Ever hear the saying “hindsight is 20 20″? Its gets used across all aspects of life and especially in the investment world. People have a tendency to simplify the gains to be made from investing after the fact. After a 40% drop in stock value everyone can sit there and say it was obvious that the market was heading towards this kind of correction. This kind of hindsight will always get novice investors so be careful if you find yourself saying the following:

• If I would have sold sooner I wouldn’t be down so much - If you find yourself saying this then most likely you’ll be timid and anxious in future investments. You’ll be prone to jumping out of stocks at the first sign of trouble and missing the eventual rebound.
• If I hadn’t sold I would have made even more money – Prior to making any investment you should understand what your goals are and have a plan. If you find yourself saying this it may distract you from your plan and keep you from exiting when you  should. This leads to impulsive investment decisions.
• If I would have bought that stock last month I would have made a ton of money – Watching stocks rise quickly is always hard especially when you are sitting on cash. If you find yourself saying this you could eventually be leaping into a rising stock before its set to come crashing to earth again. You just need accept that you’ve missed the opportunity and keep your composure.
• If I had more money I would have made made even more - You’ve made some money investing and now you are feeling good. You begin to think of all the lost opportunity had to invested more. You get over confident and decide you’ll buy on leverage or margin in order to amplify your returns. However at this point you’ve taken on far too much risk and sooner or later you’ll misstep and lose everything and owe a lot.

Conclusion

Never look to the past when investing for the future. Understand (see my article on my rule #1 to investing) what you expect from a particular investment (this should include more then just the future stock price)  and the consequences involved that way you can probably deal with all the risks involved.  Once you’ve done that act with conviction, stick to your plan and never look back.

Do you have any personal stories of how hindsight caused you to make bad investment decisions?

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A few weeks back the grocery chain Loblaws announced it was cutting prices across the board. As a customer I’m ecstatic because I frequent Loblaws for my grocery needs. What a win situation for me. However with every winner there has to be a loser and who could that be? Unfortunately price cuts lead to price wars and the investor could be on the losing end.

Whats a price war?

Companies in an attempt to increase market share decrease prices to get customers into the store. This sounds simple enough until the competitors catch wind and decide to lower their prices.  This leads to further prices cuts until in spirals downwards into a price war.

What happens to companies in prices wars?

Unfortunately as companies lower their prices, their margins profit get squeezed. This causes the companies revenue to shrink. Now they usually hope to make up this difference in revenue by increasing their market share and therefore increase the amount of merchandise they sell. However increasing market share becomes difficult as competitors also lower their prices. The price cuts could continue until neither company is generating revenue and are actually losing money which forces them to tap cash reserves. Once companies get to this point they have  a few options:

1. Raise prices again – This may seem a simple enough solution but you can end up with a lower market share then what you started with. Customers enjoy price decreases but major price increases can end up being a real shocker. The company not only will lose the new customers they’ve gotten but some existing ones that were initially loyal to the company’s brand.
2. Cut costs – Cost cutting is a popular choice in a price war. Companies can start by cutting dividends which won’t make investors happy at all. Then they’ll cut costs in store. They can cut back on staff, product circulation, and free perks.  These sort of cutbacks ruin the experience for customers who are loyal to company’s brand and can have them seeking alternative places to shop.

Aftermath of the price war

If the company wins the price war they will most likely be weak from low revenue and low cash reserves. Even with a larger market share they could be at risk of failing. It may be a long while before investors see the gains of the past. Investors could also be dealt another blow if the company sees fit to raise more capital by issuing new stock.

If the company losses the price war then not only will they have low cash reserves but have also lost market share. The company will most likely have damaged its brand in the process. They’ll have to raise cash  in order to stay afloat. Even then they may end up dieing a slow death until they eventually go bankrupt or are bought out by a competitor. Now this isn’t to say that the company can’t recover but it could be a slow process with many years of poor performance.

Conclusion

Prices wars can be long and drawn out ordeal with investors caught in the middle. Now if you think that the company you are invested in is strong enough to win the price war and rise up after the dust has settled then you can be in store for a profitable future.  However this sort of gamble can be as risky as betting on a horse race.

How do you view investments that are in the midst of a price war? Are they still good investments?

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Some of the hot stocks this past year have been McDonald’s and Wal-mart. Both seemed to buck the trend when everyone else was losing money. Generally speaking revenue is an important figure when performing an analysis on a company like Wal-mart or McDonald’s. However when dealing with retailers there is an equally important figure that gives the revenue figure some perspective, same store sales.

What are same store sales?

Same store sales is a look  at the sales of stores opened for a year or more.

Why is the same store sales figure important?

Revenue growth is an indication that a company is increasing its market share and growing. However looking at revenue alone can be misleading as an indication of growth. Companies can increase  revenue by expanding and opening more retail shops. This sort of expansion is good but unsustainable and also more expensive. Healthy companies should also be showing revenue growth in existing stores. This is where same store sales figures come in. It removes any new stores and looks to compare the revenue from the previous year with the same amount of stores in the current year.

An example

In 2009 Widgets Co. had 10 outlets and revenue of $100 million.  Now in 2010 they’ve expanded to 20 stores and increased revenue to $200 million. It’s great that revenue has doubled but so has the amount of stores. However if you don’t weed out the new stores from the revenue stream (which is what same store sales does) technically speaking sales per store would remain flat at $10 million per store. It’s conceivable that Widgets Co. could continue to expand to the point where they have a retail shop on every block in north America. If this were the case then the only growth they could achieve would be same store sales growth.This is what makes same store sales an important figure.

Do you agree or disagree about the importance of same store sales figures?

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Currency hedging is one of those things people tend to bring up but never really explain. They’ll say vague statements why they are for or against hedging and if you don’t have an understanding of the process then you are left in the dark.

What is currency hedging?

Currency hedging is an attempt to try and minimize the risk associated with currency fluctuations on foreign investments. When you buy a stock in a company in a another country you are essentially doubling your risk. Not only are you at risk that the stock could go up and down but that the exchange rate between your currency and the foreign currency can work against you. Hedging is an attempt to manage that risk. An example of the currency risk:

Sally The Fund Manager goes and buys 1 share of CompanyX for 10$ USD. At the time the exchange rate is $2 CAD = $1 USD so it would have cost her $20 CAD. After some time Sally decides to sell her position in CompanyX. To her surprise the stock has doubled and Sally sells the share for $20 USD.  Unfortunately to her surprise the exchange rate has changed as well and the Canadian dollar is now on par with the American dollar ($1 CAD = $1 USD). In the end Sally still ends with $20 CAD even though her investment doubled.

Who can hedge?

Generally speaking anyone can perform currency hedging though it’s more difficult for the individual investor since most currency hedging is done with complicated investment instruments. This leaves most  hedging to mutual funds, ETFs, hedge funds and larger institutional investors.

How is currency hedging achieved?

Larger investors (Mutual funds, ETFs, hedge funds, etc.)  use derivatives such as options and futures. These are contracts that allow an investor to buy or sell currency at a pre-determined exchange rate at some point in the future. Lets go back to our example with Sally The Fund Manager:

Prior to making the investment Sally The Fund Manager decides to sell a futures contract to provide $20 USD at a rate of $1.75 CAD = $1 USD to Bob The Hedge Fund Manager (Bob is betting the US currency will go up).   What this means is at the end of the contract Sally will give Bob $20 USD and Bob will give Sally $35 CAD. When Sally goes to sell Company X stock she also has to meet her obligation on the futures contract. Because the exchange rate is $1 CAD for $1 USD she buys $20 USD for $20 CAD. She then gives Bob the $20 USD and Bob gives her $35 CAD. Sally has made $15 from the futures contract plus the money she has earned from her investment.  In total Sally has made $35 CAD from her investments. Though she didn’t end the with $40 CAD she would have earned at the original exchange rate she did protect a large portion of her return with hedging.

Now what would have happened had the exchange rate gone to $2.50 CAD for $1 USD. Well Sally would have had to buy $20 USD for  $50 CAD. She would then give Bob the the $20USD and he would give her $35 CAD. This turns out to be a loss of $15 dollars for Sally. However this loss is offset by the additional profit from selling the CompanyX  stock. She earned $50 CAD dollars from the stock sale subtract the $15 dollar loss from the futures contract and Sally’s return is still $35 CAD.

This is great I want investments with hedging

Wait one second. The example I gave makes hedging seem like the greatest investment tool ever. There are a few points that make hedging a less attractive strategy:

• Fees -  There are fees and premiums when buying or selling these futures’ contracts and those tend to get passed on the the investor in the way of a more expensive MER.
• Tracking Issues – Canadian Capitalist points is out in the following post that even though the difference in MER between a hedged index fund and a non-hedged index fund was only %0.15 the hedged fund underperformed the non-hedged fund by over 2% on a yearly basis.
• Magnifying Losses -Even though the purpose of hedging is to limit your currency risk there is still some degree of “double risk”.  There is the possibility that the stock you bought could go down and at the same time the the exchange rate could make you loss money on your hedging strategy. This would make your losses far worse then if there was no hedging at all.
• Limiting Diversification – This final point is up for debate depending on who you ask. Some people will say that all of your investments should be in currency of the country you plan to retire in. However believe (so do I) that a little currency diversification is part of a healthy portfolio. If you buy funds or ETFs that hedge then you are removing that diversification.

So is hedging right for me?

This is a tough question that can really only be answered on a case by case basis. You would need to look at your risk appetite, investment time horizon, and your retirement goals. Though in the past it appears that if you have a long enough investment time horizon (15+ years) then there is no benefit to being hedge or un-hedged. This may not always be the case going forward so the choice is up to you.

Whats your opinion on currency hedging?  Has the current economic situation influenced that opinion at all?

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A lot of people will be looking at this market crash in the years to come and remember the great buying opportunities, but not me. I remember when this whole mess started, I was holding my Bank of America stock which I bought at a 10% discount and was ready to make out like a bandit. Well I didn’t and the market started its slow descent south (before falling off multiple cliffs). I would sit there and think to myself  “Well it can’t get worse”.  As we have all learned, yes it can. This is the lesson I’ve learned, “The markets/stock can always get worse”.

Why is this lesson important?

During bull markets people develop a sense of euphoria.   They seem to forget that there is risk associated with equities and begin to take unnecessary risks. They focus on the infinite upside and ignore the finite bottom. However, all bull markets come to end and that’s when the lesson comes into play. One day the market/stock will drop 5% and they’ll buy more stock. The next day it will drop another 5% and they’ll buy even more in hopes of doubling their money. Of course on the third day it ends up dropping another 5% but at that point they’re all out of money so they buy using leverage. The stock continues to drop while the investor sits there saying to themselves “well it can’t get any worse”. It’s this reason that so many retiree’s got caught in the crash because they assumed it things couldn’t get any worse.

Now as a young investor knowing just how bad the market can get is a sobering experience. You just can’t get that kind of experience from reading about past crashes. With most of my investing life ahead of me I feel I’m better equipped to make my investment decisions:

• If I’m considering buying a risky stock I do it knowing that things can always get worse.
• If I decide to apply for leverage to invest in a down market I do it knowing that things can get always worse.
• When deciding my age appropriate asset allocation I do it knowing that things can always get worse.

Well if things can always get worse then why invest?

This lesson isn’t a testimonial to not invest or sell at the first sign of trouble. The market is still the best place to grow your money but you need to have a plan with proper risk analysis. If your only risk analysis is “Well things can’t get that bad” then you shouldn’t be in the market. Invest knowing that the market can potentially drop by 50% or more and account for that potential scenario both financially and emotionally. Once you’ve done that then you’ll be fine.

Now I just need to keep this lesson fresh in my mind because in 20 years this whole thing may not have seem so bad and I could open my self up to more risk. Any suggestions? Maybe getting it tattooed across my knuckles?

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