kcchongnz blog

Quantifying Quality kcchongnz

kcchongnz
Publish date: Sun, 16 Jun 2019, 08:57 PM
This a kcchongnz blog

This article is purely for discussion purpose and it is definitely not a stock tip.

I happened to read about a portfolio of quality Bursa stocks held by a value investor in a internet forum recently, I computed the return of this portfolio of stocks which has lasted for 10 and a half years. This portfolio consists of high quality big-caps stocks which are followed closely by fund managers and institutional investors. The stocks are; Petronas Dagangan, Nestle, Public Bank, Dutch Lady, Heineken Malaysia, LPI, Aeon Credit, and Carlsberg.

The portfolio returned an average of 362% over the last 10 and a half years as on 4th January 2019 as compared to the return of the broad index of 52% during the same period. The compounded annual return (CAR), CAR of the portfolio was a whopping 15.4%, close to 4 times the CAR of 4.1% of the broad index. Note that they were selling at fair prices at an average PE ratio of just 14 then, not long after the US Subprime Crisis.

But how do we define a high-quality company?

Ask professional investors what they take value investing to mean, and responses will likely be consistent; buying stocks at low Price/Earnings, Price/Book, Price/Cash flows, high dividend yield etc. But ask the same people what they think of a high-quality company is, one of the classics in i3investor from a “Pro” which is repeated again and again is as below,

[Posted by qqq3 > Jun 14, 2019 4:28 PM | Report Abuse https://cdn1.i3investor.com/cm/icon/trans16.gif
quality of a company is some thing u know it once u see it., its called experience
.]

Though for the opinions of general informed public and true professionals will vary widely. Some refer to company having a high growth potential, good management, brand names, market leader of the industry and other qualitative attributes, etc. These are important qualitative attributes of a high- quality company. However, they are all subjective and opinions vary widely.

Here I quantify those qualitative attributes to three major metrics; strong and predictable cash generation; sustainably high returns on capital; and high growth opportunities. Each of these financial traits is attractive at its own right, and when they are combined, they are extremely powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.

Let us take Panasonic Manufacturing Malaysia Berhad, Panamy as an example.

 

Strong and predictable cash flows

Table 1 below shows Panamy generates consistently on average RM107.5m of cash from its operations in the last 5 years until 31 March 2019. After spending about 36% on average on capital expenses, it yields an average free cash flows, FCF, of RM70.2m a year, or RM1.16 per share. From the FCF, it has distributed a total of RM8.72 dividend for the last 5 years and the rest retained in its balance sheet. In year 2019, dividend was RM2.26 per share. Shareholders can spend it, reinvest it in Panamy, or divesify to invest in other quality stocks.Panamy is truly a cash generating machine.

Table 1: Cash flows of Panamy

Year

2019

2018

2017

2016

2015

5-yrAv

Net income

105752

131025

127118

146900

99538

122067

CFFO

120642

127200

92268

116710

91612

109686

Capex

-54386

-53522

-43615

-30491

-15340

-39471

FCF

66256

73678

48653

86219

76272

70216

FCF/share, sen

109.1

121.3

80.1

141.9

125.6

116

 

It is noted that the excellent cash flows for Panamy were generated internally without having to borrow any money, nor issue any new shares. That is because it has sustainable high return on capital from its operations.

 

Sustainable high return on capitals

Table 2 below shows the high return on capitals of the business of Panamy. Return on equity has been double digit averaging about 15%. Taking away the non-operating cash of over RM600m, the return on invested capital, ROIC are consistently in three-digit number.

Table 2: Return on capital

Year

2019

2018

2017

2016

2015

Return of equity, ROE

12.6%

14.9%

15.5%

18.9%

13.9%

Return on invested Capitals

91%

122%

147%

427%

871%

The high ROIC is basically due to the fast turnover of its inventories and the bargaining power of the company in shorter credit term to customers and longer credit term to its suppliers. For example, in 2019, it took just 21 days to turn its inventories into goods sold, 38 days to collect credit due from customers, and 72 days to pay its suppliers and creditors, resulting a cash turnover period of -14 days. It means the company doesn’t require any working capital for its business but just capital expenses. What a great business!

With the high return on capitals and excellent cash flows, the company has spent about 36% of its cash flows from operations a year for capital expenses for growth in the last 5 years.

 

Growth

In the last twelve years, revenue of Panamy grew at a reasonable compounded annual growth rate, CAGR of 6.3% from RM541m to RM1.13 billion in 2019. Its operating income grew at a much faster pace of 11.7% from RM34.4m to RM130m while net profit grew by 7.1%. The growth is decent but not fantastic. It is noted that the growth is all from internally generated funds. Table 3 below shows the financial performance of Panamy in the last 13 years from 2007 to 2019.

Table 3: Financial performance of Panamy

 

Panamy’s business generates consistent high cash flows from its high return of its capital employed. A great portion of its cash flows are distributed to shareholders with remaining reinvested for growth, which in return obtain high return on the reinvested capital and beget more cash flows for the company. Shareholders have been enjoying high dividend from investing in the company. Besides the high dividend, its share price has also risen by 221% in the last 10 years from RM11.92 to RM38.20 now as shown in the Figure below, or a CAGR of 12.4%. It is hence considered as a quality company, in my opinion. Of course its future growth prospect is more important.

 

Valuation of quality companies

In quality investing, as in any investment strategy, the risk of overpayment exists, but far less than one might think. At a glance, the price-earnings multiples of a quality business relative to its growth, in Panamy’s case at 22 at the present price of RM38.20, can look exaggerated. However, quality companies often tend to exceed estimates, meeting or beating forecasts far more frequently than poor quality companies.

Many investors might find some high-quality companies but would like to buy them when they are selling at cheaper prices later. The problem is that the day seldom comes: if a company keeps delivering operationally, its relative valuation multiple rarely contracts.

Look at Nestle Malaysia, how its share price continues to rise from RM27 ten years ago to RM148 as on 4th June 2019 now, or for a CAR of 17%. Share prices, even when at seemingly high valuation multiples, often fail to fully capture the combination of predictability and value creation in delivering earnings growth such companies offer in the long term. However, do note that the mid PE ratio 10 years ago for Nestle was about 20, certainly not dirt cheap but also inexpensive. Nestle now is selling at a PE ratio of 52, certainly not cheap now. In my opinion, investors who continue to hold Nestle at this price will obtain satisfactory return over the long-term but will not be an extra-ordinary return.

Investing in quality stocks for the long term when they are selling at reasonable price is certainly a good thing to do especially for those who have no time nor any knowledge in investing in the stock market. However, it doesn’t mean one must buy quality stock at any price. That would be foolish.

I have written a eBook on personal finance and investing. Among the topics discussed includes how to determine if a stock is a quality stock, qualitatively as well as quantitatively. It also discusses some valuation techniques to determine if a quality stock is selling at a reasonable price. To be successful in investing, these two things must come together.

If you are interested in my eBook, you can email me at ckc13invest@gmail.com

This is given free.

KC Chong

Discussions
1 person likes this. Showing 28 of 28 comments

cheoky

walao...

2019-06-16 22:56

cheoky

dont overemphasis on quality. do your own way.
ceo make money from salary.
senior make money from salary and corruption.
blue collar make money from salary and part time.
price to pay for each catagory?
ceo might become like steve job lo.

all cat can catch mice to fill stomach is good cat.

2019-06-16 23:03

probability

but not all these cats skills can be thought and having a strategy which remains relatively solid against time...

we communicate because we have something communicable...
and that's what KC doing ma

for easily teachable skills

Posted by cheoky > Jun 16, 2019 11:03 PM | Report Abuse

all cat can catch mice to fill stomach is good cat.

2019-06-16 23:40

(US/CHN trade war doesn't matter) Philip

This remark is a bit yogi sadhguru for my liking. The question remains, if all roads lead to Rome, shouldn't we choose the easiest, most efficient and least risky way of going to there?

Some cats do it by going to genting, buying binary options, over leveraging
Property loans and buying trading indicator software.

There is an easiest way to invest in stocks. Problem is, it's just not that easy.
>>>>>>>>>>

cheoky dont overemphasis on quality. do your own way.
ceo make money from salary.
senior make money from salary and corruption.
blue collar make money from salary and part time.
price to pay for each catagory?
ceo might become like steve job lo.

all cat can catch mice to fill stomach is good cat.
16/06/2019 11:03 PM

2019-06-17 06:57

3iii

Buffett's tenets:

1. Buy a business you understand.
2. Has durable competitive advantage.
3. Management with integrity, intelligence and hard-working.
4. A price that makes sense.




Over the long term, investment return is more a function of business performance than valuation, unless the valuation goes extreme.

More effort should be put into identifying good businesses and buying them at reasonable valuations.

Investors should not be obsessed with the valuation calculations. All calculations involve assumptions. They are valid only if the underlying businesses perform as expected.



It is so simple, but as Philip says, not easy for many, who prefers to take the more difficult roads.

2019-06-17 07:21

(US/CHN trade war doesn't matter) Philip

A good article. My opinion on value investors though is very different.
In fact all stocks investment are bought based on some perceived form of value.

(Value investing to mean, and responses will likely be consistent; buying stocks at low Price/Earnings, Price/Book, Price/Cash flows, high dividend yield etc.) = This opinion of the value investor basically means that one is a Ben Graham value investor. This assesses one form of quality.

Warren Buffett himself commented that Ben would not have bought many of the stocks that he holds today, least if all Berkshire Hathaway, it is true if you are that kind of Graham value investor.
I believe Warren buffet value investing adds a few more parameters: total addressable market, market share dominance and durability, business longevity, management capability for organic and inorganic expansion, long term competitive advantage. These are less direct formulaic metrics, but also gives you more insight on long term value. Any way to assess quality.

What may seem to be a bad investment for the Graham investor is a wonderful investment for the Buffett investor. Graham would never have invested in amex during salad oil crisis, nor put money into Amazon at any price.

Buffet investors would not have bought Intel, GE or a plethora of seemingly undervalued companies.

Words and terminology are very very important.

Before you can become a "value" investor, one must understand how to each investor derives value.

I like to think myself as a munger value investor. His position on value investing is based on different mental models for different businesses. You can't use the same one metric to measure the different businesses. But using multiple mental models for can valuation, you can tie things together to get the long term competitive advantage of a business.

My favorite mental models,

"People like to calculate too much, but think too little".
"The big money is not in the buying and the selling, but in the waiting."
"Hanlon's Razor."
"Occam's razor."
"Cognitive bias"
" Power law" I loved this mental model which comes from engineering. Pareto 80% of effects come from 20% causes.
Charlie munger uses more than 100 mental models to aid his thinking. I believe him as I use a lot in understanding my own investments.

2019-06-17 07:40

(US/CHN trade war doesn't matter) Philip

Apologies if I went off base, but I loved your title quantifying quality. And I thought people don't think on that term enough, but simplify their minds into thinking of investing as just a simple formula based approach.

For those interested in further understanding the depth of that term quantifying quality, take a read here. Once you get these basic mental models out of the way, use it on valuing your investment, it would change your entire scope of horizons of what is value investing.

https://getpocket.com/explore/item/mental-models-i-find-repeatedly-use...

Then when you realize how we ALL use some mental models on stock picking, imagine what happens when you have 100 different mental models that you can quantify to get a much better understanding on the long term competitive advantage of your stock.

Sorry for hijacking your thread KChongz.

If anyone is interested, I am also doing a talk on mental models for my secondary school graduates for my rotary club sponsored school tomorrow, about the vice chairman of brk, who is a trained later but studied physics, maths, architecture, biology, economics in University and the value of popping into unknown classes to understand the big picture, the overall mental model of the class. And how to use mental models to get ahead in life. I'll try to post my transcript if anyone is interested.

2019-06-17 07:53

teoct

Thanks Philip for sharing. Yes I am interested in the talk but travelling, so the transcript would be good. Thanks again.

2019-06-17 08:05

(US/CHN trade war doesn't matter) Philip

A very specific usage of hanlon's Razor is in using epf, majority shareholders that are buying or selling stocks in large quantity as a guide to buy stocks. Many i3 investors assume epf as an evil agent that wants to entrap/scare off/pump & dump/ etc as to make a big profit. When in reality, there are many different parties inside that have vastly different motives for doing things and therefore should be ignored.

For Occam's Razor I use it all the time in comparing the possibilities of the growth of a company ie reducing the usable assumptions or stretching the possibilities of a company working out, or how a company like sapura/armada will do well in the long term ( a lot of assumptions) versus a company like yinson doing well ( far less assumptions to make).

This helps immensely in me cutting down the companies that I need to monitor, and most importantly: how likely is a company like dayang ability to succeed in the next few years ( cut down the many likely and unlikely assumptions). Kyy did it with hengyuan and dayang, so did stockraider and Calvin with their projections on sapura etc.

I applied this mental model and asked myself: how likely? Everything should be kept as simple as possible, but not simpler.

2019-06-17 08:23

king36

I always learn from all the writers in I3. Thank you all.
But, Mr 3iii, good suggestions, can I ask a few questions and will appreciate your answer. Thank you in advance.

3iii Buffett's tenets:

1. Buy a business you understand. (maybe OK)
2. Has durable competitive advantage. (How to evaluate? What metrics to use?)
3. Management with integrity, intelligence and hard-working. (Not easy when you are external observer. But any tip?)
4. A price that makes sense. (Using P/E= 10 or higher? Or any metric recommended?)

2019-06-17 08:35

stockraider

U all need to Understand at one time General Electric, Citibank, Bank of America, Ford and Sears are solid Great top bluechips company and trade at huge premium, just look where are their ranking of these companies now leh ??

Thus if u invest, u need good margin safety in all business b4 u invest loh...!!

In football context :

U must Remember buying good solid business is your Offensive strategy loh...!!

Your Defensive Strategy is to buy into undervalue companies with big margin of safety loh...!!

REMEMBER TO PROTECT YOUR DOWNSIDE 1ST LOH...B4 U COUNTING YOUR CHICKEN ON THE UPSIDE MAH...!!

2019-06-17 22:34

Sslee

Dear 3iii,
You can’t manage what you can’t quantify. What get quantified gets managed. Quantified is different from measurement because measurement only involve in quantitative part of fundamental analysis in analysing financial data contain in current and past financial report. You also need to come out with certain mental/business model to quantify the Qualitative part of fundamental analysis: Economy condition, Industry condition and Company management.

Investment in stocks market is not as easy as what 3iii put in, invest in quality/good business and forget about valuation or the manage part that required constant update of economy condition, industry condition and company management.
Some good business can very fast turn sour if there is disruptor coming into the market.

Thank you

2019-06-17 23:48

3iii

Post removed.Why?

2019-06-18 11:46

stockraider

Thats is precisely what raider says loh....before 3iii corrupted the idea by buying overvalue stock with PE 50x above with no margin of safety mah....!!

Posted by Sslee > Jun 17, 2019 11:48 PM | Report Abuse

Dear 3iii,
You can’t manage what you can’t quantify. What get quantified gets managed. Quantified is different from measurement because measurement only involve in quantitative part of fundamental analysis in analysing financial data contain in current and past financial report. You also need to come out with certain mental/business model to quantify the Qualitative part of fundamental analysis: Economy condition, Industry condition and Company management.

Investment in stocks market is not as easy as what 3iii put in, invest in quality/good business and forget about valuation or the manage part that required constant update of economy condition, industry condition and company management.
Some good business can very fast turn sour if there is disruptor coming into the market.

Thank you

Posted by 3iii > Jun 18, 2019 11:46 AM | Report Abuse

>>>

Blog: Quantifying Quality kcchongnz

Jun 17, 2019 10:34 PM | Report Abuse

U all need to Understand at one time General Electric, Citibank, Bank of America, Ford and Sears are solid Great top bluechips company and trade at huge premium, just look where are their ranking of these companies now leh ??

Thus if u invest, u need good margin safety in all business b4 u invest loh...!!

In football context :

U must Remember buying good solid business is your Offensive strategy loh...!!

Your Defensive Strategy is to buy into undervalue companies with big margin of safety loh...!!

REMEMBER TO PROTECT YOUR DOWNSIDE 1ST LOH...B4 U COUNTING YOUR CHICKEN ON THE UPSIDE MAH...!!

>>>


No wonder raider's "investing" is purely speculative plays.

Poor philosophy and strategy and compounded by poor discipline makes Mr. Market.

Do not take your guide from Mr. Market. Take advantage of his follies.

2019-06-18 11:59

3iii

Post removed.Why?

2019-06-18 12:17

3iii

Post removed.Why?

2019-06-18 12:57

3iii

king36

Also read a lot of annual reports to understand the different businesses. Once you have done so, you would have build up a store of knowledge as your base to understand other businesses in the same and other sectors. There will be businesses you do not understand, and yes, you should know your CIRCLE OF COMPETENCE. It is not how big this circle of competence is that is important but knowing its boundary and NEVER to stray beyond it. That is DISCIPLINE PAR EXCELLENCE. Few in this forum has this discipline from my observation.


Finally, luck plays a small role. Luck is after-all YOUR PREPAREDNESS when opportunity presents and at the appropriate moment, you have the courage and cash to make a decisive and meaningful investment at a time when the reward to risk ratio is also in your favour (that is high return low risk situations.)


Best of luck in your investing education and journey.

2019-06-18 13:06

3iii

Your success in investing in stocks for the long term is dependent on:

1. Knowing what you are doing. Losses come from those who do not know what they are doing. (Know the tenets of Buffett)

2. Staying within your circle of competence. Never stray beyond it.

3. Invest your new capital when the upside reward to downside risk is high. Bet big. Make a meaningful investment.

4. At other times, remain a sloth. You become rich through inactivity and not through activity in the stock market.

5. Compounding is the friend of your cash. 8th wonder of the world. Invest for the long term. Reinvest your dividends.

6. Employ tactical asset allocation, if you must, but this is only usually at the extremes of the stock market. Above all, buy low. You may or may not wish to sell when high, provided your stocks are of the highest quality growth counters.

7. Stay with quality. Remember Buffett: "It is better to own a wonderful company at a fair price than a fair company at a wonderful price."

8. Read, read and read. Annual reports, quarterly reports. Know what to ignore, don't waste time on what is not knowable and not important.

9. Enjoy life.

2019-06-18 15:57

stockraider

Post removed.Why?

2019-06-18 16:39

king36

3iii king36

Thank you.
Will keep learning.

2019-06-18 17:04

(US/CHN trade war doesn't matter) Philip

I totally agree with this concept, and this is certainly something to learn for both sslee and stockraider.

I have learnt from my bad experience many many years ago that someone every the annual reports, quarterly reports and even AGM all the wordings are manipulated, positives opined, negatives redacted, so that everything looks rosy.

High quality businesses are very clear cut companies which everyone can see the competitive advantage. That by itself is a margin of safety. Those that invest simply based on NTA and simplified metrics fail to realize one thing: companies can and have been known to lose their competitive advantage due to distruption, corruptness, carelessness and mismanagement.

Funnily enough, a lot of those companies suddenly start to look like deep value investments when the share price drops at a faster rate than the NTA, cash and earnings.

But once the moat is gone, sooner or later the barbarians will come to the gate.

>>>>>

By staying with very high quality businesses (those with durable competitive advantage for a very long time), you have locked in a lot of margin of safety.

2019-06-19 13:28

(US/CHN trade war doesn't matter) Philip

A clear example is sapura. In quantifying the quality of sapura and INSAS, we realize that the share price of these 2 companies has dropped at a far faster rate than it's overall business, assets and earnings, making it look like a business selling at a wonderful price.

But make no mistake, the revenues and earnings are dropping. As it drops these investments suddenly seem like wonderful businesses to buy with lots of cash, land and business assets.

But exactly like how Kcchongz and 3iii puts it, there are many ways to quantify quality.

You can look at p/e as a measure of a company's value, profitability. A low pe can be a good thing, as it appears that you are paying a low price for the company to gain the share of earnings. A high PE is a no-no, as it means you are paying for an overpriced company.

But p/e does not define risk, debt, future company prospects. Only metrics that to be honest are easily gamed by auditors and business owners.

In that vein, you can also then look at p/e as a measure of the investors faith in the company. A high PE means investors are very hopeful, are looking forward to the company future and everyone is holding tight for the ride. While a low PE could also mean that investors are hesitant to pay top dollar for a company with limited prospects/unknown future.

2019-06-19 13:48

3iii

I am fully supportive of Philip's discourse.

I have always emphasized:

Quality first, then valuation.

In the absence of quality, do not bother with the stock. Don't bother with doing its valuation. Find another stock to study and to invest.


Yes, many "investors" may not be so insightful. Think this through.

A company with NTA of $1, EPS of $0.10, and was trading at a price of $1.50. (All based on per share)

Its P/B = $1.50/ $1.00 = 1.5x
Its P/E = $1.50/ $0.10 = 15
Its ROE = $0.10/$1.00 = 10%.


Now, a year later, its price dropped to $0.50 per share. Its historical NTA and historical EPS remained the same.

Its new financial ratios are:

P/B = 0.50/ $1.00 = 0.5
P/E = $0.50/ $0.10 = 5
ROE = $0.10/ $1.00 = 10%


WHAT CAN YOU INFER?

The obvious answer (to me) is when the price of a stock drops a lot, its valuation ratios all look very cheap indeed. Just look at the above, at $0.50 per share, this company's financial and valuation ratios based on historical datas look cheap: P/B is a discount of 50% from the Book Value and only P/E of 5.


Those who are not knowledgeable may not realise that when the price of a stock drops, all the financial ratios and valuation ratios look very cheap. It is very cheap for a reason. You will need to find out why. It is most like (for the most of them), the company is facing poor business prospects and the company is appropriately priced for the future.


If you understand this, you will realise how stupid raider and calvintaneng are.

2019-06-19 15:33

3iii

Hanlon's razor is an aphorism expressed in various ways, including:

"Never attribute to malice that which is adequately explained by stupidity."

An eponymous law, probably named after a Robert J. Hanlon, it is a philosophical razor which suggests a way of eliminating unlikely explanations for human behavior.

2019-06-19 16:21

stockraider

Use your HEAD & think lah....!!

Ask yourself why QL and topgloves consider top companies not performing this year leh ??

The answer is overvalue loh....!!

Then why MNRB & Insas performing better this year than topgloves & QL leh ??

The answer is undervalue with big margin of safety loh...!!

A good successful investor just need to buy with big margin of safety loh...!!
When the buying is right with big margin of safety , all will turn out alright loh...!!

Most importantly never never overpay loh....!!

Posted by (US/CHN trade war doesn't matter) Philip > Jun 19, 2019 1:48 PM | Report Abuse

A clear example is sapura. In quantifying the quality of sapura and INSAS, we realize that the share price of these 2 companies has dropped at a far faster rate than it's overall business, assets and earnings, making it look like a business selling at a wonderful price.

But make no mistake, the revenues and earnings are dropping. As it drops these investments suddenly seem like wonderful businesses to buy with lots of cash, land and business assets.

But exactly like how Kcchongz and 3iii puts it, there are many ways to quantify quality.

You can look at p/e as a measure of a company's value, profitability. A low pe can be a good thing, as it appears that you are paying a low price for the company to gain the share of earnings. A high PE is a no-no, as it means you are paying for an overpriced company.

But p/e does not define risk, debt, future company prospects. Only metrics that to be honest are easily gamed by auditors and business owners.

In that vein, you can also then look at p/e as a measure of the investors faith in the company. A high PE means investors are very hopeful, are looking forward to the company future and everyone is holding tight for the ride. While a low PE could also mean that investors are hesitant to pay top dollar for a company with limited prospects/unknown future.

2019-06-19 16:23

cheoky

Place buy more mnrb. I fancy dividend from mnrb. Vested interes

2019-06-19 18:22

(US/CHN trade war doesn't matter) Philip

Performing better? Totally depends on your misguided concept of performing better. But please tell me ask about how your rm3 in 3 years 3 months is going to perform better with your concept of 1 cent increase every day for sape...

I don't think of share increases as performing better. I think of business fundamentals, business strategies and revenue earnings and the business itself as a core valuation of business performance.

I rarely listen to Mr market.

>>>>>>>>>>

Then why MNRB & Insas performing better this year than topgloves & QL leh ??

2019-06-21 17:32

(US/CHN trade war doesn't matter) Philip

Maybe you should think as well.


Posted by stockraider > Jun 19, 2019 4:23 PM | Report Abuse

Use your HEAD & think lah....!!

2019-06-21 17:41

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