This article is written for the sharing on fundamental value investing which the author is passionate about. It does not in any way, constitute a buy, or a sell call.

 “… a stock is not just a piece of paper that has a name, but a share of a business that has real assets and profits.”

I have retired from my engineering career for quite some time and have been dwelling in i3investors for at least five years now, propagating fundamental value investing (FVI) to the readers who are keen to learn about FVI. To be truthful, I enjoy it very much, thanks the owners of i3investor for giving me this opportunity to express myself, and share the little knowledge I have.

I think I do have some followers judging from some positive feedback from the 302 articles I have published in i3investor. Thanks for those who have followed my articles and given me constructive feedback. However, I do have my fair share of criticisms, even many personal attacks too, the more common ones are that I, as a FVI practitioner, has no business sense, looking at waste papers (historical financial statements) and can’t answer questions about the future, using financial jargons etc. The more damaging ones are accusing me of bullshitting, misleading, and “bringing i3 readers to Amsterdam”.

Recently, I even read about an article proclaiming FVI (I don’t care about what was said about TA in general in the same article as I am not a follower of that) as misleading to investor. The only thing it matters is what the company business is, and its future growth prospect, and that is all.

Well, I don’t really know which known FVI practitioner does not look at what the company business is. I know for myself as a FVI practitioner, this is the prerequisite aspect of investing, and more, such as how it makes money and many more which will be elaborated below. I also do not know which known FVI practitioner does not care about the future of a company which his return will depend on, but just that he cares about the risks too, and that he is unable to accurately predicting the future.

But anyway, everyone is entitled to his opinion and we all should respect it. But I also believe anyone should be able to give constructive criticisms of other’s investing method. I believe that is how everyone can learn and choose his own way of investing, rather than following blindly from those who are rich, and the poor and not-so-rich have no say.

Here, I would also like to use Warren Buffet’s teaching as illustrations, as he is a true successful investor that most people agree.

After reading this article, I hope readers can judge by themselves if this FVI makes any business sense, whether looking at the financial statements is of any use, or is this just a bullshitting and misleading article, and whether I can bring anyone to Holland with it, or maybe can even save you from “Holland”.

The four financial tenets of a business

As explained in ‘The Warren Buffett Way’ by Robert Hagstrom, these are the four financial tenets that you must focus on to understand the business of a company.

• Focus on return on equity (ROE), not earnings per share (EPS)
• Calculate "owner earnings" to get a true reflection of value
• Look for companies with high profit margins
• For every dollar retained, has the company created at least a dollar of market value?

In analyzing the above, always look at multi-year averages rather than single years. It is much more difficult to manipulate figures over several years than it is for a single year or quarter, explained Warren Buffett.

From the above, inevitably, a FVI investor would have to plough through the historical financial statements of a number of years to obtain some numbers to compute the above, wouldn’t he? Why does the investor have to do that? Below explained Warren Buffett. Here I will use my favourite company, EverSendai to illustrate.

Tenet no.1: Return on Equity

Customarily, most investors measure annual company performance by looking at earnings per share (EPS), whether the present earnings, or the future earnings. Did they increase over last year? Are they high enough to brag about? Do the quarterly earnings conform to the “Golden Rule”, otherwise sell?

Even that, few investors look deeper into what these earnings are; whether they are one-time off item on sale or revaluation of property, foreign exchange gain/loss, some fuzzy “earnings” from right pocket to left pocket etc.

For his part, Buffett considers EPS a smokescreen. Most companies retain a portion of their previous year's earnings as a way of increasing their equity base, so he sees no reason to get excited about record earnings per share. There is nothing spectacular about a company that increases earnings per share by 10%, if at the same time, it is growing its equity base by 10%. That's no different, he explains, from putting money in a savings account and letting the interest accumulate and compound. Worse still, there are many companies borrow huge amount of money to improve EPS, but the marginal return is way blow its borrowing costs.

The test of economic performance, he believes, is whether a company achieves a high earnings rate on equity capital ("without undue leverage, accounting gimmickry, etc."), not whether it has consistent gains in EPS. To measure a company's annual performance, Buffett prefers return on equity, or ROE. The R is the net income from the income statement, or better still, normalized net income, and E is the equity obtained from the balance sheet.

In here, we have to see the consistency of this ROE over a period of time from the historical financial statement, not just a one-time appearance, which we are not sure if it is sustainable. Predicting the “R” from the future is not as an easy task for the FVI practitioner, and it is also difficult for others. This is not just a hearsay, but proven with bundles of rigorous academic research.

The benchmark ROE depends on many factors, individual preference is one which is arbitrary, but basically, it should be higher than the opportunity costs plus the risks involved in the business which includes the specific industry, health of the balance sheet, and the stability and visibility of earnings and cash flows. For a normal company, I would require a ROE say 12%, but for a company like Sendai, may be minimum 15%, or even 20%.

What is your requirement?

Table 1 in the Appendix shows the ROE over a period of 6 years from 2011 to 2016. Does the ROE of Sendai meet your requirement?

Tenet number 2: What are the company’s “owner earnings”?

The cash generating ability of a business determines its value. Buffett seeks out companies that generate cash in excess of their needs as opposed to companies that consume cash. It is important to understand that not all earnings are created equal. Companies with a high ratio of fixed assets to profits will require a larger share of retained earnings to remain viable. Thus, accounting earnings need to be adjusted to reflect the business cash-generating abilities. Hence a more accurate picture is provided by what Buffett calls “owner earnings”.

Owner Earnings = Net Income + Depreciation/Amortization – Capital Expenditures

A consistent growth in owner earnings is a far better measure than growth in earnings.

As capital expenses are lumpy, investors should look at the owner earnings over a period of time, rather than that of a single recent year. In this case, I will use the free cash flows of Sendai to approximate its owner earnings over a period of 6 years as shown in the Appendix.

Do you see the attraction of Sendai’s owner earnings over the years, even in those good years from 2011 to 2014 when oil price was good and perhaps business in Arab countries where most of their projects in were good? Is it creating shareholder value, or a huge value destroyer?

Tenet number 3: What are the profit margins?

High profit margins reflect not only a strong business but management’s tenacious spirit for controlling costs. Good managers seek to reduce costs all the time, regardless of whether the profits are high or low. You want to see consistent (or growing) profit margins rather than cycles of low and high, as this indicates management gets lazy at times and lets costs get out of hand.

Again, look at the net profit margin of Sendai over the years. Is it increasing, or falling rapidly, or even went into losses? Is it commensurate with the profit margin of other construction companies?

Well, of course the future may be different, as there is huge order book in the next few years. But haven’t Sendai having huge orders too in the last few years, and why will the future be so different from the past?

Tenet number 4:

Has the company created at least one dollar of market value for every dollar retained?
This is associated with rational asset allocation. You want to look for companies that only retain excess cash where doing so translates to at least the same amount of market value. This is often a long-term figure, so you want to look at the retained cash over a period of time and consider the company’s market value over the same period. If a company retains earnings for unproductive uses for a long period of time, the market will assign it a lower market value.

Table 2 below shows the earnings per share (EPS), and retained earnings per share of Sendai every year over the last 6 years. The total earnings of 10.5 sen per share over the last 6 years was not in sync with the retained earnings because of impairment along the years, especially in 2016. The total retained earnings had deteriorated by 12.7 sen, instead of increasing for a profitable company over the last 6 years. Its share price has decreased in tandem by 36 sen from about RM1.26 5 years ago to 90 sen now. This is clearly a huge shareholder value destroyer.

Conclusions

The above have shown that Sendai does has fulfilled the four financial tenets of Buffett. In the last 6 years, its ROE has been way below its cost of equity. It has no owner earnings to talk about. Its profit margin is way under the industry norm, and its retained earnings, as hence its share price has dropped by 30% over the last 5 years as a result.

For the present, Sendai reported a net profit of RM59 m for the last 9 months, a big improvement. However, after annualized, assuming it is making the same profit for the last quarter, its margin is still below 5% and ROE less than 10%, nothing to shout about especially if you look at its huge receivables and bank borrowings in excess of RM1b each.

Following FVI in general, and the financial tenets of Warren Buffett in particular for a business, to me, makes a lot of business and common sense. This can be used to avoid pitfalls in investing. It will also provide one with extra-ordinary return, way above the return of an ordinary return. This has been shown by the returns obtained by many super investors around the world following FVI. I have also provided ample evidence of my personal experience as published in various articles in i3investor.

Why is that so many so-called investor still ridiculing FVI, that it has no business sense, and that financial statements analysis are of no use for investing?

Financial statements are the language of a business.

KC Chong

Appendix

Table 1: Historical financial performance of Sendai