Investing in Bursa: Have the cake and eat it 魚與熊掌不可兼得

 “Good stuff, cheap”

Who doesn’t want to buy something which is good and cheap?

But what is “good”? And how do you know if it is “cheap”?

Don’t you want to buy a 2013 Lexus LS just by paying RM50,000? And won’t you want to buy 1000 shares of Nestle for RM2000?

That is precisely I want to talk about (again) here; buying good stocks at cheap price. Isn’t this goal tantalizing? Don’t you also want to do it too?

 First of all how do we define good companies?

1. Is a high growth company like KNM which grows its revenue unabated from 344m in 2005 to 2.37b in 2012 (a whopping CAR of 34%) a good company?
2. Is a business of low net profit margin of about 1.5% of DKSH not a good business while it has created tremendous shareholder value with its share price rising from just 48 sen 5 years ago to 7.10 now?
3. What about a high dividend stock like Guan Chong with dividend yield above 8% in 2012 with dividends paid with borrowed money as it did not even have positive cash flow from operations a good company?

My major criterion of a good company is one which provides a high return of capital. A $100 of additional capital created by a business A employing $200 of capital is more impressive than a business B employing $1000.

One major metric is the return on equity (ROE). However this metric can be and is often clouded by the capital structure, one-time-off items etc. For example a highly leveraged company can have a high ROE during the boom stage of the economy, but can have huge losses and high bankruptcy risk in times of economic crisis. A one-time-off gain item skewed the return and is hence not representative. Hence I prefer to use the return on invested capital (ROIC) where all capital contributors are taken into account, and resources not utilized in the ordinary operations such as excess cash excluded. ROIC should be higher than the costs of capitals in order to provide shareholders wealth maximizing.

Return on Capital (Modified ROIC) = EBIT / (Fixed Assets + Net Working Capital)

Other complementary attributes of a good company are good cash flows and free cash flow to ensure quality earnings, and a healthy balance sheet as a prudent risk management. Without cash flows, a company will have to continue to borrow money for preservation of its business, business expansion, buying back shares or distributing dividends. Qualitative attributes of a company such as a credible management and good corporate governance would come in handy too.

What about growth of the company? Is it important? Certainly, I have written about this how a high growth company should be valued higher than a low-growth one as appended in the link below:

http://klse.i3investor.com/blogs/kcchongnz/45456.jsp

I have also written about the unknowable future and its unpredictability. I’m not good at estimating future growth and hence I am unwilling to pay much for growth. When I make an investment, it needs to be justified even if the business doesn’t grow. It doesn’t need to be a home run if it doesn’t grow – I certainly benefit from growth – but it needs to be a base hit without growth.

Now we have more or less decided what a good company is, but exactly what price are you willing to pay for the stock of a good company?

Value

Investment success doesn’t come from “buying good things,” but rather from “buying things well.”

Tons of research has shown that investing in good companies is not necessarily a winning strategy. This is because generally 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.

A simple metric used to carry out “buying things well” is to compute the price-earnings ratio (PE) of a stock. A low PE say at less than 10 may signify that the stock is cheap. However, this metric suffers the same fate as in the computation of ROE, the unstable and manipulative E, or net profit in the bottom-line of the income statement. Hence a better metric as in the above is the use of enterprise value (EV) against the earnings before interest and tax (Ebit) to take into account of all capital providers, but excluding non-operating cash or cash equivalent. A low EV/Ebit, or a high earnings yield of more than say 15% may signify the stock is selling cheaply and vise versa.

Earnings Yield = EBIT / Enterprise Value

For those who are interested about this subject, you can refer to the following link and the discussions in the thread.

http://klse.i3investor.com/blogs/kianweiaritcles/37729.jsp

Why does this strategy of buying good stuff cheap work in Bursa?

Since buying good stuff cheap is so logical thing to do and it is intuitive, why does it still work and this advantage is not arbitraged away in a supposedly efficient market?

One major reason is the emotional biases inherent in all investors. For one, few participants in Bursa are interested in dull stocks with not much of trading activities. There is no fun watching it with little or no movement in share prices of these stocks every day. Secondly there is this institutional imperative. Fund managers are more concern about their career risks if following a winning strategy if it involves enduring long stretches of relative underperformance which does happen in the short term, but usually not in the long term. They feel that it is safer to be wrong when everyone else is losing money than to be wrong when everyone else is making money which the formula can do.

So are you ready to utilize this winning strategy, buying good stuff cheap, in Bursa for the year 2014? Do you want to share with us here?

KC Chong (On the second day of Lunar New Year)