As all of you are well-aware, for the past 11 months this year (as well as in the last several years), the stock and bond markets in the US and globally have been increasingly extremely volatile where >200 points and >2% daily up and down swings (including intra-day swings) are more common across all major market indexes globally. Confused investors and traders these days shall understand the various inter-connected factors and trends at play. In our view, there are eight factors that are of global importance:

1. Continued uncertainties in the European economy & debt crisis that has grown much more serious  and systemic for the past two years and could very likely cause negative spillover/domino effects globally. As such, European Central Bank (ECB) likely will need to act aggressively more like US Federal Reserve bank to deal with the crisis in Europe before things go out of hand (e.g.: total collapse/dissolution of unified Euro currency).

Note: The results of the Eurozone meeting in France from Dec 1 to Dec 9, 2011 will decide the future of the Euro and hence, will influence investors confidence and risk appetite.

2. Continued uncertainties in US and other developed countries’ budget deficits, constant political game by government regulators to agree on decisions to solve economic crisis and budget discipline, and still slow-moving housing sectors (housing is a large net-worth drivers for many families and hence, any increase/decrease in housing prices have multiplier impact on the economic activities)

3. Increasing risks of hard landing slow-down in the emerging economies particularly BRIC countries (Brazil, Russia, India, and China) — they are not invincible and can slow-down too since these countries’ growth largely depend on the developed countries’ consumer demands and economic conditions.

Note: China’s huge $320+ billion annual export (as of 2010, source: ECB) to EuroZone is at risks now. Fact: Shipments to the European Union, China’s biggest trade partner, fell to US$28.74 billion in October from US$31.61 billion in September 2011 (source: China Post)

4. Increasing risks of sudden bankruptcies of large globally connected financial companies due exposure to European crisis (e.g.: recently, MF Global went bankrupt after ill-conceived bets on European bonds suing leverage led by Jon Corzine, ex-Co-CEO of Goldman Sachs, ex-Senator, ex-New Jersey Governor; and potentially there will be more financial casualties like this)

Note: S&P recently in late Nov 2011 downgraded credit ratings of many major financial companies (BofA, Citibank, Wells Fargo, Morgan Stanley, Goldman Sachs, and JP Morgan), potentially further damaging investor confidence in this sector unless major economies’ regulators are nimble enough to do something fast with large-impact in a coordinated fashion globally and as recent as Dec 5, 2011, issued warning to 15 European countries for potential credit rating downgrade per Bloomberg News.

5. Reduction of risk appetite and confidence of investors in the fair game of capitalism (the essence of US so-called “free-market” economy) and ascend of high frequency trading gaming the smaller investors/traders with proprietary split-second trading algorithms to take advantages of small bid/ask gaps throughout the trading hours that make the holding period of securities shorter; as well as high profile cases involving insider trading.

Note: 2% of wealthiest Americans own probably 90% of the country’s wealth distribution and yet pay a lot less taxes than people who work for them.

6. The rise of highly leveraged ETF index securities that provide extremely risky ways to bet on market and industry/sector movement both up and down (potentially rewarding or damaging depending how one uses them intelligently) increasing overall security trading volume and market volatility.

Note: this kind of leveraged securities are now being scrutinized by financial regulators for their negative impact to regular individual investors/traders.

7. Shift of capital investment allocation preference from old/declining industries (typically publicly traded) to new industries (e.g.: privately held technology firms/ventures) powered by innovations as well as the undeniable trends that US economy is moving from manufacturing in the 19th century to services in 20th century to full-blown innovation-driven era in the 21st century (this is why, Facebook, Apple and Twitter of the world are growing fast and getting valued richly faster).

Note: The skills that have been useful to carry the US economy in the past 50 years are being phased out to accomodate new industries/sectors. Existing workforces need to be retrained to have skills necessary or else, unemployment in major developed countries will continue to be stubbornly high. Innovation is key.

8. Continued increase of the already high total compensation levels of almost all C-level executives despite their poor performance (there are certainly some CEOs who are worthy of their salaries, such as Warren Buffett) in delivering return on investments to shareholders. The discrepancies of reward systems are too significant to allow common workforces to really believe that they actually can improve their net-worths significantly overtime; this huge economic gap between have vs have-nots likely is the root of Occupy Wall Street movements which are driven by young people and recent college graduates.

Note: In the U.S., CEOs are paid 142 times more than their employees; in Britain, it’s 69-1, and Sweden, 34-1, according to Reuters.

What should investors and business people focus on now despite all the gloom and doom for the past 4 years?

Our Long-Term Views: Despite markets and economic ups and downs and uncertainties, investors and business people shall think long-term and focus on what matters and new industries. This means investors should focus on what we believe the next drivers of global economic growth which will likely be led by new/emerging and transformed sectors/industries. It is quite clear that innovations and technologies have been the driving creation of new wealths since the past 15-20 years after witnessing Google, Amazon, Facebook, and Twitter grew by leap and bound threatening older industries. I argue that this innovation-driven trend is still early and will continue to widespread affecting almost all sectors/segments of the economies especially in maturing emerging and developed countries. Hence, I believe the following innovation-driven emerging sectors will likely represent the best opportunities for wealth creation for entrepreneurs and investors in the next few decades:

1. Advanced materials that are cheaper and stronger based on easily produceable raw materials to empower better hardware and infrastructure design and products.

2. Advanced alternative energy products & services that are price-competitive and sustainable to complement oil as energy source.

3. Smart biotechnology and advanced medicine with shorter R&D cycle using more natural ingredients to speed-up time-to-markets with better results to cost-effectively improve people’s health.

4. Advanced environmental and energy saving technologies that reduce pollution, are cost-effective and provide real value to people.

5. Advanced equipment for manufacturing that enable/empower the creation of new technologies such as mobile devices and energy grid systems.

6. New-generation information technology such as web-based mobile applications with sensors integrating advanced computer, internet-based business models and traditional consumer electronics.

7. New-generation of scalable financial products & services that bypass regular brick-and-mortar presence, lower fee structure, provide more peer-to-peer transactions with less friction and less costumer acquisition costs.

8. New-generation of food and beverage products & services that provide healthier and more-natural ingredients that improve people’s life and reduce obesity level.

9. New-generation of education & training products & services that provide much more effective knowledge delivery and knowledge absorption with real-world practice that focus on designing & creating rather than consuming for children and students of any ages.

10. New-generation of innovative retailers that combine old and new form factors to market and deliver products and services that consumers want faster, cheaper focusing on higher customer satisfaction rate to accomodate more tech-savvy consumers.

As always, the market prices of many companies (private and public) in the above sectors are likely valued at premium due to their growth rate and future potential. As investors, ones shall be discipline only to strategically invest when they are valued sensibly below their fair intrinsic value based on conservative fundamental valuation analysis to increase margin of safety and return on investments as well as return of investments. Keep in mind of the following Warren Buffett’s credo: “Price is what you pay, Value is what you get.” Old and existing industries as well as workforce that do not adapt to new realities, likely will be less competitive going forward. Younger people had better focus on engineering and innovations, not only on MBAs, to secure their places in this innovation-driven global economy. Innovation is the key engine for companies globally to survive and grow, and hence essential to drive future global economic growth as Apple, Inc. and the late Steve Jobs have successfully proven to the world for the past decade.

About the Author: The author is a value-oriented private investor, a technology entrepreneur and avid observer of global economy and markets.

Disclaimer: The opinion presented above are the author’s personal view and does not by any means serve as guidance nor recommendations to buy/sell/hold/trade/invest in any assets/securities/countries/sectors/industries.

Calculating the intrinsic value of a business is both artistic and scientific in nature; and hence, two very intelligent investors or businesspersons analyzing the same company may come up with different intrinsic value figures and opinions. The discrepancies may be wide. Valuing a business requires at least a general understanding of basic business knowledge especially accounting and finance, and high dose of common sense. The first step you should know as an investor is definitely to know how to decode company’s financial statements which consist of: income statement, balance sheet statement, cash flow statement, shareholder equity statement, and important notes and disclosures to financial statements. In addition, it is equally important for investors to read top management annual letters (usually part of the company’s annual report) in order to learn about the company’s business model, track-record, and management tone, etc. To be a great investor, one does not need to be a business, finance, or accounting graduate. Common-sense is the keyword here. Anyone with IQ above 80 can be a great investor as long as he/she wants to learn few basic things as recommended by Warren Buffett, the greatest investor of all time:

1. Learn how to value a business.
2. Learn how to think about stock market (hint: be patient; in the long-run, the market is a weighing machine, not a voting machine)

“In investing, you should learn from the ways women shop.” – Peter Lynch, One Up on Wall Street.

Understanding the two key things above can simplify your life as an investor and increase your chance to be a successful investor. Now, how to value a business? For the sake of simplicity, intrinsic value of a business basically consists of two valuation components:

1. Net-Net Assets Value (NNAV) as coined by Benjamin Graham, the father of the security analysis; and

2. Owner’s Earning (OE) or Free Cash Flow (FCF) Value as hinted by Warren Buffett in several occasions in his annual reports’ letters to shareholders.

In short, the formula to calculate Intrinsic Value is:

Intrinsic Value = Net-Net Asset Value + Owner’s Earning Value

For conservatism, Net-Net Asset Value (NNAV) here is the net liquidation asset value that common stockholder can extract out of the company if the business goes under or bankrupt as a going concern. Simply you can calculate NNAV using this formula below:

NNAV = Adjusted Current Assets – (Total Liabilities + Total Value of Senior Securities)

Adjusted Current Assets are current assets that can easily be converted into cash within a year. Caution needed here; for example: in the retail apparel business, the inventory value of finished goods may be overstated since it is hard to know the current market value of the finished goods’ in the ever-changing trend & styles of apparels. Therefore, in this kind of situation, the value of the finished goods inventory should be adjusted to zero or maybe 10-15% of the stated value on the balance sheet. On the other hand, if you are dealing with company that has hidden valuable assets not shown in the balance sheet such as some land-rich railroad companies, the value of the assets may be adjusted upward accordingly provided you know the current approximate value of these hidden assets.

Total liabilities are the sum of Current Liabilities and Long-term Liabilities such as long-term debts and obligations.

Total Value of Senior Securities is the value of preferred stocks, warrants, and hybrid securities such as some flavors of convertible preferred stocks, warrants, and other exotic senior securities that appear on the balance sheet’s liability side because after all, these securities will be true liabilities just like long-term debts for common stockholders/shareowners.

Owner’s Earning or Free Cash Flow is the total amount of economic net cash in-flow you can extract from the business’s entire lifetime discounted to present time using long-term average required annual rate of return to beat inflation rate, long-term government bond rate, and other necessary risk premium rates . What is important here is the accuracy of the growth projection of the free cash flow generation of the business which requires deep understanding of the characteristic of the business and its industry as well as the condition of general economy going forward. Moreover, investor should analyze the profitability of the business operation (e.g.: analyzing the business’ Gross Profit Margin, Pre-tax margin, Net Profit Margin, Net Operating Margin, Asset Turnover, Return on Invested Capital, Return on Assets, and Return on Equity among others) as well as to be able to conclude on the company’s long-term sustainability.

Combination of macro and microeconomics analyses are also required to gauge and to analyze the competitive advantages of any businesses. For example: Coca Cola has very strong competitive advantages understanding intelligently that Coke is now still the no.1 choice among soft-drinkers and one of the most recognizable brands on earth. In addition, Coke also has massive sales & distribution channels spanning virtually in every corner of the world. Analyzing that there are still many potential long term major markets such as China and Africa, one can conclude that Coke still has quite long competitive advantage period, probably more than 30 years. On the other hand, like many of investors or traders (who mistakenly consider themselves investors) have known and learned bitterly, there were many dot-com businesses that generate nothing in 1998-2000, had virtually no competitive advantage, and yet were valued at extraordinary level by the psychologically driven “go-go” bull market in the late 1990′s. The subsequent performance results of these companies since 2000 have been disastrous. The same applies with many speculative oil & gas exploration companies in 2007-2008; many are now facing tremendous difficulties due to significantly lower oil & gas prices.

In short, Owner’s Earning Value formula is:

Owner’s Earning Value of Free Cash Flow Value = The sum of all economic cash that the business can generates throughout its lifetime discounted to the present time using appropriate long term risk-free discount rate

One should notice however, that the value of the company’s management team has not been included yet in the Intrinsic Value calculation above. Why? Because it is very hard to value the management team. What investors should expect is to be able to find truly great companies that are managed by honest, capable, and shareholder-oriented management teams, key-decision makers, and insiders. The bigger the % ownerships of common stocks that the top level managements have, the higher is the chance these top guns would act and do business on behalf of maximizing value and return for their shareholders.

The above explanation on business valuation is only a simplified version of a much longer explanation and therefore shall not be used as the only basis to value a business in great detail.

“The market is a voting machine in the short term and a weighing machine in the long term.” – Benjamin Graham.

Note: This article was originally published on 11/09/2007 at the old Sovestor.com website.

“The market is a voting machine in the short term and a weighing machine in the long term.” – Benjamin Graham.

Benjamin Graham said in his book, The Intelligent Investor, that investors should view stock market as your friend. He intelligently advises investors to ignore short-term market fluctuation and further encourage them to buy when the market manic-depressive state provides mouth-watering opportunities to invest in great companies. Profit from folly rather than become the victim of it. In the long term, the stock market performance closely tracks the long-term business performance of the publicly traded companies as well as the general economic condition. It is generally true that during rising interest rate, the stock market goes down and vice versa. However, analyzing and predicting the direction of the interest rate set by the Federal Bank is not easy and many times, waste of efforts. Investors’ time and energy are far better utilized for learning and finding great businesses currently selling at undervalued price in the market.

Note: This article was originally published on 11/09/2007 at the old Sovestor.com website.

“We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”

How do investor apply margin-of-safety? First, investor needs to understand the business he wants to invest where he can comfortably predict future cash flows of the business operation in the long term. Then he calculates the intrinsic value of the business based on conservative prediction of free cash flow using discounted cash flow valuation techniques and compares that to the market value. If the market value is close to the intrinsic value, then he should pass the stock. If the intrinsic value is twice higher than the market value or in other word, the market value is 50% of the intrinsic value, then he still needs to verify the reasons why there is such a big different. Is there anything else that needs to be considered since valuation is not an exact science? Valuing a business is part art, part science. Investor need to analyze and think about the franchise value of the product or services the company offer to its customers/clients as well as the sustainability of the business in the long term, which requires investor to analyze the competitive advantage of the business. There are many variables determining the intrinsic value of a business that many times are not clear. However, one thing is clear, the free cash flow or owner’s earning (term coined by Warren Buffett) generated by the business and operating profitability can be analyzed and calculated. Warren Buffett in his annual letter to his company’s shareholders perfectly sums up the intrinsic value implementation:

“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase-irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.”

Even after investor has carefully and painstakingly calculated the intrinsic value of a business, he can still be wrong in his judgment by a wide margin. Here, margin of safety comes in play since he will never invest unless the market value is approx 50% than his intrinsic value figure. Therefore, by applying margin-of-safety, he can be wrong 50% of the value and still be ok.

Asset is also an important variable in valuing a business. Investor can calculate the Net-Net Value of the company to consider the worst-case scenario possibility of valuing asset of the business. In addition, if a business has very valuable asset not reflected in the balance sheet, this figure could be added to the calculation of intrinsic value of the company. Sometimes, during very depressed bear market, the market value of a great business is very close to its Net-Net Asset Value, which can increase your margin of safety significantly if you buy the stock at this cheap valuation.

Margin of Safety in practice:

Situation A:
Intrinsic Value = $100 million
Market Value = $200 million
Margin of Safety = None, even negative $100 million

Situation B:
Intrinsic Value = $100 million
Market Value = $50 million
Margin of Safety = $50 million, which is 100% of market value or 50% of intrinsic value.

Here, the market value has 100% upward potential to get to the intrinsic value. Therefore situation B should be considered for investment.

“If we calculate the value of common stock to be only slightly higher than its price, we’re not interested in buying.” – Warren Buffett

Note: This article was originally published on 11/09/2007 at the old version of Sovestor.com

1. Remind yourself on the classic definition of investing and investor

Investors, young and old, amateurs and pros, all need to read and follow to their hearts the classic definition of investing as coined by Benjamin Graham, the father of security analysis and teacher of Warren E. Buffett, the most famous investor alive: “An investment operation is one which, upon thorough analysis promises safety of principal and adequate return. Operations not meeting these requirements are speculative.” It is also extremely important that one understands definition of a shrewd investor as coined by Benjamin Graham: “one who bought in a bear market when everyone else was selling and sold out in a bull market when everyone else was buying.”

2. Practice value investing and margin of safety

Warren Buffett looks for businesses that “1. have favorable and enduring economic characteristics; 2. are run by talented and honest managers and 3. are available at a sensible price.” You should do the same to increase your chance to beat the market. To be a successful investor, one needs to also be right on his/her thesis on a particular company or sector and apply margin of safety concept. You will need to do research focusing to identify the most undervalued securities or sectors that you are willing to place your capital in without disrupting your sleep at night. Mr. Graham stated that “you are neither right nor wrong because the crowd disagrees with you. You are right [or wrong] because your data and reasoning are right [or wrong].” Be contrarian based on sound reasoning, not based on mumbo-jumbo (such as investing based blindly following tips from neighbors, or co-workers without doing further research on your own)

3. Simplify your universe of securities only to what you really know and understand

If you are a doctor who really knows and understands drug and healthcare industry from A to Z, know which medicine is selling well nowadays, which drug supplier is the most reliable, then surely you should focus on this sector; this is your advantage as a doctor. Do not think you can invest more successfully in oil sector just because the news says you should buy ones unless you really understand the sector as much as you understand the industry you operate in daily. On the other hand, people who are in the oil business should focus on oil. Remember that nowadays intelligent investor can always go long or short on securities or sectors. Hence, even just by understanding one industry or one company really well, as long as you really know deeply on that one industry or one company, you can strategize how you can capitalize on your edge and become a successful investor.

Note: This article was originally published on 11/25/2007 at the old version of Sovestor.com website.

The above definition contains 3 sections in regards to a sound investment operation:

1. Thorough analysis:

Many investors do not do any thorough research. They like to take the easy road such as listening to Jim Cramer’s Mad Money every night and follow his picks blindly. A good investor should focus on the essentials such as:

• Read annual reports and quarterly reports of companies he/she is interested in
• Run stock screen to find list of profitable companies, industries/sectors with strong fundamentals selling at low valuation
• Expand investing knowledge through reading books on value investing
• Scuttle Butt – call companies, competitors, customers, to find out the competitive strength of companies he/she would like to invest in.

2. Safety of principal

Mr. Graham coined the term Margin of Safety which is the concept of buying an asset at big enough discount. Buying $1 for $0.50 or less is always preferable than buying $1 for $2. Investor should approach buying a stock as buying groceries. If you see a very high quality product selling at very low price, you would be tempted to buy, wouldn’t you?

Investor putting money in any asset need to remember these common rules: 1. Do not lose money. 2. Don’t forget rule no.1. In order to ensure investor minimize the probability of rule no.1 to happen (although it is always possible to happen), he/she should focus on the key things to ensure safety of his/her principal:

• Avoid any companies that one does not understand
• Avoid any companies that have high debt ratios
• Seek companies with high return of equity and low capital expenditures requirement
• Seek companies with strong fundamentals selling at very low valuation (e.g.: price / free cash flow <= 10 helps)
• Never buy a stock/asset at 52-Week High especially if it is at 3-5 Year High

3. Adequate return

Adequate return requires keen understanding of when the situation will change. Any asset selling a very low valuation may still be cheap in the next 5 years or even 10 years if there are no positive catalysts within this time frame. Investors need to understand clearly than adequate return can only be obtained if you correctly assess the future upward potential of the asset you invest in today within a reasonable time period. Time period could be forever if investor had a great buying opportunity that would be impossible to repeat. Investor should focus of the following key elements to ensure they buy cheap for a reason within specific timeframe:

• Assess 1 yr, 3 yr, 5 yr, 10 yr upside potential of assets and industries/sectors (e.g.: if probability is low for any positive catalysts affecting asset valuation for a very long time, the asset price could still be depressed also for a very long time)
• Compare long-term 10 yr, 30 yr government bond yield vs. AAA rated corporate bond yield vs. free cash flow yield of asset (e.g.: why invest in stock yielding 2% (based on average 5 yr free cash flow) if a long-term government bond yields 15% per annum?)
• Be patient since it takes time for a depressed asset to go up to normal valuation. Therefore when one sees opportunities to acquire a position at very low price, depending on the situation, the best way is to build up position gradually in 3 or 4 phases.
• Just as an asset could be too depressed, the same asset could be valued too high later. Hence, in order to maximize return, investors need to buy low & sell high but not too soon.

Happy Investing!

Note: This article as originally published on 03/06/2008 at old Sovestor.com site.

When there is blood on the street (read “Wall Street”), there are always professional vulture investors (the savvy hedge funds, private investment companies, investors, speculators) who are watching and moving fast to grab distressed assets. Capitalizing on market meltdown is not new thing on either Wall Street or any other market in the world. There are huge opportunities on the long-side to snap up quality assets at bargain prices. So while the savvy pros are looking at the current credit market meltdown as opportunities to snap up bargain assets (e.g.: Citadel Investment has snapped up various distressed assets), what can regular investors do? Be like the pros! Warren Buffett once said “…be fearful when others are greedy and be greedy when others are fearful.” There are 5 questions intelligent vulture investors should ask and research to identify bargain opportunities just like the professionals:

Industry/sector in meltdown: What industry or sector got clobbered the hardest on Wall Street recently?

Top 10 Companies in the industry/sector: Which companies historically were the top 10 strongest (based on market share, financial strength, etc), most profitable (high ROE, ROA, profit margin, etc), most admired (strong brand name, great customer service, great management team that hold high % of ownership, etc) in the past 5-10 years in the industry/sector?

Top 5 Companies most likely to survive: Which 5 of these top 10 companies are the least risky (read “the best positioned to weather current market storm and most likely recover first later”) in term of current financial strength/fundamental (e.g.: market share, brand-name, management talent, insider ownerships, etc), prospects (current and future), and valuation? Try to pick top 5 least risky companies; then focus your research only on these 5. The deeper you know about each of these 5 companies, the higher you chance to be successful vulture investors.

Recovery time of the industry/sector: How long (1, 2, 3+ years maybe more!) will the industry/sector most likely recover from the current meltdown based on thorough analysis of the industry/sector dynamics?

Timing of investment: When is the right time to invest in any or all of these top 5 companies based on sound business valuation (and not based on some pseudo and questionable market timing techniques, e.g.: technical analyses, momentum investing, beta, etc — academic type analyses with calculus involved is almost always questionable in the real world of intelligent investing). It is possible that at this moment, it may or may not be the right time to invest in any of these top 5 companies if the recovery will take place 5 years from now. Be patient! Intelligent vulture investors wait for the perfect pitch just like great baseball player (remember Babe Ruth?)

Where can I get answers on each of the above? It is always much easier to say something that to actually doing it. There is really no shortcut to discipline research and continuous learning. Just like pros, you will need to do some active digging and research:

Free Stock-Screeners: Try to use free stock screening tools offered by Yahoo! Finance, MSN MoneyCentral, Reuters, etc, to filter industries and companies.

Company Websites: Browse and read companies’ website especially the products & services, the history/background, financial reports (quarterly, annual), investors presentations, etc. Anything that can provide you deeper understanding on the industry and companies you are focusing on.

Online Brokerage Services: If you have online brokerage accounts, there are plenty of research reports and fundamental data available to you as their customers. Check your online brokerage services and use them.

Scuttle Butts: Talk with people in the industry and companies you are interested to research. Contact competitors. Dig down deeper anyway you can. Call the investor relations of the company. This method is called “Scuttle Butt” as coined by Philip A. Fisher, the late author of “Common Stocks and Uncommon Profits”.

Financial Websites: There are also many other useful financial websites like fool.com, seekingalpha.com, etc that may have quality content to related to the industry and companies you are targeting.

Great opportunities and success are within reach for intelligent vulture investors who do their homeworks. The rewards are huge for those who are well prepared.  This is the wisdom of intelligent vulture investors.

“Look at market fluctuations as your friend rather than your enemy.. profit from folly rather than participate in it”. — Warren Buffett