Friday, December 17, 2010

Book Review: Risk and the Smart Investor

‘Risk and the Smart Investor’ is written by David X Martin. Interestingly, the author is a former risk manager of Citibank. The book is available in NLB.

The book provides a risk management framework with anecdotes and a fictional story. It also contains some very practical advice on thinking and acting on risk. Overall, I find the book not bad.

Interesting Points:

a) Risk Management Framework:

i) Assessment

- Know where you are. Assess your current position.

- Know what you do not know. Grasp the limits of your knowledge. Question the assumptions.

ii) The Rules of the Game

- Find out your risk tolerance in relation to your goals

- Demand Transparency. Seek to fully understand the risk. Discuss the risks openly.

- Diversify

- Ensure that checks and balance are in place.

- Risk management never ends.

iii) Decision Making

- Consider all options. Always provide yourself with an exit strategy.

- Ensure that risk is managed in every step of the process

- Reputation is important. Check the reputation of everyone that you are doing business with.

- Incorporate time frames in your decision making. If your investment horizon is two years, your investing strategy should be different from the strategy for a horizon of twenty years.

iv) Re-evaluation

- Constantly review the outcomes. If you are uncertain, ask.

- Identify and learn from your mistakes.

b) Sell when the bank becomes lax on risk management process. The author sold his Citibank positions, when he learnt that Citi has discarded the use of a certain risk management program.

c) Successful risk management means that one needs not make any decision at the heat of the moment when lightning strikes.

d) For an example of risk management, Ford borrowed $23 billion before the financial crisis begun. Call it ‘defensive financing’. A year later, GM and Chrysler filed for bankruptcy and requested for government aid, while Ford remained the sole US car company standing.

Saturday, December 11, 2010

Book Review: Billion-Dollar Lessons

Billion-Dollar Lessons, What you can learn from the most inexcusable Business Failures of the Last 25 years is written by Paul Carroll and Chunka Mui. The book is available at NLB.

I am a believer in learning from other people’s failures. Thus, I am happy to see this book available in NLB. The book has two portions. One is about the failure patterns and two is on how to avoid the same mistakes.

Generally, I find the first portion of the book interesting. The second portion will be a bit dry. Nonetheless, it should be a good read for investors, since the authors did have investors (besides the corporate managers) in their mind, when they wrote this book.

Interesting Points from the book:

a) These corporate failures often do not result from failure to execute. Neither are they due to luck or timing. Instead, most failures are due to bad strategies. In other words, the strategies are bound to fail from the start, unless the company change courses.

b) Half of these failures may be avoided if companies are more aware of the potential issues. Others, while not avoidable, can be made less impactful if companies have spotted the warning signals and progressed more carefully.

c) Failures are more likely, if companies adopted one of the following seven strategies:

d) Acquisition/Merger in the hope that synergies (or one plus one is more than two) occur. The obvious example is AOL Time Warner. Companies have one-in-three chance of reaching their aim of revenue increases as a result of synergy. Companies overpay. The synergy does not apply to the customers, as customers jump to competitors. The company’s internal systems may not mesh well with the other company’s. This means that the targeted cost-savings did not materialize.

e) Financial Engineering. Aggressive accounting but not fraud. For example, a company may offer a thirty-year loan for an asset with a lifespan of fifteen years. Needless to say, the company went under in the long run, as the company is taking on a long-term risk without sufficient compensating returns. As such strategies may show large gains in the short term, the company may unwittingly enter into a vicious cycle of applying more aggressive accounting and taking on more long-term risks.

f) Rollups. This strategy is to buy many local businesses and turning them into a regional or national large company. The roll-up strategy may often be too ambitious and thus resulting in diseconomies of scale (rather than economies of scale). Rollups may need an unsustainable fast rate of acquisitions to maintain the earnings growth. The company didn’t know that it has to choose between integration or decentralization. Companies may also not cater to the possibility of tough times (e.g. company takes up a lot of debt and find itself unable to pay the interest during troubled times.).

g) Staying the course, when there is a clear threat to the business. The notable example is Kodak. Company executives may not be able to appreciate or imagine the kind of threat that may wipe out their market. Companies may find that the economics may favor the old practices and not the new technology. For example, why should we forgo a 40% gross margin business and set up a 20% margin business? The favorable economics may blind them to the possibility that the new technology may wipe off their existing business. The company may also not consider all alternatives e.g. selling off the business or cut back existing business.

h) Adjacencies. That is to move into adjacent market. The move may be less driven by the great growth in the adjacent market. Rather, the move is more driven by problems in existing business. The company may not have the required expertise for the adjacent market or under-estimate the difficulties in the adjacent market. The company over-estimates the benefits of being able to cross-sell to consumers.

i) Riding the wrong technology. The decision was made without the context of constantly improving alternative technologies. Companies may find false security in having the presence of competitors, thinking that it implies the soundness of their strategy. The company does an improper market research, which provides biased analysis of the market potential. The company did not built in possibilities for amendments in the strategy, and thus limiting their option to stop the strategy.

j) Consolidation in a mature industry. The company is pursuing this strategy to gain cost-savings and pricing power as the number of competitor is reduced. The company may acquire companies with unexpected teething problems. This may lead to diseconomies of scale. Customers of the acquired company may not stay with the new, larger company. The company may not be considering all the options like allowing itself to be acquired instead.

k) Often, companies pursuing acquisition-like strategies may take on a lot of debt. These debt will endanger the survivability of the business during troubled times.

l) While Seagate benefits from the reduced competition when it acquires Maxtor, Western Digital gains more, as it need not pay for the acquisition.

m) Porter’s guide on declining business:

i. Does the industry offer profits while revenue declines?

ii. Can the business compete successfully for the demand?

Sell the business if (i) and (ii) are ‘no’.

Sell parts of the business and increase cashflow by reducing investments/maintenance/research if (i) is ‘yes’ and (ii) is ‘no’.

Seek niche markets with high returns and the markets that are declining at a slower pace if (i) is ‘no’ and (ii) is ‘yes’. Move aggressively into these niches and exit the rest of the market.

If (i) and (ii) are ‘yes’, establish cost leadership while avoiding price wars.

n) To minimize bad strategies, create incentives to learn from failure. Create devil’s advocate. Create mechanisms to allow employee’s feedback to float to the top. Hold second meetings to pore through the earlier decision made. This will mitigate the impact of making decisions while in a ‘hot’ (or less rational) state. Lastly, have independent devil’s advocate review.

Monday, December 6, 2010

Afterthoughts about recent selling decisions

I shall record some afterthoughts of my selling decisions in the last two months.

First, I dispose my Bright World stake at around 35 cents, which is much lower than the 50+ cents now. What interests me is not the 'gains' lost. Rather, my interest is piqued by the thought that my lack of knowledge (or failure to predict) the quick rise in stock price is the cause for the gains lost. As I do not know any story that may lead to further large gains in the price of Bright World, it becomes logical for me to sell Bright World and switch to other more attractive stocks.

In short, I find it interesting that the 'gains' lost is somewhat deserved, since I do not know any reasons for further large price increases in Bright World.

Second, I dispose my Valutronics stake, after reading in a book that entering into adjacent markets may not be profitable at times. Perhaps I become more risk-averse after reading the book. Or probably, my selling decision is due to the availability bias that I suffered after reading the book.

Availability bias is a bias that I suffered from time to time. For example, I tend to buy stocks after good earnings announcement, or after some positive research report. Thankfully, this bias has not caused great grief to me.

Finally, I have also disposed my Ziwo stake, since I dislike secondary listings in Taiwan. The Taiwan listing may not provide significant increase in Ziwo's share price, since I guess that stocks listed in SGX cannot be sold in Taiex. Furthermore, the secondary listing is a dilution of shareholder's stake in the company. I dislike dilution.

Well, it seems that my selling decisions can be emotional. Conversely, my buying decisions are also emotional (i.e. anticipation of large gains).