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).