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Capital Dynamics Sdn Bhd is the first independent investment adviser in Malaysia. It has been described as "one of the country's most iconoclastic and critical research outfits".

In February 2004, Capital Dynamics Sdn Bhd launched icapital education.

Since our inception in 1988, we have remained totally independent and have been providing objective advice on Stockmarkets and Economies through iCapital.

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Home > Articles > Lessons from PN4s

Part A: Investing Lessons

 

Using the examples of the respective PN4 (see table 1) as individual investments or as constituents of a large investment portfolio would yield some interesting findings. Some of these findings shall reinforce the importance of stock selection, financial statement analysis and the need to fully understand investment risks while others would refute some of the popular myths about investing in the stock market, in general, and the KLSE in particular. These are namely the need to diversify, the strategy of market timing, dollar-cost averaging and the preference for certain characteristics of stocks.


Table 1 : PN4 companies featured in Special Stock Selection

Summary of Results

Not surprisingly, one can see from table 2 that the PN4 portfolio had fared distinctly worse than the benchmarks for all three investment periods. Besides the 8 years from 1993 to 2001, we have intentionally included the results of the PN4 portfolios during the raging bull markets from 1993 to 1997 and the following bear markets from 1997 to 2001 to highlight the two very contrasting periods.


Table 2 : Cumulative Returns of PN4 Portfolio vs Benchmarks

Noticeably evident from table 3 is that the returns of the PN4 portfolio rocketed to dizzying heights from 1993 to 1997, closely mirroring the 2nd Board Index. More striking is its spectacular free-fall during the post-1997 era, far outpacing the relevant benchmarks. One then has to raise the intriguing question as to why there was such a disparity in performance. Is it purely because of poor stock selection ? What are the characteristics inherent in the portfolio that could explain such wild swings? How can we, as investors avoid such destructive outcomes in our investments ?


Table 3 : Cumulative Returns of PN4 Portfolio vs Benchmarks

Principle No 1:

Diversification Is Necessary: Investment Principle or Great Myth ?


Investors have been told time and again that they must diversify to reduce risks. The reason is that diversification is supposed to reduce unsystematic or company/industry-specific risks and minimise investment losses. Diversification is the process of spreading risk over a broad portfolio of stocks in different companies, industries or countries and if executed correctly, the portfolio's risk shall be less than the sum of the risks of the individual stocks within the portfolio. Hence, in theory, risks could be reduced without incurring the corresponding reduction in returns and thereby, improving the portfolio's risk-return characteristics. Using our PN4 portfolio as example, can this well worn advice be accepted as gospel truth or is it just a myth that has been blindly accepted?

Number of stocks

Table 1 shows that if one buys all the 17 companies listed there, an investor would have achieved the necessary amount of diversification. Academic research has shown that it only takes 12-18 stocks to achieve adequate diversification, with some even recommending as few as 10 stocks. In our case, we have 17 stocks. With this, risk as defined in modern finance theory is already greatly reduced and would not make much difference even if the portfolio is expanded to 50 or 100 stocks.

Variety of Businesses

Another tenet of diversification says that it is more than just the quantity of stocks in a portfolio and that it has more to do with the correlation of the individual stocks with each other. What this means is that one cannot have 17 construction stocks and then call this a diversified portfolio. The nature of business of the component stocks must not be correlated also. Again, Table 1 shows a great diversity of businesses among the 17 stocks, ranging from pure stock broking to food manufacturer to automotive accessories to construction to property development to timber to ferry operator to plastic packaging to interior designing to toiletries to even a large conglomerate and the list goes on. In terms of diversity of business, the PN4 portfolio is truly diversified.

Change in Businesses

So, based on the number of stocks and the great variety of business, the PN4 portfolio would have been sufficiently diversified. Yet, as the results from tables 1 and 2 show, an investor holding this so-called adequately diversified portfolio would have seen his asset totally decimated after 1997.

One could then counter argue that a crisis like the Great Asian Crisis would destroy any portfolio. The simple answer to this is yes and no. Yes, if the portfolio comprises stocks like the PN4 companies or the many other poor performing stocks even though they were not PN4 category - examples of this is very long. No, if the portfolio is made up of properly chosen companies. For example, Section C : Capital Dynamics Portfolio had only 4 stocks on 27 August 1998, when the KLSE CI was trading at 313 points. The whole portfolio was still highly profitable but even if one were to only calculate the equity portion, it would show a market value of RM35,880 versus a total cost of RM38,531. In other words, the portfolio was far from being decimated.

The idea underlying diversification is such that when a crisis or a recession or an unexpected shock occurs, the investor is not harmed beyond repair. Obviously the PN4 portfolio failed to achieve this vital objective. A na´ve supporter of modern finance theory may then counter argue that the experience of the PN4 portfolio does not disprove the advantages of diversification per se. What caused the PN4 portfolio to perform so miserably was the fact that many of the said companies changed controlling shareholders and principal business.

11 of the 17 companies featured were either involved in the construction, property development or timber industry at one time or another while the counters related to Soh Chee Wen had leveraged share speculation as one of the major activities. For those who did not follow our previous features, CSM, Autoways, Jutajaya and Southern Plastic were previously not engaged in either the construction or timber industry. It was due to a change in management that these companies jumped on the bandwagon and the rest one might say is history (we shall further elaborate on the importance of the quality of management and its role in the eventual success or failure of companies in a later issue). Nevertheless, the 'transformation' of these companies meant that a high correlation based on their respective industries and activities existed among the PN4 portfolio and subsequently, had undermined the diversification characteristics of the portfolio and in turn, increased the portfolio's exposure to the risks associated with the ebb and flow of the industries and activities.

So, does a major change in principal activity or shareholder help to salvage the principle of diversification ? Not necessary. Many companies have changed shareholders and or core businesses without experiencing disasters. For many, the results have been the opposite. Promet in the early Nineties, for example, had successfully restructured its operations and balance sheet and was well on its way to better days until Soh Chee Wen came in. Berjaya Kawat changed name, changed controlling shareholder, changed principal business and did not become a basket case, even though it was far from a management or investment success. Globally, there are even more examples of companies that changed business and or shareholder and became roaring successes. Nokia is probably a classic example of this successful transformation.

Conventionally, many believe that the nature of a company's business has a huge bearing on the amount of diversification needed. It was felt that large multi-industry companies (that is, conglomerates) would have an internal diversification present and as such, less diversification may be necessary while stocks in highly cyclical industries require a fairer amount of diversification. On face value, the basis is sound but as clearly demonstrated by Rekapacific and many other conglomerates not featured here (for example, Renong, Lion, etc), such reasoning may not be foolproof after all.

Often neglected but more important is the nature of the business and the management and financial strengths of a particular company. That is, the long-term economics of a business, the quality of management, the balance sheet strength or weakness are factors that are much more important than the simplistic notion of diversification for the sake of diversification. It is not rocket science that it is of no use to include a large number of stocks in many different industries if each of these companies does not possess the required level of management, business and financial strength necessary to withstand the unexpected downturns or shocks or crises. If one blames the construction industry, for example, as the reason why some of these companies became PN4, how can one then explain the other construction companies that stayed strong and not falter the way the 11 stocks did?

If an investor had bought just Carlsberg, Nestle or the former Rothmans or even a more cyclical stock like OYL, this investor would have done marvellously well, crisis or no crisis. This would have gone totally the opposite direction of the diversification principle. Yet the risks would have been much less than the PN4 portfolio before they become PN4 companies while the returns would have been far superior. Does this mean that an investor should not diversify and just have a portfolio that is focused?

At the end, what is the lesson that our subscribers have to learn from the PN4 portfolio ? Do not diversify just for the sake of diversifying. It is a myth. It makes you have the illusion that you are investing conservatively when in effect all that you are doing is to act conventionally. As the PN4 portfolios shows, this can lead to a total disaster, leading to a very high risk, negative return strategy. Whether an investor should diversify or not does not depend on how many stocks there are in a portfolio nor does it depend on whether the businesses are related or not. It boils down to one simple fact - how skilful the investor is. If the subscriber is experienced and skilful enough in analysing businesses and management, then, it does not make sense to diversify. An investor does not need to know every business or every management to succeed. Just stick to what you know best and keep on improving them. A classic example of a low risk, high return portfolio with little diversification is Section C : Capital Dynamics Portfolio. Mind you, the results are not based on a short bull market. Its superior performance of 18% return per annum is based on 12 long years. For subscribers who do not have the skills or experience, just follow Section C or even Section D. For those who are not bothered to acquire the skills and knowledge needed, they should ask themselves whether they should be investing in the stock market in the first place.

Principle No 2:

Will Market Timing Yield Higher Returns ?


Market timing is a much-favoured investment strategy of institutional investors and has often found its way to ordinary investors, with most of them having misplaced faith in their own abilities to accurately time their entries and exits from the market. Section D : The CD Timer in i Capital is an example of market timing style. Is this strategy viable? What are the inherent risks involved? Let us once again make use of the PN4 portfolio to illustrate the principles involved.


Figure 1 : Bull Market Returns.1993 to 1997

Figure 2 : Bear Market Returns.1997 to 2001

Reference to figure 1 would indicate the attractive seduction of this strategy working and in fact, if investors had bought the PN4 portfolio in 1993 and correctly exited in 1997, they would have quadrupled their capital - hence the simplistic allure of market timing. This strategy would also work if they had entered the market in 1999 and exited in 2000. Great but what are the probabilities of such accurate entries and exits ? Can they be repeated consistently ? But more importantly, what would the losses be if one got it all wrong? An alert subscriber would have noticed that the above figures may allow the potential gains or losses to be quantified but not the probabilities or risks involved. We shall try to illustrate this important deficiency in a simple way. Please refer to table 4 below.


Table 4 : % returns of PN4 portfolio (equally weighted) from 1993 to 2001

First, a guide on how to use the matrix. The % returns are on a cumulative basis. If you look at the cell "1993-1994", you will find 133.27%. What this means is that if you enter or bought the PN4 portfolio in 1993 and exit or sold in 1994, you would have made a whopping 133.27%. If you had bought in 1993 and then sold it in 2001, you would have made losses of 55.88%. Or if you had the fortune of entering in 1997 and the fortune of selling in 2001, you would have a fortunate loss of 90.49%. Some very interesting investment "secrets" can be gathered from the above matrix, which incorporates investments made during the period between 1993 and 2001.

[i]. One is the ability to quantify the probability of success or failure. Success would naturally be the ability to realize positive returns or profits and conversely, negative returns/losses are deemed failures. From the matrix, only 11 out of the 36 possible combinations would show a success. As such, the success rate is not surprisingly low, at a mere 30% or 11/36. This means that out of 10 tries, an investor would lose 7 times, which is actually worse than tossing a coin. Surely, these are probabilities that no investor would want to accept.

[ii]. Proponents of a market timing strategy may counter argue that for some of those 11 successful hits (in bold), they would achieve a doubling or tripling of their capital, and hence, these would have offset the losses and the overall portfolio may still gain. This would make a market timing strategy worthwhile. Possible but on the flipside, what would the damage be if they were wrong?

[iii]. It seems that an investor has almost a 50% chance (17 out of 36) of losing at least half of his capital during this period. Remember, if you lose 50% of your investment, you would need a 100% return on your portfolio for you to go back to its original cost. Based on table 4 above, one can see that a situation where a 100% return is achieved in a single year is very rare. To investors who value their hard-earned savings, such unfavourable odds and debilitating losses are plainly unacceptable.

[iv]. With the benefit of the data shown above, would this still be an attractive investment strategy ? Based on what we have shown, market timing as a consistent investment strategy is definitely not for the ordinary investors. Its popularity is caused by the na´ve hope that one can time the buying and selling accurately on a consistent basis. In the first place, this investment strategy must have inputs from top-down, macro-economic analysis and technical analysis. We would urge our subscribers to be very careful in using this investment style. The possibility of fast, substantial gains and the lure of the market may be too tempting to most but investors that were badly burnt would attest that the return does not commensurate with the risks.

[v]. For subscribers that still prefer a market-timing approach, all is not lost. An example of a profitable top-down/market timing style is Section D : The CD Timer in i Capital. Started in Apr 1994 when the KLSE CI was 966, this medium-term portfolio has beaten the KLSE handsomely. For The C D Timer, its compound return from Apr 1994 to Jun 2003 is 9% per annum, compared with -3.55% per annum for the KLSE CI and -5.09% per annum for the EMAS Index. This is a long track record, stretching more than 9 years, capturing bulls and bears. Based on The C D Timer, the simple conclusion is that a top-down/market timing approach can beat the KLSE handsomely. The entire Section A in i Capital is based on a top-down/market timing approach. To improve your chances of success, read all the contents in Section A religiously and consistently. Otherwise, just follow Section D.

Subscribers are encouraged to refine the above matrix for their own investments, as we have only displayed a crude model. Matrices that incorporate half-yearly or even quarterly time periods would yield significant enhancement to the model but the basic principles remain intact.

  

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