The Real Deal of Business Deals and Investments

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

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

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.

The End of A Beginning

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

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

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)

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.