Investing tricks of the wealthy

Average investors can apply the same techniques to their own investments, no matter the size of their portfolio

Dec 19, 2007
By BEN FOK

RECENTLY, I asked a wealth manager whether an average investor can make more money by mimicking the investment strategies of the rich. He answered: not really. Later he explained that the rich invest differently because, well, they're different. They can take more risks because they have more money to lose. Furthermore, they can speculate and have a short-term view because losing money is not a problem for them.

Well, I do not totally agree with his opinion. For the past few years, I have been advising wealthy people on their financial well-being. As a financial adviser, my job is to help these rich clients search for financial services who meet their needs. Throughout my interaction with them, I have gained an insight into how they accumulate wealth.

I can tell that the rich don't necessarily have any special insights into which stocks or assets are going to soar. But what they do have is the confidence to apply a disciplined and systematic approach to managing their money. They have the habit of applying common sense to each investment opportunity facing them. Even though the interests of wealthy investors are not always necessarily aligned with those of the average investor, there are a number of principles and strategies employed by wealthy investors that do apply to virtually anyone who seeks to invest for the future.

It is a common fact that most financial textbooks teach us that in order to build wealth we need diversification, wealth preservation and strategic growth. To me, this not an accurate statement in itself because two of those strategies - diversification and preservation - don't help to build wealth. Perhaps the rich use these two strategies to maintain wealth.

After they have accumulated great wealth, they didn't use the strategies during the accumulation phase and they tend to preserve the wealth they have built. Yet average investors have not yet reached the ranks of the financially independent, so they are generally more concerned about investment growth and losses. The wealthy, as a general rule, do not have this concern. At the same time, they also learn how to avoid taxes legally so that they can keep their money working for them and learn how to pass their assets on to the future generations without the government taking a huge part of what they spent their lives building.

Another common perception is that the rich take more risk, therefore they accumulate wealth faster. However, the truth is that the majority of rich people do not build their fortunes by speculating on high-risk investments as is commonly believed. My experience tells me that the rich do not heavily rely on high-risk investment vehicles like hedge funds or venture capital funds but are moderate risk takers who put more than half of their money into listed securities and keep a large amount as cash. The reason for this is that they have so much money that even if they do not meet their goals for investment growth, it would not be bad news to them; however losing their financial independence would be devastating.

So how do the rich invest? Unlike the average investor, the rich think long term in most of their investment strategies. They believe that there is power in long-term thinking and many of them make it habit of doing so. Great investors like Warren Buffett - his successes in investment include Washington Post Co, where Berkshire invested US$11 million in 1973 and which investment was worth US$1.3 billion at the end of 2006. That is 33 years of holding power which demonstrates his investment philosophy - always invest for the long term. Hence, most rich do not engage in short-term speculation but have a long-term goal in mind.

However, the rich make use of risk by taking advantage of risk. They often build fortunes using volatile assets and investments but that does not mean they were engaging in risky behaviour. They understand the risk and embrace risk because they know it always brings an opportunity for growth; however, the average investor is fearful of risk. Nevertheless, taking risk for the rich does not mean taking a shot in the dark. The rich take calculated risk that means to gain knowledge first and to consider the consequences of failing before taking action. The rich overcome fear with knowledge as knowledge can cause fear to fade away.

The rich also demand value for their money. Otherwise, how do you think they got to be rich in the first place? Value to them is buying assets at a discount to its intrinsic value. So for them the right time to buy is when there is weakness in the market. They buy when others are despondently selling and sell when others are greedily buying. This requires the greatest fortitude but also has the greatest rewards. This bargain-hunting approach to buying value will enable them to buy quality assets at reasonable prices. So they buy when there is bad news and sell on good news. For instance, some of the wealthy invest because they understand that the weakness is only temporary, and the stock price had fully priced in negative news and it was time for them to hunt for bargains again.

If we look back at the Singapore stock market, there are many opportunities for investors to bargain hunt and buy on bad news, e.g. the Asian financial crisis in 1997/98, the Sept 11 terrorist attack and SARS. The rich take advantage of these negative events to buy assets, whether in real estate or stocks and that's where value can be found. However, the average investor will seek to sell and get out of a bear market fearing that the asset will fall in value.

To the rich, probably now is the best time to sell and get out of the market, where all assets prices have gone up in value. Over the past years, we have very good reports about our economic growth and all the good news are now factored into the stock price, so for the rich it's time to sell.

Another investing secret of the rich is that they approach investing like a business. They set up a business plan, establish annual targets, then analyse the results and they have reasonable expectation. At the end of the day what they want to achieve is increasing their net worth and not their income. The rich truly understand the meaning of working smart not working hard: to focus on growing your net worth is working smart but working for an income is working hard. As their net worth grows, they do not increase their spending, instead they increase their investment. By repeating this over the years, once their net worth is built to a certain level, they are free to do what they want. Hence, to increase your net worth you need patience, knowledge, and wisdom.

Often they are not willing to pay more for investment services simply because they find a particular adviser to be charming or knowledgeable. Nor do they chase after the hottest manager or the most publicised fund. Instead, they go shopping for the best combination of reasonable fees and consistently good performance. However, they will pay for advice from people who have specialised knowledge in a field they need to learn about. They don't believe in free advice as it can often be the most expensive advice.

As you can see, most investing secrets of the rich are nothing more than a combination of basic common sense and knowledge. The difference between the rich and the average investor is that they have the self-confidence to stick to the basics and to find out what they need to know. They don't get caught up in the theory of the week or the trend of the month. It's an approach that's easy to articulate but difficult to follow.

However, average investors can learn important lessons from the wealthy, specifically the need to manage both risk and their own investment expectations. The failure to match expectations to the risk an investor is willing to take can result in frequent switching among investments, or even worse. Now the good news for the average investor is that you can apply many of the same techniques to your own investments, no matter how big or small your portfolio is.

Not all bonus issues are good news

BONUS share issues are usually viewed positively. Investors welcome them and companies always present such issues as efforts to reward shareholders. And there have been no shortage of bonus issues on the Singapore Exchange (SGX) in recent months. At least a dozen or so SGX-listed companies have announced bonus issues, according to filings with the stock exchange.

However, like most things, bonus issues aren't always all that they are made out to be.

A bonus issue refers to the issue of new shares to existing shareholders at no cost and in direct proportion to their existing shareholdings in the company. So in a 1-for-4 bonus issue, for instance, shareholders get one new share for every four existing shares they hold.

Because bonus issues are free, it is well understood that they do not directly benefit the company. This is unlike rights issues (where shareholders pay for rights shares at a discount to the market price) which raise funds for the company. Bonus issues also do not materially alter the balance sheet of a company. They are normally done using the retained earnings of a company and involve a book entry transferring an amount from retained profits to share capital. This is also known as the capitalisation of reserves.

But do bonus issues really benefit shareholders, as companies make them out to be?

This is debatable. It can be argued that, theoretically, a bonus issue brings no additional benefit to the shareholder.

While it is true that the shareholder would end up with more shares at no cost, the share price would - theoretically at least - also adjust downwards accordingly to what the market calls the theoretical ex-price. Issuing bonus shares also has the effect of diluting earnings per share.

One way shareholders would benefit from a bonus issue is when the adjusted lower share price makes the stock more affordable and encourages more investors to invest in it. This would result in more liquidity and potentially more upside for the share price.

This would be what companies want shareholders to believe, and indeed, is the rationale given in every bonus issue announcement. Such an outcome is not a given, however, and the share price performance depends not just on having more shares in issue but on a host of other factors.

There are, in fact, some hidden dangers in bonus issues.

For one, companies may be making bonus issues in lieu of dividends. So while getting more shares at no cost, shareholders may be forgoing cash dividends. In some cases, like when a company needs to conserve cash to expand its business, there are sound reasons for a bonus issue in lieu of dividends. But this does not apply to all situations, and shareholders should ask if a bonus issue is masking the lack of dividends when these should be forthcoming.

Another danger is when a penny stock makes a bonus issue. While there may be a good reason for a high-priced stock to make a bonus issue to improve affordability and boost liquidity, it's harder to apply this logic to penny stocks which are already affordable in the first place. So if a penny stock becomes even cheaper, it may pull in speculators rather than long-term investors. Indeed, institutional shareholders - which companies value - are known to shun very low-priced stocks. Attracting speculators and the syndicates may boost the share price in the short term, but if this comes at the expense of having serious investors as stakeholders, it could ultimately curb the upside potential of a stock in the long term.

The other thing to watch out for is when recently listed companies make bonus issues. Companies often say they are rewarding shareholders' loyalty when they make a bonus issue. For a newly listed company, however, there really is no shareholders' loyalty to speak of. So the motives a company has in making a bonus issue in such a situation should be questioned.

Of course, there are many bond fide bonus issues made by companies which are doing well, are confident of their future prospects and are genuinely seeking to reward shareholders. But investors should not see all bonus issues as good news. There may well be a sting at the end of the tail.

Super stock returns: ROE/PTB v ROE v PTB

A company that is able to generate a high return on equity - one that exceeds its cost of equity - should trade at a higher price than the book value of its equity. And vice versa. But if a company generates a relatively high ROE, yet is trading at a relatively low price-to-book ratio (PTB), careful analysis is warranted.

There could be legitimate reasons for the low valuation. For example, the earnings were due to exceptional items. If not, the stock may be under-priced.

But without any detailed analysis other than simply grouping stocks based on ROE/PTB, I found that investors can actually generate super returns.

By investing in the 10 per cent of stocks with the highest ROE/PTB every year between 1990 and 2006, and holding each portfolio for a year, one could have turned $100 into $34,000 over the past 17 years. That's a compounded return of 41 per cent a year. All the calculations exclude transaction costs.

If we assume that the investor had lost 10 per cent of the portfolio value to transaction costs every year, the return is still a respectable 27 per cent a year. But in absolute terms the portfolio value today, at $5,678, is significantly less than the $34,000 which excludes transaction costs.

From the above, we can see that ROE/PTB is a good screening tool.

Separate rankings

If we pick stocks just based on ROE or just based on PTB, do we get results that are as good?

I decided to test this based on the same set of data last week. This time around, I ranked stocks based purely on their ROEs first. Again, I grouped them into 10 portfolios, with the first 10 per cent or first decile being stocks with the lowest ROEs. The 10th decile was made up of stocks with the highest ROEs.

As can be seen from the chart, screening stocks using just their ROE still yields good returns. $100 invested in the highest ROE portfolio every year would grow to $8,752 today. That's a compounded annual return of 30 per cent.

But it would lag the performance of the basket of stocks with high ROE yet low PTB.

For both the first and second screening, I excluded loss-making companies.

Next, I ranked the stocks based on their PTB ratios. For this, I did not remove loss-making companies. The first decile is made up of stocks with the lowest PTB ratios. Some could even have negative PTB ratios. And the 10th decile consists of stocks with high PTB ratios.

As you can see from the third chart, there is a clear distinction in performance as well. The lower the PTB, the higher the return. And conversely, the higher the PTB, the lower the return. The lowest PTB stocks generated about 15 per cent return a year, while the highest PTB stocks chalked up a 7.3 per cent loss a year.

However, the returns of portfolio ranked purely on PTB ratio lagged those screened by ROE/PTB or purely on ROE.

One of the reasons for the under-performance could be the continued poor performance of loss-making companies. Other studies previously have found PTB to be the best predictor stock performance. Particularly so when there is a turnaround in the economy. This is also evident in five portfolios that The Business Times tracks every Monday.

But it takes guts to go against the crowd and buy into downtrodden stocks.

So perhaps, the ROE/PTB is a more comfortable approach for many. And as the results above indicated, it is rather rewarding as well.

It does, however, require a little more work. The use of ROE/PTB takes into consideration not only the underlying earnings capacity of a company, but also how much of that has been factored into its stock price.

So if a company can rake in good earnings and good growth and its share price has fully reflected that, it may not be a good stock to buy. What one wants is good earnings growth that is not recognised by the market.

Variations

A reader pointed out that with some simplifications, ROE is earnings per share (EPS) divided by net tangible assets (NTA). And PTB is price per share divided by NTA.

Dividing the former by the latter gives us EPS divided by price per share, which is earnings yield. So stocks with high ROE/PTB are also those with high earnings yield.

And we could go one step further. Earnings yield is the inverse of price-earnings (PE) ratio. So stocks with high earnings yield are also low PE stocks.

'Notwithstanding the mathematical accuracy, ROE relative to value is an interesting approach to investing,' he wrote. 'I have been using something similar for some time to good effect (ROE divided by PE coupled with some other criteria like minimum dividend payout and low debt to equity).

'A variation was also suggested in the book The Little Book That Beats The Market by Joel Greenblatt which uses ROE divided by return on invested capital (to correct for the use of excessive financial leverage). He even has a website www.magicformulainvesting.com to automatically select US stocks that meet the criteria.'

The reader added that the most comprehensive book he has come across on this is What Works On Wall Street by James P O'Shaughnessy.

Below is a table - using data from Bloomberg - showing 30 stocks with high ROE/PTB. Some of the numbers may be skewed by one-off items, so some analysis is advised before any action is taken.

Go for stocks with high return on equity but low price-to-book ratio

ONE way to value a company is to ascertain how much abnormal earnings - that is, earnings above the cost of its capital - it will be able to generate in the future. This stream of abnormal earnings is then discounted to its present value. Add that number to the current book value of the capital and you arrive at how much the company is worth.

This way of calculation has intuitive appeal. It implies that if a company can earn a rate of return that is equivalent to its cost of capital, then investors should be willing to pay no more than the book value for the stock.

Book value is the original capital invested by the company in its various assets to start up its business after taking into account depreciation.

On the other hand, if the company is able to generate earnings above its cost of capital, then investors should be willing to pay more than the book value of its assets. Conversely, if a company's net earnings cannot even cover its cost of capital, then investors will only invest in the company if it is trading below its book value.

We can see how much the market is valuing a company by comparing the market value of its equity, that is its market capitalisation, with the book value of its equity.

So if a company's market cap is $100 million, and the book value of its equity is $50 million, then this company is trading at two times its book value. This measure is also referred to as the price-to-book (PTB) ratio.

A PTB ratio of two times implies that investors are confident that the company can earn significantly above its cost of capital for a sustained period of time.

We can actually derive the formula for PTB from the abnormal earnings formula. The latter says that to arrive at what a company's shares are worth, we take the current book value of its equity, and add the discounted future stream of net profits which is in excess of the cost of equity. The discount rate used is the cost of equity.

So if we scale the formula with book value on both sides, we get PTB value on the left-hand side, and abnormal return on equity (ROE), among other things, on the right-hand side.

This suggests that a company's PTB ratio is a function of three factors: its future abnormal ROE, the growth in its book equity, and its cost of equity.

Abnormal ROE is defined as ROE less the cost of equity.

Firms with positive abnormal ROE are able to invest their net assets to create value for shareholders, and as mentioned earlier, will have a PTB ratio greater than one.

Strong ROE-PTB links

The whole point of what has been said so far is to show that there is a strong relationship between PTB ratios and ROEs. Companies with high ROE should trade at higher PTB ratio compared with those with lower ROE.

So perhaps one way to spot mispricings by the market is to identify stocks with high ROE but low PTB ratio.

Will such a strategy pay off? Well, I did some back-testing and the results are phenomenal.

I download the ROEs and PTBs of all the companies listed on the Singapore Exchange from 1990 until 2007. These are the yearly numbers on Jan 1 of each year.

I then divide the ROE numbers with PTBs, and rank the stocks based on that number. The top-ranked stock would have the highest ROE relative to its PTB. The lower-ranked stocks would have low ROE and high PTB.

I then split all the stocks equally into 10 groups. The first group, or the first decile, is the top 10 per cent of stocks with the highest ROEs relative to their PTB ratios. The 10th decile comprises those with the lowest ROEs and highest PTB ratios. Then there's a group of loss-making companies.

Compounded returns

Assuming that an investor did this on Jan 1, 1990. Based on data from Thomson Financial Datastream, there were 39 stocks then. After ranking them, he invested $100 in the top four stocks with the highest ROE/PTB.

On Jan 1, 1991, he did the same screening again. Then he divested the initial four stocks and reinvested the proceeds into a new batch of stocks with the highest ROE/PTB.

And he consistently did that for the past 17 years. How do you think his $100 would have grown to? A whopping $34,048.

That's a compounded return of 41 per cent a year. The above calculations did not take into consideration transaction costs. If it did, a huge chunk of profits would disappear.

But the point is, there is a very clear relationship between stock returns and ROE/PTB. As can be seen from the chart, the top 10 per cent of companies with the highest ROE/PTB turned $100 into $34,048 in 17 years.

The next 10 per cent managed to grow the pot to $4,710 - that's still quite a decent 25 per cent a year. The following 10 per cent, or the third decile, managed $958 for a return of 14 per cent a year.

And as we move to stocks with lower and lower ROE/PTBs, the return shrinks correspondingly.

The fifth decile grew only 3.8 per cent a year and the 10th decile - the 10 per cent of the market with the lowest ROE/PTB - shrank the $100 to just $25. It is very clear from the findings that it doesn't make sense buying stocks with low ROE and high PTB.

This screening process takes into consideration the underlying earnings capacity of a company in relation to how the market is valuing the company. Those with high ROE but low PTB are clear cases of mispricing. That's why the back-testing shows such a phenomenal performance.

But of course, a firm's ROE is affected by such factors as barriers to entry in their industries, change in production or delivery technologies, and quality of management. These factors tend to force ROEs to decay over time. But since in the above testing, the holding period is just one year, the decay is not so much a factor.

So the next time you study a stock, look at its ROE relative to its PTB as well. If the ROE is high, but its PTB is high as well, then perhaps the good fundamentals have been reflected in the share price. However, if you find a stock with high ROE but relatively low PTB, then you may potentially have on your hands an undiscovered gem.