CFA Institute Investment Foundations Program: Chapter 18 – Risk Management (Part III)

In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here).  It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing.  Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.

There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations.  This series of articles will highlight the core knowledge of each chapter.

Chapter 18 provides an overview of the risk management. The learning outcome of chapter 18 is as follows:

·       Define risk and identify types of risk;

·       Define risk management;

·       Describe a risk management process;

·       Describe risk management functions;

·       Describe benefits and costs of risk management;

·       Define operational risk and explain how it is managed;

·       Define compliance risk and explain how it is managed;

·       Define investment risk and explain how it is managed;

·       Define value at risk and describe its advantages and weaknesses.

Operational risk is the risk of losses from inadequate or failed people, systems, and internal policies and procedures, as well as from external events that are beyond the control of the company but that affect its operations. The reduction of operational risk requires companies to manage people to reduce human failures ranging from unintentional errors to fraudulent activities; manage systems, particularly IT and communication systems, and ensure compliance with internal policies and procedures; and manage political, legal, and settlement risks.

One example of operational risk that has a human component and that is more frequent in the financial services industry than in any other industry is rogue trading. Rogue trading refers to situations wherein traders bypass management controls and place unauthorised trades, at times causing large losses for the companies they work for. Rogue trading may involve fraudulent trading that is done for personal enrichment or to make up losses. Exhibit 1 lists a number of rogue trading incidents that occurred in the past.

Compliance risk is the risk that a company fails to comply with all applicable rules, laws, and regulations. The company may face sanctions and damage to its reputation as a result of non-compliance. Examples of key compliance risks that have the potential to inflict serious damage on investment firms and their employees include corruption, inadequate tax reporting, insider trading, and money laundering.

Investment risks take different forms depending on the company’s investments and operations. Investment firms typically experience: market risk, caused by changes in market conditions affecting prices; credit risk, caused by borrowers’ inability and/or unwillingness to make timely payments of interest and principal; and liquidity risk, caused by difficulties in buying or selling assets or securities quickly without a significant concession in price.

Value at risk, which provides an estimate of the minimum loss of value that can be expected for a given period of time with a given probability, is a widely-used metric to measure risk. By relying on historical data and making assumptions about the distribution of returns, VaR suffers from weaknesses that are typical of all measures that rely on models.

Although most companies in the investment industry have dedicated risk management functions, it is important to remember that risk is not just the responsibility of the risk management team—everyone is a risk manager. So, even if you are not a risk management specialist, you should still seek to understand risk management process, systems, and tools and participate in risk management activities in your organisation.

Source: https://www.cfainstitute.org/en/programs/investment-foundations

Value at risk:

A often overestimates the frequency of losses.

B assumes that the distribution of returns is random.

C provides an estimate of the minimum loss of value that can be expected.

pollcode.com free polls

Innovate or Die: How These 5 Companies Failed?

The only constant thing in today’s rapidly transforming world is change. Failure to innovate can be dangerous. Here are 5 companies that failed in recent years due to lack of innovation.

1. Blockbuster (1985-2010)

Founded in 1985, Blockbuster provided home movie and video game rental services. Unable to transition towards a digital mode, Blockbuster filed for bankruptcy in 2010. In 2000, Blockbuster had rejected Netflix’s offer to sell their company to Blockbuster for USD50 million. Why? Because it was seen as a “very small niche business” and was losing money at that time. As of July 2017, Netflix had 103.95 million subscribers worldwide and a revenue of USD8.8 billion.

2. Polaroid (1937-2001)

Founded in 1937, Polaroid instant film and cameras successfully captured a market that had few competitors. However, Polaroid was unable to anticipate the impact that digital cameras would have on its film business. Falling into the ‘success trap’ by exploiting only their business activities, Polaroid neglected the need to explore new territory and enhance their long-term viability. The original Polaroid Corporation was declared bankrupt in 2001 and its brand and assets were sold off.

3. Toy “R” Us (1948-2017)

Amazon began to allow other toy vendors to sell on its site in spite of the contract with Toy “R” Us. As a result, Toy “R” Us sued Amazon to end the agreement in 2004 and therefore missed the opportunity to develop its own e-commerce presence early on.

4. Kodak (1889-2012)

Kodak could not keep up with the digital revolution. They hesitated to fully embrace the transition to digital which led to its demise. For example, Kodak invested billions of dollars into developing technology for taking pictures using mobile phones and other digital devices. However, it held back from developing digital cameras as it was afraid of eradicating its all-important film business. Kodak filed for bankruptcy in 2012 and re-emerged in 2013 as a much smaller, consolidated company focused on serving commercial customers.

5. General Motors (1908-2009)

General Motors was one of the most important car manufacturers for more than 100 years. Failure to innovate and blatantly ignoring competition were key to the company’s demise. As GM focused predominantly on profiting from finance, the business neglected to improve the quality of its product, failed to adapt GM to changes in customer needs and did not invest in new technologies.

Through a major bailout from the US government, the current company, General Motors Company ("new GM"), was formed in 2009 and purchased the majority of the assets of the old GM, including the brand "General Motors".

Many companies or even individuals love to stick with the methods or models which once brought them huge returns. Making significant changes could be difficult but companies that don’t respond to changing markets or fail to acknowledge trends, may miss out on opportunities and put their businesses at risk.

Reference:

1. Frances Goh, 10 Companies That Failed To Innovate, Resulting In Business Failure www.collectivecampus.io/

2. Bianca Miller Cole, Innovate Or Die: How A Lack Of Innovation Can Cause Business Failure www.forbes.com

Covid-19: What Economic Measures?

Covid-19 has impacted the global economy. Malaysia is not exempted. Sectors such as tourism (hotels, cruise liners) and transport face immediate impact. Others may include manufacturing, retail, F&B, property, gaming, education and other services will show secondary impact. Healthcare and producers of gloves, masks and other surgical or medical items face positive outlook.

Source:https://www.euronews.com

So what can the Government do?

·       Create a stabilisation fund for firms and workers to draw on. Its size is probably 2% of GDP. The fund will help retain workers for firms impacted by Covid-19;

·       A one-time tax relief for firms impacted by Covid-19, i.e. no tax for one year? ;

·       Rental and lease payment (six months) support for businesses impacted (F&B and retail);

·       Hotels (and Airbnbs) receive support for room occupancy impact and room cancellations. Current (monthly) occupancy level is compared to a break-even level (say, 50%) and that will be the support level provided (for 6 months);

·       The transport sector (e-hailing, taxis, rail) will have direct financial support and/or rebates on fuel/gas/electricity used;

·       Aviation sector will have lower landing and parking fees and rebates on taxes (arrivals may fall 30-40% of total projected traffic);

·       Banks to provide moratorium on principal loan repayment for affected sectors; and

·       Cash flow support grants for six months to cover fixed costs of firms impacted or those self-employed.

There are many other possibilities to stabilise the situation. But it requires speed and some imagination to reverse the downward spiral. And, of course, a dose of good fortune or providence!

Labour Demand Met by Refugees or Foreigners?

Pakistan is naturally elated that Malaysia needs up to 150,000 low-skilled workers as security guards. Pakistan earned USD23 billion in remittances in 2019.

We used to import Nepalese as security guards. At least, we did not fear a security risk by employing them. But why use foreign labour when there are retired police personnel or army veterans? Unless their salary demand is way above the Nepalese or now the Pakistanis. But why Pakistan? It is a known terrorist “hotbed” – ask India, they will give you a detailed explanation of the workings of ISI (Inter Services Intelligence).

The present broken system fosters corruption, exploitation and abuse of power. Then there is the plight of over 178,000 refugees and asylum seekers registered with UNHCR in Malaysia. Why not use them, if the retired army or police folks are not interested? It is a time for us to have a framework for refugees with opportunity to work, access to healthcare and education.

The think tank IDEAS in a report dated April 2019 reached the following key conclusions:

(i)       grant refugees the right to work, which will have a positive impact on the economy and public finances. Their contribution to annual GDP could increase to over RM3 billion by 2024;

(ii)       refugees could potentially create 4,000 jobs for Malaysia;

(iii)      tax contribution could increase to over RM50 million by 2024;

(iv)      it is part of the PH manifesto; and

(v)      in the longer term, GDP contribution and tax payments will be substantial.

We also have a pool of undocumented migrant workers and that’s shown below:

So do we need the Pakistani contribution? Unless we are going for shariah compliant, Wahabbi police force on our streets!

References:

1.       Give priority to refugees instead of importing more foreign labour, Dennis Ignatius, FMT

2.       The economic impact of granting refugees in Malaysia the right to work, Laurence Todd, Adli Amirullah, Wan Ya Shin, IDEAS

It Can’t Happen Here!

Timothy Snyder, Housum Professor of History at Yale University, is one of the foremost scholars in the U.S. He wrote a book, “On Tyranny: Twenty Lessons from the 20^th Century”.

After the November election, Snyder wrote a profile of Hitler, a short piece that made no direct comparisons to any contemporary figure. But reading the facts of the historical case alarmed most readers. Snyder admits that history doesn’t actually repeat itself. But we’re far too quick, he says, to dismiss that idea as a cliché “and not think about history at all. History shows a range of possibilities.” Similar events occur across time under similar kinds of conditions. And it is, of course, possible to learn from the past.

Rather than making a historical case for viewing the U.S. as exactly like one of the totalitarian regimes of WWII Europe, Snyder presents 20 lessons we might learn from those

times and use creatively in our own where they apply. The following suggestions would make us wiser, more self-aware, proactive, responsible citizens, whatever lies ahead.

1.         Do not obey in advance

            Much of the power of authoritarianism is freely given. Anticipatory obedience teaches authorities what is possible and accelerates unfreedom.

2.         Defend an institution

            Follow the courts or the media, or a court or a newspaper. Do not speak of “our institutions” unless you are making them yours by acting on their behalf. Institutions don’t protect themselves. They go down like dominoes unless each is defended from the beginning.

3.         Recall professional ethics

            When the leaders of state set a negative example, professional commitments to just practice become much more important. It is hard to break a rule of law state without lawyers, and it is hard to have show trials without judges. And it is hard to have a real trial without evidence or witness.

4.         When listening to politicians, distinguish certain words

            Look out for the expansive use of “terrorism” and “extremism.” Be alive to the fatal notions of “exception” and “emergency.” Be angry about the treacherous use of patriotic vocabulary.

5.         Be calm when the unthinkable arrives

When the terrorist attack comes, remember that all authoritarians at all times either await or plan such events in order to consolidate power.

6.         Be kind to our language

            Avoid pronouncing the phrases everyone else does. Think up your own way of speaking, even if only to convey that thing you think everyone is saying.

7.         Stand out

            Someone has to. It is easy, in words and deeds, to follow along. It can feel strange to do or say something different. But without that unease, there is no freedom. And the moment you set an example, the spell of the status quo is broken, and others will follow.

8.         Believe in truth

To abandon facts is to abandon freedom. If nothing is true, then no one can criticize power, because there is no basis upon which to do so. If nothing is true, then all is spectacle.

9.         Investigate

            Figure things out for yourself. Spend more time with long articles. Subsidize  investigative journalism by subscribing to print media. Realize that some of what is on your screen is there to harm you. Learn about sites that investigate foreign propaganda pushes.

10.       Practice corporeal politics

            Power wants your body softening in your chair and your emotions dissipating on the screen. Get outside. Put your body in unfamiliar places with unfamiliar people. Make new friends and march with them.

           

11.       Make eye contact and small talk

            This is not just polite. It is a way to stay in touch with your surroundings, break down unnecessary social barriers, and come to understand whom you should and should not trust.

12.       Take responsibility for the face of the world

Notice the swastikas and the other signs of hate. Do not look away and do not get used to them. Remove them yourself and set an example for others to do so.

13.       Hinder the one-party state

            The parties that took over states were once something else. They exploited a historical moment to make political life impossible for their rivals. Vote in local and state elections while you can.

14.       Give regularly to good causes, if you can

            Pick a charity and set up autopay. Then you will know that you have made a free choice that is supporting civil society helping others doing something good.

15.       Establish a private life

            Nastier rulers will use what they know about you to push you around. Scrub your computer of malware. Have personal exchanges in person. For the same reason, resolve any legal trouble. Authoritarianism works as a blackmail state, looking for the hook on which to hang you. Try not to have too many hooks.

16.       Learn from others in other countries

            Keep up your friendships abroad, or make new friends abroad.. And no country is going to find a solution by itself. Make sure you and your family have passports.

17.       Watch out for the paramilitaries

            When the men with guns who have always claimed to be against the system start wearing uniforms and marching around with torches and pictures of a Leader, the end is nigh.

18.       Be reflective if you must be armed

If you carry a weapon in public service, God bless you and keep you. But know that evils of the past involved policemen and soldiers finding themselves, one day, doing irregular things. Be ready to say no.

19.       Be as courageous as you can

            If none of us is prepared to die for freedom, then all of us will die in unfreedom.

20.       Be a patriot

            The current president is not. Set a good example of what America means for the generations to come. They will need it.

This may be about America but could apply to any nation on earth! Stay blessed!

P.S.     When I wrote this piece I had no inkling of the night of 23^rd February or the day of 24^th  February.

            Malaysians voted in a PH government. But a couple of men want to bring back the “tainted” to power. Greed, power and position can mesmerize men (and some women). It cannot be right for a “backdoor” government to rule. The cost of this is an economic catastrophe. May God have mercy on us and give our Agong the wisdom to do what is right. God Bless Malaysia!

Reference:

20 lessons from 20^th century about how to defend democracy from authoritarianism, according to Yale Historian Timothy Snyder ( http://www.openculture.com)

Bursa Malaysia Beneish M-Score Database

In a previous article (Read more here), Beneish M-Score, a method to detect potential financial manipulation was discussed.  Beneish M-Score was introduced by Dr. Messod Beneish, an accounting professor at Indiana University’s Kelly School of Business in a research paper in 1991.  For M-Score that is smaller than -1.78 (more negative) is classified as non-manipulator.  Whereas for M-Score that is larger than -1.78 (moving towards zero or positive) is classified as a possible manipulation.

M-Score can be calculated using publicly available information such as financial statement from official annual report.  However, to calculate M-Score for all companies listed on Bursa Malaysia requires additional effort such as big data automation.  Firstly, a database of financial statement for every listed company in Bursa Malaysia has to be maintained digitally.  Secondly, an automation script has to be developed to extract the relevant info from the financial statement.  Thirdly, the extracted data will be fed into the M-Score database for calculation.  Lastly, if further analysis is required, the relevant M-Score info will be analysed by financial analysis.

We have built the M-Score database spanning from 2015 – 2018.  2019 database is work in progress as not all companies have published their 2019 financial data.  Below is a sample of three companies listed on Bursa Malaysia that failed the M-Score test for four consecutive years.

Company	Dec – 2018	Dec – 2017	Dec – 2016	Dec – 2015
PASUKHAS	1.738	- 1.363	- 0.842	- 1.661
PESTECH	- 1.564	- 1.146	- 0.921	- 1.737
ACOUSTECH	- 0.034	2.546	- 1.161	0.965

Fortunately, most of the companies listed on Bursa Malaysia passed the M-Score test for 2015 – 2018.  Below are examples of companies which scored well between 2015 – 2018.

Company	Dec – 2018	Dec – 2017	Dec – 2016	Dec – 2015
ANCOM	- 2.579	- 2.380	- 2.254	- 2.701
CBIP	- 2.259	- 1.807	- 2.094	- 2.439
DIGI	- 2.630	- 2.831	- 2.430	- 2.568
FREIGHT	- 2.747	- 2.147	- 2.432	- 2.855
GENM	- 3.059	- 2.264	- 3.034	- 2.286
IOI	- 2.430	-  2.029	- 2.243	- 2.670
KPJ	- 2.979	- 2.689	- 2.395	- 2.363
NESTLE	- 3.143	- 2.412	- 2.953	- 2.974
ORIENTAL	- 2.645	- 2.796	- 2.146	- 2.553
YTL CORP	- 2.317	- 2.623	- 2.295	- 2.690

To access the full list, selected companies, or in-depth M-Score analysis reports, please contact info@mpcap.com.my for pricing information.