This article is for learning, sharing and discussion purpose. It does not constitute a buy or a sell call.

In my previous article, I have discussed about how to identify quality growth stocks.

http://klse.i3investor.com/blogs/kcchongnz/70874.jsp

In summary, a quality growth stock must have good growth in profit and cash flow in tandem with its revenue growth achieved internally like that of Pintaras Jaya. Pintaras Jaya’s net profit grew at a compounded annual rate (CAGR) of 18.5% for the last 10 years from RM9.9m in 2004 to RM54.2m in 2014 without having to ask a single sen from its shareholders and borrow any money from the bank.  Instead it has been distributing hefty and ever increasing dividends from 5 sen eight years ago, up to 30 sen per share in 2014 based on the original share capital of RM80m.

In contrast, although London Biscuit revenue has been growing at a CAGR of 20% for the last 10 years, through high price acquisitions, increasing assets utilized with increasing borrowings and new shares issues. Despite of that, its net profit hardly moved. As the number of shares issued have increased substantially, earnings per share (EPS) has dropped by 57% from 20.5 sen 5 years ago to the latest 8.8 sen for the financial year ended 31^st December 2014. Dividend, paid using money from right issues and increasing borrowings from banks, has decreased from 15 sen in 2006, to just 1 sen for the last few years.

A high quality growth company like Pintaras also produces plenty of cash flow, in particular free cash flow after spending money on capital expenses for growth. A poor quality growth company like London Biscuits doesn’t have any cash left after capital expenses. In fact, it put up its hand to ask additional money from shareholders and banks all the time in the name of growth. In actual fact, its high growth is a huge destroyer of shareholder value instead with its return on capital of 4%, way below its cost on capitals estimated to be about 12%.

It is hence easy to identify a quality growth company as opposed to a shareholder value destroying growth company. However, being able to identify that is only the first level thinking. One also needs to analyse if a good quality company is not expensive, and a poor quality company is cheap to invest.

Valuation: Back to the Past

Let us go back to the past of 5 years ago to reflect if Pintaras was worthwhile to invest in, and if London biscuits was clearly a lemon to avoid at that time. I know some readers will not be happy as I am using the same examples most of the time to illustrate my points. However, for those who are patience, we may all learn something very useful from these two excellent examples here.

London Biscuits

When London Biscuits announced its final 2010 financial results ended 31^st December at the end of February 2011 with earnings per share (EPS) of 15.7 sen, LonBis was trading at RM1.00 apiece. At that price, the P/E ratio was just 6.4, a very low value, and hence very cheap indeed, so it appears to. That is how most investors rely on when valuing a share, the simplistic PE ratio, including almost all professional analysts and investment bankers. PE ratio is alright for some companies but often it presents a whole lot of problems. You can refer to the following link of what I am talking about.

http://klse.i3investor.com/blogs/kcchongnz/63417.jsp

To summarise, the E in this P/E ratio is an accounting number which can mean anything. For many poorly managed companies, almost all the E reported are dodgy numbers as discussed in the appended article here.

http://klse.i3investor.com/blogs/kcchongnz/45373.jsp

Hence I prefer to use another not-easy-to-manipulate metric in times Enterprise value (EV) over its earnings before interest and tax (Ebit), or operating profit as discussed in the same article in PE ratio above, especially for those companies which has substantial debts and minority interest like LonBis. Please refer to the appended link to understand what EV is and its importance in valuation.

At an enterprise value of 12.3 times its Ebit 5 years ago, or a before tax earnings yield of 8%, LonBis at RM1.00 was not exactly cheap, considering its poor return on capital, which was at 6.1% then and trending downwards, way below its cost of capital of about 12%.

Price-to-book wise, LonBisc appears to be cheap at o.4 times. This it deserves it due to its low ROIC.

Its price of just two and a half times cash flow from operations is deceivingly cheap as its CFFO consists of substantial depreciation write back. Not until you consider its free cash flow which is most of the time negative the few years before 2010 because of the management “playing with” the buying and selling of property, plant and equipment all the time! Table 1 in the Appendix shows its “Purchase of PPE” is all the time substantially higher than the CFFO. What kind of business is it when the company needs to spend more upgrading its PPE than the cash it receives, every year consistently without fail? Yet the management wasted away more money in acquiring shares of other public company such as Lay Hong, Khee San at high price resulting heavy losses in investing activities.

For other valuation techniques, please refer to the link below:

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

Hence I would not invest in LonBis 5 years ago by considering its low return on capital lower than its costs which is a huge shareholder value destroyer, and its dodgy management actions in manipulation of PPE, empire building and further aggravating its already persistent negative free cash flow.

Pintaras Jaya

When Pintaras announced its final 2010 financial results at the end of June 2011 with earnings per share (EPS) of 26 sen, it was trading at RM1.60 apiece. At that price, the P/E ratio was just 6.2, very low and not forgetting that it has a huge amount of excess cash amounting to RM1.22 per share then. Its enterprise value is also extremely low at just 1.2 times its Ebit. Its cash flows were also very healthy with FCF positive all the years. With the abundance of FCF, management has been increasing dividend payment and investing in equity funds earnings higher return from its cash. How could one go wrong investing in Pintaras then?

The question is a good high growth company of Pintaras at a pre-one-for-one bonus price RM8.70 now, after rising more than 4 folds in share prices in just 5 years, too expensive any more to invest? And a poor growth company of London Biscuits at 80 sen now, after dropping by 20% since 5 years ago while the broad market rose by more than 50% during the same period, a value buy?

Price Vs Growth and Value

Pintaras at the adjusted price of RM4.35 after the bonus issues is trading at a PE ratio of 12.8 and an enterprise value of 8.2 times its 2014 Ebit. It is certainly much more expensive than before. However, with its high return on capital of 30%, healthy balance sheet and cash flow, and the huge increase in job in the coming one year and hence potential for future growth, I believe it is still not expensive at all. A quality high growth company deserves a higher valuation.

On the other hand, LonBis at 80 sen, is trading at a PE ratio of 9.1, and an enterprise value 11.5 times its Ebit. This I consider very expensive considering its low and declining ROIC of just 4%, heavy borrowings and huge negative FCF of RM25m. I still won’t touch it with a ten feet pole.

Knowing how to identify a high quality growth company and what is a poor quality growth company, and their price versus value relationship will certainly improve one’s investing experience. I am certain that Pintaras and LonBis are not the exceptions. Please refer to the link below.

http://klse.i3investor.com/blogs/kcchongnz/63777.jsp

Investing, as opposed to speculating and gambling, is not a game of hope, luck and chance.

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operation not meeting these requirements are speculative”         Benjamin Graham

For those who are interested to gain some valuable knowledge in identifying good growth companies, and most of all, buy them cheap, please contact me at ckc15trainig2@gmail.com

K C Chong (on the 11^th day of Chinese New Year 2015)

Appendix

Table 1