The Dogs and Puppies of STI

Many academia and literature says that active investors cannot beat the index. However, if you believe that this is true but still want to beat the index, then it follows that the key to beating the index must lies within the index itself, i.e. the portfolio of stocks that beat the index must come from the index component stocks.

In my previous post, I mentioned that an equal-weighted portfolio of the Straits Times Index (STI) component stocks can beat the index easily. In this post, we will discuss whether a "Dogs of STI" investment strategy can beat the index and even outperform the equal-weighted portfolio of STI component stocks.

The Dogs of STI replicates the investment strategy of the Dogs of the Dow. In this strategy, the 10 highest yielding Dow Jones Industrial Average (DJIA) component stocks are selected for investment in the following year. This strategy has returned 10.8% per annum over the past 20 years, matching the returns of DJIA and beating the Standard and Poor's 500 index's return of 9.6%.

What is the rationale behind the Dogs of the Dow investment strategy? Proponents of the strategy argue that blue chip companies do not change their dividends regularly to reflect changes in business conditions whereas stock prices regularly fluctuate according to business conditions. Hence, a stock that is higher yield than average would most likely be near the bottom of the business cycle and the stock price is likely to recover more than that of lower-yielding stocks. It suggests that the management of the companies believes their stocks are oversold and are willing to back them up by paying a relatively high dividend. By investing in the Dogs of the Dow, investors gain both by the higher price appreciation and the higher dividend yield.

Besides the Dogs of the Dow, there is a related investment strategy known as the "Small Dogs of the Dow" or "Puppies of the Dow". In this strategy, the same 10 stocks are selected as in the Dogs of the Dow. From this list, the 5 lowest-priced stocks are selected as the Puppies of the Dow. This smaller portfolio outperforms even the Dogs of the Dow, returning 12.5% versus 10.8% for the Dogs of the Dow over a 20-year period. 

So, how would a "Dogs of STI" and "Puppies of STI" portfolio perform? The table below shows the Dogs and Puppies of STI over a 13-year period since 2000 (Please refer to the previous post on Who Says You Can't Beat the Index? for limitations of the stock price data). Stocks highlighted in orange are the Puppies of STI while stocks highlighted in yellow make up the rest of the Dogs of STI.

Dogs and Puppies of STI Selected at End of Year

 

Returns of Dogs and Puppies of STI in Following Year (W/o Dividends)

Returns of Dogs and Puppies of STI in Following Year (With Dividends)

As shown above, the Dogs of STI outperforms the STI and even the equal-weight portfolios of STI and STI without the heavy weights (i.e. DBS, OCBC, Singtel and UOB). The average return including dividends is 19.3%, higher than STI's 6.7%, equal-weighted STI's 14.1% and equal-weighted STI without the heavyweights of 15.4%. The Puppies of STI performed even better than the Dogs of STI, returning 21.0% over the same period.

The outperformance of both the Dogs and Puppies is not due to dividends alone. Without dividends, the price appreciation (12.7% for Dogs and 13.3% for Puppies) already outperformed that of the STI (3.9%), equal-weighted STI (9.7%) and equal-weight STI without the heavyweights (11.0%). The inclusion of dividends further increased the outperformance of the Dogs and Puppies. The table below shows the outperformance relative to the STI, equal-weighted STI and equal-weighted STI without the heavyweights with and without dividends included.

	Dogs of STI		Puppies of STI
	No Dividends	With Dividends	No Dividends	With Dividends
STI	8.8%	12.6%	9.4%	14.3%
Equal-weighted STI	3.0%	5.2%	3.6%	6.9%
Equal-weighted STI w/o Heavyweights	1.7%	3.8%	2.2%	5.5%

On a dollar basis, over a 13-year period ending in Dec 2013, a $10,000 investment in the Dogs of STI with dividends reinvested would become $99,158 while a $10,000 investment in the Puppies of STI would become $119,182. This compares very well with STI ($23,235), equal-weighted STI ($55,554) and equal-weighted STI without the heavyweights ($64,369). So, dogs (and puppies) are Man's best friends apply to investors as well :)


See related blog posts:

• The Dogs and Puppies of STI for 2015
• Who Says You Can't Beat the Index?
• The Bounceback Portfolio of STI

Who Says You Can't Beat the Index?

Numerous academia and literature have impressed upon us that active investors like us cannot beat the index. This large no. of academia and literature cannot be wrong. Nevertheless, after reviewing the returns of the Straits Times Index (STI) over the past 26 years, I have an inkling that we might be able to beat the index after all. 

Over the past 26 years from Jan 1988 till Nov 2013, the returns of the Dow Jones Industrial Average, Standard & Poor's 500, Nasdaq Composite and Hang Seng Index have averaged (computed as geometric average) about 8.5%, 7.8%, 10.0% and 9.3% respectively. The returns of STI, in contrast, averaged about 5.0%, similar to FTSE's return of 5.2%. The only index among those studied that performed worse than STI is the Nikkei index, which returned -1.6%. At a return of 5.0%, it should not be difficult in beating the index. 

To understand the poor performance of STI, I collected the price of the 30 component stocks of STI (the prices are available only from 2000 onwards from Yahoo! Finance) and computed their individual performances. It turned out that on an equal-weighted basis (i.e. all component stocks have equal weights in the index), the return since 2000 is actually much higher, at 9.7% compared to 3.9% for the STI. See the table below for the computation. (Note that there are gaps in the prices due to corporate actions. For example, SPH, prior to Jun 2004, was priced around $20. After a 5-for-1 stock split, the price became around $4. The data from Yahoo! Finance only recorded the price after the stock split but not before. Nevertheless, it does not significantly affect the conclusion below.)

Returns of STI Component Stocks (Without Dividends)

The reason for the lower performance of STI is because stocks with higher market capitalisation are given higher weights in the index. The 10 stocks with the highest weights are namely DBS, OCBC, Singtel, UOB, Keppel Corp, Jardine Matheson, Jardine Strategic, Genting Singapore, Global Logistics Properties and Hong Kong Land in that order. These stocks have a total weight of 65.7% in the index. If we consider only the first 4 heavyweight stocks (namely, DBS, OCBC, Singtel and UOB), which have a combined weight of 40.9%, their return since 2000 is only 2.9%. This pulled down the performance of the rest of the STI component stocks.

If we include dividends, the results would be similar. The average return of STI is 6.7%, which is slightly less than that of the 4 heavyweight stocks of 7.5%. In contrast, the average return for a portfolio of equal-weighted STI component stocks is 14.1%.

Returns of STI Component Stocks (With Dividends)

Thus, a simple way of beating the index is to construct a portfolio of equal-weighted STI component stocks. Considering dividends, this will return 14.1%, more than double the returns of STI of 6.7%. Alternatively, by omitting the 4 heavyweights of DBS, OCBC, Singtel and UOB, the portfolio will return an even higher 15.4%. On a dollar basis, over the 13 years since 2000, a $10,000 investment in STI with dividends reinvested would become $23,235. An equal-weighted portfolio of all STI component stocks would become $55,554. An equal-weighted portfolio of STI minus the heavyweights would become $64,369. So, who says you cannot beat the index?

Wish everybody a Happy, Prosperous and Healthy 2014!


See related blog posts:

• The Dogs and Puppies of STI
• The Bounceback Portfolio of STI
• Betting Against the STI Component Stock Changes

Wealth Management Lessons from the Railroad Tycoon

It is rare that computer games have lessons to teach us, but the Railroad Tycoon has a number of lessons in wealth management to offer to us.

First of all, let me introduce what the Railroad Tycoon is all about. It is a game in which you set up a railroad company and build railroads linking cities and resources together and transporting resources among the cities. There is an objective for each game, which could be to achieve a certain wealth or connect 2 far away cities together by a certain year. 

Building Rail Roads and Transporting Resources among Cities

Besides building railroads and scheduling trains to run, Railroad Tycoon also has a stock market of all the railroad companies. Personally, you can buy and sell shares, including on margin. As the executive Chairman of your railroad company, you can also issue new shares or bonds or buy back them.

Stock Market in the Railroad Tycoon

To keep the stock market realistic, Railroad Tycoon keeps a record of the company's balance sheets, income statements and cashflow statements for the past years. Here, you can carry out a financial analysis of the company if you wish.

Balance Sheet of the Company

Income Statement of the Company

 

Financial Statement of the Company

The reason why Railroad Tycoon has wealth management lessons to offer is because you play the executive Chairman of the company, where you can make all the decisions from running the company to deciding what to do with the company's funds. So, it offers a glimpse of how companies in the real world are run. Here are some of the lessons I got from playing the Railroad Tycoon.

Lesson #1: To Be Successful in the Stock Market, Your Company Must First Be Well Run

To achieve the objectives in some games, it is necessary to play the stock market, such as buying shares on margin, attempting merger with a rival railroad company etc. However, in order to be successful in the stock market, it is important to be successful as a businessman first. If your railroad company is not well run, its share price will languish and you will face margin calls from the brokers. Conversely, if the railroad company is well run, its share price will increase, offering you greater margin to buy more shares of your own company or that of others.

Lesson #2: Boring Companies Can Be Very Profitable

In the game, besides transporting the resources produced by companies, you can also invest in them using the railroad company's money. So, the more resources you transport from that company, the more profitable it is. Boring companies, such as grain mills, cattle yards, sheep farms, etc. can actually be very profitable. The resources they produce do not need to undergo many processes and hence it is easier to make large profits from them. For example, you just need to transport the grains from the grain mill in City 1 to the bakery in City 2 to produce food for the people in City 3. 

In contrast, "high-tech" companies (the game era can be as early as 1850s) like steel mills requires more resources and processes. It requires both coal and iron ore to produce steel to be manufactured into goods for the people. So, you need as many as 5 cities with the required resources to deliver the finished products. It is more difficult for the steel mill to be profitable.

Lesson #3: If One Company is Profitable, All in the Vertically Integrated Chain Can Be Profitable

From the previous section, you can see that companies can be vertically integrated together. By successfully integrating the related companies together (e.g. grain mill + bakery, or coal mine + iron mine + steel mill + tool & die factory) through the railroads and train services, all can be very profitable at the same time.

Lesson #4: Share Buy-Backs are Independent of Price

As an outsider in the real world, we often think that companies engage in share back-buys because they think that the share price is too low and does not reflect the actual worth of the company. In Railroad Tycoon, if your company is profitable, you can engage in share buy-backs as well. However, it is not always when the share price has fallen below the actual value when I engage in share buy-backs. I do so when the share price has fallen and there is increased risk of margin calls from the brokers. At other times, it might be to buy out the other shareholders using the company's cash. Sometimes, the company might be so profitable and you just want to get rid of the excess cash. So, even if the share price is on a high and there is no risk of margin calls, I would engage in share buy-backs. The share price does not really affect when I engage in share buy-backs. In fact, the higher the share price, the easier is the task of spending money! So, share buy-backs do not necessarily mean that the share price is low.

Conclusion

As small-time investors, we often do not know how companies in the real world are run. The Railroad Tycoon offers a chance to be the executive Chairman of a company. While not fully reflective of the real world, you get some valuable insights into how companies are run.

Wishing everybody a Merry Christmas :)


See related blog posts:

• What I Learnt About Stock Investments from the DomiNations Game

Deciding How Much Tax You Want to Pay

It is the time of the year when you start to see newspaper articles and blog posts extolling the virtues of contributing to the Supplementary Retirement Scheme (SRS). SRS is part of the overall tax planning when you list down your incomes and personal tax reliefs for the year to estimate how much tax you need to pay in the next year. It is like seeing your tax bill 6 months in advance. But the advantage is that this tax bill is not finalised yet. If you don't like the tax amount shown, you could still explore ways to reduce the amount. 

Tax Planning for Yourself

Below is a screenshot of the tax calculator downloaded from IRAS' website. 

Tax Calculator to Decide How Much Tax You Want to Pay

Here, you could see all the possible personal tax reliefs that could be claimed. You could run through each of them to see whether you are eligible for it. The hyperlinks in the tax calculator links you to an explanation and the eligibility conditions for each of these tax reliefs. If you find that the estimated tax amount is too high for your liking, then you might want to consider additional tax reliefs, such as CPF cash top-up relief and SRS relief. However, to be eligible for these reliefs, you will need to incur some expenses or contribute some money first. For example, to be eligible for the parent tax relief, you will need to incur at least $2,000 to support your parents. To qualify for CPF cash top-up and SRS reliefs, you will need to contribute some money into them.

CPF cash top-ups can be a good way of supporting your parents, especially if they are over the monthly drawdown age of the CPF Minimum Sum Scheme (ranging from 60 to 65 years old). You can top-up their CPF accounts using cash either via a lump sum or monthly contributions and be eligible for the CPF cash top-up relief while they can receive monthly payouts from CPF. Whatever money still kept in the CPF attracts an interest rate of 4%, which is very attractive compared to today's low interest rates for bank savings.

Notwithstanding the above, it is not necessary to contribute the maximum towards CPF and/or SRS to fully maximise the tax benefits. Contribute what you can afford and it will go some ways towards saving some money for yourself. Ideally, tax planning should be carried out on a regularly basis, especially during the times when you receive your mid-year, year-end and/or performance bonuses to spread out the amount to be contributed so that it is not so onerous. In fact, for CPF cash-tops, you could even sign up for monthly contributions through GIRO.

Tax Optimisation for Your Family

Besides doing tax planning for yourself, you could also optimise the tax bill for your entire family. For example, the parent tax relief could only be claimed by 1 sibling for each parent. Ideally, this should be claimed by the person with the highest tax bracket as this will result in the largest reduction in the tax amount. There are also different amounts that could be claimed under the parent tax relief. For siblings who are staying with their parents, they can claim a higher tax relief of $7,000 compared to only $4,500 for those who are not. Hence, this can also influence who should be the one claiming the parent tax relief.

Likewise, for the Qualifying Child Relief, you could also decide with your spouse who should be the one claiming this relief so as to minimise the tax bill for the family.

Conclusion

Nobody likes to pay income tax. Tax planning will help to reduce the amount of tax you and your family need to pay. Tax planning is not necessarily for the rich, even middle-income families can benefit from it.


See related blog posts:

• SRS Exit Strategy
• Maximising the Benefits from SRS
• Minimising the Costs from SRS and CPF Investments 

Doing Your Own Insurance Planning

I guess most people are familiar with the concept of insurance planning. Whenever you buy an insurance policy, the insurance agent will first carry out insurance planning to determine your needs. She will ask you some questions related to your monthly income, expenses, amount of assets, liabilities, etc. before proposing a suitable insurance policy. Since this is such an important step to determining your insurance needs, why not do your own insurance planning? 

Benefits of Insurance Planning

There are several benefits to doing your own insurance planning. Firstly, the results are likely to be more accurate. During the discussion with the insurance agent, unless you come prepared, you will be hard-pressed to estimate how much your expenses, assets and liabilities are. Some are also not comfortable disclosing the actual income or assets for whatever reasons. But in the comfort of your home and away from all the strangers, you have all the time to find out all these figures accurately. There is also the advantage of updating the insurance plan as regularly as you wish, without the need to seek another review session with the insurance agent.

The second benefit of insurance planning is knowing how your insurance needs vary with time and the age that you no longer need any insurance. This is important for those who prefer to buy term insurance and invest the rest of the money over life insurance. By knowing when the coverage is no longer needed, you can save more money for investment.

The third benefit is you can carry out sensitivity analysis to find out which parameter affects the insurance needs the most. For example, the disability income insurance that I have comes with an option for a 2.5% escalation in benefits every year. Is it better to increase the coverage by another $1,000 per month or opt for the 2.5% escalation? Sensitivity analysis tells me that it is better to increase the coverage than to have the escalation. Similarly, sensitivity analysis also tells me when can I retire given the expected income, expenses, assets and liabilities. Finally, sensitivity analysis tells me which of these parameters are my best friend and worst enemy.

Worst Enemy: Interest Rate

Here, interest rate refers to inflation. Inflation is the worst enemy because all expenses go up, thus increasing the insurance needs. Inflation on medical costs and education is likely to be higher than general inflation. Through insurance planning, I have realised that if a potential liability costs $10,000 today, we should really be covering for 3-4 times that amount (depending on the expected inflation rate), because if and when the liability were to happen in 20-30 years down the road, inflation is going to increase it by 3-4 times.

Best Friend: Interest Rate Too!

If inflation were the worst enemy, investment rate of return would be the best friend. If we could grow our wealth at a higher rate of return than inflation, then our wealth could keep pace with the expenses. The insurance needs will also be much more manageable. After all, when we pay insurance premiums to the insurance companies, they also invest the money to make sure that it grows sufficiently large to cover the sum assured when the liability happens. Insurance is not just about risk pooling but also about investment!

Notwithstanding the above, in my last blog post, I have highlighted that it might be difficult to invest at a high rate of returns when one is not in the best of health. This then becomes a double whammy, because one is unable to generate high returns while at the same time the insurance needs go up. Thus, health is all important and is the capital to generate wealth.

Conclusion

In conclusion, insurance planning is an important step in identifying one's insurance needs. It provides insights into how the insurance needs vary with time and the key parameters that significantly affect the coverage needed. Given its importance, why not do it yourself?

2 words of caution are needed, though. Firstly, the model to determine the insurance needs must be correct, otherwise, it will result in either under-coverage or over-coverage. Secondly, like all models, it is rubbish-in, rubbish-out. Not only the model must be correct, the inputs must also be accurate too! Nevertheless, given its importance, it is worth investing the time in building and fine-tuning the model and establishing accurate input parameters.


See related blog posts:

• How Much Does One's Financial Independence Depend on One's Health?
• Preference for Regular Payout Insurance
• Unforeseen Risk in My Medical Insurance

How Much Does One's Financial Independence Depend on One's Health?

It is an aspiration for most people to be financially free. Being financially free means being able to do what one likes without being tied down to a job that one doesn't like. This is usually achieved by having alternative sources of income that do not depend on one's job, such as dividends and rental income. However, how much does one's financial independence depends on one's health?

When one is healthy, one is able to analyse financial statements or read technical charts and make investment decisions. However, when one is unhealthy, all these take a back seat. As La Papillion pointed out in his comments to my previous blog post, financial issues are the last thing on one's mind; the first thing being spending more time with one's family and trying one's best to recover as fast as possible. Investment decisions that used to be made fairly quickly now get procrastinated. If timing plays a key role in the returns one gets, then the returns become diminished with procrastination. Financial statements that used to be read with care now becomes a chore and an obstacle to investment. Thus, is it truly financial independence when it depends on a healthy person to achieve it?

One may argue that regular dividends and rental income require minimal efforts to achieve. However, one still has to watch over the performance of the companies to make sure that the regular dividends can continue uninterrupted. History is full of examples of excellent, high dividend-paying companies that have failed. Rental income also requires one to look for new tenants when the lease expires and to carry out repairs to upkeep the property. So, efforts are required to maintain the regular income. Nevertheless, this post is not to belittle the financial independence that some have achieved. Being financially free is a great achievement that takes many years of hard work and financial prudence to achieve. Rather, this post is to allow one to ponder how much one's hard-won financial independence is dependent on one's health. If one's financial independence is not dependent on one's health, then that financial independence could also be transferred to one's loved ones so that they too could be financially free. 

I have not found an answer to how one can be truly financially free. But the closest thing to a company that can continue forever is an index, which renews itself based on economic trends and replaces outdated component stocks with new ones. And the closest thing to minimal maintenance of the investment portfolio is to create a regular savings plan which invests a fixed amount of money in the selected fund. The good thing about index investing is that it beats most of the actively managed funds.

Health is wealth. When one is healthy, one has the capital to be wealthy. But when one is not healthy, even wealth cannot buy health.


See related blog posts:

• Unforeseen Risk in My Medical Insurance
• Preference for Regular Payout Insurance
• Building A Lasting Portfolio for Future Generations

Preference for Regular Payout Insurance

I have a couple of insurance policies; these can roughly be grouped into 2 categories -- those that I didn't opt out and those that I voluntarily bought. Insurance policies that fall in the former group are CPF's Dependents' Protection Scheme and Home Protection Scheme (HPS) while insurance policies that fall in the latter group are the "as-charged" Medishield plan and disability income insurance. The key difference between the 2 groups is the former has lump-sum, one-time payouts while the latter have variable or regular payouts over a period of time. As shown in the title of this blog post, my preference is always for regular payouts over lump-sum payouts.

For insurance to be effective, the asset (from insurance payout) must match the liability. Not only must the value of the asset and liability match, the timing of these cashflows must match as well. An asset that is realised one year after the liability falls due is no help at all. The reverse is also true, as will be shown later, but it is always better to have the asset earlier than the liability. Thus, when buying insurance, one must estimate the nature of the liability and find the appropriate insurance to match both the value and timing of the liability. 

When an unfortunate incident happens, it is likely to have 2 components, an initial period when there is high cash outlay such as due to surgery, and an recuperation period when the cash outlay is lower than that during the initial period but is regular, such as due to follow-up consultations, medication or loss of employment. Depending on the nature of the incident, the initial period will dominate for some incidents (e.g. accidents) while the recuperation period will dominate for other incidents (e.g. disability). Insurance with lump-sum, one-time payouts will be useful for the first type while insurance with regular payouts will be useful for the second type.

It is not wise to use a lump-sum insurance to cover a liability with regular expenses, as there is no certainty that the one-time payout is sufficient to cover the regular expenses even if the value of the payout and expenses roughly match. Take for example, a one-time $100K insurance payout and a liability that requires $3K in expenses a month over 3 years. The payout only needs to be invested at a rate of 3.1% to support the required cash outflow. It looks simple enough and does not require a bull market to achieve this rate of return. However, how can one be certain that there will not be a bear market that ruins the investment? Hence, there are challenges in trying to convert a lump-sum payout to a regular payout. Moreover, considering that the person is no longer as healthy as before, would he still be able to invest as well as he is when he is healthy? Thus, it is best to leave the risk of investing to the insurer and look for a regular-payout insurance to cover such a liability.

Notwithstanding the above, it may be possible to modify the cashflow of the original liability such that the asset and liability now match. For example, a loan obligation may require regular monthly repayments. It is possible to make a lump-sum repayment to either extinguish or reduce the amount of monthly repayment required in the future. A lump-sum insurance will work well in such cases. CPF's HPS plan falls into this category by extinguishing the loan when an unfortunate incident happens. 

In conclusion, it is important to match the asset to the liability. Buying the right insurance matters.

See related blog posts:

• There is Really a Regular-Payout Term Insurance
• The Ideal Insurance Payouts
• Doing Your Own Insurance Planning