The game that public listed companies play

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

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.

Cooking a recipe for an excellent investment opportunity

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).

How to Start Investing

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.

Recommended Resources for Value Investing

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

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

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

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

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

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.