“Individual decisions can be badly thought through, and yet be successful, or exceeding well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome”               Robert Rubin.

All gofers will need a full sets of golf clubs in order to play reasonably well; a putter, a sand wedge, a pitching iron and the rest of the irons number 4 to 9. A couple of woods of 3 and 5 and the driver will make up a full set. We don’t need a fancy and a custom-made set of clubs which costs tens of thousands of dollars. But I won’t think an ordinary golfer can pay a round of good golf without a putter, a wedge, some irons and a driver. How well can you hit a ball out of a sand bunker if you don’t have a sand wedge?

Golf is a difficult enough sport in the first place and doesn’t need to be made harder by not having a full set of clubs at your disposal.

Similarly for investing on your own, it is a hard enough activity to do successfully. So it is very important that we all have a full set of “investment clubs” at our disposal. There are various investment opportunities present in the stock market. Some companies derive their value from their earnings power, some from the value of their assets, and yet some stocks derive their implicit value from the underlying assets. Hence we must have the ability to analyze, interpret and identify the values of different types of companies, whether they are earnings based, or asset based and analyze and value them using the right investment approaches.

In my last article, I have presented a third portfolio of mine published in i3investor for the stocks selected for the year 2014 with individual analysis of each of them as discussed in i3investor during the time of stock selection. I have promised to review them and discuss about the process and outcome and the role of luck in investing as presented in my last article here:

http://klse.i3investor.com/blogs/kcchongnz/79050.jsp

The portfolio and investment strategies

My third portfolios consists of a collection of 15 stocks as shown in Table 1 in the Appendix. The average return of the portfolio as on 26^th June 2015 is 17% with a median of 13.3% for the one and a half year period as shown in Table 1 in the appendix. This return is still better than the broad market return of -4.3% during the same period. There are 9 winners and 6 losers. The big winners are Latitude +128%, Prestariang +117%, Magni-Tech +49%, Pintaras +35%, Tasco +29%, Uchitech +24%, and Scientex +21%. These stocks were all selected based on the Magic Formula principle of Joel Greenblatt.

There are three stocks in the portfolio which were selected based on the asset based negative enterprise value and the Graham net net working capital investing strategies with the principle as explained here:

http://klse.i3investor.com/blogs/kcchongnz/45296.jsp

Those stocks are Kuchai +13%, Perak Corp -16% and Plenitude -33%. Note the big loss in Plenitude.

There was another investment strategy used in the portfolio, investing in derivatives of company warrants. The stocks involves are MRCB warrants, -46% and BIMB W, -42%. These have incurred heavy losses as at to date.

Process and outcome

From the outcome of the return of the stocks of the portfolio, it appears that the Magic Formula investment strategy way outperformed the rest of the strategies, and the market by a wide margin. All the stocks return with the minimum of 21% while the broad market was down by 4.3%. Latitude Tree and Prestariang returned more than 120%.

The asset based negative enterprise value and Graham net net working capital strategy yielded surprisingly poor results with Perak Corp and Plenitude way under-performed the market. The use of derivatives investing in the company warrants of MRCB and BIMB yields disastrous results.

The Magic Formula: Earnings based valuation

The principle of the Magic Formula investing is intuitive; investing in good companies with high return on invested capital (ROIC) at cheap price of high earnings yield (EY) in term of Ebit/Enterprise value. It has shown this strategy has worked well in the past and it is still working well now as shown in the following link.

http://klse.i3investor.com/blogs/kcchongnz/51631.jsp

The top performer of the Magic formula is latitude Tree which returned 128%. I first talked about Latitude Tree some time in 2013 when its share price was just RM1.26.

http://klse.i3investor.com/blogs/stock_pick_challenge_2013_2h/40360.jsp

In the above article, the Magic Formula was discussed on the three furniture stocks with high ROIC and EY; they are Homeritz, Lii Hen and Latitude Tree. All of them returned more than 100%.

In another article published in i3investor below, I discussed about the excellent cash flow from operations and free cash flow of Latitude Tree. I even did some thorough valuations of Latitude using discount free cash flows analysis and Gordon Constant Growth Model here which shows Latitude was trading at a huge margin of safety of more than 60%:

http://klse.i3investor.com/blogs/kcchongnz/48173.jsp

I still discussed about it a few more times, mostly on its “Magic Formula” metrics. The last is here, discussing about its good reinvestment opportunity of earning high return with its retained earnings:

http://klse.i3investor.com/blogs/kcchongnz/77997.jsp

Prestariang (+117%) is another Magic Formula stock with light asset, high ROIC of 150%!

http://klse.i3investor.com/blogs/stock_pick_challenge_2013_2h/42400.jsp

Prestariang requires little capital for reinvestment for growth, and hence it is a cash generating machine producing large amount of free cash flows, amounting to a whopping 35% of its revenue. It pays good dividends from its FCF. It had no debts. And best of all, it was trading at a relatively low P/E ratio of just 13. A discount free cash flow analysis in the link above shows it was trading at a margin of safety of 30% from its intrinsic value.

Magni-Tech was also with a high ROIC of 24%, I mentioned that I was willing to pay a price of EV/Ebit of 10 for it, or RM3.50 when it was trading at a price of just RM2.69 then as shown in the link below.

http://klse.i3investor.com/blogs/kcchongnz/51356.jsp

Magni had abundant FCF too with FCF amounting to 16% (>>5%) of its invested capital. A discount free cash flow analysis using some conservative assumptions shows its intrinsic value was RM3.62, or a 26% margin of safety. It closed at RM3.73 today on 30/6/2015.

Pintaras was still chosen even after its share price has risen considerably not long ago. The investment thesis then was documented here using purely fundamental analysis of buying good company at cheap price, or specifically the magic Formula investing strategy:

http://klse.i3investor.com/blogs/kcchongnz/54243.jsp

http://klse.i3investor.com/blogs/kcchongnz/54146.jsp

http://klse.i3investor.com/blogs/kcchongnz/53944.jsp

http://klse.i3investor.com/blogs/kcchongnz/50101.jsp

http://klse.i3investor.com/blogs/kcchongnz/49969.jsp

http://klse.i3investor.com/blogs/kcchongnz/46752.jsp

http://klse.i3investor.com/blogs/kcchongnz/46573.jsp

http://klse.i3investor.com/blogs/kcchongnz/46430.jsp

http://klse.i3investor.com/blogs/kcchongnz/46408.jsp

http://klse.i3investor.com/blogs/kcchongnz/45693.jsp

Besides the use of Magic Formula, various qualitative and quantitative analysis and valuation techniques were carried out. There was also a valuation technique based on Vitaly Katsenelson’s Absolute PE ratio valuation here:

http://klse.i3investor.com/blogs/kcchongnz/46422.jsp

The analysis and valuation of other Magic Formula stocks of Tasco, Uchitech and Scientex were carried out in similar manner.

http://klse.i3investor.com/blogs/kcchongnz/57483.jsp

http://klse.i3investor.com/blogs/kcchongnz/62058.jsp

http://klse.i3investor.com/blogs/kcchongnz/56316.jsp

Almost all the companies following the Magic Formula investing strategy above have high ROIC, good cash flow and healthy balance sheet. Many of them such as Pintaras, Magni-Tech, Prestariang, Tasco, Uchitech, have no debts but plenty of cash in their balance sheets.

So who said a company having too much cash and without debts won’t do well? Who said a company must borrow a lot of money to do business in order to do well?

And notice that I never talk about growth. In actual fact, all those stocks above were high growth stocks, maybe except for Uchitech. Without talking about growth in my evaluation, I did not have to pay for the growth expectation. But that doesn’t mean I did not benefit from it. I did.

The outcome of investing using the Magic Formula appears to be as expected and not as a result of luck.

Asset based valuations

The investment thesis of Kuchai Development was based on the negative enterprise value; i.e. its cash and cash equivalent and non-operating assets is so high that if liquidated and all liabilities paid, investors have huge amount of money, much more than the price they pay, to pocket and still own the ordinary business of the company.

http://klse.i3investor.com/blogs/kcchongnz/45296.jsp

Its return of 13.3% is still ok compared to the negative return of the broad market at -4.3%. No complain at all.

The investment thesis of Perak Corp basing on risk-arbitrage of the proposed takeover price of RM3.90 was aborted because of the rejection of a major shareholder, Sime Darby.

http://klse.i3investor.com/blogs/kcchongnz/48584.jsp

In my opinion, the investment thesis failed because the potential upside of 21 sen didn’t justify the risk of high capital layout of RM2.69 per share. It failed badly initially when the price of Perak Corp went down to about RM2.10. It has now recovered to RM3.10 with the 30 sen special dividend. The loss in this stock is 16%, not that bad. The outcome for Plenitude was somewhat unexpected.

Plenitude’s investment thesis was based on Graham net net working capital. It is an asset based valuation just basing on a discounted value of its working capital less all liabilities, ignoring its fixed assets in property, plant and equipment, intangibles, tax recoverable etc.

http://klse.i3investor.com/blogs/kcchongnz/59102.jsp

Moreover, earnings and cash flows wise, Plenitude is also very good with good earnings and low relative valuations. It has good cash flows and plenty of free cash flows ever year. However, its share price has retreated by a large amount of 33% since then. This outcome is rather a surprise to me as I have reviewed the process of investment for it, and I still think it may be a little too early to say it is a failure. The quality of its assets in cash and cash equivalent, investment properties and land bought long ago and not revalued, are high. May be I have made an error of judgment somewhere which I am not aware of.

Asset based valuation seems to be not a good valuation method according to the experience above, maybe for the short term. Or was the underperformance due to luck? I am not sure.

The derivatives

The prices of the company warrants of MRCB and BIMB have retreated by more than 42%. Obviously something somewhere is not right for the use of option pricing for valuation of these options. 

http://klse.i3investor.com/blogs/kcchongnz/49210.jsp

http://klse.i3investor.com/blogs/kcchongnz/58419.jsp

http://klse.i3investor.com/blogs/kcchongnz/68735.jsp

http://klse.i3investor.com/blogs/kcchongnz/68905.jsp

When valuing options, I was only concern about the share price of the underlying companies and their volatilities as that is what option prices depends on. I remember the implied volatility was not high and hence the warrants are inexpensive. I did not go into details of the business of the companies. For example MRCB has not been doing well in the past though there seems to be bright future for its businesses in the future. It has high debt and a GLC company which normally I am not favour of.

I did not look into the business of BIMB in details either. It seems to be doing fairly well with its operating performance. The warrants had a long time of 9 years before expiry but the premium was not high at all. In another words there is plenty of time value for the warrants. It has good gearing too which is favourable as a derivative. It can be used as a form of financial risk management. For example, the gearing for BIMB is more than 10 times. One only needs to invest about one tenth of his money to get the same return if investing in the underlying shares with much higher investment outlay.

But why are the warrants not performing? Are there any problems with its business or something I am not aware of? Or the option pricing model is simply not useful in real life investing? Or what Warren Buffett said is always true? That

”Derivatives are weapons of mass destruction”.

For those who are interested to learn about using various strategies and valuation methods to analyse and value companies, please contact me at

ckc14invest@gmail.com

K C Chong (30^th June 2015)

Table 1: My third Portfolio