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Three Simple FX Trading Strategies

Bonds Valuation

The formula used for the valuation of bonds is shown below (if coupon payments are paid annually):

where	CP	=	Annual coupon payment
	i	=	Yield to maturity
	n	=	Number of payments (years)
	FV	=	Face value (par value)

If coupon payments are paid semi-annually then:

As for bonds that pay coupon payments quarterly, then just replace 2 in the formula above with 4.

The following table shows some of the yield of bonds with their expected value respectively (assuming coupon payments are paid semiannually):

Coupon Rate	Yield	Par Value	Bond Value
10%	8%	1000	1197.93
10%	10%	1000	1000.00
10%	12%	1000	849.54

So, the higher the yield for a bond, the lower is the present value of the bond.

Dividend Cover and Payout Ratio

The dividend cover ratio gives an idea to external parties about the results of operation of a company that might drop leaving the amount of dividends to be paid from the result of the year unchanged or reduced.

Dividend cover ratio that is more than 1.0 (> 1.0) indicates that the ordinary dividends should be paid our for the year.

However, dividend cover ratio that is less then 1.0 (< 1.0) shows that the company is not earning enough profits to pay out as dividends. Therefore, the company is using past retained earnings to fund the dividends payment. This may be a danger sign for potential investors.

The dividend cover ratio is just the opposite of the payout ratio.

Payout ratio that is more than 1.0 (> 1.0) implies that retained earnings are being used to payout as dividends.

Picturesque Waterfall

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The Bay Bridge by Night

Martin Whitman

Profile:

Martin Whitman is Founder and Portfolio Manager of the Third Avenue Value Fund (TAVFX). From inception in November 1990 through October 2007, his fund has returned an annualized average of 16.83%. In the same period, the S&P 500 index returned an average 12.33% annually.

Investing Philosophy:

Whitman is a "buy and hold" value investor. He buys stock in companies when he thinks that the company has strong finances, competent management, and the business is understandable. Also the company's stock must be cheap, meaning it trades at a significant discount to intrinsic value. The market price must lie substantially below a conservative valuation of the business as a private entity, or as a takeover candidate. He generally sells an investment only when there has been a fundamental change in the business or capital structure of the company that significantly affects the investment's inherent value, or when he believes that the market value of an investment is overpriced relative to its intrinsic value.

A Value Approach to Investing

Since the founding in 1986, Third Avenue Management has utilized a disciplined fundamental, bottom-up approach to identify appropriate investments with the sole objective of delivering superior returns with limited investment risk, over the long term.

Martin Whitman is guided by one proven value philosophy, which focuses on the strength of a company's balance sheet and the discounted price of its securities. The belief is that a strong, well-managed company can survive difficult environments, and the price of its securities will eventually reflect its true intrinsic value.

Third Avenue Management's research approach is opportunistic and not constrained by market capitalization, industry sector, or geographic location.

What He Looks For

One proven value philosophy guides each of the investments. He seeks to invest in safe companies that are cheaply priced. Key criteria are as follows:

Safe Companies

• Strong finances
• Competent management
• Understandable business

Cheaply Priced

• Significant discount to intrinsic value

Martin Whitman analyzes companies from the bottom up, reviewing all public documents, speaking with outside experts and contacts, identifying value and risk drivers and interviewing management before making an investment decision.

He analyzes the quality and quantity of resources existing in a business, rather than its projected future revenues and earnings. He thinks that the current balance sheet is the best, albeit not the only, measure of a company's value. Predictions based on future operating earnings do not capture the possible impact of corporate events such as mergers and acquisitions, changes of control, management buyouts, share repurchases, refinancing, reorganizations, asset sales, spin-offs, investments in new ventures and corporate liquidations.

His stringent research gives him conviction in his best ideas, allowing him to establish concentrated positions.

He invests only in companies that he believes to have the potential to create value for his clients over the long term, withstanding cyclical downturns and evolving as leaders among their competition. His long-term focus is to minimize portfolio turnover and enhances the tax efficiency of his funds and private portfolios.

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Snowy Winter

Emerald Lake

Hedging with Options

Scenario:

Let’s say a fund manager achieved returns of 15% on his portfolio over the last 10 months compared to a market return of 10%. The portfolio is a close approximation of the KLSE Composite Index. The fund manager is concerned that there is a strong chance of the market moving down over the next two months. He seeks to preserve the majority of the returns.

Solution:

One possible solution is to use a put option on the KLCI. Assume the following data as at 30 April:

Fund size:	RM 10 million
Portfolio beta:	1.0
Current Composite Index:	1130
Current June KLCI Futures:	1140

KLCI Options	Premium
1075 put	20.00
1100 put	28.00
1125 put	38.00

Number of contracts to be purchased	=
	=
	=	87 contracts

The fund manager decides to use at-the-money puts for downward protection. He subsequently purchases 87 June 1125 puts at 38 points, an outlay of RM 330,600 (87 × 38 × 100).

Profit Pay-off Diagram

As can be seen, the hedged position has removed the risk of loss from a fall in the market. The trade-off for this reduced risk is the outlay of RM 330,600 (3.3% of the portfolio). Since the fund has a 5% buffer between the portfolio performance and the benchmark index, the fund remains ahead of the measure. The fund also has the prospect of significant outperformance if the fund manager’s view of the market proves to be correct.

The Look Out

Courage Vs Wealth

Mr. Benjamin paid all of his children's tuition. His daughter and sons all attended private elementary and high schools, prestigious private colleges, medical colleges and graduate schools. Mr. Benjamin paid for all of it - room, board, tuition, books and related expenses. Who is this man who demonstrated the ability to fund these enormous tuition bills - a highly paid physician or perhaps CEO of a major public corporation?

 

Before he retired, Mr. Benjamin was a school-bus driver who generated enough income to send his children to private colleges, medical school, and graduate school. He was frugal but being frugal is not enough to pay six-figure tuition bills.

 

When they were young, Mr. Benjamin realized that his children were extremely bright. He realized that each would greatly benefit from a top-quality education. So he constantly worried about funding that education with his low-paying job. Consequently, Mr. Benjamin began a 'self improvement' reading program. The central topic of it was investing.

 

Being a bus driver had one side benefit. It gave Mr. Benjamin several hours of free time each day. His fellow drivers often used this time for snoozing, reading newspapers and magazines, drinking coffee or chatting. Mr. Benjamin used his downtime more wisely. He read about various types of investments. Early in his self-study program, he discovered the truth about the long-run returns generated by corporate bonds, passbook savings accounts, treasury bills, municipal bonds, CDs, stocks, precious metals and real estate.

 

Mr. Benjamin concluded that after adjusting for inflation and taxes, only stocks paid a real return on one's investment dollars. However, his mother had always told him never to invest in the stock market. She was around during the stock market crash in 1929. But the 1929 downturn was included in Mr. Benjamin's calculations and he knew that in spite of the crash, the stocks outperformed all other investment alternatives in the long run.

 

Mr. Benjamin eventually became a serious investor in the stock market. Every extra dollar he and his wife would muster was earmarked for stocks but not just any stocks. Mr. Benjamin spent much of his free time studying specific corporations and their stock offerings. Over the years, he became an expert in his chosen vocation.

 

The result of Mr. Benjamin's self-improvement reading and investing program was that when he recently retired, the former bus driver had a net worth in excess of $ 3 million. That is $ 3 million after sending his children to the finest, most expensive schools in the country.

 

What is the point? Mr. Benjamin became financially independent because he had courage. It takes courage to invest in the stock market. The market guarantees nothing. It goes up and down! Often, people get in the market late and get out early and they lose a lot of money. Mr. Benjamin was always a long-term investor. He never let fear outweigh the knowledge he obtained from his reading program. When he bought a stock, he rarely sold it within ten years of his initial investment. In good times and bad, he held on to his picks. He frequently had some fears and concerns but dealing with fear in a positive manner is a foundation stone of becoming wealthy.

 

It takes courage to invest in public corporation as well as in one's own business enterprise. However, it takes even more courage to hold on to one's investments when the public mood is full of fear and panic. Without courage Mr. Benjamin's children would not be doctors today.

(Adapted from The Millionaire Mind)

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Buffett’s Investing Style vs Malaysian Stock Market

World famous stock market guru, Warren Buffett, made headlines when he bought substantial stakes in technology and services giant General Electric Co (GE) and financial heavyweight Goldman Sachs Group.

Just when everyone else was pulling out their investments from Wall Street, Buffett stepped in to inject some US$8bil in these two companies via his investment company Berkshire Hathaway Inc.

“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well,” he once said.

But is Buffett’s value investing style suitable for the Malaysian equity market and investors?

“Yes, it provides great opportunities to buy now if you are buying for long-term,” said Aberdeen Asset Management Sdn Bhd managing director Gerald Ambrose, adding that the current stock pricing “is irrational” due to the heavy selldown by foreign funds.

He said investors should hold good stocks for “as long as possible” as stock investment was about investing in a company’s management and market strategy.

Jupiter Securities Sdn Bhd executive director of operations Tan Chee Siong said Buffet was very careful with his investments and rarely found stocks that met his requirements.

The five main criteria Buffett uses for stock selection are earnings versus growth, high return on equity, minimal debts, strength of management and simple business model.

Buffett’s strategy was more of a “concentration of a few solid stocks” in a few industries that he could understand, Tan noted.

However, he cautioned that the local bourse, as an emerging market, could be more volatile and that market sentiment could easily be influenced by many external factors.

“We must remember that if we talk about investment in the local equity market, the duration should be shorter and we need to take profit whenever there are signs of big changes in market trend and our economic performance,” he said.

Meanwhile, Aseambankers head of research Vincent Khoo said investors should generally hold on to three principles — “be long-term oriented, only buy what you can afford and be focused in what you buy.”He said investors should hold on to good stocks for as long as possible.

“Blue chip stocks, for example, can ride through bad times and will recover over time,” he said. Being among the most successful and trusted investors’, Buffett’s investment in GE and Goldman Sachs restored some investor confidence on Wall Street.

Buffett, who is also known as “The Oracle of Omaha”, is an astute long-term investor and has always investigated the underlying fundamentals of a company, rather than market sentiment.

He has always determined the intrinsic value of a business and paid a good price for it. He believes price is what you pay, value is what you get.

Being prudent, Buffett is said to never invest in any business that he could not understand, a principle that paid off when he escaped the dotcom market crash. His investment principle is simple — always analyse a company’s annual reports to check its fundamentals and know what you are investing in.

Buffett, who is chairman of Berkshire Hathaway, the most expensive stock on Wall Street, said in a letter to shareholders last year that Berkshire was seeking to invest in companies with favourable long-term prospects and competitive advantage in a stable industry.

To him, “if a business does well, the stock eventually follows.” One of his most successful investments was PetroChina. Buffett bought a stake in the Chinese oil and gas firm for an initial sum of US$500 million and later sold it for US$3.5 billion. He has also made successful investments in companies such as Coca-Cola, American Express and Gillette.

John Paulson

John Paulson Made Billions on Drop in Housing Values

Born in the lower middle-class New York borough of Queens, John Paulson is the biggest-earning man in the world's top-earning industry. He took home $3.7bn (about £2bn) last year, putting him top of Alpha magazine's ranking of hedge fund managers.

He made this fortune by outsmarting Wall Street's top financial institutions. Unlike Citigroup, Bear Stearns, Lehman Brothers and Merrill Lynch, he predicted that the sub-prime mortgage industry would collapse - and he placed a huge bet on a downturn in home loans. Paulson's success from others' misfortune has drawn comparisons with George Soros, who made millions from the Bank of England's woes in 1992 by betting against the pound on Black Wednesday.

One group representing homeowners struggling to keep their properties dubbed Paulson's profits "obscene". Paulson has responded by donating $15m to a charity aiding people who are fighting foreclosure.

Paulson, 52, is married with two daughters. He enjoys skiing and running. He studied science at New York University, has an MBA from Harvard and set up his fund, Paulson & Co, in 1994. He never gives interviews and is guarded about his methods - he even embeds hi-tech software in his emails to prevent them being forwarded. He is now the President of Paulson & Co., Inc., New York.

Paulson & Co.’s merger arbitrage/event-driven focus derived from Mr. Paulson’s early experience as an investment banker. After a first job with Odyssey Partners, his career went into high gear when he joined the mergers and acquisition practice at Bear Stearns Cos. Inc. Prior to founding Paulson & Co. in 1995, he was a general partner of Gruss Partners LP, a merger arbitrage specialist. In the course of his career, Mr. Paulson has dealt with a wide range of company transactions, including both friendly and hostile tender offers, mergers, divestitures, recapitalizations and other company reorganizations and financings.

What induced you to move into money management?

When I in was in M&A at Bear Stearns, one of our clients was Marty Gruss. He ran a very successful risk arbitrage firm, Gruss Partners. … It was a small partnership and very profitable. Bears Stearns also was a partnership at the time and also very profitable. But it didn’t really compare to the type of profits that could be made in principal investing, investing your own money and earning the returns, rather than earning fees. I realized that there’s a limitation on what you can earn from fees and that the highest rewards would come from investing your own money, where there are no limitations on your earnings. That’s when I decided to move from investment banking to money management, and I became a general partner of Gruss Partners.

Describe your investment philosophy.

I really picked up my investment philosophy from Marty and his father, Joseph Gruss. He had two sayings that guided me going forward.

The first was: Watch the downside, the upside will take care of itself. That’s been a very important guiding philosophy for me. Our goal is to preserve principal, not to lose money. Our investors will forgive us if our returns don’t beat the S&P in a given year, but we are not forgiven if we have significant drawdowns.

The other saying really drives the same point from a different angle: Risk arbitrage is not about making money, it’s about not losing money. If you can minimize the downside, you get to keep all your earnings and that helps performance.

Would you say that your investment style is concentrated?

Yes and no. No, when you look at most activist funds, they tend to have five or 10 positions and that’s 100% of their portfolio. Some have only five positions. We’re much more diversified; our average position size is just 2.5%. However, when we do feel strongly about a position, we will take that up to 12% in our merger fund and 10% in our event fund. That is (higher) than some funds. We feel it’s important to have the flexibility to go to 10% because in order to outperform, you have to be able to allocate a sizable position to what you think could be a high-return investment. It’s only when you have a substantial allocation to a high-return (security) that you can influence the overall portfolio.

Are you tired of talking about subprime mortgages yet?

No, I’m still excited about it. I think we’ve got a winner with this. It’s been a very profitable investment for us, but we think we have only realized 25% of the (potential) that we expect to make in this area. The investment is very much consistent with our overall philosophy that if you watch the downside, the upside will take care of itself.

What attracted us to this particular position is that overall, we feel that we are in a credit bubble. We feel that there is too much risk going long (in) credit instruments since spreads are so tight. So we concluded that the best opportunities were on the short side.

The beauty of shorting a bond is that the maximum you can lose is the spread over the benchmark; yet if the bond defaults, you can potentially make more. So it’s an asymmetrical risk-return tradeoff. In the case of subprime securities, we targeted the triple-B bonds, which are the lowest tranches in the subprime securitization.

In a typical securitization, you have 18 to 20 different tranches with the lowest … taking the first loss. The triple-B bond has about 5% subordination, meaning that if the loss is greater than 5%, the bond will be impaired. And if it’s more than 6%, the bond will be extinguished. The yield was only 1% over LIBOR (the London interbank offered rate) so by shorting this particular bond, if I was wrong, I could lose 1%, but if I was right, I could make 100%. The downside was very limited but it had very substantial upside, and we like those types of investments.

We felt the exuberance in the credit markets and the massive liquidity was severely mispricing these securities. The more we analyzed the underlying quality of these loans, we thought it was highly probable that the losses in these pools would be more than 5%, that the bonds would be impaired and in many instances, extinguished. We thought it was a terrific risk-return tradeoff where you can risk 1% and make 100%.

We decided to put that investment either as a hedge or an absolute-return investment in all of our funds with the amount and the specific security depending on the nature of the funds. But generally, in our merger funds we agreed to spend about 1.5% on the short position and then we set up separate credit funds where we took a more concentrated position for investors who wanted that.

Ultimately in 2007, initially in January, but then in February, the market re-evaluated the risk of these securities. People paid more attention to the underlying credit quality of these securities and the potential losses that could occur. That caused the securities to fall materially in value and for the spreads to widen resulting in margin calls on these funds.

Are you still committed to subprime?

Yes. The performance of these pools will not be decided over one month or two months. They will be decided over the next three years. Our investment (commitment is not based on) looking at what these bonds trade at today or tomorrow, but what the losses in these pools will be two or three years from now. Our estimates are that the losses will be well in excess of 6% or 7% and that as time goes on and these losses are realized, the bonds will be downgraded and they will fall much further.

Have you considered going public?

For us, we don’t really need to. I think it would be premature (at this point) in our evolution to consider selling the firm or a piece of it. Our goal is to continue to focus on performance and building our capabilities, building … the investment platform. I’d like the firm to exist without me and (that requires) a developed infrastructure. So at some point in the future, going public or selling part of the firm will be issues we will have to think about. But it’s not on our radar screen now.