Inflation is of grave concern to both consumers and investors alike. Inflation impacts not just spending capabilities but also real returns of assets. As such, economists measure inflation with great fervor. The most looked after inflation indicator is the CPI (consumer price index). It measures the changes in the price levels of consumer goods and services purchased by households.

While we do know of past inflation information as they’re regularly published in the press and the net, what we are more concerned with is the expected inflation. This forward looking, non-deterministic data is however, easily gotten for the USA economy. USA has a large liquid homogenous national debt market which is in general considered as risk free. We can derive the expected inflation data from delta of the nominal bonds (treasury bonds) and TIPS (treasury inflation protected securities) yields as published currently.

To give an example, the current 10-year and 30-year yields of TIPS are -0.13% and 0.87% respectively. The current 10-year and 30-year yields of nominal bonds are 2.18% and 3.27%. Thus, to arrive at the expected inflation, we subtract the nominal yields of bonds with the TIPS yields. The expected inflation over the next 10 and 30 years are thus 2.31% and 2.4%. As can be seen, the difference between 10 and 30 years’ expected inflation is not that great. This reflects the stable nature of long term expected inflation.

The expected inflation data derived as such belongs to the consensus of the US debt holders in general and should be pretty authoritative as a vote by the free market system under the command of the invisible hand.

We can take the USA expected inflation data from here and project the expected inflation for Singapore. I do not know how to project an accurate expected inflation for Singapore but my gut feeling is that it should not differ too greatly from the US data since both of us are major trading partners and cross-country investments and travel are high.

It looks like Singapore listed Reit/property-related stocks are of good investment value right now. Most of them are value stocks! Just look at the P/B ratios, they’re all well below 1! That means that it’s cheaper to buy these property stocks than the actual property themselves! This presents us with a buying opportunity.  I expect the prices to mean revert back to at least the book value. Nevertheless, it should be noted that sometimes, value stocks remain depressed in price for an extended period of time. Patience is a virtue in investing.

While I do not advocate investing too much in property-related stocks, a little tilt in this direction should be pretty harmless. Let’s see how this sector goes in the next 5 years.

To measure whether a stock/mutual fund/ETF is cheap or dear, we need to employ the help of stock valuations. There are various stock valuation ratios, the most popular ones are price/earning, price/book, price/sale, price/cash flow and dividend yield. Out of the five, the most commonly used ones are perhaps the P/E and P/B ratios. The 2 ratios are relatively easy to visualize and stock analysts and the press like to quote them on a regular basis. In particular, the P/E ratio is frequently compared to its historical average of 15 to justify whether to buy, sell or hold. While the values are great tools of the trade, the valuations need to be taken with a pinch of salt. You’ve to understand the nuances involved to make use of them.

First the P/E, the reverse of P/E is the E/P. This is commonly known as the earning yield. Some people argued that the long term real rate of return of a stock can be estimated using the earning yield. Sooner or later, they reasoned, the earning yields will be distributed to the shareholders via dividends or a liquidation of the business. Why is it a real return is because the underlying company holds onto productive real assets that can go up in prices in time with the inflation rates. However, this fallacy about using the P/E ratio as a return measure is unjustified as we shall see in a short while.

I do a little bit of spreadsheet from the excellent website http://www.multpl.com/. The historical S&P prices are from 1881 till 2012 so the range is of the longest possible term. Annualized earning yield (E/P) from the range of data is 7.03%. Dividend yield is 4.28% and annualized real price increase is 1.67%. As you can see, the total return from S&P500 is 5.95% which is 1.08% lower than the earning yield. While 1.08% might seem like a small amount over a single year, it can compound to a princely sum over 13 decades. In fact, if you invest in index funds/ETFs, the amount can pay for the expense ratio several times over!

Why is it the case where there is a difference is indeed puzzling, we can only speculate about the reasons. One reason could possibly be because of stock options. Over most of the history, stock options are granted as is without a need for the corporate to expense it. Thus, the earnings of the S&P500 companies are overvalued by the amount of the stock options granted. Luckily for us investors, stock exchanges worldwide are moving towards a regime where stock options now have to be expensed by regulation. This is good news as earnings are now more accurately recorded and corporations will not grant stock options haphazardly as it now impacts its bottom line. However, the issue is not fully resolved yet as companies still can play around with the valuations of the stock options. Since stock options are converted into actual stocks in the future, we do not know the actual value of the stock options granted when it’s issued. The most common way out is to estimate the value of the stock options via Black-Scholes option pricing model. As the calculation requires the input of the volatility of the underlying stocks, companies have the leg room to wriggle with the pricing by choosing a volatility that suits them.

Besides stock options, another reason might be the accounting methodology used. While we have been using the GAAP standard for many years, the standard still leaves some room for corporate shenanigan. However, it’s nevertheless the gold standard and will serve us well for many more years to come.

The third reason could be because of downright corporate thievery. While the corporate structure might be strict, real assets could however be moved out or stolen from the company without the management knowing about it.

Besides the differences between earning yields and actual returns, P/E also suffers from the problem of having different methodologies of calculating it.  In general, there’re 2 ways to calculate P/E – the trailing P/E and the projected P/E.  Both have their merits and downsides, trailing P/E shines as it’s the actual P/E recorded by the accounting data but it lacks recency.  Projected P/E is great as it’s forward looking but its downside is that it’s projected information, which isn’t accurate.  Besides, projected P/E has the problem of being too optimistic on the earnings as the analysts who do the projections on the stocks have their hands in the investment banking business.  There is thus a conflict of interest involved.

So much so about the P/E ratio, we next talk about the P/B ratio. While P/B is an important ratio, it however has its flaws. Book value measures only the value at which the assets are carried on the balance sheets. It does not calculate or attempt to calculate the “software” part of the company. This issue is particularly important since we are moving from a manufacturing economy to a service/information era. The technical knowhow and finesse of employees and management are not valued. Brands are not valued. Computer system crafted by skill programmers are also expensed and not valued.

If you think that P/B ratios have been rising over the years as we moved towards an informational era, you’re right! Large-blend stocks B/P (the inverse of P/B) has reduced from 1.01 in 1926 to 0.57 in 2011. Large-growth stocks B/P has reduced from 0.46 to 0.24. The reduction in book value is tremendous, so much so that historical comparison is no longer valid. This is very much unlike the P/E ratio whose values are historically relevant.

As you can see, P/E and P/B ratios are not the holy grail of valuations. However, P/E and P/B are still important considerations given the caveats that we have seen.

Most of us, working adults, save. We save for various reasons, such as for the inevitable rainy days or for our children’s education. One major reason for our savings is for our retirement funds. In personal finance, it’s important to save early as young as possible and adequately for our desired retirement lifestyle. I shall explain the rationale for the save early, save adequately mantra.

Suppose we assume that we save $10,000 at the start of every year and we invest all of our savings in equities earning a return of 7% annualized. If we were to start at the age of 25 for 10 years and then make no outlay afterwards, we would amass a total sum of $1.13 million at the age of 65. Wow! Not bad for a base of only $100,000.

Now, let’s suppose that we lax a little and start at the age of 35 and save $10,000 every year for the next 30 years till 65. What do we get? The second case would earn us a total of $1.01 million. As you can see, the amount is lesser even though we save 3 times the amount ($300,000). It is thus important for us to save early and net the power of compounding.

Remember the adage of the magic of compounding when you’ve the urge to buy your next iPhone or Honda Civic.

First of all, I would like to state that I’m not against leverage per se. Leverage has its usefulness. For example, families borrow money to buy their dream home; without leverage, they would have to wait decades in order to do it. Companies use leverage to obtain working capital, expand into new arena and as start-up capital. Leverage is also used extensively by banks to take in deposits and loan out money. Without leverage, there would be many lost business opportunities and the economy would not have the lubricant to function as well as it does.

That being said, however, leverage in investments in stocks and shares by individual investors has questionable value. Very often, individual investors obtain capital by taking a loan and invest the proceeds with the expectation of obtaining a higher than average return. Some open a margin account with a local brokerage at high margin rates while others dabble in derivatives or instruments such as leverage ETF or banks’ structured products. Those who have the misfortune to invest in such products usually have poor results. Some instruments such as futures and options can even get you wiped out within days! The peril of leverage could not be more understated.

The problem with leverage investments is that the loan you obtained most likely needs to be collateralized. High tide raises all boats and when the going is good, financial institutions rush to provide you with liquidity but when things got tough, you’ve to repay part of your loan to maintain the gearing ratio. If you cannot repay, the financial institutions will perform margin selling of your collateral to obtain capital. This is the crux of the matter – you as the investor have to sell off your assets at your low point and are not given more time to wait for the inevitable recovery to come. When the eventual recovery does come, you’re now asset light again and miss out on the good opportunity. This results in the frequently quoted adage that it takes a 100% gain to recovery from a 50% loss. The phenomenon is also known as volatility drag. As you can see, the short term nature of the debt we as individual investor can obtain is greatly to our disadvantage.

To further exacerbate the matter, some financial institutions charge a 5% to 10% interest rate on the loan. This is pretty high as it covers a large portion of the expected equity premium. As a frame of comparison, the stock markets return less than 10% over the very long term. Furthermore, we’ve to account for the commissions and slippage due to the ongoing trading required by the maintenance of gearing ratios.

To make the matter clearer, I’ve back tested multiple mutual funds over periods of several years to illustrate the detriment of leverages. To simplify the matter, I assume that slippages, commissions and interests charges are zero and we simply measure the effects of leverages and volatility drag have on the mutual funds. The single-fund portfolios are formed according to the gearing ratio and rebalanced on a daily basis back to their gearing ratios as the fund prices fluctuate.

This is the result of the returns of the various mutual funds leveraged by different ratios.

As you can see, the results are not that impressive. For all cases of leverages, you get x-times the risk but not x-times the returns. The 3x portfolios are particularly damaging to your wealth if you take into account of slippages, commissions and interest charges. Only the S&P500 portfolios have decent but not great results due to leveraging. The USA high dividend yield fund is particular abysmal in this regards. For some funds, returns improved only slightly as the leverages go up while for others, returns actually dropped (some precipitously). The greatest falls can be seen as we move from 2x to 3x leverages.

The data file used to crunch the result is available online for viewing. It is written in Excel 2007/2010 format. The source of the mutual fund prices are from Yahoo! Finance.

As you can see from the results, all individual investors alike should reconsider before taking the plunge in leveraging their portfolios. History shows that the results are not good. The best results are gotten from portfolios that have a balance of stocks and bonds. The highest equity contents a portfolio can contain should be 100% stocks.  The questionable excess returns of leverages and the horrendous equity-related risks are simply not worth it!

HDB flat prices have skyrocketed over the past few years. Owners expectedly smirk as their net worth climbs into stratosphere. Some figure that their retirement could possibly bank on the rising property market as their can downsize their house later and profit the balance. The younger generation, however, is not so fortunate. How are our little knights and princesses going to live happily ever after if they can’t afford their own castle?

The Singapore government has predictably taken notice of this issue and expectedly implemented cooling off measures for the property market. One of the strategies is to increase the supply of new flats into the marketplace. Witness the numerous Build-to-Order flats released over the past year or so. This should ideally curb the rampant upward swings of the housing prices in the short to mid-term. However, the question remains, is the HDB flat a good investment medium given the circumstances? Will the prices collapse given the higher supply of flats and rein in the foreign worker count after the election? Will the falling birth rates and an increasingly single population cause a fall in the demand of flats and thus resulting in a reduction in flats’ prices? Would-be flat owners are unsurprisingly concerned.

First, we look at the situation from the angle of the yields of flats as if they are rented. Even if you were to live in your flat, this is your imputed rent as should you not have purchased a flat, you would have to rent it somewhere else. We look at 3, 4 and 5 room flats in Jurong West, Ang Mo Kio, Seng Kang and Toa Payoh.

As you can see, while the prices of HDB flats are high, the rentals are equally eye-popping. Thus, the yields of flats range from 5.6% to 6.9%. Under the current economic circumstances, this is a respectable gross yield if you consider the alternatives. Saving deposits earn next to nothing. Money markets earn 0.5%. STI ETF earns 3.3%. 20-year SGS bonds earn 2.4%. You get the idea (even the ill-fated mini-bonds have only 4% returns). Note that HDB and STI ETF yields are in real terms, i.e. their values should rise with inflation while that of debt instruments such as saving deposits, money markets and SGS bonds are nominal yields. Given the high yields of HDB flats, a crash of 50% or more in the prices of HDBs is unfathomable if we assume rentals were to remain constant. If that unfortunate crash were to happen, gross yields will get to double-digit level and loads of people will take money out of the banks and investment vehicles and snap up HDB flats!

A lot of people are uneasy that HDBs have 99-year tenure. The land that your flat sits on does indeed have 99-year tenure. However, you own the structure sitting on top of it. What happens after the 99-year tenure is unknown yet as there’s no flat that’s that old. However, you should be able to renew the tenure of the land and not have to rebuild the structure again. You should suffer slight depreciation charges against your flat over time as some areas of the building might need to be upgraded.

Even if the Singapore government were to decide to confiscate the flat after the 99-year tenure, HDBs are still of good value as you would have “earned” back the principal in less than 20 years via the rentals. While your rental should rise with inflation, your mortgage installments are however fixed at a constant rate. This is assuming that interest rates remain at its current low level and the high rentals will not fall. However, the circumstances might change and topple the ideals.

House ownership brings with it a new sense of pride and belonging. If your time horizon is long term and you expect the rental not to fall and you can afford the down payment, HDBs are a good investment as the installments over a 30-year period is even lower than the rental, i.e. aside from the down payment; you pay nothing and own the flat outright after the 30-year installment period. For couples finding a place to live, the government has sizeable subsides to encourage home ownership. This is a once in a lifetime opportunity not to be squandered away.

Considering that the government population policy is to allow foreign migrant workers to replace the falling birth rates and then some more to boost economic growth, we should see the demand of flats to increase with time, this coupled with the fact that we are land-scarce put an upward pressure on housing price/rental over the long term. Over the shorter term, things are less certain as prices also ebbs-and-flows with the economy which has unforeseeable cycles. All-in-all, buying a flat now would’ve locked in the current price/rental over the future. For those buying to live in it, you can consider the purchase price as pre-paid rent for the next 99 years. Whether the purchase makes sense or not 30 years from now is an unknown, it really depends on your foresight and luck.

“Compound interest is the eighth wonder of the world.  He who understands it, earns it… he who doesn’t… pays it.” – Albert Einstein

Once upon a time, in the ancient land of the warring elephants and sprawling paddy fields, there lived a distinguished Siam king endowed with immense wisdom.  Under his judicious rule, the kingdom flourished with triumphant battles against his enemies and bountiful harvests within his kingdom’s boundaries.

The shrewd king had a cerebral leisure pursuit – he liked to occupy himself in the intellectual game of Chess to learn the arts of war.  He spent hours immersing himself in the profound game and in no time he became the strongest player of all time in his kingdom.

With no one close enough to challenge him in the game, the king naturally felt bored.  He soon sought the kingdom and beyond for players that could contest him in the intricate game but everyone who confronted him failed.

One day, a Persian Grandmaster on board a ship paid Siam a visit.  The gracious king soon heard about it and welcomed the Grandmaster with a sumptuous meal.  After the extravagant banquet, the king challenged the Grandmaster to a game.  The grandmaster delightfully consented.

After a grueling 10 hours contest, the king eventually lost the game to the more skillful grandmaster.  Although the king had unfortunately lost, he was ecstatic that he could find his match.  The king pleasantly inquired the Grandmaster what kind of gift he would like to receive from the king.

The Grandmaster pondered for a moment and replied, “The chess board is made up of an 8-by-8 grid of boxes.”  He then continued, “I would like to have a grain of rice on the first box, double that amount on the second box and then double that amount again on the next box.  And so on and so forth for all 64 boxes.”  The benevolent king was puzzled, why did the Grandmaster request so little when he could give the Grandmaster much more?  But he gladly agreed to the Grandmaster’s request.

The king proceeded to order his subjects to give out the rice as agreed upon.  First box is 1 grain, second box is 2 grains, third box is 4 grains, and fourth box is 8 grains…

Upon reaching the 10th box, it’s 1024 grains.  That’s barely one tenth of a cup size – it’s nothing for a prosperous kingdom like Siam.  The king marveled at what a good deal he’d arrived at and raised the question to the Grandmaster, “would you like to reconsider your request again?”  The Grandmaster gentlely thanked the king and politely declined.

The truth of the matter raised its ugly head as the dispensing of the gift proceeded.  On the 20^th box, it’s 1 million grains already.  That’s 20 kg worth of rice.  It’s still affordable.  But on the 30^th box, the subjects had to cart in 20 tons of rice.  By the time the 40^th box was reached, all the warehouses in the kingdom were exhausted and there was no more rice left.  The giving out of the gift could simply not continue or it would have bankrupted the nation.

Needless to say, the king was now furious.  The no longer benevolent king ordered his guards to behead the Grandmaster for his trickery.  The Grandmaster cried foul but his wailing fell into deaf ears.

That, my friend, is the story of the magic of compounding.

There are literary tens of thousands of stocks traded in major regulated exchanges worldwide.  The million-dollar question for the would-be investor is what stocks derive the highest returns?  To arrive at an answer, we’ve to come out with a working functional investment strategy.  There’re many types of good investing strategy, small-cap value investing is one such turbo-charged investment tactics.

Small-cap investing refers to the investment in small-capitalization stocks while value investing refers to the investment in low price/book, price/earnings, price/cash flow, price/sales and high dividend yield stocks.  The consensus for small-cap value investing arises due to the historical higher returns of SCV investing.  Some finance academics argue that the higher returns are because SCV stocks are riskier and that risks and returns are correlated, i.e. they are a risk story while others debate that it’s more of a behavioral issue, i.e. their high returns are a free lunch and investors should grab them while they’re there.

Personally, I feel that small-cap investing is riskier thus resulting in their higher returns.  Small-cap stocks tend to have more volatile stocks price fluctuations.  The companies tend to operate in small niche markets with undiversified product lines.  Some of the products they sell might even be untested in the mass market!  However, because of their smaller size, they’ve more legroom to grow and expand.  This is unlike large companies where their products are already matured and highly penetrated in the markets, thus limiting their future growth.

On the other hand, I feel that the value premium is more of a free lunch.  While growth stocks tend to grow faster (somewhat in the near future) and are stars of the stock markets with a bright future, there’s no reason why companies with stronger fundamentals (value stocks) should have a premium in returns.  The matter of the fact is that value stocks are being under-valued in terms of prices (above and beyond what’s fair) and investors are handsomely rewarded by loading up with them instead of growth stocks.

Regardless of the reasons for their high profits, the excess returns have been spectacular historically and it’s persistent over different countries and long-term periods.

In this article, I shall focus my discussion on SCV investing in the USA market due to the availability of long-term and clean data and because of the size of the market itself.  I derive my points from the data gleaned from the Kenneth French data library which is freely download-able over the Internet at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.  My source of stock prices will be based on the file “6 Portfolios Form on Size and Book-to-Market (2×3)” as the constituent stocks inside the portfolios are widely diversified and reasonably comparable to SCV ETFs/mutual funds/Unit Trusts on the market.  The portfolios are divided into large-caps and smalls caps and then into growth, blend and value style.

The portfolios are very long-term in nature, they backdate from 1926 till now (84 and a half years).  That’s about as long range a set of clean data as you can get.  It’s important to backtest the strategy with long-term data as we can remove doubts as to whether the SCV strategy is period specific.

First the cumulative returns (1927-2011).

I use large-cap blend as the benchmark as it’s the most frequently quoted in the news and media.  As you can see from the table, small-cap blend beats large-cap blend by 3.2% and large-cap value beats large-cap blend by 1.6%.  This validates that style investing in value and small-cap stocks has its merits.  Small-cap value beats large-cap blend by a whopping 4.8% annualized.

To put things into perspective, if a 25 year-old youngster were to invest $10,000 in small-cap value stocks and do nothing else and then draw it 40 years later at a retirement age of 65; he would have accumulated $2.41 million!  This is a growth of 241 times!  The point is, very few investors in investing history has such a stellar performance.  This result best exemplified the benefits of long-term buy-and-hold and the power of SCV investing.

This chart shows the growth of 1 dollar from 1927 till 2011.

Note that the chart is a logarithmic chart.  Each unit in the vertical axis is 10 times the size of the unit below.  The stocks might trend in a straight line towards the top, but in actual fact, they are growing exponentially in nominal terms.

If we take investing periods of 5 years as the short term, 10 years as the mid-term and 20 years or longer as the long term, we can further examine the efficacy of SCV over shorter term periods than provided in the data library file.

If we subdivide the French’s data library historical prices into 20 year periods, we’ve 4 distinct sub periods.

From the table, all periods and styles have positive returns and the returns are all strongly positive.  SCB beats LCB 4 times out of 4.  LCV beats LCB 3 times out of 4.  SCV beats LCB 4 times out of 4.  SCV is the top performer for all 4 periods.  The premiums of SCV stocks range from 4.7% to 7.9%.  Please note the compounded significance of even 4.7% (the lowest) over a single 20-year period.

Next, we look at 10 year periods.  We have 8 distinct sub periods.

Based on the table, all periods and styles also have positive returns.  SCB beats LCB 8 out of 8 times.  LCV beats LCB 5 out of 8 times.  SCV beats LCB 7 out of 8 times.  SCV is the top performer in 5 periods while LCV is top in 2 periods.  The premiums of SCV over LCB range from 0.0% to 11.3%

How about 5 year periods?  We will have a look at it next.

Here, stock investing is no longer a sure thing.  There are periods where stock investing got slaughtered no matter what style you adopt.  Even SCV stocks have 3 periods where there are negative returns.  Also, SCV stocks lose out to LCB 4 out of a possible 17 times.  The premiums of SCV stocks over LCB ranges from -6.1% to 23.2%.  As you can see, the range of SCV premiums is quite wild/unpredictable over the shorter term.

The lesson learned from historical evidence is that stock investing is viable only for the long term.  Over the shorter term, results are kind of erratic with negative returns for some periods.  If your funds are short term in nature with needs to draw on them for housing, retirement or education, do not invest in the stock market.  You would definitely not want to dabble in the stock market only to discover later that you’re at the beginning of a major bear market.

Also, for the long term, although SCV stocks have the highest returns, stock investing is viable no matter which style you adopt to. Even SCG stocks, which has the lowest returns of them all, is strongly positive.  The most important determinant for success is that you can buy-and-hold through the ups-and-downs periods.  The results are all positive in nominal terms, what style you adopt only affects how much you make subsequently.

The conclusion of this exercise is that it’s definitely possible to tilt a well-diversified portfolio to small-cap value stocks to increase returns.  Historically, SCV investing has served us well.  While it’s not a sure thing that the SCV premium will persist in the future, it’s a better bet to assume that it will.