I read an interesting article recently written by a e-friend titled, “How You Can Become A Successful Full Time Investor”. It is a good article as despite that catching title, the writer though confident, yet not over-confident, shared his knowledge and experience. Despite of the “bold” title, the writer did responsibly imply that it is not a “sure thing”. This is definitely a good guidance for the young investors, unlike some unhealthy touting of stocks and encouraging the use of margin finance to the public to get rich quick. The writer has some principles to follow, and those principles are basically following the fundamental approach of investing. That is to me the most important point to become a successful investor.

Why do I consider fundamental investing the “right path” of investing?

A friend of mine who is a very successful investor in the stock market for decades told me he has talked to scores of remisiers to find out how have their retail clients been doing in the stock market. Invariably, everyone told him that more than 90% have under-performed and most of them lost money in the stock market. When asked what kind of stocks they bought, and the answers were the same; most of them speculated in the stock market in buying rubbish stocks touted by the media, their friends and relatives, analysts and investment bankers, individuals they have trusted, all with their own agenda. Hence my article “Never buy any stock by anybody” in the link below,

https://klse.i3investor.com/blogs/kcchongnz/157367.jsp

In my opinion, to be successful in investing in the stock market, “The Most Important Thing” is avoid speculating in the stock market as above but by treating investing in a stock as akin to investing in part of a business, or to become a small partner of the business.

The pertinent question then is; what is a good, or bad business or company?

1. The Business

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Warren Buffett

To look from the business angle, or what some term it as “business sense” is consider a few things regarding the business such as the durability of the business, its stability in earnings and cash flows, return on capitals, financial health, growth prospect etc.

1. Durability of a business

A good business should be one which produces goods and services which are in good demand; food, household products, packaging products, rubber gloves, music, games, data, courier and logistic services, etc. It is even much better if there is a high demand of the products in the markets all over the world. The company has a competitive edge and be able to produce better similar goods and services than its competitors either through quality or cost advantage. More importantly, the demand of the products and services, and the competitive advantage is durable, and will likely to persist in the future. In this case, the company would likely to have a favorable future prospect.

Investing is about the future, not the past. But no one can predict the future of a business or the company. Understanding the business as above will enhance the probability of success in investing in the business.

In this aspect, for example provider of household electrical products, Panasonic Malaysia Berhad, or Panamy, with its established brands and record of quality home electrical products selling locally, in the fast growing Asean and Arab countries, would likely to have a durable business and a competitive edge, some kind of a moat.

2. Stability of earnings and cash flows

The historical performance of the company is a reasonable proxy for the future of the company. If the company has been able to weather storms in the past and perform consistently well in different operating environments, then it will likely continue to do so in the future and will able to survive no matter how tough the environment. Good cash flows indicate the good quality of earnings, not something just illusional, but real. Without free cash flows, a company will not be able to grow, distribute dividends to its shareholders, but have to continue to borrow money for preservation of its business.

Take Panamy with its past performance as shown in Table 1 in the Appendix as an example. Panamy has a long record of more than 30 years of operating history in Malaysia and in the Asean, Arabian and other countries. It has been making profit and good cash flows for all these years. It still did so during the financial crisis 10 years ago, in fact, even increasing profit during that time as shown in Table 1.

3. Return on capital

Another major criterion of a good company is one which provides a high return of capital.

A $100 of additional capital created by a business A employing $500 of capital, or 20% return, is undoubtedly more impressive than a business B employing $5000 and returning $250 of additional capital, or just a return of 5%.

One major metric is the return on equity (ROE), the net profit achieved with the equity, or the net asset belonging to the common shareholders. Companies that boast a high ROE with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdrawal cash and reinvest it elsewhere.

ROE is often used to compare with the cost of equity, or the required return of the money of the shareholders, Re. A common Re is about 10%, considerably higher than the return of fixed deposit of banks, considering the risks involved investing in a stock.

Panamy’s ROE has been consistently above 15% in the recent years as shown in Table 1, way above the normal required return of shareholders of 10%.

4. Financial health

A company with solid financial position (and those with good cash flows) can weather through any form of economic and financial crisis with more certainty of survival.

Panamy has zero debt and huge amount of cash of RM650m, or RM10.70 per share in its bank account. It distributes a total of RM2.33 per share of dividend for the current year, or a dividend yield of more than 6% at the present price of RM38.10. With a healthy balance sheet (and excellent cash flows), it is envisaged that good dividend will persist.

In comparison of all the attributes of a business above, Eversendai is involved in a dog-eat-dog highly competitive construction industry. Its operating history as shown in Table 2 in the Appendix is short, with jagged and volatile earnings of a few years completely wiped out by a single year of losses in 2016. ROE has not been good in most years.  In fact, ROE has been way below the required return of rational investors. Cash flows, especially free flows have been poor and in huge negative numbers. Its debts, as a result, has been building up and ballooning to RM1.15 billion now. Certainly, Sendai can’t be defined as a good company.

5. Growth

What about growth of the company? Is it important? Certainly, as a growing company will earn increasing profits going forward and shareholders will gain more and more from the business in the future.

The revenue of Panamy has been growing at a compounded annual growth rate, CAGR of 5.3% for the last twelve years. Its net profit grew at a much faster pace at CAGR of 11.5%. Last two years, it has spent RM100m, considerable more than it did before in capital expenses, and it has shown the benefit of the capex from the growth in revenue and profit in the last couple of years as shown in Table 1. It is likely that its business will continue to grow for the next few years.

Sendai appears to be having higher order book in the next couple of years too. The question is will it be able to break through the past losing streak and emerge a winner in the future? Increase in revenue and jobs are important but increase in profit, and profit turns to cash flows, and earning higher return than capital employed are more important. Time will tell as future is inherently unpredictable.

Aren’t the above all about so-called “business sense”? If not, what is “business sense” then?

Yet, many investors emphasize on the quality of its management before investing in its stock.

2. Smart and capable, honest and credible management

“Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you. You think about it; it’s true. If you hire somebody without [integrity], you really want them to be dumb and lazy.” Warren Buffett

A capable management is generally smart and competent in running the business in increasing long-term shareholder value. He has achieved many accomplishments and performed well relative to the company’s status and competitive position in its industry.  A good management is with sufficient quality will take the company forward in the right direction.

The capability of a management can often be gauged from what they have said, what they have accomplished and done through the years as reviewed through the annual reports and the past performance of its business.

A good management keeps in mind the interest of the shareholders who are the owners of the company. He rewards the minority shareholders with good dividend when affordable and carry out own stock repurchases when they are selling cheap. A good management is rationale in allocation of the capital of the company, by reinvesting the free cash flows well to earn return higher than the cost of capital and increasing shareholder value.

Honesty and credibility of the management is more important than smart and capable so that they are unlikely to put their hands in the till and shareholders are not short-changed. On the hand, a smart management is more dangerous to the financial health of the minority shareholders if he is dishonest.

Haven’t you heard of companies which their businesses have been deteriorating, and no dividend has been given for years, and instead, multiple cash calls were made in a short period of time to carry out value destroying projects or acquisitions, and yet the management is living in big house and drive luxurious cars, not only one car, but many sport and luxurious cars? Is that a signal of a good management and good company to invest in?

Conclusions

Now you have read about what a good business or company is, are you ready to invest in some good companies and its stocks to build long-term wealth safely, slowly but surely?

I do not think so, not until you have acquired the language of a business on how to identify a good company.  Moreover, finding a good company is just part of the puzzle. There are other aspects which are prerequisite to be successful in investing such as having an estimate of the value of the companies to compare with the price, the psychology and behavioral aspect of investing etc.

We can discuss about this next time.

Yes, hoping to build long-term wealth is not easy as just following a simple rule, follow the tips of others, leverage up with margin and hope to make it in a short term as propagated in the internet space. There is no such big frog jumping around. कोई नहीं.

To be successful in building long-term wealth (forget about quick road to riches), one must have the knowledge, the general knowledge about business and industries, the specific knowledge about the companies, and confidence (not over-confidence). Confidence can only come with knowledge and experience, and not just a slogan. All these require time and effort. There is really no free lunch in this world.

Meanwhile, if you wish to learn about all these with the aim of building long-term wealth in a more predictable manner, with some effort, you may email me at,

ckc14invest@gmail.com

Note: The companies used in this article are merely for illustration purpose. They are not meant as examples in any advice for sale or purchase.

KC Chong

Appendix

Table 1: Past performance of Panamy

Table 2: Past performance of Eversendai