Joe's Investment Blog

The Real Deal of Business Deals and Investments

2010-07-01T03:00:00.013+08:00

Preamble

I have been out on my own for a period of 8 months so far - re-skilling, traveling around the world from Hawaii to New York to Germany and China to shake hands and establish material sources, all the while burning up what little savings I have. And it was only until just recently that I managed to ink my first deal, a small sum that is just sufficient to cover my costs in exchange for a good project reference.

This 8 months has been a great journey, and a very humbling experience. The most important of all my takeaways was understanding the real essence of conducting business in the real world. It is truly something that can never be learnt in classroom, or just talking to friends.

Commonalities in the lines of the greatest investors - importance of management and ethics

It dawned on me why the greatest investors of all times always talk about a similar topic - Phillip Fisher in "Common Stocks, Uncommon Profits" spoke about using the 'scuttlebutt' approach to assess the management team; Warren Buffett spoke a lot in his letters to shareholders about ethics and how a company management ought to behave in terms of being shareholder oriented and proper accounting of options. Or in Collins' "Built to Last", which he spoke of the importance of a management team that focuses on building a clockwork system instead of being ego-centric. I could finally appreciate it all, firsthand.

The essence of a business - people, ethics and responsibility

If one analyses a business, takes away the financial accounts, mysterious cloak of systems and strip it right down to it's most fundamental essence - we are really talking about people, their ethics and sense of responsibility. People run the systems, they select the products and sell their services to meet a real world need. In essence, a business transaction is a case of a client taking a risk on another person to address certain needs, value add, or solve some problems. It does not matter whether the transaction is a few dollars, or millions; what remains unchanged is the trust and responsibility that is placed upon one when money exchanges hands.

A second dimension of business ethics is the treatment of the staff - hiring someone is more than just that getting someone to fill a gap or another hire-and-fire HR concept. It means providing that person a livelihood, a stable income so that he can pay his housing loans and bring the bread home to feed his family. It is an added responsibility on the employer to then ensure that the business is sustainable to keep everyone on the payroll.

Doing business calls for one to have a high order of character and leadership, only then, can one build a strong team around him to effectively run different parts of the business machinery. Only then, can one talk about moving from goodness to greatness.

Conducting investment in the words of a venture capitalist

I once asked a venture capitalist on how he decides to make an investment in business proposal, and he tells me "All business proposals appear similar - payback period of 2-3 years, 50% absolute returns, exit strategy of public listing in 5 years, marketing plans, strategic positioning, etc - almost impeccable. But at the end of the day, the determining factor is my assessment of the person and the team running the show. I just want to know if this person is credible, trustworthy, and responsible enough to make the best of my money" What an enlightening last liner, that all of us always fail to see.

The real deal

In all our stock investments, we should carry with us that same eye for this critical detail - the effectiveness and trustworthiness of the management and the staff. Accounting numbers can be fudged to show stellar PE/gearing ratios, such reports are custom made to impress. So place some focus on assessing the people running the company. The real deal comes when you pose as a customer to walk the production floors, and when you meet the company staff in person.

Re-defining 'Competitive Advantage' - Reflections of a practitioner

2010-02-19T02:03:00.012+08:00

Preamble

I recently took the first step in my quest to build a family business empire with my father. It started when I witnessed how my dad has transformed my uncle's firm from a 250k firm into a 4mil annual revenue firm in just 1 year. So, why not churn the money in our own backyard instead, I thought. The concept then was simple - one has a 30years of experience and business contacts behind him, while another makes up for it with energy, youth and a hunger to learn and achieve. I thought a father-son team is just perfect.

As with any company, the importance of having clear directions on the outset cannot be overstated - it provides the bearings that will keep the company moving forward and not straying out of tracks. And one of the most important question is always to determine where is one's competitive advantage in the slaughterhouse of a free-market system.

I am never a hard-core theoretician; ideas like 'cost-leadership' from those conventional books by Michael Porter and the academics alike never seem to register in my head regardless of how many times I read them. And no, neither is this going to be another chapter from Jim Collins' "Built to Last"; I prefer to form my own ideas/definitions of things from my own experience.

What is a competitive advantage?

Put simply, a competitive advantage is like a moat around a castle which prevents profits from being eroded away from the company. It demarcates and protects one's territories from potential aggressors. Without a moat, you are no different from mediocre rest and it is only a matter of time that you are banished into ignominy by ceaseless tides of new entrants.

A current-day business moat can take many forms, depending on the nature of the business. If you are in a trading/distribution business, an exclusive/sole distributorship will be your moat - you and only you will be allowed to represent/sell the product in a specified geographical region. If you are in manufacturing/technology, patents/trade secrets and technical know-how that meet the needs of the industry will keep the company bloodlines flowing. If you are in consumer-related products, brand and product quality are the ones that will roll in those paychecks for you.

Let's not talk about intangibles like customer brand loyalty, relations with suppliers, etc. These are too elusive and hard to pin some numerical values. We focus the discussion on what can be measured, and controlled.

The real game of patents: you do not own what you cannot defend

A patent is essentially an exclusive right granted by a government to an inventor in exchange for this public disclosure of the know-how. The intent is that the public domain 'body of knowledge' is enriched, at the same time the government has provided a commercial incentive to drive innovation and development in the private sector - the inventor can ask for a fee from anyone who utilizes their ideas. Patents can last for 25 years before they expire and become freely available public information for anyone to use.

The problems with patents is that who to enforce it? No one is going to do the enforcing on your behalf. You can own 1,000 patents, but if you do not have the capability to actively monitor for infringements, have large-sums of money for lawyers to file for litigation claims internationally, these patents are just like academic paper publications.

Moreover, it is never too hard to modify a patented idea and then re-classifying or re-terming it and taa-daa, it's a new idea all over again. If this new idea is highly lucrative, it is a natural magnet that will attract a bevy of competitors who will twist your idea around to create look-alike & then file for their own patent. And if you do not know or have money to challenge them, you lose the game.

So, patents as a competitive advantage? I will rule this out for a majority of the businesses in the small-medium phase, unless I am in the likes of HP (which has a dedicated department just for patent infringement monitoring and litigation claims).

Trade secrets: today's subordinates tomorrow's competitor

Keeping secrets in one's closet is a very challenging act, you need to judiciously monitor your crew to detect any signs of ill-intent. It can take ten years to create your own restaurant brand like Fish & Co, and all it takes are some moments of carelessness and a staff will start another restaurant like Manhattan Fish Market with very similar recipes and menus. Yes litigation claims can take place, and your competitor will take the profits earned to pay for your damages and then life goes on. Today's subordinates will become tomorrow's competitors easily, as long as they have worked long enough and snooped enough details. So, trade secrets as my key competitive edge? It's too weak to stand on its own.

Exclusive/sole distributorship agreements

These agreements have a caveat - generally you will need to sign a supply agreement with the supplier with a promised minimum sale of products worth, say, US$1mil per year. Then you will be offered discounted prices for their products. In the event that you fail to meet the quota, a penalty will be levied upon your company.

Exclusive/sole distributorship are very rare because there are a lot of unwritten penalties on the supplier's end - they will rely on you and you alone to expand their sales and business in that particular geographical region. Exclusive/sole agreements rarely take place in the real world unless you have a very strong and established presence in that industry that the supplier wishes to leverage on. Besides, nothing is really stopping your supplier from using other means like setting up another company to sell his wares to a different distributor.

So, unless you have sales offices all over that particular region and has a very strong marketing ability, securing exclusive distributorship agreements is really just another dream.

The dimension of time, the state of flux and their influence on competitive advantage

These existing competitive advantages function like a moat for any company, but what is often ignored is the factor of time and state of flux. New markets called 'blue oceans' may be discovered as one finds a new societal need or more efficient way of doing things, but over time, barriers to entry break down and entrants enter; new markets become old ones; blue oceans turn into 'red oceans'. These conventional definitions do not take into account the dimension of time and decay. Just as the water in the moats can dry up over time, there is no silver bullet to keep a company going endlessly; no one thing can sustain an entity long enough beyond your productive years.

Therefore, if one seeks to undertake a quest to build an empire from the smallest building blocks, yes you need barriers like the above but they do not last long - you need something that is more durable, timeless, maybe even formless.

My perspective? A concoction of First Mover's Advantage, innovation, and a stretched goal beyond profits

First Mover's Advantage (FMA) is a concept that derives its origins from military warfare doctrine. It is the idea that the one who makes a pre-emptive maneuver and secures key resources or vantage points will be one-up against the competitors. In business, the company to secure a footing in the provision of a new product, new service, or in a new market - wins. Because the company will have established a reputation and a track record of being tried-tested-proven as well a good front-to-back-end systems, while the rest will now try to play catch-up.

However, FMA will only guarantee the company an initial advantage; it is only a matter of time that other companies will catch up - the speed of your competitors correlates to the lucrative profits. As barriers to entry break down, you need a strategy that is more than FMA to stay afloat.

Although this sounds cliche, it is quite the truth: the importance of innovation cannot be overstated. Put simply, it means a spirit, an attitude to constantly seek new ideas, new ways of doing the same thing, new products, new solutions; inventing and then re-inventing. Only then, can you be ahead of your competitors. While everyone is grappling with playing catch-up, you are in front of the game.

But innovation cannot stand on it's own - the underpinning structure has to be one that is currently a profitable venture with excess to spare. And more importantly, it has to foster a certain related outcome that is oriented in an aligned direction. The company leaders must also aspire for a stretched goal that goes beyond profits - one that may not happen in the next decade. It is this goal that will drive it forward to new unexplored frontiers, keep it churning ceaselessly. It is also this goal that will help to draw in and retain the best talent.

Building an empire is not an easy task, it will take a lifetime of dedication, day-to-day persistence, hard work, a strong committed team of employees, plenty of goodwill with everyone in the industry, and a little bit of luck to top it off.

The game that public listed companies play

2009-10-13T00:12:00.018+08:00

I recently got to know an Indian businessman who hails as a managing director from one of the leading solar companies back in India. Through some discussion with him as an experienced practitioner, someone who has been through the ups and falls in business for the last 25 years, I gleaned new insights. This is a man who is of exceptional drive, outstanding salesman pitching skills, voracious appetite for opportunities anywhere in the world.

He simply made one simple comment, "You know Joe, managing a public listed company is a totally different ball game from that of a privately held company." I pondered on what he said while he just smiled at me with his shrewd eyes looking straight at me - what a simple yet immensely profound statement that was.

Company equity as the most valuable asset to any businessman

For the true businessman, the company entity is usually synonymous with the founder and it is unthinkable to divorce into two distinct entities. The company is the work of the founder that is built upon endless years of toiling and tears, and what the businessman have is equity in the company, which should be his most valuable thing. Therefore, equity in his own business should always be the last thing that a businessman will want to part away with.

This begs the next question then: when should a businessman part with equity? This will be based on a question of cost/benefit. According to business startup professional consultants, (I happen to know one who is actively teaching in NUS), there are certain pre-conditions that must be met before a businessman considers parting his equity: firstly, the other party shares the common vision for the company; secondly, this new partner either brings value to the table through capital injection or has a set of skills/knowledge/contacts/reputation that will bring the company another quantum leap forward; thirdly, rewarding loyal and capable staff - you part a bit of your equity to someone who has stuck with you through thick and thin, so that you build a sense of ownership and loyalty in them.

Of course, be mindful that good friends does not mean good partners. Friendship should never be the basis for setting up a partnership. However, alternative means of showing appreciation like profit-sharing schemes can be adopted.

The sad fact of life

Ask the experts and they will say, "the most profitable companies are usually privately held companies". This makes perfect sense that a passionate businessman will definitely want to keep a dollar-churning machine in his own backyard, quietly generating returns for himself. A highly profitable business can grow organically by rolling it's own profits year over year; it can finance it's own expansion.

I am a skeptic. After meeting a few dynamic and shrewd businessmen who have been in their fields for 20 over years, I tend to believe that all businessman who go for public listing of their company are looking to cash out of their own business, either partially or fully, for a tidy sum. It is a form of exit strategy basically. But all of them will nicely hash it under the lovely reason of raising capital for expansion. This may not be necessarily true for all, but definitely, I will say it applies for 90% of the case. Put me in that situation, I will do the same too. Idealists, face it, this is the sad fact of life.

Playing the game of a public listed company versus that of a privately held company

Allow me to illustrate this in a simple example: in a private company, I will not sign a deal of US$20million if I know I am going to suffer a loss of US$2million; it makes zero economic sense for me. BUT, in a public company, I might consider signing that deal even though it will make a loss. Imagine this: holding a press conference to announce that I have signed a US$20mil deal; media splashes this in the front page, stock price skyrockets multiple folds over the next few days, and I can sell off some shares for a pretty tidy profit. In good times, news of directors selling off stakes are glossed over in the media by the reported US$20mil deal and the US$2mil loss will not surface in the annual reports until the contract is completed in say, 3 years.

And wind it forward. 3 years from now, the business cycle is now in the recessionary stage, share prices dip a lot in general, I report a loss of US$2million, I tell the public, this is inevitable as the whole industry is suffering from a economic recession and the company is not spared either, but we will do our best to maximize shareholder's interests. Then I take advantage of the situation and buy back my company shares as equity is much cheaper now, and this puts out a very favourable signal for all investors because they view insider buying as a positive sign. In the end? The company signed a loss making deal, but I made a profit from selling out at high prices and then increasing my stakes back at a lower price. No one will possibly ever know that I signed a loss-making deal that costs the company US$2mil.

That's the key. The game of a public listed company is played through the eyes of the media, a strong public confidence in the company precedes, if not, is as important as the real profitability. Without strong public confidence, you risk major investors in the company starting to sell out their shares and jump ship, bankers may start calling up to recall loans or re-rate your credit standing, cut your credit line, suppliers start losing confidence and will accept no deferred payments, only cash upfront. This starts a downward spiral that ultimately affects the company cashflows and ultimately threatens its survivability. You need to tightly manage public expectations, if not, there will be a serious backlash. Based on my past few years observation on SGX, companies that keep an active and well-managed public relations (PR) with the media and the analyst agencies respond better in terms of stock prices to any company announcements like 20% profits, etc. But to the companies that purely focus their efforts on their core business, their share prices seldom budge.

In contrast, the privately held company accounts to no one by the businessman himself, he owes it to himself to keep his balance sheet strong and cashflows positive.

Game over for the retail investor? No, put your eggs in the basket still, and watch out for any danger signs

The same old mantra applies, company CEOs that frequently feature in the financial headlines for days after days, beware beware beware. And take note of companies that have a sudden change in key appointment holders like the CFO resigning just weeks before the results are released. This is a serious indication that there are some major moral/principle disagreements between the board members (e.g. distortion of reporting the truth in financial statements)

It does not mean we should stay away from investing in public listed companies too, because there are still a lot of credible and serious businessman out there who truly need that capital for expanding their market presence. We can partake in the expansionary journey and make our hard-earned money work harder for us. And of course, you are in safer hands of a company that quietly makes its profits, distributes it to shareholders quietly, silently develop new capabilities and market them, stays away from the limelight of any public media.

Wanna stay in the game? Keep to those sagely rules of thumb of smart investing.

Cigar Butt Picking and S-chips

2009-09-08T22:47:00.010+08:00

What are 'cigar butts'?

'Cigar butt' is a termed coined by Warren Buffett, the world's richest man. It refers to listed companies that are good for just "one last puff", and one school of thought in stock investment originating from Benjamin Graham (aka founding father of value investment) is to pick up cigar butts, or stocks that are trading at a net tangible asset value that is higher than its current stock price. That is like equivalent to buying an asset at less than what it costs, with little regards for the profitability or stability in cashflow generation of the company. This is done in the hope that one day, when business turns arounds, the share price will appreciate enough for the investor to sell off at a decent profit - that is the "one last puff" Buffett was referring to, otherwise also termed as a 'net-net' share.

The obsolescence of 'cigar butt' - seeing value beyond apparent value

This philosophy of 'cigar butt' persisted for many years, but this was until Buffett met his good friend Charlie Munger, who is instrumental in shaking up the archaic foundations of value investment philosophy net tangible assets as the premise. Munger, a corporate lawyer, had plenty of experience in corporate law matters and he is the person who brought a brand new investment paradigm by insisting that intangible but real aspects of a business must be taken into valuation. These intangible aspects include the brand value, goodwill with existing suppliers and customers, and the reputation of the company; valuing a business based on net tangible asset (NTA) value paints an unrealistic and obscured picture of the company. It was Munger, who made the frugal Buffett believe that it is worth paying a much higher price for See's Candy that has tangible assets worth less than its current share price.

The risks of cigar butt picking and value investments

I was having an "intellectual sparring" with my younger brother about the philosophy and methodology of investing. My younger brother is a value investor who adopted the idea of "collecting as many cigar butts as possible", whereas I am a person who adopts multi-faceted perspective on the valuation of a company. He shared with me his extensive research into this SGX listed company called Changtian chemicals that is trading at like Price-Earnings Ratio of 2 (i.e. theoretically the company only takes 2 years of pure profits to match its current share price -> this is a ridiculous market valuation because the median of PE ratio is about 10~15 for SGX) with little current liabilities and hoards of cash, trading at 'net-net' price. Changtian Chemicals is a China-based company that is listed in Singapore, market players call them 'S-chips'. PE of 2 and NTA more than price -> Such kind of statistics can give you a very sizable safety margin that Buffett (pre-Munger era) might raise an eyebrow at first glance, but a closer examination and Buffett might just say otherwise.

Why not cigar butt picking for S-chips?

Firstly, the value investor in Singapore is already significantly disadvantaged as compared to counterparts in the United States with a very sluggish market response to good undervalued stocks. Experienced folks will tell you that value investment is for the long haul, requiring a patience of at least 2~3 years before the market re-prices the stock. Even then, there's a very real risk of de-listing, or acquisition by private investors who have the financial muscle to offer the retail investors ridiculously low price offers. There have been so many classic examples, like Pokka (see here), because the market has persistently shown its disdain for such a boring business, the parent company in Japan has decided to delist.

Secondly, there is a significant number of corporate scandals for S-chips in recent years, including big giants (or so, as touted by the media) Ferrochina to China Aviation Oil. Unless you really understand the company and the industry inside out, there is good reason to doubt the integrity on any S-chip company. Even if the companies like Changtian prove to be honest businesses, the scars of these scandals will overshadow everything else and it is very likely an impossibility for the market to re-price and allow you to encash your investment in the next 5-10 years.

So, cigar butt picking for S-chips? Beware, you may never get that one last puff.

The End of A Beginning

2009-03-22T22:23:00.012+08:00

Evolution of investment approach into a higher order

It has been some time since I submitted any additions to my own investment blog. I should say my interest in investments and businesses has evolved to a higher order. From being a keen third-party business observer and investment analyst to actually blazing a trail of my own - I am leaving my cushy job as a well-paid aviation engineer, to venture into real estate development in China with my Dad.

The salaried investor is immune to business risks of their investment holdings, whereas, the traiblazing businessman shoulders it all - the risks, the pain, the failures, the profits, the joy of being in control. Moving from a 3rd party investor towards being the businessman, investor all together - that is definitely an evolution of an investment approach to a higher order.

Taking stock

My holdings

Till date, a majority of my savings are held up in big stakes in 3 key companies: Adampak (largest), ASL Marine and Apex Pal. All of which are purchased in recent months at rock-bottom prices and all of which I know are in safe good hands of a keen management holding majority stakes. I will continue monitoring the performance of these few companies. In particular mention, Adampak, if it can indeed live up to its expectations as a crown jewel in the waiting.

Development of a sound investment philosophy

This blog has served me well. It has provided me a good forum to articulate in crystal clarity my own investment methodology and the how-to, from the mental model to the initial stock selection to an eventual decision to lock in. And it should serve others well too. I think that what is articulated here is self-sufficient, like a little Swiss Army Knife, for anyone to jumpstart on the ins and outs of investment. For the accidental surfer who knows nothing about investment but keen to know more, read the articles, and the samples on Adampak, which provides a good model of how in-depth an analysis should go - beyond numbers and reports.

Looking forward

Looking forward, it is not likely that I will have regular postings to this blog. But do not be mistaken, this is just the end of a new beginning. When inspiration and new insights are gained in terms of business or investment philosophy, I will have fresh postings. Wish me well, and thanks to my blog readers.

Cooking a recipe for an excellent investment opportunity

2008-11-11T01:48:00.023+08:00

This article builds upon what was addressed in Investment Methodology. All the articles should neatly sum up what I believe defines an excellent investment opportunity from a business perspective. For the uninitiated, this series of articles are probably useful as a start read, but for the seasoned value investors, perhaps you can look elsewhere (or share your thoughts via comments/shoutbox)

Disclaimer: The belowmentioned recipe cooks a soup not for the faint-hearted or the ordinary man on the street.

Reference material: The Intelligent Investor by Benjamin Graham, Common Stocks Uncommon Profits by Philip Fisher, Built to Last by Jim Collins

The First Ingredient of an excellent investment opportunity: Outstanding Management

The directors own a significant stake in the company, increase their stakeholdings over time and never sell out any single stock.

The intent of going public listing must be to purely raise capital and still retain control to expand the business further. It must never be a case of a shrewd businessman who desires to sell-off the business and start washing his hands off for retirement with millions of dollars from the equity issuance. Knowing that a director has a significant vested interest gives the retail investor an added assurance that the directors take complete ownership in ensuring the company's profitability. Also, it is desirable to know that the directors never sell down his stakes and instead continues to buy in when prices are depressed.

The management stays within its circle of competency and does not diversify into areas of business that they are not familiar with.

If the company is good at producing bubble gum and has been doing so profitably for the last 20 years, that is their circle of competency. I would not expect them to diversify into unfamiliar industries. This dilutes their area of focus and it is also much more difficult to perform valuation and business analysis. A company that produces soft drinks and also invest in investment property clouds the financial statements too much for a valuation on ROE to be accurately measured. Likewise, a company that is adept at producing beer should continue to develop to eventually achieve world domination in the beer industry.

The directors are humble people who stay out of the media limelight

Based on a whole spate of scandals of directors in listed companies, it has been quite obvious that CEOs that bask in the media limelight, with so many public interviews and constant stream of over-promising news have been correlated to an issue with integrity. Hence, this theory of good directors stay out of media limelight has a certain element of truth in it.

The directors are prudent people who avoid using derivatives and complicated financial instruments, and are very transparent in their financial records

This is very arguable. But given the difficulties where accounting methods and standards were not originally designed to accurately reflect such derivative instruments and coupled with the risk arising from internal control and possible abuse, I would prefer corporations that stay away from such financial instruments.

Financial records tell a million tales. Directors who accord a high degree of transparency in the accounts allow the retail investor greater insights of the business. We may be informed that the company has grown it's revenue 20+% for the last year, but for a good investment valuation we would also like to know how the various market segments and different product ranges have performed. Some companies provide good resolution, while some do not as it is not a requirement in Singapore's Financial Reporting Standards.

The company grows the leaders from internal succession planning, not through a 'musical chair' change of white knights

There are many case studies of how the descent of white knights bring about a turning point in the companies, like how Carlos, who serves on both Renault and Nissan as CEO, manages to turn Nissan around in a matter of years with his visionary ideas. But I would prefer that the management team are the ones that grew up together with the company. Such people are the ones who knows what works and has been working well to bring in profits; they are the ones who have a closer rapport with the entire company crew.

(This is an interesting trait that Jim Collins concluded in his empirical study of all the NYSE companies, as written in Built to Last. He and 60 graduates performed a thorough study that sifted through all NYSE companies to identify the winning traits of a 100-years-old corporation. It was concluded that corporations that last beyond a lifetime of profitability promote the CEOs through internal succession and growth. Corporations that rely on a white knight usually rise fast but vanish into oblivion like fireworks.)

The Second Ingredient for an excellent investment opportunity: Outstanding Business

When Warren Buffett acquired Berkshire Hathaway, it was an almost-drowning textile company. But he repeatedly injected fresh capital in a bid to revive the flagging business before finally arriving at a neat conclusion that is subsequently widely termed as "flogging a dead horse" - you can change the management team of any business, but you will not be able change a business with poor economics and prospects. Having an outstanding business is another ingredient for an excellent investment opportunity.

High barriers to entry; high returns on equity, high profit margin for the last 5 years

A good business must be one that possesses a strong moat to prevent an erosion of its profitability. It must be sufficiently difficult to break into the market either because of the complexity of the business or the brand and reputation of the incumbents are immensely strong. Companies that own rubber plantations are also ruled out here because the barriers to entry are so low and the companies have to compete on being the lowest cost producer.

Large corporations which are blue chips generally produce lower returns on equity by virtue of their size. As an investor, I will prefer a company that is at its growth stage and have a very high returns on equity for the last 5 years.

Asset light, conservatively financed, powerful cashflow generators

Companies that are heavy in assets require an immense amount of capital to generate revenue. An example is airline companies that own million dollar jets. And usually, such companies have a comparatively low holding in cash type assets. This makes them immensely vulnerable in times of economic recession. What is happening to US airline companies now is self-evident: where they are seeking for mergers or takeovers to survive declining revenue due to declining passengers; without which business continuity is in question.

Companies that are powerful cashflow generators are the ones that can grow organically with minimal debt or necessity to raise capital through issuing capital. They are either providers or high value services like event management or creative designs, or they can be those that rely on a few machinery that run 24-hours a day to generate a disproportionately large amount of revenue.

A case in point

Have you not forgotten the days in the recent past where we hear of U.S. airlines failing and seeking mergers? It's the same thing. The airline industry heavily rely on high cost fixed assets to expand their capacity and grow revenue, with low operating cashflows. This inevitably makes then immensely vulnerable in bad times.

The Third Ingredient of an excellent investment opportunity: Outstanding Value

Significant margin of safety, extreme market pessimism

You can elect to own a part of an outstanding business run by an outstanding management at a fair price and it is still a sound investment decision. But being able to own it a significant discount in terms of price to intrinsic value makes it an outstanding investment decision. You have a good margin of safety for provision of errors in estimates, and you can sleep soundly at night.

Such moments of good value will only emerge when the market is extremely pessimistic about the future outlook of the economy.

Measuring value using a summation of free cash flow discounted to present day

Buffett and various value investing thinkers have conceptualised the measurement of value as such: the company's intrinsic value is basically a summation of estimated cashflow that will be generated over a period of years and discounted to present day prices by factoring in risk-free rates and inflation.

The components of this cashflow or free cashflow is basically: operating cashflow - estimated annual capital expenditure - estimated depreciation expense.

Why the presence of the annual capital expenditure and depreciation expenses? Machines break down over time to a point of beyond economic repair, and capital has to be continuously injected over time to replenish the production capability. Also, such machines are usually capitalised as an asset on the balance sheet and the cost is slowly expended off from the books using accounting depreciation methods; an accurate measure of incoming cashflow has to account for this.

What about company operating in the red?

For companies that are operating in the red for the short run with negative cashflows, the discounted cash flow model cannot be applied to obtain a quantifiable measure of the value of the company.

Under such situations, discerning true business value from a bad business operating model requires astute judgment. It requires the investor to examine the existing business and market conditions. A qualitative assessment has to be made: (a) Are the losses accrued to a weakening in business fundamentals of shifting market demands, profitability, cost-push reasons, leadership capability, or other hidden reasons? (b) Or are the losses a temporal condition due to rapid expansion or internal restructuring and the effects are not likely to persist in the longer run. And given time, the business will surge forward?

Such kind of investments are only for the stout-hearted investors who are able to see value that is beyond apparent value.

Concluding Remarks

All three elements are crucial in identifying an excellent investment opportunity - the Man, the Machine, the Moment. No single element stands on its own. When rigorously applied, one should be able to seek out conservative, and yet excellent investment opportunities.

As usual, your mileage may vary (YMMV).

A Cursory Study of Derivatives and Financial Accounting

2008-10-19T10:40:00.029+08:00

The Sage of Omaha dubbed derivatives as the weapons of mass destruction (read: Warren Buffet on derivatives). In fact, derivatives, specifically credit default swaps, are the instruments that are responsible for the recent financial crisis that vaporised billions of dollars from the global financial system.

And as I read more and more annual reports of companies, I repeatedly encounter derivative financial instruments that were accounted for in the balance sheet. The point to note here is that it is not unusual to notice that a small amount is reflected in the balance sheet under 'Fair Value adjustment of derivative financial instruments', but if you dig deeper into the financial footnotes (which is buried deep within the annual report), you will notice that the contract notional amount dwarfs what is stated on the balance sheet by many times. e.g. a fair value adjustment of S$10mil, but the notional contract amount is S$300mil. To the lay investor, such large variance in declared numbers versus 'buried' data does makes one wonder if the company has been cooking the accounts a la Enron style.

Derivatives: What are they?

The intent of derivatives is to reduce the risk of one party and "eliminate bumps for one party", as how Buffett coined it. The value of such instruments are dependent (or derived from) on the underlying value of other financial instruments, hence the name derivatives.

There are three major classifications for derivatives: options, forwards/futures, swaps. In modern day economics, all three elements feature in a company's financial statements. Options (or rights to buy) are given out to employees as part of their Employee Share Option Scheme (ESOS). Forwards/futures are employed by companies to derive some form of stability and predictability in commodity or currency prices for the next few years. Swaps are used on interest bearing loans so that the companies can swap floating interest rates with another party in return for a fixed interest rate.

Futures/forwards and swaps marry the demands of two different groups of investors: one who desires stability, and another who desires to profit from the speculative movements. But in any case, as a whole, it's a zero sum game in the transfer of wealth between both parties.

Such derivatives are either traded over-the-counter (OTC), i.e. private deals that are executed by market makers, or through an organised exchange like NYMEX. In over-the-counter contracts, it's basically a legal agreement between two parties without going through any intermediary. For swaps, over-the-counter deals are the most common method of transaction. For organised exchanges, typically a margin account is opened and a collateral is placed as a form of guarantee.

Forward/Futures contracts

Here's why companies will consider futures/forwards: currency rates and commodity prices (e.g. steel) fluctuate significantly. If a company frequently have to deal with foreign currencies or buy commodities in its day-to-day operations, it makes sense for the company to have some form of stability and predictability in its income sources by entering a forward contract with another party. In this way, risks in price movements are removed and the company does not have to constantly worry about costs increase over the short run.

Basically, two parties will arrange to come together and agree on a price of the currency/commodity to be exercised at certain time in the future. As a form of mutual assurance, an asset is placed under collateral by both parties, i.e. in the event of default by one party, the collateralised asset will be seized to fulfill the original promise.

Interest Rate Swaps

Companies take loans, which banks offer at floating interest rates, dependent on the monetary policy of the central bank and the market conditions. However, if the company also desires to enjoy some form of stability and predictability in its interest payments, they can enter into a contract with another party where their floating rates are swapped for a fixed interest rate.

Points to note about derivatives

Counter-party risk

Transactions executed over-the-counter have an underlying assumption: both parties are able to honour their financial obligations as stated in the contract. However, in the event that either party is unable the service it's obligations, then such a mechanism will have failed as a risk management tool and the affected party will then have to pay at the existing market rates.

Collateral and creditworthiness

Forwards/futures are based on an underlying collateral asset as well as the creditworthiness of the company. This meant that the company is exposed to additional risks: in the event that the underlying collateral asset loses value significantly, or the company's credit rating is downgraded, it may be enforced upon the company to "top up" its collateral within a short span of time. Without which, the company will face liquidity problems; assets will then be placed on fire sale prices, and the company may face bankruptcy.

Preclusion of any favourable fluctuations

Since a certain fixed value is locked in, engaging in swaps or forwards/futures also meant that the companies are precluded from enjoying any favourable fluctuations. And such are clocked as "potential loss" or "net negative gain on fair value adjustment'

Financial loopholes

Such derivatives can be buried and made invisible in the financial statements. What the company simply has to do is to create an associate company or subsidiary and hide the accounts for such derivatives within. Large amounts of assets can be placed as collateral for derivative trading, and what only appears is a change in the net asset value of the associate company with no mention of derivatives at all in the entire annual report. In fact, this is how a lot of companies in US went under in the recent past, and the public is kept in the dark all the while.

Potential Pandora's Box

In the wrong hands, derivatives can be very dangerous tools. If there are insufficient controls in place, a rogue trader in the company who is overly empowered to leverage and make decisions for selfish reasons can easily bring a company down to its knees overnight. Take a look at this latest piece of news, look at how 3 rogue traders vapourised US$81 million from the company and made attempts to cover it up.

Derivatives gains and losses as a distraction

Gains or losses of derivatives are mandated to be reported on the financial statements and are subject to public scrutiny. Such gains/losses can grow to become a very major distraction to the company management. Instead of focusing on growing profits from operations, what is feared is that the management will direct more attention at at growing their accounting profits from derivatives trading.

Valuation of derivatives

Singapore follows the standards, word for word, as set by International Accounting Standards Boards (IASB) (read here). Under the accounting rules as stated in IAS39, the companies are required to measure the value of the contracts based on the prices in the market at that point in time, and this is also known as fair value and mark-to-market accounting. The net change in the value of the contract is then reported on the balance sheet as "net fair value adjustment of derivative financial instruments".

The profits or losses accruing from this realisation of fair value are then reported on the statements. However, in reality, such losses are just opportunity cost as a result of the company's decision to hedge against fluctuations, while the one time extraordinary gains are pure luck due to market movements of currency or commodity prices.

What to take note of

For an accurate measure of intrinsic value, businesses must be valued based on their operating profits, such one time extraordinary gains arising from derivatives sales are not to be taken into consideration. Conversely, when a company reports losses, the keen-eyed investor must be sharp enough to discern these "potential losses" from actual losses accruing from operations.

My final comments on derivatives: Beware, Beware, Beware

Swaps and futures/forwards are double-edged swords: the outcome of the use of it hinges a lot on the person who wields it. Companies that employ such derivative financial instruments must use it only for risk hedging. However, this is very difficult to ascertain and such companies are deemed to be more risky. It's never a comforting thought that an internal rogue trader can bring about the collapse of the entire company overnight through derivative trading. So, to avoid having any sleepless nights, one should refrain from investing in such companies. It is little wonder that Warren Buffett shut down an arm of derivatives trading in one of his businesses.

So, to invest? Or not to?

On this point, I hold a different view from the Sage. All investment decisions are made based on a simple baseline of risk-reward: such companies should be considered for as a worthwhile investment when the value proposition in terms of risk-reward spread provides an extremely compelling argument. The marginal increase in risk has a corresponding large increase in potential returns.

1. there is an impressive profitability of more than 20% sustained growth
2. high margin of safety in the comparison of price/intrinsic value and Book Value
3. sustainable competitive advantages and barriers to entry are high

To mitigate investor's risks arising from the presence of derivatives to an acceptable level, the companies must fulfill the below conditions, over and above all the other criteria for a high quality company:

1.The directors hold very significant stakes in the company, in excess of 50%.
2.The directors have sufficiently demonstrated that a robust system of controls and check-and-balance is well in place to prevent systemic abuse of derivatives.
3.An esteemed chartered accountant sits on the independent board of directors to provide for check-and-balance.

As usual, YMMV.

(For further reading on derivatives, check out this wikipedia link)

A Cursory Study of Real Estate Investment Trusts (REITs)

2008-10-09T00:01:00.016+08:00

As the global financial crisis continues to deepen, I continue to dig deeper into my wallet to do some shopping. What struck me is that there are many SGX-listed stocks that are trading below their Net Asset Value, and many of such stocks belong to the category of REITs.

Disclaimer: the author is not vested in any REITs

A short synopsis on REITS

Real Estate Investment Trust (REIT) is basically a collective investment scheme where funds are raised through an equity fund raising, and the money is then placed in the hands of managers to invest in high quality real estate. The rental income and returns from such real estate investments are then distributed back by a certain mandatory percentage to all the investors in the form of dividends. In essence, for the retail investor, investing in REITs is like investing your money in a small part of a large property like Suntec City mall.

Key Characteristics of REITs

REITs allow the general public to enjoy all the benefits of owning a property at a small cost, and at the same time, enjoy the liquidity of a listed stock.

In a way, REITs are like mutual funds – a large pool of investors concentrate a pool of money in the hands of a few managers who will invest in real estate on their behalf. However, the key difference is a much higher level of transparency and accountability: (1) all transactions of the REITs are made known publicly, but transactions of the mutual fund managers are not made known to the public (2) the management of the REIT is made known and any changes in key appointment holders are to be made known publicly, but for mutual funds, the managers are faceless and nameless.

Funding Model of REITs

Companies are either funded by equity or by debt. For REITs, it is not unusual to find that they have a very high debt leverage i.e. REITs use large sums of short term borrowings mixed with funds raised through equity to purchase high quality assets and generate cashflow through rental income.

As almost 90% of the rental income is mandated by law to be distributed back, and 10% and less is retained, it is impossible for REITs to grow organically through internal cashflow generation. Therefore, REITs are only constrained to raise funds in a few ways:

(1) Sale of properties that have appreciated in value

(2) Borrow through either long term of short term debt

(3) Issue new shares and raise funds from the public

Each of these options have their own disadvantages and limitations. As the retail investor, you have to be savvy about REIT’s funding model.

For (1), sale of properties that have appreciated in value means that the management must have identified other real estate opportunities to invest the excess cash, or else it will be distributed back to the shareholders in the form of dividend. This will mean that the asset base of the REIT is drawn down.

For (2), increasing the borrowing means that the risk free rate (or opportunity cost) per share correspondingly increases. Also, a greater sum of interest payments are made to the bank regularly. However, if the management is able to use the leverage to increase the dividend per share and net asset value, then this is a good option.

For (3), I view it as the least desirable of all the options. Suppose when the stock market and economy is having a downturn, opportunities for bargains abound and it is perhaps the best time to buy properties. But because share prices then are depressed, a lot more shares have to be issued to raise the same amount of capital, this in turn, brings about a greater dilution to existing shareholders’ holdings.

If you are a retail investor who is not keen to continually increase your investment holdings, equity fund raising is the greatest bane of them all. For you to participate and maintain your percentage holdings and the dividend rate, you will have to invest more money by subscribing to the new shares. If you choose not to participate, your per share asset worth is diluted, and your dividend rate is reduced. To the layman this can just mean, “Just put more money in, I will return you with a higher dividend. But if you don’t, your dividend rate will naturally have to decline due to dilution”

Therefore, for this option, the management should have a very compelling reason to raise such funds to purchase these assets.

From my perspective as a retail investor, the more desirable options are (1) and (2).

Debt Structure

One point to note about REITs is the debt structure. This is a critical determination factor on whether the REIT will face cashflow or financing problems in the next few years. Typically, the REITs will take up long term debts that are due after several years. The area of concern is whether, the REITs target for a 'bullet repayment', or a gradual instalment repayment. If it is a bullet repayment, which normally is a very large sum that the REIT cannot afford to pay down, the REIT will be faced with three options again: (1) raise funds through equity issuance, (2) sell off one key asset to pay off the loan, (3) extend the debt with the bank.

Further to what was raised in the previous paragraphs, (1) and (2) are heavily dependent on the economic conditions during that point in time where we know it's uncertain. If the industry is doing very badly, the REITs may have problems selling off their assets at good prices to pay off the loans.

Another critical factor for REITs is the credit rating by external agencies. This is because banks use the credit rating to determine if they have to tighten or loosen the loans to the REIT. Due to the high debt leverage of REITs, and low level of current assets, in the event that banks lose confidence on the REIT manager, what we will witness is a 'run on the REIT' and the REIT will have to bankrupt itself by quickly selling off all its long term assets to pay off the bank liabilities.

Valuation of REITs

In light of the characteristics of REITs, the dimensions in valuation and areas of focus in carrying out analysis varies slightly from that of the usual publicly listed stock. This is primarily because directors of REITs are paid a management fee and normally do not have a significant vested interest in the REIT itself.

Without this comforting factor of “directors will swim and sink with the rest of us”, there is ample room for them to mess around the financial regulations to their own selfish interest and at the expense of the trust of the retail investor. For example, if the cashflow generation from the assets are detected to be weak, the management may decide on a stopgap measure like issuing more shares on the pretext of raising funds for acquisition, but the funds are then used to be distributed back to shareholders in the form of dividends.

The valuation of REITs will have to place a strong emphasis on measuring the quality of the management, and detecting any incoherence in policies.

Over and above existing financial indicators like Net Asset Value (NAV) per share, Distribution Per Unit (DPU), dividend yield, Leverage Ratio, Debt structure, Cashflow, we have to examine the track record of the managers in the following aspects:

(a) The number of times management sought to raise capital through issuance of shares or increment of debt, and has this over time translated to higher DPU and higher NAV. Also, take particular notice of whether the assets purchased through equity issuance are contributing significantly to the asset worth and DPU with high occupancy rates.

(b) The ability of the management to identify good property investements, and to convert them into profits by selling off, and then using the money to buy into other properties.

Variations of REITs

One interesting variant of REITs are shipping trusts. The key difference is that the funds raised are used to purchased ships for chartering, instead of buying land and property. Likewise, the rental earned from chartering are then distributed back to the shareholders.

But there are a few primary differences: (1) the ships bought by the shipping trusts have a fixed service life of 20~30 years. This means that the ships are subjected to depreciation in value over time, until it becomes scrap. This has to be factored in the valuation (2) do not expect the asset value of the ships to appreciate significantly in the secondary market. Unless there is a dire demand for ships, I do not expect that these ships can always be sold off at a profit to other shipping firms. (Perhaps locally listed shipping trusts like Rickmers Marine and First Ship List Trust may prove me wrong)

Concluding remarks

REITs can be good alternative investment vehicle, what really matters is that one must have performed your due diligence to discern a high quality REIT from a low quality and dubious entity. With the convenience of the stock market, the value investor can exploit the wild gyrations of the stock market to his advantage by buying in at low prices. At low prices, the corresponding dividend rate is increased.

For further reading on REITs, do check out Wikipedia.

As usual, YMMV.

Three Signs of A Market Soaking in fear

2008-09-26T23:25:00.010+08:00

Times have been extremely chaotic. There are some glaring signs of immense fear that signals for the value investor to awaken from hibernation and pick up some bargains:

1. Long queues outside financial institutions

When the sub-prime crisis brought about a possible collapse of AIG, the local policyholders started surrendering their insurance policies despite repeated calls from MAS that everyone's money is safe. Investors started dumping their holdings in the stock market for fear of greater implications to come. We read of news where policyholders said that they felt "safer in having cold hard cash from AIA." This a definite sign of mass panic and investors riddled with immense fear.

2. A wildly gyrating stock market that fluctuates +/- 10% or 1000+ points over 5 days

Dow Jones Industrial Average swung by a difference of 1000+ points over a short period of 5 days, driven by a mere piece of news of a possible US$700b bailout plan by the US government. This is a colossal move of 10+% in a matter of days and is purely irrational behaviour.

3. Do you also feel the fear and stampeding tremors too?

The fear of a financial meltdown and currency fallout was so prevalent and real that at a point in time even I, an ardent impassioned and rational person, was influenced to think that it might be a wiser choice to stay by the sidelines and do nothing but hold on to cash.

Fear is such a powerful weapon, where there was once I started doubting my own judgments. It was an immense internal struggle on whether to-act or not-to-act. However, the better half of me eventually won: I decided to make a move now.

Be greedy when everyone is fearful

The greater the fear is, the greater courage the value investor must have to act in a rational manner that will go in the opposite direction of the stampeding herd; only then will he be able to reap gains when the time comes.

This reminds me of how Warren Buffet recently acted to acquire a US$5b stake in Goldman Sachs.

As long as (1) the financials of the company have been evaluated to be sound, and (2) there is a significant margin of safety in the price to intrinsic value, and (3) there are good prospects and growth drivers for the company to grow continuously even in recessionary years, the value investor must trust in my own independent judgment and make decisions based on that.

I have started to do my shopping. Have you?

A Cursory Study of Eu Yan Sang

2008-09-21T10:48:00.015+08:00

Eu Yan Sang strikes me as a very interesting business proposition. Apparently, in the entire Traditional Chinese Medicine industry in Singapore (and probably the region as well), the only well-known brand is Eu Yang Sang. This definitely warrants a further investigation into the entire business.

Disclaimer: The author is not vested. YMMV.

Industry Overview

When Traditional Chinese Medicine (TCM) was introduced, it was initially not well received by the masses and the medical fraternity. It was then believed to be 'alternative medicine', where the effects of the medication are hard to measure and difficult to draw correlative conclusions. But in recent years, as scientific methods of measurement advanced and studies were conducted on various aspects of TCM, the medical fraternity grew to recognize the benefits of acupuncture, traditional chinese herbs, and 'tieh ta'. We are witnessing a tectonic shift in perspectives of TCM; the paradigm shift is slow but definite.

The traditional chinese medicine industry worldwide is highly fragmented with so many small and unknown players, countless unknown brands of Chinese medicine. Besides Eu Yan Sang, there are no other brands that I can associate TCM with at the moment.

Company Synopsis

Eu Yan Sang's business proliferates all aspects of TCM ranging from clinics to products and herbs distributorship. The company has created a strong retail brand, incorporated scientific methods of measurement to ensure products are of high quality and consistency, established trained general practitioner clinics. In addition, the company has established distributor and retail channels to sell their TCM products which include Bak Foong pills for pregnant ladies and bird's nest drink.

Over the last couple years, Eu Yan Sang made efforts to tap into the growing numbers of health-conscious people by setting up a large concept store of Red-White-Pure, like a one-stop hub for all things related to TCM, ranging from dining to therapy and retail galleries. However, this endeavour failed miserably. A simple google on "red white pure" and instantly I got to read so many yucky reviews on the restaurant food.

Competitive Advantages

1. A strong brand in retail products

Eu Yan Sang has a very good brand in their retail products. Ask any shopper what products/brands they associate with TCM, and Eu Yan Sang naturally comes to one's mind. The other customer touchpoints of clinics and herb distributorship further reinforce the brand of Eu Yan Sang.

2. Sole distributorship for world's finest ginseng - Wisconsin Ginseng

Wisconsin ginseng is famous for being the world's finest form of ginseng with the highest concentration of gisenocides, a chemical that makes consumption of ginseng highly beneficial to the health of human beings. In 2006, Eu Yan Sang managed to secure from the Board of Wisconsin Ginseng a right to exclusively manage, distribute and sell Wisconsin Ginseng.

This is a Buffett classic type of toll bridge economics, or sustainable competitive advantage, that will help the company generate enduring profits for a very long time to come.

3. Differentiated products - high in quality and consistency

The general retailers use arbitrary methods of visual, touch and smells to identify the herbs. The probabilities and occurrences of mis-prescription, and product quality problems are significantly higher, as the method of identification will then rests on the skill of the individual staff.

What sets Eu Yan Sang apart from the rest is that it leverages on scientific methods to ensure the quality and consistency of all the retail products. They employ modern methods that are equivalent to DNA fingerprinting to check and ensure products are consistent and correct.

My Final Comments

On cost controls, revenue expansion

Eu Yan Sang has been making losses for the last few financial quarters; although there's a growing revenue base, costs are spiraling and chewing off the profit margin. Despite the multiple competitive advantages possessed by Eu Yan Sang, it is very disappointing to know that that management has somehow not been able to effectively capitalise on them and generate enduring profits.

On business strategy

Proliferation of Eu Yan Sang products in South East Asia countries is not significant, and much less in China. There remains a huge latent market in South East Asia that is untapped. However, Eu Yan Sang has taken the direction to 'educate' the westerners on the benefits of TCM; they have been expanding their presence in Australia and the United States. Is this business strategy successful? I guess the financial numbers will have to speak for themselves.

Everytime I pass by Eu Yan Sang retail stores, what consistently struck me are the vast retail space and the lack of customers, mostly a few at any one time. While I agree that it is important to strengthen the consumer brand through establishing shopfronts, the management must be conigzant that not a lot of consumers buy health products every day, and must less so for TCM products. Spawning shopfronts at expensive shopping malls and incurring high rental costs may not be a very wise and prudent move.

On transparency

When key appointment holders resign and are replaced just weeks (or was it days?) prior to the the results release, it doesn't reflect well on the company and leaves one's imagination to run wild, was there a serious conflict of opinion that made the CFO decide to leave?

On attractiveness as an investment

Eu Yan Sang was successful at the initial years of public listing; but it made some costly mistakes too. It is only in recent months that they have finally completed cleaning up their balance sheet and restructured the company. As to whether it has potential to become a great investment opportunity, there is still much to be seen.

The Lurking Dangers behind Structured Investment Products

2008-09-19T11:47:00.020+08:00

I read with great interest, when Straits Times posted the article on how a certain structured product of High Notes 5 in DBS is currently facing the problem of an imminent dissolution due to the collapse of Lehman Brothers. To understand more about structured products, you may read http://www.askdrmoney.com/Analysis_Structured_Explained.htm

Brilliant marketing + investment products = Beware of the devil in the fine print

I do not deny the benefits of leaving your money in the care of professionals and experts, but the biggest gripe is most if not all structured products use clever marketing words to mislead and imply statements that are not true, and the disclaimers are always written in the smallest font in the last line of the brochure. Words like "9% payout on 1st year..." does not necessarily mean you will receive an investment return of 9%, but rather 9% is tapped from your initial investment and repaid to you.

Sadly, so many people take things at face value, make uninformed decisions and always end up on the losing side of the deal.

There's a brilliant website that read and analyzed several structured products of Singapore Banks. You may want to read them at http://www.askdrmoney.com/Analysis_Structured_Bank_Products.htm

So, if you ever want to consider investing in structured products, think again.

Analysis of Adampak (Part III - An Interview with the CEO)

2008-09-05T09:10:00.017+08:00

I was invited by nextinsight.com.sg to publish this article at http://www.nextinsight.com.sg/content/view/602/60/

I had the great honour to meet up with Adampak CEO Mr Chua on 29th August at Adampak's office at Loyang Way. Prior to this meetup, I had submitted the analysis and list of queries lock-stock-and-barrel, to him via his secretary. He had already read through everything and gave me very interesting observations about Adampak and its business. I did not make any recordings, as it will be too rude; everything existed as just a verbal discussion that flowed for 90 mins.

I have summarized and properly categorised my takeaways from my conversation with him, as below. In all my analyses, as more information is acquired, it is only natural that the perceptions evolve and are refined to greater accuracy. Penned in this blog will be the observations and corrections to past erroneous perceptions. Please do not be alarmed as you encounter conflicting propositions as compared to earlier research reports.

Disclaimer: The author is vested in Adampak. YMMV.

On business strategy:

1. Gun for the big deals from the MNCs in any available sector

Mr Chua revealed that Adampak's business strategy is to focus on securing contracts from big time multi-national corporations and making their name known amongst them. Business from other MNCs will then automatically come through referrals etc. Gunning for deals from MNCs is a good strategy and there are two key benefits: firstly, Adampak can ride along on the bustling growth of the MNCs; secondly, increased resilience to regional economic impact. In 1997 when Asian was struck with the financial crisis, sales of Adampak continued to increase at double digit growth, simply because a bulk of Adampak's sales went to US, European MNCs.

The fact that 90% of Adampak's sales derives from the electronic sector is an outcome that is just somehow generated as Adampak just grew it's portfolio over the years; there was no deliberated or active efforts on a particular market focus.

2. Establishing a localised presence as a proximity advantage

In Mr Chua's words, "In this competitive industry, the first one in, wins." In the manufacturing industry, for customer companies to engage a manufacturer, they have to first go through a lengthy qualification process to assess whether the manufacturer is up to standards and can match their requirements. It is after the qualification process that the manufacturer will stand a chance at gaining a part of the contract. A localised presence has helped Adampak obtain more customers who have qualified their plant.

The best exemplification is China. Adampak set up a factory in Suzhou Industrial Park geographically sited alongside many MNCs and the company has an added proximity advantage over other non-local label suppliers based in South-East Asia. In many ways, this move has helped to increase the list of customers who qualified Adampak's plant. In recent months, the number of suppliers based in China has increased sufficiently for a break even point to be achieved at Adampak Suzhou. And it is expected for the number of qualified suppliers to continue to grow

3. Building strong relationships with suppliers to achieve a preferred label converter status and increase revenue streams

Over the years, Adampak has forged strong relations with their suppliers. Today, Adampak is a preferred label converter to 3M, which will recommend their clients to adopt Adampak's services. This further lends credence to Adampak's reputation and opens up an additional revenue stream.

4. Building a strong reputation of quality, reliability, consistency in service delivery

At first glance, it does appear that anyone can do the job of printing labels. But to be able to do the job, consistently, every time is an immense challenge. This is a critical success factor: over the last 20+ years, Adampak has built a strong brand of being able to consistently deliver high quality products on schedule. The brand is there, and the big corporations like HP, FedEx, Seagate, P&G, major telcos, etc. all know Adampak for its ability to consistently deliver at the lowest cost. It was also revealed that HP has been using Adampak's services for the last 20 years since the Adampak was founded. How amazing for a little factory that started in Loyang Avenue!

On growth drivers

RFID
"RFID faces a chicken and egg problem. No one wants to take the lead in adoption; everyone just want to be the follower of a tried, tested technology". Those were words of Mr Chua. The history of barcode labels is a very good case study. It used to be very expensive in the early phases of industry adoption, every company only started to catch on the wave when major players started using it and costs concurrently went down. Likewise, RFID in 3rd Party Logistics will definitely come as the next big wave, as it greatly simplifies inventory management, let's wait patiently to see this sector blossom.

On competitors

According to Mr Chua, it is hard to claim that Adampak is the industry leader in South-East Asia because the coverage is just too difficult to ascertain. There are so many companies operating in a similar fashion in the region, and all are covering different scopes with different strategies. Just to name a few, like Brady, Zephyr (these I know) and ITW, etc. I would estimate there are 10 odd competitors in this industry.

Nonetheless, Adampak is certainly no small player here. Mr Chua shared that a lot of MNCs know Adampak when it comes to die-cut products and high end labels, and companies acknowledge Adampak's reputation for a consistent delivery of quality products. This is a good sign of a company that probably counts as the top few of the list.

He also revealed that Zephyr did make an attempt to break into China many years back, but the venture failed miserably and never materialised, and this made Zephyr's management adopt a more conservative approach of keeping to local confines of Malaysia and China.

On production capacity and scaling up capabilities rapidly

Adampak's factories run 24 hours shift. Mr Chua shared, "in this industry, there's no way you can survive if you work only on 1 shift". The plants run at full capacity for 5 full working days, and during peak periods, the staff work overtime. Clearly, Adampak is running at maximum operating capacity, with little evidence of any excesses.

One of the critical success factors for the manufacturing business is the ability to flex and scale up production capacity rapidly within a very short notice. If a company does not have strong processes in place, achieving a rapid scaling up will not be possible. Mr Chua shared that Adampak has the ability to set up new plants, new factories and get them up and running in a matter of 2~3 months.

On financial management

The sense of financial prudence

Mr Chua shared that the management closely watches the returns on equity. In addition, the company practises a good sense of financial prudence because the management is always fully cognizant of the risks involved in credit calls when banks face a liquidity crunch. Adampak has consistently maintained a high current ratio (current assets over current liabilities), whereby the short term borrowings and liabilities are well within the company's capabilities to repay within 1 year.

Good cashflow management

He also mentioned that Adampak happens to be doing well in this area and is very fortunate because "the customers see the company not as bankers", and their clients have been very prompt and regular with their payments. This is another sign of a well managed business where the company has a very strong relationship of trust and goodwill with their clients.

On process re-engineering and cost rationalization

Adampak does not have a specific department on this. But what they have are a few key staff trained in Six-Sigma (a qualification in process streamlining to reduce costs). Initiatives on cost rationalization are always on-going. For quality checks, computerised imaging was employed a few years back, but there are problems with obtaining a consistent output. Hence the idea was shelved and manual labour is retained. "Nothing beats a visual check", he says.

Putting the money at where there are greatest cost savings/avoidance

If there are any projects ongoing, Mr Chua cited that the company will generally invest more resources to refine the key processes that are potential show-stoppers in the entire manufacturing process. For example, one of the showstoppers in the label manufacturing chain is the punching of label holes and unwarranted retention of debris that causes clogging. This was mentioned by Mr Chua to be a real problem where resources in engineering were diverted to improve the process because of the immense costs of failure in the entire chain.

On Aident
Mr Chua shared that the original plans for Aident was to secure a public listing on the Malaysian Stock Exchange. However, for some reasons, this did not materialise.

I vaguely recalled that in one of my conversations with a Malaysian factory businessman, he mentioned that for anyone to go on a public listing in M'sia, 50% of the company shares will have to go to the government. That is why, there are so many companies that do not want to go public listing to raise funds, because by doing so, they will have lost control of the company and will be reduced to doing the bidding of the government. This is anecdotal evidence, and has yet to be verified. But this might just be one of the reasons that Aident's listing never materialised and Adampak decided to acquire Aident.

On dilution of earnings post-consolidation with Aident
Mr Chua enlightened that the gross profit margin dilution is primarily due to a consolidation with Aident. For 1H07, profits from the associate company Aident were accounted for, but not the revenue. Whereas for 1H08, post-consolidation, the revenue is now included, hence this accounts for the decline.

On impact of inflation and cost increases

I further asked Mr Chua on the impact of inflation on Adampak's business. He gave a very straightforward reply that these are factors that are not within Adampak's control, and when raw material costs increases, Adampak just transfer the cost increases to the customer. This also meant that Adampak should be insulated from damaging effects on cost increases in raw material

On employees

Giving where credit is due, and striving to reduce employee turnover to a minimum

Adampak's management strongly believes in the principle of rewarding the employees for their efforts. This could probably explain why admin expenses generally rose in a 1:1 ratio to revenue, while maintaining a very strong ROE. And this principle has done Adampak a lot of good. Mr Chua shared that it's a well known fact that "Adampak has one of the lowest employee turnover rates around"

This is comforting, because with a HR policy that focuses on rewarding good managers for their efforts, I do not have to worry about excellent managers being poached by other companies.

On management succession planning

I asked him on the plans for management succession planning, he mentioned that this has already put in place - all the managers running different segments of the company. As for the question of importing foreign talent to helm the ship, like many Singapore companeies, Mr Chua said that the issue is not on foreign talent, but on finding the right man for the right job. He is confident that if he is not around, his managers can step up and run the company as well as he does.

On the board of directors

A strong representation of independent directors with experience across multiple industries

Mr Chua also shared that the representation of solid independent directors who hold concurrent appointments on other companies' board helped a lot. The executive management has received good advice from these people who are able to draw on their industry experience.

My final remarks

I think Adampak is a very good company, that is well worth the money I put in as investment. From a financial perspective: the intrinsic value is much higher than the current share price of S$0.22, and there's a very significant margin of safety. Moreover, the net asset value approximates S$0.18 cents per share. Their current significant exposure to the electronics industry will also mean that they may ride along the economic cycles, but I do not expect their ardent clients like HP and Fed-Ex to go out of business, so I am not really worried.

(A sidenote, I realised that HDD are dirt-cheap now. Now, don't you think that developing nations will be very hungry over the next few years for such low-cost storage?)

From a people perspective: it is well managed by a strong team, and this is validated by every single touch point I have with Adampak. From asking of AGM minutes, to requesting for a meetup with the CEO, to posing as a customer to test the sales staff competency, to warm customer service officers who gladly brought me around the factory floor to see a group of workers who are going about their tasks professionally. The team has not failed my expectations thus far. The management is financially prudent, and people like Mr Chua comes across as a forthcoming person an astute businessman.

Does it really bother me if there will be a recessionary year ahead and that electronics industry may be affected? Not at all. Even if the stock market shuts down for the next 12 months, I can continue to sleep well, knowing that the company will continue running and my money will be in good hands. I have done my due diligence to the best of my abilities, and the entire study tells me that the odds are in my favour. Let's wait to see if this gem will really shimmer and shine so brightly that the market cannot ignore anymore.

For Adampak, I have done more than sufficient as an analyst and part owner. It's time to move on to understand other businesses, while keeping this in view.

(P.S. Mr Chua was visibly impressed when he knew that all the written analyst reports I submitted to him came from an engineer. "Not many engineers I know write as well", he said. What a compliment! I guess I was just short of submitting my resume to seek employment in Adampak. :P )

How to Start Investing

2008-08-27T22:07:00.012+08:00

I have frequently been approached by my friends and colleagues on what stocks to buy and how to start investing. Then I realised that an element is missing in this blog that has not been addressed: that is, how to start investing in businesses via the Stock Exchange.

Simple.

1. Go for the low lying fruits lying just above and around you

Start by looking around you and keeping a keen eye to identify which products and services are provided by companies that are listed in Singapore's Stock Exchange. Perhaps it will never occur to you that so many products and services you experience in your daily life all belong to listed companies:
- a can of green tea from Pokka, or canned drinks from F&N
- massage chairs by OSIM
- traditional chinese medicine by Eu Yan Sang
- nice Jap restaurants like Sakae Sushi that are operated by Apex Pal
- famous brands like Raoul managed by a company called FJ Benjamin
- niche watchshops like Hour Glass that sell watches that are horological art
- our favourite family bookstores like MPH and Popular
- Singapore's newspaper monopoly by Singapore Press Holdings
- our favourite 1st Class, World Class Singapore Airlines
- "Eng Seng" sprayed on some temporary roadblocks come from the construction company Chip Eng Seng
- banks like OCBC, DBS, UOB, etc.

(The mention of these listed companies does not constitute a recommendation from me...)

And the list goes on.

2. Target businesses that have a geographical proximity to you

There's always this question: what about companies listed on New York Stock Exchange like Intel, Dell, Microsoft - why not consider them too? You could, but do you remember what sages like Sun Tze and Clausewitz said about the principles of conducting a warfare? Always fight a battle on grounds where you have a good grasp on the terrain. Likewise, companies listed on New York Stock Exchange are geographically very far from home ground and this also meant that the information sources are confined to the internet. If I have to invest my money, like how I will wage a war, the entire operation will be conducted on grounds that I am most familiar with. Risks are lower, and my confidence of success is much higher.

(For more info on how Sun Tze's war principles can apply to investing, read the following articles written by another fellow investment blogger, Sun Tze: Chapter 1 - Deliberation, Chapter 2 - Planning, Chapter 4 - Tactics.)

3. Doing your due diligence: Performing the different levels of business analysis

After looking around you, pick one area that you have a specific interest, it is best if is a product that you can relate to tangibly and you have an active interest to find out more. Then read up on it from reports and announcements found on http://www.sgx.com/, sift through posts in forums in http://www.wallstraits.com/, www.wookup.com/huatopedia. Talk to your friends - ask what they think of Sakae Sushi (as an example) food and service quality. Ask employees or ex-staff about how they find their bosses. Make your research as exhaustive and complete as possible. All these will give you a pretty good idea on the nature of the business and the prospects of the industry.

The framework for analysing the business is clearly laid out in the various articles I have written on investment methodology.

4. "Inactivity strikes as intelligent behaviour" - Warren Buffett

The next step after conducting all analysis is to take one step back. Briefly sense what the stock market climate is like and observe. Is there an immense sense of euphoria where people believe that the market will be shooting through the roofs tomorrow? Do you read of articles about university students are suddenly all investing, and aunties throwing in their life savings into the market? These are signs, but never act base on them. What you have to do is to take note of all these observations and remain inactive in trading activity, and continue reading up and finding out more about your companies. Inactivity is intelligent behaviour.

When the time comes where you can take advantage of bargain prices of listed companies, act swiftly and decisively to swoop in, because such opportunities are rare.

Gold: Insurance for your wealth

2008-08-25T22:24:00.023+08:00

Investment in gold deserves a mention in this blog, because gold is an important asset class from the perspective of a wealth insurance, but usually this is not known and not considered by people generally.

Disclaimer: This article merely expresses the authors views and are not recommendations for action by the reader. YMMV.

Concept of money as a medium of exchange
Before we talk about gold investment, allow me to talk a little on background of money. Some explain money as "Money is what money does", which means that money is a medium of exchange. In the good old days, money notes is designated to be a promissory note of guarantee and as a means of convenience to replace physical gold as the currency. It was a medium of exchange that allows one to trade between different items using a common denominator of value, and over time, the entire world economy grew to depend on money as its lifeblood.

The Bretton Woods system
As the world progressed into modern times and global trade and commerce started to bloom, it was recognised that there's a need to establish a common policy for international monetary management. The Bretton Woods system was established in 1944 as a set of rules of commercial and financial relations among the major industrial nations. It was also in the same time period that an international regulatory financial body like International Monetary Fund (IMF) was established. The primary feature of the Bretton Woods system is that the nations are obliged to peg their currency at a certain fixed rate to gold with a 1% spread between the buy and sell rates. It was a good and stable system that is in a way backed by physical gold. For the world's dominant leader, the US dollar was pegged at USD35 per ounce of gold.

However, by early 1970s, US's participation in the Vietnam war accelerated inflation, and for the first time in modern history, the nation as a whole began running a trade deficit. The reasons for an accelerated inflation can be attributed to a massive consumption of resources and the government began to finance this consumption by printing more money notes. As this war went on, people started to swap their dollars for physical gold. Because of excess printing of money by the US government, nations began demanding US to fulfil its promise to pay, by a conversion of dollars into gold. This came to a tipping point where US's gold coverage deteriorates from 55% to 22% and it represented the point where holders of the dollar lost faith in US's ability to cut it's budget and trade deficits.

Collapse of the Bretton Woods system and emergence of the floating currency
In 1971, the United States devalued its currency from USD35 per ounce of gold, to USD38 per ounce of gold. In 1972, it reached USD70 per ounce. In 1973, the Bretton Woods currency markets closed and subsequently reopened as a floating currency regime where the dollar is no longer pegged at a fixed rate to gold. Today, the exchange rate stands at startling rate of USD823 per ounce of gold and this is expected to rise further.

Fiat money and the risks of hyperinflation
As United States grew to became the modern day economic powerhouse, the dollar became the de facto currency that many countries view as gold. The dollars became a favourite denomination for countries to keep in their vaults as foreign currency deposits.

And as the circumstances in the world evolved, it somehow becomes apparent to me that our world's economy now hinges on fiat money - money is designated as a medium of exchange because the government said so. It runs purely on the confidence in the government, and holds no intrinsic value. For the world's economy to fall apart, all it takes is for a critical mass of people to lose faith in their government's currency and began collectively raising prices mindlessly. Humans have the herd instinct, once the confidence is shaken, things can spiral out beyond control like what happened in Zimbabwe, where money completely loses its effectiveness as a medium of exchange. (read here)

Gold: insurance of wealth against runaway inflation
Gold is an asset class that will not lose its effectiveness as a medium of exchange because of the underlying intrinsic value and limited global supply. It is an excellent form of liquid asset class that can help insure us against a currency fallout. The risk of a currency fallout is remote, but it is there and as a rational human being, I will want to guard against such a catastrophic situation. Let me draw an analogy: we buy life insurance even though the risks of death and critical illness are statistically remote - for the simple reason that we want to preserve our state of wealth and minimise impact on our loved ones if something unfortunate strikes. Likewise, buying some gold can help to preserve our hard earned wealth and standard of living should an unfortunate case of currency fallout strikes. Although very unlikely, I do not completely rule out that possibility. And if ever a currency fallout does happen, I want to know that I can still use ounces of physical gold to sustain my daily needs.

Buying how much gold is enough then?
Historically, when hyperinflation occurs and prices rise beyond 1000%, gold prices will also rise more than 1000%. A good rule of thumb to start with is that we should probably strive to build 10% of our net worth in gold. So in the event of hyperinflation, gold price can be expected to rise such that we can still retain 100% of our current net worth.

Methods on investing in gold
We can invest in gold in basically 3 different forms. Either physical bullion, paper gold certificates, or Exchange Traded Funds. If you think of buying gold, it can be acquired in the form of physical bullion from official websites like http://www.kitco.com/. The online market also allows one to sell off gold. Just a comment on physical bullion: the bigger the gold bar, the cheaper it is in terms of per ounce, but also less liquid. Gold is much more liquid in forms of widely recognised coins like the Canadian Mapleleaf coin (see picture above)

A fellow forumer, who is incidentally my brother, has written excellent articles on gold investing. (Read How to Invest in Gold, History and going forward, Investing in Gold)

For further information and open forums on investments in gold, you can go to http://www.goldclubasia.com/

Other interesting points about gold:
Market movements have shown that crude oil prices and gold are in many ways correlated. It has been widely recognised that oil and gold have one of the strongest historical commodities relationship. It is even more interesting to note that back in 1975, oil was pegged at USD75 per barrel, as compared today's prices of USD113 per barrel. Now, compare that against the gold exchange rates: in 1975, USD40 per ounce of gold. Today, it is USD823 per ounce of gold.

I shall leave you at this thought. For further reading, see here.

Analysis of Adampak (Part II)

2008-08-16T02:00:00.024+08:00

Comments on 1HFY08 Results Released on 15th August

(Updated as at 19 August 08, after a release of new information found in 1H08 briefing slides)

(Following a few valid points raised by a fellow investment blogger donmihaihai, I relooked and amended to reflect greater clarity.)

Revenue at US$28m for 1H08 as compared to earlier year (1H07) grew by 49%, cost of sales grew by 57.8%, reducing the gross profit margin by 4 percentage points (as compared to 1H07). Given an estimated inventory turnover ratio (cost of sales = US$19m / Inventory = US$7m) of 2.7, the raw material inventory (est. to take up 62% of all inventory, from FY07 AR) is not expected to last beyond 3 months. From this, it can be infered that inflationary pressure on material prices over the last 6 months have been factored into the rise in cost of sales.

(Effects of exchange rate between USD and SGD on profit margin are more fuzzy here to draw direct relations, so I shall not comment on it)

The administrative/distribution expenses rose in tandem (approx. 49%) with the revenue growth - this is reasonable from a retrospective point of view because historical trends have shown that Adampak's admin/distribution expenses growth correlates to revenue growth on a 1:1 ratio. Balance sheet is healthy with a current ratio of (46mil/12mil) of 3.8.

Comparatively, Brady, the global market leader for labelling, is doing much worse and has only registered a 1% growth in revenue for Apr 08 in the Asia-Pacific region (as compared to similar quarter in 2007), and 10% overall sales growth.

Revenue Structure

Examining the revenue structure reveals that Adampak has an inherent business vulnerability that must be addressed in the longer run. i.e. over-dependence on the HDD market. The management acknowledged that efforts must be made to expand their scope of business into other sectors like pharmaceuticals, telecommunications, etc. But it remains to be seen if Adampak can achieve diversification into other sectors and reduce its exposure in the HDD industry. For 1H08, 45% (compared to 49% in 1H07) of the revenue was derived from sales to HDD manufacturers like Seagate.

An overly focused revenue structure is a double edged sword: on one hand, the company is able to ride on the rapid expansion of the HDD industry; but on the other hand, it is definitely not healthy in the long run as Adampak's performance will be half (literally) dependent on the HDD industry.

For RFID sales, revenue registered a growth of 57% from US$0.5m to US$0.8m. By absolute figures, this is a modest figure but definitely not sluggish. While there are serious challenges for RFID to achieve a ubiquitous status, it will definitely come. Let's maintain a close watch on this.

Pre-Aident consolidation versus Post-Aident merger
From the 1H08 results briefing slides, if we assume that Aident was already fully merged with Adampak in 1H07 as a single entity, then compare the sales against that of 1H08 when they have fully merged, we see that sales to telecom products fell by 46% from US$4.2m to US$2.3m. Sales to other electronics sector shrunk by 6% from US$9.7m to US$9.1m. Are this as a result of slowing demand in the electronics products? Does this imply that there were some inherent inefficiencies in Aident's business that brought about the decision of the management to shut down their plant in Shanghai?

It is also noteworthy that it was mentioned that Adampak accrued the lower net profit margin due to the consolidation of Aident's results, as compared to the earlier year which was based on a 1 month equity accounting (i.e. apportioning the results of Aident by the percentage of Adampak's ownership). Such a statement necessarily implies that management acquired Aident, which is a company that is less profitable.

There are many questions that needs answers. But I believe that Adampak's management made this strategic acquisition for good reasons of expanding fast to rapidly penetrate Asian markets like Malaysia and China by leveraging on the established processes and infrastructure of Aident. And all the time, the management is fully aware of the need to restructure and streamline Aident's operations for greater efficiency.

A financially prudent and candid management
The management has also demonstrated financial prudence by curtailing their purchases on plant and equipment (1H08 US$0.2m compared to 1H07 US$1.2m) to conserve cash holdings, brace for a slowdown in global demand, and prevent built up of excess production capacity.

What consistently struck me in my entire analysis was the candid nature of the management about areas of their business that was not doing so well.

Final remarks
Adampak has so far done extremely well in light of the inflationary pressures and slowdown in global demand. Profit margins may be slightly squeezed in view of rough times ahead, but given an efficient cost structure and strong balance sheet, the company will definitely be able to continue to inch forward and expand their market share. Also, management and the business development personnel must continue to aggressively expand sales to other industry sectors to minimise their risk exposure.

Let's wait and see if this gem will ultimately shine in time to come. In the meantime, I will just enjoy the generous dividends. YMMV.

A Precursor to Investment - Adequate Insurance Planning

2008-08-11T00:33:00.017+08:00

Insurance planning deserves a special mention in this investment blog, because it underpins all good personal investments. This is perhaps one underlying aspect that is usually overlooked when one talks about investment. When struck with a unforeseen crisis, without adequate insurance planning, even the most outstanding investor will have to liquidate his precious golden egg and all gains will vanish before his very eyes. Therefore, it is of utmost importance that one ensures that he has arranged for sufficient coverage before embarking on any investing venture to build his nest egg.

I will briefly cover a few key aspects and share my perspectives on insurance and basic financial planning. I do not claim to be a financial planning or insurance expert, but I believe the below pointers I have to share are what experts will probably advise you too.

Disclaimer: What will be expressed here are the views of an author, who is definitely not a financial planner or insurance agent. The views are not completely exhaustive and only to the best of the author's knowledge. Readers are strongly advised to seek the services of a specialised insurance agent or financial planner.

Insurance: Intent
The primary intent of insurance is about the preservation of you and your family's state of financial well being when something unfortunate strikes. Preservation of financial well being meant you will not have the need to vastly alter your state of finances, i.e. liquidate stocks/funds, take loans, or worse still, sell your physical assets to pay for medical bills or to sustain the expenses required to maintain your family's current quality of life. The bottomline for preservation of financial well being is that your finances must not be unduly stressed when crisis strikes.

Now, the secondary intent of insurance is that it can also serve as a form of low risk savings planning. For basic life insurance, the yearly premiums that you have paid will accumulate a cash value within your policy. At a certain stage in your life, you can choose to surrender the policy for a lump sum of cash if you feel that you are more than sufficiently covered. In addition, there are more complex insurance products like endowment/savings policies, which you can pay a regular annual sum towards a plan to distribute either a steady stream of income, or allow you to encash a lump sum at different stages in your life. For example, you can get an insurance that gives you a lump sum, or activate a steady stream of income when you hit 40, 50 and 60 years old. You can also look out for insurance instruments that are like savings plans for you to encash an amount when your child needs a lump sum for his tertiary studies.

The question is: do you want to see insurance as purely an expense, or a form of savings as well? Usually, the general public's answer (which makes sense) is a middle between both extremes: they normally view insurance as a form of retirement planning which provides a certain amount of coverage still.

Scope of insurance coverage

The four key areas that must be covered are: death, disability, critical illnesses, hospitalization. These are four areas that will deal the biggest blow to anyone's finances if not appropriately covered. I think it is of paramount importance that anyone make sures that these four areas are well covered.

The fifth area of 'accident coverage' is optional and dependent on whether you operate in an environment that constantly exposes you to a range of possible work related injuries. And if your agent advises you that there will be no way that you will be able to claim under any current insurance plan, and you have some spare cash, you might want to consider putting away any possible financial worries arising from such little accidents. These injuries should not be life threatening or require you to undergo intensive operations, but significant and frequent enough to frustrate you from saving up to build that lovely golden nest egg.

Assured Amount: the Four dimensions
The next consideration about insurance is on the assured amount. What is the rule of thumb to decide on the sum assured? If you pass on, what is the amount you want to leave behind for your loved ones? If you turn disabled, what is the income you want to regularly generate for your family? If struck with a critical illness, what is the lump sum you need to cover for all the medical fees?

Death: Ideally, we hope to be able to maintain our family's quality of life for the next 20 years, this timeframe is definitely good enough to finance my children towards independence and my family to adapt to my absence. But to the average Joe (which is me) who earns the average income, this is unrealistic. We may want to revise our targets down then, 10 years worth of expenses probably? Let's look at a few case studies on how you can compute your sum assured: for the singles like me (ladies, you are welcomed to drop me a message), who contribute a monthly 'piety' sum to my parents, I will want to preserve this monthly payout for a good 15 years if I have to pass on. Then I use this to work backwards to determine on my desired total sum assured, and work out a sum that my current income will be able to sustain. If I have a family to feed, I will estimate an average annualised expense and project it for 'X' years ahead, X being a variable that depends on how much I can reasonably afford to fork out now.

Disability: Now let's take another perspective on sum assured: What if the person enters a situation whereby life deals a blow that leaves him income-less, but fully conscious and disabled? Well, he is still there, and his family needs money and he needs money to go on. Insurance plans with disability income comes in here. It is hard to pin a figure on how much is enough, because the family will have to be realistic and adjust downwards their quality of life. Given current standards of living, a good figure to grasp with is S$10,000 per annum (or about 1k per month) of disability annual income with probably a one lump sum payout. I think with this sum of disability income, one will be able to sustain a very basic standard of living without putting undue strain on the family.

Critical Illness: Statistics reveal that usually the median of the cost of one time medical cost for the the most common critical illness is around S$50,000. Critical illnesses strike hard on finances and when it comes, the bills come fast and furious in immense sums. No one will want to have to sell their family's dwelling or take on a bank loan to pay for those bills.

Hospitalisation: These fees do not kill your finances; but the monthly bills of 2k or 3k and more due to treatment and long term hospitalisation will bleed anyone's bank dry. The Singapore Government provides us with a Medishield that is partly and mandatory funded by our monthly income. This is a good plan, but the amount and coverage is somewhat lacking. It is good to consider hospitalisation insurance plans that enhance your coverage further. The costs are affordable, and recommended to ensure you do not sell away a Warren Buffett share to pay for these hospitalisation bills.

Investment-Linked Plans
There are also many insurance linked plans. These plans provide you with a certain coverage, but your cash premiums are invested in mutual fund products e.g. "Asia Pacific Growth Fund". These plans can probably yield higher returns. If you ask me as a matter of opinion, I would recommend for anyone to have a clean segregation between what is meant for insurance and what is meant for investment. For insurance, you want a fuss free, low risk and high confidence on a strong shield for your finances. For investment, you are looking at higher risk, for higher returns. Mixing both up in mumbo-jumbo plans complicate anyone's financial planning.

Term Life Insurance
Term life insurance is a cheap form of life insurance. The difference being that it holds no cash value. It only provides coverage for a specified term (say 1 year, 5 years, etc), therafter, the insured personnel can choose to renew the policy but pay much higher premiums. The intent is a pure death benefit to provide coverage for the insured, so the immediate premium price is much lower. If you talk to an insurance agent, and compare the premiums against that of a whole life insurance, it is generally true that the premium for term life will escalate significantly compared to a whole life over a period of time. If you ask me, I would recommend from a layman's perspective that one should go for a whole life insurance, where the annual premiums are fixed and correlative to your age (i.e. lower your age, cheaper the annual premium, and have a cash value at the end, with a similar coverage).

However, there can be situations where term life insurance fits your insurance planning. For example, SAF offers a Group Term Life insurance that covers until 70 years old, where a S$600 annual premium can provide you approx. S$100k coverage. You may decide to have a clear segregation between your retirement planning and insurance, and you see your insurance as a form of expense. In addition, you do not desire to have a death benefit beyond 70 years old because you believe that your dependents' quality of life will no longer depend on you anymore then. In this situation, buying a term insurance fits your designated outcome.

For the experts and insurance savvy ones, you may hold a different view. YMMV.

Completing your 'shield'
In addition to insurance, it is highly recommended for anyone to set aside a sum that is worth at least 6 months of income to buffer against any change to your current level of income. We function in a global economy where matters are eternally in a state of flux; there's no way we are able to guarantee that our current income level will not be disrupted by a loss of employment or loss of income. I think 6 months is a reasonable timeframe for anyone to pick himself up after enduring such a blow. And once you are done with all these preparation work, you can say that you shield is more or less complete, and that you can start embarking on your investing venture.

Final Remarks
I have broadly covered on aspects in insurance planning and building a strong shield in finances. It's not exhaustive, but I have shared will probably rev up the layman with a good ground to start with.

If you have thought nothing about insurance and have been obsessed with investing every single penny to surpass Warren Buffett, (like I was in University days), my dear friend, it is time to rethink again.

Analysis of Adampak (Part I)

2008-08-09T22:37:00.033+08:00

Over the last few days, I applied Buffett principles and Fisher's concept of 'scuttlebutt' to deeply understand my investment holdings. So I went and approached two companies Adampak and Zephyr as a potential client. By conversing with various senior executives in both companies, I managed to glean a lot of insights that are otherwise not found on financial reports or the internet. For the lay reader, from this blog entry you will be able to gain a much better understanding into the business of labelling and RFIDs.

I would like to thank a fellow forumer named dydx in http://www.wallstraits.com/ who surfaced this gemlike company listed on SGX to everyone (read thread http://www.wallstraits.com/community/viewthread.php?tid=2764 and http://www.wallstraits.com/wsforum/showthread.php?tid=218).

Disclaimer: The author is vested in Adampak. YMMV.

1. Overview

Products and Services
Adampak products and services are in the area of manufacturing labels for any products that requires some form of labeling. Their labels range from serialized barcodes, generic paste-on labels, tamper-proof labels, labels and seals for use in electronic circuit boards (clean-room 100 and 1000 requirements), insertion of Radio Frequency Identification Tags (RFID) onto labels.

In recent years, Adampak acquired 100% stake in Aident, and hence expanded its business laterally into precision die-cut components, as well as enlarged the manufacturing base to reach into Malaysia.

Industry analysis
Product labels have grown to become ubiquitous and indispensable in our daily lives. And as human’s insatiable need for more products grow indefinitely, the demand for labels will also grow in pace. The global market size for labels is estimated to be worth US$2.0 billion in terms of sales[1]

From a manufacturing perspective, labeling services are critical in the entire product value chain. Companies rely heavily on the labeling services to firstly, perform effective inventory management (using barcodes or RFID), secondly, to communicate key information visually (e.g. from manufacturer to distributor to suppliers to front line sales).

Dividing the pie for service redundancy
In view of the criticality in the entire value chain, companies are cautious in awarding their contracts to the label manufacturers. They will normally adopt a policy distributing the required number of labels amongst the shortlisted manufacturers. This prevents a single point of failure in the entire value chain by building in a layer of service redundancy. For instance, say HP requires 1,000,000 labels for their entire series of printers, if there are three competitors, they will split the pie accordingly and award each label manufacturer a part of the entire contract. Should one label manufacturer’s operations suspend, the customers will be able to fall back on another substituting firm and prevent a catastrophic disruption of the product value chain.

Market Dominance and Barriers to Entry
The prior paragraph implies that the industry will never allow the creation of a monopoly. One manufacturer may be able to eat a majority of the pie, but it will never be able to swallow it complete; in the longer run, many will perish and at the same time, none will be able to achieve complete market dominance; the competition will always taper out to an equilibrium comprising several key players in the industry.

At first glance, the labeling business appears to be a commodity-like industry, with low barriers to entry for potential competitors. But a closer look reveals otherwise. For those companies that have an impressive clientele of most global clients, with 30 to 40 years of industry experience, with consistent delivery of high quality products – these are invisible barriers to entry. For instance, HP will naturally be disinclined to switch to a new China label manufacturer entrant that has not yet been tried tested and proven, and avoid any risk of their product labels fading or falling off at the consumer’s end; they will prefer to stay with the reliable incumbents like Adampak. In addition, for any competitor to take on Adampak in terms of being the lowest cost producer, it must be able to achieve a significant scale of operation to derive economies of scales. It is also quite apparent that extensive experience is required in terms of running a labeling business and managing the technicalities of operations.

As long as the incumbents continue to consistently deliver quality labels at the lowest possible cost, I do not see why product companies like HP will take a risk and perform a switch on such critical services.

Exposure to economic cycles of boom and bust
Adampak and Zephyr currently derive a majority of their sales from pharmaceuticals, electronics, hard drives, telecommunication products. Therefore their businesses are inadvertently driven by demand in the various sectors. While they are making efforts to expand into other industries like 3rd Party Logistics, it will be inadvertent that their sales and profits will depend on the expansion and contraction of the various sectors during economic cycles of boom of bust.

Competitor Analysis: History of the Three Kingdoms
For industrial applications, Adampak, Zephyr and Brady – all these three companies hail as the giants who take up majority of the global pie of labeling services. In the South-East-Asia region, Adampak & Zephyr hail as the two industry leaders. This is based on the fact that their clientele include an impressive list of MNCs like HP, Fed-Ex, DHL, Merck, Seagate, Maxtor, etc. etc. While on the international arena, all three of them compete for contracts from the big companies. There are other labelers, but judging at the Adampak and Brady’s ability to grow sales so consistently and rapidly over the last few years, it does seem that they are gradually scalping sales from the smaller competitors.

Zephyr (pronounced as Zef-fee) is a privately held company based in Singapore. It has 2 factories in Malaysia and 1 in Singapore, as compared to Adampak’s 8 multi-national factories spread over Philippines, China, Thailand, Malaysia and Singapore. Sources from industry insiders revealed that Adampak started out as a sub-contractor of Zephyr. When Zephyr is not able to fully satisfy the sales due to production capacity, the spillover deals went to Adampak. Adampak subsequently cut the umbilical cord, moved forward and went public in 2002. Adampak took the bold move and seized the opportunity to launch into China, while at the same time, Zephyr was cautious of operations in China, so it stayed within the confines of Singapore and Malaysia.

Now, Brady is a US based company with a very extensive range of label services. It has a global outreach with offices and factories spread across Europe, America and Asia. For FY07, it has achieved sales of US$1.3 billion, with 25% of the sales of some US$520m from Asia Pacific countries. In recent years, it has been trying to make attempts to secure its foothold in the Asian region. To break into the Asian markets, Brady took a move to setup factories and offices in Asia, and once attempted mounted a takeover bid on Zephyr.

Competitors Analysis: Financials

From comparisons from FY06 and FY07 annual reports, Zephyr’s revenue dipped slightly by 5% from S$44m to S$42m[2], while Adampak has been fast soaring ahead with revenues growing by 50% from US$31.8m to US$47.8m. Zephyr’s profit margin for FY07 is 26.7%, while Adampak’s gross profit margin is 33%.

In addition, profit/sales ratio for Zephyr is 13.3%, Brady’s is 8%, and Adampak leads with a profit/sales ratio of 15%. In terms of efficiency in cost structure, Adampak emerges as the clear winner here. In terms of Return on Assets (as a measure of profit per dollar of asset), Zephyr has ROA of 13.4%, Brady's is 6%, Adampak leads the pack with an ROA of 16%.

Comparatively in terms of growth, Zephyr is languishing (-5% growth for FY07, and only a total 12% growth since 2003 from then S$39m to FY07 S$44m) as it watches Adampak rapidly expand into Asian markets. If Adampak can continue to sustain its current rate of growth, it is only a matter of time that Adampak will overtake Zephyr to become the South-East Asia’s industry leader. Adampak is well anchored in the Asian markets but the company faces stiff challenges from the goliath incumbent Brady. Given Adampak’s well established network and factories well positioned in South East Asia, I do not rule out a possibility that Brady will extend a takeover bid for Adampak for it to leapfrog and expand its presence in Asian countries.

Areas of Improvement for Adampak
For Adampak to continue to maintain its edge in this industry, efforts must be continually made to leverage on technology to reduce costs and streamline operations. What is observed from a ground tour is that there are many areas that can be further improved with the aid of technology. For example, quality checks on barcodes are performed to 100% by manual visual checks, and this can be expedited by incorporating computerized image recognition technology to replace labour and speed up such checks. This is perhaps just one of the many possible areas of improvements. In addition, instead of a manufacturer offering labeling services, Adampak can consider forging strong relationships with partner companies in related industries to provide customized turnkey solutions for customers. i.e. Adampak can become the customer’s single point of contact from setting up of a label system to printing of labels.

Adampak's business strategy
It is in my opinion that Adampak adopts a strategy that (1) maintains a niche specialization in label manufacturing, (2) leverage on resources in developing nations to reduce production and labour costs, and (3) grows business aggressively in Asian regions by establishing a localised presence.

Challenges of Industry and growth drivers

It was several years ago that RFID was slated as the next wave in 3rd Party Logistics. However, RFID technology faces immense challenges to attain a status that is as ubiquitous as the barcode. Firstly, cost: the transponders are highly expensive, and firms think twice on adoption of such technology for their inventory management needs. Insiders revealed that current RFID technology costs about 10 times more compared to barcode. Secondly, lack of a common standard. Currently, there is a lack of a common standard in production and RFID technology is still largely proprietary as firms with the know-how closely guard the secrets. Finding substitutes are hard and practically non-existent at the moment. Without readily available substitutes to create service redundancy, the take up rate of RFID is consequently reduced. Liberalization and wide adoption of RFID technology by companies for 3rd Party logistics remains to be seen.

Final Remarks
Quotes from Brady’s FY07 report
“Fiscal 2007 was marked by challenges and progress for Brady. While sales grew 34 percent over last year, we were disappointed by a 5 percent increase in net income, which fell well short of our expectations. This was primarily driven by challenges we faced in our OEM markets, with increased pricing pressure from our customers, a loss of focus due to major acquisition integration efforts and some loss of market share. We responded quickly to correct our cost structure, refocus our OEM sales force in Asia and integrate recent acquisitions.”

Was Brady’s CEO referring to a loss of market share to up and rising competitors like Adampak? I would think so. The deeper I analyze the business; the more I am convinced that Adampak is well poised to become the next Unisteel of labels.

2. Management Quality
Is the management of (a) an unquestionable integrity, (b) holds a vested interest, (c) highly competent and (d) shareholder oriented?

Vested Interest
The executive management has a significant vested interest in the company. Executive Director Mr Anthony Tay Song Seng holds a 32% stake in the company with 85 mil shares, while CEO Mr Chua Cheng Song holds a 2% stake with 6.1 mil shares. In addition, in recent months, the Executive Director has steadily been increasing his holdings through open market purchase. As a minority shareholder, the above facts provide immense confidence that the management will be acting in the best interests of the shareholder.

Management stability & integrity
There is also great stability in the management as there have been no changes in the key appointment holders for the last 7 years of listings. This is a good indication of a good and united leadership core. Management has thus far been forthcoming and candid – be it about the challenges the company faces, or the quality of earnings in light of rough times ahead. Management integrity is also spotless, with no clear signs of inconsistencies.

Management competency
The executive director Mr Anthony Tay Song Seng is the founder of the company with more than 25 years of experience in the industry. CEO Mr Chua has been with the company for a period of 10 years. At the manager level, at least 50% of the appointment holders had experience level ranging from 10 years to 20 years in the industry. The independent directors comprise of two chartered accountants, Mr Goh Siang Khin and Mr Lee Joo Hai, and one lawyer Mr Teo Kiang Kok. In addition, interestingly, both independent directors served a stint in Unisteel, and hence they will definitely be able to add value to Adampak from their experience in Unisteel. All of them have an illustrious professional track record in either accountancy or the law practice. This is a very strong representation, and enhances the shareholder confidence in the accuracy and transparency of the financial statements.

Shareholder oriented
Adampak has consistently and unfailingly made good its promise to share the wealth generated from its operations with the shareholders. Although there’s no formal dividend policy, Adampak has distributed approx. 30% of profits to all shareholders for the last few years. This is not expected to change in the near future as the management will likely remain in operation.

My Impression of Adampak’s staff
I went into Adampak posing as a potential customer. I was greeted with a forthcoming Customer Service Manager, and happened to bump into the Executive Director Anthony dressed in tee-shirt and jeans just stepping out from the production floor, probably after doing his ground walkabout. He gave me the first impression as a very down-to-earth and hands on person who knows his stuff. A casual walkabout at the production floor reveals that several technicians are highly experienced with over 20 years of service in this industry.

3. Business Fundamentals & Valuation

Adampak has excellent business fundamentals. For FY2007, using Owner’s Earnings (3.242 mil) / Share Capital (15.5 mil) ROE = 20.9%. For FY2006, ROE is 25.6%. It has a high current ratio of 4, and runs on low debt to finance its growth. The Net Tangible Asset Value as at FY07 is US$0.14, or S$0.19. Using the FY07 operating cashflow of S$0.0275, and a projected growth rate of 15%, assuming Adampak has no terminal value and stays in business for 7 years, Adampak’s intrinsic value is estimated to be S$0.38, which is actually a very conservative estimate of intrinsic value. Take this value and compare to current share price, there is a significant margin of safety of 1.57.

[1] US$2.0 billion is a figure that is derived based on Brady (market leader) Annual Report sales of US$1.3b. A good ballpark estimate is that Brady has cornered some 60~70% of the global market share, while the rest went to smaller labeling manufacturers.
[2] Information source of private company Zephyr is from downloaded annual reports at www.acra.gov.sg

Institutional Funds

2008-08-05T18:45:00.006+08:00

The institutional fund manager's job is getting immensely difficult these days. With the recent malaise plaguing the financial industry, the fund managers will have an even harder time in future to strive to outperform the benchmark, earn their keep, keep their bosses and financial risk analysts satisfied.

Disclaimer: The below are not directed at any specific funds or agencies; it is merely an expression of the author's opinion on the efficacy of institutional fund management. YMMV.

Institutional fund managers face immense challenges.

Firstly, their portfolio performance is rigourously benchmarked using various indicators across the entire board of fund managers very regularly, like every 3 months. Secondly, they have to maintain a mandatory percentage of cash float for people who may be redeeming their funds. Thirdly, not forgetting, fund managers are increasingly bugged with justifying to a team of risk managers on why certain decisions they make have mitigated financial risks to the benefit of fund holders. Fourthly, they are to invest within the strict bounds of an investment policy that defines what is deemed as a "stable" or "balanced" or "dynamic" portfolio; there are no ways that they can deviate from this policy.

Feels like these measures of investment policy statement, risk managers, quarterly performance ranking, are good for the fund investors eh? Take a closer look and reality reveals otherwise.

A Performance Ranking Induced Myopia in Investment Horizon

The great implication of quarterly performance ranking is that fund managers are forced by circumstances to adopt a very short-term myopic perspective towards managing investments. Structure drives behaviour, the more regular their performance ranking, the more myopic they become. To maintain that mandatory cash float, fund managers will usually look through their list of investments: those investments that are good and have yielded solid gains are the first to be sold, while the losers are retained inside the portfolio. And they have to be careful that there is not too much excess float going around, because they have to invest the excess to obtain good gains.

Influence of Forces and Demand and Supply on Fund Performance

There will also be times when they have made good investments in excellent businesses, but the gains can only realised by the market after an extended period say 12 months, but because they are forced to maintain the float, they often have to sell out prematuredly probably at a loss or break even point. This is a classic case in point that fund performances are in many ways heavily influenced by consumer demand and supply of the fund float. So, sometimes if the funds you bought have performed badly, do not always thumb it on the fund manager, sometimes it is an outcome that is driven by consumer demand.

Portfolio Churning

Normally, what fund managers are 'coerced' into doing is call 'portfolio churning' - they will sell out on good investments to maintain the float, buy back into them when there's excess, keep the lousy ones in the hope of recovery in a bull market, and along the way, incur greater transaction costs that ultimately end up as management fees. Look out for the end-of-year volume on the Singapore Stock Exchange, you will notice unusually high volume of trades, this is because fund managers are near their year end reporting times, and you have large fund investors hopping around.

The Nameless & Faceless Fund Manager

Now, to complicate matters further, fund managers do not always remain in that fund always. Their appointment constantly change. Your returns are in many ways like unpredictable seasons and monsoons, all hinging on the skill of one person, unknown to you, hidden behind the name of a fund. If you get Peter Lynch or John Neff, good for you; but if you get an amateur finance manager, good luck to you then.

If you look across all the funds, there are some of the funds that seem to track the indexes (e.g. Dow, STI, Hang Seng, Kospi, S&P, JCI) pretty closely, well that's because the funds just buy index stocks. Then there are some that outperform the market slight, some that do extremely well, but most of them languish in mediocre gains.

So, is investing in institutional funds, entrusting your money to a group of professional money managers the way to go? I think as a DIY investor, I can probably do as well, if not better than them.

As usual, YMMV.

Why I Decided to Create My Own Investment Blog

2008-07-20T15:43:00.006+08:00

I have been doing investing myself since year 2000 when I was still a student studying in National University of Singapore. There have been many moments of losses mixed with moments of gain. I have witnessed the panic selling after 9/11, as well as how the SARS impacted Singapore's economy. Most importantly, I have appreciated the complexities and entanglements between a rational mind and human emotions, and the impact it has on making investment decisions

My Gains and Losses: Graduating from the School of Value Investing
My losses are like 'school fees' paid for lifelong lessons in investment and valuing businesses. The point of 'graduation' came last year when I felt I have acquired immense confidence to apply value investing principles with a significant level of success, and it occurred to me on the importance of crystallizing the principles and paradigms of thought in a clear and explicit manner in the form of articles.

The Purpose of this Blog
This blog articulates my framework of investing and freely shares with all readers my investment knowledge. For non-starters, this blog will equip them with the basic knowledge on how they can take on investing by themselves. In addition, there will be specific references and sharings of analysis of a few companies.

I have gained immensely from the wisdom of the forefathers of value investing, and I hope you will be able to learn as much from what I have to share. Watch me as I rigorously apply the principles of value investing and achieve annual returns that consistently outperform the market and exceed the performance of the professional fund managers

Recommended Resources for Value Investing

2008-07-20T15:29:00.007+08:00

I would say that my investment philosophy started with just bumping around and mindless dabbling. It was over time that as I read and studied that things became clearer and an investment ideology emerges. Below are some resources that I accumulated over the years.

*1. What is Value Investing? by Lawrence A. Cunningham
- Good introduction to investing in general, and why the philosophy of value investing dominates

*2. The Essential Buffett by Robert G. Hagstroms
- Details on the science and art of the investing methodology behind the world's most successful investor Warren Buffett
- A must read if you buy into the philosophy of Value Investing

*3. Common Stocks and Uncommon Profits by Philip A. Fisher
- A classic on investing that brings new dimensions and perspectives to value investing

*4. The Interpretation of Financial Statements by Benjamin Graham
- A starter's guide, and a classic, to reading financial statements written in plain English

*5. The Intelligent Investor by Benjamin Graham (dry read, but certain chapters explain key concepts and must be read)
- Ben Graham is the mentor of Warren Buffett, this is the must read for any investor

*6. Essays of Warren Buffett: Lessons for investors and managers by Lawrence A. Cunningham
- A compilation into themes of all the letters written by Warren Buffett
- Alternatively, can find all the letters at berkshirehathaway.com

*7. Sun Tzu on Investing by Curtis J. Montgomery
- Curtis is a Singapore investor with a website at wallstraits.com
- Good read to draw a few pointers from Sun Tzu

The below reads are for you to expand horizons.

7. Security Analysis by Benjamin Graham (for reference only, and advanced reading. Very DRY)
- An intense text on how to quantitatively analyse stocks

8. Buffett: The Making of an American Capitalist by Roger Lowenstein (recommended for leisure reading)
- Good biography on how Warren Buffett came to be. With the mistakes and lessons he has learnt over the years

9. The Starbucks Experience: 5 principles for turning the ordinary into extraordinary by Joseph Michelli
- Recommended leisure read to expand horizons
- Good to know how Starbucks evolved from a small time business to a world enterprise

10. Built to Last: Successful habits of visionary companies by Jim Collins (recommended for lateral knowledge)
- Not exactly investing, but explains to you why world's greatest companies come to be and can last beyond 100 years
- Excellent read to expand horizons, and definitely help for investment purposes

11. Good to Great by Jim Collins (recommended for lateral knowledge)
- Not exactly investing either, introduces you to what companies and businesses are on their way to greatness

Websites to Visit

www.Wallstraits.com
- Value Investing website of Curtis J. Montgomery.
- Interesting articles on investing

www.sgx.com
- Singapore Exchange website with all the listed company information
- Includes annual reports, up-to-date business announcements

Business Grapevines - Places to fish for information

Channelnewsasia.com Forum "Market Talk"
- Mostly rubbish. But sifting through with patience will sometimes reveal posts on hidden gems.

Sharejunction.com & shareinvestor.com Forums
- Mostly rubbish posts too. But think of it as a source and tipoff

Wallstraits.com Forums
- Excellent sharing forum. Best place to sift for bargain hunters
Online Brokerages

I would recommend POEMS as a start www.poems.com
- Good tool that research and compile all listed companies info for last 5 years

Second & Third Level of Stock Screening

2008-07-20T15:27:00.006+08:00

The Second Level of Business Analysis

The second level of business analysis adopts a different approach. It requires the investor to have a much deeper understanding of the people and the processes of the company through unusual means of obtaining information.

The four aspects we are interested in here:

1. Marketing strength
2. Sales ability
3. Research & Development capabilities
4. People factor

1. Is the company a strong marketing organization?
2. Is the company an above average sales organization?
3. Does the company have outstanding labour and executive relations?
4. For consumer franchises, are the storefronts consistently packed?
5. For production companies, are the book orders filled for next few years?
6. Does the company have depth in the management?
7. How effective are the company’s research and development efforts in relation to its size?
- Quality of research personnel

Reference text:
- Common stocks and uncommon profits by Philip Fisher
- The Essays of Warren Buffett by Larry Cunningham

The Third Level of Business Analysis

The third level of business analysis base its principles of analysis on a few concepts empirically distilled by Jim Collins in his book "Built to Last". The investor seeks to determine if the company can become larger than life and enter the likes of HP, 3M, P&G, General Electric, Ford, etc. This is much more demanding approach and requires the investor to have a very intimate understanding of the company from ground-up and top-down.

1. Does the company pursue a purpose that is greater than profits?
2. Does the company preserve a set of core principles and ideology, but also actively stimulate progress?
3. Does the company have audacious and stretched goals?
4. Does the company possess a cult-like culture?
5. Does the company develop its top management from internally?

Reference text:
- Built to Last by Jim Collins
- Good to Great by Jim Collins

First Level of Stock Screening

2008-07-20T15:16:00.006+08:00

The first level of business analysis (or stock screening) uses only information freely available in the public domain. It allows the lay investor to understand and quantitatively measure the four dimensions of a business:

1. management quality
2. business fundamentals
3. financial strength
4. intrinsic value

The seven step screens will be able to help identify a good investment opportunity. However, the individual screens must not be used in isolation as it will not correctly represent the entire business quality.

Reference texts:
- The Intelligent Investor by Benjamin Graham
- Buffettology by Mary Graham
- What is value investing by Larry Cunningham

Management Quality
Is the management of an unquestionable integrity, holds a vested interest, highly competent and shareholder oriented?
- CEO/Chairman/Executive Directors > 10% stake
- Executive Officers > 10 years industry experience

Business Fundamentals
Does the company have a significant profit margin for its products and services, with a high Returns on Equity?
- Profits / Equity > 1.15 or 15% ROE

Does the company possess high barriers to entry and a durable competitive edge?
- Low cost producer enjoying significant economies of scale
- Strong brand with ability to set prices

Does the company have products and services with sufficient market potential to expand the company to twice its size in 5 years?
- Growth drivers
- R & D efforts: R&D / assets

Financial Strength
Does the company require massive amounts of debt and equity financing to sustain its growth and profits?
- Current Assets / Current Liabilities of > 1.5

Is the company effective at managing its cash flow?
- Operating Cash Flow / Current Liabilities > 1.5

Intrinsic Value
Is the company at an attractive valuation with a significant margin of safety?
- Net Tangible Asset / Price > 1.0
- Intrinsic Value (Discounted Cash Flow) / Price > 1.5

Three Levels of Stock Screening

2008-07-20T15:11:00.007+08:00

The recommended process for carrying out business analysis is divided into multiple levels. Each level varies depending on depth and accessibility of the information.

The First Level Screen

The first level deals with material public information that is freely available to anyone. It allows the lay investor to be able to conduct a first cut analysis to determine if a company is worth investing through information found in the public domain. Although the risk level due to misinformation is high (I estimate that public domain information accounts for only 30%), an outstanding management coupled with a significant margin of safety applied in determining the company’s intrinsic value will significantly mitigate the investor’s risk.

The Second Level Screen

The second level serves as a check-and-balance and validation of the first level information. The analyst uses unorthodox means to obtain material and insider information that is not easily acquired in the public domain. E.g. the investors can pose as customers to understand service level, sales staff competency or employee satisfaction. Through such unorthodox means, the investor can glean insights that are not easily available to public. The second level screen is a significant move in providing validation to the analysis in the first level, as well as uncovering any possible problems that is hidden from the public eye.

The Third Level Screen

In this level, the investor strives to acquire an intimate understanding of the workings of the business, processes, visions, company culture, philosophy, management succession planning, people buy-in factor, team dynamics. The investor is interested to determine if the company can evolve a profitable enterprise that lasts beyond a century, filled with people who are builders of a true lasting legacy like a endlessly ticking clock tower. There are many profitable businesses that grow fast but decay after some time; but, like Warren Buffett, the value investor seeks to have ownership in a profitable business that will last forever.

Recommendations

It is recommended for any investor to understand his investments as much as possible, but the different levels of screen demands increasing amount of time and resources. How much is enough, would actually depend on how much time and resources one can set aside for your investments. For the uninitiated investor, probably the first level will suffice as a start. Given the inability to commit more time and resources to perform a full fledged analysis, this level is recommended for all DIY investors. And do take note that there must be a significant margin of safety and the study must be carried out merticulously to accurately ascertain the transparency and integrity of the management. Those companies with a management that have signs of inconsistency or possible lack of transparency should be avoided at all times.

The second and third level screens, when appropriately applied, will further lower the investor risk due to half-truths of public domain information. For any investor who is not holding a job as a finance analyst, to carry out this level of analysis entails taking leave from work to visit the company, talk to their staff, pose as customers, etc. This level can be seen as too much to ask for from DIY investors, but is probably more suitable for the part time or full time research analyst who is able to commit more resources. Nonetheless, if you are willing to invest your good money and spend time to read annual reports, why not consider taking it one step further to talk to people?

Paradigms of Thought in Value Investing

2008-07-20T15:09:00.007+08:00

There exist several ideas central to value investing:

1. Concept of Mr Market

This concept of Mr Market is first coined by the father of value investing, Benjamin Graham. He tells of this story where the stock market is like a salesman named Mr Market who suffers from extreme mood swings. Every day, Mr Market will unfailingly come knocking at your office. If he feels extremely optimistic, he will offer businesses for sale at a high price to you with a very convincing pitch that he knows the company will soar towards stellar heights come tomorrow. And there will also be days when Mr Market will come to you with a very depressed sentiment because there’s a riot happening on the other end of the planet; he will probably offer the same businesses at incredulously low prices even though the business is still overflowing with endless streams of income.

The relationship between the value investor and Mr Market

The value investor is not to partake in Mr Market’s fleeting moments of optimism and depression. What he has to do is to perform his own independent evaluation and use Mr Market to his own advantage – by either buying excellent businesses at rock-bottom prices, or to sell off businesses at a price that is higher than the underlying intrinsic value.

2. Concept of Margin of Safety

The principle of margin of safety is a concept coined by Benjamin Graham in his authoritative book “The Intelligent Investor”. It states that a transaction to hold a stake in a stock should only be executed when there exists a significant disparity between the price and the estimated worth. This disparity is termed a margin of safety as it provides a tolerance for valuation errors due to ‘fudged’ financial figures and etc.

3. Concept of Circle of Competence

Warren Buffett firmly believed that if he cannot understand the business and its products and services, then he will avoid holding stakes in such companies. Likewise, the value investor should only acquire stakes in business that he understands and is deeply familiar with; the value investor stays within his circle of competence.

Fundamental Tenets of a Value Investor

2008-07-20T15:04:00.009+08:00

There are four fundamental tenets in value investing:

1. Value investing is part ownership of excellent businesses.
2. There will always exist a disparity in the price of the business versus its underlying value.
3. The primary basis for buying into or selling out of businesses depends on a measure of underlying value versus the current market price.
4. The stock market only exists as a convenient means to buy into or sell out of businesses.

Requirements to be a Value Investor

It does not take much for one to be a value investor. There’s no requirement to be a financial expert, economist or have an accountancy degree – these are only ‘good-to-have’ as they accelerate the learning curve. What is more important is for the person to have (1) rational thinking, (2) an open mind with a willingness to adopt new perspectives and (3) to have emotional disengagement from the stock market, courage and patience.

A Rational Mind. The value investor must be one that has a desire to improve his knowledge through his own reading up or cross-sharing with others, and apply what he has learnt in school to perform his own independent analysis. He must be open to acceptance of new ideas that challenge how the general population will perceive things; only then will he be able to see what others cannot see, and achieve what the general crowd will not be able to achieve.

Emotional disengagement from stock market To become a value investor, one has to disengage from the emotions and mood swings of the stock market fluctuations. Only when this is achieved, will one be able to make sound and rational decisions, while capitalizing on the herd’s foolish behaviour.

Courage – The next most important virtue after intelligence. It requires immense courage to act against herd behaviour and run in the opposite direction. The next step after completing a thorough financial analysis is to wait for opportunity. When the opportunity comes, the investor must trust in his independent judgment and take action swiftly and decisively.

Patience – “Inactivity strikes us as intelligent behaviour”. The value investor has to be patient and recognize the fact that as long as value of the company has been correctly ascertained and acquired at a significant bargain, the price will take care of itself – in due time, the stock market will rise to match the underlying value. He will look away from the stock market, and direct his efforts to understand the business further, acquire new perspectives in valuing businesses. If the business’s underlying value strengthens over time, but the stock market does not price that in, the value investor will be even happier to acquire bigger stakes with a greater value-for-money proposition.

Are you a Value Investor?

2008-07-20T15:00:00.008+08:00

“Investing is most successful when it is most businesslike” – so said the father of value investing, Benjamin Graham, who is also the mentor of the world’s richest man Warren Buffett. Value investing requires a paradigm shift from the common perception of companies listed on the stock market as a bunch of ticking numbers to thinking of oneself as truly a part owner of a business. To express it succinctly, value investing is about ownership of an excellent business at a price that is a fraction of its worth.

Are you a Value Investor?

Characteristics of a non-Value Investor

Investors who have acquired the Holy Grail of Value Investing are few and far between. I would reckon that more than 95% of the investor population comprises of non-value investors. This group of people generally does not recognize that there will always be a disparity between price and value. Amongst them will be a lot of people who are emotionally correlated to the fluctuations of the economy and the stock market – when the stock market is bullish, their portfolio value rises and they are happy; when the stock market is bearish and their portfolio looks mediocre, they are unhappy. Their actions are driven by their emotions.

Amongst this group will also have people who profess to be technical analyst (TA) or computational clairvoyants who claim that they are able to predict future price movements by drawing charts based on historical prices and volume. Amongst them will be people who are opportunists and gamblers who hop on the bandwagon of certain news in the hope of obtaining a quick profit. There is also the group of Efficient Market Theory believers who firmly insist that information is perfect, and that all prices reflect the company’s underlying value; they firmly believe that all efforts to perform an investment analysis are futile and it is more worthwhile looking at global trends.

Characteristics of a Value Investor

At any point in time, value investors keep things simple and they only seek to obtain answers to one question: what is the company’s underlying worth? The fundamental difference between a value and non-value investor is that a value investor recognizes that there will always be a disparity between price and value of the business; there will always be room to capitalize on situations where the price grossly misrepresents the company’s value.

Value investors think independently and do not follow the herd’s behaviour. They are emotionally disengaged from daily stock market fluctuations; their decisions on buy/sell are strictly based on a sound and rational judgment of the business quality versus the price. Value investors are highly risk-averse; they only seek to invest in companies that fall into their circle of competence – they thoroughly understand the industry requirements and business model of the companies they hold stakes in. They sleep soundly all the time, even if the stock market closes for a prolonged period. As long as the company continues to operate profitably, value investors will remain inactive.

Value investors are very intelligent; they will awake from their inactivity or ‘slumber’ to swop in for bargains when everyone is fearful, and they will not hesitate to sell off their businesses at a significant profit when everyone else has a sense of unfounded optimism.

So, are you a value investor?