Tuesday, January 25, 2011

Volume 3 Issue 4: Intelligent Investing

Investing in Inflation - Part 2

In Part 1, we established how inflation is one of any investor's worst enemy. In this issue of the Mainstreeter, we will take a look at some of the possible ways to invest, and will venture into explaining why investing in equities can possibly counter inflation better than all the other investment vehicles.

In Economics @ Home Volume 1 Issue 11, we discussed other possible means to invest because of the fact that placing your money in fixed deposits is a slow but sure way of becoming poorer. Here is an extract from that issue:

"Although more and more people are becoming aware of investing their money in the stock market, many are still wary of its risks. People are afraid of the unknown and are even more lazy to learn about the stock market. I am not here to allay your fear of the stock market, but merely to explore some alternatives that might actually generate some real positive returns. I will tackle these investment vehicles in the order of least practical to the most practical in my own point of view. I take no responsibility for the performance of these investments because most of them require some amount of knowledge and skill as well as a lot of hard work. After all, there is no such thing as a free lunch. I cannot and will not advise anyone to just dump your money in any of these vehicles and hope that they generate luxurious returns because that is not possible and it is also illegal for me to induce purchases in some of these investments because I do not have an investment advisor license.
1. Fixed Deposits
I cannot mention enough how useless these instruments are in terms of growing your funds. The era of high interest rates are gone. With expected inflation to be low in the coming years, there is very little chance for interest rates to be scaled upwards. Even so, on average, fixed deposit interest rates merely track inflation over the long run. In fact, the yield spread could even be used as a predictor of expected inflation. That exemplifies how strong the correlation is. So, there is no way of beating inflation if you place your funds in fixed deposits. However, it is important to note that these investments are basically risk-free.
2. Amanah Saham Bonds (and other Amanah Saham stuff)
I feel these funds are more for entertainment value than for anything else. Even, the ones that guarantee 5% returns for the next however many years still have very little potential to beat inflation. Nonetheless, these instruments are slightly better than fixed deposits, which is why many people are willing to spend hours waiting in line at the banks to subscribe to these funds. An even funnier fund is the one that invests in equities. It promises to track the KLCI. There is almost no skill in that because any person with a trading account can basically allocate his funds equally throughout the KLCI counters and you would basically get the same performance, but without incurring management fees.
3. Property Investments
This one is pretty debatable. While it may generate potentially high returns, I feel it is not practical for beginner investors like you and me because of three reasons. First, its initial capital outlay is extremely high. The down payment to purchase property is very high, which may tie up our funds to invest in other opportunities as and when they emerge. Second, property investment is extremely illiquid. This ties in closely to the first reason because it is extremely difficult to dispose off these investments when we want to realize our gains or purchase other opportunities that we deem to be better. Third, in most cases, we have to incur guaranteed costs while our incoming cash flow is unpredictable. That is to say, we have to pay monthly instalments on our loan while we may have difficulty renting out the property, assuming that the property is already completed.
4. Unit Trusts (Equity funds, to be specific)
This category is huge. There are tons of different types of unit trusts. However, I will focus mainly on equity funds because the rest are just a combination of 1, 2 and equities. First of all, let me explain what a unit trust is. Basically, it is a collection of funds from investors with a particular set of investment objectives placed in the hands of a fund manager to invest according to those objectives. Equity funds is a unit trust fund that invests predominantly in equities (stocks, if you're unfamiliar with the term equities). One of the main attractions of equity funds is that the potential returns tend to be higher. Nonetheless, this is debatable because the performance of the fund greatly depends on the abilities of the fund manager. So, due diligence is still needed when selecting a fund to invest in. Like I have preached before, there's no such thing as a free lunch.
Why do I feel that this is more practical than the previous three investment vehicles? First, the concept of unit trust allows one to invest with very small capital. Minimum initial investments are around RM1,000. Second, if we can find an able fund manager, we can ride on the "expertise" of the fund manager to obtain better than average returns. Typically, decent performing unit trusts average about 8% per annum in the long run. That is far higher than your long run FD rate. As to why the returns are so high, it is because the funds are invested in equities, which are companies listed in the stock market, which (hopefully) run a good business to churn a good profit that allows high returns on investments.
The drawback of unit trusts is, however, the management fees that you have to pay the fund manager. While this is not a fee that you have to fork out money and pay regularly, but it will be deducted from the fund based on the performance of the fund manager. Usually, this fee tends to be rather high. In addition to that, there is a commission that needs to be paid to the agents of unit trusts for marketing the unit trusts for the company. These fees can sometimes eat into the returns of our investments. Nonetheless, unit trusts tend to outperform plain deposits in the long run.
5. Equities
This is the most interesting and possibly the most promising investment vehicle of all. While diving into share investment without any knowledge is risky, knowing what you are doing reduces most of the riskiness involved. It is true that the risks of investments are there, but due diligence to ensure a high margin of safety minimizes the risks involved. Ben Graham, the guru of value investing said "Investing is most intelligent when it is most business-like". This sentence sums up what investing is all about.
Imagine yourself starting a business. Think of a list of criteria of how you want your business to be. These are the criteria that you should be looking for in the companies that you invest in. I do not condone speculation and will never do so. I am an advocate of value investing and the idea of value investing is simple. It is like paying RM5 for something that is worth RM10. If this does not attract you, then it will never attract you at all.
While the idea is simple, the work is hard. Most people would preach the risk-return trade-off in investing by saying that in search of higher returns, we must take more risks. This is totally untrue. What I know to be definitely true is that in search of higher returns, we must do more work. The key phrase of this issue is "due diligence"...
...you should note that one of the most important things in investing is that there is no formula for it. There is no one true way to grow your money. There are many ways to grow your resources. Some are able to grow it at a faster rate, some at a more conservative rate. One thing for sure is that nothing comes for free. Effort is essential."

While it is obvious that I have a huge affinity towards investing in stocks, it does not mean that all other investments are inferior. As I mentioned above, there is no one true way to making huge returns. However, to return to the point of this issue, how can investing in equities beat inflation?

For starters, the potential returns are much higher than fixed deposits and the inflation rate, of course, with the caveat that you do your homework.

The second bolster to inflation is from the firms' abilities to pass on their costs to consumers. There are certain businesses which have the ability to pass on rising costs to their customers through increases in the prices of goods sold. The kind of businesses that have this ability are those that have a price inelastic demand. There are many reasons that may cause the demand for certain goods to be price inelastic. They include the degree of substitutability, degree of necessity, price as a percentage of income as well as degree of loyalty from consumers. We will discuss these factors in a later issue.

What I hope to point out is that in face of inflation, strong businesses are able to maintain their earnings because of their ability to pass on the increase in the prices of raw materials to their customers, fully or partially. This allows them to buffer their earnings. And as an investor, or rather, an owner of such a company, hearing this is good news. This is because the company's earnings would rise in tandem with inflation. In the long run, the value of our investments would rise along with inflation as well, thus protecting our investments from being eroded by inflation. We would be literally investing in inflation.

In short, this would be an extra criteria when looking for companies to invest to add on to our margin of safety.

No comments:

Post a Comment