kcchongnz blog
The Most Important Thing: Cash flow is King kcchongnz
“revenue is vanity, cash flow is sanity, but cash is king”.
In this link “Does fundamental value investing has any predictive power?” below, I have described some rigorous studies that using value investing such as just buying cheap in any form, be it be low P/B, P/E or P/CF (and also P/D) give better return than the broad markets and with lower risks. The higher return is more pronounced for small market capitalized stocks.
http://klse.i3investor.com/blogs/kcchongnz/92580.jsp
In the same link above, I have also shown the track records of certain school of investors, the school of value investing following the philosophies and methodologies of the grand master of value investing, Benjamin Graham, who had generated annual compounded returns (CAR) of between 18% and 29% over long track records lasting between 13 to 28 years, out-performing the broad market by very wide margins.
In my subsequent article on “From Graham to Greenblatt” in the link below, Joel Greenblatt in his Magic Formula value investing, replaces the problematic P/E ratio which measure “cheapness” to a better and more predictive metric of enterprise value/Ebit, or the reverse of it as earnings yield, EY.
http://klse.i3investor.com/blogs/kcchongnz/92871.jsp
Greenblatt, besides looking at cheapness, with his better “cheapness” metric of EY, also looks at the “goodness” of a company; and only buy not only it is cheap, it must also be good, and the metric he used to measure “Goodness” is the return on invested capital, or ROIC. How can you go wrong then?
Yes, things can go wrong, sometimes terribly wrong. The problem lies on the “E” in EY, and “R” in ROIC, or operating income, are accounting numbers, or accounting profits. Accountants are genius who can convince you a black cat is white. Yes, they are that good.
Go another step further, look at the cash flows, and free cash flows in particular, and invest in a company not only good and cheap in accounting numbers, but also good cash flows over a period of time.
Move over earnings, give space for cash flows
Whilst it may look better to have large inflows of revenue from sales or profits, the most important focus for a business is cash flow.
Enron Corporation, a darling company in 1990s, rose as high as number seven on Fortune magazine’s list of the top 500 U.S. companies. In 2000, the company employed 21,000 people and posted revenue of $111 billion. Over the next year, however, Enron’s stock price began a dramatic slide, dropping from $90.75 in August 2000 to $0.26 by closing on November 30, 2001. On this day in history, the Enron Corporation files for Chapter 11 bankruptcy protection in a New York court, sparking one of the largest corporate scandals in U.S. history.
Look at Enron’s four years’ financial performance and cash flow from 1997 to 2000 as shown in Table 1 below with its net income galloped by 832% from $105m to $979m before it went belly up.
Table 1: Enron cash flow, $m
|
Year |
1997 |
1998 |
1999 |
2000 |
|
Net Income |
105 |
703 |
893 |
979 |
|
D&A |
600 |
827 |
870 |
855 |
|
Non-cash charges |
-65 |
-233 |
-1000 |
1769 |
|
Capital expenses, normalised |
-2000 |
-2000 |
-2000 |
-2000 |
|
FCF |
-1360 |
-703 |
-1237 |
1603 |
|
|
|
|
|
|
Focussed on net income, profit growth and PE ratio, Enron became a darling stock and Wall Street sent Enron’s stock price soaring from about $30 to $100 from 1997 to 2000. However, from year 1997 to 1999, the company burned all its revenues and required an additional $3b of capital expenses just to open its doors. In year 2000, even the seemingly good cash flows were manipulated by capitalization of expenses which should be in the income statement, and adding cash inflows from investments held for trading which were, worse, under related party transactions, etc., meaning those positive FCF in 2000 were fake.
Importance of cash flows
Few businesses can survive long without the ability to generate cash. Basically, a business needs to pay all the expenses such as administration, marketing, workers, plant and equipment, materials etc. to produce goods and services. After deducting cash to pay for all these stuff, and sold or executed the services and receive cash, you get some cash left over from the operations, termed cash flows from operations (CFFO). The net income/profit (NI) or earnings figure, the income statement’s “bottom line,” is based on the principles of accrual accounting. Accrual accounting attempts to match expenses with revenues regardless of when the cash transactions that deal with the creation of the goods being sold and the receipt from the sale occurred. In essence, accrual accounting is not entirely concerned with when “cash trades hands.” However, over a long period of time, the cash figure should match closely the net profit figure.
FCF is whatever cash is left after all operating expenses, including capital expenses for growth, like buying new plant and machineries. FCF is like the end all goal of companies. The point is to do so well that you make so much money that even after all the checks written to expand the business you still have a lot of cash. With this FCF a company can pay out dividend consistently, buy back its shares when they are selling cheap, pare down loans, or invest in other profitable ventures, all done without assuming more debts, or issuing more shares.
A case study in Bursa on cash flows
I have written an article for a once a darling company in Bursa, London Biscuits as an example to illustrate the problem of focussing on profit and profit growth, but neglecting cash flows in the link below.
http://klse.i3investor.com/blogs/kcchongnz/60180.jsp
London Biscuit’s revenue grows at a very high compounded annual growth rate of 18% for the last 11 years. Profits also grow, albeit at a slower but reasonable rate of 6% as shown in Table 2 in the Appendix.
Better still, the cash flows from operations (CFFO) were almost always positive, and they are generally more than the net income throughout the years, except for the most recent year in 2015. Few investors realize that that was because of the huge amount of depreciation, which is non-cash, is added back to CFFO. Why not, they spend millions and millions buying PPE every year? Money spent on capital expenses is capitalized in the balance sheet and not expended in the income statement. It is only after looking at its cash flows from investment activities that you can see tons of money were thrown as capital expenses consistently every year, resulting in negative FCF every year. Over the last 12 years, RM172m in net profit and CFFO were made, but the company spent a net of RM500m buying plant and equipment.
Why is it bad since the company is making “profit” every year?
Dividend was cut progressively from 15 sen a share 9 years ago in 2006 to nothing this year. Its net debts have increased from RM81m 10 years ago to RM254m. Besides it has make a number of cash calls for rights issues and warrant issues, resulting its share capital increases from 68.2m 11 years ago to 186.5m now. There is a huge destroyer of shareholder value.
How has its share price been performing in the last 10 years? Figure 1 below shows the return of London Biscuit in red, against the return of the broad market in blue. A picture paints a thousand words.
Figure 1: Return of share price of London Biscuit Vs KLCI for the last 10 years.
Cash return on invested capital (CROIC) and cash Yield (CY)
I have explained in my previous post, “Do you have any No-Brainer Investment” regarding what cash yield (CY) is and why is it important in the link below,
http://klse.i3investor.com/blogs/kcchongnz/76694.jsp
Like interest rate, cash yield (CY) for stock holders investing in a stock is simply
CY = Free cash flow (FCFE) / Price,
FCFE is the free cash flows available to equity shareholders
Price is the market capitalization (MC) of a company, P = share price * no. of shares outstanding
A CY of more than 5% investing in a stock is good as it is more than the return from the fixed deposit in banks, and it is in cash too. A CY of 10% and above would be excellent investment.
CROIC shows how much free cash flow per dollar the business generates from invested capital. Many savvy investors find this to be the ultimate performance metric as it shows so clearly how effective management is and the strength of the business.
CROIC = FCFF/Invested Capital
FCFF is the free cash flow for the whole firm, or for both the equity and debt holders.
The higher the CROIC, the more cash the company is generating and it also indicates that the business is a profitable one, or a good company. Similarly, a CROIC or CY of more than 5% is considered good, more than 10% would be considered as excellent.
Let us look at a portfolio of stocks in Bursa with high CY and CROIC and a couple with low numbers and see how the portfolio and individual stocks perform over a long enough period of time.
Return of “GE13 Watch” Portfolio set up on 21st January 2013
My portfolio of 10 stocks were generally selected using the principles of Magic Formula Investing of Joel Greenblatt, except for Pantech and Kimlun, which were selected with their high growth stories as explained in my previous article “From Graham to Greenblatt” in the link below.
http://klse.i3investor.com/blogs/kcchongnz/92871.jsp
During the three years and two months’ period from 20th January 2013 to 10th March 2016, KLCI only went up by a meagre 3.7% from 1631 to 1691. The Small Cap Index went up much higher by 24.9% during the same period. However, my “GE13 Watch” Portfolio went up by an average of 132.7%, or a CAGR of 31% as shown in Table 3 in the Appendix, way outperforms both the indices.
The salient feature is the two highest returns stocks of Prestariang and SKP Resources were accompanied with very high total combined score of CROIC and CY of more than 20%. Interestingly, the worst performer, Pantech, at a small loss of 6.3%, has negative CY and CROIC. Was that a coincidence?
Conclusions
"Investment is most intelligent when it is most business-like". Warren Buffet
Statistics have consistently shown that more than 85% of investors, fund managers and individual investors included, underperformed the broad market for various reasons. However, research has also provided ample evidence that the followers of value investing from a certain school, that of Graham, have consistently beating the market by wide margins, just by buying stocks cheap.
Many successful value investors have moved beyond just buying cheap, but good and cheap, and have deeper insights and metrics of what are considered cheap, and what constitute good. Business owners also don’t make money with “profits”. Business can’t grow with obscure “profit” without FCF.
The above principles and methodologies of value investing are logical, intuitive and plausible. Those value investors following the above principles and methodologies, I believe, constitute the majority of the 15% of investors who consistently beating the market as shown in various research.
For individual retail investors, the intention to be the exceptional 15% of the investors to beat the broad market, and avoid to be the 85% of the suckers in the stock market, should be obvious.
If you intend to be some of the earlier 15% investors, please email me at the email address for the various services available to you.
“You know… you keep doing the same things and you keep getting the same result over and over again.” Warren Buffett
K C Chong
Appendix
Table 2: Cash flows of London Biscuit
Table 3:CY and ROIC of “GE13 Watch”
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Discussions
11 people like this. Showing 44 of 44 comments
Wonder why so many people love to do great things in i3 without charging?
How wonderful & fantastic in life!
2016-03-16 13:55
KC..its been quite sometime since you made some stocks comparison like you did for furniture stocks earlier....it will be nice to have such comparison again for furniture / any other competitors of similar nature if possible.
2016-03-16 15:06
Posted by Probability > Mar 16, 2016 03:06 PM | Report Abuse
KC..its been quite sometime since you made some stocks comparison like you did for furniture stocks earlier....it will be nice to have such comparison again for furniture / any other competitors of similar nature if possible.
I have been doing this for a number of times in this forum, and I encourage you guys to do it now. It will definitely improve your thought process and analytical and report writing skills.
If you want to get investing ideas, there are some good ones here too. If you want more, you can go to our Facebook group. There are plenty of good ideas from many good analysts in our group now. They are even better than many professionals. No need to look too far.
2016-03-16 17:45
Ok KC... yup...
hmm...really not that easy to come out with such write ups.
Sometimes even understanding other people's write up is quite difficult...(e.g Icon's Airasia, JT Yeo' OKA)...for my lazy brain...he he..
2016-03-16 18:27
Fed raise interest --> market crash --> many bankrupt
Fed pause interest hike --> market stagnant
Fed drop interest rate --> print more money --> market recovery --> bank suffer NIRP.
Tough decision neither way market is about to crash.
No wonder the rich move to more safer vehicle
Property hard metal gold, mineral oil etc.
Who care about market.
2016-03-17 00:38
Yellen's last option, reproduce the 2008 money printing card, print more money let the market crash first before showing the card.
2016-03-17 00:41
who don't you say the most important thing is Monopoly?
cash flow is King....as if the world don't change one. The plant and machinery don't age one.
competitors all dead already one.
everybody wants to be King. A lot of them died trying.
and even Kings get disposed.
2016-03-17 01:34
stockmanmy who don't you say the most important thing is Monopoly?
Halo khawan this article is about value investing in particularly about the importance of cash flow not play play monopoly n if u're looking for monopoly here is where u can get it :) got plenty of dif version too - maybe the King one as well :)
http://www.hasbro.com/en-us/brands/monopoly/toys-games?gclid=CLmbq6mKxssCFdJOgQodaRgNtg&gclsrc=ds
2016-03-17 04:53
So the interest rate didn't changed, what now?
With low interest rate and bad market condition, better buy only necessity instead of throwing your money at risk.
2016-03-17 09:25
cash is king should apply to both investor and the investee.
in an low interest rate environment, capacity and ability to borrow is perhaps the new King.
2016-03-17 09:28
The problem with fed is they don't want to print more money to rescue bankruptcy energy company, this will spill over to banking sector soon and the rest of the plc
2016-03-17 09:52
I am not a critic of the FED.....
I am a critic of Ah Jib who wants to put his own man in BNM.
2016-03-17 10:11
We have depreciation of currency and high inflation, how come cash can be king. how? It is not that cash is King. You have to be able to do something that people will need in the future, be useful. Be useful and not be king. Even got money also can not do everything in life, got money no need to die is it? Be Productive: buy useful assets, the kind of assets that don't always ask for people for money but can give people money in the future. Cash is King. You think money can buy everything is it?
2016-03-17 10:58
While positive cash flow is indeed an important element in the health of a company, what's more important is the human assets and most importantly, a passionate and caring leader for the company. We have today a leader who says cash is king but leading us to an absymal pit. Warren Buffet selects leaders to drive his portfolios of profitable companies. The leaders know what is needed from them.
2016-03-17 11:58
Economy has not recover the ringgit will not strengthen that much. If you want to know when the ringgit is strengthening, wait until GDP is growing more. The Foreign guy, Mark Forbus is confusing you. The ringgit now is tied to GDP of Malaysia and the whole world. If you are not expecting GDP of Malaysia and the whole world growing very fast, don't expect the ringgit to appreicate very fast in teh future.
2016-03-17 13:42
I know what is worrying the youngster today, they rush into the market to make some quick buck and hoping it will enough to curb the inflation, but they couldn't wait at all, that is why they are still doing it today. They never experience recession before and thought they can make money even if during recession.
2016-03-17 14:08
They could be lucky and make some quick buck
Obviously it is not about investing by being luckiest among all.
Luckiest guy can make few round of quick buck and may end up loss everything in the end, I had seen countless example of this restless youngster think they are exceptional.
2016-03-17 16:55
What make our ringgit strengthening well is the high tax amount to protect the market
In the U.S. they couldn't increase their tax or interest as agressively as they want. A 0.25% increased is too big for them to absorb it, but we have this gst of 6%, it is more than gdp amount, and even more than enough to make our ringgit stronger. Besides gst, there is still many tax subsidies cut which is very good move to save the currency from inflating, price of goods is high, it isn't matter as long as the ringgit is strong we can opt for imported cheap goods if local goods isn't price competitive. It should be short term issues.
2016-03-17 17:02
Posted by ag397 > Mar 16, 2016 07:18 PM | Report Abuse
what is the facebook gruop name kc? tq
This is a closed group for those attending my online investment course and set up by a participant of my course.
2016-03-17 17:59
Kcchongnz thanks for the great effort. A growing cash balance is something I always look at, management, debt levels (currency matters here),growing assets , NTA and so much more. I am still puzzled by some counters that are growing internally but on the external are not showing growth in share price. On the other hand the share price is at near historical low level. Could you kindly look at TA GLOBAL and tell why it is behaving so sickly. Thanks.
2016-03-18 21:26
Is cash important? Yes. Airasia great cash with low crude oil, buy now
2016-03-18 23:57
Posted by singh1 > Mar 18, 2016 09:26 PM | Report Abuse
Kcchongnz thanks for the great effort. A growing cash balance is something I always look at, management, debt levels (currency matters here),growing assets , NTA and so much more. I am still puzzled by some counters that are growing internally but on the external are not showing growth in share price. On the other hand the share price is at near historical low level. Could you kindly look at TA GLOBAL and tell why it is behaving so sickly. Thanks.
First of all I don't know about TA Global. If you want my opinion about it, you should show me some figures why you think its share price should be higher, such as its ROE, ROIC, cash flows, P/E, FCF/P, or whatever you think is relevant.
2016-03-19 00:22
All share prices have two components.
I call it the two factor model .
it is intrinsic valuation of existing business plus X factor.
It is the valuation of the X factor that people have to put equal if not more attention than the valuation of existing business.
2016-03-19 01:57
Hi Kcchongnz, is Scientx worth the current price tag? It's CY has dropped but profit margin has improved for 1Q2016.
2016-03-19 20:26
Posted by latjiu > Mar 19, 2016 08:26 PM | Report Abuse
Hi Kcchongnz, is Scientx worth the current price tag? It's CY has dropped but profit margin has improved for 1Q2016.
You and only you should decide on it. If you need guidance on how to make your own decision, you are encouraged to refer to these posts:
http://klse.i3investor.com/blogs/kcchongnz/92580.jsp
http://klse.i3investor.com/blogs/kcchongnz/92871.jsp
http://klse.i3investor.com/blogs/kcchongnz/93172.jsp
Good luck.
Yes, investing needs luck too.
2016-03-20 01:19
The X factor for Scientex is that it has the best management and best strategy in Malaysia. How much is that much?
Posted by latjiu > Mar 19, 2016 08:26 PM | Report Abuse
Hi Kcchongnz, is Scientx worth the current price tag? It's CY has dropped but profit margin has improved for 1Q2016.
2016-03-20 02:14
The X factor for Scientex is that it has the best management and best strategy in Malaysia. How much is that much?
easily $ 15 this year.
2016-03-20 02:15
both Scientex and Top Glove have many satisfied shareholders.
but Scientex is on the way to be a top conglomerate with little competition while Top Glove will remain subject to the fortunes of his industry and intense competition.
2016-03-20 05:08
stock picking is not just about number crunching....its about strategies and strategic management and about the X factors.
2016-03-20 05:10
Posted by Desa20201956 > Mar 20, 2016 05:10 AM | Report Abuse
stock picking is not just about number crunching....its about strategies and strategic management and about the X factors.
"A head full of dew water"
2016-03-20 09:04
Kc....you have heard of strong profits weak cash flow.....cannot buy according to you.
Have you heard of strong cash flow weak profits? can buy?
Coastal will have strong cash flows weak profits this year....can buy?
Coastal has 1 billion inventories of generic boats, another 1 billion of designed to order contracts.
In view of market conditions, their contracts will have thin margins and they intend to dispose of their inventories at low to negative margins just to get rid of the inventories.....They will have two billion dollars cash flows , very weak profits.......can buy?
2016-03-21 17:44
Agree. Hence paperplane2016 said KC is a bias people which I supported.
Posted by Desa20201956 > Mar 21, 2016 05:44 PM | Report Abuse
Kc....you have heard of strong profits weak cash flow.....cannot buy according to you.
Have you heard of strong cash flow weak profits? can buy?
Coastal will have strong cash flows weak profits this year....can buy?
Coastal has 1 billion inventories of generic boats, another 1 billion of designed to order contracts.
In view of market conditions, their contracts will have thin margins and they intend to dispose of their inventories at low to negative margins just to get rid of the inventories.....They will have two billion dollars cash flows , very weak profits.......can buy?
2016-03-21 17:48
Posted by donfollowblindly > Mar 21, 2016 05:48 PM | Report Abuse
Agree. Hence paperplane2016 said KC is a bias people which I supported.
Posted by Desa20201956 > Mar 21, 2016 05:44 PM | Report Abuse
Kc....you have heard of strong profits weak cash flow.....cannot buy according to you.
Have you heard of strong cash flow weak profits? can buy?
Coastal will have strong cash flows weak profits this year....can buy?
Coastal has 1 billion inventories of generic boats, another 1 billion of designed to order contracts.
In view of market conditions, their contracts will have thin margins and they intend to dispose of their inventories at low to negative margins just to get rid of the inventories.....They will have two billion dollars cash flows , very weak profits.......can buy?
First I will answer that always follow blindly fellow first.
I, kcchongnz, is just one person. I am not having two heads and two bodies. So I am a person, not a "people".
Just what do you mean by "KC is a bias people"? Again you are following blindly on what others said. Everything you do is just following blindly. the one you follow didn't even understood what I was trying to convey in my article. Why do you use this name "dontfollowblndly"?
Next one is this Desa's comment.
Investing is not so simple. Anybody who thinks it is easy is stupid!
The above is said by a well-known super investor in the world, Charles Munger, who had made billions USD for himself and his investors, not just any Tom, Dick and Harry who claims to be super investor.
Investing is not that simple like what you are shouting, what "x" or "f" factor lah, instinct lah, make fast decision lah, quoting from what Robbin something lah. They are all craps. Nonsense craps!
Whether a company with strong profit and poor cash flows or vice versa can invest or not, there are many things to consider. Anybody who knows about proper investing won't just ask a simplistic yes or no question like that, unless he has no clue of what investing is about.
2016-03-21 18:24
All share prices have two components...the valuation of existing business and the X factor.
all the 10 formulas and 20 ratios derived from the accounts will only give you one aspect of the share. All the number crunchings are subject to the Law of garbage In, garbage Out.
How can you hope to get a proper picture of the share if all the attention is on the 10 formulas and 20 ratios you are trying to peddle?
2016-03-21 18:33
I like KYY style.....in the pursue of simplicity.
At the age of 83, settle on the simplest 1 rule and one formula to rule them all.
that is where you get conviction. From great convictions, you get great profits when you are right....and margin to the max.
That's call conviction. No fickle minded yes no yes no ratios.
Die die la...that is how all self made tycoons are .
2016-03-21 18:41
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2016-03-16 13:30