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Sunday, June 21, 2015

Overconfidence, Market uncertainty, Portfolio Diversification and Leverage kcchongnz

I have been writing some articles with very critical comments about some stocks which I truly think are totally rubbish like these.
These articles are just my opinions and I could be wrong (but not yet), but they were generally well accepted by all readers in i3investor because they were written to share knowledge and learn from each other. They were written to discuss about issues, and not about people.
 However, I used to have great reservation in writing articles giving comments about some investment strategies of some well-respected people, and I tried to be cautious because they seem to hurt the feeling of their followers, as many treat them as idols. For example, don’t talk anything bad about what happened to icap. TTB’s followers will get agitated.
And do not give negative comments of the stocks ColdEye had owned before even though he had made some mistakes which we can learned from, although it was an old portfolio of his:
ColeEye is the local investor I most respect of, No. 1. For my course participants, the first thing I do is to distribute a eBookk of his and encourage all participants to read it first before each course officially starts. I do respect, but not idolize any guru in investing. I don’t think ColdEye even mind when I critically commented on his stocks in that portfolio. He is a much bigger man than that, I strongly believe. But we can learned from his mistakes. I believe if he reads i3investors, he would even share with us his mistakes and give us tips on how to avoid those mistakes. To me, it is more important to learn from the mistakes of super investors, rather than their success. We will learn more. But why are their followers so agitated?
See when I gave some negative comments on a stock called V.S Industries, a stock promoted by another super investor in Bursa?
I didn’t say V.S is not good but just mentioned a few concerns about the business and a number of his followers jumped on me. To tell you the truth, this super investor is also an idol of mine. I respect him, not in his stock investment and margin financing advice though, but as a senior citizen and a senior in my engineering profession, and his immense social and philanthropic contributions to the society.
Yeah, too many threads until he was “angry’ with me, as told by one of my friends here. Sorry, my intention was never to make him angry, as I have said, I respect him, but just to present my view. I thought it may be also good for him to know opposite views, maybe not him but others. Who knows?

Today, I would like to talk about how we can learn from him, more specifically his mistakes in investing so that we can avoid some of the pitfalls in investing. May be he could also chip in to teach us some lessons. Don’t you think these are more useful lessons? Your critical comments are welcomed.

The cognitive bias of overconfidence
Confidence is a quality personal trait for our career and whatever we do. When we have confidence, good results can be achieved easier. For example, if we are confident, we can do better in public speaking or networking. In investing, I believe one can do better too if he has the confidence to stand away from the crowd, provided he has the right experience, knowledge and the proper approach.
Overconfidence may be a healthy attribute too. It makes us feel good about ourselves, creating a positive framework with which to get through life's experiences. Unfortunately, being overconfident of our investment skills can lead to some disastrous results in investing in the stock market.
Let us look at these statements in the blog below:
Quote: [R. Sawit: In all my life, I have never been surer of making money than now in buying of R Sawit.
I have studied almost all the plantation stocks and in my opinion R. Sawit is the cheapest in terms of NTA and its profit growth prospect in the next few years. ……
Since the rights issues and the bonus issues were listed on 9th Nov, the daily volume traded has increased to a level that has not seen before. It closed at RM 0.83 on 9th Nov 2011. ……
As you know, I do not or very seldom recommend people to buy any share. But in this case, I am doing it because I strongly believe this share is the cheapest plantation company in terms of NTA and profit growth prospect in the next few years which is the single most important criterion in share selection.
Most of the palm trees are below 10 years old and their plan to continue planting on their remaining about 23,545 ha in the next 3 years. Imagine the increase value of this additional planted area?  
………. Which business can give you more than 100% profit margin?
Total planted acreage is 49,300 ha. The cost per ha is 108672 million divided by 49,300 = Rm 21,756. 
IOI announces about 3 months ago that they are buying about 11,900 ha of oil palm plantation from Dutaland Bhd for Rm 830 million cash = Rm 69,740 per ha.] Unquote 10th November 2011

Rimbunan Sawit’s share price did rise up to an adjusted price of about RM1.20 6 months later when the retail investors were chasing its bonus (free shares) and rights issues in mid-February 2012. However, its share price has since retreated by 56% to 52.5 sen at the close on 19th June 2015, from almost 4 years ago, while the broad market has a total return of 28% during the same period as shown in Figure 1 below. Of course we know who the people who made big money are when the share price ran up from 80 sen to RM1.20, and who those who got stuck with a hot potato are. No prize for guessing right. What happened to the “cheapest in terms of NTA and its profit growth prospect in the next few years.” stock?
Many issues were raised and commented in the blog at that time, but all brushed aside, due to the overconfidence of the blog owner and the writer. Among the issues raised were:
  1. Was the value based on per hectare of land area comparable between that of DutaLand which is in the Klang Valley, and that of RSawit in Sarawak?
  2. Are the management equally capable, and as credible, IOI and RSawit?
  3. Are their soil conditions, yields comparable?
  4. A comment here which was so critical, Blue Angel said...
I think you have "forgotten" to take into account dilutive impacts of preference shareholders converting to ordinary shares. If taking that into account, trailing PE for RSawit should be around 25x now, more expensive than Genting Plantation or any other big cap plantation stocks.
  1.  Another one here, K C said...
Dali,
Can you please answer Blue angel's concern? If you are not sure, can you get back to KYY? I know you are not obliged to but I think you are responsible to clarify it. The irredeemable convertible preference shares are more than the ordinary shares before the right exercise. This means that the number of shares eventually will be more than doubled the 1300 m shares mentioned! A huge overstatement of its earnings per share potential
  1. How were the trees of RSawit planted? Were they at first just simply grew everyway wildly, and how to compare with IOI’s modern planting technology?
  2. Numerous others issues

Marker uncertainty
The most fatal oversight is negligence of the uncertainty of the market, the uncertainty of the palm oil price movement, trying to project and extrapolate a rosy prospect of the palm oil price in the future, instead of recognizing the cyclical nature of commodity prices and the power of mean reverting. Its price has dropped by 37% from USD1053 in November 2011 to USD662 per tonne now. Ignoring the market uncertainty, the competitions from soya oil, and thinking that trees grow to the sky itself is a form of fatal overconfidence.

Failure to diversify
Overconfidence also results in an investor feeling too bullish about a particular sector and concentrate all his eggs in one basket. Consider these statements:
[Koon Yew Yin 27th March 2014
About 80% of my total investment is on the plantation sector. I have Kulim, FGV, SOP, TH Plantation and Jaya Tiasa and their closing prices are Rm 3.40, 4.46, 6.40, 2.00 and 2.75 respectively. I must warn you that if you decide to buy, you are doing it at your own risk. ]
I did write a piece on FGVB 7 months ago when FGVB was at RM4.14. I am not sure if anyone took any heed on it.
http://klse.i3investor.com/blogs/kcchongnz/66355.jsp
These are the closing price of those plantation stocks on 19th June 2015. Kulim 2.55 (-25%), FGVB 1.75 (-61%), SOP 4.85 (-24%), THP 1.58 (-21%), and Jtiasa 1.60 (-42%).
It really pays to diversify. Don’t you agree? Or is it still wise to put 80% of one’s investment in just one sector? What is the cost of overconfidence in investing?

The cost of overconfidence
We have seen that overconfidence cause one to concentrate investments in a single stock or a single sector and fail to have a diversified portfolio of stocks in various sector in case he may be wrong as the investment world is full of uncertainties. Overconfidence causes one overly optimistic assessment of one’s knowledge and ability or control over a situation, and buying risky investments because he believes they are not risky.  Overconfidence also causes one to seek only evidence confirming his own views and ignore contradicting evidences, and worst of all ridicule others for giving some good contradictory opinions which may be good for him.

Leverage, the fatal blow
What about if one combines overconfidence with leverage, say 50% in margin finance which one is very proud of making money all this while by doing so? He will lose all his equity and still left with some debts to pay the investment banks. If the market drop 30%, one needs to gain 60% to get back to normal, provided the investment banks don't force sell your stocks.
When you combine overconfidence and leverage, you get some pretty interesting results.
"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious," explained Buffett in his 2010 shareholder letter.

"But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."


Conclusions
In my opinion, it pays to have good humility in investing, recognize our shortcoming that we are far from invincible and could be wrong, and get the free lunch in diversification, as a defence against uncertainties, because investing is full of uncertainties, something we can never foresee. Generating superior return is certainly an important aim, but safeguarding assets and protecting them from losses is just as crucial.
Well, I never say one cannot use margin finance. It is his prerogative. But never encourage the pubic to use margin finance and this I will emphasize again and again as I view it as a good maxim to be propagated to our younger generation. Invest safely with your excess money, for long term wealth building.
I sincerely hope this article is viewed in a positive light as a mean of learning from past experience, for all of us.
For those who are interested in investing in a safe way for long term wealth building, please contact me for a fee-based online course at
ckc14invest@gmail.com

K C Chong (21st June 2015)

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