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)