from the collapse of the world markets. Almost any stock will make money and stock selection is not really important.

However, from May 2010 onwards, it has become more of an "alpha trade" as markets move sideways. Stock selection becomes more important. "Alpha trade" entails active portfolio management, much like hedge funds.

Emerging market plays typically also require "alpha trading" to get higher returns.


Volatitility

Bonds - 4 to 10%
FX - 10-14%
Equity - 20-80%

As such bond plays are susceptible to foreign exchange risks while equity players typically do not concern themselves with foreign exchange rates.


Business Cycle
Possible mappings:

Yield Curve

1. Growth periods last longer than recessionary periods (japan exception)
2. Yield curve becomes steeper upon start of recession. Market priced for recovery already.

Miscellaneous

1. Retail investors should behave more like institutions
1. Go for the long haul -> less trades, stablise the portfolio
2. Have a strategy and stick to it
3. Get rid of the emotions
2. Public views = Winning views!
1. It is the price that public perceive that matters, not what the experts calculated

What cause DOW to climb?

source: yahoo

Looking at the chart, DOW started a gradual climb from 1985-1995, a span of 10 years.

Then from 1995-2000, the climb was exponential and extremely spectacular.

Question is, how did we achieved such a steep climb?

1985-2000

Notable technology improvement during this period (source: http://inventors.about.com):

• Microsoft windows - started the advancement of computer usage
• Web Wide Web - started the advancement of information availability and dissemination

This period is noted as the golden age of information technology.

Possible Causes

1) It is likely that with better information availability, people starts to be able to track and follow companies and economy news, allowing them the ability to value companies better. As such, companies with cheap valuations were picked up, pushing the markets higher.

2) Effects/Results of the success of financial engineering. Stock markets are pretty much driven by the financial products made available.

3) Better awareness of Value Investing through the well known success of Warren Buffett.

Most importantly in my opinion, the demand for stocks increased (source: http://www.markpeterdavis.com/getventure/2009/03/a-timeline-of-financial-technical-innovation.html):

• 1886: 1M volume
• 1961: 4M volume
• 1992: 200M volume
• 2007: 5000M volume

Note: All these are hypothesis without concrete facts to back them up.

Is the current level sustainable?

Possible yes, as more countries become affluence and their citizens start trading shares (eg. China, India).

Will we have another exponential growth?

Possibly no at this moment. Unless we have new factors that would push demand up exponentially, it is not realistic to expect DOW to keep growing at the rate experiences in the 1995-2000 period.

Sovereignty Debt: Why Greece is in trouble and Japan is not

Problem with Greece

The answer lies in the following:

1) Who holds the debt. For Japan, most of its debt are held by its citizens, and thus it is very much in control although its debt/GDP ratio is very high as well.  A big portion of Greece's debt is held by other countries such as France and Germany and when these countries press Greece for the money, Greece will be in trouble.

2) Ability to inflat its currency. Japan can choose to inflat its currency to reduce the cost of debt.

3) Pension scheme and percentage of civil servants. Greece has very generous pension benefits for its civil servants, and have relatively high percentage of civil servants of its work force.


Problem with Japan

Japan has a different problem. It has to do with the following factors:

1) Demographics. Rapidly aging population, resulting in less consumer spending and thus leading to deflation.

2) Savings habit. The money printed by the government goes right into the people's savings accounts, again leading to less consumer spending, in turn leading to deflation.


Who bears the burden

We have seen that the burden is passed from:

Institutions -> Consumers -> Government who now bears most of the debts

These burden can be borne (and resolve) by the following:

1) Future Generations (eg. 2-3 generations paying off the properties in Japan)
2) Trading Partners (eg. pressure on china to revalue yuan)
3) Debtors (inflat to make debt cheaper)
4) Government (simulating growth. revenue/tax will increase and thus fiscal deficit will decrease)

Portfolio Management

Key Objectives

• Achieve streams of cash flow
• Manage risk

Strategy

• Core portfolio + Opportunistic portfolio

Core portfolio should be as steady as possible, with the Opportunistic portfolio taking on higher risks to try for higher returns

• Core portfolio will have to cater to the following 4 situations, with the investment vehicles best suited for particular situation, and still able to satisfy the 2 objectives.

	Raising Growth	Falling Growth
Raising Inflation	Property (cash flow thru rental yield)	Inflation-linked bonds (cash flow thru coupon payment)
Falling Inflation	Equities (cash flow thru dividends)	Nominal bonds (cash flow thru coupon payment)

• Opportunistic portfolio can comprise of emerging market indices, small cap equities, etc

Analyzing Companies

Just to drop some mental notes for reference.

When to use Price-Earnings (PE) ratio and when to use Price-Book (PB) ratio

Typically, use PB for banks, capital intensive, violatile, and cyclical industries. The rest PE will be more relevant. Of course, no harm looking at both, but need to know which is more relevant for the particular company.

Valuation

For conglomerates, use sum-of-the-parts valuation to get the fair value for the company.

Using the right tools

For range markets, use range tools like stochastic oscillator, RSI, bollinger bands.
For trend markets, use trending tools like MACD, moving averages, trendlines.

Indicators

VIX index to observe the volativity of the market.
M2 $ supply to observe the liquidity of the market.
Yield curve to observe the steepness of the curve (gradient) to observe the volativity of the market.

Stop Loss

Stop loss level should be adjusted only at significant price movements, else will end up activating the stop loss prematurely.

Other things to look out for

1. Insider trading transactions. Typically, if the management is buying in themselves, they are trying to signal that they are confident and bullish about their company.
2. Volume of the transactions. A low transaction stock could result in a liquity trap, whereby if you need to get back your $ fast, you will end up selling at a much lower price just to get a buyer.
3. Owners of the company. Find out about their style, whether they are here for the long haul (eg. GIC, Temasek, Capital Group), or out to make a quick buck.
4. Seasonality of the company stock. Some company stock tend to go up during certain months of the year. Most of the time it is the cyclical effect of their earnings, or the dividends.

Subtle stuff from Annual Reports

Some items from Annual Reports that are often passed over, but warrants some scrutiny.

1) Amount of tax that the company pays as a percentage of their earnings before tax
If the percentage is less than those typically levied by the country, do not be too happy and think that the company is good at managing their taxes! On the contrary, this could (not always, but could) be a tell-tale sign that the earnings reported in the Income Statement is overstated. Thus actual tax paid to the taxman is lesser. This info can be found in the Income Statement and Cashflow Statement.

2) Depreciation Policy
Look at how lax or conservative their depreciation policy is. For example, a conservative company may depreciate their plants over say, 10 years. While another company may depreciate it over 30 years. The one that depreciate over a longer period, may be able to report a higher earnings figures since the depreciation expenses are lower (spreaded over a longer period), even though both may have the same revenue and other cost expenses. This information can be found under the Financial Notes section of the Annual Report.

3) Financial Commitments and Obligations
These may include items like operating leases. For account purposes, if an event is deemed likely to happen, it will have to be accounted in the Balance Sheet. If an event is deemed 50%-50% of happening, then it will be reflected under the Financial Notes section of the Annual Report. However, sometimes a event that is bound to happen, such as a commitment for a long term lease which is not paid up yet, ends up in the financial notes. Such commitment has to be paid for eventually, and may rank in situ with a interest-free debt.

What you need to know about Price Earning Ratio

The concept of Price Earning (PE) ratio should be pretty well-known by now. PE Ratio is the no. of times you are paying for every $1 that the company earns. For example, if Apple earns $10 per share, and the stock price is trading at $100, then the PE is simply 100/10 = 10. So you will be paying $10 for every $1 that Apply earns if you buy the stock now. From another perspective, it will take Apple 10 years to earn what you paid for the stock.

However, PE ratio, if not analyzed in the right context, will end up as a misleading number, and simply, just a number.

2 key scenario drives PE ratio.

I need a higher return NOW

why do i need a higher return now?

1) Inflation is going up. I need a higher return to offset the inflation loss in the value of $.
2) Tax is going up. Again, I need a higher return.
3) Risk of the company is high. High risk = high return expected.

In the above situations, I will only be willing to pay a lower PE, so that I will increase my chance of realising a higher return (think buy low sell high).

I can make do with a higher return in FUTURE

Again, why?

1) Return on Equity (ROE) of the company is high. Thus every $ re-invested by the company in terms of capital expenditure (thus lowering the earnings) should reap higher earnings in future.
2) Growth of the company is high. Again, I will be hoping for higher earnings in future.

In such situations, I will be willing to pay a higher PE now, so that I may get to enjoy higher earnings in future (think buy high sell higher).

Summary

Inflation up, PE should be lower
Tax up, PE should be lower
Risk up, PE should be lower

ROE up, PE can be higher
Growth up, PE can be higher