Tea with Matthew Seah: Margin of safety.

Matthew shares with us a simple and important concept to invest more safely:

The intrinsic value of a company could be calculated base on our estimations of various aspects of the business, both tangible and intangible. Hence one would require to look at both qualitative and quantitative aspects of the business in order to give a more holistic valuation of a company.

Company valuation can be done using 2 broad types of valuation models:
- absolute valuation; and
- relative valuation.

Absolute valuation is a valuation method that give you an absolute value to compare against the current market price. Absolute valuation method is broadly termed as a discounted “cash flow” method. The different models calculates future cash flows -- dividend (Discounted Dividend Model), free cash flow (Discounted Free Cash Flow Model), operating cash flow (Discounted Operating Cash Flow Model), residual income (Discounted Residual Income Model), etc -- and discount these future values to present value.

Relative valuation is a valuation method that compares certain metrics -- price to earnings ratio (P/E), price to book ratio (P/B), price to sales ratio (PSR), total enterprise value to earnings before interest, tax, depreciation and amortisation (TEV/EBITDA), etc -- against the industry or market average.

Each of these valuation models, including those not mentioned, have their pros and cons. 

Do note that even with complete knowledge of the business, company valuation is still an estimation of what the value of the organisation as other external factors such as macro trends and policy changes in the future is difficult to predict.

So how to overcome this miscalculation?

Introducing Margin of Safety. 

The concept of margin of safety originated from Benjamin Graham and he wrote about it in the very last chapter of The Intelligent Investor (Chapter 20: “Margin of Safety” as the Central Concept of Investment).

Simply put, when market price is below your estimation of the intrinsic value, the difference is the margin of safety. The lower the market price of the stock, the more undervalued it is, and the greater the margin of safety. In essence, the risk of losing money is lower when buying an undervalued company with a large margin of safety.

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” 
- Seth Klarman

Margin of safety doesn't guarantee a successful investment, but it does provide room for error in an our judgment when calculating the value of a company.

Related post:
3 points to note in investing.

Matthew answers questions on STI ETF (Part 2).

Thank You and Matthew Seah for the help! Appreciate it  I still have a few more questions to ask regarding STI ETFs which would require Matthew's or your help.  

SPDR STI: 

1) Matthew mentioned that "It is wrong to say that they paid $12M when they had $5M in cash. What you see as cash is only a snap shot “at 30 June 2015”. What has been paid out is cash they had previously from dividends collected over the six months prior, less management fees. " Based on this, am i right to say that net income would be a better gauge to determine whether the fund is paying dividends more than it can afford?

2) There is a significant increase in liabilities in 2013 due to purchases awaiting settlements. What purchases did they make? And how did they manage to pay off such a large amount by 2014? 

3) There is a change in source of credit rating in 2015. And the rating as a result improved from B*- to AA-. Did they change the rating source in order to improve their credit rating? Is this a source of concern?

Nikko AM STI:

1) Why is there suddenly an amount due to shareholder in 2015 under payable? 

2) The tracking error provided by nikko am is on a 3year annualised basis while for spdr, it is based on rolling 1year tracking error. Is it fair to compare this 2 tracking error directly? Is it sufficient to just look at the current tracking error in the fact sheet or should i look for past years tracking error of both ETFs? Where can i find past years tracking error of both ETFs? It wasn't in the annual report.

General: 

1) Would my returns be better if i chose to start DCA under a RSP plan when the index is cheaper as compared to when the index is higher?

Thank you and looking forward to your reply! 

From Matthew Seah:

SPDR STI 1) yes
2) The only liabilities the fund has is payables. Payables come mainly in the form of cash due to the brokerage at T+3. Since STI ETF is a cash ETF, they would have sufficient cash before purchasing the STI components.
3) you can review the credit ratings at http://investors.statestreet.com/CustomPage/Index?KeyGenPage=302726

Nikko AM STI ETF
1) Distribution payable is the cumulative dividends, less fees collected to be distributed to shareholders on a semi annual basis.
Are special dividends from any STI components? Is there a change in dividend yield when there is a switch of a STI component?
2) I am not sure where to find tracking error. But you can calculate by yourself.using excel and historical data for STI, SPDR and Nikko AM ETFs. The tracking error is generally very low and is not much of a concern.

General
1)http://singaporeanstocksinvestor.blogspot.sg/2013/08/tea-with-matthew-seah-dollar-cost.html
read the comments as well for the Nikko AM STI ETF simulator
one ETF starts before the great financial crisis, the other starts near the bottom



Related post:
Matthew answers questions on SPDR STI ETF.

Matthew Seah answers questions on SPDR STI ETF.

Dear AK,

I am SH, one of your many blog readers. I am currently 21 years old and i am planning to make my first investment through a STI ETF. (Still deciding between spdr and nikko). However i have quite a number of questions regarding SPDR STI ETF; especially after reading its annual report, which i hope you can help to clarify.

These are the questions:

Unitholders’ contributions/(withdrawals)

Creation of units:

2015: 31,366,855

2014: 59,145,817

Cancellation of units:

2015: (149,927,298)

2014: (6,664,213)

Change in net assets attributable to unitholders resulting from net creation and cancellation of units:

2015: (118,560,443)

2014: 52,481,604

Distributions NOTE4

2015: (12,106,500)

2014: (10,726,000)

Total (decrease)/increase in net assets attributable to unitholders:

2015: (109,105,696)
2014: 69,068,372

QN: I found the above information in the annual report but I couldn’t understand what it means. Can you explain?

Matthew Seah: "Each unit of STI ETF is a share of STI ETF. Units are created or cancelled due to the injection of fresh funds or the withdrawal of money from the fund respectively."

Qn: 1 What is net asset attributable to unit holder? Does it just mean net asset value?

Matthew Seah: "Net asset attributable to unit holder is the net asset value, after fees are deducted for selling all the stocks and derivatives (if any) that the fund owns to convert everything into cash."

2 What is collective investment scheme?

Matthew Seah: "A collective investment scheme is a scheme which pools moneys from many people for the sole purpose of investing the pooled funds.

"Mutual funds, unit trusts, endowments and ETFs are examples of collective investment scheme."

3 Quoted derivatives in the form of nil paid rights from Jardine C&C on 15/07/15. What does this mean? I heard that spdr etf uses derivatives to try and minimise tracking error. Is this a significant proportion? What are the risk of it?

Matthew Seah: "Jardine C&C has made a rights offer of 1 for 9 shares.

Click to enlarge.

"STI ETF owns 112,541 shares of Jardine C&C.

"That equates to 12,504 rights that you see on the annual report."

4 If they pay dividends from cash, it seems that they are paying out more than what they have. They only have S$5M+ of cash but paid out 12M+ for 2015?!

Matthew Seah: "It is wrong to say that they paid $12M when they had $5M in cash. What you see as cash is only a snap shot “at 30 June 2015”. What has been paid out is cash they had previously from dividends collected over the six months prior, less management fees.

"Likewise, suppose your bank account has $5,000. It would be erroneous to say the $12,000 you have already spent is more than what you originally had, which was $17,000."

5 Does portfolio turnover ratio have different meaning if the calculation is based on purchases instead of sales? Is lower ratio better?

Matthew Seah: "For a turnover to happen, $1 in stock A have to be sold to purchase $1 in stock B. The portfolio turnover ratio will be the same regardless of purchase or sales.

"A higher purchase happens when there is a net investment inflow, i.e. more investors buying STI ETF units. Alternatively, a higher sales happens when there is a net investment outflow when investors liquidate their holdings. However, these higher purchases/sales numbers are not turnover as no portfolio rebalancing occurs.

"A lower ratio is better."

6 There is a significant increase in portfolio turnover ratio from 31Dec 2014-2015. It jumped from 0.94% to 9.77%! Do you have any idea why it is so? Is it due to the replacement of 3 of sti constituents in 2015? It is considered a one-off kind of thing right?

Matthew Seah: "It is indeed caused primarily by the replacements of STI constituents. It would be one-off when FTSE does not change the constituents on a regular basis. Generally, investors would consider such rebalancing to be one-off."

7 There is a significant increase in payables in 31 DEC 2015 compared to 30 JUN 2015. Is it due to the losses incurred due to the changing of constituents in STI?

Matthew Seah: "Payables in the ETF comes in 2 forms:

"‘Accruals for expenses’ and ‘Amount due to the Manager’. It just meant the fund owes money to to the Manager and third parties. These have nothing to do with losses incurred."

8 Is there a chance/under what circumstances the sti etf will close down?

Matthew Seah: "STI ETF is unlikely to close down."

9. If you are the one considering to buy the sti etf, other than the tracking error, expense ratio, portfolio turnover ratio, p/e, what else would you look at when analysing this etf? Would you read into the past years’ annual report?

Matthew Seah: "Nothing else, really. You should read past annual reports to compare all the parameters you have mentioned to ensure that the Manager has kept tracking error, expense ratio and turnover ratios low, or lower (better) over the years."

10. Where can I get past few years of annual report? I can only find annual report for 2015 and the semi-annual report for 31DEC 2015 on the official website
Matthew Seah:"You can contact them at http://www.spdrs.com.sg/contact/index.html"

Read another blog post on ETFs by Matthew Seah: HERE.

Tea with Matthew Seah: Exchange Traded Funds (ETFs).

ASSI's most prolific guest blogger, Matthew Seah, readily agreed to contribute this guest blog when I asked him if he could do it. Such an obliging and intelligent fellow.

During the 4th “Evening with AK and friends” session, a young man mentioned cash-based and synthetic ETFs. After some discussion, AK shot an arrow for me to do a guest blog on ETFs, so here it is.

Firstly, exchange traded funds (ETF) are investment funds that can be traded on the stock exchange, hence the term ‘exchange traded’.

The main objective of an ETF is to replicate the performance of a basket of stocks of an underlying benchmark. An ETF is a passively managed fund and generally charge lower fees compared to actively managed funds. Hence the kind of returns you can expect from investing in an ETF is equal to the performance of the underlying benchmark minus management fees.


Alright! Now ETFs can be categorised into 2 broad types: cash-based or synthetic.

Synthetic ETF

Synthetic ETFs are more complex than cash-based ETFs. Synthetic ETFs creates a similar benchmark with the use of derivatives such as options, forwards, swaps and participatory notes. Like with all derivatives, synthetic ETFs are all Specified Investment Products (SIPs) on SGX.

As the use of derivatives are complex and often non-transparent in nature, MAS has kindly restricted trading of synthetic ETFs by requiring investors to go through customer knowledge assessment before they can trade synthetic ETFs.

Cash-based ETF

Cash-based ETFs are simple funds that allocate whatever capital pooled into the fund into a similar portfolio as the underlying benchmark. For example, the capital in Nikko AM STI ETF is used to invest in the 30 STI components stocks according to the weightage of each stock in the STI.

This is a preferred form for the safety seeking investor, as no third party credit risk is involved.


So what are the added risks involved in synthetic ETFs not found in cash-based ETFs?

Synthetic ETFs enter into contracts with third parties, or counterparties, when using derivative products. Hence there is counterparty risk where the counterparty might default on their obligations. Thus, your returns will depend on the ability of the counterparty to honour its commitments to the ETF.

With derivatives, leverage may be used to increase returns. While leverage may generate higher returns, it could also cause the ETF to lose more than the market.

Conflict of interest may occur when the counterparty and the ETF are from the same financial institution.

You can find out more about how ETFs are structured and their risks here.


How do I know if the ETF is synthetic or cash based?

Highlighted red is where you can determine if an ETF is synthetic or not. A ‘X@’ in the SIP column would indicate that the ETF is synthetic.

A ‘@’ indicate that the ETF is an SIP and customer knowledge assessment is required.

An empty box, i.e. ABF SG Bond ETF, indicates that the ETF is a cash-based ETF.

Why do ETFs use derivative products?

1. Some markets like many emerging markets are inaccessible to the ETF, hence derivative products have to be used in order to gain access to the stocks.
2. Derivatives when used properly, are hedging tools and can reduce risks and improve portfolio management for the ETF.

Lastly, as a result of doing some search for more information, I have found that the MAS converted some ETFs, previously classified as SIPs, to excluded investment product (EIPs). The ETFs that were converted to EIPs will be predominantly cash-based and only use derivatives for efficient portfolio management including the hedging of risks.

Therefore, you would expect those with only a ‘@’ to eventually convert into an EIP under the new framework.

Here is the list of ETFs I found online:

"Following strong market feedback that earlier versions of the Specified Investment Products (SIP) regime had been overly broad, the Monetary Authority of Singapore (MAS) has tweaked its rules to exclude simple funds from the often cumbersome safeguards required to invest in more complex products.

"In a bid to encourage investments in exchange traded funds (ETFs), Singapore Exchange (SGX) will also waive ETF clearing fees from June 1 to Dec 31, 2015.

"Under the previous rules, products such as gold exchange traded funds and funds that invested in a particular country were treated the same way as leveraged products or those that tracked synthetic benchmarks. Under the SIP framework, investors who wanted to buy those products had to be assessed by their financial institutions for their ability to understand those products. A lack of competency or experience in understanding those products would require additional safeguards to be put in place before the investment could be allowed.

"But the new rules, which took effect on Wednesday, carved out exemptions from the SIP requirements for funds that trade in gold as well as those that use derivatives only for hedging or efficient portfolio management purposes."

(Source: The Business Times, 30 April 2015.)

Thank you, Matthew!

Related post:
The 4th Evening with AK and friends: A success!

Tea with Matthew Seah: Investment scams.

This is another contribution from one of ASSI's most prolific guest bloggers, Matthew Seah:

Recently I got to know of a likely fraudulent company selling US distressed properties in a declining city. 

Thought I could clear some air about how fraudulent investment operations work.





After doing some quick search, I found an easy to understand video from the Financial Industry Regulatory Authority, Inc.

How to Spot Investment Fraud?


.




Here are some other warnings signs which I think are also easily recognisable:

Promises of high, guaranteed investment returns with little or no risk.

“If it sounds too good to be true, it probably is.” Many fraudsters claim 12 – 24% or even higher returns. 

Unless their names are Warren Buffett, Peter Lynch, or George Soros, most investments can’t generate 12% returns consistently. 

Furthermore, all investments carry some degree of risk, so a 12% guaranteed return sounds amusing to me.

Unlicensed or “exempt” sellers or dealers.

If the investment company is unlicensed or “exempted” from registration, chances are they are not regulated by MAS. 

MAS has an Investor Alert List for anyone with internet access to do a quick check on the spot.





Secretive or complex strategies.

Oftentimes, fraudulent investments comes with complex and secretive strategies. 

Ask them how the investment generates its returns and to provide supporting documentation. 

Sometimes, my friends who are already in such schemes would answer 

“I cannot tell you because it is a trade secret/proprietary/non-disclosure” 

or 

“Others might copy our business model if I tell you.” 





With no transparency, it is highly doubtful that the investment would be legitimate, don’t you think?

Scams come in many shapes and sizes. 

If you do not know if it is a scam, but are in doubt, best to stay away. =D




Related posts:
1. Advice from a fraudster.
2. Thought process of a scam victim.
3. (See the 3rd point I made at a conference).
4. Invest in real estate for high returns.

Tea with Matthew Seah: Wealth Triangle.

Wondering how we can be wealthier? Here is another guest blog from Matthew Seah to nudge us along in the right direction.

For me, there are 3 ways to generate wealth and they are the essential tenets of my wealth building triangle:

 

1. Increase Income;

2. Reduce Expense, thereby saving what remains;

3. Invest a portion of that savings.

Due to our different circumstances, some may find it harder to strengthen one or more of these 3 legs of the triangle. However, do note that you will certainly get wealthier if you sufficiently strengthen one or more of these 3 tenets in your own wealth triangle.

In order to get wealthier at a faster rate, you must increase your income, spend less money and make your money work harder.

 

To increase your income, you can:

1. earn more at your current job;

2. get a higher paying job;

3. get additional job(s);

4. create multiple sources of income.

There are several ways to spend less money and they involve cutting back spending on excesses and wants. AK has been blogging about frugal living. So, you can learn from him.

And, finally, investing a portion of what you have saved. This not only increases your income by investing in income-generating assets, it could also increase your net worth through capital gains. You can also use leverage to increase your money’s ability to grow but do note that leverage is a double edged sword and you could lose more than your capital if used wrongly.

The ways to increase wealth are many and possibly infinite. So be creative and think of how you could make yourself rich. Of course don’t make the wrong type of money to be rich.

Some money, we cannot touch.

Some money, we should not make.

 

Related posts:
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2. Have a huge amount of savings and cannot retire?
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