Disclaimer: This article is written for the purpose of discussing my thought on a buy or sell process basing on a fundamental approach. It is not a recommendation to buy or sell any particular stock.

The first stock pick challenge initiated by Tan KW from early January 2013 ended by the end of July 2013. Tan KW initiated another “Stock Pick Challenge 2013 2H” starting from 1^st August 2013. I have chosen a diversified portfolio of 11 stocks as compiled in the link here:

 http://klse.i3investor.com/servlets/pfs/19386.jsp

The stocks were chosen basing on fundamental value investing. Most of those stock ideas came from our discussions in i3investor on various investment strategies, in particular the principles of Joel Greenblatt Magic Formula as well as the ideas from Cold Eye on his 5 yardsticks in investing which I modified and fit in some benchmark numbers as shown in the discussions initiated by me in i3investor in the links appended below:

http://klse.i3investor.com/servlets/forum/900255072.jsp

http://klse.i3investor.com/servlets/forum/900214344.jsp

In this “Stock Pick Challenge”, I have provide written justifications on my investment thesis, including the valuation on every stock chosen as shown in the link below for sharing and discussion purpose.

http://klse.i3investor.com/blogs/stock_pick_challenge_2013_2h/blidx.jsp

The analysis of those stocks include financial statement interpretations and valuations. For those who are interested the value investing criteria are encouraged to read each article posted.

I generally walk the talk and invest myself on those stocks I have written if I think they are good stocks to invest in at the right prices. Where did I find money to invest in this portfolio of stocks? Yes, it was from the sale of half the stocks in MyFirstPortfolio when those stocks no longer meeting the principles of the Magic Formula when their share prices have risen substantially mostly, or their business has deteriorated as discussed in the following thread.

http://klse.i3investor.com/blogs/kcchongnz/67653.jsp

MySecondPortfolio

The stocks in MySecondPortfolio were mostly brought to my attention by my readers in i3investor and the participants of my online investment course before I put them together in MySecondPortfolio with my investment thesis. One would notice that all stocks in my portfolio are small to medium capitalized stocks. but why?

I am a fundamental value investor  trying to find good companies trading at cheap price. It is hard to find them in the large capitalized stocks which I classify as good companies by the metrics of high return of equity and return of capitals. These stocks are closely followed and owned by local and foreign funds and hence would likely to be fully or overvalued.  Furthermore a large company is hard to have high growth. A 50m increase in profit is 50% growth for a 100m revenue company, but just a 5% growth for a 1b revenue company.

Kenneth French, a Dartmouth College finance professor found that a single dollar invested in the small capitalized stocks in US market grew to $5522 in a period of 74 years from the year 1926 to 2000, as compared to $2128 for investing in large company stocks. His findings in the UK, Japan and several MSCI countries yield unambiguous results, with the small capitalized stocks returned an average of 2.6% better than the large caps per year.

The small caps are indeed the hidden gems in the stock market, including in Bursa. Those selected by me generally have the following attributes:

1. Their business is durable and likely to last for many more years to come.
2. They have good financial position with little debts, or if with significant debts, their profit and cash flow can easily cover many times interest payment.
3. They have good quality and consistent earnings. Cash flow from operations  (CFFO) is equal or above net profit on average.
4.  They generally have positive free cash flow (FCF). Often FCF is abundant at more than 10% of revenue and invested capital.
5. They have high return of equity and invested capital, at least more than 10%.
6. Most of all, they are trading at low multiples such as PE ratio, P/B, enterprise value/Ebit, EV/Ebitda, EV/Sales, Price/FCF  etc.

http://klse.i3investor.com/blogs/kcchongnz/54664.jsp

7. There is little or even none analyst coverage.
8. Scant institutional ownership.

The Return of MySecondPortfolio

After 17 months have passed at the end of year 2014, the average return of the portfolio is 54.4%, compared to the return of the broad KLCI of just 3.4%. This mean the alpha is a whopping 51%. Out of the 11 stocks in the portfolio, 9 are in the positive return territory with two more than 100% return; Datasonic at 275% and Homeritz at 113% as shown in Table 1 in the appendix. There are three under-performers; Tien Wah at -20%, Haio at -9.4% and Kumpulan Fima at +1.5%.

I am happy with the results. Invest in a diversified portfolio of stocks with the outcome of more positive return than negative, and a couple with outsized return while the negative return is minimal. That is the result each investor should strive for. So this time, which are the stocks I should continue to keep in my portfolio?

A Review of stocks in MySecondPortfolio: Which to retain and which to sell?

A review to decide which stock to keep or to sell again involves evaluating if the company is still a good company and if the present price is still worth keeping, or sell at a profit and use the proceeds to scout for better investments. Yes, I would use the principle of the Magic Formula again.

Table 2 shows the metrics for the Magic Formula for the stocks in the portfolio. Kumpulan Fima and Pintaras are not listed here as they are a duplicate of the stocks in MyFirstPortfolio.  I have mentioned before that I should keep them as they still meet the criteria of the Magic Formula.

Tien Wah’s business core earnings was adversely affected by the strict regulations of advertisement in the cigarette packets in Australia and other countries. Its earnings has dropped drastically as a result with a ROIC of just 7%. Moreover due to low earnings, its EY at 9% is also not high enough. It fails both metrics of the Magic formula and has been discarded from MySecondPortfolio.

Datasonic has undergone two corporate exercises since 17 months ago, a split of 1 share to 5 shares and subsequent a 1 for 1 bonus issues. It’s adjusted share price has risen to above RM2.00 in March 2014, and then fell back substantially to the close of RM1.23 at the year. It was really a Rule Breaker, and a great reward for those risk takers. It still has good earnings visibility in the near future and a great company with ROIC of 38%. However, its share price has risen too much and at RM1.23, its EY at just 7%. Moreover there will be a slowdown in its growth of identity cards as the extreme high growth is not possible to go on forever. I have excluded this stock from the portfolio as a result.

Haio’s ROIC remains high at 37.4%. Its share price has dropped by 9.4%, resulting its EY reasonably high at 15.3% with its share price at RM2.20 now. Hence this stock still meets the Magic Formula and will be kept in the portfolio. Haio was once a high flier 5 years ago when its share price was above RM5.00. I hope that with the persistence phenomenon of mean reverting in investing, its share price will over-perform again in the future.

Homeritz’s share price has risen substantially by 113.4% since I first started writing about it. This stock was alerted by a reader of my articles in i3investor with his Magic Formula. He is a participant of my first online course in fundamental value investing. I examined Homeritz business and found it was interesting and included it in my portfolio. After a home run with its share price gaining over 100%, its business and fundamentals continue to improve with ROIC remaining high at 42.1%, the highest among the furniture stocks as discussed here:

http://klse.i3investor.com/blogs/kcchongnz/66908.jsp

A high ROIC company requires minimal reinvestment needs and most of its earnings can be distributed as dividends to shareholders. With 4.8 sen dividend last year, the dividend yield is 5.5%, much higher than one can get from fixed deposit. At 86 sen, its second Magic Formula metric of earnings yield (EV) is also high at 19.3%. As it is mainly dealing in the export market, in particular the US market, with the weakening of Ringgit against USD, there may be some bright future for its business going forward. Hence Homeritz will definitely remains in MySecondPortfolio.

Fibon was also alerted to me by a reader and a course participant of my online investment course. He came up with his own investment thesis on it. It is a smallish company with little turnover and hence earnings is volatile. However, it has a very healthy balance sheet and hence is not as risky as other small companies in times of economic downturn. Its share price rose the highest of 66 sen end of 2013 before retreating to a close of 40 sen end of last year. With its high ROIC at 33.4% and EV at 31.4%, it remains as an attractive Magic Formula stock. Its earnings recently has subdued somewhat but I think it will still meet the Magic Formula metrics. Hence it remains in MySecondPortfolio.

Daiman’s ROIC at 9.0% appears to be low. However, Daiman was chosen based on Graham net current asset valuation, similar to Plenitude in MyFirstPortfolio.

http://klse.i3investor.com/blogs/stock_pick_challenge_2013_2h/36493.jsp

Daiman’s share price rose to a high of RM4.00 half a year ago before retreating to a close of RM2.65 end of last year. As Daiman remains a Graham net current asset value candidate, it will remain in MySecondPortfolio. Hopefully one day someone or some events will unlock and unleash  its high latent asset value.

MFCB was also brought to my attention by another reader of i3investor and also a course participant. It has stable and increasing earnings and cash flow for the last few years after the recovery from the US sublime crisis. At RM2.40 end of 2014, its EY is high at 25.8%, double my requirement. It has a good ROIC too at 15.8%. Why is it selling at such a cheap price? Is it because of the concern that its power generating agreements  in China and East Malaysia will not be renewed? I have no idea. The most recent investment bank report gives a target price of RM3.85 to MFCB.

http://klse.i3investor.com/blogs/PublicInvest/66542.jsp

Willowglen was also brought to my attention by the same person as that of Fibon. Its share price went up to more than 90 sen 4 months ago before retreating to the close of 75 sen on 31^st December 2014. Its share price have risen by 49.1% % since 17 months ago after the correction. However, as you can see from Table 2, its ROIC is one of the highest at 40.9%, and yet its EY remain high at 16.3% and way above the requirements. Hence it stays in MySecondPortfolio.

CBIP has a 1 for 1 bonus and rights issues with warrants about a year ago. It has risen by 50.8% since 17 months ago. However, as you can see its ROIC and EY remain high at 30.6% and 13% respective, Hence it also stays in MySecondPortfolio.

Conclusions

The portfolio has return an average of 54.4% compared to KLCI during the same 17 months period. However, most of the stocks, except Tien Wah for its deteriorating business and Datasonic for its meteoric rise in share price, will remain in MySecondPortfolio as long term investments due to their high ROIC and EY, and hence good companies selling at cheap prices.

What would I invest in with the proceeds of the sale of Datasonic and Tien Wah?

For those who are interested in fundamental value investing for a small fee, please contact me at

Ckc13invest@gmail.com

K C Chong (On the eighth day of New Year 2015)

Appendix

Table 1: Return of MySecondPortfolio

Table 2: Magic Formula for MySecondportfolio

*Adjusted to price before bonus issues. Stock returns are approximate only.