Aesop's Investment Axiom

According to Warren Buffett, the formula for valuing an asset purchased for gain is the same now as it was when articulated by Aesop long ago.

From the 2000 Berkshire Hathaway (BRKa) shareholder letter:

"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush -- and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars.

Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe. 

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation."

Somehow a distinction between growth investing and value investing is frequently still made.

It's a distinction without a real difference.

Some will no doubt disagree.

Investing well over the long run requires many things, of course. Yet it ultimately depends upon understanding how to judge correctly, within a useful range, what something is worth -- regardless of its growth profile -- then paying an appropriate discount for it.

The necessity for a discount reflects the inherently imprecise nature of judging value. It also reflects the fact that not everything that's important can be known and misjudgments will inevitably be made. Simplistic valuation metrics like price to earnings are only useful if they happen to be a meaningful proxy for the amount of future net cash an investment will likely generate.

Unfortunately, that's often not the case.

More from the letter:

"...Aesop's proposition and the third variable -- that is, interest rates -- are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. 

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let's call this phenomenon the IBT -- Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights."

How much cash will be generated, when it will generated, and what the prevailing risk-free interest rate is what's all-important. Once there's a meaningful estimate (within a range), the amount and timing of cash flows can then be discounted using an appropriate interest rate.

So it's not, as some might think, growth per se that's necessarily important.

If interest rates are very high, the cash produced in the future needs to be available to the investor sooner than later.

If prevailing rates are very low, the investor can afford to wait quite some time for that cash.

The investment process ultimately rests upon the foundation of knowing how to judge what something is worth consistently well. Lack that ability and everything built upon that foundation crumbles. Others skills and abilities won't be able to compensate for that shortcoming.

Otherwise, it comes down to thinking independently, an even temperament, discipline, and an awareness of limitations. It's less about IQ than some seem to think.

A speculator will, of course, have an entirely different way of looking at this. For a speculator (with a long position, of course), a large drop in the price of an asset is not a good thing. For an investor, a large drop in the value of an asset is not a good thing.

A drop in value means that the net cash to be produced over the life of an asset was misjudged.

A drop in price may mean the psychology of the market has changed (though it surely could also reflect fundamental factors). A temporary drop in price will be a good thing for the investor who's judged value well.

Speculators try to gauge price action. In general, they try to figure out what someone else will be willing to pay in the future.*

That certainly doesn't mean there's something inherently wrong with speculation. There isn't.

It's just that there is a real difference -- in both required skill set and temperament -- between trying to figure out what others will pay for an asset at some later time, and figuring out what an asset itself can produce over its useful life in economic value.

From this interview with Warren Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."

Let's hope we don't always have to go back 2,600 years or so to find investment wisdom.

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Tune Insurance: Where does it swings?

I am amazed with the Malaysian market - at a time when some are afraid of Airasia's growth prospects due to competition from presumable Malindo, we are celebrating the high price valuation of Tune Insurance. (have you heard of Malindo news nowadays - is the March launch still on, BTW?)

Now, let me put this right. Airasia is offering a service which people would like to have - i.e. cheap travel. Tune Insurance which is an exclusive partner to Airasia is offering something which we can do without...travel insurance. Once in a while we may be afraid of the risks associated with flying, but if we are afraid, why fly? A travel insurance will not do much help except enriching the provider. Airasia as in other low costs airlines like Ryanair will push for these kind of services as they are fringe income from the Low-Costs airline business. But, overtime as I see it regulators will want these airlines to be much more upfront - such as the case of Australia summoning Airasia for misleading customers in its pricing.

No doubt I still very much like Airasia as I think it is going to be the leading contender in the low frills airline business in much parts of Asia, I think that Tune Insurance is overpriced. I am reading somewhere that at its current traded price of RM1.35 (market capitalisation of RM1.014 billion), the prospective PE for FY2013 is somewhere along 16x? Is it possible? Lets look at the Proforma Income Statement for the past 4 years. Firstly, lets look at the red block for Operating Revenue. Notice the growth in revenue and if you look at the Audited Report for 2009 to 2011, the travel insurance business has very high profit margin.

Proforma Income Statement for Tune Insurance

How not possible that it is not highly profitable in terms of margin? The marketing is all done by Airasia. A minimal fee and commission is probably paid to Airasia - that's all AND look at the gross claims paid. Nobody is claiming because there is not much you can claim from the coverage terms in the insurance anyway. Additionally, its costs is all in the commission and fees paid. If there's no sales, there's no commission to be paid. In fact, Tune Insurance has no costs literally speaking except for the "gwailo" CEO which it does not need - unless you need the slang when being interviewed by BFM.

That is why as you can see it, once the main business i.e. airline business is becoming successful - Tony and his team are reaping the benefits from this travel insurance business. I do not see how this insurance business is not profitable. It is a LPI (Lonpac) to Public Bank - a hugely successful bank in Malaysia. Lonpac does not do much marketing - Public Bank does most of the marketing. In fact, what's a potential loss to Airasia from its additional source of income from insurance will be a gain to Tune Insurance and can be vice versa, anytime. The CEO's job for the insurance company must be a good one!

Anyway, now that we know it is highly impossible that Tune Insurance will not be a hugely profitable business in terms of margin (unless there is a major plane crash - and even that I think it is covered), what about its growth and other potentials. The travel insurance will grow in tandem with Airasia's in Malaysia - probably slightly better growth due to the high inelasticity in its ability to price - who will notice if Tune is to add another RM1 or two?

But for its other side of business...Mid of last year Tune Insurance bought over a very small general insurance business despite the hugely competitive environment as there were several much bigger and more competitive insurance companies having their M&As over the last few years. That acquisition is what you see in the segmental revenue as below.

Segmental revenue

As you can see above, the revenue from travel insurance is being dwarfed by other general insurance business in 2012. This percentage will get bigger with the full year income being recognised. What about the impact? As much as the travel insurance business is highly profitable, the motor and non-motor insurance is NOT. It is a totally different business for Tune. It is highly competitive, highly regulated and highly not TUNE.

If it is pitching a different tune for the other general (motor and non-motor insurance), then I probably would buy it - something like they are going full-fledged online and selling it cheaper. The pitch as at now however is (not convincing for the price paid for) i.e. the "beautiful" low cost no frills airline (Airasia) and Tune Insurance is to be riding on the strength of that growth while it now has another side of business with 1,000 agents selling for the motor and non-motor general insurance. That does not go past me as P&O is only valued at less than RM400 million. How is Tune supposed to be worth more than RM1 billion.

Why did it acquire that insurance business anyway if it is not attractive in terms of prospects? It is cheap for one - with the money raised from the IPO, it has already covered the acquisition price. Tune needs to be a larger insurance company to survive despite the profits as there are minimal regulations requirements as a insurance company that it needs to meet. Another thing is that with the higher revenue - the income statement looks good. Who will pay for a company with RM1 billion valuation but its revenue is just a meager RM55 million?

Now back to the valuation again. The travel insurance is great but the other general insurance is not. For it to meet the 16x PE for this year as claimed in some newspapers, it all depends on how much can the Tune group swings the profits - and the list of directors in Tune Insurance are very much capable of that. That's why I am not interested.

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Grantham: Investing in a low-growth world

In Jeremy Grantham's latest letter, he asks whether lower GDP growth logically leads to reduced stock returns.

Grantham answers that question this way:

"This is where I break ranks with many pessimists because I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability.

He adds, parenthetically, that their may be some effects of lower GDP growth that will lower equity returns in a minor way. This gets covered in more detail later in the letter. Otherwise, as far as stock returns go, growth is just not as big a factor as some might think.

All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse."

In fact, growth can be a negative factor. According to Grantham, it turns out that growth companies and countries underperform...

"The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of 'value' stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that 'value' or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market's faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain't so."

While maybe not intuitive, that high growth rates will have a high correlation with investor returns is far from a given.
(Regular readers obviously know that this has been covered more than a few times on this blog.)

High levels of growth should, of course, generally lead to more desirable investment outcomes, right? As it turns out, not necessarily. If interested, here are some of the prior posts that deal with variations of this subject:

Buffett: Stocks, Bonds, and Coupons - January 2013
Maximizing Per-Share Value - October 2012
Death of Equities Greatly Exaggerated - August 2012
Stock Returns & GDP Growth - July 2012
Why Growth May Matter Less Than Investors Think - July 2012
Ben Graham: Better Than Average Expected Growth - March 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
The Growth Myth - June 2009

Fast-growing countries, industries, and individual businesses have a whole range of possible investor outcomes with above average returns far from being certain.

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter

Wait, growth can be a negative thing?

Some might choose to treat all this as anomaly. Yet, it's often not a bad idea to explore in some depth what's against conventional wisdom -- what's not intuitive. Occasionally, that's where the more useful insights reside. 

Growth, of course, can be a good thing but some seem to think, from an investor point of view, it is always a good thing. What gets in the way? Well, investors often pay too much for attractive future prospects. Also, high growth prospects invite in lots of capital and competition. Lots of well-financed capable competitors can lead to undesirable core economics and a wide range of unpredictable outcomes.*

The real question becomes whether growth will have a favorable impact on the per share value created over a very long time. Sometimes it does. Sometimes it does not. 

The primary drivers of long-term returns is the price that's paid relative to well-judged intrinsic value, return on capital**, and whether real durable advantages exist. 

A good business needs little capital. It can return the excess capital produced to shareholders. It can use it to finance opportunities at an attractive long-term return. It can do these things while maintaining or even increasing the size and strength of its economic moat (has no trouble defending its core business economics). 

This just requires business leaders who do not choose growth for its own sake over per share returns for its shareholders. 

Far from a certainty. 

Unfortunately, sometimes the fastest growing, most promising, dynamic, and exciting areas of opportunity produce less attractive risk-adjusted returns and a wider range of outcomes.

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Another election fear: Currency?

Malaysian Ringgit has gone through a bad patch over the last 1 week. It seems that the General Election is having its effect on our currency as well? As below, usually Ringgit traded within a range against Thai Baht - most of the time trading around 1 MYR = 10.10 THB. Most recently, MYR has weakened to 9.58.

The usually stable MYR against Thai Baht faced a change where MYR dropped significantly over the last week

Usually, currency trading over the short term really reflect the sentiment rather than longer term fundamentals. Why has MYR dropped? Funds pull out? These are short term funds so to speak - have foreign funds been selling on our stock market as over the recent month, most markets have been performing with the exception of Malaysian market. Or could it be the currency traders have been shorting the Malaysian Ringgit?

The sharp drop in MYR against Euro. Pretty much the same against most other major currencies

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