Financial Intelligence

1
Financial Intelligence Personal Finances
Investing 101

• Bob Y. Chan
• Outline fore talk 4
• October 30, 2003

2
Synopsis of last talk

• Whom do you work for?
• On borrowing money
• On Taxes
• How smart are you vs. the market?

3
Outline for Talk 4

• A brief introduction to security analysis
• Fashion is the great governor of this world
• Firm foundations of stock value
• Efficient markets what does it mean?

4
Introduction to security analysis

• Ultimately, want to make money
• Many different means

5
Security analysis (cont.)

• Focus on
• Human nature / social behavior
• Macro-economic factors
• Market movements
• Industries / sectors
• Individual companies
• Short-term price movements

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Security analysis (cont.)

• Some fundamental assumptions
• Smart people can beat other (average) investors
• You can find out what other people neglect
• These findings are worth something
• May be, the market has made a mistake
• Then finally, the market finds out the mistake
  and corrects it! (very important)

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Security analysis (cont.)

• What if these assumptions are wrong?
• The market is too smart
• Hundreds of smart (and hungry) people already
  working very hard to dig out whatever is worth
  something
• Institutions hire Ph.D.s, MBAs, CFAs, etc. and
  use super computers to make better search!
• Is there really anything left?

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Security analysis (cont.)

• The market is too dumb
• Suppose you are very smart, and the market makes
  a mistake
• What if you are the only smart guy, and the other
  people are always very dumb?
• If the market does not corrects itself, your
  finding is still worthless!

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Security analysis (cont.)

• So why bother?
• You need some metrics to swim in the sea of
  investing
• Build a consistently effective investment process
• Allows you to eliminate what does not work
• If you know more about investing, you can avoid
  making big mistakes!

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Example - skirt analysis

• Rationale market tends to move up when people
  feel merry and move down when people feel bad
• Observation ladies (esp. young ladies) tend to
  wear shorter skirts when the general atmosphere
  is more happy

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Skirt analysis (cont.)

• Rule when young ladies wear short skirt, markets
  tend to move up
• If the skirt length is shorter, markets tend to
  move higher
• Problem to the professionals this is too
  simple!

12
Football analysis

• Background
• American football has two leagues
• NFL
• AFL
• Each year (in January) a team will win the world
  championship called Super Bowl
• Just looking at records, NFL teams win more
  championships

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Football analysis (cont.)

• Just looking at statistics, stock market usually
  moves up at end of year
• Prediction rule if an NFL team wins the Super
  Bowl, the stock market will go up!
• Statistical analysis this is amazingly accurate
• Problem with a pro but there is no reason!

14
Security analysis

• Bottom line
• Do you really care?
• Which one can you tolerate?
• It is very simple
• There is no rationale
• It does not work

15
Castle-in-the-Air

• Fashion is the great governor of this world
• Everything in this world is the result of crowd
  psychology
• Price of anything is determined by the law of
  supply and demand
• Key is to catch what the market thinks before
  others do!

16
The Internet bubble - Netscape

• August 8, 1994 Netscape listed on NASDAQ
• Founded by Jim Clark, a 54 yr old ex-Stanford
  professor who founded Silicon Graphics Inc.
• First attempt to exploit the Internet for
  commercial use

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Netscape (cont.)

• Advanced Research Project Agency Network
  (ARPANET) was founded in 1960s as a Dept. of
  Defense project on various university campus
• Grew to around 100,000 sites in 1989
• 1989 Tim Berners-Lee in Geneva invented
  specifications and named it World Wide Web and
  the HTML

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Netscape (cont.)

• However, searching on the WWW was still painfully
  difficult
• 1992 Marc Andreessen, 21, was studying at U. of
  Illinois and worked part time for 6.85 / hr at
  National Center for Supercomputing Applications

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Netscape (cont.)

• Developed a software called Mosaic that allows
  cut and paste of words, pictures, etc.
• Allows content to be searched and viewed with
  ease browsing was made possible Mosaic
  became the predominant browser on WWW

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Netscape (cont.)

• Soon 1,000,000 were using Mosaic to browse the
  WWW, and Internet usage exploded with annual
  growth rate 342,000
• Jan 1994 Jim Clark was kicked out of SGI and
  found Andreesseen on the web
• Founded Mosaic Communications and developed
  Mozilla

21
Netscape (cont.)

• Company later renamed Netscape software
  Navigator
• Clark put in 4.25 million of his own money
• funded by venture capital firm Kleiner Perkins
  Caufield Byers with 5 million for 20
• 1995 Jim Barksdale (from McCaw Cellular) joined
  as CEO

22
Netscape (cont.)

• Wanted to sell 5 million shares for 12 14 a
  share
• Reports shown that investors wanted to buy 100
  million shares
• Finally, decided to double IPO price at 28
  (market capitalization 1 billion!)

23
Netscape (cont.)

• When market opened, there was no trading in 90
  minutes
• First ask was 71
• Market closed at 58.25, market capitalization
  of Netscape became 2.3 billion

24
The Internet bubble - Yahoo

• Founded by Jerry Yang and David Filo when both
  were graduate students at Stanford
• As their Ph.D. adviser went on sabbatical, they
  used the computer (and the Internet) to kill time
• Need new tools to organize the rapidly growing
  contents

25
Yahoo (cont.)

• Invented indexing tool called Jerrys Fast Track
  to Mosaic (i.e., early version of Netscape),
  later called Jerry and Daves Guide to the World
  Wide Web
• Many people use this free tool, page views grew
  to 100,000 in late 1994

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Yahoo (cont.)

• Desperately need money to continue the service
• Talked to venture capital firm Sequoia Capital,
  backer of Oracle, Cisco, etc.
• Paid 1 million for 25 in Spring of 1995
• Toke in Tim Koogle (aged 43) to run the company

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Yahoo (cont.)

• April 12, 1996 IPO
• Priced at 13, opened at 24.5, zoomed to 43 and
  closed at 33
• On the first day of trading, market
  capitalization was 849 million
• Yang and Filo were each worth 132 million!

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Internet bubble (cont.)

• After these stars many Internet companies were
  offered to the market
• Most do not have earnings, dividends, or even
  assets!
• Valuation was purely based on how much investors
  are willing to pay!

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Castle-in-the-air - critique

• Trick works as long as there is another bigger
  fool in line
• People do make money, many lose money later
• Depends on the investment horizon
• Can you really get out before the music stops?

30
Firm foundation approach

• Focus on investments that pays their own way
• Look at
• Earnings
• Dividend
• Growth rate
• Usually need knowledge in accounting and economics

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Firm foundation (cont.)

• Basically fundamental analysis was founded in
  1930s after the Wall Street collapsed in 1929
• Before that, no one knew how to measure the value
  of a stock scientifically
• Look at the intrinsic value of a comapny

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Firm foundation (cont.)

• But, even the masters make big mistakes
• 1929 Irwin Fisher, a Yale Professor known as
  father of intrinsic value, said that the stock
  market had reached an everlasting plateau
• In the great depression, Graham and Dodd wrote a
  book Security Analysis, arguing that there is
  an intrinsic value of a stock given the dividend
  and earning of the company

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Firm foundation (cont.)

• Many things got developed since then. But, one
  student of Benjamin Graham studied the
  fundamental analysis well got successful in
  real life investment
• Guys name is called Warren Buffett. He acquired
  a listed spinning mill called Berkshire Hathaway
  and turned it into an investment company

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Firm foundation (cont.)

• Stock price of Berkshire Hathaway was 71 in
  1973. Today it is 76,500
• Warren Buffet is one of the richest man in the
  world

35
What we know about capital markets

• How accurate knowledge plays depends on what
  time horizon we are looking at
• Over long period, market would follow laws of
  economics (and physics!)
• Within short period, there can be wide and
  erratic swings (because human psychology plays a
  role)

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If so, can we predict the future?

• Depends how efficient is the capital market
• If the market is efficient, then information gets
  reflected in prices fairly quickly
• Note refer to available information, which might
  not be always true

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Can we predict the future? (cont.)

• If all information is always reflected in the
  prices, the change in the price reflects new
  information
• If there is any pattern in the arrival of
  information, even the pattern should be reflected
• Hence only new information moves prices

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Can we predict the future? (cont.)

• New information arrives randomly
• Therefore prices would follow a random walk

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Random walk

• Implications
• Prices are good indicators of value
• The past cannot predict the future
• Prices follow a random walk
• Is it true?

40
Random walk (cont.)

• In the last 30 years, thousands of studies had
  been done on this subject
• Basically the answer is mostly yes
• Especially, you cannot use the past to predict
  the future
• This is particularly true when we look at very
  short time horizon

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Random walk (cont.)

• However, over the medium to long term, prices
  tend to go back to basics (economics, accounting
  information, etc.)
• Also the property of mean reversion that
  prices tend to swing back to a long run
  equilibrium level

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Random walk (cont.)

• Conclusion even with random walk (i.e.,
  efficient capital markets), you can plan your
  investment well and go well