Below discussion is copy from kcchongnz post on http://klse.i3investor.com/servlets/forum/900255072.jsp

Posted by kcchongnz at May 25, 2013 12:03 PM

In search of excellent: Are good companies good investments? 

Many seasoned investors would have told you to invest in good companies and you will never go wrong. The core of the story is history backs you up; Public Bank, Nestle, GAB, Maybank, BAT etc. Well managed companies are also less risky. But is it really true that good companies are good investments? 

First of all how do we define good companies? This is important because many novice investors are confused what are the attributes of a good company; many of them falsely think that a good company is one its stock is going to be manipulated sky high by insiders and that everyone will profit from it. 

My criteria of a good company is a well-run company with good corporate governance; no unfair related party transactions, independent board of directors. A more measurable metric for good company is its financial performance; a durable business, constant growth in its business, a return on invested capital higher than the cost of capital, good cash flows and healthy balance sheet. More specifically the company must have sustainable future economic value added in its business. 

However, research has shown that investing in good companies is not a winning strategy. This is because the market has built into it these expectations. The biggest danger is that the firm will lose its luster over time and that the premium paid will dissipate. It is only when markets underestimate the value of firm quality that this strategy stands a chance of making excess returns. There is a strong tendency on the part of companies to move toward the average over time, or mean reversion. So what investors can do to profit from investing in good companies by: 

1. Buy good companies that are not being recognized by the market as such. 
2. Buy good companies when others throw because of overreaction to disappointing news even though the news may not have significant long-term value consequences. 
3. Buy when the entire sectors or even markets may be marked down in response to bad news about a few companies in the sector or market. 

Screens for buying good companies can be as followed: 
1. Return on invested capital (ROIC) > Weighted average cost of capital (WACC) 
2. Price/Book < 2.0 
3. Price Earnings ratio < 25 

This is to avoid under-performance due to the usual high price of the stocks of good companies. 
Do you have your attributes of a good company? What are your screens for investing in a good company? What are the stocks from your screens?

Posted by kcchongnz > May 29, 2013 08:40 AM | Report Abuse X

plutus, this thread is about investing in a great company, not a undervalued stock. The strategy is first to find the great company; good governance, social responsible company, high return of investors capitals, durable business with lasting moat, good cash flows etc. Normally a great company's stock is sold at high valuation. Hence before investing in a great company you have found, you need to check if the valuation is reasonable. For a great company, even a PE ratio of 20 may not be high. don't you agree? 

If I want to embark on a strategy to buy value stock, I will first go find a company trading at low PE ratio, say 10 (of course this ratio will depend on the sector, size and the prevailing market ratio etc), then I will check if there is other criteria which are too much compromised. For example, my value stock must have a growth of at least 5%, not so much debt say Debt-to-capital ratio <60%, that the quality of earnings is good (meaning good CFFO too) so that I am not cheated with managed earnings, etc.

Posted by kcchongnz > Jun 16, 2013 12:16 PM | Report Abuse X

Posted by houseofordos > Jun 15, 2013 05:21 PM | Report Abuse 
KC, 
Nice sharing... I think Muar Ban Lee, Willowglen also fits nicely into this criteria... To add... 
P/B ratio of 2 may not be too expensive if we are looking at asset light companies so again comparison to sector average or peers will tell a better picture 
P/E ratio of 25 is a good starting point, P/E =25 = earnings yield of 4% which exceeds FD rate. P/E ratio should be further compared to the sector or index average before decision is made.. 
Other screens I normally use are :- 
Debt to equity < 0.5 
Dividend yield > 5% 

house, agree with you regarding your P/B=2 and P/E=25 are not high for investing in a good company. I am emphasizing "good" companies here. 

Regarding your screen for D/E<0.5, and DY>5%, I am afraid you may lose out some fantastic companies to invest in if you put your requirements too stringent. Many good companies can leverage high with D/E even much higher than 1 to earn good ROE. A good business is good to have more debt because for good business, leverage enhances return to equity holders. I did not study good companies like Nestle, Carlsberg, BAT, Maxis, GAB etc, but i think they make good use of leverage to enhance ROE. Also a good company with steady cash flows have no worry of paying interest payment. 

The other DY which at the start I have mentioned that there is no statistically evidence to show that high DY companies provide high total return. Think about it, a company pays out too much dividends is because they have nothing better to do with the money. A growth company which pays out too much dividend will suffer lower growth rate if less money is reinvested in the business.

Additional Notes on WACC

 Posted by kcchongnz > May 27, 2013 11:43 AM | Report Abuse X

Posted by Tan KW > May 26, 2013 07:05 PM | Report Abuse 
@kcchongnz how you get the WACC? need to calculate by yourself? 

If a company has 200m equity and 100m debts and the cost of equity you use say 12%, and cost of borrowings at 7%, 

WACC=200/300*12%+100/300*7%=10.3%. 

I use 12% as my required return for investing in a company with ok but not so good balance sheet and cash flow. If they have healthy balance sheet and excellent cash flow, I may use 10%.

Posted by Tan KW > Jun 1, 2013 08:55 PM | Report Abuse 

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@kcchongnz for your reading http://klse.i3investor.com/blogs/kianweiaritcles/30873.jsp 

is this a good way to determine WACC?

osted by Tan KW > Jun 1, 2013 09:22 PM | Report Abuse 

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@kcchongnz based on the above link 

i think different companies might have different cost of capital, and we can use the CAPM to find out the cost of capital.. but the problem is i am not sure how can we able to locate the input for the CAPM calculations... 

- Risk-free Rate - maybe we can use the FD rate? 
- Beta - yahoo finance seem not provide beta for KLSE stock... or we can get it some where else? 
- Risk Premium - another ????

Posted by kcchongnz > Jun 2, 2013 05:30 AM | Report Abuse 

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TanKW, yes, the link you provided is the way to calculate WACC, the "academic" way. My last example to calculate didn't adjust the tax shield for cost of debt. for example if borrowing cost is 6%, the after-tax cost of debt is 6%*(1-25%)=4.5%; assuming tax rate is 25%. 

Risk free rate you can use the FD rate, but the more appropriate rate may be the 20-year MGS rate. Beta is the movement of the stock price in relation to the market obtained through a statistic analysis of standard deviation of the stock price. Risk premium is what an investor required over and above the risk free rate. Calculation of beta is tedious but in the US market, beta is provided from many free sites. I am not sure in Bursa. Anybody knows where to get it appreciate can let me know. 

The above is too academic. Actual finance and investment need not to be that precise. So I normally make my own judgement. for example if a company has healthy balance sheet and good cash flow, my required return is 10%, 15% if the company is risky with big bets, poor balance sheet and not much cash flow. 

Hope the above help.

Additional notes on Corporate Governance

Posted by kcchongnz > Jun 12, 2013 05:46 AM

Management and corporate governance of a good company. A Look at Pintaras Jaya. 

Most investors view the value of management as reflected by its stock price. There is some truth to this over the long run, but strong performance in the short run doesn't guarantee good management. One of the best example in Bursa is KNM group. Everyone is familiar with how the flamboyant CEO has been doing to jack up its share price by repeatedly issuing misleading statements about its future, engaging in company share buybacks to jack up the share price, engaging in acquisition spree all over the world which destroy value etc, instead of concentrating in improving the operation efficiencies and the bottom-line of the business. One better example is the failed Enron Corporation in this book, “Conspiracy Theory: the True Enron Story”. 

Both the key man in Pintaras Jaya, Chairman and Managing Director Dr Chiu Hong Keong, aged 58, the founder of Pintaras , and Ir Khoo Keow Pin, aged 56, an Executive Director, are geotechnical engineer by training and have worked in the construction industry, in particularly the geotechnical works involving design and construct heavy foundation and retaining structure works for the whole of their career. The valuable specialized knowledge they possess ensures the effective operations and management of the company. 

The management is compensated fairly with their salary each year. Total management compensation for last year was RM2 million, just about 1% of its turnover last year. There has been no options granted to anybody in the management before. Dr Chiu who holds the position of both the Chairman and Managing Director paid himself for less than RM800k a year, even though the company made a profit before tax of RM54m last year. 

In actual fact, Dr Chiu and his management team does not required to be paid high salary for their commitment to the company. Dr Chiu and his spouse hold about 73% of the total of 80 m shares in Pintaras. When a dividend of 20 sen was paid last year, they pocketed about RM12m. So why is there a need to have high salary and compensation from the company? This high percentage of insider holding in itself aligns the interest of shareholders and the management and hence minimize the agency problem in a corporation. 

In corporate governance, the Board comprises 4 Executive Directors, a Non-Independent Non-Executive Director and 3 Independent Non-Executive Directors. They have a vast range of experience and knowledge in the areas of business, engineering and finance. The Independent Non-Executive Directors do not form part of the management and are not connected with major shareholders. They provide a fair representation of the shareholder’s interest. So far, there have not been any unfair related party transactions in the company. 

The management also has a focus strategy in its business. It concentrates in what the company can do the best, i.e. to embark on design and construction works of its niche market in deep foundation and basement work with less competition and higher margins, rather than engaging in every kind of construction work where the competition is keen and margin is low. 

The above are some of the high quality of management I think one should focus on when investing in a company.